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

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Personal Finance: A Gospel Perspective

Insurance: Basics, Life and Disability Insurance

Objectives

A. Understand the basics of insurance

B. Understand life insurance

C. Understand disability insurance

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A. 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.)

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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.)

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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

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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

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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.

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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?

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Frequency of Loss

Severity of Loss

High

High

Low

Low

Avoid

ReduceTransfer

Reduce

Assume

Reduce

Assume

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• 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

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Questions

Any questions on the insurance basics?

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A. 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?

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What is 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

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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.

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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

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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.

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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

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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

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III. Who needs Life Insurance?

Who needs life insurance?• Not everyone needs life insurance. Those who do

include:Single or married with dependents or childrenMarried, single income couple where the

spouse has insufficient work skills or savingsBusiness owners who wish to transfer their

businesses to the next generationThose whose estate exceeds the estate tax-free

transfer threshold

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IV. 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.

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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

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How much Life Insurance? (continued)

How is it calculated?1. Adjust salary down to compensate for the

reduction in household expenses2. 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

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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

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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

Life Insurance and Investment Plan

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

Age

Tot

al D

olla

rs in

(00

0s)

Investments Term Cash Value Total Protection

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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

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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

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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

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Understanding Term Insurance: The Process

+ Premium Payments

Your Insurance Policy

- Mortality Costs

- Expense Costs (very small)

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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

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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

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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. 1-10 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

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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?

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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

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Understanding Cash Value Insurance: The Process

+ Premium Payments

+ Investment Income

+ Dividends (if participating)

Your Cash-Value Insurance Policy

- Mortality Costs

- Expense Costs (may

be significant)

A major benefit is to be able to borrow against your policy tax-free

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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

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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.

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Investment Premium Face AmountType General Description Investment Flexibility Flexibility Flexibility

Nonguaranteed Low cost, low None N/A None Noneterm control

Yearly renewableand convertible Higher cost, None N/A None Noneterm more control

Whole Life Dividends provide Insurance company None None Noneinvestment return long-term bonds

and mortgages

Variable Life You direct the Common stocks, Maximum None Noneinvestments money market,

bonds, etc.

Universal Life Current interest Short-term interest None Maximum Maximumrates investments

Variable Universal Control Disclosure Common stocks, Maximum Maximum MaximumLife money market,

bonds, etc.

Term Only = Mortality and Expenses Only

Term Plus = Mortality, Expenses and Investment

Source: Ben G. Baldwin, The New Life Insurance Investment Advisor, 2nd ed., McGraw Hill, New York,

2002, pp. 31, 50, 77, and 88.

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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.

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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

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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.

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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 significantSource: 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.

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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)

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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.

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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)

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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

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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

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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

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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

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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

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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?

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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?

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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 http://www.ambest.com/ • Fitch Ratings 800-893-4824• Moody’s 212-553-0377• Standard & Poor’s 212-438-2400• Weiss Research 800-289-9222

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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

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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.

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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

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Case Study #3 Answer

a. Earnings Multiple Approach

Salary $50,000

Expense reduction 0.74 26% reduction (3 to 2)

Amount needed 37,000

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: 8.0 times salary

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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.

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Questions

• Do you have any questions on life insurance?

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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

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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

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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%

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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

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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

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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

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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

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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

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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

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Questions

Any questions on disability insurance?

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

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