Class 6
Insurance and Risk
Management
George D. Krempley
Bus. Fin. 640
Winter 2008
Agenda
• Review
– Premature Death
– Financial Impact of Premature Death on
Different Types of Families
– Methods for Determining Amount of Life
Insurance to Own
• Types of Life Insurance
• Life Insurance Contractual Provisions
Premature Death
• The death of a family head with outstanding
unfulfilled financial obligations can cause serious
financial problems for the surviving family members
– The deceased’s future earnings are lost forever
– Additional expenses are incurred, e.g., funeral expenses,
uninsured medical bills, and estate settlement costs
– Some families will experience a reduction in their
standard of living
– Noneconomic costs are incurred, e.g., grief
Economic Justification of Life
Insurance
• The purchase of life insurance is financially
justified if
– The insured has earned income and,
– Others are dependent on those earnings for financial
support
Financial Impact of Premature Death
on Different Types of Families
• The need for life insurance varies across family
types:
– Single person
– Single-parent family
– Two income earners with children
– Traditional family
– Blended family
– Sandwiched family
Amount of Life Insurance to Own
• Three approaches can be used to estimate the
amount of life insurance to own:
– The human life value approach
• The amount needed depends on the insured’s human life value,
which is the present value of the family’s share of the deceased
breadwinner’s future earnings
• To calculate:
– Estimate the individual’s average annual earnings over his or her
productive lifetime
– Deduct taxes, insurance premiums and self-maintenance costs
– Using a reasonable discount rate, determine the present value of
the family’s share of earnings for the number of years until
retirement
Amount of Life Insurance to Own
– The needs approach
• The amount needed depends on the financial needs that must be
met if the family head should die
• Important family needs must consider:
– An estate clearance fund: cash needed for burial expenses,
uninsured medical bills, and taxes
– Income needed for the readjustment period, a 1-2 year period in
which the family adjusts to its new living standard
– The dependency period is the period until the youngest child
reaches age 18
– Life income to the surviving spouse, including income during and
after the blackout period. The blackout period refers to the period
from the time that Social Security survivor benefits terminate to the
time the benefits are resumed
– Families should also consider special needs, e.g., funds for college
education and emergencies
Amount of Life Insurance to Own
– The capital retention approach
• This approach preserves the capital needed to provide income to
the family
– Income-producing assets are preserved for the heirs
• To calculate:
– Prepare a personal balance sheet
– Determine the amount of income-producing capital
– Determine the amount of additional capital needed to meet the family
needs
Amount of Life Insurance to Own
• Most families own an insufficient amount of life insurance
– About one in five households have no life insurance
– Consumers procrastinate, and have difficulty in making correct
decisions about the purchase of life insurance
• Many families have only a limited amount of discretionary
income
– The purchase of life insurance reduces the amount of discretionary
income available for other needs
– Many families are in debt and have little savings
– After payment of high priority expenses, such as a mortgage, food
and utilities, many families have only a limited amount of income to
purchase life insurance
Types of Life Insurance
• Life insurance policies can be classified in
two general categories:
– Term insurance provide temporary protection
– Cash-value life insurance has a savings
component and builds cash values
– There are many variations of both types
available today
High Level Contrast: Term and Life
Insurance
• Term - Pure life insurance
• Whole Life Insurance - Cash value policies
– Pure life insurance + Savings accumulation
– Examples
• ordinary life
• universal life
• variable life
Characteristics of Term Life
Insurance
• Under a term insurance policy, protection is temporary
– Protection expires at the end of the policy period, unless renewed
• Most term policies are renewable for additional periods
• Premiums increase at each renewal
• Represents ¼ of policies
• Almost ½ of death protection purchased
• Premium increases over time
Characteristics of Term Life
Insurance
– Most term policies are convertible, which means
the policy can be exchanged for a cash-value
policy without evidence of insurability
• Under the attained-age method, the premium charged
for the new policy is based on the insured’s attained
age at the time of conversion
• Under the original-age method, the premium charged
for the new policy is based on the insured's original
age when the term insurance was first purchased
Types of Term Life Insurance
• Yearly-renewable term insurance is issued for a one-year period
• Term insurance can also be issued for 5 or more years
• A term to age 65 policy provides protection to age 65, at which time the
policy expires
• Under a decreasing term insurance policy, the face value gradually
declines each year
• Under a reentry term insurance policy, renewal premiums are based on
select (lower) mortality rates if the insured can periodically demonstrate
acceptable evidence of insurability (i.e., good health)
• Under a return of premiums term, the premiums are refunded if the
policyowner outlives the term of the policy
Decreasing Term Insurance
• Decreasing term
– Face amount gradually declines over policy
period
– Premiums remain level
– Some policies structured so that premiums
fully paid several years before coverage
expires
– Sometimes used to cover a mortgage
Situations When Term Insurance Is
Appropriate
1. The amount of income that can be spent on life
insurance is limited
2. The need for protection is temporary
3. The insured wants to guarantee future
insurability
Limitations of Term Life Insurance
• Term insurance premiums increase with age at an
increasing rate and eventually reach prohibitive
levels
• Therefore, term insurance is inappropriate if there
is a need for permanent protection
• Term insurance is also inappropriate if you wish to
save money for a specific need
Exhibit 11.2 Examples of Term
Life Insurance Premiums
Yearly Renewable Term – Deeper Look
• Provides life insurance for one year only.
