Risk Management and Insurance Planning Chapter 26 Tools & Techniques of Financial Planning Copyright...

Risk Management and Insurance Planning

Chapter 26Tools & Techniques of

Financial Planning

Copyright 2009, The National Underwriter Company 1

Understanding Risk Management

• Understanding risk management starts with understanding the two terms:

– Risk – The uncertainty of loss. “Pure risk” is the occurrence of some uncertain event that can only result in a loss, such as from a hurricane or fire. “Speculative risk” includes the possibility of gain or loss, such as a stock investment, casino gambling, or playing the lottery.

– Management entails a process of planning, organizing, directing, and monitoring.



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Understanding Risk Management

For personal financial planning purposes, risk can be defined as the uncertainty of financial loss (that is, pure risk – excluding investment loss), and risk management is concerned only with minimizing the risk of such losses.

– Risk management is not insurance management, although the insurance product does provide a tool in the risk management process.



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The Purpose of Risk Management

The need for an organized approach to deal with risk potentials cannot be overstated.

– It is important to apply the steps of risk management to provide consistency as you review all of a client’s loss exposures.

– Always keep in mind the goal of reducing the likelihood that something important will be overlooked.



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Purpose of Risk Management

Viewed from other perspectives, the purpose of risk management is

1. Conserve assets – Allow an individual or business to continue normal activities with as little disruption as possible, without financial hardship.

2. Balance resources – Assess exposures before and after a loss to evaluate benefit of a technique.



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Steps in the Risk Management Process

• Step 1 – Identify, Analyze and Measure.

• Step 2 – Select the Risk Management Technique.

• Step 3 – Implement the Techniques Chosen.

• Step 4 – Monitor the Results.



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Step 1 - Identify, Analyze and Measure

There are four general categories of identifiable possible loss exposure:

– Physicala) property - home, auto, personal propertyb) loss of income or profit due to increased expenses

– Financial – liability due to intentional act or negligence of the client or others

– Contractual – loss assumed under a contract or through an association with others

– Human – value of human lifea) key employeeb) financial needs associated with an accident, illness, or death



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Identify Possible Causes

• The next phase is to identify the possible causes of a loss, that is, the perils. For example, common causes of property loss include fire, lightening, and flood.

• Insurance can manage a particular risk, in two ways.

1. The policy identifies the perils specifically insured.

2. The policy insures all perils except those specifically excluded.



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Measure the Loss Potential

• When attempting to measure the loss potential, the factors in determining the amount of the loss include

• The value of the property• The value of assets exposed to liability claims (e.g., as

a result of an auto accident)– You would consider the amount you can afford to lose and the

amount of liability insurance that is appropriate. In this context, basic life insurance needs would be analyzed looking to the loss of income, the assets already accumulated, and the financial needs, which must be funded.

One of the first loss exposures that most financial planners handle with insurance is liability arising out of home or auto in excess of current policy limits. An umbrella liability policy, which picks up when the regular insurance runs out, is inexpensive ($150-$300 per year for $1–2 million coverage.)



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Perils

Perils, either uninsurable or requiring specific coverage, typically include

– Flood, sewer backup, and surface water runoff– Earthquake or earth movement– War, rebellion, and insurrection – Nuclear action, radiation, and contamination– Normal wear and tear, deterioration, contamination,

pollution, and damage by domestic animals, vermin, or rodents



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Step 2 - Select the Risk Management Technique

The common risk management techniques are:

– Risk avoidance

– Risk control

– Risk retention

– Risk transfer – non-insurance

– Risk transfer – insurance



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Risk Avoidance

• Risk avoidance is just what it sounds like: Avoiding the situation that would put you at risk.

• This is typically the least practical method of managing risk. For example, a car will never hit you if you never leave your house, but what kind of a life is that?

• Risk avoidance can be prudent. For example, not leaving your house in a major snowstorm is risk avoidance.



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Risk Control

• Risk can often be reduced or controlled by preventive measures. For example

– Regular physical exams

– Keeping smoke detectors and fire extinguishers in key locations in the home

– Maintaining proper legal documentation for business activities and relationships



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Risk Retention

• Some risks are retained because they cannot be otherwise managed or insured.

– The most common example of such a risk is war damage. Other risks are retained because the cost of insurance is too high for the benefit received.

– For example, higher deductibles and co-pay levels have become more prevalent for medical insurance because the cost of such insurance for the lower levels of expenses is simply excessive.



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Risk Transfer

• Risk transfer techniques do not really reduce or even “transfer” the risk. Instead, they provide for the repayment of loss. Methods of risk transfer include

• Indemnity or hold harmless agreements.• Requiring sub-contractors or contractors to retain

responsibility for certain risks.• Requiring lessees to retain certain risk (e.g., car

leases).Risk sharing is essentially a combination of risk retention and risk transfer.



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Insurance

• Except for life insurance, insurance is the one product you purchase from which you hope you never benefit.

• The purchase of insurance provides the most common method of risk transfer or sharing.

