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Life Insurance and Annuities

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Tax Treatment of Life Insurance. Death benefits are not taxed ... Term Insurance ... Endowment Insurance ... – PowerPoint PPT presentation

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Title: Life Insurance and Annuities


1
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

2
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)

3
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

4
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

5
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

6
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?

7
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

8
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
  • __________

9
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
  • ____________

10
Pricing 1-Year Term
  • Premium increases as probability of dying
    increases

11
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

12
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
    _____ ______

13
Pricing 2-Year Term
  • Single premium
  • Level Premium

14
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.

15
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)

16
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)

17
Whole Life Insurance
  • If insured dies,
  • beneficiaries receive face amount
  • death protection cash value
  • Structured so
  • cash value ? over time
  • death protection ? over time

18
Whole Life Insurance
19
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

20
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

21
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

22
Factors Affecting UL Cash Value
23
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
24
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

25
Overview of Annuity Contracts
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