1. Chapter 15 (not 15.8) Selected Chapter questions: 1,5,6 1

2.  Supplemental Medical Coverage. ◦ Similar to group plans, but purchased by individuals: ◦ Most common types are extended health and dental plans.  Disability Income Insurance. ◦ Provides income while insured is unable to work. ◦ Definition of disability is defined under the policy. ◦ 2 types of policies: Short Term Disability and Long Term Disability. Chapter 15 BU3532

3.  Critical Illness Insurance ◦ Combines elements of life, health and disability policies. ◦ Usually pays lump sum to insured on occurrence of covered illness after a survival period.  Long Term Care Insurance. ◦ Covers home care and facility care. ◦ Depends less on one’s health history than one’s lifestyle and mobility. Chapter 15 BU3533

4.  2 broad types of individual life insurance. ◦ Term insurance – death protection. ◦ Cash Value Policies – death protection and savings accumulation, called the cash value. ◦ Most common cash value policies are whole life, universal life and variable life. Chapter 15 BU3534

5.  Surrender: ◦ Terminate the policy. ◦ Early policy surrenders are called lapses.  Cash value: ◦ The amount policyholder receives for cash value policy when (s)he surrenders policy. ◦ Amount received  with number of years policy is in force. Chapter 15 BU3535

6.  Death benefit: ◦ Amount received by beneficiaries when the insured dies. ◦ For term insurance, whole life and some universal life products, death benefit = face value. ◦ For some universal life products, death benefit = face amount + cash value.  Death protection = death benefit – cash value. Chapter 15 BU3536

7.  Bundles death protection coverage with savings accumulation.  Why? ◦ Individual budget reasons. ◦ Permanent life insurance protection. ◦ Tax advantages.  Disadvantages: ◦ Tax advantages only accrue if insurance protection purchased. ◦ High transactions costs. Chapter 15 BU3537

8.  Death benefit over a fixed term.  Pure death protection.  No savings feature - no cash value.  Premiums increase over time.  Most are guaranteed renewable.  At renewable date, policyholder may purchase cash value policy without proving insurability. Chapter 15 BU3538

9.  A small market in North America.  Pays the face amount. ◦ If the insured dies OR ◦ If the insured survives the policy term.  Savings vehicle, no tax advantage here. Chapter 15 BU3539

10.  Purchased either by single premium, or level premiums over policy life.  Level death benefit over life of policy paid when policyholder dies or reaches 100.  Pre-pay for increasing probability of death.  Cash value received by policyholder if policy is surrendered early.  Some policy features: ◦ Decreasing amount. ◦ Indexing. ◦ Guaranteed insurability. Chapter 15 BU35310 Most are indexed. Only 6 times in policy life.

11.  Cash value grows each year while death protection declines  level face value.  Cash value growth is given by fixed schedule.  Example: If policy has cash value of $25,000 and face amount $100,000 when insured dies, beneficiaries receive $100,000 or $25,000 in cash value and $75,000 in death protection. Chapter 15BU353 11 100 Death protection cash value Face Amount

12.  Pays annual dividends.  Dividends paid if actual experience better than expected experience.  Treated as return of premiums, not taxable.  Why such a conservative approach? Chapter 15 BU35312

13.  Policyholder use of dividends: ◦ Can increase face amounts (paid-up additions). ◦ Pay portion of next premium.  Illustrated dividends: ◦ When policy is first sold, agent must show effect of dividend usage based on current payment rates. ◦ Potential for legal difficulties. Chapter 15 BU35313

14. Surrender OptionsPolicy Loans  Surrendered for cash value.  2 options: ◦ Paid-up insurance. ◦ Extended term insurance.  Borrow against policy’s cash value.  Owes the principal plus the interest.  Why does policyholder pay interest on his/her own money?  If the policyholder dies prior to repayment, loan balance reduces the death benefit. Chapter 15 BU35314

15.  Generally front-end load expense charges.  Return earned on the savings part is relatively low for the first few years.  Implications of front-end loading: ◦ Implicit returns on savings accumulated through life insurance will be low or even negative if the policy is dropped early. ◦ Insurers with lower lapse rates can offer policies with higher returns. Chapter 15 BU35315

16. Similarities to Whole Life Differences from Whole LIfe  Provides permanent death protection and savings accumulation.  Policy loans available.  Offers greater flexibility with premium payments. ◦ No fixed premium schedule. ◦ Often premium payment can be missed.  The cash value varies explicitly over time based on premium payments, expense and mortality charges, and credited interest.  Partial surrenders instead of policy loans. Chapter 15 BU35316

17.  Policy has 2 possible types of death benefits:  Level death benefit: ◦ Death protection decreases as cash value increases. Chapter 15BU353 17 Death benefit = face amount unless cash value approaches face amount. Age Death protection cash value Death benefit

18.  Variable death benefit option.  Death benefit varies with cash value. ◦ Benefit = face value + cash value. Chapter 15BU353 18 Age Death benefit Cash value Death protection

19.  The cash value of a universal life policy varies over time.  Death benefit & savings accumulation are unbundled.  Usually guarantee a minimum interest rate. Chapter 15 BU35319 Cash value at beginning of the period + Premium payments at beginning of the period - Mortality charge at beginning of period - Expense charge at the beginning of the period + Interest credited at the end of the period Cash value at the end of the period

