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CHAPTER 8:

INSURING YOUR LIFE

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Basic Insurance Concepts

Basic purposes of insurance:

Protect you and your dependents from losing the assets that you’ve already acquired.

Shield you and your family from an interruption in your expected earnings.

8-3Insurance Planning Needs: Auto & Homeowners Insurance

– Reimburses for damage or destruction to existing assets

Life Insurance– Replaces income lost due to premature

death

Disability Insurance – Replaces income lost due to disability

Hospitalization & Health Insurance – Covers medical costs from illness or

accident

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Concept of Risk

Risk is defined as uncertainty with respect to economic loss.

Insurance planning is used to reduce the risk that losses will cause financial devastation.

Risk can be dealt with in the following ways:

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Risk Avoidance:

Not participating in activities that have the risk of loss.

Example—not driving to avoid the risk of an auto accident.

Risk avoidance is not always practical or possible!

8-6Loss Prevention and Control: Prevention reduces the chance that a

loss will occur.

Example: Driving within the speed limit reduces the likelihood of an accident.

Control reduces the severity of a loss once it occurs.

Example: Wearing a seat belt can minimize the effects of an accident.

8-7Risk Assumption: You bear the risk of loss yourself.

Example: When your calculator gets stolen, you bear the cost out of pocket.

Transferring Risk: Pay someone else to bear your risk of loss.

Example: You transfer the risk to the insurance company when you buy an insurance policy.

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Underwriting

Process in which the insurance company decides whom to insure and the rate to be charged.

Company must guard against adverse selection, a disproportionate number of bad risks.

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Combine the loss experiences of large numbers of people.

Calculate probability of frequency of occurrence and amount of loss using past experience.

Charge rates in proportion to level of risk.

It is economically feasible for insurance companies to assume risk because they:

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Benefits of Life Insurance

Financial protection for dependents:

–Provide financial security for those who depend on your income.

–Prevent a decline in their standard of living.

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–Before death, cash value in life insurance policies usually protected against legal judgments and bankruptcy proceedings.

–After death, possible to keep benefits out of estate and away from creditors.

Protection from creditors:

8-12Tax benefits:–Savings portion grows tax free unless

withdrawn.

– For taxpayers in higher income brackets, these relatively low returns become more attractive as income taxes take a greater bite from current income and short-term capital gains.

–Proceeds not income taxable to beneficiaries.

–Possible to avoid estate taxation on proceeds.

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Medium for savings:

–Provides a means of forced savings for those who would not do so otherwise.

–Provides preservation of capital for those who desire a relatively safe, conservative investment.

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Do You Need Life Insurance?

Consider life insurance – If you have dependents who count on

your financial support.– If you have debts you would like to clear,

like a home mortgage.

You may not need life insurance– If no one depends on your support.– If you are a child.

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Techniques for estimating life insurance needs: Multiple-of-Earnings Method

Multiply annual earnings by an arbitrary number

Needs Analysis Method

Estimate needs and examine available resources

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How Much Life Insurance Is Right For You?

Family income Additional expenses Special needs of

dependents Pay off debts Liquidity

Step 1: Assess Family’s Economic Needs

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Savings and investments Social Security benefits Pension or retirement plans Other life insurance Income of surviving spouse or

children Real estate or other assets

Step 2: Evaluate Financial Resources

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This is the amount of life insurance needed to provide your family with the desired standard of living.

Step 3: Calculate the Difference

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What Kind of Policy Is Right for You?

Benefit paid if insured dies during the policy period.

When time period over, no more protection unless renewed.

No savings component.

1. Term insurance:

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Types of Term Insurance:

Straight term

Coverage remains the same while premiums increase.

Decreasing term

Premiums remain the same while coverage decreases.

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Important features to look for in term insurance: Renewability

Allows insured to renew policy without evidence of insurability.

Convertibility

Allows insured to convert to whole life policy without evidence of insurability.

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Advantages of Term: Economical way for young families

to purchase large amounts of life insurance.

Provides for needs that will disappear over time.

Disadvantages of Term: Premiums become more costly as you

get older. Does not build cash value.

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2. Whole life insurance:

Provides death protection plus a savings feature called cash value.

If policy canceled prior to death, insured has right to cash value; this is the nonforfeiture right.

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How the cash value accumulates in a $200,000 whole life policy:

$200,000

$100,000

$030 40 50 60 70 80 90 100

CashValue

Age of insured

8-25Types of Whole Life Policies:

Continuous premium (straight life)Level premiums paid until death or cancellation of policy.

Limited payment Level premiums paid for a specified number of years; insurance remains in force until death.

Single premiumLifetime coverage purchased with a single premium.

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Advantages of Whole Life:

Provides a savings vehicle.

Cash value can be borrowed against.

Premiums remain constant.

Cash value accumulates tax-free until redeemed.

8-27Disadvantages of Whole Life: Dollar for dollar provides less death protection

than term for young people.

Relatively low return on savings.

Loans must be repaid with interest or—

Tax penalties may be assessed on cash values withdrawn early.

If you have a loan outstanding when you die, that amount is subtracted from the face value of your policy.

8-283. Universal life insurance: Provides death protection plus a

savings feature.

Premiums are “unbundled” into 2 separate accounts.

Savings grow at the current interest rate vs. guaranteed minimum rate.

Provides flexibility in premiums paid and death benefit.

Understand the risks before you buy!

8-294. Other Types of Life Insurance:

Variable life insurance

–Provides death protection plus a savings, or cash value, feature.

–Cash value can be invested in a variety of mutual funds for greater possible return.

–Returns not guaranteed and actual death benefit can vary.

8-30 Variable universal life insurance–Combines the flexibility of premium

payment feature of universal with the investment choices offered by variable.

Group life insurance–Usually term insurance that is offered

through employers.

–Premiums usually lower than those on individually purchased policies.

8-31 Credit and mortgage life insurance– Type of decreasing term insurance.

–Pays off outstanding loan balance if borrower dies before loan is repaid.

–Usually a costly form of coverage.

–Consider increasing your regular term insurance coverage instead.

Industrial life insurance–Whole life policies with small face

amounts.

– For low-income families.

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Buying Life Insurance

Know the amount and type of coverage you need.

Compare costs and features.

Select a large, highly rated, financially secure company.

Select a reputable agent.

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Key Life Insurance Contract Features

Beneficiary clause Settlement options Policy loans Premium payments Grace period Nonforfeiture options Policy reinstatement Change of policy

Multiple indemnity Disability clause Guaranteed

purchase options Suicide clause Exclusions Participation Living benefits Viatical Settlement