• The transfer of risk is to the insurance company (for a price) and the risk sharing is in the form of deductibles and co-pays.



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Levels of Risk Management

While reviewing the specific risk management techniques, be sure to consider the various levels of need for risk management:

– Severe – potential to cause demise of a family or business

– Important – could cause serious hardship, but not total loss

– Optional – exposures that have negligible consequences



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Step 3 – Implement the Techniques Chosen

Risk avoidance and reduction are primarily a matter of personal commitment and habit.

– Being responsible and cautious in everyday activities and endeavors is the crux of minimizing risks that can be, at least in part, controlled.

– Simple examples include driving within speed limits, proper diet and exercise, and smoke detectors and fire extinguishers.



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Evaluate the Risk

• In evaluating the degree to which to rely on risk retention and sharing consideration should be given to the levels of reserves in cash and other liquid assets available and needed to cover loss contingencies.

• You don’t want to be forced to sell assets or incur debt at inappropriate times should a loss occur.



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Insurance as a Technique of Risk Management

• Insurance, the most common technique of risk management, is typically used when there is no other effective way to protect against the risk of significant, if not unrecoverable, loss.

• The purchase of insurance requires its own analysis of purpose, amount, and type. This is a process that most clients are unprepared to undertake alone.



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Variety of Insurance Products

• Automobile• Homeowner• Umbrella liability• Professional liability• General business

Liability

• Business interruption• Life• Disability• Medical• Long term care

Most financial planners cannot deal with all of the disparate insurance products available for the variety of insurable needs. This is where the financial planner’s duty to consult arises.



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Step 4 – Monitor the Results

• In the financial planning process, there is a continuing need to evaluate the effectiveness of the chosen tools to accomplish the identified goals.

• Risk management is no different. – Change is ever present. – Environmental and personal changes may increase or

decrease ones risk of loss. – For example, as a client accumulates more assets, he has

more to lose if sued as a result of a “slip and fall” accident on his front walkway.



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Re-Evaluate

The inevitability of changing circumstances and risk of loss leads to the unavoidable conclusion that the risk management techniques in place must also be re-evaluated, and if appropriate, modified or replaced.

– How frequently should this be done? • Clearly when there is a major event that impacts the need for

insurance, such as the sale of a business, a review is appropriate.

• Regular, periodic reviews are also in order. Yearly routine reviews are probably too frequent. Every three years or so is not out of line.



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Guidelines for Selecting an Insurance Company

• Prior to the age of the Internet market for nearly all products and services, it was nearly impossible to purchase any insurance other than through a licensed insurance agent or broker.

• Even today, the vast majority of insurance is obtained through the agent/broker network.

• How do you know what to look for in the broker who represents your clients’ interests or the company agent you rely on for the best insurance product?



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Positive Characteristics of an Agent

• Consider the person or firm that has:

– In-depth knowledge of insurance and support resources

– Knowledge of which insurance company to use and the access to an acceptable choice of companies

– Effective follow-up service for inquiries and claims

– The respect of clients

– Clout with insurers and the respect of the claims adjusters



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Guidelines for Selecting an Insurance Company

• In recent years, much has been said and written about the fiscal soundness of many insurance companies.

• The concern that the insurance company chosen will be able to pay any claims submitted is of course important.



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Factors in Picking the Company

• Consider all of these factors in deciding which companies fulfill your clients’ needs:

– Strong financial condition

– Appropriate underwriting philosophy

– Prompt and fair claims policies and procedures

– Prompt and accurate service

– Reasonable price, consistent with the quality of service



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Insurance Reliability

• The insurance industry is so broad and diverse that it is nearly impossible for any consumer to know which companies are best suited for his needs.

• In addition to the reliance from the insurance agent, individuals can look to reports and guidance from a variety of insurance company rating agencies.



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Reliable Insurance Companies

These rating agencies are relied upon in part by many insurance brokers:

– A.M. Best

– Fitch, Inc. (Duff & Phelps)

– Moody’s

– Standard & Poor’s

– Weiss Research



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Risk and Insurance – Terms and Concepts

• Indemnity• Actual Cash Value• Insurable Interest• Coinsurance• “Other Insurance”

Clause

• Negligence• Contributory Negligence• Comparative

Negligence• Assumption of Risk

Before proceeding with our explanation of the more common types of insurance, a review of some general insurance terms and concepts is in order.



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Indemnity

• The principle of indemnity requires that an insured shall not be compensated by an insurer in an amount greater than the economic loss. The insured is thus indemnified for the loss, made whole (if the insurance coverage is adequate), but not enriched.

• Indemnity is typically a property and casualty insurance concept, not applicable to life insurance. There are a few exceptions to this limitation with property insurance, however.



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Exceptions to the Concept of Indemnity

• Replacement cost insurance – Assuming costs to replace exceed the owners cost to construct or purchase the property, the insured would be enriched.

• Insurance coverage valued at a stated amount, regardless of actual value – This approach is becoming more common in high-end automobile insurance policies that will establish the amount of coverage for the car if totaled, regardless of its actual value just before the accident.

