FIL 351 LIFE INSURANCE

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FIL 351LIFE INSURANCE

• Prof. George Flanigan
• Insurance Industry Professor.

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• HLV
• Needs Approach
• Single People.
• Single Parent Families
• Two income Earners
• Traditional Families
• Blended Families
• Sandwiched Family.

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NEEDS ANALYSIS CHART
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FEDERAL ESTATE TAX

• The federal estate tax, also known as a death
  tax, is a tax imposed on wealth transfers made at
  the holders death.
• Virtually from the time it was enacted in 1917,
  there has been pressure for repeal of the federal
  estate tax.
• Congress enacted legislation to repeal the tax in
  2000, but President Clinton vetoed the bill.

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PRE-EGTRRA - 2001 ESTATE TAX

• The federal estate tax applies to ones taxable
  estate the gross estate minus allowable
  deduction, but any tax payable is subject to a
  unified credit that reduces the actual tax
  payable.
• The unified credit was 229,550 in 2001, which
  exempted 675,000 from the estate tax.
• The equivalent exemption was scheduled to
  increase to 1 million in 2006.

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PRE-EGTRRA - 2001 ESTATE TAX

• Estates in excess of the exempt amount were taxed
  at rates from 37 percent to 55 percent
  (applicable to estates in excess of 3 million).
• A 5 percent surtax applied to estates from 10
  million to 21 million.

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(No Transcript)
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ESTATE PLANNING STRATEGIES

• Marital Deduction.
• Maximizing effect of unified gift-estate tax
  credit.
• Reduce value of the estate by gifts prior to
  death.

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PROBABILITIES OF DEATH AND DISABILITIES
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ELIGIBILITY AND QUALIFICATION

• Quarter of coverage one quarter for 870 in
  earnings in 2002.
• Fully insured status 40 quarters of coverage.
• Currently insured status 6 of the last 13
  quarters.

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FINANCING

• FICA tax originally 1, 7.65 by 2002 (payable
  by employer and employee).
• The tax base originally 3,000, 84,900 by
  2002.
• Medicare tax is not subject to the wage base. It
  applies to total earned income without limit.

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AMOUNT OF BENEFITS

• All benefits are based on Primary Insurance
  Amount (PIA).
• PIA is amount to which worker would be entitled
  for retirement at age 65.
• PIA is based on workers average earnings during
  period of employment, subject to certain
  adjustments.

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COMPUTING THE PIA

• Computation period
• year worker reaches age 22 until year before
  worker reaches age 62, dies, or is disabled.
• Up to 5 years may be dropped. Minimum 2 years in
  computation.
• Earnings are indexed to determine Average Indexed
  Monthly Earnings (AIME).
• Primary Insurance Amount is computed from AIME by
  formula.

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LOSS OF BENEFITS DISQUALIFYING INCOME

• Disqualifying income is not a needs test but a
  retirement test.
• Beginning in 1999, loss of benefits for
  disqualifying income applies only to persons
  under age 65.
• Under age 65, 11,280 was exempt in 2002.
• If earnings exceed exempt amount, benefit is
  reduced by 1 for each 2 the exempt amount is
  exceeded.

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TAXATION OF SOCIAL SECURITY BENEFITS

• Amount of benefits subject to tax depends on
  combined income and filing status.
• Combined income is the sum of adjusted gross
  income, tax exempt interest, and one-half the
  social security benefit.
• If combined income is between 25,000 and
  34,000, up to 50 of social security benefits
  may be taxed.
• If combined income is over 34,000, up to 85 of
  the benefits may be taxed.
• For those filing joint returns, break points are
  32,000 and 44,000.

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FUTURE PROJECTIONS

• Trust funds have increased from about 45 billion
  in 1982 to more than 1 trillion in 2001.
• Based on intermediate assumptions, trust funds
  will peak at about 3.5 trillion in 2016.
• After 2016, deficits will deplete the Trust funds
  by 2038.

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PROPOSALS FOR CHANGE

• Change in system of financing.
• Change in benefit levels
• Original retirement age was 65.
• It is scheduled to increase to 67 by 2022.
• Some have recommended further increase.
• Proposal for privatization would allow workers
  to invest in private alternatives to social
  security (i.e. invest in the private sector).

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PRINCIPLES OF WORKERS COMPENSATION

• Negligence is no longer a factor in determining
  liability.
• Indemnity is partial but final.
• Periodic payments are made to workers.
• Cost of the program is made a cost of production.
• Insurance is required.

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OVERVIEW OF WORKERS COMPENSATION LAWS

• Persons covered
• None of the laws cover all employees.
• Most frequently excluded classes are agricultural
  and domestic employees.
• Laws permit employer of persons excluded to bring
  these workers under the law voluntarily.

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WORKERS COMPENSATION BENEFITS

• Medical Expenses.
• Total Temporary Disability.
• Partial Temporary Disability.
• Total Permanent Disability.
• Partial Permanent Disability.
• Survivors Death Benefit.
• Rehabilitation Benefits.

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SOME UNIQUE CHARACTERISTICS OF LIFE INSURANCE

• The event insured is an eventual certainty and
  the probability of loss increases from year to
  year.
• Life insurance does not violate requisites of an
  insurable risk it is not the possibility of
  death that is insured, but of untimely death.
• No possibility of partial loss. All policies are
  cash payment policies.

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LIFE INSURANCE NOT A CONTRACT OF INDEMNITY

• Principle of indemnity applies on a modified
  basis in the case of life insurance.
• When person taking out the policy is the insured,
  insurable interest is not an issue.
• every individual has an unlimited insurable
  interest in his or her own life.
• that insurable interest may be freely assigned.
• Persons other than insured must have an insurable
  interest only at inception of policy.

