This preview shows page 1. Sign up to view the full content.
Unformatted text preview: Chapter 4 Copyright© 2011 Money Education, LLC Chapter 4 The Personal Risk Management Process
2 Personal risk management is a systematic process for identifying, evaluating, and managing the pure risk
exposures faced by an individual. There are seven steps:
• Determining the objectives of the risk management program.
The risks to which the individual is exposed are identified.
The identified risks for the probability of occurrence and severity of
the loss are evaluated.
The alternatives for managing the risks are determined.
The most appropriate alternative for each risk is selected.
The risk management plan selected is implemented.
The planner should periodically evaluate and review the risk
management program. Copyright© 2011 Money Education, LLC Chapter 4 The Personal Risk Management Process
3 Determining the objectives of the risk management
program for the individual.
• Risk management objectives can range from obtaining
the most cost-effective protection against risk to
continuing an income stream after a loss. • A client’s stated objective may be to insure only those
risks that have the potential of catastrophic financial loss,
and to do so at the minimum premium using as many
premium management techniques as are available. Chapter 4 Copyright© 2011 Money Education, LLC The Personal Risk Management Process
4 Identifying Risk Exposures
• The planner should identify all of the client’s possible
pure risk (possibility of loss, but no possibility of gain)
exposures. • Personal risks cause the loss of income or alternatively
cause an increase in the cost of living. • Property risks cause the loss of property. • Liability risks cause financial loss. Copyright© 2011 Money Education, LLC Chapter 4 The Personal Risk Management Process
5 Evaluating the Identified Risks
• Loss frequency is the expected number of losses that will
occur within a given period of time. • Loss severity refers to the potential size or financial
damage of a loss. • Perils are the proximate or actual causes of a loss. Copyright© 2011 Money Education, LLC Chapter 4 The Personal Risk Management Process
6 A general approach to insuring individual risks is as follows:
• For untimely death (early in life), the client needs income
replacement insurance (life insurance).
For untimely death (late in life), the client needs sufficient assets to
maintain his lifestyle for his full life.
For disability (pre-retirement), the client needs disability.
For healthcare, all clients need health care coverage.
For property losses, the client should insure only up to the fair
market value of the property.
For liability , most clients will need a personal liability umbrella
policy (PLUP). Chapter 4 Copyright© 2011 Money Education, LLC Determining and Selecting the Best Risk
7 Low Frequency of
Occurrence High Frequency of
Occurrence High Severity
(catastrophic financial loss)
(e.g., long-term disability) Transfer and/or share
risk using insurance Avoid risk Low Severity
loss)(e.g., car gets dented in
parking lot) Retain risk Retain / reduce risk
(park far away from
heavy parking area) Copyright© 2011 Money Education, LLC Chapter 4 Implementing a Risk Management Plan Based
on the Selected Alternatives
8 A risk management plan should reflect the chosen response to a risk scenario. If risk reduction is the appropriate response to a given risk, the proper risk reduction program must be designed and
implemented. To retain a risk, determine whether an emergency fund will be used. To transfer a risk, an assessment, and selection of an insurer follows. Copyright© 2011 Money Education, LLC Chapter 4 Periodically Evaluating and Reviewing the
Individual Risk Management Program
9 The purpose of periodic evaluation and review is twofold: First, things change over time, and risk exposures can
change as well.
• Second, errors in judgment regarding the selected
alternatives may occur.
• Chapter 4 Copyright© 2011 Money Education, LLC Perils
10 A peril is the proximate or actual cause of a loss. An open-perils policy covers all risks of loss that are not
specifically excluded from the policy.
• A named-perils policy provides protection against losses
caused by the perils that are specifically listed as covered
in the policy.
• Copyright© 2011 Money Education, LLC Chapter 4 Hazards
11 A hazard is a condition that creates or increases the likelihood of a loss occurring. The three main types of hazards are: Physical hazard
• Morale hazard
• Copyright© 2011 Money Education, LLC Chapter 4 Insurable Losses
12 Several conditions must exist before a risk is considered insurable:
• A large number of homogeneous (similar) exposure units
must exist to help develop statistics for forecasting losses
(frequency and severity).