• Valued policy laws – Some states require payment on the limits of the policy if the property is totally destroyed.



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Actual Cash Value

• Actual cash value – As it relates to the indemnity principle, the actual cash value of lost or damaged property is the maximum amount that will be paid to indemnify an insured.

• This amount will usually be less than “replacement cost” as a result of normal depreciation, wear, and tear.



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Insurable Interest

• For a person to purchase insurance and be able to collect on a claim, there must be something that the policyholder or beneficiary will lose if there is property loss, injury to others (or damage their property), or if the insured dies or becomes disabled due to accident or sickness.

• A stranger does not have an insurable interest in purchasing life insurance on another person.



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Coinsurance

• Coinsurance is a clause in an insurance contract that requires the policyholder to purchase insurance in an amount at least equal to a specific percentage of the value of the property.

– If the insured complies, the insurer will pay dollar-for-dollar up to the policy limit.

– If the insured does not comply, the insured’s recovery is reduced in proportion to the deficiency.

– This sort of provision is common in real property insurance policies.



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Coinsurance

• As an example of coinsurance, assume the property damage provisions of a commercial building insurance contract has an 80% coinsurance requirement. The building is worth $1,000,000. A fire occurs causing $200,000 of damage.– If the owner purchased at least $800,000 property insurance

(80% of value), then 100% of the valid claim ($200,000) will be paid.

– If the owner obtains only $600,000 property insurance coverage (60%), only $150,000, or 75% of the loss will be paid by the carrier, representing the pro rata portion of the required coinsurance amount ($600,000/$800,000).



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“Other Insurance”

• “Other insurance” clause is a provision that spells out the way that a loss will be apportioned between that policy and any other insurance the insured has available to cover the same loss. – For example, the medical provisions of an automobile policy

will, under its provisions, be coordinated with other medical coverage in order to avoid a double up of benefits.

• An “other insurance” clause is a common technique used to implement the indemnity principle.

• Property insurance policies generally use a pro rata “other insurance” clause to apportion responsibility among multiple coverage providers.



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Negligence

• For liability insurance purposes, negligence is typically defined as the failure to use such care as a reasonably prudent and careful person would use under such circumstances.

• When this failure results in injury to another or damage to property, a person determined to be negligent may be found liable for the resulting injury and damage and be legally bound to provide compensation.



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Contributory Negligence

• Contributory negligence – This is a form of defense against a claim of negligence.

– The defendant claims that the plaintiff (injured party) contributed to the loss by acting in a manner that was itself negligent.

– If it can be shown the loss would not have occurred but for the contributory negligence of the plaintiff, the claim against the defendant may be overcome.



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Comparative Negligence

• Comparative negligence – This approach to assigning responsibility for a loss, used by many jurisdictions, is intended to provide a balance between the extremes of strict negligence and contributory negligence.

– Under this concept, losses must be allocated and apportioned according to the degree to which each party contributed to the injury or damage.

– The result, typically, is a partial recovery by the plaintiff, not all or nothing.



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Assumption of Risk

• Assumption of risk – Participants in certain activities known to have an inherent element of danger have, by participating, assumed the risk, relieving other participants or sponsors in the activity of any special duty to protect them.

• For example, persons who engage in skydiving have assumed the risk of dying by falling. They are usually required to sign papers warning them of the risk before being allowed to participate in the sport.



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Life Insurance – The Basics

Life insurance is a unique wealth creation tool that plays a major role in the estate planning process. In evaluating the use of this tool, the following steps are indicated:

– Purpose of Life Insurance

– Amount of Life Insurance

– Types of Life Insurance

– Ownership of Life Insurance

– Beneficiary of Life Insurance



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Purpose of Life Insurance

Life insurance, as an estate building or estate conversion tool, is often used for the following specific purposes:

– Provide for the income needs of a surviving spouse, children, and other dependents

– Pay federal and state death taxes and other costs of the estate– Pay outstanding debts– Provide for children’s education– Shift wealth from one generation to another in the most cost effective

manner possible– Meet “special” financial demands of physically or mentally handicapped

or learning-disabled family members (children, parents, siblings, or other dependents)

– Benefit a charity– Create an “instant estate”



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Life Insurance for Business

• The following business needs for life insurance may also play a role in the estate planning process:

• Fund a buy-sell agreement

• Finance a Death Benefit Only (D.B.O.) plan

• Provide a basic level of financial security for the families of company employees

• Recruit, retain, and reward key employees



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Amount of Life Insurance

• The starting point in determining the amount of life insurance to have is distinguishing true needs from desires. – Creating a financial reserve to fund the future lifestyle needs of a

surviving spouse and children (until they are through college and independent) is a need.

– On the other hand, purchasing life insurance in order to simply enlarge the size of your children’s inheritance, beyond what they may actually require, is a desire.



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Important Planning Process

• At the beginning of the estate planning process, most clients are not aware of how much cash will be required to settle their estates.

