Chapter 10 Life Insurance Planning and Purchasing Decisions

							                    Chapter 10
             Life Insurance Planning
            and Purchasing Decisions
• Appropriate amount and type of insurance
• Measuring the cost
• Issues with Illustrations and Replacement
• Substandard coverage
• Viatical agreements and Life settlements
• Business uses of life insurance
• Tax treatment of life insurance
• Life insurance in estate planning
        Determining Amount of
         Life Insurance Need
• Multiple of Income Approach - simplistic
  approach to life insurance planning that
  determines life insurance needs based on the
  client’s current annual income

• Human Life Value Approach – capitalizing
  the present value of a person’s estimated
  future income that will be used to support
  those dependent on that income
         Determining Amount of
          Life Insurance Need
• Financial Needs Analysis – an approach to
  determine how much life insurance a client
  needs if the principal sum is to be liquidated
  in meeting the client's financial objectives for
  his or her survivors
• Capital Needs Analysis - an approach to
  determine how much life insurance is needed
  to provide a principal sum adequate to fund
  survivors’ needs while preserving the
  principal
              Financial Needs
Lump-sum (Cash) Needs
• Final illness costs
• Outstanding debt
• Estate administration and taxes
• Probate and legal expenses
• Funeral, burial, etc.
• Short-term living and household expenses
• Emergency fund
              Financial needs
Ongoing Income Needs
• Readjustment income
• Dependency period- minor children
• Blackout period- period between when
  youngest child turns 16 and spouse turns 60
• Surviving Spouse income with social security
  and pension
           Financial Needs Analysis

• Identify lump-sum and ongoing income needs
• Identify resources
      Needs – resources = deficit
• Calculate deficit for each period
• Determine NPV (net present value) of the deficit
for each period using appropriate discount rate
Life insurance in that amount funds previously
unfunded objectives
               Example: The Stringers
 INCOME

 $70,000


 $60,000


 $50,000


 $40,000

                                                 Income Gap
 $30,000


 $20,000
                       Earned Income

 $10,000
                                                                   Pension, Social
               Social Security                                     Security,   Misc .

Amy’s
           27 28                       41   45                65
 Age

Laura’s
           4   5                       18   22
  Age
         Capital Needs Analysis
• Complete a financial needs analysis to
  determine capital needs
• Determine client’s net worth
• Subtract illiquid assets (not used for income)
• Subtract lump-sum needs
• Needs – resources = deficit
• Deficit/applicable interest rate
  – Resulting capital sum will produce enough
    income to meet the deficit without
    liquidating capital fund
     Choosing Type of Insurance
Term features
• Temporary coverage
• Low initial premium
• Rising premium
• Margin for adverse selection
• Level, increasing, or decreasing death
  benefits
Appropriate use of term
• Hedge a loan
• Offset speculative business investment
• Dependent children
  Buy Term and Invest the Difference?

• Safety of principal and income

• Rate of return

• Liquidity

• Assurance that saving will be done (forced
  saving)
      Choosing Type of Insurance
• Length of the planned premium-paying period
• Emphasis on saving vs. protection
• When death benefits are needed
• Desire for inflation protection
• Importance of yield vs. safety in savings
• Unbundling of cost components
• Premium flexibility
     Measuring Cost of Insurance
• Surrender cost index
  – estimates the net cost of life insurance on
    a time-value-adjusted basis, assuming the
    policy will be surrendered at a specified
    time (10 or 20 years)
• Net payment cost index
  – estimates the net cost of life insurance on
    a time-value-adjusted basis assuming that
    the death benefit will be paid at a specified
    time period (10 or 20 years)
         Life Insurance Illustrations
• Tables or graphs depicting a policy’s
  performance over a period of years
• Includes nonguaranteed elements. Company
  makes assumptions about future performance
• They are of limited value for comparing different
  policies
• NAIC model regulation prohibits inappropriate
  use of illustrations, requires annual reports on
  universal life policies
                  Replacement
• Replacing existing life insurance policy with another
• To prevent financial harm to the policyowner, agents
  and insurers must follow prescribed procedures
• Includes 1035 exchanges