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TYPES OF LIFE INSURANCE

Term Insurance Cash
Value Insurance Pure
Protection Insurance and
Savings
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RATIONALE FOR DIFFERENT FORMS

• 1. Premium eventually becomes unaffordable for
  person who wants to continue coverage
• age 21 1.07
• age 30 1.35
• age 40 2.42
• age 50 4.96
• age 60 9.47
• age 70 22.11
• age 80 65.99
• age 90 190.75
• 2. Insurers developed the principle of the level
  premium as a practical method of providing
  lifetime insurance.

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COMPARISON OF TERM WHOLE LIFE PREMIUMS

• Level premium reflects an overcharge during the
  early years of the policy, which is offset by an
  undercharge in later years.
• Reserve does not increase and then diminish,
  because overpayments by those who die are
  forfeited to the reserve for the survivors.

Increasing term premium

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INCREASE IN RESERVE ON WHOLE LIFE POLICY
1,000
Decreasing Amount of Protection
Increasing Savings Element
Insureds Age
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TAX TREATMENT OF LIFE INSURANCE

• Life insurance policies are granted favorable tax
  treatment in two ways
• Amounts payable to beneficiary at the death of
  the insured are not generally included in taxable
  income.
• Income earned on the cash surrender value is not
  taxed until the policy is terminated and the gain
  is received.
• Further, the cost of life insurance is deductible
  as part of the basis in computing taxable gain.

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TAX TREATMENT OF LIFE INSURANCE

• Favorable tax treatment is allowed only for
  contracts that meet the Internal Revenue Code
  definition of life insurance.
• Internal Revenue Code establishes two tests to
  determine if a contract is life insurance.
• If the contract fails to meet one of the two
  tests, earnings on the cash surrender value is
  currently taxable to the insured.

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CASH VALUE ACCUMULATION TEST

• Cash Value Accumulation test will be met if cash
  surrender value of the policy does not at any
  time exceed the Net Single Premium that is
  required to fund future benefits, assuming
  maturity no earlier than age 95.
• Computation uses the greater of a 4 interest
  rate or the rate guaranteed by the contract.
• CASH VALUE CORRIDOR TEST

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PERCENTAGES FOR CASH VALUE CORRIDOR TEST
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CURRENT LIFE INSURANCE PRODUCTS

• Renewable term guarantees the insured the right
  to continue coverage for a number of additional
  periods.
• Convertible term guarantees the insured the
  right to exchange the policy for some type of
  permanent insurance.
• Advantages and disadvantages of term
• provides greatest amount of protection for
• given dollar outlay.
• temporary protection only.

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CURRENT LIFE INSURANCE PRODUCTS

• Whole Life
• Straight whole life provides protection for
  insureds entire lifetime (until age 100) with
  premiums payable for lifetime.
• Limited-pay whole life provides protection for
  entire lifetime (until age 100) with (higher)
  premiums payable for a shorter time.
• Single Premium Life.

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CURRENT LIFE INSURANCE PRODUCTS

• Universal Life
• Introduced in 1979 by a brokerage firm.
• Subject to specified limitations, premium, cash
  value, and level of protection can be adjusted up
  or down to meet insureds needs.
• Premiums are credited to a fund, which is
  credited with policys share of investment
  earnings.
• Fund provides source of funds to pay cost of pure
  protection (term) under the policy.

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CURRENT LIFE INSURANCE PRODUCTS

• Variable Life Insurance
• A whole life contract in which insured has the
  right to direct how cash value will be invested.
• Insured bears the investment risk in the form of
  fluctuations in cash value and amount of
  protection.
• Amount of premium is fixed, but cash value and
  face amount vary, subject to a minimum.
• Variable universal life combines features of
  universal and variable life insurance.

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CURRENT LIFE INSURANCE PRODUCTS

• Endowment Life Insurance
• Endowment contracts no longer meet the Internal
  Revenue Code definition of life insurance.
• Endowment policies are issued for a term period
  such as 10 or 20 years.
• Endowment policies promise to pay face amount if
  the insured dies during the policy period and
  also to pay the face amount if the insured
  survives the policy period.

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PARTICIPATING NON-PARTICIPATING LIFE INSURANCE

• Participating policies pay dividends.
• Originally issued only by mutual insurers.
• Dividend varies from margin built into premium.

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GENERAL CLASSIFICATIONS OF LIFE INSURANCE

• Ordinary life 58.8 of insurance in force.
• Industrial less than 1 (0.2) today, compared
  with 10 at one time.
• Group life 40 of life insurance in force.
• Credit life insurance about 1.2.
• Total life insurance in force exceeds 15
  trillion.

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OTHER TYPES OF LIFE INSURANCE

• Besides life insurance issued by legal reserve
  insurers, a small amount (about 2.5) of life
  insurance is written by other types of insurers.
• Savings bank life insurance (NY, Mass, Conn).
• Fraternal life insurance.
• Veterans life insurance.
• Wisconsin state life insurance fund.

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LIFE INSURANCE PREMIUM COMPUTATION

• Mortality 1980 CSO Table (separate tables for
  male/female).
• Interest time value of money.
• Loading for insurer expenses, taxes, profit.

