Class 11 Insurance and Risk Management

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Class 11Insurance and RiskManagement

• George D. Krempley
• Bus. Fin. 640
• Autumn Quarter 2006

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Premature Death

• Death of a family head with outstanding
  unfulfilled financial obligations
• Examples
• Dependants to support
• Children to educate
• Unpaid mortgage

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Life Expectancy

• Climbed to record high of 77.2 years in 2001
• Sharp reduction in chance of premature death
  since 1900 due to
• Significant medical breakthroughs
• Health improvements arising from better economic
  conditions and higher incomes
• Public health and sanitation improvements

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EXHIBIT 16.1 Improvements in Life Expectancy
over the Past Century
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Costs of Premature Death

• Family shares of deceaseds wage earnings lost
  forever
• Additional expenses
• Funeral expense
• Uninsured medical bills
• Estate settlement costs
• Federal estate taxes

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Costs of Premature Death (cont.)

• Insufficient income causes some families to
  experience a reduced standard of living
• Non-economic losses
• Emotional grief
• Loss of parental role model
• Loss of guidance and counseling for children

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What is the insured event?

• Life insurance is valued policy, not a contract
  of indemnity.
• The insured event is the uncertainty of the time
  of death
• Because of this uncertainty, the family head may
  die with outstanding financial obligations

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Economic Justification of Life Insurance

• Economic justification arises if
• The Insured earns an income
• Others are dependent on that income for at least
  part of their financial support
• Premature death creates the loss of wage earning
  ability upon which others are dependent

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Premature Death Financial Impact Depends on
Family Make-up

• Single People
• Single-Parent Families
• Two-Income Earners
• Traditional Families
• Blended Families
• Sandwiched Families

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Methods for Determining the Amount of Life
Insurance to Own

• Human life value approach
• Needs approach
• Capital retention approach

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Determining the Amount of Life Insurance to
OwnNeeds Approach

• Estate clearance fund
• Income during readjustment period
• Income during dependency period
• Life income to surviving spouse
• During blackout period
• After blackout period
• Special needs
• Mortgage redemption fund
• Educational fund
• Emergency fund
• Retirement Needs

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EXHIBIT 16.2 How Much Life Insurance Do You Need?
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Product Overview

• Term - Pure life insurance
• Cash value policies
• Pure life insurance Savings accumulation
• Examples
• whole life
• universal life
• variable life

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Product Overview

• Can obtain savings accumulation by surrendering
  the policy
• Why bundle death protection savings
  accumulation?
• Tax advantaged method of saving

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EXHIBIT 16.3 Relationship Between the Net Amount
at Risk and Legal Reserve
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Terminology

• Death benefit amount beneficiaries receive
• Cash value amount of savings accumulation
• Death protection amount of pure death
  protection death benefit - cash value
• Face amount stated amount of coverage

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Term Insurance

• ¼ of policies
• Almost ½ of death protection purchased
• Guaranteed renewable
• Premium increases over time

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Whole Life Insurance

• Policy period ends when insured reaches 100
• Equivalent to endowment policy to 100
• Premiums
• single premium
• limited pay
• continuous premium

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Whole Life Insurance

• Premiums generally do not increase over time
• Probability of dying increases over time
• Higher upfront premiums than with term
• Policyholder prepays part of the cost of future
  death protection
• entitled to prepayments if policy is surrendered
• this is the cash value (savings accumulation)

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Whole Life Insurance

• If insured dies,
• beneficiaries receive face amount
• death protection cash value
• Structured so
• cash value ? over time
• death protection ? over time

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Whole Life Insurance
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Tax Treatment of Life Insurance

• Death benefits are not taxed
• Income tax is not paid on increases in cash value
  while the policy is in force
• Upon surrender, income tax is paid on
• Cash surrender value - sum of all premiums
• sum of all policyholder dividends

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Implications of Tax Treatment

• Implicit returns on savings accumulation
• Escape taxation if insured dies
• Tax deferred if the policy is surrendered
• Partially taxed if policy is surrendered
• Amount which is taxed is less than implicit
  return because part of premiums is cost of death
  protection

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State Laws Require Rates To Be

• Adequate
• Not excessive
• Not unfairly discriminatory

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Business Rate-Making Objectives

• Simplicity
• Stability
• Responsiveness
• Encourage loss prevention

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EXHIBIT 27.1 Commissioners 1980 Standard
Ordinary Mortality Table, Male Lives
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EXHIBIT 27.1 (continued) Commissioners 1980
Standard Ordinary Mortality Table, Male Lives
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EXHIBIT 27.2 Present Value of 1 at 5 Percent
Compound Interest
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EXHIBIT 27.3 Figuring the NSP for a Five-Year
Term Insurance Policy