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  2. 2. <ul><li>APPROPRIATE AMOUNT OF LIFE INSURANCE </li></ul><ul><li>Multiple of Income Approach </li></ul><ul><li>Usually 5-7 times income. Too simplistic but very common. </li></ul><ul><li>Financial Needs Approach </li></ul><ul><ul><li>a) Lump sum needs are identified </li></ul></ul><ul><ul><ul><li>Last illness expenses (not covered by insurance) </li></ul></ul></ul><ul><ul><ul><li>Repayment of debts (possibly including a mortgage) </li></ul></ul></ul><ul><ul><ul><li>Estate taxes, if appropriate </li></ul></ul></ul><ul><ul><ul><li>Probate and attorney’s expenses </li></ul></ul></ul><ul><ul><ul><li>Funeral and burial expenses </li></ul></ul></ul><ul><ul><ul><li>Short-term household operational expenses </li></ul></ul></ul><ul><ul><ul><li>Emergency funds </li></ul></ul></ul><ul><li>b) Income needs are identified </li></ul><ul><li>Readjustment income </li></ul><ul><li>Family dependency period—goes until the youngest child </li></ul><ul><li>becomes self-sufficient. </li></ul><ul><li>Blackout period of income for spouse—goes from end of family </li></ul><ul><li>dependency period until the spouse is eligible for SS again. </li></ul><ul><li>Income for spouse after blackout period </li></ul><ul><li>c) Existing resources </li></ul><ul><li>d) Calculate the present value of income needs </li></ul>
  3. 3. Capital Needs Analysis Approach This approach assumes capital will not be liquidated and therefore is more appropriate if an estate is to be left to heirs. It requires more insurance than the needs approach. Example: Mark wants his family to receive $60,000 annually. He also wants to establish an emergency fund, pay off debts, and establish an educational fund.
  4. 4. ASSETS: House $250,000 Cars 15,000 Personal property 45,000 Securities (incl. 401(k) 228,000 Checking account 2,000 Individual and group life insurance 200,000 Private pension death benefit 20,000 Total $760,000 LIABILITIES: Mortgage $200,000 Car loan 10,000 Charge accounts and other bills 5,000 Total $215,000
  5. 5. Determine the amount of income-producing capital from the personal balance sheet. Total Assets $760,000 Less: Mortgage payoff 200,000 Car loan 10,000 Charge accounts 5,000 Final expenses 10,000 Emergency fund 10,000 Educational fund 120,000 Non-income producing capital (house, cars, & personal property) 310,000 Total deductions $665,000 Capital available (Assets–deductions) = $95,000
  6. 6. Income objective $60,000 Less: Income from capital now available $ 5,700 ($95,000 X .06) Social security survivor benefits 14,000 Income shortage $40,300 Total new capital required (40,300 / .06) $671,667
  7. 7. MEASURING THE COST OF LIFE INSURANCE Traditional Net Cost Method Total premiums paid over 20 years, minus accumulated dividends, minus the guaranteed cash value at that time equals the net cost. Often this would be negative, implying the insurance cost nothing and in fact produced a profit. This method ignored the ______________. Total premiums for 20 years $2,642 Subtract dividends for 20 years -599 Net premiums for 20 years $2,043 Subtract cash value at the end of 20 yrs. -2,294 Insurance cost for 20 years - $251 Net Cost per Year (-251 / 20) -$12.55 Net Cost per $1,000 per year (-$12.55 / 10) - $1.26
  8. 8. The Interest Adjusted Cost Methods The time value of money is taken into consideration by applying an interest factor to each element of cost. Surrender Cost Index Measures the cost of life insurance assuming you surrender the policy at the end of some period, such as 20 years. Total premiums for 20 years, each accumulated @ 5% $4,586 Subtract dividends for 20 years, each accumulated @ 5% - 824 Net premiums for 20 years $3,762 Subtract the cash value at the end of 20 years - 2,294 Insurance cost for 20 years $1,468 Amount to which $1 deposited at the beginning of each year will accumulate to in 20 years at 5% $34.719 Interest adjusted cost per year ($1,468 / 34.719) $42.28 Cost per $1,000 per year ($42.28 / 10) $4.23
  9. 9. EXAMPLE—SURRENDER COST INDEX Assume: Face $50,000, Annual Premium $1,000, Annual Dividend $100 20 Yr. Cash Value $25,000 Step 1: 1,000 pmt , 20 N, 5 I/Y, CPT FV It is $34,719 (begin. of yr) Step 2: 100 pmt, 20 N, 5 I/Y, CPT FV It is 3,307 (end of yr) Step 3: Subtract step 2 and the cash value from step 1 34,719 – 3,307 – 25,000 = $6,412 (This is the cost of the insurance over the 20 year period) Step 4: 20 N, 5 I/Y, 6,412 FV, CPT PMT It is $184.68 This spreads the cost over 20 years if money is worth 5% and payments are made at the beginning of the year. The $184.68 is the level annual cost. Step 5: Divide the level annual cost by the number of thousands of dollars of death benefit. $184.68 / 50 = $3.70 (the cost per $1,000 of coverage)
  10. 10. Net Payment Cost Index Based on the assumption that the policy will NOT be surrendered. It is calculated exactly the same as above except there is no deduction for the cash value because the policy will not be surrendered. <ul><li>Caveats </li></ul><ul><li>There are substantial cost variations among insurers. </li></ul><ul><li>Compare policies, not insurers </li></ul><ul><li>Compare only similar plans of insurance </li></ul><ul><li>Ignore small variations in cost. The true cost cannot be </li></ul><ul><li>known in advance. </li></ul><ul><li>5. Cost is only one consideration. </li></ul>
  11. 11. LIFE INSURANCE POLICY REPLACEMENT Replacement is legal, twisting is not. Agents have incentives to replace policies because of high first year commissions. Replacement can be detrimental because: 1. policy has already paid high first year expenses 2. premiums might be higher because of the higher attained age 3. new suicide and incontestable clauses If a new policy is a replacement, the agent must: 1. include a statement with the application noting that the policy is a replacement 2. give notice to the other insurer of the proposed replacement 3. must give the applicant at least a 20 day free look.