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COMMISSIONERS 1980 STANDARD ORDINARY MORTALITY
TABLE
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ONE YEAR TERM POLICY

• Alive at age 21 9,810,509
• Number who will die 10,497
• 1 year term policy without interest
• 10,497,000
• 9,810,509 1.07
• 1 year term policy with interest
• 10,497,780 x 0.95694
• 9,810,509
  1.02

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ANNUAL TERM FOR FIVE YEARS

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NET SINGLE PREMIUM 5-YEAR TERM POLICY
5-year term net single premium 47,787,890
9,810,509 4.8710
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NET SINGLE PREMIUM 5-YEAR ANNUITY DUE
5-year annuity due premium 44,912,264
9,810,509 4.5779
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NET SINGLE PREMIUM WHOLE LIFE POLICY
Whole Life net single premium 1,052,972,752
9,810,509 1.07.33
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NET LEVEL PREMIUM CONVERSION

• 4.5779 is the actuarial equivalent of
• 1 now and a 1 payment.
• every year for 4 years.
• Therefore,
• 4.5779 4.8710 1 X
• X 1.064

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RESERVE ON LIFE INSURANCE POLICIES

• Reserve Present Value of -
  Present Value of
• Future Benefits
  Future Premiums

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POLICY RESERVES VARIOUS CONTRACTS
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BENEFIT CERTAIN CONTRACTS

• Benefit Certain Contracts are those under which,
  if the insured persists in premium payments, the
  policy will eventually mature and benefits will
  be payable.
• Cash value policies, under which benefits are
  payable whether the insured lives or dies are
  benefit certain contracts.
• Ignoring the interest on premiums paid, the net
  single premium on benefit certain policies equals
  the face of the policy.

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BENEFIT UNCERTAIN CONTRACTS

• Benefit uncertain contracts are those under
  which, if the insured persists in premium
  payments for the entire policy period, the
  insurer may or may not be obligated to make
  payment.

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• One year term rate

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• Five year term rate

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• Five Year Endowment

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• Five Year Annuity due

Annual premium 5-year endowment 3.865 1
520 X X 134.50
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GENERAL PROVISIONS IN LIFE INSURANCE CONTRACTS

• Entire contract clause.
• Ownership clause.
• Beneficiary clause.
• Incontestable clause.
• Misstatement of age clause.
• Grace period clause.
• Reinstatement clause.
• Suicide clause.
• Aviation exclusions.
• War clause.

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OWNERSHIP CLAUSE

• Ownership rights
• right to assign or transfer the policy.
• right to receive cash value and dividends.
• right to borrow against the policy.
• Usually, the insured is the owner.
• In the event of the death of the insured, the
  beneficiary becomes the owner.

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INCEPTION OF THE LIFE CONTRACT

• If the application is submitted without the
  initial premium, the insurer makes an offer to
  the insured and no contract until offer is
  accepted.
• If the initial premium is submitted with the
  application, the insurer acknowledges receipt of
  the premium with a conditional binding receipt.
• Conditional binding receipt makes the policy
  effective at date of application if the applicant
  is found to have met the insurers underwriting
  standards.

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BENEFICIARY DESIGNATIONS

• Primary Contingent
• Revocable Irrevocable

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REINSTATEMENT

• If a lapsed policy has not been surrendered for
  its cash value, it may be reinstated within 5
  years from the date of lapse.
• Reinstatement requires that the insured
• provide evidence of insurability.
• pay overdue premiums plus interest.
• reinstate any indebtedness with interest.

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SETTLEMENT OPTIONS

• The interest option.
• Installments for a fixed period.
• Installments for a fixed amount.
• Life income options.

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TABLE 14.1 Installments for a Fixed Period
1 84.65 11 9.09
21 5.56 2 43.05 12
8.46 22 5.39 3 29.19
13 7.94 23
5.24 4 22.27 14 7.49
24 5.07 5 18.12 15
7.10 25 4.93 6 15.35
16 6.76 26 4.84 7
13.38 17 6.47
27 4.73 8 11.90 18
6.20 28 4.63 9 10.75
19 5.97 29 4.53 10
9.83 20 5.75 30 4.45
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LIFE INCOME OPTIONS

• Straight life income.
• Life income with period certain.
• Life income with cash refund.
• Life income with installment refund.
• Joint and survivor income.

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CHAPTER 14 THE LIFE INSURANCE CONTRACT GENERAL
PROVISIONS
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JOINT AND SURVIVOR LIFE INCOME OPTION
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TAXATION OF POLICY PROCEEDS

• Benefits under a life insurance policy are not
  subject to the federal income tax, except for
  post-death interest on the policy proceeds.
• Monthly proceeds for 10 years on a 100,000 death
  benefit will be 983, or 11,796 annually.
• 10,000 annually is the tax-exempt death benefit.
• The 1,796 annually represents taxable interest.
• When proceeds are payable under a life income
  option, the taxable interest is determined based
  on the beneficiarys life expectancy using IRS
  mortality tables.

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TABLE OF GUARANTEED VALUES END OF
100,000 POLICY CASH PAID-UP EXTENDED
TERM YEAR JANUARY 1 VALUE INSURANCE
INSURANCE TO 1 1987
0 0
2 1988 1,078 5,000
3 1989 2,201
9,800 4 1990 3,371
14,400 5 1991
4,588 18,700 6
1992 5,852 22,900
7 1993 7,165 26,800
8 1994 8,528
30,500 9 1995
9,942 34,100 10
1996 11,411 37,400
11 1997 12,933 40,600
12 1998 14,515 43,700
13 1999 16,156
46,600 14 2000
17,860 49,300 15
2001 19,629 51,900
16 2002 21,466 54,400
17 2003 23,370
56,800 18 2004 25,341
59,000 19 2005
27,380 61,100 20
2006 29,486 63,100 AGE 60
2011 38,328 71,800 AGE
65 2016 47,545 78,800
AGE 70 2021 56,741 84,400

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POLICY LOAN PROVISION

• Insured may obtain a loan from the insurer equal
  to the policy cash value.
• Loan is subject to a delay clause, up to 6
  months.
• Interest of 5 or 6 on older contracts, 8 on
  newer contracts.
• Since 1980, NAIC rules allow variable interest
  rate on policy loans.