Issues in replacement
• pay high first-year expenses again?
• higher premium?
• new suicide clause?
• new incontestable clause?
• more or less favorable policy terms?
          Section 1035 Exchange
• Defers tax implications of policy replacement
• Old and new contract must cover same insured
  and have same policyowner
• Life contract may be exchanged for annuity,
  annuity may be exchange for life insurance, but
  annuity may not be exchanged for life insurance
• Must follow certain required procedures, such as
  life to life, life to annuity, annuity to annuity
    Substandard Coverage Methods
• Rate-up age method
   – bases premium rate and policy values on an age older than
     the actual age. Used when extra mortality is increasing.
     Increases policy values
• Extra percentage tables
   – separate, higher-than-normal mortality rates are used in
     calculating the premium when hazard is increasing. Normally
     no change in policy values
• Flat extra premium
   – charging a specified extra premium per $1,000 of insurance
     regardless of age. Normally temporary. No change in cash
     values or dividends. Extra mortality is constant
• Lien
   – death proceeds are reduced if death occurs within the first
     few years of coverage. Often prohibited by state law.
           Viatical Agreements and
                Life Settlements
• Viatical settlement- sale of a life insurance policy
  where insured is terminally ill and doctor-certified to
  have less than 2 years life expectancy.
• Policyowner sells policy to third party for more than
  cash value but less than face amount.
• New owner responsible for premium payments and
  receives death benefit payable.
• Life settlements involve sale of policy to investors or
  others where terminal illness is not a factor.
• Can raise cash for seniors who need cash but no
  longer need, want or can afford life insurance
• Raises ethical issues, with much state regulatory
  activity currently (STOLI, IILI)
           Business Insurance
• Key Employee Insurance - protects a
  business against possibility of income loss
  and/or expense increase following a key
  employee’s death Employer owns policy and
  is beneficiary. Premium not tax-deductible

• Buy-Sell Agreement - a contract binding the
  owner of a business interest to sell the
  business interest for a specified or
  determinable price at his or her death or
  disability and a designated purchaser to buy
  at that time
           Buy-Sell Agreements
• Entity Agreement - a business buy-sell
  agreement in which the business itself is the
  designated purchaser of the deceased's
  business interest

• Cross-Purchase Agreement - a business buy-
  sell agreement in which the surviving co-owners
  will be the purchasers of the business interest of
  a deceased owner
             Section 79 Plans
• Employer-sponsored group life plans that
  permit the employer to take a tax deduction
  on premium payments for coverage up to
  $50,000 if plan is not discriminatory

• Coverage above $50,000 is taxable income
  for employees based on premium rates
  specified in Table I by the IRS
          Split-Dollar Life Insurance
• A plan under which two parties, usually an employer and
  an insured employee, share the premium costs, death
  proceeds, and perhaps cash value of a life insurance
  policy pursuant to a prearranged agreement

• If employee owns policy, employer paid premiums
  treated as loans. Employee pays market-interest rate

• If employer owns policy and pays premium, employee
  pays tax on economic benefit on value of life insurance
  protection and employee’s interest in cash value
  increases
   Tax Treatment of Life Insurance
Death Benefits
   – Generally not taxable income to beneficiary
   – Exceptions
       • Transfer for value rule (policy transferred for
         valuable consideration)
       • Failing IRS definition of life insurance
Living benefits
• Dividends, withdrawals, policy loans, and cash
  surrender
   – Returns exceeding policyholder’s basis taxable
   – Inside buildup not taxable
   – 1035 exchange not taxable
           Income Tax Definition
              of Life Insurance
• Cash Value Accumulation Test- determines if
  a life insurance policy meets the definition of life
  insurance for federal income tax purposes. To
  qualify, the cash value must not exceed the net single
  premium needed to fund the policy's death benefit.

• Guideline Premium and Corridor Test –a
  two-pronged test determines if a life insurance policy
  meets the definition of a life insurance policy for
  federal income tax purposes. The test relates to both
  the size of the total premium paid and the size of the
  death benefit relative to the cash value.
    Tax Treatment of Life Insurance
• Inside Buildup - the increase in the cash value
  or investment fund of a permanent life insurance
  policy is not taxable while in the policy


• Modified Endowment Contract (MEC) - a life
  insurance policy that fails to meet the IRC’s 7-
  pay test. Distributions receive less favorable tax
  treatment than other life insurance contracts.
  MEC’s taxed like an annuity
     Tax Treatment of Life Insurance
Deductibility of Premium Payments
• Generally, premiums for personally owned
  individual life insurance is not tax-deductible
• Three situations in which life insurance
  premiums may be deductible
   – Charitable contribution
   – Employer sponsored benefit (if taxable to
     employee)
   – As part of Alimony for ex-spouse
     Transfer Taxation - Gift Tax
Gift tax- a tax imposed on transfers of property
  by gift during the donor's lifetime

Gift - for federal gift tax purposes, a completed
  transfer and acceptance of property for less
  than full and adequate consideration

