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Personal Finance: A Gospel Perspective

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1 Personal Finance: A Gospel Perspective
Insurance: Basics, Life and Disability Insurance

2 Objectives A. Understand the basics of insurance B. Understand life insurance C. Understand disability insurance

3 Insurance Basics Insurance is an important part of becoming financially self-reliant. Elder Marvin J. Ashton said: Appropriately involve yourself in an insurance program. It is most important to have sufficient medical, automobile, and homeowner’s insurance and an adequate life insurance program. Costs associated with illness, accident, and death may be so large that uninsured families can be financially burdened for many years. (Marvin J. Ashton, “Guide to Family Finance,” Liahona, Apr. 2000, 42.)

4 Insurance Basics (continued)
President N. Eldon Tanner further commented: With rising medical costs, health insurance is the only way most families can meet serious accident, illness, or maternity costs, particularly those for premature births. Life insurance provides income continuation when the provider prematurely dies. Every family should make provision for proper health and life insurance. (N. Eldon Tanner, “Constancy Amid Change,” Ensign, Nov. 1979, 80.)

5 Insurance Basics (continued)
What is insurance? Insurance is a legal contract between you and an insurance firm whereby the firm agrees for a premium (fee) to pay you compensation for certain kinds of losses or events, i.e., death, sickness, compensation for accidents, loss of ability to work, legal expenses, etc. What are the major types of insurance? Life Insurance, Health Insurance, and Auto, Home, Disability, and Liability Insurance

6 Insurance (continued)
What is the purpose of insurance? The purpose of insurance is to transfer the risk of certain types of losses or events from yourself to another institution. By transferring risk, it can help you and those you love achieve your specific goals if you die, get sick or become unable to work Specific goals may include: To take care of your spouse and children To raise children without working outside the home To be able to go to college and on missions

7 Insurance (continued)
How do you eliminate risk? Avoid it. You can take care of yourself, avoid high risk occupations, eat well, and exercise. Reduce it. You can reduce some risks by adding fire extinguishers and burglar alarms, adding airbags, or getting regular medical checkups Assume it. You can assume the risk through self-insurance. If the costs are not too high, you can assume some risks yourself Transfer it. You can transfer the risk to others by purchasing insurance. You are paying premiums to transfer the risk to an insurance company.

8 Insurance (continued)
Should you insure against all losses? No. Some losses are not as critical as others. Insure against the critical or serious losses Can you classify your risks? Yes. I like two thoughts: Frequency of loss How often does the loss happen? Severity of loss How severe are the results if the loss happens?

9 Insurance (continued)
Frequency of Loss Low High Avoid Reduce High Transfer Severity of Loss Reduce Assume Reduce Assume Low

10 Insurance (continued)
What is the key to insurance? You need to balance the cost of reducing risk with the severity of the loss Insure against high severity losses that rarely occur—those that could have a major impact on the financial condition of you and your family Reduce and avoid those other risks that you can

11 Questions Any questions on the insurance basics?

12 Understand Life Insurance
Case Study #3. Jonathan is a widower with two children and earns $50,000 per year. His group life insurance policy from work will pay 3 times his salary. He has $70,000 saved in his company 401K, $10,000 in a Roth IRA, and $5,000 in his savings account. He wants to purchase life insurance until is youngest graduates from college in 20 years. He is not concerned about his outstanding mortgage, as his kids could go live with his brother in the event of his death. a. Assuming his brother can earn 3% after-tax and inflation, use the earning multiple approach to calculate his life insurance needs. b. What other information would you need to calculate the needs approach for Jonathan?

13 What is life insurance? Why have life insurance?
Insurance that provides compensation to your beneficiaries should you die prematurely. This is a high severity risk Why have life insurance? It transfers the economic loss of death from an individual to a insurance company by way of a life insurance contract It can help us take care of our own and extended families should we die Death is not an excuse for disobedience

14 Life Insurance (continued)
Other Benefits: Estate Planning Life insurance products can be helpful in making sure there are sufficient funds for estate tax purposes An owner has a business worth $3 million. When he dies, he wants the business to pass to his son. How can life insurance help? The owner puts the business in a trust, with the son as trustee, and buys a $750,000 life insurance policy, with his trust as beneficiary. When he dies, the trust takes the $750,000 policy and pays the estate taxes. The son is the beneficiary and now owns the business estate-tax free.