  12. 12. SUBSTANDARD COVERAGE The timing of extra mortality is important. The earlier the extra mortality, the greater the risk to the insurer. Some impairments present an extra hazard that increases over time, in some the hazard remains about constant, and in others it decreases as a person gets older. METHODS OF TREATING SUBSTANDARD RISKS Increase in age When an insured’s age is rated-up, he pays the same premium, gets the same dividends and cash values at those at the higher ages. In other words, he is treated in every way as if he were X years older. Very simple and the insured gets the higher values. Used when the extra mortality increases with age because it puts the insured higher on the mortality curve.
  13. 13. Extra percentage tables Insurers establish 3-12 extra classifications, depending on how much extra risk they are willing to take. For example, it can be 120, 140, 160 and 180. The insured then pays that percentage times the normal premium. Cash values may or may not be changed. It is the most common method for dealing with increasing hazard risks. Flat extra premium A flat extra premium is charged that does not vary with the age of the insured. The entire extra amount is assumed to be needed to pay for the extra hazard so therefore there is no change in the cash values or dividends. Used when the hazard is constant (e.g. occupation) and may be removed if the condition changes.
  14. 14. Liens The death benefit is reduced for the time period of the lien, which will vary with the impairment. Everything else is standard. Used when the extra hazard is decreasing. Can be a problem if the beneficiary is not aware. Other methods Sometimes the insured is placed in a special category that pays lower dividends. Or the insurer might limit the plan of insurance to one that has relatively little net amount at risk. It is common practice to remove a substandard rating upon proof that the insured is no longer substandard.
  15. 15. VIATICAL AGREEMENTS Methods of obtaining funds prior to death include policy loans, bank loans, loans from the beneficiary, insurer’s accelerated benefits provision and viatical settlements, which is simply the sale of the policy. The price is usually 30-80% of the face, depending on a number of factors, mostly the insured’s health. There are viatical brokers. To be tax exempt, the insured must be terminally ill (expected to live 2 years or less) or permanently and severely disabled. Also, if the state requires licensing, the viatical settlement provider must be licensed. If the state does not require licensing, some requirements of the NAIC model bill must be met. Even if tax exempt, capital gains taxes may be imposed on the difference between the settlement received and the total premiums paid. Other concerns are: 1. sale proceeds may make the viator ineligible for assistance 2. personal and financial information may be made available to others
  16. 16. LIFE SETTLEMENTS (Also known as Senior Settlements, Lifetime Settlements, or High Net Worth Settlements) These are similar to viatical settlements except: 1. The health issues may not be terminal or chronic, although there must be some health issues. According to industry standards, life expectancy must be 12 years or less (not 2 years). 2. The minimum amount is usually $100,000 (which is larger than with viaticals). 3. The policy being sold is underperforming or is undesirable in some way, e.g., it may be “rated” and the insurer is unwilling to remove the rating. 4. The sale proceeds are not tax-free. The excess of the amount received in the sale over the seller’s basis is taxed as ordinary income.
  17. 17. BUSINESS USES OF LIFE INSURANCE Key Person Insurance Small and medium sized companies often have key employees whose death would cause a significant financial loss to the company. Large companies rarely, if ever, have this exposure. The business is the applicant, premium payor, beneficiary of the policy. Premiums are NOT tax deductible but death proceeds are tax free. The amount of insurance to buy is hard to estimate, but depends on the factors that make the person a key employee. Term insurance can be used, but often a cash value policy is used because it then can be used to provide a retirement benefit to the employee.
  18. 18. Buy-Sell Agreements Many problems arise when the owner of a small business dies. Problems with suppliers, creditors, and employees are common. A buy-sell agreement obligates the heirs to sell and another party (or parties) to buy the business. The agreement should spell out the purpose of the agreement, the clear obligation of the parties, a restriction on the transfer of the business (or at least a right of first refusal), the purchase price (which may be set or determined in some fashion), and the method of funding. Entity Approach . The business itself enters into the agreement and the firm carries insurance on the owner and the firm is the beneficiary. The company is obligated to buy the owner’s interest and the interest is then divided among the surviving buyers. Cross Purchase Approach . Each partner or stockholder buys a policy on the lives of the other owners. With 3 partners, six separate policies will be required. (# of partners x # of partners – 1) i.e., 3 x 2 = 6.