• Insured losses must be accidental from the insured’s
• Intentional acts of the insured resulting in a loss are
generally not insurable.
• Insured losses must be measurable and determinable.
• The loss must not pose a catastrophic risk for the insurer
who has limited reserves.
Chapter 4 Copyright© 2011 Money Education, LLC Insurance as a Legal Contract
13 Elements of a Valid Contract Offer and acceptance
• Lawful purpose
• Copyright© 2011 Money Education, LLC Chapter 4 Insurance as a Legal Contract
14 Insurance, as a contract, has some unique characteristics.
Utmost good faith
Principle of indemnity
Conditioned upon the payment of premiums Copyright© 2011 Money Education, LLC Chapter 4 Insurance on the Person
15 Life Insurance Life insurance at its essence is income replacement
• Dependency is the critical issue to life insurance needs.
• Chapter 4 Copyright© 2011 Money Education, LLC Insurance on the Person
16 Assuming that a client needs life insurance, how much should they have? There are three methods used to
determine the amount of life insurance needed. They are:
• Human Life Value Method
• Financial Needs Method
• Capitalization of Earnings Method Copyright© 2011 Money Education, LLC Chapter 4 Human Life Value Method
17 The Human Life Value (HLV) method uses projected future earnings as the basis for measuring life insurance needs. Copyright© 2011 Money Education, LLC Chapter 4 Human Life Value Method
18 Byron, who is married and the father of four, is 38 years old and expects to continue to work until age 67. He earns
$65,000 per year and expects annual salary increases of
3%. Byron expects inflation to be 3% over his working life,
and the appropriate risk-free discount rate is 5%. His
personal consumption is equal to 20% of after-tax earnings,
and his combined federal and state marginal tax bracket is
25%. Chapter 4 Copyright© 2011 Money Education, LLC Human Life Value Method
19 Step 1: Calculate the Family’s Share of Earnings (FSE)
$65,000 = Annual taxes = $65,000 x 0.25 = $16,250 = (After-tax income x consumption %) Personal Consumption = [(($65,000 - $16,250) x 0.20)] = Annual earnings – (annual taxes + annual personal
consumption) = $65,000 – ($16,250 + $9,750) = FSE
(Family’s Share of Earnings) $9,750 = $39,000
Copyright© 2011 Money Education, LLC Chapter 4 Human Life Value Method
20 Step 2: Calculate Work Life Expectancy (WLE)
WLE = Expected age of retirement – current age WLE =
= 64 – 35
29 years Copyright© 2011 Money Education, LLC Chapter 4 Human Life Value Method
21 Step 3: Determine Human Life Value (HLV)*
Future Value (FV)
Interest Rate (i)
Term of Years (n)
Human Life Value (PV) = 0
= 1.9417 [[(1.05 ÷1.03) – 1] x 100]
= $858,596 (Present Value of an
Ordinary Annuity) * See Chapter 6 for assistance with time value of money calculations.
Chapter 4 Copyright© 2011 Money Education, LLC Financial Needs Method
22 The financial needs method evaluates the income replacement and
lump-sum needs of survivors in the event of an income producer’s
untimely death. Common financial needs are as follows:
Lump-sum (cash) needs
Final expenses and debt repayment needs
Mortgage liquidation or payment fund needs
Education expense needs
Emergency expense needs
Income (cash flow) needs
Readjustment period needs
Dependency period needs
Spousal life income (pre- and post retirement) needs Copyright© 2011 Money Education, LLC Chapter 4 Example (1 of 4)
23 Assume Adam, age 35, earns $65,000 annually. His spouse, Alexis, age
34, is a homemaker, and they have one child, age 5. The couple assumes
an average annual inflation rate of 3%. Adam and Alexis have set the
following goals and assumptions:
Income needed - readjustment period (1 year)
Income needed - dependency period
Income needed - “empty nest” period $55,250
$40,000 Estate expenses and debts $15,000 Education fund needed (in today’s dollars)
Emergency fund needed $72,000
$15,000 Investment assets (cash/cash equivalents) current $200,000 Alexis’ life expectancy
Discount rate 85 years
Copyright© 2011 Money Education, LLC Chapter 4 Example (2 of 4) Step 1: Calculate the family’s income (cash flow) needs for each period.