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DIVIDEND PROVISIONS

• Cash.
• Applied to payment of current premium.
• Purchase paid up additions.
• Left to accumulate.

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• 500,000 90 Life
• For Joe Client Age 30 Male
• Contract Premium 6,210.00
• Premiums Annual Mo. ISA
  Annual Income
• _at_60 39,084
  _at_65 64,306
  _at_76 187,750
• Insurance
  6,210.00 540.27 Based on current
  (2-16-03)
• 
  Installment Refund rates may change
• Indexed Protection 370.00
  32.19
• Disability Waiver 150.00 13.05
• IPB Waiver 85.00
  7.40
• 300,000 Accidental Death
  216.00 18.80
• 100,000 Additional Purchase 150.00
  13.05
• Subject to underwriting limits
• Premium included throughout
• Non-guaranteed illustrated values and benefits
  include dividends. Dividends assume no loans

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DISABILITY WAIVER OF PREMIUM

• Insurer agrees to waive all premiums coming due
  after the insured has become totally and
  permanently disabled as a result of sickness or
  bodily injury.
• Disability must commence before some specified
  age, usually age 55 or 50, but as high as 65 in
  some contracts.
• Disability must have lasted for six months.
• Premiums are waived from commencement of the
  disability, including the first six months.

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DISABILITY WAIVER OF PREMIUM

• One of the most important aspects of the
  disability waiver of premium provision is the
  definition of disability.
• Disability usually defined as the inability of
  the insured to engage in his or her own
  occupation during the first two years of
  incapacity.
• Thereafter, disability is defined in terms of an
  occupation for which the insured is reasonably
  fitted by education, training, or experience.

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ACCIDENTAL DEATH BENEFIT

• Commonly known as double indemnity
• Pays an additional sum equal to the face of the
  policy if the death of the insured is caused by
  accident.
• Death must result, directly and independently of
  all other causes, from accidental bodily injury
  and within 90 days after the injury.
• The accidental bodily injury and death must occur
  before a specified age, usually age 70.

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GUARANTEED INSURABILITY OPTION

• Permits an insured to purchase additional amounts
  of insurance at stated intervals without
  providing evidence of insurability.
• The customary option dates are at ages 25, 28,
  31, 34, 37, and 40.
• The option amount is limited to the face amount
  of the basic policy or a specified option amount,
  whichever is the smaller.
• The maximum amount of each option was originally
  10,000, but limits of 25,000 and higher are now
  available.

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COMMON DISASTER CLAUSE

• Uniform Simultaneous Death Act provides that
  where the insured and the beneficiary have died
  and there is no evidence that they died other
  than simultaneously, life insurance proceeds
  shall be distributed as if the insured survived
  the beneficiary.
• Where there is evidence that the beneficiary
  survived the insured, even for a short time, the
  life insurance proceeds go to the beneficiary and
  then to his or her estate.

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SPENDTHRIFT CLAUSE

• The Spendthrift Clause denies the beneficiary the
  right to commute, alienate, or assign his or her
  interest in the policy proceeds.
• Used only in conjunction with an installment
  settlement option.
• Provides some protection against the
  beneficiarys extravagance that might result in
  the dissipation of the policy proceeds.
• Also provides some protection against claims made
  by creditors of the beneficiary.

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COST-OF-LIVING RIDERS

• Under a cost-of-living rider, the insurer offers
  the insured additional coverage (for which the
  insured pays an added premium) when the Consumer
  Price Index Increases.
• Principal advantage is that the additional
  insurance is offered without evidence of
  insurability.
• If the insured rejects any of the increases, the
  insurer may require evidence of insurability for
  the next increase.

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MORTGAGE REDEMPTION POLICY
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JOINT MORTGAGE REDEMPTION POLICY

• Decreasing term, written on two lives.
• Designed to cover mortgage obligation of a
  two-income couple in the event one dies.
• Premium is slightly less than separate individual
  mortgage protection policies on each partner.

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SURVIVORSHIP WHOLE LIFE

• Also called second-to-die policy.
• Insures two lives and pays only at the time of
  the second death.
• Designed to cover estate taxes payable at the
  death of a surviving spouse, since marital
  deduction will not be available under the federal
  estate tax.

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OTHER SPECIAL POLICIES

• Return of Cash Value Policy.
• Return of Premium Policy.
• Family Protection Policy.
• Family Income Policy.
• Family Maintenance Policy.

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MODIFIED WHOLE LIFE

• Premium for first 3 to 5 years is slightly higher
  than premium for term.
• At end of 3-to-5 year period, premium increases
  to slightly more than premium for whole life at
  inception, but less than whole life premium at
  the attained age.
• First 5 Years Thereafter
• 5-year term converted to whole life 4.23
  14.99
• Modified Whole life
  4.58 13.54
• Convertible Term

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GRADED-PREMIUM WHOLE LIFE

• Initial premium is quite low, but gradually
  increases and levels off sometime between the
  10th and 20th year.
• Cash values do not develop until year 10 and are
  relatively low, even by year 20.

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Modified Whole Life
Graded Premium Whole Life
Whole Life
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SINGLE PREMIUM LIFE

• Single premium creates an immediate cash value
  that is sufficient to fund cost of benefits over
  the life of the policy.
• Written on both traditional whole life and
  variable life basis.
• Rate of return on traditional policies may be
  guaranteed for
• 1 to 5 years.
• Earnings accumulate tax-free until the policy is
  cashed in.
• Usually no front-loaded commission, but subject
  to surrender charge that diminishes and
  disappears after from 7 to 10 years.
• Beware corridor rules.