• Insured may renew for successive one-
year periods, with no evidence of
insurability.
Cost: Yearly Renewable Term
• Pure premium is determined by the
mortality rate at each attained age.
• Gradual premium increase during the early
years.
• Premiums rise sharply in the later years.
Pure Premium: Yearly Renewable
Term
• Males
• $1000 face amount
Age Pure Premium
30 1.73
40 3.02
50 6.71
60 16.08
70 39.51
80 98.84
Level Premium Method
• Premiums do not increase year to year.
• Premiums in early years exceed amount
required to pay current age death claims.
• Premiums paid in the later years fall far short of
death claims
• Redundant premiums (plus compound interest)
are used to supplement inadequate premiums
paid during the later years.
Legal Reserve
• Since the redundant premiums will be needed
later, a legal reserve is required.
• Fundamental purpose of the legal reserve is
lifetime protection.
• As the legal reserve increases, the net amount
at risk declines.
• As a result, the cost of insurance is reasonable
at all ages.
Cash Values
• Cash values are the by-product of level premium
method.
• Cash values and the legal reserve are computed
separately.
• Loading for expenses and high acquisition costs cause
cash values to be initially below the legal reserve
• Nevertheless, large amounts are saved annually by
customers in the form of accumulated cash values
Overview: Whole Life Insurance
• Premiums generally do not increase over time
• 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)
Types of Whole Life Insurance
• Whole life insurance is a cash value policy
that provides lifetime protection
– A stated amount is paid to a designated
beneficiary when the insured dies, regardless of
when the death occurs
– Types include:
● Ordinary life
● Universal life
● Limited-payment life
● Variable universal life
● Endowment insurance
● Current assumption whole life
● Variable life
● Indeterminate-premium whole life
Ordinary Life Insurance
• Ordinary life insurance is a level-premium policy that
provides lifetime protection
• An ordinary life policy is appropriate when lifetime protection
is needed
• Higher upfront premiums than with term, but premiums do
not increase over time
• Premiums are level throughout the premium paying period
• Since the probability of dying increases over time,
Policyholder ―prepays‖ part of the cost of future death
protection
Ordinary Life Insurance
• Other names: straight life and continuous
premium whole life.
• A claim is a certainty
• Either the Insured dies prior to age 100, or
the policy endows at age 100
Ordinary Life (cont.)
• The excess premiums paid during the early years are
used to supplement the inadequate premiums paid
during the later years of the policy. It is referred to as a
legal reserve
• The insurer’s legal reserve is a liability that must be
offset by sufficient financial assets
• The net amount at risk is the difference between the
legal reserve and the face amount of coverage
• As a by-product, policyholder builds equity in the policy
Ordinary Life (cont.)