• In addition, many clients do not understand that a forced sale of a closely held business, real estate interest, or other illiquid asset will generally yield significantly less than could be expected under a planned disposition.



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The Needs Analysis

• The impact of a liquidity needs analysis can be illustrated graphically using software that will generate a simple, demonstrative flowchart.

• There are many available software programs that can easily generate an analysis under alternative scenarios, factoring in such variables as projected dates of death and estimated rates of inflation.

• The financial planner should use judgment and experience in estimating and evaluating the reasonableness of assumptions and variables reflected in the analysis.



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Review the Analyses

• In many instances the planner is called upon to review liquidity needs analyses prepared by others whose ultimate aim is to sell products (whether or not appropriate) in order to fund “projected shortfalls.” The planner should carefully scrutinize these analyses and the underlying assumptions.



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Types of Life Insurance

• Despite what many individuals have been led to believe, it is not always best to “buy term life insurance and invest the difference.”

• Certain forms of life insurance are more effective than others to perform specific estate planning goals. – If liquidity is not needed until the death of both husband and

wife, and there is no viable source for such liquidity except life insurance, a survivorship, or second-to-die policy (typically a cash value policy that does not pay the death benefit until the death of both named insureds) may be most appropriate.



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Three Basic Elements

• All forms of life insurance consist of three basic elements:

– Mortality Cost

– Administrative Costs

– Investment Performance



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Mortality Cost

• Mortality cost – The amount of funds required to fund the reserves needed to pay death benefits, as actuarially computed.

• As you would expect, mortality charges increase every insurance period (e.g., every year) simply because the insured gets older and is closer to his ultimate end.



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Administrative costs

• Administrative costs – For both mutual and stock companies, the cost of operating the insurance company.

• For stock companies, the component includes the shareholders’ expected profit.



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Investment Performance

• Investment performance – Both the overall earnings of the insurance company’s investments and earnings of the invested cash value of funds ascribed to individual insurance policies are important.– Investment performance is most critical with insurance

policies that are intended to accumulate cash values for the benefit of the insurance owner (reduced premiums) or the beneficiary (higher death benefits).

– However, even with term insurance, the insurance company’s investment performance can affect future premium costs.



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Basic Types of Life Insurance

The basic types of life insurance include the following:– Term Life Insurance– Whole Life Insurance– Universal Life Insurance– Variable Life Insurance– Variable Universal Life Insurance– Private Placement Variable Life Insurance– Survivorship Life Insurance



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Term Life Insurance

1. Term life insurance is typically the simplest form of life insurance.

– It provides the beneficiary only with life insurance protection.

– There is no built-in savings element (cash value), as with, for example, whole life insurance.



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Lowest Cost Life Insurance

• The lowest cost life insurance is usually non-guaranteed, non-renewable term.

– This most basic policy provides that after each insurance period (usually one year), the insured must re-prove he is healthy enough to be re-insured.

– In addition, as with any term policy, the premium will increase every period (year) as mortality costs rise.



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Renewable Term Policy

• A yearly renewable term policy will provide the guarantee that the term insurance coverage will be available to the insured, but the guarantee has an associated cost (higher premium).

• In addition, the annual insurance premium will increase continually due to increasing mortality charges, so long as the policy remains in force.



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Predetermined Period

• A term policy for a predetermined period, such as five, ten, or fifteen years, will have a higher annual premium cost than a yearly renewable term policy, but only in the earlier years. – In the later years of the multi-year, level premium term, the

comparable premiums of yearly renewable term will be higher. – The relative total cost of these two policy types will depend on

the magnitude of the adjustments the insurance company makes each year to the premium of the annual renewable policy.

– The fixed multi-period policy usually makes sense where the insured wants the comfort of knowing what the insurance will cost for the entire planned coverage period.



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Advantages of Term Insurance

• Term insurance is generally most advantageous when the insurance need is limited to an identifiable period of time, especially if that period does not extend beyond fifteen to twenty years.

– If the only need for the life insurance policy under consideration were to fund the college education needs for a twelve-year-old child, term insurance would usually be most cost effective.



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Whole Life Insurance

Whole life insurance is the traditional “cash value” policy with level premium payments designed to remain in force over the entire life of the insured individual.

– This form of insurance is appropriate for meeting insurance needs the insured will have for his entire life, such as estate liquidity.

– It generally includes a savings or cash value reserve element. – Premiums paid in excess of the mortality and administrative costs of

the policy are added to the accumulating cash value of the policy. – This cash value earns interest that also accumulates in the policy. – It is the accumulation of cash reserves in the earlier years of the

policy that enable the policy to retain a level premium over the life of the insured.



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Fixed Schedules

• Whole life policies typically have fixed and guaranteed schedules of cash value that can be borrowed against by the policy owner for any reason, or which can be taken in cash upon the surrender of the contract.

• The level premiums are generally fixed at a specific amount applicable over the entire term of the policy (generally to age 100).