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PROTECTION AND CASH VALUE PER 100 PREMIUM

• At age 25, a 100 premium will purchase
• 
  
  
  Cash Value
• l Protection in 20 years
  l
• Yearly-renewable term 78,000
  0
• Ten-year term policy 57,000
  0
• Whole life policy
  11,300 1,671
• Paid-up at age 65
  10,250 1,695
• Twenty-pay life policy 7,400
  1,798

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BUY TERM AND INVEST THE DIFFERENCE

• The choice between term and cash value life
  insurance is usually not a risk management
  decision, it is an investment decision.
• The choice is not between term and cash value
  life insurance, but between cash value life
  insurance and other investments.
• In making this choice, cash value life insurance
  should be judged against the same standards as
  other investments.

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LIFE INSURANCE AS AN INVESTMENT

• A considerable amount of literature much from
  vendors of competing investments condemns life
  insurance as an investment.
• Much of this literature oversimplifies a complex
  issue.
• There are some situations in which life insurance
  compares favorably with other investment
  alternatives.

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LIFE INSURANCE AS AN INVESTMENT

• Compulsion often cited as an advantage but not
  particularly compelling.
• Tax treatment is more persuasive
• Increments to cash value not taxed until
  received.
• Insured allowed to deduct cost of protection in
  computing taxable gain.
• Complementary function of protecting against
  premature death at the same time it provides an
  accumulation.

90

SAMPLE POLICY

• Face Amount 100,000
• Premium 1,533
• CV20 29,486
• 20 x 1,533 30,660
• Net Cost 30,660
• - 29,486
• 1,174 (Net Cost)
• Per year 58.70
• Per year, per 1,000 0.59
• Compare to Cost of Term
• Year 35 2.50 per 1,000
• Year 45 4.46 per 1,000
• Year 54 7.79 per 1,000

91

• ALLOW FOR TIME VALUE OF MONEY
• PV 1st Premium
  1,533.00
• PV of following 19 premium 18,526.79
• 20,059.79
• PV CV in 20 years - 11,112.98
• 
  8,946.81

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LIFE INSURANCE AS AN INVESTMENT - NEGATIVES

• Life insurance policies have a relatively high
  expense component.
• Front-loaded commissions make return during early
  years negative and in the long-run less
  attractive than alternatives.
• Actual rate of return depends on the time for
  which the policy is held.
• If insurance is considered as an investment, it
  should be considered only as a long-term
  investment.

93
MARKETING REFORM IN LIFE INSURANCE

• In the mid-1990s, many segments of the life
  insurance industry were subject to extensive
  criticism for their market conduct.
• Headlines referred to practices such as churning,
  or improper replacements.
• Vanishing premiums that did not vanish.
• Misrepresentations during the sales process.
• Many insurers were subject to class action
  lawsuits and regulatory actions.

94
MARKETING REFORM IN LIFE INSURANCE

• Two areas of concern were illustrations used in
  marketing and the replacement of older policies
  with the newer interest sensitive contracts.
• In response, the NAIC developed new model
  regulations to address life insurance marketing
  practices.

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LIFE INSURANCE AND DIVORCE AGREEMENTS

• A divorce proceeding may require purchase of new
  insurance or may require continuation of existing
  insurance, or the transfer of existing insurance
  policies to a former spouse.
• These transactions can have tax implications.
• In general, tax treatment of premiums paid for
  life insurance follow the rules applicable to
  alimony payments.
• Spouse who is obligated to pay alimony can fund
  future alimony payments through the purchase of
  an annuity for the spouse to whom the payments
  are due.

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ANNUITIES AND PENSION BENEFITS AND RETIREMENT

• ANNUITIES
• Reverse application of the law of large numbers.
• Lifetime guaranteed income to annuitant.
• Persons who live longer offset those who live
  shorter.
• Every payment to annuitant is part interest, part
  principal, and part survivorship benefit.
• Fixed versus Variable.
• Immediate versus Deferred.
• Single Premium versus Installment.
• Single Life versus Two or More Lives.
• Pure Life Annuity versus Annuity Certain.

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THE IMPORTANCE OF ANNUITIES

• If Roy Peabody is 65 years old, has saved over
  the years 200,000, and the current rate of
  interest is 6, he has the following options

98
OPTION 2

• Roy has decided that he has had enough of saving
  for the kids. He wants to live the good life in
  Florida, but will require 4,000 more annually to
  do so.
  

99
OPTION 3

• Roy decides to move to Florida and discovers the
  joys of golf and fishing. He figures that he
  will not live much longer so 20,000 annually
  seems like a better retirement income.

100

OPTION 4

• Roy has decided to see some of the world, in
  addition to golfing and fishing. He needs to
  increase his retirement income to 25,000
  annually.

101
OPTION 5

• Roy decides to buy an annuity. An investment of
  200,000 made with Non-Qualified funds will
  provide an income under the following annuity
  options, age 65 male

102
ANNUITY CERTAIN CONTRACTS

• Pure life annuity.
• Life annuity with period certain.
• Life annuity with installment refund.
• Life annuity with cash refund.

103
SPECIALIZED ANNUITIES

• Single-Premium Deferred Annuity
• Increased popularity since TRA-86 eliminated
• many tax shelters.
• Currently taxed same as other annuities
  earnings accumulate on tax-deferred basis.
• Some insurers sell SPDAs with deposit premium as
  low as 2,500, but more common minimum is 10,000.

104
VARIABLE ANNUITY

• Designed as a means of coping with inflation.
• Premiums invested in common stocks or similar
  investments.
• Based on assumption that the value of a
  diversified
• portfolio of common stocks will change in the
  same
• direction as price level.
• Variable annuity may be variable during
  accumulation
• period and fixed during payout period or
  variable during both periods.