• Equity or savings element is called:
– Cash Surrender Value
• Cash surrender value
– Can be obtained by surrendering policy
– Or can be borrowed against under policy
loan provision
Ordinary Life Uses
1. Appropriate when lifetime protection is
needed in such cases as:
– Estate clearance fund
– Federal estate taxes
– Divorce settlement
– Desire to leave a large bequest whenever
death occurs
2. Can also be used to accumulate savings
Biggest Limitation of Ordinary Life
• Purchase of ordinary life may cause a
person to be underinsured
– Savings or lifetime protection may not be the
priority
– Term insurance might be a better choice
Exhibit 11.3 Relationship Between the
Net Amount at Risk and Legal Reserve
(1980 CSO Mortality Table)
Cash Surrender Values
• A policyholder overpays for insurance protection
during the early years, resulting in a legal reserve
and the accumulation of cash values
• Because of the loading for expenses and high first-
year acquisition costs, cash values are initially
below the legal reserve
• The policyowner has the right to borrow the cash
value or exercise a cash surrender options
Limited Payment Life Insurance
• Under a limited-payment life insurance policy, the insured
has lifetime protection, and premiums are level, but they are
paid only for a certain period
– Examples: 10, 20, 30, or to age 65
• A single-premium whole life policy provides lifetime
protection with a single premium
• Not likely to be suitable for modest income people
Endowment Insurance
• Endowment policy pays face amount if
insured dies within a specified period
• If the insured survives to the end of
endowment period, the face amount is
paid to the policyowner
Endowment Insurance (cont.)
• Impacted by Deficit Reduction Act of 1984
– New endowment policies no longer meet tax
definition of life insurance
– Caused most life insurers to discontinue sale
of new endowment policies
Endowment Insurance (cont.)
• As a result, endowment policies no longer play a
significant role
– Now represent less than 1% of total life insurance in
force
• However, many older endowment policies are
still in force
– Some are used in tax-qualified retirement plans
Important Variations of Whole Life
1. Variable Life Insurance
2. Universal Life Insurance
3. Variable Universal Life Insurance
4. Current Assumption Whole Life Insurance
5. Indeterminate Premium Whole Life Insurance
Background - Variations of Whole Life
• Life insurance experienced intense
competition from other financial products.
• To remain competitive and overcome
criticism, new products were developed.
• The new products combine insurance
protection and the savings (investment)
component in innovative ways.
Variable Life Insurance
• Variable life insurance is a fixed-premium policy in which the
death benefit and cash values vary according to the
investment experience of a separate account maintained by
the insurer
– The premium is level
– If the investment experience is favorable, the face amount of
insurance is increased
– Cash surrender values are not guaranteed
– Although the insurer bears the risk of excessive mortality and
expenses, the policyholder bears the risk of poor investment results
Variable Life Insurance: Investment
Feature
• Entire policy reserve is held in a separate account
• Policy owner has the option to invest the cash value in a
variety of investments, such as:
– Common stock fund
– Bond fund
– Balanced fund
– Money market fund
– International fund
Variable Life Insurance: Cash
Surrender Values
• Actual cash values depend on investment
experience.
• No minimum guaranteed cash values.
• Insurer bears risk of excessive mortality and
expenses.
• Policy owner bears risk of poor investment
results
Universal Life Insurance
• Universal Life Insurance is a flexible premium
policy that provides lifetime protection
– After the first premium, the policyholder decides
the amount and frequency of payments
• Most policies have a target premium, but the
policyowner is not obligated to pay it
Universal Life Insurance
• The protection and savings components are
unbundled
– the policyholder’s statement shows the premiums
paid, death benefit, and value of the cash value
account
– It also shows the mortality charge and the
interest credited to the cash value account
Universal Life Cash Value
• Universal Life cash values do not follow
a fixed schedule
• Cash values vary 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
Advantages of
Universal Life Insurance
• Universal life provides considerable
flexibility
• Cash withdrawals are permitted
• Policies receive favorable federal income
tax treatment
Universal Life Insurance
– There are two forms of universal life insurance:
• Option A pays a level death benefit during the early
years
– The death benefit increases in later years to meet the
corridor test required by the Internal Revenue Code
• Option B provides for an increasing death benefit
– The death benefit is equal to a constant net amount at risk
plus the accumulated cash value
Exhibit 11.4 Two forms of Universal Life
Insurance Death Benefits
Limitations of Universal Life
• Insurers advertise misleading rates of return
• Cash-value and premium-payment projections
based on higher interest rates are misleading
and invalid
• Insurers can increase the current mortality
charge to recoup expenses
• A policy may lapse because some policyowners
do not have a firm commitment to pay premiums
Annual disclosure Statement
• Shows:
– Premiums paid
– Death Benefit
– Value of cash value account
– Mortality charge
– Expense charges
– Interest credited
Exhibit 11.5 $100,000 Universal Life Policy, Level
Death Benefit, Male Age 25, Nonsmoker, 5.5
Percent Assumed Interest
Exhibit 11.5 $100,000 Universal Life Policy, Level
Death Benefit, Male Age 25, Nonsmoker, 5.5
Percent Assumed Interest
Variable Universal Life Insurance
• Variable universal life is an important variation of
whole life insurance
– Most are sold as investments
– Similar to universal life except that:
• The policy owner decides how the premiums are invested
• The policy does not guarantee a minimum interest rate or
minimum cash value
– These policies have relatively high expense charges,
including front-end loads for sales commissions, back-end
surrender charges, and investment management fees
Characteristics: Variable Universal Life
• Flexible Premiums
• Cash values invested in a wide variety of investments
• No minimum guaranteed rate of interest, and cash
values are not guaranteed.
