Life Insurance and Annuities

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Life Insurance and Annuities

• Terminology
• Types of life insurance products
• Tax treatment of life insurance
• Term insurance
• Endowment insurance
• Whole life insurance
• Universal insurance
• Variable insurance

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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
• death benefit (for term, whole life, some
  universal life)
• death benefit - cash value (for some universal
  life)
• Cash surrender value the amount of money that
  the policyholder can withdraw (cash value -
  surrender penalty)

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Life Insurance Products General Introduction

• Term insurance
• pure life insurance
• Cash value life insurance
• pure life insurance Savings accumulation
• whole life
• universal life
• variable life
• Variable universal life

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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 b/c part of premiums is cost of death
  protection

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Term Insurance

• Typically provides pure death protection over a
  fixed term, usually one year or five years. There
  is no savings feature and therefore no cash
  surrender value.
• Data
• 1/4 of policies
• almost half of death protection purchased
• Guaranteed renewable
• Premium increases over time. Why?

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Life Insurance Pricing

• Ignore expenses and risk load
• gt focus on net premiums
• Use mortality table
• Probability of dying at age x conditional on
  living through age x-1
• Example Probability of male dying at age 40
  0.00302
• Assume
• Premiums paid at beginning of year
• Claims paid at end of year

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Pricing 1-Year Term

• Find fair premium for 100,000 1-year term for 40
  year-old
• Interest rate 10
• Insurers cash flows
• Beg. of Year End of Year
• 100,000 with
  prob 0.00302
• Loss
• 0
  with prob. 0.99698
• Expected claim cost ________
• Premium Present value of expected claim cost
• __________

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Pricing 1-Year Term

• Find fair premium for 100,000 1-year term for 41
  year-old
• Interest rate 10
• Insurers cash flows
• Beg. of Year End of Year
• -100,000 with
  prob ____________
• Premium
• 0
  with prob. ____________
• Expected claim cost ___________
• Premium Present value of expected claim cost
• ____________

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Pricing 1-Year Term

• Premium increases as probability of dying
  increases

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Pricing 2-Year Term

• Find fair premium for 100,000 2-year term for 40
  year-old
• Insurers claim costs
• Beg. of Year 1 End of Year 1 End of Year 2
• -100,000
  -100,000
• with prob 0.00302 with prob x
• 0 0
• with prob. 0.99698 with prob 1-x

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Pricing 2-Year Term

• What is x? it is the probability of a 40
  year-old dying in his 42nd year?
• Mortality table
• Number Number
• Age of People of Deaths
• 40 937723 2832
• 41 934891 3076
• Probability of 40 year-old dying in 41st year
  _____ ______
• Probability of 40 year-old dying in 42nd year
  _____ ______

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Pricing 2-Year Term

• Single premium
• Level Premium

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Endowment Insurance

• Pays face amount if the insured dies, or if the
  insured survives the policy period
• It is similar to a saving account
• The US no longer grants tax advantage to
  endowment policies unless they have a very long
  duration, such as whole life insurance.

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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 a level premium paid for a 10-year
  or 20-year period
• continuous premium level premium continue until
  the policyholder dies, surrenders the policy, or
  reaches the age of 100 (whichever comes first)

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Whole Life Insurance

• Premiums generally do not increase over time
• But probability of dying increases over time
• gt 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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Participating Policies

• Can (and usually does) pay annual dividends
• always with mutual companies
• often with stock companies
• Why? - premiums based on conservative assumptions
• Key assumptions interest rate levels and
  mortality rates
• These variables are correlated across
  policyholders
• Insurers methods of dealing with correlated
  risk
• Bear the correlated risk and hold a lot of
  capital
• Share correlated risk with policyholders
• Illustrated versus actual dividends

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Other Whole Life Policy Provisions

• Surrender Options
• Take cash value
• Use cash value as a single premium for
• paid up whole life
• term policy
• Policy loans
• borrow against cash value
• interest now varies with market rates
• in 1970s 80s, fixed rate gt disintermediation
• Front-end expense charges
• gt Cash value grows slowly at first
• gt Implicit return on savings accumulation
• initially low

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Universal Life

• Similar to whole life
• Main differences
• Greater flexibility in premium payments
• Cash value does not follow a fixed schedule it
  varies with
• policyholders premium payments
• insurers expense and mortality charges
• rate insurer uses to credit interest to cash
  value
• minimum rate usually guaranteed
• rate often linked to short term interest rates

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Factors Affecting UL Cash Value
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Death Benefit Options with Universal Life

• Level death benefit (as with Whole Life)
• Death benefit varies with cash value

Death benefit
Death benefit
Cash value
Cash value
age
age
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Variable Life

• Similar to whole life
• Main differences
• Cash value does not follow a fixed schedule it
  varies with
• return earned on portfolio of mutual funds chosen
  by policyholder
• Death benefit
• minimum is guaranteed, but varies with cash value

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Overview of Annuity Contracts