15 Life Insurance (continued)
Retirement Planning The cash-value portion of life insurance grows tax-free, after (lots of) fees and expenses An investor wants to save for retirement. He has already invested the maximum in his 401k, Roth IRA, and other vehicles. How can life insurance help? A cash value product provides both a death benefit and savings component. The cash value portion grows tax deferred after fees and expenses The investor can borrow against the cash value in the insurance contract for a low-cost loan. He will pay a specified interest rate for the loan, and if not paid back, the death benefit is reduced

16 Life Insurance (continued)
Forced Savings For those without the discipline, life insurance can be an expensive type of forced savings The investor is unable to save for retirement, although he is good at paying his bills. How can life insurance help? The investor purchases a cash-value product with low fees and expenses, and can direct, to a degree, where the assets are invested. This become forced savings to aid in achieving the investor’s goals. The investor, upon retirement (or even before), can then borrow against the account.

17 I. Why Life Insurance? Why Life Insurance?
Insurance is for emergency planning and control of your life We have been commanded to keep adequate insurance Death is not an excuse for not taking care of our families

18 II. How does Life Insurance Work?
Insurance is an example of risk pooling Individuals transfer (share) their financial risks with others to reduce catastrophic losses from: Death Accidents, or Health problems

19 III. Who needs Life Insurance?
Not everyone needs life insurance. Those who do include: Single or married with dependents or children Married, single income couple where the spouse has insufficient work skills or savings Business owners who wish to transfer their businesses to the next generation Those whose estate exceeds the estate tax-free transfer threshold

20 How much Life Insurance?
How do you determine your Life Insurance needs? From the old LDS Handbook for Families it states: Insure the family’s breadwinner first, then others, if desired, as income permits. At a minimum, get enough life insurance to pay for such things as a funeral, taxes, mortgage on the home, car payments, and other debts. The next priority should be to get enough insurance that, supplemented by any government retirement benefits the surviving spouse may be entitled to, there will be sufficient to provide for the family and to make provisions for the children’s education and missions. “Handbook for Families: Preparing for Emergencies,” Ensign, Dec. 1990, 59.

21 How much Life Insurance? (continued)
There are two different methods of determining how much life insurance. The earnings multiple approach The goal is earnings replacement It seeks to replace the annual salary stream of a bread winner for X years, normally 5 – 15 times gross salary is recommended. The lower general interest rates, the higher the multiple needed

22 How much Life Insurance? (continued)
How is it calculated? 1. Adjust salary down to compensate for the reduction in household expenses 2. Choose the appropriate interest rate to match the assumed after-tax and after-inflation earnings on the policy settlement. 3. Determine the income stream replacement and annuity

23 The Needs Approach How is it calculated? 1. Adjust the salary downward
2. Add up all funding needs The total needs of the beneficiaries includes: immediate, debt elimination, transitional, dependency, spousal life income, education, and retirement funds 3. Subtract current insurance coverage and other available assets This is additional coverage necessary 4. Determine the income stream replacement and calculate the needed annuity

24 Life Insurance and Your Investment Plan
Cash value: with guaranteed insurability option paid up till age 65. Term: Five-year guaranteed renewable term in $50,000 and $100,000 increments; can add and drop as necessary. Investment: Includes individual and employer sponsored retirement plans

25 V. What Kind of Life Insurance?
What are the different types of life insurance? Term insurance Cash value (or endowment) Note: All life insurance is term insurance. The difference is that cash-value insurance has a separate investment component that accrues, after fees and expenses (and these may be substantial), without taxes

26 Life Insurance Policy Terms
Premium The monthly cost of the policy Face value The benefit due upon death Insured The person whose life is covered by the policy Policy owner The individual or business that pays for and owns the policy Beneficiary The recipient of the benefit upon the death of the insured

27 Different Types of Life Insurance
What is Term Insurance? Insurance protection for the insured over a specific term or time period. What are its advantages? It is the least expensive form of insurance Death benefit coverage is for a specific term What are its disadvantages? It is only valid if the insured dies during the term Insurance may not be renewed once your term expires Advancing age increases the cost of insurance

28 Understanding Term Insurance: The Process
+ Premium Payments Your Insurance Policy - Mortality Costs - Expense Costs (very small)

29 Term Insurance (continued)
What are the different types of Term Insurance? Renewable term insurance Can be renewed for a specific number of years Generally have a guaranteed maximum premium for some period of time The longer the guaranteed premium (.i.e., 10 years), the higher the monthly or annual premium

