1. 1 Ins301 Chp15 –Part1 Life Insurance and Annuities Terminology Types of life insurance products Tax treatment of life insurance Term insurance Endowment insurance Whole life insurance Universal insurance Variable insurance

2. 2 Ins301 Chp15 –Part1 Terminology Death benefit = amount beneficiaries receive Cash value = amount of savings accumulation Death protection = amount of pure death protection = death benefit - cash value Face amount = stated amount of coverage = death benefit (for term, whole life, & some universal life) = death benefit - cash value (for some universal life) Cash surrender value = the amount of money that the policyholder can withdraw (=cash value - surrender penalty)

3. 3 Ins301 Chp15 –Part1 Life Insurance Products: General Introduction Term insurance pure life insurance Cash value life insurance pure life insurance + Savings accumulation whole life universal life variable life Variable universal life

4. 4 Ins301 Chp15 –Part1 Tax Treatment of Life Insurance Death benefits are not taxed Income tax is not paid on increases in cash value while the policy is in force Upon surrender, income tax is paid on Cash surrender value - sum of all premiums + sum of all policyholder dividends

5. 5 Ins301 Chp15 –Part1 Implications of Tax Treatment Implicit returns on savings accumulation Escape taxation if insured dies Tax deferred if the policy is surrendered Partially taxed if policy is surrendered  Amount which is taxed is less than implicit return b/c part of premiums is cost of death protection

6. 6 Ins301 Chp15 –Part1 Term Insurance Typically provides pure death protection over a fixed term, usually one year or five years. There is no savings feature and therefore no cash surrender value. Data 1/4 of policies almost half of death protection purchased Guaranteed renewable Premium increases over time. Why?

7. 7 Ins301 Chp15 –Part1 Life Insurance Pricing Ignore expenses and risk load ==> focus on net premiums Use mortality table Probability of dying at age x conditional on living through age x-1 Example: Probability of male dying at age 40 = 0.00302 Assume Premiums paid at beginning of year Claims paid at end of year

8. 8 Ins301 Chp15 –Part1 Pricing 1-Year Term Find fair premium for $100,000 1-year term for 40 year-old  Interest rate = 10%  Insurer’s cash flows: Beg. of YearEnd of Year $100,000 with prob 0.00302 Loss $0 with prob. 0.99698 Expected claim cost = ________ Premium = Present value of expected claim cost = __________

9. 9 Ins301 Chp15 –Part1 Pricing 1-Year Term Find fair premium for $100,000 1-year term for 41 year-old  Interest rate = 10%  Insurer’s cash flows: Beg. of YearEnd of Year -$100,000 with prob ____________ Premium $0 with prob. ____________ Expected claim cost = ___________ Premium = Present value of expected claim cost = ____________

10. 10 Ins301 Chp15 –Part1 Pricing 1-Year Term Premium increases as probability of dying increases

11. 11 Ins301 Chp15 –Part1 Pricing 2-Year Term Find fair premium for $100,000 2-year term for 40 year-old Insurer’s claim costs: Beg. of Year 1End of Year 1End of Year 2 -$100,000 -$100,000 with prob 0.00302with prob x $0$0 with prob. 0.99698with prob 1-x

12. 12 Ins301 Chp15 –Part1 Pricing 2-Year Term What is x? – it is the probability of a 40 year-old dying in his 42nd year? Mortality table: NumberNumber Ageof Peopleof Deaths 409377232832 419348913076  Probability of 40 year-old dying in 41st year =_____ = ______ Probability of 40 year-old dying in 42nd year =_____ = ______

13. 13 Ins301 Chp15 –Part1 Pricing 2-Year Term Single premium Level Premium

14. 14 Ins301 Chp15 –Part1 Endowment Insurance Pays face amount if the insured dies, or if the insured survives the policy period It is similar to a saving account The US no longer grants tax advantage to endowment policies unless they have a very long duration, such as whole life insurance.

15. 15 Ins301 Chp15 –Part1 Whole Life Insurance Policy period ends when insured reaches 100 Equivalent to endowment policy to 100 Premiums single premium limited pay – a level premium paid for a 10-year or 20-year period continuous premium – level premium continue until the policyholder dies, surrenders the policy, or reaches the age of 100 (whichever comes first)

16. 16 Ins301 Chp15 –Part1 Whole Life Insurance Premiums generally do not increase over time But probability of dying increases over time ==> higher upfront premiums than with term Policyholder “prepays” part of the cost of future death protection  entitled to prepayments if policy is surrendered  this is the cash value (savings accumulation)

17. 17 Ins301 Chp15 –Part1 Whole Life Insurance If insured dies, beneficiaries receive face amount = death protection + cash value Structured so cash value  over time death protection  over time

18. 18 Ins301 Chp15 –Part1 Whole Life Insurance

19. 19 Ins301 Chp15 –Part1 Participating Policies Can (and usually does) pay annual dividends  always with mutual companies  often with stock companies Why? - premiums based on conservative assumptions  Key assumptions: interest rate levels and mortality rates  These variables are correlated across policyholders  Insurer’s methods of dealing with correlated risk:  Bear the correlated risk and hold a lot of capital  Share correlated risk with policyholders Illustrated versus actual dividends

20. 20 Ins301 Chp15 –Part1 Other Whole Life Policy Provisions Surrender Options Take cash value Use cash value as a single premium for  paid up whole life  term policy Policy loans borrow against cash value  interest now varies with market rates  in 1970s & 80s, fixed rate ==> disintermediation Front-end expense charges ==> Cash value grows slowly at first ==> Implicit return on savings accumulation initially low

21. 21 Ins301 Chp15 –Part1 Universal Life Similar to whole life Main differences: Greater flexibility in premium payments Cash value does not follow a fixed schedule; it varies with  policyholder’s premium payments  insurer’s expense and mortality charges  rate insurer uses to credit interest to cash value  minimum rate usually guaranteed  rate often linked to short term interest rates

22. 22 Ins301 Chp15 –Part1 Factors Affecting UL Cash Value

23. 23 Ins301 Chp15 –Part1 Death Benefit Options with Universal Life Level death benefit (as with Whole Life) Death benefit varies with cash value age Cash value Death benefit

24. 24 Ins301 Chp15 –Part1 Variable Life Similar to whole life Main differences: Cash value does not follow a fixed schedule; it varies with  return earned on portfolio of mutual funds chosen by policyholder Death benefit  minimum is guaranteed, but varies with cash value

25. 25 Ins301 Chp15 –Part1 Overview of Annuity Contracts