105
QUALIFIED RETIREMENT PLANS

• A qualified retirement plan is one that
  conforms to the requirements of the Internal
  Revenue Code (I.R.C.) that must be met for
  favorable tax treatment.
• Contributions tax-deductible by the employer when
  made.
• Contributions and investment earnings both
  accumulate without tax until distributed to the
  employee, usually at retirement.

106
CONTRIBUTORY AND NONCONTRIBUTORY PLANS

• Retirement plans may be noncontributory (entire
  cost paid by the employer) or contributory (with
  contributions added by the employee).
• Employee contributions may be voluntary, or they
  may be required for participation.
• Employee contributions not usually deductible by
  the employees, but investment income on such
  contributions is not taxed until distributed.

107
FEDERAL REGULATION OF PRIVATE RETIREMENT PLANS

• The Employee Retirement Income Security Act
  (ERISA) of 1974 was the most sweeping overhaul of
  private pensions in the history of the country.
• ERISA prescribes which employees must be included
  in a plan, sets minimum vesting requirements,
  specifies contribution limits, and sets minimum
  funding requirements.
• ERISA also requires extensive reporting and
  disclosure information about pension and welfare
  programs to the Secretary of Labor, the IRS, and
  to those covered by the plan and their
  beneficiaries.

108
VESTING REQUIREMENTS

• Vesting refers to the right of an employee to
  benefits accrued if employment terminates before
  retirement.
• ERISA requires that a qualified plan meet one of
  the following schedules
• No vesting for 3 years, with 100 vesting after 3
  years (called cliff vesting).
• 20 vesting after 2 years of service, with 20
  per year thereafter, so that 100 vesting exists
  after 6 years of service.

109
TYPES OF QUALIFIED RETIREMENT PLANS

• Defined Contribution.
• Defined Benefit.
• Qualified Profit-Sharing Plan.
• Keogh Plan.
• 401(k) Plans.
• Employee Stock Ownership Plan.

110
SURS PLAN FOR YOUR PROFESSORS

• 2.2 years of service Average High Four
• Professor Tom
• 1. Taught for 30 years
• 2. His highest gross income was
• 27 67,200
• 28 69,900
• 29 70,600
• last year 72,000 l
• Average 69,925
• Pension Benefit 2.2
• 30
• 69,925
• 46,150

111
PREMATURE DISTRIBUTIONS

• 10 penalty prior to age 59 1/2 except for
• Deductible medical expenses.
• In form of lifetime annuity.
• At age 55 by worker who meets plan requirements
  for retirement.

112
TAXATION OF DISTRIBUTIONS

• Retirement benefits traditionally paid to
  participants in form of a lifetime annuity
  although many offer lump sum.
• Installment distributions taxable only to the
  extent they exceed employees investment in the
  contract.
• Lump-sum distributions may be rolled-over into an
  annuity and taxed under installment rules.

113
TRADITIONAL INDIVIDUAL RETIREMENT ACCOUNTS

• Anyone with earned income less than 70 1/2 might
  be eligible to contribute to IRA account.
• Limit is 3,000 spousal is 3,000 as well.
• Contributions fully tax deductible if (1) not
  covered by a company sponsored or (2) covered by
  a pension plan but income less than 33,000
  (50,000).
• Phase out in 2001 33,000 - 43,000.
• Anyone with income over 43,000 is better off
  with Roth.

114
NEW ROTH IRA

• Since January of 1998, contributions permitted to
  Roth IRA
• Contributions made only on a non-deductible
  basis.
• All earnings on the contributions compound
  tax-free as long as they are not withdrawn for a
  least five years and there are no taxes due when
  the funds are withdrawn for retirement (i.e.,
  after age 59 1/2).
• Annual contributions of 100 of compensation up
  to 3,000 per individual may be permitted.
• Single taxpayers with income of up to 95,000 or
  couples filing jointly with annual income up to
  150,000 can contribute full 3,000 annually.
• No requirement that withdrawals commence at 70
  1/2 and contributions to a Roth IRA may continue
  after age 70 1/2 if the individual or spouse has
  earned income.
• Individuals can have a Traditional IRA and a Roth
  IRA, but cannot contribute more than combined
  total of 3,000 per year between both of these
  accounts.

115
CHAPTER 20

• HEALTH INSURANCE PERILS
• Sickness.
• Accident.
• HEALTH INSURANCE LOSSES
• Lost income (disability).
• Extra expenses (medical expense).

116
GROUP INSURANCE WORKS BEST WHEN

• Insurance is incidental to group.
• Flow of persons through group.
• Benefits not selected.
• Minimum participation requirement (100
  noncontributing).
• Part paid for by third party (employer, etc.)
• MUCH OF HEALTH INSURANCE MARKET IS GROUP.

117
NEED FOR DISABILITY INCOME INSURANCE

• Probability of disability at most ages before
  retirement is greater than the probability of
  death.
• Disability can be both total and permanent.
  Disability ranks with death in severity.
• When persons other than the disabled person were
  supported by the lost income, the problem is more
  severe.

118
PROTECTION FROM OTHER SOURCES

• Workers Compensation for work-related
  disabilities.
• Compulsory Temporary Disability programs in
  California, Hawaii, New Jersey, New York, Rhode
  Island, and Puerto Rico.
• OASDI for total and permanent disability.
• Demanding test.
• Many applications rejected.
• Total and permanent.
• 6 month wait.
• Employer-provided sick leave or cash benefits.

119
DISABILITY INCOME UNDERWRITING AND PRICING

• Occupational Classes and Underwriting
• Insurers divide risks into three general classes,
  in descending order of desirability
• Professional.
• White collar.
• Blue collar.
• In life insurance, group policies tend to be more
  liberal in disability income insurance,
  individual policies are generally more liberal.
• Taxation if pay with after tax dollars,
  payments tax free.

