Chapter 9

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

1.
2.
3.
4.
5.

Life Insurance
Annuities
Health Insurance & HSAs
Long-Term Care
Disability

2007 DF Institute, Inc.

Individual Life Insurance Policies

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Life Insurance Commonly Classified as

Follows:
Term insurance
Whole life insurance also known as cash
value (CV) insurance
Universal life insurance
Variable universal life
Equity-indexed universal life
2007 DF Institute, Inc.

Term Insurance
CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Term insurance
Pure insurance death protection for a
TERM of time (e.g., X years, while employed)
with no cash value
Most is renewable continue without proving
insurability (can be expensive!)
Most is convertible exchange to a whole life
policy without proving insurability

2007 DF Institute, Inc.

Term Insurance: Types

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Annual renewable term (ART or YRT): no

evidence of insurability, but annually increasing
premium based on insureds age (can get
expensive fast).

Level term/level premium: Same premium for

coverage period of 5, 10, 15 to 40 years, then
annually increasing premium, unless good health
or proof of insurability. Most common Term option
in financial planning.

2007 DF Institute, Inc.

Term Insurance: Types

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Decreasing term: Level premium but face

value, or amount of coverage, declines.
Premiums may end before term ends (e.g. pay off
a mortgage declining need).

Reentry: Lower premium with proof of

insurability so preferred rate available OR policy
stated guaranteed maximum rate (rewards policy
holders in good health)

2007 DF Institute, Inc.

Term Insurance: Riders

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Rider: Additional coverage for something not specifically

covered within the primary policy.
Waiver of premium for disability

90 day to 6 month waiting periods apply before premium is waived.

Accidental death benefit (death within 90 days of accident, double

indemnity face value of policy * 2)

Accelerated death benefit, living benefit,Terminal/ Compromised

life expectancy.

Return of premium Returns premium to insured or bene (+ DB)

Spouse and Child insurance Coverage for spouse/child
2007 DF Institute, Inc.

Term Insurance
CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Affordable: Maximum coverage/amount of premium. Cost

effective for early to mid portion of lifetime.
Fulfills temporary need (until achieving financial
independence/accomplishing goals, like Ed funding)
Protects insurability guaranteed renewable
Cost prohibitive at older ages (not viewed as lifetime
protection)
No savings feature (but lower premiums buy term and
invest the difference)
No lifetime coverage most end 65/70 (exception if convertible to a
permanent policy necessary policy feature)
2007 DF Institute, Inc.

Term Insurance: Pros/Cons

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

+ Cheapest coverage, mortality + co. profit

+ Protection for additional need term
+ Protects insurability: guaranteed renewable or
convertible
Prohibitively expensive with age
No savings

( if goal strategy, + low ROI for whole life)

Buy Term & Invest the Difference

No lifetime coverage, due to cost

2007 DF Institute, Inc.

Whole Life Insurance

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Permanent protection age 100

Cash value build up
Guaranteed & increases at a steady rate (low
return conservative)
Can surrender for cash value
Can borrow against the cash value
Tax-deferred accumulation
No FDIC insurance

2007 DF Institute, Inc.

Whole Life Insurance

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Level premium (in general)

Moderate premium (higher than term)

Mortality charges death benefit

Pre-pay future mortality costs.
Policy is guaranteed to pay out (Term is not)

Administrative costs and insurer profit

2007 DF Institute, Inc.

Whole Life Insurance: Types

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Ordinary life/continuous premium (until death or age 100

living benefit paid at age 100 if insured living)
Limited-pay policy; paid up policy (premiums paid for
limited # of years) High initial premiums
Modified life (lower premium first 3-5 yrs.) good if cf low early on
Single premium/MEC Lump sum at time of contract. Potential
for MEC (taxation/penalty issues), cover MECs later.

2007 DF Institute, Inc.

Whole Life Insurance: Types

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Current assumption (interest sensitive) CAWL

New money interest rates (additions to CV) and current mortality
assumptions (costs, subtractions from CVk) to determine cash
values
Ins Co shares investment experience and profits with policy
owner.
Interest rate floor (guaranteed minimum).

Variable life: fixed premium but face/cash values depend on investment

performance; guaranteed face amount as minimum
Policy holder invests cash value in subaccounts and bears the investment risk.

Joint life: first- or last-to-die policies underwriting based

on one with longest life expectancy
Pays DB out at the first or second death.
2007 DF Institute, Inc.