(1 year) Child’s Age
(7-16) Child’s Age
(17-18) Blackout Period
(Age 46-60) Retirement
(25 years) Annual Income
Needed $55,250 $55,250 $55,250 $40,000 $36,000 Less OASDI
(Social Security) $20,000 $20,000 $10,000 0 $18,000 Net Annual Income
Needed (PMT) $35,250 $35,250 $45,250 $40,000 $18,000 i = (1.06 ÷ 1.03) – 1
x 100 2.9126 2.9126 2.9126 2.9126 2.9126 N = years needed 1 10 2 15 25 PV of net annual
(use begin mode) $34,252 $310,832 $89,219 $494,547 $325,730 Discount Period
Today 0 1 11 years 12 years 26 years $34,252 $302,035 $65,058 $350,417 $154,410 PV of total annual income needed: $906,172 ($34,252 + $302,035 + $65,058 + $350,417 + $154,410)
Chapter 4 - 24 - Copyright© 2011 Money Education, LLC Example (3 of 4)
25 Step 2: Calculate the family’s lump-sum funding needs.
Final expenses and debts $15,000 Education funding needed
(in today’s dollars) $72,000 Emergency Fund $15,000 Total lump-sum funding needs $102,000 Copyright© 2011 Money Education, LLC Chapter 4 Example (4 of 4)
26 Step 3: Calculate the insurance death benefit needed.
Total Needed $1,008,172* Less the life insurance already in place $0 Less current liquid assets $200,000 Net death benefit needed $808,172 * ($906,172 + $102,000) Copyright© 2011 Money Education, LLC Chapter 4 Capitalization of Earnings Method (1 of 4)
27 The capitalization of earnings method uses a numerator
and denominator to determine life insurance needs. The
initial numerator is the client’s gross income and the
initial denominator is the riskless rate of return (U.S.
Treasury Bonds). Recall the Adam example: Assume Adam, age 35, earns $65,000 annually. His
spouse, Alexis, age 34, is a homemaker, and they have
one child, age 5. The couple assumes an average annual
inflation rate of 3%. Chapter 4 Copyright© 2011 Money Education, LLC Capitalization of Earnings Method (2 of 4)
Treasury Bond $65,000
0.06 = $1,083,333 Life Insurance Needed There are adjustments to make to the numerator for taxes
($16,250) and personal consumption ($9,750) and
adjustments to make to the denominator for inflation (3%). $65,000-$16,250-$9,750
[(1.06 ÷ 1.03) – 1] $39,000
0.029126 = $1,339,000 Life Insurance Needed Copyright© 2011 Money Education, LLC Chapter 4 Capitalization of Earnings Method (3 of 4)
29 Summary Life Insurance
Needed Human Life Value Method $858,596 Financial Needs Method $808,172 Capitalization Income Method $1,339,000 Copyright© 2011 Money Education, LLC Chapter 4 Capitalization of Earnings Method (4 of 4)
30 From using all three of these methods, we conclude that
if life insurance is needed, it should be sufficient if it is
approximately 12 - 16 x the client’s gross pay ($65,000 x
12 = $780,000 to $65,000 x 16 = $1,040,000). Note that the average of the methods is $1,001,923. Chapter 4 Copyright© 2011 Money Education, LLC Types of Life Insurance
31 There are two general types of life insurance
• Permanent The basic difference between term life insurance and
permanent life insurance is that where permanent insurance
has a savings and investment component, term does not. Term life insurance is “pure insurance” and is for a stated
temporary period of time (10, 20, 25, 30 years). Term insurance is attractive to consumers because the
premiums are significantly lower than the premiums for
permanent policies. Copyright© 2011 Money Education, LLC Chapter 4 Health Insurance
32 A health insurance plan provides benefits to the insured
in the event of sickness or personal injury. Indemnity coverage allows the insured to choose health
care providers. Reimbursement is based on services provided, and a
deductible and/or a payment portion of services billed
may be required of the insured. Coverage will include a deductible, copayment, and stop
loss amount. Copyright© 2011 Money Education, LLC Chapter 4 High Deductible Health Plan (HDHP)
33 A High Deductible Health Plan (HDHP) is an
inexpensive health insurance plan that provides benefits
after a high deductible is met.