120
DISABILITY INCOME CONTRACTS PERILS COVERED

• Accident only generally called accident
  insurance.
• Accident and sickness generally called
  disability income insurance.

121
DISABILITY INCOME CONTRACTS WAITING PERIODS
AND LIMITATIONS

• Waiting Periods in disability income policies act
  like a deductible (60 or 90 days)
• Insurers generally limit percentage of
  individuals income they will insure
• About 60 of workers wage under short-term
• policies (group).
• 67 under long-term disability Northwestern
  Mutual.
• To protect against possible malingering.

122
DEFINITIONS OF TOTAL DISABILITY

• Own occupation.
• Own occupation or occupation reasonably suited
  for on basis of background, training, experience,
  or income.
• Any occupation social security definition.
• Two-tier definition
• Own (for 2, 5 years, or even until 65)
• Then any or reasonably suited
• Prime contracts give insured Your Choice, so
  after 2, 5 years can stop working altogether (no
  more partial, see below) or stop getting
  benefits
• Lesser contract the claims adjuster determines
  whether you can go to work

123
DEFINITIONS OF TOTAL DISABILITY continued

• Partial disability insured cannot work as much
  as used to before accident and can collect
  difference (called Loss of Earnings approach).
• Pays partial on earnings now l
• pre-loss
  earning.

124
DEFINITIONS OF SICKNESS PREEXISTING CONDITIONS

• Sickness commencing after policy inception.
• Sickness first manifesting itself after
  inception.
• Group disability income plans tend to have no
  exclusions or less restrictive exclusions for
  preexisting conditions.
• Prim individually underwritten contracts check
  today and ignore pre-existing condition.

125
OPTIONAL BENEFIT PROVISIONS

• Guaranteed Insurability Option.
• Cost-of-Living Adjustment Benefit.
• Waiver of Premium (may be built in).

126
INDIVIDUAL HEALTH POLICY CONTINUANCE PROVISIONS

• Noncancelable guaranteed renewable at
  guaranteed cost.
• Guaranteed renewable cost can increase but only
  for entire group in rating category.
• Conditionally renewable only if certain
  conditions like good health.
• Renewable at company option.
• Cancelable.

127
SELECTED UNIFORM PROVISIONS

• Entire contract like life insurance.
• Time limit on defenses incontestable.
• Grace period similar to life but different days
  depending on frequency of payment period.
• Reinstatement similar to life insurance.

128
SELECTED OPTIONAL PROVISIONS

• Change of occupation changes benefit not in
  prime.
• Misstatement of age changes benefit.
• Relation of earnings to insurance reduces benefit
  if making less than when policy written.
• Illegal occupation no coverage.
• Intoxicants and narcotics, no coverage.

129
TAXATION OF DISABILITY INCOME BENEFITS

• Benefits from individual disability income
  policies not subject to federal income tax.
• Premiums paid by individuals for disability
  income insurance are not deductible for federal
  tax purposes.
• Sick pay and other disability income payments
  that have been paid for by the employer treated
  as wages and taxable.

130
COST OF DISABILITY INCOME INSURANCE

• Premium for disability income depends on
• Occupation, age, and sex of the insured.
• Period for which benefits are payable.
• Amount of the weekly or monthly benefit.
• Length of the waiting period.
• Most disabilities are short-term coverage for
  longer periods of disability more economical.
• Waiting period or elimination period
  significant influence on cost.

131
FEE FOR SERVICE

• The coverage provided by Blue Cross and Blue
  Shield and insurance companies came to be called
  fee-for-service coverage.
• Under this approach, insureds were free to choose
  doctors, hospitals and other health care
  providers, without insurer approval.
• The provider and insured agreed on the level of
  care and the insurer would pay some or all of the
  providers changes, directly or by reimbursing the
  insured.

132
FEE FOR SERVICE

• Initially, most fee for service plans provided
  first-dollar coverage (without participation in
  cost by the insured).
• Eventually, insurers attempted to control costs
  through deductibles and share-loss coinsurance,
  under which the patient bears a part of the cost.

133
MEDICARE

• In 1965, government entered the market when
  Congress established the Medicare program to
  provide medical expense insurance to persons over
  age 65.
• The same legislation created Medicaid, a
  state-federal medical assistance program for
  low-income persons.
• During the years immediately following Medicare
  in 1965, the cost of health care (and of private
  health insurance) increased dramatically.

134
MANAGED CARE ORGANIZATIONS

• The solution was the concept of managed care,
  which represented a change not only in the
  financing of health care, but in its delivery as
  well.
• New types of insurers, such as health
  maintenance organizations, not only provide for
  the financing of
• health care, it also delivers that care.
• The insurance element in HMOs lies in the way
  they
• charge, called capitation.
• In return for a fixed monthly fee, the individual
  receives virtually all required medical care,
  subject to a nominal charge when visiting a
  physician.

135
HEALTH MAINTENANCE ORGANIZATIONS

• Whatever the arrangement with the physicians, the
  fee-for-service system is replaced by a system of
  capitation.
• The subscriber chooses a primary-care physician
  (gatekeeper), who determines what care is
  received and when the patient is referred to
  specialists.
• Emergency services are provided outside the
  network in case of a sudden illness or injury,
  which, if not treated, could jeopardize the
  subscribers life or health.

136
PREFERRED PROVIDER ORGANIZATIONS

• A preferred provider organization is a network of
  providers (doctors and hospitals) with whom an
  insurance company contracts to provide services.
• The provider offers to discount those services
  and to set up special utilization review programs
  to control medical expenses.
• In return, the insurer promises to increase
  patient volume by providing higher rates of
  reimbursement when the care is received from the
  network.
• The insured is permitted to seek care from other
  providers, but pays a penalty in the form of
  increased deductibles and coinsurance.

