Risk and insurance management fin440 chapter 10 life insurance

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Chapter 13
Buying Life
Insurance

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13-2
Determining the Cost of Life Insurance
• The cost of a life insurance policy is the
difference between what you pay and what
you get back
• When determining the cost of life
insurance, four major factors must be
considered:
1. Annual premiums
2. Cash values
3. Dividends
4. Time value of money

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13-3
Determining the Cost of Life Insurance
• Under the traditional net cost method, the cash value and
expected dividends are subtracted from annual premiums to
obtain a net cost per year figure. If the annual premium for
a $10,000 ordinary life insurance policy issued to a female,
age 20, is $132.10 (paid at start of policy period).
Accumulated dividends over a 20-year period are $599, and
the cash-surrender value at the end of the twentieth year is
$2,294. The average cost per year is minus $12.55 (- +1.26
per +1,000).
– This method does not consider the time value of money
– In addition, the insurance illustration often showed the
insurance to be free (to have a negative cost). This is contrary
to common sense, because no insurer can provide free
insurance and remain in business.

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13-4
Exhibit 13.1 Traditional Net Cost Method

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13-5
Determining the Cost of Life Insurance
• The interest-adjusted cost method is more
accurate because it considers the time value
of money
• Interest-adjusted cost indices come in two
forms:
– The surrender cost index is useful if the owner
expects to surrender the policy after some time
period
– The net payment cost index is useful if the owner
expects to keep the policy in force

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13-6
Exhibit 13.2 Surrender Cost Index

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13-7
Exhibit 13.3 Net Payment Cost Index

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13-8
Determining the Cost of Life Insurance
• Interest-adjusted cost indices can be used
to compare policies across insurers
– There is a wide variation in costs indices across
insurers – it pays to shop around!
– Most consumers use premiums as a basis for
comparison, but agents will supply cost indices

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13-9
Determining the Cost of Life Insurance
• The Life Insurance Policy Illustration Model Act
requires insurers to present certain information to
applicants for life insurance
– The goal is to reduce misunderstanding of policy values by
policyowners, and reduce deceptive sales practices by
agents
– A narrative summary describes the basic characteristics of
the policy
– A numeric summary shows the premium outlay, value of the
accumulation account, cash surrender values and death
benefit
– The act also prohibits certain sales practices and requires the
insurer to provide an annual report

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13-10
Rate of Return on Saving Component
• The annual rate of return earned on the
savings component of a policy is an
important consideration if you intend to
invest over a long period of time
• The Linton yield is the average annual rate
of return on a cash value policy if it is held
for a specified number of years

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13-11
Exhibit 13.5 Average Annual Rates of Return
for 109 Cash-Value Policies by Year of Policy

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13-12
Rate of Return on Saving Component
• The yearly rate of return method is based on a
formula:
• The information needed for the calculation is
readily available to consumers
1
r
policy yea
the
of
beginning
at the
policy
the
in
available
amount
component
protection
the
of
price
assumed
r
policy yea
the
of
end
at the
policy
the
in
available
amount
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
















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13-13
For example, assume that Isiah purchased a $100,000 participating
ordinary life policy at age 35. He is now age 42 at the beginning of the
eighth policy year. He would like to know the yearly rate of return on the
saving component for the eighth year of the policy. The annual premium is
$1,500. The cash value in the policy is $7,800 at the end of the seventh
policy year and $9,200 at the end of the eighth policy year. The eighth-year
dividend is $400.

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13-14
Exhibit 13.6 Benchmark Prices

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13-15
Taxation of Life Insurance
• Life insurance proceeds paid in a lump
sum to a designated beneficiary are
generally received income-tax free
– The interest component of periodic payments is
taxable as ordinary income
– Premiums are generally not deductible
– Dividends are not taxable, but interest on
dividends retained is taxable
– If a policy is surrendered for its cash value, any
gain is taxable as ordinary income

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13-16
Exhibit 13.8 Shopping For Life Insurance