• Policy has relatively high expense charges.
• Policy has a substantial investment risk.
Exhibit 11.6 Comparison of Major
Life Insurance Contracts
Other Types of Whole Life
Insurance
• A modified life policy is a whole life policy in which
premiums are lower for the first three to five years
and higher thereafter
• Preferred risk policies are sold at lower rates to
individuals whose mortality experience is expected
to be lower than average (e.g., a non-smoker)
• Second-to-die life insurance insures two or more
lives and pays the death benefit upon the death of
the second or last insured
– Usually whole life, but can be term
Life Insurance Contractual Provisions
• Ownership Clause
• Entire Contract Clause
• Incontestable Clause
• Suicide Clause
• Grace Period
• Reinstatement Clause
Life Insurance Contractual Provisions
(cont.)
• Misstatement of Age Clause
• Beneficiary Designation
• Change of Plan Provision
• Exclusions and Restrictions
• Assignment Clause
• Policy Loan Provision
• Automatic Premium Loan
Ownership Clause
• Possible owners:
– Insured
– Beneficiary
– Third party
Owner’s Rights
• Change the beneficiary (unless
irrevocable)
• Surrender the policy
• Receive dividends
• Elect settlement options
Ownership Change
• File appropriate form with company
• Policy may need to be endorsed
• Key point:
– Generally, owner free to exercise rights
– Without beneficiary’s consent
Entire Contract Clause
• Life insurance contract and attached
application
– Constitute the entire contract between the
parties
Entire Contract Clause (cont.)
• Statements made on application are:
– Representations
– Not warranties
• Claim cannot be denied unless:
– Statement made is a material representation
and,
– Statement is part of the application
Two-fold Purpose: Entire Contract
Clause
1. Prevents the Insurer from amending
policy without consent of owner
2. Protects the beneficiary
Incontestable Clause
• Insurer has 2 years to contest the policy
on the basis of:
– Material misrepresentation
– Concealment
– Fraud
Incontestable Clause
• Exception: Limited set of outrageous fraud
situations clearly violating public interest
– Purchase with intent to murder insured
– A person other than applicant takes medical
exam
– Insurable interest does not exist at policy
inception
Suicide Clause
• If insured commits suicide within two years
of policy issuance date,
– Face amount will not be paid
– Instead, refund of premium will be made
• Purpose: Reduce adverse selection
Suicide Clause: Legal Framework
• Legal presumption against finding of
suicide
• Death normally considered an
unintentional act
• Insurer has burden of proof to prove
insured committed suicide
Grace Period
• 31-day period in which overdue premium
can be paid without lapse of policy.
• Insurance is in-force during grace period
• Universal life and other flexible premium
policies provide:
– Longer grace periods
– E. g., 61 days
Reinstatement Clause
• Provision allowing policy owner to reinstate a
lapsed policy
• Requirements:
– Evidence of insurability
– Payment of past-due premiums
– Re-payment or reinstatement of policy loans
– Reinstatement must occur within a certain period,
such as three years or five years
– Policy must not have been surrendered for its cash
value.