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Maximum Mortality Charges

• These policies also provide for guaranteed maximum mortality charges and guaranteed minimum interest (earnings) rates.

– These guarantees, and the planned fixed premiums have a cost.

– In order to receive the certainties of future cost the policy owner expects from a whole life policy, the basic annual premium will be set at a very high level.



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Universal Life Insurance

Universal life insurance (UL) is a form of “cash value” policy with the following variations from traditional whole life:

– UL provides the policy owner a great deal more flexibility in the payment of insurance premiums.

– Subject to certain limiting tax rules, premiums can be increased or decreased from year to year, or may even be skipped.

– The primary concern for the owner is that a sufficient cash value be maintained to cover the future mortality and administrative costs without imposing huge prospective premium requirements.



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Universal Life Insurance

• Policyholders may, within limits and subject to the insurance company’s insurability standards with respect to increases, change the death benefit levels of the policies.

• Regulations generally require separate disclosure of administrative expenses, mortality charges and earnings rates for universal life contracts.

• Policyholders have access to the cash value of their policies either through policy loans or direct withdrawals. Whole life policies generally only provide for cash via loans.



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Level Death Benefit or Increasing Death Benefit

• Upon the purchase of a universal policy, a policy owner may choose either a level death benefit (Option A or Option I), or an increasing death benefit (Option B or Option II). – Option A, which is generally the only option available under

traditional whole life, provides for a death benefit equal to the greater of the face amount of the policy or the cash value as of the date of death.

– Under Option B (generally not available with a whole life policy), the death benefit is equal to the sum of the face amount of the policy and the cash value at the death of the insured.



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Option A

• Assume the face amount of a universal policy is $1,000,000 and the cash value at the death of the insured is $900,000, under Option A the death benefit would be the $1,000,000 face amount of the policy.

• If the cash value at death is $1,100,000, the death benefit under option A would be the $1,100,000 cash value.



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Option B

• Assuming the same $1,000,000 face amount of coverage, with a cash value of $900,000, the death benefit would be $1,900,000 ($1,000,0000 face plus $900,000 cash value).

• If the cash value at death is $1,100,000, the death benefit would be $2,100,000 ($1,000,0000 face plus $1,100,000 cash value).



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Option B Comes at a Price

• The choice of an Option B death benefit has a commensurately higher premium cost.

• If the policy in effect provides for an increasing death benefit, then there would be a comparable increase in annual mortality charges.

• However, if you are looking for a simple technique to provide for increasing future insurance needs, without future proof of insurability, an Option B death benefit election should be considered.



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One Way Switch

• Option B is only available at the purchase of the policy.

– While you can choose to level the death benefit and switch from B to A at any time while the policy is in force, a switch from an A election to B is generally not allowed.

– It would result in an increase in coverage, and risk to the insurance company, without a showing of qualifying good health.



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Maximum Mortality Charges and Minimum Earnings Rates• Consistent with traditional whole life, universal

insurance does provide for guaranteed maximum mortality charges and minimum earnings rates. – The cash values of universal policies are managed by the

insurance company as part of the company’s general investment accounts.

– This means that the funds belong to the insurance company that accounts for them on behalf of the policyholder.

– Consequently, the cash values of whole life and universal policies are exposed to the other creditors of the insurance company.



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Variable Life Insurance

• Variable life insurance, like traditional whole life, has a fixed premium and a minimum guaranteed death benefit.

• Unlike either whole life or universal life, the risk and reward of investment decisions with straight variable life insurance is more clearly shifted to the policyholder.

• The cash reserve of a variable policy is maintained in a segregated investment account, and the policyholder, not the insurance company, determines how the reserve funds will be invested.

• The investment choices are generally in the form of mutual funds, and usually include some variety of equity funds, bond funds, balanced funds, and money market funds.

• The policyholder has the flexibility to change the mix of investments among the available funds.



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Risk of the Insurer

• The segregated investment accounts are treated as securities and are subject to SEC regulation.

• The segregated accounts belong to the policy owner, not the insurance company, and are thus not subject to the risk of the insurer’s creditor vulnerability.



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Securing the Risk

• With straight variable, the policy’s death benefit will vary with the performance of the investment accounts, but cannot be decreased below the original coverage amount (face) of the policy, so long as the contractual premium payments are maintained.



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Variable Universal Life Insurance

• Variable universal life insurance (VUL) combines the critical attributes of both variable life and universal life.

• As with variable contracts, VUL policies provide for flexibility in the payment of premiums and limited flexibility to alter the death benefit.

• Separate disclosure of administrative expenses, mortality charges, earnings rates and investment expenses are required.

• At the time of purchase, the policy owner may choose between a level (Option A) or increasing (Option B) death benefit.



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Not Guaranteed

• Investments are maintained in separate accounts, regulated by the SEC, and investments are managed by the policy owner, using the available mutual fund options of the policy.