20.  Similar to whole life: ◦ Generally have fixed and level premiums. ◦ Policy loans offered.  Main differences: ◦ Cash value varies with return earned on portfolio of assets chosen by policyholder. ◦ Death benefit varies with cash value with minimum guarantee. Chapter 15 BU35320

21.  Death benefits are not taxed.  No income tax paid on increases in cash value when the policy is in force.  Upon surrender, income tax is paid on the increase in value: ◦ C.V. – (  premiums - cost of pure insurance –  dividends).  So….. ◦ If insured dies – returns are not taxed. ◦ If insured lives – tax is deferred until funds are received. Chapter 15 BU35321

22.  Remember, these are value contracts.  One rule of thumb: coverage should equal 6 to 10 times annual income.  Another rule: forecast the consumption needs of dependents. ◦ This depends on each person’s family situation. Chapter 15 BU35322

23.  Large and growing part of life insurance business.  Annuities used as risk management tool - ◦ Protection against outliving resources.  2 periods associated with annuities: ◦ Accumulation period:  Policyholder pays premiums. ◦ Payout period:  Insurer makes payments. Chapter 15 BU35323

24.  Straight life: ◦ Annuity pays out until death.  Annuity certain: ◦ Pays out for a fixed number of years.  Life annuity with period certain: ◦ Pays out for a fixed number of years and then will pay out until death.  Joint and last survivor: ◦ End at death of two people. ◦ Payment may be reduced after death of first. Chapter 15 BU35324

25.  Fixed annuities: ◦ Return credited varies with interest rates. ◦ Insurer guarantees a minimum rate.  Variable annuities: ◦ Return credited varies with return on assets chosen by contract holder. Chapter 15 BU35325

26. Premium Payments 1. Single premium 2. Fixed period, level premium up to advanced age 3. Flexible premium over time Annuity benefits begin 1. Immediately (i.e. at the end of 1 period) 2. Deferred Annuity benefits end 1. Fixed number of years. 2. Death of 1 or more individuals 3. Combination of above Insurer payments 1. Fixed 2. Vary with interest rates, guaranteed minimum 3. Vary with portfolio chosen by policyholder Chapter 15BU353 26

27.  Focus on net premiums & ignore expenses and risk (contingency) loadings.  Use mortality table. Chapter 15BU353 27 = 6501/ 890,645 = 7038/ 884,144

28.  Assume premium is paid at beginning of year, and claim paid at end of year.  Find fair premium for $100,000 1-year term for a 51 year-old if interest rate is 4%. Chapter 15BU353 28

29.  Find fair premium for $100,000 2-year term for a 51 year- old.  Assume that a single premium is paid up front and that the interest rate is 4%.  Benefits are paid at the end of the year of death.  Solution: ◦ Calculate the probability that a 51 year old will die in 1 year and in 2 years. ◦ Use these to calculate insurer’s expected discounted claims costs. Chapter 15BU353 29

30.  Redo previous example assuming that premiums are paid at the beginning of each of the 2 years.  Remember that you can only pay a premium if you are alive! Chapter 15BU353 30

31.  If an individual wants coverage for 2 years has 3 choices: ◦ Purchase 2 1-year term contracts.  1 year premium for 51 year old: $702 payable at time 0.  1 year premium for 52 year old:, payable at time 1. ◦ Purchase 2-year contract with single payment.  Premium already calculated as $1433 payable at time 0. ◦ Purchase 2-year contract with level payments.  Premium already calculated as $733 a year. Chapter 15 BU35331

32.  Adjust year 2 premiums: ◦ For mortality and time value of money. Chapter 15BU353 32 765.38*(1-.0073)/1.04 733*(1-.0073)/1.04

33.  Annual premiums for successive term policies reflect the annual cost of insuring. ◦ Annual cost = $702 and $765.38.  With a 2-year policy, annual premium is $733 ◦ Premium in year 1 > $702. ◦ Premium in year 2 < $765.38.  With whole life policies (and universal and variable life): ◦ Difference can be large. ◦ Gives rise to cash value. Chapter 15 BU35333

34.  Consider life annuity of $1000 per year purchased by individual who is 70 years old. Suppose the interest rate is 4%. Chapter 15BU353 34 0.9605*0.9567 = 0.9189*0.9524 = 960.49/1.04=

35.  Apply same principles used with term.  Forecast expected cash flows to age 100: ◦ Recall at age 100, the policy will pay if policyholder is alive or dead.  The lump sum single premium is then the present value of the future expected claims costs.  For a continuous level premium – same procedure as pricing term policies with level payments.  Can also use similar principles to calculate limited payment whole life premiums. Chapter 15 BU35335

36.  Insurer testing for HIV provides a good example of how the cost of gathering information about mortality risk can sometimes cause insurers not to gather information. Insurers commonly use blood tests to identify HIV. However since blood tests are not free, insurers only use blood tests if the expected costs of misclassification exceed the cost of the test. Suppose the blood test is $100 and the probabilities of death for HIV infected males is 20 times the probability of a non infected male. Let 4% be the relevant interest rate. Chapter 15 BU35336

37. a) What are the expected claim costs for a 30 year old male applying for $100,000 of 1 year term insurance if he is HIV positive? HIV negative? b) Suppose that 1000 30 year old males apply for insurance. The insurer knows that 2% of them are HIV positive but needs the blood test to identify those specific applicants. Should the insurer give all applicants a blood test? Chapter 15BU353 37