30 Term Insurance (continued)
Decreasing term insurance Premiums remain constant while the face amount of coverage decreases This takes into account the fact that the mortality cost of term insurance increases in later years Generally for a specific loss coverage, such as mortgage or child dependency where need changes Convertible term life insurance Term policy that can be changed to cash-value policy within a specific number of years

31 Term Insurance (continued)
Why are premiums for term much less than cash-value? You are only paying for insurance for a specific period, i.e. risk is priced one period at a time 95% of term policies lapse without payment It is generally for a shorter period, i.e years. The longer the period, the more insurance companies must charge higher fees in the early years to offset the more expensive mortality charges and fees in the later years Term is generally easier and cheaper to administer Fees and sales charges are less complex

32 Term Insurance (continued)
Key questions when purchasing term insurance: How long can I keep this policy? What are the renewal terms of the contract? When will my premiums increase? Can I convert my term policy to a permanent or cash-value policy? What are the details? How strong is the company financially?

33 Cash-Value Insurance What is cash-value or permanent insurance?
It is an insurance contract that is purchased for your entire life with premiums divided between death protection and savings. What are its advantages? Provides insurance that cannot be cancelled Can be used for estate, retirement, and “forced” savings What are its disadvantages? It is very complex and expensive Unless premiums are paid, it can expire worthless Certain cash-value products can lose money

34 Understanding Cash Value Insurance: The Process
+ Premium Payments + Investment Income + Dividends (if participating) Your Cash-Value Insurance Policy - Mortality Costs A major benefit is to be able to borrow against your policy tax-free - Expense Costs (may be significant)

35 Cash-Value Insurance (continued)
Different types of cash-value insurance? Whole life. For those who want term protection with a savings element Universal life insurance. For those who want a flexible policy that combines term protection and tax-deferred savings Variable life. For those who want term protection and to manage their own investments with an opportunity for tax-deferred savings. Variable Universal Life. For those who want term protection, full policy flexibility, and to manage their own investments

36 Cash-Value Insurance (continued)
The differences in cash-value products relate to the goals, types of investments, and flexibility Goals: The type of return and risk the insured are willing to take with their investments. Types of investments: The types of investment vehicles the non-mortality portion of the premiums are invested in, i.e., long-term bonds, short-term cash, stocks, etc. Investment, premium and face amount flexibility: The ability to change the type of investments, monthly premium amounts, or the face value amount during the life of the contract.

37 Cash-Value Insurance (continued)
Source: Ben G. Baldwin, The New Life Insurance Investment Advisor, 2nd ed., McGraw Hill, New York, 2002, pp. 31, 50, 77, and 88.

38 Cash-Value Insurance (continued)
The key is to understand why you want cash-value life insurance Understand your needs Understand the individual polices of competing life insurance companies, i.e., the charges and deductions of the insurance company, and fees and expenses of the mutual funds/assets invested in Select the policy that gives you maximum benefit at the lowest possible cost to you.

39 Cash-Value Insurance (continued)
Why are cash value premiums higher than term? It is priced for your entire life Earlier premiums must be priced higher to take into account that mortality costs increase as you age It includes a savings component These savings must be funded It cannot be terminated by the insurance company 95% of all cash-value policies are paid It is more costly and time consuming to administer There are more and higher up-front and operating fees, and sales and other charges are higher

40 Cash-value Insurance (continued)
Watch your expenses carefully Expenses on a typical Variable Universal Life policy at the account level include: Minimum Average Maximum Sales Charges * 0.0% 8.0% 10.0% State Premium Taxes 0.75% 2.0% 5.0% DAC Tax * 0.0% 1.5% 2.0% First-year Expense * $200 $350 $700 Administration Fees/month * $4 $6 $15 Mortality and Expense 0.4% 0.7% 1.3% Source: Ben G. Baldwin, “The New Life Insurance Investment Advisor,” 2nd ed., McGraw Hill, New York, 2002, p.106. * These expenses will vary among competing insurance policies from different companies.

41 Cash-Value Insurance (continued)
Expenses at the sub-account level (i.e. the individual investment level) include: Asset Charges Minimum Average Maximum Investment Management * 0.4% .8% 2.8% 12-b1 Fees * 0.0% 0.0% 0.5% Overall Expense Ratio * 1.0% 1.5% 4.4% Policy Loans as % Contract Surrender Value *, Interest spread 75%,4% 90%,2% 100%,0% Surrender Charges * can be significant Source: Baldwin, p.106 * These expenses will vary depending on the mutual funds or assets chosen for the sub-accounts. Mutual fund expenses can be reduced through research on comparable funds and comparison shopping.