• However, unlike the other forms of cash value policy, VUL provides for– No guaranteed minimum cash value– No guaranteed minimum earnings rate– No guaranteed minimum death benefit (although maximum

mortality charges are guaranteed)



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Risks for Potential

• VUL is popular in circumstances where the policy owner is willing to assume these risks in exchange for the potential of a greater increase in cash value while maintaining the highest level of flexibility and control over the variable policy’s components.



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Private Placement Variable Life Insurance

• Private placement variable life insurance is a special type of variable (typically VUL) life insurance geared toward the needs and resources of very wealthy individuals. Such policies typically– Require a large premium (usually $1,000,000 or more)– Allow the policyholder to choose from among approved

money managers (rather than just mutual funds) to manage investments in the policy account

– Charge lower investment management loads than imposed by standard variable policies.



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Survivorship Life Insurance

• Survivorship life insurance, also known as second-to-die, joint life, or last survivor life insurance, provides for the payment of death benefits only after both insured individuals have died.

• Since the insurance company does not have to make a death benefit payment until after the two deaths, survivorship insurance is most frequently used as a tool to provide liquidity to pay estate taxes, or to create an estate for transfer to future generations, when the last of a husband and wife couple dies.

• Its popularity increased dramatically as a result of the unlimited marital deduction.



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“Cash Value” Covering Two Lives

• Survivorship life insurance is generally structured as a level premium “cash value” policy (usually whole life, universal, or VUL) covering two lives, but almost any reasonable variation is possible, if appropriate for the client’s goals.

• Such variations might include insurance on more than two lives.



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Paid After Both Individuals Dies

• From a cost perspective, survivorship insurance is typically cheaper than comparable insurance on either of the insured lives.

• This makes sense since no death benefit is paid until after two individuals die.

• No matter how much older one insured is than the other, and even if the older spouse is seriously ill, there is always a possibility the younger, healthy spouse will die sooner, for example, as a result of an accident.



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Ownership of Life Insurance

• Typically life insurance is owned by the individual whose life is insured.

• However, under federal estate tax law, if the insured retains any “incidence of ownership,” the death benefit proceeds of the life insurance policy will be included in the taxable estate of the insured, whether the insured’s estate or someone other than the person or entity is named as the beneficiary of the policy.

• In order to avoid this undesired estate tax result, a policy on the life of the identified insured is often purchased and owned by the beneficiary or some other person.



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Ownership of Life Insurance

• If the beneficiary of the policy is the insured’s surviving spouse, having that spouse also own the policy usually does not have a material estate effect since the proceeds of the policy, if included in the decedent’s taxable estate would be eligible for the unlimited marital deduction.

• However, if for example the insured’s children are the intended beneficiaries, ownership by the children or an irrevocable trust created for the benefit of the children, would be appropriate owners of the life insurance.



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Beneficiary of Life Insurance

• While life insurance is intended to provide a lump sum of cash for an identified beneficiary, it is not always the client’s intention that all of the cash be made available immediately or all at one time, even if deferred.

• It may also be the client’s goal to make sure the insurance proceeds remain available to provide income for an extended period of time and/or for multiple beneficiaries and generations.



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Basic Tax Implications of Life Insurance

Income Taxes– Generally, life insurance death benefits proceeds are

excludable from the recipient’s gross income for federal and state income tax purposes.

– However, if prior to death a policy or an interest in a policy has been sold or otherwise transferred for valuable consideration, the death benefit proceeds will be taxable to the recipient/transferee to the extent the insurance proceeds exceed the total of the purchase price for the policy and any additional premiums paid by the transferee/owner (Purchaser’s basis in the policy).

– This is known as the “transfer for value” rule.



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Taxable Transfer for Value

• If Joe purchased a $100,000 policy insuring the life of his brother-in-law, Howard, for $40,000 and paid additional premiums of $5,000 before Howard died, Joe’s basis in the policy would be $45,000. Upon receiving the $100,000 upon Howard’s death, Joe would have $55,000 of taxable income.



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Exceptions to the Transfer Value Rule

• Exceptions to the transfer for value rule are available for a sale or transfer to 1. the insured2. a partner of the insured3. a partnership in which the insured is a partner4. a corporation of which the insured is a shareholder or officer5. if the transferee’s basis in the insurance policy is determined,

in whole or in part, by the transferor’s basis.

• A slight oversimplification of the exceptions is that if the transfer does not result in a tax basis change, the transfer for value rule will not make the death benefit proceeds taxable to the transferee.



Financial Planning


Exceptions to the Transfer Value Rule (cont’d)

• If in the previous example, Joe and Howard were business partners, as well as brothers-in-law, the sale of the insurance policy would be exempt from transfer for value rule and Joe would not have taxable income when he received the insurance death benefit.

• Generally, transfers between spouses made after July 18, 1984 or transfers which are incident to a divorce, even if for value, are excluded from the transfer for value rule.