137
POINT-OF-SERVICE PLANS

• Eventually some HMOs adopted procedures that made
  them more like PPOs, adopting what are known as
  point-of-service plans (POS).
• A POS plan operates like a PPO, since the
  employee retains the right to use any provider,
  but pays a cost when using a provider outside the
  network.
• At the same time, a POS plan is like an HMO,
  since care received through the network is
  managed by a primary care physician, or
  gatekeeper.
• Penalties for using a non-network provider are
  usually greater than the penalties under a PPO.

138
DOMINANCE OF MANAGED CARE

• HMOs, PPOs, and POS plans all involve an
  arrangement between the insurers and a network of
  providers and offer insureds financial incentives
  to use the providers in the network.
• Thirty years ago, 90 percent of insureds had
  fee-for-service plans.
• Today, 32 of employees are enrolled in PPOs, 33
  are enrolled in HMOs, 17 are enrolled in POS
  plans, and 18 are in fee-for-service plans.

139
ACCESS TO HEALTH CARE

• It is estimated that 44 million Americans have no
  health insurance.
• About three-fourths of the uninsured are
  employees and their dependents
• About half of these workers have insurance
  available at their place of employment but elect
  not to purchase it.
• Some of the uninsureds are unemployed and about
  one-third have incomes at or below the poverty
  level but do not qualify for Medicaid.

140
ACCESS TO HEALTH CARE

• The problem of access is not limited to the
  economically disadvantaged.
• It also exists for persons who are unable to
  obtain
• health insurance in the standard market.
• Plans of small employers may exclude coverage for
  some employees.
• Persons who must purchase insurance individually
  sometimes find that they cannot obtain it.
• It is estimated, however, that only 3 percent of
  uninsured lack insurance because they are unable
  to obtain it from a provider.

141
HIGH COST OF HEALTH CARE

• National expenditures for health care, as a
  percentage of GNP, have increased from 4.4
  percent of GNP in 1950 to over 13 percent by
  2001.
• The Aging Population.
• Improved Medical Technology.
• Excessive Capacity.
• Defensive Medicine.

142
COBRA

• Requires continuance of employer-sponsored group
  health insurance under specified circumstances
• 18 months for terminated employees.
• 36 months for spouses of deceased, divorced, or
  separated workers or dependent children whose
  eligibility for coverage ceases.
• The COBRA participant pays a premium based on the
  existing group rate.

143
TRADITIONAL FORMS OF MEDICAL EXPENSE INSURANCE

• Base Plan Coverage
• Hospitalization Insurance
• Surgical Expense and
• Physicians Expense Insurance
• Major Medical Insurance

144
MAJOR MEDICAL INSURANCE

• High maximum (or unlimited).
• Deductible.
• Coinsurance or share-loss provision.

145
MAJOR MEDICAL EXAMPLE

• Deductible 500
• 80/20
• Stop Loss (not deductible) 3,000
• Expense 19,000
• Insurer Pays 14,800 700
• Insured Pays 500 3,000
• (19,000 500) x 20 3,700

146
EXCLUSIONS UNDER HEALTH INSURANCE POLICIES

• Individual policy exclusions tend to be more
  extensive than those in group policies and some
  group contracts contain more exclusions than
  others.
• Exclusions typical of those in individual or
  group contracts include
• Expenses payable under workers comp or any
  occupational disease law.
• Personal comfort items (e.g., television,
  telephone, air conditioners).
• Elective cosmetic surgery.
• Routine medical care (e.g., annual physical,
  birth control, well-baby care).
• Hearing aids and eyeglasses.
• Dental work.

147
EXCLUSIONS UNDER HEALTH INSURANCE POLICIES

• Experimental procedures.
• Expenses resulting from self-inflicted injuries.
• Expenses resulting from war or any act of war.
• Expenses incurred while on active duty with the
  armed forces.
• Services received in government hospital received
  without charge.
• Expenses arising out of mental or nervous
  disorders.
• (Some policies cover mental and nervous
  disorders subject to a lower maximum or only for
  a percentage of the costs covered.)

148
LIMITED HEALTH INSURANCE CONTRACTS

• Dread disease policies.
• Travel Accident.

149
SOME SPECIALIZED USES OF LIFE INSURANCE IN
BUSINESS

• In addition to their use in fringe benefit
  programs and funding retirement benefits, life
  insurance serves several other functions in the
  business firm
• funding business purchase agreements.
• protecting the firm against the loss of a key
  employee.
• additional compensation to executives and other
  valuable employees.

150
BUSINESS CONTINUATION INSURANCE

• Death or disability of an owner can create
  serious problems for remaining owners.
• Ideal solution is to arrange for sale of each
  owners interest prior to death through a
  buy-and-sell agreement
• cross purchase plan.
• entity plan.
• Life insurance may be used to fund the
  buy-and-sell agreement.

151
KEY PERSON INSURANCE

• An employee who make a significant contribution
  to success of the organization is a key person.
• Death (or disability) of a key person can be a
  source of loss to the organization.
• Key person life insurance is designed to
  compensate for such loss.
• Greatest difficulty in insuring key persons is
  determining the amount for which they should be
  insured.

152
DEFERRED COMPENSATION

• Employer agrees to make payments to an employee
  after retirement, or to employees spouse if the
  employee dies, if the employee continues his or
  her employment with the firm to a specified age.
• Employee incurs no federal tax liability on the
  employers promise as long as there is no
  constructive receipt.
• Employers often fund deferred comp arrangements
  through cash value life insurance.

153

• Questions ??