Class 15 Insurance and Risk Management

1
Class 15Insurance and RiskManagement

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

2
Todays Agenda

• Life Settlement Options
• Life Insurance Net Single Premium Calculation
• Annuity principle
• Types of annuities
• Taxation of Individual Annuities
• Individual Retirement Accounts
• Traditional IRA
• Roth IRA

3
Life Insurance Settlement Options

• Cashmost proceeds are paid as cash
• Interest Option
• Fixed Period Option
• Fixed Amount Option
• Life Income Options

4
Advantages Non-cash Settlement Options

• Periodic income to the family
• Guaranteed principal and interest
• Can be useful in life insurance planning
• Long-term guarantees
• No additional cost

5
Non-Cash Settlement Options Disadvantages

• Higher yields elsewhere
• Settlement agreement may be inflexible and
  restrictive.
• Life income options not attractive at younger
  ages
• Insurance windfall can create problems for the
  beneficiary.

6
Interest Settlement Option

• Interest paid to the beneficiary
• Minimum interest rate guaranteed
• Beneficiary can make withdrawals
• Advantages
• flexibility, may allow change to another option
• Main disadvantage higher returns elsewhere.

7
Fixed Period Settlement Option

• Pays monthly, quarterly, semiannual, or annual
  payments
• Death of beneficiary
• Remaining payments go to a contingent beneficiary
  
• To the estate of primary beneficiary if the
  contingent beneficiary dies
• Useswhen income needed for definite period of
  time
• Social Security black-out period
• readjustment period
• family dependency period
• Limitationsinflexible partial withdrawals not
  allowed

8
Fixed Amount Settlement Option

• Specified amount paid to beneficiary each time
  period
• Advantages
• Considerable flexibility on withdrawals
• May allow change to another option or
• Increase and decrease in fixed amount

9
EXHIBIT 18.2 Fixed-Period Option (Minimum
Monthly Income Payments per 1000 Proceeds, 3
Percent Interest)
10
EXHIBIT 18.3 Life Income Options (Minimum
Monthly Income Payments per 1000 Proceeds)
11
EXHIBIT 18.4 Joint-and-Survivor Life Income
Option (Minimum Monthly Income Payments per 1000
Proceeds)
12
Use of a Trust

• Alternative to Settlement Option
• Desirable when
• Amount of insurance is substantial
• Judgment in amount and timing of pay-outs is
  required
• Example situations
• Minor children
• Mentally handicapped adult
• Disadvantages
• Must pay trustees fee
• Returns not guaranteed

13
EXHIBIT 27.1 Commissioners 1980 Standard
Ordinary Mortality Table, Male Lives
14
EXHIBIT 27.1 (continued) Commissioners 1980
Standard Ordinary Mortality Table, Male Lives
15
EXHIBIT 27.2 Present Value of 1 at 5 Percent
Compound Interest
16
EXHIBIT 27.3 Figuring the NSP for a Five-Year
Term Insurance Policy
17
Annuity Contracts

• Large and growing part of life insurance business
• Divide contract period in two
• Accumulation period
• Policyholder pays premiums
• Payout period (liquidation period)
• Insurer makes payments

18
Use of Annuities

• Risk management perspective
• Protection against outliving resources
• Savings perspective
• Tax advantaged method of saving
• Implicit returns are tax deferred

19
Annuity Principle

• Periodic payment that continues for
• Fixed period, or
• Duration of a designated life or lives
• Annuitant
• Person who receives periodic payment, or
• Whose life governs duration of payment

20
Annuity Vs. Life Insurance

• Life Insurance
• Creates an immediate estate
• Protects against dying too soon
• Annuity
• Provides a lifetime income that cannot be
  outlived
• Protects against living too long

21
Overview of Annuity Contracts
22
Types of Annuities

• Fixed
• Variable
• Equity-indexed

23
Fixed Annuity

• Periodic payments to annuitant that are
• fixed
• guaranteed

24
Fixed Annuity Accumulation Period

• Premiums credited with interest
• Guaranteed minimum rate
• In some states, recently indexed to 5-year
  Treasury bond
• Current rate

25
Fixed Annuity Liquidation Period

• This is the payout period
• Accumulated cash is annuitized
• Guaranteed lifetime income
• No protection against inflation

26
Payment of Benefits

• Immediate annuity
• Deferred annuity

27
Deferred Annuity Premium methods

• Single premium
• Level premium
• Flexible premium

28
Payment of Benefits

• Immediate
• Deferred

29
Annuity Settlement Options

• Cash
• Life Annuity (no refund)
• Also known as straight life annuity
• Life Annuity with guaranteed payments
• Also known as period certain

30
Annuity Settlement Options (cont.)

• Installment Refund Option
• Joint and Survivor Annuity

31
Overview Variable Annuity

• Provides inflation hedge by maintaining real
  purchasing power of periodic payments during
  retirement.
• During accumulation period, premiums are
  invested, and accumulation units are acquired.
• At retirement, accumulation units are converted
  into annuity units.
• Quantity of annuity remains constant
• But, the value of the annuity unit changes
  periodically depending on the value of the
  subaccount in which the premiums are invested.
• As a result, amount of monthly income changes
  periodically based on the value of the subaccount.