42 Cash-Value Insurance (continued)
It is not uncommon for the deductions and fees to range between 5% and 15% of every dollar you put into some types of cash-value insurance. As such, the cash-value portion of this life insurance grows slower than a term policy with the remainder invested Cash-value insurance is not for everyone, but it may be for some Key is to understand your needs and the needs cash-value insurance can fill Estate planning, Retirement planning, after all other tax-deferred vehicles have been filled, and Forced savings (but it is not as good as other savings vehicles)

43 Cash-value Insurance Important questions to ask about cash-value insurance: Are the premiums within my budget? Are costs reasonable? Can I commit to these premiums over the long-term? On a variable life policy, what is the assumed interest rate in the illustration? Is the classification shown in the illustration appropriate for me (i.e. smoker/non smoker, male/female) Which figures are guaranteed and which are not? Will I be notified if the non-guaranteed amounts change? Is the death benefit guaranteed? Will the premiums always be the same, even if interest rates are lower that the illustration? Is the illustrated premium sufficient to guarantee protection for my entire life? Is the “current rate” illustrated actually the rate paid recently? What was the current rate in each of the last five years? What assumptions have been used regarding company expenses, dividends, and policy lapse rates? Does all my cash value earn the current rate? Is the illustration based on the “cash surrender value” or “cash value?” The cash surrender value is usually lower and reflects what will be paid if the policy is cancelled.

44 Cash-value Insurance for Students
Key Questions: Can you commit to the premiums over the long-term? How can you, when you may not have a job? Do you need the tax benefits now? A 401k or IRA may be better? Fill those first Are the rates of return guaranteed? No. Be careful of people selling these products who do not know what they are selling? Do you have a history of medical problems that would preclude your ability to get term insurance? In this case, you “might” look into cash-value or convertible term insurance)

45 Determining Which Type of Life Insurance Is Best for You
For most, convertible (convertible to a cash-value policy) renewable (up to 30 years) term is the cheapest and best alternative (especially for students) Goal: Income Replacement of breadwinner Relatively low cost Affordable coverage when life insurance is needed the most Can afford to carry the coverage needed for the time needed While it becomes very expensive with age, it may be less necessary as your other assets grow so you may need less insurance in the future

46 Which Life Insurance Is Best (continued)
Cash-value insurance may be the best choice if you meet very specific criteria: Goal: Medical Insurability. You have a history of medical problems (and if you already have convertible term insurance) you can’t be denied life insurance if you convert Goal: Estate Planning. Your assets are very large, and you have estate planning issues (i.e., you need to shield some of your assets should you die) Goal: Retirement Savings. You have already invested the maximums in your tax deferred accounts (IRA, 401k, Roth, SEP-IRA, etc.) and want additional tax-deferred savings

47 Which Life Insurance Is Best (continued)
Still unsure of yourself? Consider a renewable convertible term policy. It allows the low cost of term insurance, with the ability to convert to a cash policy in the future within a specific number of years It gives you time to re-evaluate your current situation and still retain coverage for you and your family

48 Which Life Insurance Is Best (continued)
Note of caution: Because of the complexity and high setup costs for cash-value life insurance, it is very expensive to change. It is therefore of critical importance that you understand why you are buying and what you are buying before you purchase your policy. These contracts are very expensive to change Consumers lose a significant amount of money each year because they buy policies they don’t understand and then cancel them a few years later. Remember the key principles of insurance

49 Steps to Buying Life Insurance
1. Understand what you want Know yourself Know your goals Know your budget Know how much insurance you need Know how much money you want to spend

50 Steps to Buying Life Insurance (continued)
2. Compare costs of competing policies Do your homework and shop around, not just on price, but on benefits, coverage, and exclusions. Possible comparisons: Annual Premiums: Participating or non-participating? If participating, the 5 year dividend history? This year? Total premium cost over the next 10 years (excluding dividends) In 10 years, what will be your cash/loan value? Paid-up conversion value? Extended term conversion value?

51 Steps to Buying Life Insurance (continued)
Compare costs (continued) Total Premium cost over 20 years? In 20 years, what will be your cash/loan value? Paid-up conversion value? Extended term conversion value? At what interest rate can you borrow against the policy? Is the interest rate guaranteed?

