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Chapter 10

CFIN502- Chapter 10- Life, Health, and Disability Income.docx

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Ryerson University
FIN 502
Joan Lobo

CFIN502- Chapter 10- Life, Health, and Disability Income LIFE INSURANCE  Means of financing the risk of the premature and untimely death of a family member  Loss of income due to the unanticipated death of a family member is an insupportable risk for most families  Common way to finance such risk—to find other people to share it through insurance  Basic terms o Insured- person upon whose death the death benefit of the insurance policy will be paid o Beneficiary- persons who receives the death benefit or face value of the policy upon the death of the insured o Death benefit or face value- dollar amount that will be paid to the beneficiary if the insured dies o Premium- dollar amount that must be paid to the insurance company o Owner- person who pays the premium o Policy term- period during which the insurance is in force o Rate- cost of each unit insurance o Insurability- qualification for the insured to be insured o Guaranteed insurability- provision that allows the insured to buy additional life insurance at certain specified future dates without proof of insurability  Do you need life insurance? o Basic purpose—ensure that your financial dependents will be provided for financially in the event of your unanticipated death o If you don’t have dependents you don’t need life insurance o Ultimate test—whether the standard of living of the remainder of the family will fall materially in the event of death of one family member  3 important questions in life insurance 1. Do I need life insurance? Who needs life insurance? 2. How much life insurance do you need? How many people estimate the appropriate amount of insurance they should buy? 3. What kinds of life insurance are sold in the market? What kind of life insurance should you buy? o First question one needs life insurance if one has financial dependents and if the standard of living these dependents is expected to fall as a result of one’s premature and unanticipated death  How much life insurance does a family need? o Two approachesincome approach and expense approach o The income approach—estimates the face value of the life insurance by calculating the present value of the insured’s expected future income  Present value of the insured expected future income is conceptually the insured’s human capital  Three issues  What is present discount rate of the insured’s expected future income?  How to we handle inflation? o Insured’s income may appear to rise every year but, after accounting for inflation, there may not be any increase at all  The income stream of an individual is very uncertain, and fraught with risk o Income over ones lifetime may go up or down; indeed, it may become zero if and when the person is unemployed  First 2 issues look at real income and using real rate of interest  Real rate of interest- usually measured by the nominal rate of interest minus the expected rate of inflation  The basic benchmark of the income approach o Present value of the insured’s lifetime earnings assuming no growth in real earnings and using the real rate of interest as the discount rate 1 CFIN502- Chapter 10- Life, Health, and Disability Income o Calculations—fine present value of an annuity of your current salary; length of the annuity will be the expected number of working years; discount rate will be the real rate of interest  Usual adjustments to the basic benchmark o Income tax issue  Replicating the lump-sum amount that yields the income annuity before tax  We place the beneficiary in the same financial position after-tax as if the insured were still living  Beneficiary will pay tax at a lower rate in most situations  Face value amount of a life insurance policy is not taxable income for the beneficiary—premiums are not tax deductible  Payments the beneficiary lives on for the years after the insured’s death are partly taxable interest and partly non-taxable return of principal  Principal amount required to replace the insured’s income is less than the amount calculated o Rule-of-thumb adjustment  Families may want to insure only 70%-80% of the insured’s future income  The expense approach o Life insurance face value amount that the family need is the amount that will provide enough funds to pay those expected expenses of the beneficiaries that are not covered o If insured dies, life insurance death benefit is invested and used as the expenses occur o Difference between income and expense approach—former calculates the present value of the insured’s future income, while the latter calculates the present value of the beneficiaries future expenses o Calculated the present value of the shortfall up to the point of retirement o Implicit assumption here is that after retirement there will be no income shortfall o If there is expected income shortfall post retirement—extend present value calculation to include post retirement income shortfall  The basic benchmark of the expense approach o Present value of the insured’s expected income shortfall from not until retirement o No shortfall—no need to buy life insurance under the expense approach o Approximate bench mark  Dividing the average annual income shortfall by the discount rate, and multiplying the answer by an adjustment factor 70% to 80%  Six steps to determine how much coverage you’ll need 1. Draw up the (projected) balance sheet of the individual deaths 2. Determine the capital and the assets available that can be invested to generate an annual income for the dependents 3. Add to the above (i) all government payments, such as the survivor benefits from the CPP, workers compensation, (ii) spouses income 4. Estimate the expenses required for the dependents to live comfortably 5. Subtract the amounts in step 3 from that of step 4 to get required income shortfall 6. Calculate the capital (life insurance face value) needed to generate the supplemental income in step 5  The human capital approach o Life insurance shares the financial risk of your human capital on the dimension of how long you live o Valuing your human capital is another way to estimate how much life insurance