Whole Life: Dividend Options

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Cash (receive check)

Reduce premium
Accumulate at [with] interest:

Interest is taxable

Dividends held on deposit with insurance company and earn interest

Either added to DB at death or added to the CV if surrendered

Paid-up additions: no insurability required

Increases both DB and CV
Equal to what a single premium would purchase

One-year term insurance: Annually renewable term

or term = to cash value of the policy (cheap as term), with
balance of dividends as paid up life or accumulate at interest
2007 DF Institute, Inc.

Whole Life: Nonforfeiture Options

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Apply if policy is discontinued during insureds lifetime.

Cash surrender value (cash value less any surrender

charges)
Cost basis = tax-free return of basis.
Gain (above cost basis) = ordinary income
No longer need death benefit.

Reduced paid-up insurance

Use CV as a single premium to buy a paid up policy (uses current
age to determine how much the premium will buy)

Extended term insurance

Use CV as a single premium to buy term insurance equal to the
original policy FV that lasts as long as the CV will support it.
Note: see the nonforfeiture table in Scholar folder as an example
2007 DF Institute, Inc.

Whole Life: Riders

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Waiver of premium (All premiums waived due to

disability)

Accidental death benefit (typically death within 90

days)

Spouse and childrens riders (term)

Term insurance (later convert to permanent)
Living benefits (life expectancy 12 months or less)
Paid-up insurance additions (premiums purchase
additional death benefit amounts)
2007 DF Institute, Inc.

Whole Life: Pros/Cons

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

+ Fixed premiums
+ Tax-deferred growth
+ Whole life/permanent protection

Inflexible premium risk of policies lapse

Gradual/slow cash value -- Low IRR (unless a variable policy
that is invested well)
* Consider M&E charges compared to the CV invested in an
IRA or regular brokerage account.
Surrender charges -- $$$$ (during first few years need to
understand the surrender schedule prior to recommending
the policy to be surrendered).
2007 DF Institute, Inc.

Universal Life Insurance

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Premium and cash value flexibility

Ability to change death benefit amount
Current assumed interest rate that is = to
or > the guaranteed rate in the policy
(whole life based upon long-term return of
an insurers account)
Fewer guarantees than whole life, so risk
shifted from insurer (the co.) to the policy
owner
2007 DF Institute, Inc.

Structure of a Universal Life Policy

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

2007 DF Institute, Inc.

Universal Life
Death Benefit Options
CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Option A (Option 1)

Level death benefit (can increase later, see

below)
NAR equals death benefit less cash value
Death benefit may increase in later years to
prevent an investment instead of a life
insurance policy DEFRA corridor

Option B (Option 2)
Increasing death benefit (DB + CV)
NAR remains level throughout the policy
See Exhibit 9.4, page 314
Net amount at risk (NAR) = difference between the cash value and
the death benefit
2007 DF Institute, Inc.

Universal Life
Premiums
CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Policyowner can choose how much to pay.

Typically a required target amount for a
number of years

Possible to stop premium payments if policy

CV is sufficient to cover M&E charges.
OR, could just pay the M&E charges.
Flexible options when it comes to premium
payments with UL (major difference from
WL).
2007 DF Institute, Inc.

Variable Universal Life

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Flexible premiums and death benefits:

Premium, death benefit and cash value flexibility of universal
life + investments and increasing/decreasing face value of a
variable policy

Self-directed investments:
Policyowner directs investment and bears investment risk
(sub-accounts or separate accounts representing asset
classes)

2007 DF Institute, Inc.

Variable Universal Life Features

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

VUL policy structure:

Like a UL, mortality charges and admin expenses deducted
from the cash value
InVestment earnings fund the cash value

Agents/brokers who sell VUL must have state life

license and FINRA securities license Series 6 or
Series 7
Death benefits:
Death benefit: Option A or B

2007 DF Institute, Inc.

UL and VUL Riders

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Waiver of premium or monthly deductions:

Requires insured to be permanently/totally disabled before
X age, typically 65 and meet waiting period
Two riders: waiver for mortality and expense charges OR
waiver of the original target premium

Accidental death benefit: Requires death within 90 days of

accident; double indemnity

Other insured: Level term for spouse/children; typically

convertible

Living benefits: Requires life expectancy of 12 months or

less; life expectancy period may vary with state
2007 DF Institute, Inc.

UL and VUL: Pros/Cons

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

+ Flexible premiums for changing situations

+ Flexible death benefit
+ Current assumptions: better cash value; lower mortality charge
- Flexible premiums, no fixed commitment: polices lapse.
Many require min/max premiums or targets for X years

- Misleading rates of return and long-term illustrations may

mean the target premium is NOT enough to keep policy

in force and may be higher than a whole life policy
- UL costs may not be much less than a whole life for a
guaranteed cash value and death benefit (costs may be
similar or higher to WL, but more risk is shifted to
the policy owner)
2007 DF Institute, Inc.