2011 Maximum Deductible
and Out of Pocket
2011 Individual $5,950 Family Chapter 4 $1,200
$2,400 $11,900 Copyright© 2011 Money Education, LLC Managed Care Options
34 A Health Maintenance Organization (HMO) plan
provides access to a network of participating medical
providers including physicians, hospitals, and other
medical professionals and facilities. A Preferred Provider Organization (PPO) charges on feefor-service basis. The medical providers are paid by the
insurer on an agreed upon discounted fee schedule. The insured is encouraged to use in-network healthcare
providers to maintain lower costs. If the insured chooses
an out-of-network medical provider, additional expenses
may be incurred. Copyright© 2011 Money Education, LLC Chapter 4 Long Term Disability (LTD)
35 Disability insurance provides replacement income to the insured while
the insured is unable to work because of sickness (illness) or injury
The critical issues or provisions related to disability insurance include:
Definition of disability
o Own Occupation
o Any Occupation
Coverage for both sickness and accidents
Amount of benefits per month / year
Term of benefits
Elimination period (waiting period of self insurance)
Whether or not the policy is non-cancelable or guaranteed
Copyright© 2011 Money Education, LLC Chapter 4 LTD Critical Issues
36 Disability definitions also include:
• Partial Disability
• Elimination Period
• Non-cancelable Insurance
• Guaranteed Renewable Insurance Chapter 4 Copyright© 2011 Money Education, LLC Long Term Care Insurance
37 Long-term care insurance pays benefits when the
insured is unable to perform at least two of the activities
of daily living (ADL) which include:
• Transferring (bed to chair)
• Continence Copyright© 2011 Money Education, LLC Chapter 4 Homeowners and Renters Insurance
38 The frequency of a loss of a home is small, but the severity, if
it happens, is potentially financially catastrophic. Homeowners insurance coverage is a package policy
covering dwelling, dwelling extensions (garage), personal
property, loss of use, medical payments for others, and
liability. Most homeowners and renters are not knowledgeable about
insurance and should generally purchase open perils and
replacement value for all property in a homeowners policy. •
• Actual cash value is the depreciated value of property.
Replacement cost is the current cost to replace the property.
Copyright© 2011 Money Education, LLC Chapter 4 Automobile Insurance
39 The Personal Automobile Policy (PAP) is organized into six parts:
Part A- Liability coverage for bodily injury and property damage to others.
Part B - Medical payments coverage (used to mitigate damage and not
necessarily related to fault); may benefit anyone in the accident.
Part C - Uninsured motorist coverage - covers uninsured and
underinsured motorist who cause damage to the insured passengers or the
Part D - Coverage for damage to the insured automobile, comprehensive
(e.g., theft, tree falling etc.) and collision (striking any inanimate object
Part E - Duties of the insured (notify insurer, file proof of claim, and
cooperate with any investigation).
Part F - General Provisions - Various provisions including that coverage is
only valid in the U.S., its territories, and Canada (not Mexico or other
foreign countries). Chapter 4 Copyright© 2011 Money Education, LLC Personal Liability Insurance
40 Liability policies provide for a legal defense as well as for
paying a claim up to the limit of the policy. The Personal Liability Umbrella Policy (PLUP) provides
excess liability coverage and legal defense for claims that
may arise and that exceed the limits of the underlying
homeowners and automobile policies. Chapter 4 Copyright© 2011 Money Education, LLC ...
View Full Document
This note was uploaded on 02/27/2012 for the course FIN 132 taught by Professor Afda during the Spring '12 term at Centenary College New Jersey.
- Spring '12