1 Ins301 Chp15 –Part1 Life Insurance and Annuities Terminology Types of life insurance products Tax treatment of life insurance Term insurance Endowment

Ins301 Chp15 –Part1 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


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)


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


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


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


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?


Life Insurance Pricing

Ignore expenses and risk load ==> 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


Pricing 1-Year Term

Find fair premium for $100,000 1-year term for 40 year-old

Interest rate = 10% Insurer’s 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

= __________


Pricing 1-Year Term


Interest rate = 10% Insurer’s 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= ____________


Pricing 1-Year Term

Premium increases as probability of dying increases

$0

$200

$400

$600

$800

$1,000

35 40 45 50 55 60 65 70 75 80 85 90 95

Age

Expe

cted

Cla

im C

osts


Pricing 2-Year Term


Insurer’s 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


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 =_____ = ______


Pricing 2-Year Term

Single premium

Level Premium


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.


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)



Premiums generally do not increase over time But 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)



If insured dies, beneficiaries receive face amount

= death protection + cash value

Structured so cash value over time death protection over time




Pricing Single Premium Whole Life

Apply same principles used with term insurance Forecast expected cash flows to age 100 Find single premium

= PV of expected cost Assume

no expenses or profits 5% interest rate policy will not lapse


Pricing Single Premium Whole Life

Age

Probability of 40

year old dying in

year at left

Expected

claim cost

Present value of

expected claim cost

40 0.003020 $302.00 $302.00/1.05 = $288

41 0.003280 $328.00 $328.00/1.052 = $298

42 0.003538 $353.80 $353.80/1.053 = $306

43 0.003832 $383.20 $383.20/1.054 = $315

44 0.004133 $413.30 $413.30/1.055 = $324

45

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

96 0.004032 $403.20 $403.20/1.0557 = $25

97 0.003098 $309.80 $309.80/1.0558 = $18

98 0.002207 $220.70 $220.70/1.0559 = $12

99 0.001147 $114.70 $114.7/1.0560 = $6

Total 22,373 Single Premium


Continuous Level Premium Whole Life

Continuous level premium Same premium is paid until insured dies or reaches 100 Equivalent to a life annuity

Present value of a life annuity that pays $P starting at age 40 = 16.30 * P

Find P so that PV of premium payments = PV of costs 16.30 * P = $22,373 ==> P = $1,372.58


Limited Payment Whole Life

Limited payment level premium Same premium is paid for fixed number of years Example: 20 years Equivalent to a 20 year annuity

Present value of a 20-year annuity that pays $P starting at age 40 = $12.58 x P

Find P so that PV of premium payments = PV of costs

12.58 x P = $22,373 ==> P = $1,778.45


Comparison of Cash Values in Whole Life

$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

$70,000

$80,000

$90,000

$100,000

40 44 48 52 56 60 64 68 72 76 80 84 88 92 96

Age

CASh

VALUES

payments for life

20 Year Payments

Single Premium


How Much Life Insurance Should be Purchased?

Rules of thumb Death benefit = 8 times income

Forecast beneficiaries sources & uses of funds Uses:

Living expenses Education expenses

Sources: Social security Earnings


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 Insurer’s 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


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 ==> disintermediation

Front-end expense charges==> Cash value grows slowly at first==> Implicit return on savings accumulation

initially low


Universal Life

Similar to whole life Main differences:

Greater flexibility in premium payments Cash value does not follow a fixed schedule; it varies

with policyholder’s premium payments insurer’s 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


Factors Affecting UL Cash Value

Cash valueat beginning of period

+

Premium paymentsat beginning of period

-

Mortality chargeat beginning of period

-

Expense chargeat beginning of period

+

Interest creditedat end of period

=

Cash valueat end of period


Death Benefit Options with Universal Life

Level death benefit (as with Whole Life)

Death benefit varies with cash value

age age

Cash value

Cash value

Death benefit Death

benefit


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


Life Insurance and Annuities (part3)

What is annuities The purpose of annuity Classification of annuity Overview of annuity contracts


What is Annuity

An annuity is simply a series of periodic payments. An annuity contract is an insurance policy that

promises to make a series of payments for a fixed period or over someone’s lifetime

It is typically used as long-term retirement funding vehicles.


Two Periods of Annuity

Accumulation period-- the period when the policyholder pays premiums to

the insurer Payout period

-- the insurer makes payments to the policyholder


Purpose of Annuity

Risk management purpose Reduce the risk that savings are exhausted before

the annuitant dies tax-deferred saving vehicle

Returns earned from these contracts are not taxed until the insurer distribute them


Classification of Annuity

Immediate annuity and deferred annuity Immediate Deferred

Flexible premium deferred annuities (FPDAs) Single premium deferred annuities (SPDAs)

Fixed annuity and variable annuity Fixed annuity Variable annuity


Overview of Annuity Contracts

Characteristic Variations

Premium payments (a) Single premium

(b) Fixed period, level premium up to an advanced age

(c) Flexible premium over time

Annuity benefits begin (a) Immediately

(b) Deferred

Annuity benefits end (a) Fixed number of years

(b) Death of one or more individuals

(c) Combination of (a) and (b)

Insurer payments (a) Fixed

(b) Vary with interest rates, with guaranteed minimum

(c) Vary with returns on stock and bond funds chosen by policyholder

Documents

1 Ins301 Chp15 –Part1 Life Insurance and Annuities Terminology Types of life insurance products Tax treatment of life insurance Term insurance Endowment