VUL: Pros/Cons
CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

+ Investment & tax shelters

+ Premium & investment flexibility, including changing subaccounts without tax liability
+ Current assumptions (interest & M&E, can mean cheaper
expenses than whole life)
- Premium flexibility
NO cash value guarantee, unless using fixed income account
Relatively high fees, commissions, surrender charges + M&E
+ monthly administrative charges
Investment risk; market declines require more premiums for
insurance or the policy lapses
2007 DF Institute, Inc.

Modified Endowment Contracts

(MECs) (only
(only policies
policies sold
sold after
after 6/20/88)
6/20/88)
CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

If cumulative premium payments exceed the net level premium

(as defined by IRC) during the 1st 7 years, the policy is MEC.
7-pay test: Amount invested cannot exceed the net level
premium for a 7-pay life policy, given the year 1 face amount,
age & life expectancy of the insured; IRC calculation

OR7 years following a material change (increase/decrease of

cash or death benefit)
IF determined MEC, loans & withdrawals (above basis)
LIFO treatment (income/gains distributed and taxed first)
10% penalty (< age 59)
Death benefits are not affected if policy determined MEC

Big deal if surrendering a policy (identified on a

stmt/illustration)

2007 DF Institute, Inc.

Summary
CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

See Exhibit 9.5 for summary of various

policies and features.

2007 DF Institute, Inc.

Group Life Insurance Save $$

Group term

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Cost of coverage >$50k: Section 79 income subject to income tax &

SS & Medicare
May have option to increase coverage
May have option to convert to whole life, if employment ends
Most common.

Group whole life insurance

Premiums taxable to the employee, generally

Group universal life

Employee paid supplement to term; no evidence of insurability to
stated max of coverage

Group VUL
Low fees/surrender charges
Tax-favored investment vehicle
M&E Charges, purchase only if need of DB (protection) element
2007 DF Institute, Inc.

Policy Selection & Cost Comparisons

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Policy Selection consider the policy owner:

Policy cost budget available to pay the premium
Duration of the need term or lifetime
Amount of coverage (life needs analysis)
Risk tolerance -- consider a variable product?

Policy Selection consider the policy illustrations:

Illustrations are NOT guarantees of policy performance
Know the assumptions used and interpret the illustration
with care

2007 DF Institute, Inc.

Policy Selection & Cost Comparisons

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Interest-adjusted cost indices (to compare life

policies)
Interest-adjusted surrender cost index
Interest-adjusted net payment cost index
Surrender cost index (compares cash value and
costs given a surrender date)

Net payment cost index (death benefit cost comparison

in X (10 or 20) years)

CAREFULLY judge the accuracy/representativeness of policy

illustrations
2007 DF Institute, Inc.

Policy Replacement
CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Belth price of protection model: benchmark

price per $1,000 of coverage (can do for
Term, just no CV component: how many
$1,000s premium divided by how many
$1,000s))
NOTE: Minus sign missing BELOW, correct
in text p. 323: (1 + i) (CV1 + D)

2007 DF Institute, Inc.

Life Insurance Health Ratings

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Life Insurance Health Ratings:

http://www.lifequote.com/Policy-Rate-Classifications/how-do-rate-classifications-work.html

2007 DF Institute, Inc.

Life Insurance Policy Provisions

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Grace period (31 days to pay premium after due date)

Incontestability (insurer cannot cancel after in force for 2 years if
discover material misrepresentation or concealment)

Entire contract clause (application part of the contract statements

made in contract can void/alter the contract)

Misstatement of age or gender (usually discovered at death upon

receipt of death certificate DB of policy can be adjusted due to this)

Assignment
Absolute (full transfer ownership)
Collateral (as security for a loan or debt)

Suicide (usually a 2 year window)

2007 DF Institute, Inc.

Life Insurance Policy Provisions

(cont.)
(cont.)

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Reinstatement: 31 days (no insurability) to 5 years (insurability)

after the grace period ends

Policy loans (borrow against cash value with interest)

Automatic premium loan: Pay premium with loan
Must request on application or later in writing

Beneficiary designations
Revocable (can change) and irrevocable (cant
change typically used with divorce settlements)

Primary and contingent (1st/2nd)

Survivorship clause (common disaster: 30 or 60 days

survival) insured & bene die within this period, proceeds part of
insureds estate.

2007 DF Institute, Inc.

Life Insurance Policy Provisions

(cont.)
(cont.)