you need o Should yield a higher value than the expense method if both are done carefully o Value of difference between the two estimates is the expected bequest left to the next generation 2 CFIN502- Chapter 10- Life, Health, and Disability Income THE PRINCIPAL TYPES OF LIFE INSURANCE  Different kinds of life insurance—term life, whole life, endowment, universal life, group life, single premium, level premium, increasing premium, participating, non-participating, and decreasing term policies  Two types—term life policies and insurance policies that have savings/investment features o Term life policies—pure life insurance policies without savings/ investment features  Term life insurance- plain life insurance without a savings component o Pays the face value to the beneficiaries if the insured dies before the expiry date— doesn’t die they collect nothing o Participating term policy- insurance company will pay back to the insured each year an amount of money called dividends o Non-participating term policy- policy pays no dividends back to the insured  Premium is higher on a participating policy than the premium on non- participating policy o Net premium- premium minus dividend id the true annual cost of a participating policy o Level term insurance- if the face value of the policy stays the same throughout the term of the insurance contract o Decreasing term- face value declines as the policy approaches expiry  Useful for mortgage borrowers—principal of the mortgage declines over time o Term policy is “not permanent” or “non-renewable” as long payments are made on time o Term- number of years the policy is automatically renewed  The pure premium o Pure premium- if they charge premiums to the policyholders so that the present value of revenues received by the insurance company is equal to the expected present value of the benefits paid to the beneficiaries o Insurance premium that one pay is equal to the pure premium plus the insurance company’s service costs and profit o Depends on likelihood of the insured dying during insurance coverage period o Premiums are paid at the beginning of the year o Benefits are paid throughout the year o Premium on tern insurance policy will increase with insured’s age probability of death increases with age o Term policies best suited for the person who wants lower life insurance premiums in the early years of the policy in order to have more money to spend or invest  Also people who will not need life insurance in the later years of life when the premiums become very high o Notations  M- face amount of insurance policy  x i probability that an individual aged x will survive I more years  Qx+iprobability that an individual aged (x+i) will die during the next year  k- discount rate  T- term of the insurance policy ∑ ( ) o Net single premium (NSP)= ( ) o Net annual premium (NAP)= NSP ∑ ( )  Based on an annuity due insurance premiums are paid at the start of the period  Term life insurance policy o Factors that affect the actual premium insured pays age, gender, specific health conditions, cost of selling and administrating the policy, ability of potential insured persons to choose policies beneficial to them, duration of the policy o Size of the policy matters—it takes the same time to administer a single policy, regardless of size 3 CFIN502- Chapter 10- Life, Health, and Disability Income o Person who takes out policy that expires at end of year will get a cheap premium only 1 year of risk to assume o Person takes out 10 year policy—serious risk after first year but company cannot rescind the policy o Group term insurance—advantage of cheaper administrative costs but the disadvantage of what we call adverse selection o Adverse selection- occurs whenever something is priced to reflect an average quality o Those who are healthy have the greatest incentive to stay insured within a group o Insurance companies must price to compensate for this adverse selection o Convertible insurance- on leaving employer, the employee can convert the insurance to a non-group policy, provided he or she can pass a medical exam  Life insurance with savings/ investing features o There is a type of life insurance policy where premiums are constant, or even decreasing each year even though the probability od dying increases with age o Insurance company sets the premium at a level that is higher than the expected mortality costs in the early years of the policy  Policy holder—over payer in early years and under paying in later years o Cash surrender value- overpayment in early years is invested and accumulated by the insurance company o Whole life insurance- pays the face amount to the beneficiaries when the insured dies  Face amount is paid without any restrictions policy remains in force for the life of insured  Level premium- premium is constant throughout insured lifetime o Endowment life policy- pay the face amount to the beneficiaries id the insured dies  Will also pay the face amount to the insured—amount paid is called endowment—if the insured lives to a certain age  Set in such a way that the savings component will be invested to reach the endowment value a specific date o Universal life insurance-combination of term insurance and side investment fund  Policyholder maintains the insurance portion of the premium every year— insurance policy is forced  Money accumulated in the investment portion can be used to pay the minimum premium required to maintain insurance portion  Very flexible  After investment fund is saved up—policy holder can make whatever premium payments they want  Term policy VS non-term policy o Two major types  Term policies—pure insurance policies without savings/ investment components  Premium rate of a term insurance policy will always increase as the insured gets older  Non-term insured policies—pure insurance components and savings/ investment components  Policy holder pays a higher premium than that of a comparable term insurance in the early years of the policy—part of the premium goes to a ‘savings account’  Money in savings account will be used to reduce the future premiums or will be returned to the policy holder if they cancel o You should buy term life insurance for protection and ‘invest the dif
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