Chapter 13 3/2/2015. Agenda. Determining the Cost of Life Insurance 3. Buying Life Insurance

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1 Chapter 13 Buying Life Insurance Agenda 2 Determining the Cost of Life Insurance Rate of Return on Saving Component Taxation of Life Insurance Shopping for Life Insurance Determining the Cost of Life Insurance 3 The cost of a life insurance policy is the difference between what you pay and what you get back When determining the cost of life insurance, four major factors must be considered: 1. Annual premiums 2. Cash values 3. Dividends 4. Time value of money 1

2 Determining the Cost of Life Insurance 4 Under the traditional net cost method, the cash value and expected dividends are subtracted from annual premiums to obtain a net cost per year figure This method does not consider the time value of money Traditional Net Cost Method 5 Determining the Cost of Life Insurance 6 The interest-adjusted cost method is more accurate because it considers the time value of money Two interest-adjusted cost indices: The surrender cost index is useful if the owner expects to surrender the policy after some time period The net payment cost index is useful if the owner expects to keep the policy in force 2

3 Surrender Cost Index 7 Surrender Cost Index 8 Net Premiums: Compute the FVA of the premiums Subtract the FV of the dividends Subtract the Cash Value (@ 20 yrs) Apply the discount factor Divide Net Premium by FVAD of $1 FVAD = [(1+r)/r][(1+r) T 1] Divide by Coverage Net Payment Cost Index 9 3

4 Net Payment Cost Index 10 Net Premiums: Compute the FVA of the premiums Subtract the FV of the dividends Apply the discount factor Divide Net Premium by FVAD of $1 FVAD = [(1+r)/r][(1+r) T 1] Divide by Coverage Determining the Cost of Life Insurance 11 Interest-adjusted cost indices can be used to compare policies across insurers There is a wide variation in costs indices across insurers it pays to shop around! Most consumers use premiums as a basis for comparison, but agents will supply cost indices Comparison of Interest-Adjusted Costs for Selected Companies 12 4

5 13 Determining the Cost of Life Insurance The Life Insurance Policy Illustration Model Act requires insurers to present certain information to applicants for life insurance The goal is to reduce misunderstanding of policy values by policyowners, and reduce deceptive sales practices by agents A narrative summary describes the basic characteristics of the policy A numeric summary shows the premium outlay, value of the accumulation account, cash surrender values and death benefit The act also prohibits certain sales practices and requires the insurer to provide an annual report Rate of Return on Saving Component 14 The annual rate of return earned on the savings component of a policy is an important consideration if you intend to invest over a long period of time The Linton yield is the average annual rate of return on a cash value policy if it is held for a specified number of years Current information is not readily available to consumers, so the method has limited use Average Annual Rates of Return for 109 Cash-Value Policies by Year of Policy 15 5

6 Rate of Return on Saving Component The yearly rate of return method is based on a formula: The information needed for the calculation is readily available to consumers 16 Benchmark Prices 17 Taxation of Life Insurance 18 Life insurance proceeds paid in a lump sum to a designated beneficiary are generally received incometax free The interest component of periodic payments is taxable as ordinary income Premiums are generally not deductible Dividends are not taxable, but interest on dividends retained is taxable If a policy is surrendered for its cash value, any gain is taxable as ordinary income 6

7 Taxation of Life Insurance 19 Proceeds from a life insurance policy are included in the gross estate of the insured for federal estate-tax purposes if: the insured has any ownership interest they are payable to the estate The proceeds may be removed from the gross estate if the policyowner makes an absolute assignment of the policy to someone else The policyowner must make the assignment more than three years before death Taxation of Life Insurance 20 A federal estate tax is payable if the decedent's taxable estate exceeds certain limits A tentative tax on the taxable estate value is calculated The gross estate includes property you own, one-half of the value of property owned jointly with your spouse, life insurance death proceeds in which you have ownership interest The gross estate may be reduced by certain deductions, such as a marital deduction, in determining the taxable estate The taxable estate may be reduced or eliminated by a tax credit called a unified credit The amount of property exempt from taxation will increase in the future Federal estate taxes are scheduled to expire in 2010 Tax will be reinstated in 2011 unless Congress acts Calculating Federal Estate Taxes * 21 7

8 Calculating Federal Estate Taxes * 22 Calculating Federal Estate Taxes 23 Individual dies in 2010 No estate tax Basis for future tax changed Individual dies on 2011, 2012 $5M exemption, 35% tax rate 99.5% of estates are expemt Individual dies on $1M exemption, 55% tax rate Shopping For Life Insurance 24 8

9 Rating Categories for Major Rating Agencies 25 Chapter 13 Appendix Calculation of Life Insurance Premiums 27 Premium Calculations in Life Insurance The net single premium (NSP) is defined as the present value of the future death benefit The NSP is based on three assumptions: Premiums are paid at the beginning of the policy year Death claims are paid at the end of the policy year The death rate is uniform throughout the year This is just an Expected Present Value calc. 9

10 Calculating the Net Single Premium for Term Insurance For yearly renewable term insurance, the cost of each year s insurance is easily determined: 28 Commissioners 2001 Standard Ordinary (CSO) Table of Mortality, Male Lives (selected ages) Present Value of $1 at 5.5% compound interest 10

11 31 Calculating the Net Single Premium for Term Insurance For a five-year term policy, the cost of each year s mortality must be computed separately for each of the five years and then added together to determine the NSP Calculating the NSP for a Five-Year Term Insurance Policy, Male, Age Calculating the Net Single Premium for Ordinary Life For an ordinary life insurance policy, the cost of each year s mortality must be computed separately for each year to the end of the mortality table, and then added together to determine the NSP 11

12 Calculating the Net Annual Level Premium The net annual level premium is calculated using a formula: If premiums are paid for life, the premium is called a whole life annuity due If premiums are paid for only a temporary period, the premium is called a temporary life annuity due 34 Policy Reserves 35 Under the level-premium method for paying premiums, premiums paid during early years are higher than necessary to pay death claims The excess premiums are reflected in the policy reserve Policy reserves are a liability item on the insurer s balance sheet that must be offset by assets equal to that amount The policy reserve is the difference between the PV of future benefits and the PV of future net premiums The policy reserve has two purposes: It is a formal recognition of the insurer s obligation to pay future claims It is a legal test of the insurer s solvency Prospective Reserve Ordinary Life Insurance (1980 CSO mortality table) 36 12

13 Policy Reserves 37 The retrospective reserve represents the net premiums collected by the insurer for a particular block of policies, plus interest earnings at an assumed rate, less the amounts paid out as death claims The prospective reserve is the difference between the present value of future benefits and the present value of future net premiums Both methods will produce the same level of reserves at the end of any given year under the same actuarial assumptions Policy Reserves 38 A terminal reserve is the reserve at the end of any given policy year The initial reserve is the reserve at the beginning of any policy year The mean reserve is the average of the terminal and initial reserves. It is used to indicate the insurer s reserve liabilities on its annual statement Case Application 39 13