Annual Exclusion - the amount of a gift
 exempt from federal transfer taxation (for
 2008, $12,000). Can be doubled if the donor
 is married and the donor's spouse elects to
 split the gift (2008- $24,000)
    Transfer Taxation - Estate Tax
• Estate tax - a tax imposed by the federal
  government and many states on the right of a
  person to transfer property at death

• Gross Estate - for federal estate tax
  purposes, the property of a decedent that
  passes by will and by other means

• Incident of ownership - any right to the
  economic benefits of a piece of property,
  such as a life insurance policy
    Life Insurance in Estate Planning
Federal Estate Taxation of Life Insurance
Life insurance included in the estate if:
• proceeds payable to the estate or executor
• insured had incidents of ownership
• insured had incidence of ownership on
transferred policy within 3 years of death
    Life Insurance in Estate Planning
Techniques using Life Insurance in Estate
  Planning
• Gifts of life insurance policies to ILIT (Irrevocable
  life insurance trust) or family member. Prevent
  estate inclusion using annual exclusion
• Providing estate liquidity, pay estate expenses
• Enhance estate value
• Wealth replacement
• Use of second-to-die policies (for unlimited
  marital deduction)
             Annuities - Chapter 11
•   Nature and Types of annuities
•   Joint annuities
•   Variable annuities
•   Indexed annuities
•   Actuarial considerations, fees and charges
•   Federal income tax treatment
•   Uses of annuities
•   Ethical issues
•   Uses of annuities in structured settlements
•   Impaired risk annuities
              Types of Annuities
• Annuity - a periodic payment to begin at a
  specified or contingent date and continue for a
  fixed period or for the duration of a designated
  life or lives

• Annuitant - the person whose life governs the
  duration of benefit payments under a life annuity
              Types of Annuities
• Annuity certain - an annuity with benefit
  payments that continue for a definite period of
  time without being linked to the duration of a
  specified human life (fixed period annuity
• Life (whole life) annuity - an annuity whose
  benefit payments continue for the duration of a
  designated life
• Temporary life annuity - an annuity whose
  benefit payments continue until the earlier of the
  death of a designated person or the end of a
  specified period of time. The term life with
  annuity indicates a life contingency
      Life Insurance versus Annuities
Life insurance
• Protect against loss of income from premature death
• Pooling—those who live longer subsidize those who
   don’t
• Premiums based on mortality table focusing on
   probabilities of death
• Premiums discounted for future interest earnings
Annuities
• Protect against loss of income from longevity
• Pooling—those who die early subsidize those who live
   long
• Different mortality table- annuitants live longer. Focuses
   on probability of surviving
• Premiums (deposits) discounted
            Types of Annuities
• Joint (joint-life) annuity - benefit
  payments continue only until the first death
  among specified lives (rarely used)

• Joint-and-last-survivor annuity - benefit
  payments continue until the last death
  among specified lives
            Types of Annuities
• Immediate annuity - benefit payments begin
  one payment interval after the date of purchase
• Deferred annuity - benefit payments begin
  more than one payment interval after the date of
  purchase
• Accumulation period - period during which
  premiums (deposits) are paid to the insurer
• Liquidation period - period during which
  benefits are paid by the insurer
              Types of Annuities
• Pure (straight life) annuity - provides no
  guaranteed minimum number of benefit
  payments or refund of the purchase price; pays
  for life of the annuitant; stops at death. Provides
  highest payout and greatest risk. Also called life-
  no refund annuity

• Refund annuity - promises to return a portion or
  all of the purchase price or to provide a
  guaranteed minimum number of benefit
  payments, no matter how early in the liquidation
  period the annuitant dies
              Types of Annuities
• Installment refund annuity - if the annuitant
  dies before receiving total benefit payments
  equal to the purchase price of the annuity, the
  difference will be refunded in the form of
  continuing benefit payments

• Cash refund annuity - if the annuitant dies
  before receiving total benefit payments equal to
  the purchase price of the annuity, all or a stated
  percentage of the difference will be refunded in
  cash
             Types of Annuities
• Fixed annuity - provides a stated periodic dollar
  benefit regardless of the insurer's investment
  return
• Variable annuity - benefit payments vary with
  changes in investment performance
• Life annuity certain - provides a guaranteed
  minimum number of benefit payments whether
  the annuitant lives or dies. Combines an annuity
  certain and a pure deferred life annuity. Also
  called period-certain
           Annuity Contract Design
• Premiums quoted in $100 of annual premium or per $10
  of monthly income
• Minimum guaranteed rate of interest
• Secondary higher guaranteed rate (for first several
  years)
• Cash withdrawals may reduce secondary rate
• Bail-out provision (% drop in rate allows withdrawal)
• Cash option (withdrawal or partial surrender - allows an
  annuitant, at the start of the liquidation period, to
  withdraw the funds in cash rather than as an annuity
         Variable Annuity Contract
Accumulation units - number of units bought and
 value of each unit vary depending on when
 purchases are made. Units reflect market value,
 like NAV of mutual fund shares