Reinstated Policy Vs. New Policy:
Advantages
• Lower premiums
• No additional acquisition expenses
• Higher cash values and dividends
• Suicide and incontestable clause may have expired
• Reinstated policy may contain more favorable policy
conditions (e. g, lower interest rate on loans)
Reinstated Policy: Disadvantages
• Substantial cash outlay required if policy
lapsed for several years
• New life products could have lower
premiums because of:
– Lower mortality rates
– Lower expense assumptions
Misstatement of Age or Sex Clause
• Any amount payable under policy (Death
benefit, cash value, etc.)
• Reflects the amount that premiums would
have purchased if the correct age and sex
had been used.
Misstatement of Age Example
• Male age 35 applies for $20,000 of ordinary life
– Misstates age as 34.
– Actual premium rate charged, age 34, per $1000 of coverage =
$19.
– Premium rate that should have been charged, age 35, per $1000
of coverage = $20.
• If insured dies and misstatement of age is discovered,
death benefit payment reduced as follows:
– 19/20 x $20,000 = $19,000
Beneficiary Designation
• Primary and contingent
• Revocable and irrevocable
• Specific and class
Primary Vs. Contingent Beneficiary
• Primary: First beneficiary entitled to
receive policy proceeds upon insured’s
death
• Contingent: Entitled to receive proceeds if
primary beneficiary dies before the insured
Key Issue: Primary Vs. Contingent
Beneficiary
• Many families name children as contingent
beneficiaries
• Minor children lack legal capacity to
receive policy proceeds directly
Primary Vs. Contingent Issue (cont)
• Many insurers will require a guardian to be
named
• If court appoints guardian, payment may
be delayed and legal expenses incurred.
Primary Vs. Contingent Issue (cont)
• Two possible solutions:
1. Name guardian in will who can legally
receive death proceeds on children’s behalf.
2. Pay policy proceeds to a trustee, who has
discretion and authority to use funds for
children’s welfare
Revocable Vs. Irrevocable
Beneficiary
• Revocable: Policyowner reserves right to
change beneficiary without beneficiary’s consent
• Irrevocable: Beneficiary cannot be changed
without beneficiary’s consent
• Most policies provide that if irrevocable
beneficiary dies before insured,
– All rights to policy revert to owner, who then can
name a new beneficiary
Specific Vs. Class Beneficiary
• Specific: Beneficiary specifically named and
identified
• Class: Member of a class is designated as
beneficiary.
• Most Insurers restrict class designations
because of:
– Problems with identifying members of the class
• Class designation requires great care
Example: ―My Children‖ Vs.
―Children of Insured‖
• ―My children‖ means all children of insured share
equally in policy proceeds, including
– Legitimate
– Illegitimate
– Adopted
• ―Children of Insured‖
– Includes insured’s children by any marriage
– Excludes spouses children by a former marriage
Change of Plan Provision
• Purpose: Provide flexibility to policyowner
to respond to changing needs for
insurance
• Allows exchange of present policy for
different contract
Change of Plan Provision: Rules
1. Change to higher-premium policy:
– Policyowner pays difference in policy reserve
of new policy versus original contract
– No evidence of insurability required
Change of Plan Provision: Rules
2. Change to lower-premium policy:
– Insurer refunds difference in cash values
– Evidence of insurability is required
• Reduced cash value increases insurer’s net
amount at risk
• Lower premium policy provides higher pure
insurance protection
Exclusions and Restrictions
• Suicide clause
– First two years only (most contracts)
– Whole Life Policy in Appendix C has one-year suicide
clause (See p. 681)
• War clause
– Excludes payment if insured dies as a direct result of
war
– Purpose: To reduce adverse selection
– Not contained in all policies
Exclusions and Restrictions (cont.)
• Aviation exclusion – variations:
– Exclude aviation deaths other than as fare-
paying passenger on regularly schedule
airline
– Exclude military aviation or cover at additional
premium only
– Exclude private pilot not meeting certain flight
standards, or charge higher premium
Exclusions and Restrictions (cont.)