52 Steps to Buying Life Insurance (continued)
3. Select only a high-quality insurance company based on company ratings Price is not the only criteria. You also want the company to be around to pay the benefits. Remember, you are looking for a long-term insurance relationship Ratings Companies: A.M. Best Fitch Ratings Moody’s Standard & Poor’s Weiss Research

53 Steps to Buying Life Insurance (continued)
4. Select an insurance agent with whom you feel comfortable and are not pressured Study the agent’s recommendations and ask for a point-by-point explanation if there are items you don’t understand Understand how the agent is getting compensated If they can’t (or won’t) explain all the costs and benefits, go to someone who can Do your homework

54 Steps to Buying Life Insurance (continued)
5. Use wisdom in your decisions Make sure you check out the insurance company and read your policy when you receive it to ensure it is correct. It must all be in writing! Consider alternative approaches: the net or an advisor Make sure you feel good about the decision before you sign anything or send money. Don’t rush into a decision. Make your check payable to the insurance company, not the agent, and be sure you are given a receipt for all money’s given.

55 Steps to Buying Life Insurance (continued)
There is a difference between choosing an agent, and being chosen by an agent. The selection decision is up to you—use it wisely. Read your policy carefully during your “free-look” period. Review your insurance policy annually after that. If you are changing policies, make sure you clearly understand the consequences. Surrendering your policy to buy another could be very, very, very (get the hint) costly. If you have a complaint, contact your agent and the state insurance department

56 Case Study #3 Answer a. Earnings Multiple Approach Salary $50,000
Expense reduction % reduction (3 to 2) Amount needed ,000 Life insurance needed $550,467 PMT = 37,000, I = 3%, N = 20 Company life insurance ($150,000) or 3 times salary Additional needed $400,467 Multiple needed: times salary

57 Case Study #3 Answer (continued)
b. Other information for a needs approach would be funeral expenses, debt elimination, children’s educational expenses, mission expenses, social security benefits, etc. Notice that the earnings multiple approach does not take into account your individual level of savings or your current financial condition.

58 Questions Do you have any questions on life insurance?

59 B. Understand the Key Areas of Disability Insurance
What is disability insurance? Disability is similar to life insurance, but is really “earning-power” insurance Insurance that in the event that income is interrupted due to illness, sickness, or accident, you will still have income Who needs disability insurance? Anyone who depends on income from a job Disability only kicks in if there is a financial catastrophe in the making

60 Disability Insurance (continued)
What are the sources of disability insurance? Employers Government Private providers Isn’t worker’s compensation sufficient? What about if the accident is not work-related? Coverage is determined by individual states, with wide variability Social Security benefits vary depending on how many years you have paid into the system, your salary, how long the disability is expected to last

61 Disability Insurance (continued)
How much coverage should I have? You should have enough coverage to maintain your living standard should you no longer be able to work Your investment income will not stop with a disability, but your income from working will stop If you have sufficient savings, you may not need much insurance, perhaps only 30% of after-tax income If you have little savings, you may need a lot, perhaps 80%

62 Disability Insurance (continued)
What are the key areas of disability insurance? Definition of disability What exactly does the policy consider a disability? Stick with a policy that defines disability as an inability to perform your normal job. A combination definition may include “if you can’t perform your normal job for the first 2 years, and afterwards any occupation for which you are reasonably suited” may be acceptable

63 Disability Insurance (continued)
Residual or part-time payments when returning to work part-time Some policies offer partial disability payments that allow workers to return to work part-time These payments make up the difference between part-time and full-time work

64 Disability Insurance (continued)
Benefit Duration Policies state how long the benefits will continue Most policies provide benefits for a maximum period or until the disability ends (or the disabled reaches age 65 or 70). Short-term disability policies generally provide benefits from 6 months to 2 years, after a wait of 8 to 20 days Only a long-term policy makes much sense. Your emergency fund protects short-term

65 Disability Insurance (continued)
Waiting or Elimination Period Policies determine the waiting period before the benefits begin Most policies have waiting periods of between 1 and 6 months. Generally the longer the waiting period, the less-expensive the policy

66 Disability Insurance (continued)
Waiver of Premium What is the waiver of premium? It is a good idea to have a waiver of premium provision, which waives the premium payments if you become disabled Non cancelable Make sure your policy that cannot be cancelled. This protects you and guarantees your policy is renewable

67 Disability Insurance (continued)
Rehabilitation Coverage What is the rehabilitation coverage? This provides for vocational rehabilitation, allowing the policyholder to be retrained for employment through employment-related educational and job-training programs. Cost of Living Rider This provides for inflation adjustments to protect you from the impact of inflation

68 Questions Any questions on disability insurance?


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