Annuity units - number of annuity units distributed
 periodically is constant, but their value varies
 depending on company assumptions regarding
 mortality, expense and investment experience.
 Units revalued annually to determine life income
 per unit for coming year
              Indexed Annuity
• Guarantees a minimum fixed rate of interest
  credits but also provides higher credits if a
  specified common stock index rises sufficiently
• Many variations in products regarding
   – Participation rates
   – Cap rates
   – Indexing formula
• Possible SEC regulation requiring product to be
  treated as a security
               Annuity Mortality
• Purchasers of annuities have generally lower
  mortality rates than others (adverse selection).

• Mortality rates for most people, including
  annuitants, have been declining.

• A high percentage of annuitants are women,
  who have greater average longevity than men.
             Fees and Charges
• Mortality and expense charge

• Investment management fee

• Administrative or maintenance fee

• Front-end load

• Surrender charge (back-end load)
     Federal Income Tax Treatment
   Amounts received during accumulation period
–Taxable to the extent of income earned (LIFO)
–10% tax on withdrawals before 59 ½

      Amounts received during liquidation period
–Depends on exclusion ratio – amount invested/the
amount expected to be received as life annuity.
–Amount excluded ratio x payment = tax-free return of
principal.
–Excluded amount, presumed to be return of investment,
is not taxable
–Balance is taxable
                   Annuity Uses
• Those seeking to accumulate an estate or hedge against
  adverse financial developments
• Those seeking guaranteed income, especially retirement
• Charitable gift annuities - can meet three goals:
   – contributing to religious, educational, or other
     charitable organization
   – providing life income for annuitant(s)
   – minimizing taxes
• Impaired-risk annuities - increased annuity payments (or
  reduced premiums) reflect annuitant’s reduced life
  expectancy due to injury or poor health
                 Ethical Issues
Insurance producer and/or insurer should have
reasonable grounds for believing the proposed
annuity is suitable for the consumer based on
facts the consumer provides concerning
   – financial status
   – tax status
   – investment objectives
   – other reasonable information
• There is regulatory concern about suitability for
older clients, especially with variable annuities
           Charitable Gift Annuity
• Charitably-inclined client donates cash or other
  asset to charity.
• Charity pays annuity income for life of annuitant
  to donor or other beneficiary (called a charitable
  lead trust)
• Client entitled to immediate tax deduction for
  irrevocable gift to charity based on value of gift
  and IRS annuity tables that determine present
  value of annuity based on age and federal
  interest rate, like exclusion ratio.
            Structured Settlement
• An agreement to pay a specified set of periodic
  benefits in lieu of (or in addition to) a single,
  lump-sum amount

• Used when settling liability claims for bodily
  injury or wrongful death

• Provide financial security, management of
  benefits, guaranteed payout, and benefits that
  can be matched to need (court order)
       Self-Test Questions Chapter 10
1. Using a simple multiple of earnings method to determine the
   amount of life insurance needed ignores key information about how
   much a client has already accumulated.
2. The financial needs analysis approach considers both lump-sum
    needs at death and ongoing income needs.
3. With the financial needs analysis approach, the amount of additional
   life insurance needed is determined by subtracting the resources
   already available from the resources needed by the surviving
   dependents if the client should die today, assuming all future
   income payments are composed solely of investment earnings on a
   capital sum.
4. A major advantage of the financial needs analysis approach is that it
   fails to take into account factors that may be difficult to forecast,
   such as Social Security benefits and future earnings by a spouse.
5. Although term insurance is available in the marketplace, virtually all
   client life insurance needs are best met with whole life insurance.
      Self-Test Questions Chapter 11
1. The person whose life governs the duration of payments
in an annuity is called the annuitant.
2. Annuities serve essentially the same function as life
insurance.
3. If Jack would like to accumulate money for his planned
retirement in 20 years, he should purchase an immediate
annuity with periodic premiums.
4. If Rachel purchased a life annuity with 20 years certain
to liquidate her retirement savings and was still alive at the
end of 20 years, her annuity benefit payments would
cease.
5. An installment refund annuity promises to keep paying
installment benefits to the annuitant and/or beneficiary until
the total equals the purchase price of the annuity plus
interest at a guaranteed rate.