• Hazardous activities may be discovered in
initial underwriting:
– Auto racing
– Scuba diving
– Hang-gliding
– Travel or residence in a dangerous country
• Underwriter may exclude or cover only
with payment of extra premium
Payment of Premium
• Payment modes: Annual, semi-annual, quarterly
or monthly
• Carrying charge is relatively expensive
• Example – p.249
o Annual premium: $1,000
o Semiannual premium: $520
o Apparent charge: 4% = $40/1000
o Effective carrying charge:
16.7% = $40/($1000-520) x 2
Assignment Clause
• Life Insurance policy is freely assignable
• Two types of assignment
1. Absolute assignment
2. Collateral assignment
Absolute Assignment
• All ownership rights are transferred to a new
owner:
– Church
– Charity
– Educational Institution
– Insured
– Beneficiary
• New owner receives all ownership rights in the
policy
Collateral Assignment
• Policyowner assigns policy as collateral for a loan
– Previously, American Bankers Association assignment form
was typically used.
– Now, insurers generally use their own collateral assignment
forms.
• Collateral assignment confers limited rights in the
policy
– Assignee entitled to receive death proceeds only to extent of
loan
– Balance of proceeds are paid to beneficiary
Impact of Assignment Clause
• If Insurer is notified of assignment,
– A new contract exists between insurer and assignee
– Insurer recognizes assignee’s rights as superior to
beneficiary’s rights
• If Insurer is not notified of assignment,
– Proceeds are paid to named beneficiary
– Insurer is relieved of any further obligation
– Even if a valid assignment is in existence
Policy Loan Provision
• Allows policyowner to borrow the cash value
– The policyowner must pay interest on the loan to offset the loss
of interest to the insurer
– A policy could lapse if the policyowner does not repay a loan and
the total indebtedness exceeds the available cash value
• Advantages:
– Low annual percentage rate
– No paperwork, no credit check
– Flexibility in repaying, no fixed repayment schedule
• Disadvantages
– Heavy borrowing may cause policy to lapse
– Amount of protection is reduced
Automatic Premium Loan
• Under the automatic premium loan provision, an overdue
premium is automatically borrowed from the cash value
after the grace period expires
• Purpose—to prevent the policy from lapsing
• Main disadvantages:
– Policyowner may become lazy and exhaust some or all of the
cash values
– If cash values are reduced, amount of protection is reduced
– If cash values become exhausted, policy will lapse
Participating Policies
• Participating policy definition:
– Policy which pays dividends
• Participating policy:
– Gives policyowner right to share in the
divisible surplus of insurer
– Can be issued by both a stock insurer and a
mutual insurer
Sources of Surplus for Dividends
1. Higher interest earnings than assumed
2. Lower mortality than expected
3. Lower operating expenses than expected
Dividend Options
1. Cash
2. Reduction of premiums
3. Accumulate at interest
4. Paid-up additions
5. Term insurance
Dividend Options (cont.)
• Cash:
– Dividend payable after policy in force for a
stated period
– Policyowner receives a check usually on
anniversary date
• Reduction of premiums
– Dividend used to reduce the next premium
coming due.
Dividend Options (cont.)
• Accumulate at interest
– Company guarantees minimum rate on dividend
accumulations
– But, may pay a higher rate depending on market
conditions.
• Paid-up additions
– Dividend used as a single premium to buy additional
amounts of paid-up insurance.
Dividend Options (cont.)
• Term insurance (Fifth Dividend)
– Dividend used to purchase term insurance.
• Two options:
1. One-year term
2. Yearly renewal term (limited availability)
Other Dividend Uses
• Convert policy to a paid-up contract
• Policy becomes paid-up
– when reserve value of basic contract
– plus reserve value of paid up additions
– equals reserve value of net single premium
paid-up policy
– at insured’s attained age
Other Divided Uses (cont.)
• Mature policy as an endowment
• Policy will mature:
– When the reserve of basic contract
– Plus reserve of paid-up additions
– Equal the face amount of the policy
Nonforfeiture Options
• The payment to a withdrawing policyowner is known
as a nonforfeiture value or cash surrender value
– A policyowner has a right to the policy’s accumulated
cash value; all states have standard nonforfeiture laws
Non-forfeiture Options
1. Cash Value
2. Reduced Paid-up Insurance
3. Extended Term Insurance
Reduced Paid-Up Insurance
• Cash value used to buy a reduced paid-up
policy
• Appropriate option when person has
limited income, but still has some life
insurance needs
Extended Term Insurance
• Cash value used to extend full face
amount of insurance:
– into the future as term insurance
– for a certain number of years and days.