Financial Planning


Federal Estate and Gift Taxes

• The death benefit proceeds of a life insurance policy are generally included in the gross estate of the insured for federal estate tax purposes if– The insured’s estate is the named beneficiary of the life

insurance policy– The insured possessed any incidence of ownership in the

policy (such as the right to change beneficiaries, surrender the policy, or borrow against the cash value of the policy) at the time of death

– The insured died within three years following the transfer of his ownership interest in the policy



Financial Planning


Gift Tax

• Gifts of life insurance policies or gifts of premium payments may be subject to the federal gift tax.

• The value of the gift is based on the fair market value of the insurance policy at the time of the gift of the policy or, in the case of the premium payments, the cash amount of the premium paid.



Financial Planning


Health and Medical Insurance

• There are two general types of health insurance plans:– Traditional or indemnity (“fee-for-service”)– Managed care, usually in one of the following form of

organization:• Health Maintenance Organization (HMO)

• Point of Service (POS)

• Preferred Provider Organization (PPO)



Financial Planning


Covered Expenses

• The essential expenses usually covered by medical insurance include:– Doctor visits– Preventive care– Diagnostic tests– Hospital and extended care– Emergency services– Prescription medications.



Financial Planning


Other Coverage Areas

• Other coverage areas include– Family planning, OB-GYN– Maternity and well baby care– Dental care– Vision care– Mental health– Substance abuse– Chronic disease care– Physical therapy



Financial Planning


Indemnity Medical Insurance

• Indemnity medical insurance programs generally provide for a reimbursement of the insured medical expenses upon proof of incurring the expense or by paying the allowed expense directly to the service provider.

• Expenses are generally completely covered (subject to deductible and co-pay requirements), no matter what happens.



Financial Planning


Characteristics of an Indemnity Program

• The major emphasis in an indemnity program is on patient choice, patient responsibility, and immediate patient care. – These programs provide for more

flexibility and typically more comprehensive coverage, but are much more expensive than any managed care program.



Financial Planning


Managed Care Medical Insurance

Managed care medical insurance focuses on preventive medicine and lower cost. There are three kinds of managed care:

– Health Maintenance Organization (HMO)

– Point of Service (POS)

– Preferred Provider Organization (PPO).



Financial Planning


HMO

• A Health Maintenance Organization (HMO) charges a set fee for which it provides specified health care during a membership period.

• The insured must use the HMO’s doctors and facilities (with more flexible provisions for emergency or out-of-area needs).



Financial Planning


Point of Service Program

• A Point of Service (POS) program is in effect an option available from some HMO’s which permits the participants to use any health care provider, subject to a penalty in the form of the insured paying a higher portion of the total cost than if an “in-network” provider were used.



Financial Planning


Preferred Provider Organization

• A Preferred Provider Organization (PPO) is a health care delivery system that contracts with medical care providers to offer services at discounted fees to the PPO members.

– Similar to HMOs, instead of reimbursing for expenses incurred, a PPO charges a set fee for which it provides specified health care during the coverage period.

– Unlike HMOs, however, participants in a PPO typically are allowed to choose between in-network and out-of-network providers, paying a higher cost for out-of-network services.



Financial Planning


Homeowner Insurance

The purpose of homeowner insurance is to protect homeowner or residential tenant from

– Loss or damage to their property, such as• Dwelling

• Other structures at the residence

• Personal property

• Loss of use

– Liability claims• Comprehensive liability coverage

• Medical payments to others



Financial Planning


Risks Should be Evaluated

• Certain risks should be evaluated independently, either because recent occurrences have made coverage expensive or impossible to obtain, or because the possibility of loss from the risk may vary from situation to situation. Examples of such risks include– Flood – need separate policy– Landslide – may be “bought back” with a rider, if excluded

from the basic policy– Earthquake – need separate policy



Financial Planning


Risks Excluded Unconditionally

• Other specific risks are almost always excluded unconditionally. Homeowners are expected to handle these issues as normal household “maintenance”:

– Mold

– Rust

– Rot

– Fungi



Financial Planning


Insuring Property

• There are two basic approaches to insuring property:

– “Normal perils” coverage – Perils not listed are not covered.

– “All risks open perils” coverage – Only perils specifically excluded are not covered. This is typically broader, and more expensive coverage.



Financial Planning


Variable Premium Costs

Factors that may cause the premium cost of homeowner insurance to vary include:

– Physical damage coverage (typically for at least 80% of the cost to rebuild)

– Amount of coverage (stated as a percentage of coverage on primary dwelling) for

• Other structure (Usually 10%)• Personal property (Usually 50% for “unscheduled property” plus additional

premiums for specifically scheduled (listed) items)• Loss of use (Usually 20%)

– Deductible for property damages (Generally $250 to $1,000)– Limit on liability coverage (generally $100,000 (basic) to $500,000) –

coordinated with “umbrella liability coverage– Medical payments to other ($1,000 basic)– Damage to property of others ($500 basic)



Financial Planning


Automobile Insurance

The basic components of an automobile insurance policy are

– Part A – liability coverage

– Part B – medical payments

– Part C – uninsured (underinsured) motorists

– Part D – damage to the insured’s vehicle



Financial Planning


People who are Covered

Persons generally covered by the policy include

– The named insured and any family member.

