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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 Management Alternatives 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 (non-catastrophic financial 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 Moral 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 standpoint. • 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 Legal competency • Consideration • Lawful purpose • • Copyright© 2011 Money Education, LLC Chapter 4 Insurance as a Legal Contract 14 Insurance, as a contract, has some unique characteristics. • • • • • • • Unilateral Aleatory Adhesive Utmost good faith Principle of indemnity Insurable interest 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 insurance. • 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) Annual Earnings $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) Annual PMT Interest Rate (i) Term of Years (n) Human Life Value (PV) = 0 = $39,000 = 1.9417 [[(1.05 ÷1.03) – 1] x 100] = 29 = $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 $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 6% Copyright© 2011 Money Education, LLC Chapter 4 Example (2 of 4) Step 1: Calculate the family’s income (cash flow) needs for each period. Readjustment (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 income needed (use begin mode) $34,252 $310,832 $89,219 $494,547 $325,730 Discount Period Present Value 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) 28 Income 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 • Term • 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. Minimum Deductible 2011 Maximum Deductible and Out of Pocket Expenses 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 (accident). The critical issues or provisions related to disability insurance include: • Definition of disability o Own Occupation o Any Occupation o Hybrid • 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 renewable 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: • Eating • Bathing • Dressing • Toileting • 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 insured’s property. • Part D - Coverage for damage to the insured automobile, comprehensive (e.g., theft, tree falling etc.) and collision (striking any inanimate object while moving). • 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 ...
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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.

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