Exhibit 12.1 Table of Guaranteed
Values*
Settlement Options
• The policyowner can choose among several options for
paying the policy proceeds
– Or, the beneficiary may be granted the choice
• The most common options include:
– Proceeds are paid in a lump sum
– Under the interest option, the proceeds are retained by the insurer,
and interest is periodically paid to the beneficiary
• The beneficiary can be given withdrawal rights
– Under the fixed-period option, the proceeds are paid to a beneficiary
over some fixed period of time
– Under the fixed-amount option, a fixed amount is periodically paid to
the beneficiary until the principal and interest are exhausted
Settlement Options
– Under the life income option, installment payments are
paid only while the beneficiary is alive and cease on the
beneficiary’s death
• There is no refund feature or guarantee of payments
– Other life income options include:
• Life income with guaranteed period: if the beneficiary dies before
receiving the guaranteed number of years of payments, the
remaining payments are paid to a contingent beneficiary
• Life income with guaranteed total amount: if the beneficiary dies
before receiving installment payments equal to the total amount
of insurance placed under the option, the payments continue until
the total amount paid equals the total amount of insurance
• Under the joint-and-survivor settlement option, income payments
are paid to two persons during their lifetimes, such as a husband
and wife
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
• Uses—when income needed for definite period of time:
– Social Security ―black-out‖ period
– readjustment period
– family dependency period
• Limitations—inflexible; partial withdrawals not allowed
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
Life Income Settlement Options
1. Life income only
2. Life income with a period certain
3. Life income with refund option
4. Joint-and-survivor life income option
Exhibit 12.2 Income for Elected Period
(minimum monthly payment per $1000
of proceeds)
Exhibit 12.3 Life Income with
Guaranteed Period (minimum monthly
payment per $1000 of proceeds)
Exhibit 12.4 Life Income with Guaranteed
Total Amount (minimum monthly payment
per $1000 of proceeds)
Exhibit 12.5 Joint-and-Survivor Income
Option 10-Year Guaranteed Period
(minimum monthly payment per $1000 of
proceeds)
Settlement Options
A. Cash—most proceeds are paid as cash
B. Interest Option
C. Fixed Period Option
D. Fixed Amount Option
E. Life Income Options
Settlement Options: Advantages
• Periodic income to the family
• Guaranteed principal and interest
• Can be useful in life insurance planning
• Long-term guarantees
• No additional cost
Settlement Option: 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.
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.
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 trustee’s fee
– Returns not guaranteed
Additional Life Insurance Benefits
• Waiver-of-Premium
• Guaranteed Purchase Option
• Double Indemnity Rider
• Cost-of-Living Rider
• Accelerated Death Benefits Rider
Additional Life Insurance Benefits
• Other benefits can be added to a life insurance policy for an
additional premium
– Under a waiver-of-premium provision, if the insured becomes totally
disabled, all premiums coming due during the period of disability are
waived
• In many cases, total disability means that the insured cannot do any of
the essential duties of his or her job for which he or she is suited based
on schooling, training, or experience
– The guaranteed purchase option permits the policyowner to
purchase additional amounts of life insurance at specified times in
the future without evidence of insurability
• The option guarantees the purchase of specified amounts of life
insurance in the future even though the insured may become
uninsurable
Additional Life Insurance Benefits
• The accidental death benefit rider doubles the face amount
of life insurance if death occurs as a result of an accident
– Also known as double indemnity
• The cost-of-living rider allows the policyowner to purchase
one-year term insurance equal to the percentage change in
the consumer price index with no evidence of insurability
• The accelerated death benefits rider allows insureds who
are terminally ill to collect part or all of their life insurance
benefits before they die
– Forms include: a terminal illness rider, catastrophic illness rider, and
long-term care rider
Additional Life Insurance Benefits
• A viatical settlement is the sale of a life insurance policy
by a terminally ill insured to another party, typically an
investor group, who hopes to profit by the insured’s early
death
• A life settlement is the sale of a life insurance policy by a
policyowner who no longer needs or wants the insurance
• These options create a moral hazard problem, and may
not be adequately regulated by the states