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Aviation exclusion: noncommercial only; premiums returned;

not as common today

War exclusion: no pmt of DB, instead, premiums + interest

returned to the beneficiary

Simultaneous death: When not determinable as to

who died first. Assumes insured died LAST insured survived

the beneficiary. Proceeds to additional beneficiaries OR the insureds

estate.

2007 DF Institute, Inc.

Life Insurance Settlement Options

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Lump Sum OR. Some alternatives*

Interest only (Ins co retains DB and pays the bene interest)

Fixed amount (Specific amount paid until depleted)
Fixed period (Maximum payment for period of time)
Life income (Specific amount for life)
Life income with period certain (Life or specific period, whichever is
longer)
Life income with refund
Joint and last survivor income
* May be appropriate if bene cant manage lump sum (in lieu of a trust)

2007 DF Institute, Inc.

Life Annuity Contracts

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

When do payments begin?

Immediate (now)
Deferred (later point in time)

How are premiums paid?

Flexible premium (vary premium deposits)
Single premium (lump sum)

How is the payment determined?

Fixed annuity (specific interest rate)
Variable annuity subaccounts, accumulation units
Equity indexed annuity participation rate of a
market index (e.g. S&P 500 + guaranteed return of
principal
2007 DF Institute, Inc.

Life Annuity Contracts

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

What is the timing of the annuity payments or

annuitization?
Straight life annuity
Life with period certain annuity (e.g., 10 or 20 years)

Guarantee of a specific period of time or life, whichever is greater.

Installment refund annuity (continued annuity to beneficiary

refund after annuitants death) Refund based on amount paid out

compared to purchase price of annuity.
Cash refund annuity (lump sum refund after annuitants death)
Refund based on amount paid out compared to purchase price of
annuity.

Joint and survivor annuity (provides for the annuitant and a

survivor)
100%, 75%, 50%

2007 DF Institute, Inc.

Taxation of Life Insurance

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

No tax on policy proceeds paid to beneficiary

Dividends are not taxable unless withdrawn and in
excess of premiums paid
Except for MECs, loans against the cash value
are tax free
1035 exchanges of life insurance policies or
annuities are not subject to tax the cost basis
transfers

2007 DF Institute, Inc.

Taxation of Life Insurance

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Dividends as return of principal are not taxable

unless they > premiums, then taxed as income
Withdrawals
FIFO treatment until all premiums paid out Tax-free
return of premiums
LIFO treatment for MECs + 10% on taxable gains before
age 59 - Gain out first

Policy surrender
Lump sum, if greater than basis then taxable
Interest only payment is taxable
Installment payment of basis & interest; interest is taxable
based on the exclusion ratio
2007 DF Institute, Inc.

Taxation of Life Insurance

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Section 1035 exchanges:

gains from the original contract

are not taxed, but deferred, if applicable

2 life, 2 annuity, 2 endowment (restrictions apply) OR life for annuity or

endowment OR endowment for annuity NOTE: no annuity for life or endowment

For transfers for valuable consideration, proceeds

lose tax-free status if transfer is not a gift or a transfer to the

insureds business (partner, partnership, corporation).
Otherwise included in gross income of transferee (i.e., the
RECIPIENT), for amount proceeds exceed the basis

Premiums are not tax deductible except to employer

for group life. Recall Section 79 income calculation if policy

exceeds $50,000

Premiums paid as alimony handled same as alimony:

income for recipient and deduction for payer

2007 DF Institute, Inc.

Taxation of Death Benefits

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Lump sum distribution is not taxable

Interest-only payments are taxable
Installment payments are % taxable for interest and
untaxed for basis, with the % determined by ratio of
face amount of policy compared to total payments
expected (the exclusion ratio, slide 44)

2007 DF Institute, Inc.

Taxation of Viatical Agreements

CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Viatical agreements sell policy to 3rd party

Proceeds are tax free to insured (usually a lower

amount than the DB)
Proceeds beyond purchase price and premiums
paid taxable to purchaser (Difference between
purchase price and DB)
Terminal illness: life expectancy of 2 years or
less
Chronic illness: Significant cognitive impairment
OR unable to perform 2 of 6 ADLs

2007 DF Institute, Inc.

Taxation of Annuities
CHAPTER 9: MANAGING LIFE, HEALTH, AND DISABILITY RISKS

Annuities

Inclusion/exclusion ratio to determine

nontaxable portion of each payment
100% taxable after principal has been fully
paid out
Unrecovered basis, in case of death, allows for
a deduction on the decedents final 1040 form
Investment in the Contract
Expected Return

2007 DF Institute, Inc.

= Exclusion ratio