  19. 19. Split-Dollar Life Insurance The cost of permanent insurance is split between the employer and the employee, with the employer paying the annual increase in the cash value and the employee paying the remainder. The employer retains the right to receive the cash value at the employee’s death and the employee’s beneficiary receives the net amount at risk. SIMPLE EXAMPLE OF SPLIT DOLLAR (Annual premium is $20,000) CASH INCREASE IN Ee Er YEAR VALUE CASH VALUE PAYS PAYS 1 -0- ---- $20,000 -0- 2 $6,000 $6,000 14,000 $6,000 3 14,000 8,000 12,000 8,000 4 23,000 9,000 11,000 9,000 5 37,000 14,000 6,000 14,000 6 60,000 23,000 -0- 23,000 Thereafter, the employer pays the annual increase in the cash value and the employee pays nothing.
  20. 20. ENDORSEMENT METHOD The employer owns the policy and pays the premium. When the insured dies the employer collects the death proceeds, retains the total amount paid in premiums, and pays the remainder to the insured’s beneficiary. Each year the employee pays income tax on the value of the economic benefit received, i.e. the amount paid by the employer (usually the increase in cash value). COLLATERAL ASSIGNMENT METHOD The employee owns the policy and the employer’s contribution is treated as a loan and the employee is taxed on the difference between the market interest rate and any interest being charged by the employer (usually zero). Using the previous example the employer’s loan in the second year is $6,000. If the market rate is 10%, the taxable income is $600.
  21. 21. Split dollar life insurance is best used for providing low-cost life insurance protection to executives who are in their 30’s, 40’s, or early 50’s (because the cost to the executive is usually prohibitive at older ages). Still used in private companies but Sarbanes-Oxley (2002) prohibits a publicly owned company from using corporate funds to pay for insurance for its officers and directors .
  22. 22. TAX TREATMENT OF LIFE INSURANCE DEATH PROCEEDS Generally, death proceeds are received free of income tax. Viatical settlements and accelerated death benefits are also exempt. If a policy is placed under a settlement option, any interest is taxable. Death proceeds are taxable if the policy has been transferred for value. The transfer-for-value rule does NOT apply to: Transfers when the transferee-owner is the insured Transfers to a partner of the insured Transfers to a partnership (in which the insured is a partner) Transfers to a corporation (in which the insured is a shareholder or officer). If the proceeds are taxable, the beneficiary pay any amount in excess of the amount paid for the policy plus subsequent premiums.
  23. 23. LIVING PROCEEDS The “inside build-up” is not taxed as long as it is inside the policy. Loans are not taxable (unless it is a MEC). If a policy is surrendered for cash, the excess of the surrender value (if any) in excess of the policyholder’s current basis in the policy is taxable. (Dividends reduce the basis). Generally, a withdrawal is first treated as a nontaxable return of basis. The excess, if any, of the amount of the withdrawal over the current basis is taxable. If a withdrawal in the first 15 policy years reduces the death benefit (as in a universal life policy) the withdrawal will be taxed first.
  24. 24. INCOME TAXATION IF A POLICY IS SURRENDERED ASSUME: Cash value = $40,000 Outstanding policy loan = 15,000 Total dividends received = 6,000 Total premiums paid = 35,000 How much taxable gain will result? Basis: Premiums paid = $35,000 Minus dividends = 6,000 Basis = $29,000 Surrender value = $40,000 Minus basis = 29,000 Taxable gain = $11,000 (ordinary income) How much CASH will be received? $40,000 - $15,000 or $25,000
  25. 25. DEDUCTIBILITY OF PREMIUM PAYMENTS Premiums generally are not deductible—whether used for business or personal purposes. They can be deductible if they are charitable contributions, if they constitute alimony, or if the premiums are paid on a policy for an employee when the death benefit is paid to the employee’s beneficiary (e.g., group insurance).
  26. 26. TRANSFER TAXATION OF LIFE INSURANCE Life insurance proceeds are included in the decedent’s estate for federal estate tax purposes if: (1) the proceeds are payable to the executor (estate) (2) the insured possessed “incidents of ownership” (3) incidents of ownership were transferred within 3 years of death “ Incidents of ownership” include rights of the insured (or his estate) to one or more economic benefits from the policy. These “ incidents” are not always clear cut and many have been litigated.
  27. 27. The following are generally considered “incidents:” The right to: 1. cancel the policy 2. assign the policy 3. surrender the policy 4. obtain a policy loan 5. change the beneficiary 6. change contingent beneficiaries Being a beneficiary is NOT an incident of ownership. Paying premiums does not necessarily create an “incident.”
  28. 28. Normally, death proceeds should never be payable to the insured’s estate: a) proceeds will become subject to the claims of creditors b) proceeds will be subject to probate costs c) proceeds will be included in the estate for federal estate tax purposes.