32
Variable Annuity Basic Characteristics

• Premiums used to purchase accumulation units
• Units invested in common stocks and other
  investments
• At retirement, converted to annuity units
• In both cases, value of units varies with market

33
Variable Annuity Guaranteed Death Benefit

• If annuitant dies before retirement, amount paid
  to beneficiary will be higher of
• Amount invested in contract
• Value of account at time of death
• Some newer variable annuities offer enhanced
  death benefits
• Rising floor
• Stepped up benefits

34
Variable Annuity Fees and Expenses

• Typical charges
• Investment management charge
• Administrative charge
• Mortality and expense risk charge
• Surrender charge
• Some may have front-end load
• Total fees and expenses could exceed 2 of assets

35
Variable Annuity Investment Performance

• Owner given investment choices, similar to mutual
  funds
• Portfolios called sub-accounts
• Funds can be transferred without tax consequences
• Investment performance varies widely depending
  on
• Insurer
• Type of investment
• Expense rate

36
Overview Equity-indexed Annuity

• An equity-indexed annuity is a fixed, deferred
  annuity
• Allows annuity owner to participate in the growth
  of the stock market
• Also provides downside protection against the
  loss of principal and prior interest earnings if
  the annuity is held to term.
• The interest credited is based on a stock market
  index, typically Standard and Poors 500
  Composite Stock Index (SP 500).
• The annuity is credited with part of the gain in
  the index.
• A few insurers have participation rates of 100
  percent.

37
Equity Indexed Annuity

• Participation rate Percent of stock index that
  is credited to the contract
• Participation rates generally range from 25
  percent to 90 percent of the gain in the stock
  index.
• Cap on the maximum percentage of gain
• Maximum percentage of gain that is credited to
  the contract

38
Equity Indexed Annuity Indexing Method

• Method for crediting excess interest to contract
• Several methods used
• Annual reset method
• Interest earnings calculated changed on annual
  change in stock market
• Index starting point is reset annually
• Also called ratchet method

39
Equity-Index Annuity Guaranteed Minimum Value

• Applies to E-A annuities with terms greater than
  one year
• Protects loss of principal if held to term
• Typical minimum value 90 of single value
  accumulated at 3 interest
• During first 3 4 years, investor may experience
  loss of principal

40
Taxation of Individual Annuities

• Premiums are not income-tax deductible
• Investment income is tax-deferred
• Accumulates free of taxes until distributed
• Premature distribution (before 59 ½) subject to
  10 penalty tax

41
Taxation of Individual Annuities (cont.)

• Net cost of periodic annuity payment not subject
  to taxation
• Exclusion ratio determines taxable and
  non-taxable portions
• Exclusion Ratio Investment in Contract/Expected
  Return
• Example, p.444 of text

42
Individual Retirement Accounts

• Traditional IRA
• Roth IRA

43
Traditional IRA

• Eligibility requirements
• Annual contribution limits
• Income tax deduction of traditional IRA
  contributions
• Special phase-out rule for spouses
• Savers credit

44
Traditional IRA (cont)

• Withdrawal of funds
• Taxation of distributions
• Establishing a traditional IRA
• IRA investments
• IRA rollover account

45
Traditional IRA Eligibility Requirements

• Traditional IRA has two eligibility requirements.
  
• Participant must have taxable compensation during
  the year
• Can include wages and salaries, bonuses,
  commissions, and self-employment income.
• Participant must be under age 70 1/2.

46
Traditional IRA Annual Contribution Limit

• For 2004, maximum annual IRA contribution for
  workers under age 50 was 3000.
• Workers age 50 and older could contribute a
  maximum of 3500 each year.
• If the participant had nonworking or low-earning
  spouse, maximum annual IRA contribution could be
  increased to 6000 (spousal IRA).
• However, the maximum annual contribution to each
  account is limited to 3000. Under present law,
  the annual IRA contribution limits will increase
  in the future.

47
Roth IRA

• Income limits
• Single taxpayers 95,000 or less
• Married filing jointly 150,000 or less
• Conversion to a Roth IRA
• Limited to taxpayers with adjusted gross income
  of 100,000 or less

48
Traditional IRA Tax Treatment

• Workers to deduct part or all of their IRA
  contributions.
• Deduction is limited to workers
• Whose taxable compensation is below certain
  annual thresholds
• Are not active participants in an employer
  sponsored retirement plan.

49
Traditional IRA Tax Treatment (cont.)

• Investment income accumulates income-tax free on
  a tax-deferred basis
• Distributions are taxed as ordinary income.

50
Roth IRA Tax Treatment

• Annual contributions to a Roth IRA are not
  income-tax deductible.
• Investment income accumulates income-tax free
• Qualified distributions are not taxable if
  certain requirements are met.
• A qualified distribution is any distribution that
  (1) is made after a five-year period beginning
  with the first tax year for which a Roth
  contribution is made, and (2) is made for any of
  the following reasons

51
Roth IRA Tax Treatment

• A qualified distribution is any distribution that
  is made
• After a five-year period beginning with the first
  tax year for which a Roth contribution is made
• For any of the following reasons
• The individual is age 59 1/2 or older.
• The individual is disabled.
• Distribution is paid to a beneficiary or to the
  estate after the individuals death.
• Distribution is used to pay qualified first-time
  homebuyer expenses (maximum of 10,000).