– Any person using the covered vehicle with the insured’s permission.

– Any person or organization for a liability arising out of any covered person’s use of the covered vehicle on behalf of the insured person or organization.



Financial Planning


Automobile Liability Coverage

Automobile liability coverage ((Part A) will often have most or all of the following exclusions:

– Any vehicles while they are used to haul property or persons for a fee.

– Vehicles with fewer than four wheels (separate motorcycle coverage is available).

– Bodily injury to employees of the insured.– Property rented to, used by, or in the care of the insured

(may be an add-on).– A person who intentionally causes bodily injury or property

damage.



Financial Planning


Single or Split Limit

• Liability coverage may be either single limit or split limit. With single limit coverage, the amount shown in the policy as the maximum limit of liability coverage applies to the total of all bodily injuries and damages from one accident. Split limit coverage provides separate limits to the different coverage elements that may occur in an accident. For example, a split limit of $100,000/$300,000/$100,000 would provide for– A $100,000 limit for injury to one person– A $300,000 limit for injuries to all individuals– A $100,000 limit for property damage in the accident

It is important to tie in these limits of coverage with umbrella liability coverage that may be in place in order to avoid a possible gap or unnecessary duplication of coverage.



Financial Planning


Automobile Medical Payment Coverage

Automobile medical payment coverage (Part B) generally covers medical services for the insured, relatives, and anyone else in the insured’s vehicle injured in the accident.

– Part B generally does not cover pedestrians or occupants of other vehicles.

– Payment is usually prompt, without waiting for a determination of liability.

• Such coverage may be subject to an “other insurance” clause, requiring coordination with other medical insurance coverage of the affected individuals.



Financial Planning


Uninsured Motorist

• Under uninsured motorist (Part C) coverage, if an insured individual is injured in an accident with an uninsured (or underinsured) motorist, the insured can look to his own insurance carrier to pay him, as if the company were the insurer of the other party (subject to the limits of the injured party’s policy).

• The insured is also covered if injured by a hit-and-run accident when the operator of the other vehicle cannot be identified. – While not mandatory, this coverage is at least optional in

almost all states.



Financial Planning


Damage to the Insured’s Property

• The coverage for damage to the insured’s property (Part D) relates to the value of the insured’s car. The level of coverage, and the related premium will typically decrease as the vehicle ages and its mileage increases.

• The coverage applies whether or not the insured is at fault.



Financial Planning


Covered Perils

• The covered perils are

– Collision – reimburses policyholder for damage to the car sustained by reason of a collision. The premium can be mitigated with a higher deductible.

– Other than collision (OTC) – effectively “all-risk” physical damage coverage (everything but excluded items, such as collision, war losses, damage due to wear and tear, road damage to tires, freezing and mechanical or electrical breakdown).



Financial Planning


Umbrella Liability Insurance

• Also called Excess Liability or Personal Catastrophe coverage, umbrella liability insurance provides personal liability coverage protecting individuals and families from large (excess) personal liability claims.

– The policy supplements the underlying liability coverage provided in homeowner and auto insurance policies.

– Homeowner and auto liability coverage in effect provide a “deductible” for umbrella coverage.



Financial Planning


Umbrella Liability Insurance (cont’d)

• Obviously, umbrella coverage requires coordination with what must be adequate homeowner and auto coverage in order to avoid any gaps in liability coverage.

• An umbrella policy of from $3,000,000 to $5,000,000 or more is not unreasonable, particularly in light of recent unprecedented litigation awards.

• Quite simply, the more you have, the more you have at risk.



Financial Planning


Terrorism and Insurance

• Following “9/11”, it is no surprise that insurance carriers wanted to exclude from their property and casualty policies all damages resulting from act of terrorism.

• In order to assure that such risks are insurable, the Terrorism Risk Insurance Act of 2002 was enacted.



Financial Planning


Terrorism and Insurance (cont’d)

• The 2002 Act established a temporary Federal Terrorism Insurance Program that provides for a transparent system of shared public and private compensation for insured losses from acts of terrorism.

• The Act is intended to allow for a transitional period for the private markets to stabilize and “adjust” to the impact of contemporary terrorism on providers and users of commercial insurance.



Financial Planning


Terrorism and Insurance (cont’d)

• As a result of the Terrorism Risk Insurance Act, consumers have the right to purchase insurance coverage for losses from “acts of terrorism” that are certified by the Secretary of the Treasury, in concurrence with the Secretary of State and the Attorney General of the United States. – For this purpose, an “act of terrorism” is defined as “a violent act

dangerous to human life or property…committed by individual(s) acting on behalf of any foreign person or interest as part of an effort to coerce the civilian population of the United States.”

– Under the formula, the United States pays 90% of covered losses exceeding established deductibles (paid by the insurance company).

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Risk Management and Insurance Planning Chapter 26 Tools & Techniques of Financial Planning Copyright...

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