Life Ins BFIN 341 PDF

CFP Education Program Introduction Throughout history there are numerous examples of drawing a small, proportional amount from the assets of all to prevent the financial ruin of an unfortunate individual We now know this concept as the basic principle of insu...

CFP Education Program Introduction Throughout history there are numerous examples of drawing a small, proportional amount from the assets of all to prevent the financial ruin of an unfortunate individual We now know this concept as the basic principle of insurance: a small amount collected from many can be used to alleviate the financial distress of a few, provided that a system for predicting the chance of losses is reasonable to the circumstances The purchase of a life insurance policy results in the transfer of the true risk of loss from the individual to the insurance carrier, and the insurance company uses science to minimize the overall risk associated with the issuance of life insurance contracts  CFP Education Program Parties To The Contract Insurer/Carrier – Life insurance carriers are owned in two different ways:  Stock Company The insurance company issues share capital similar to other corporations In Canada, federal insurance laws require that stock-based insurance carriers have two classes of directors, where one class is elected by the shareholders while the other class is elected by the policyholders who own participating policies, which is a type of insurance policy whereby the policy owner is entitled to participate in the profits of the company  Mutual Company The company is owned and operated by and for the benefit of its policy owners Mutual insurers have no share capital and thus no shareholders to receive any profits; profits are returned to policy owners through dividends With a mutual company, there is only one class of directors: those elected by the policy owners  CFP Education Program Parties To The Contract cont. Policy Owner – With life insurance, the “policy owner” is the individual with whom the insurance carrier forms a contract – The policy owner has the right to name a beneficiary to receive the benefit specified under the terms of the insurance contract, has the authority to deal with the insurance policy in any way he or she chooses, unless she signs away some or all rights, and has the right to access the cash value in the policy or to borrow against the policy's cash value – Ownership of a life insurance contract may be transferred through an “absolute assignment” to another person who then becomes the owner of the policy with full authority – Where the policy owner differs from the life insured, the policy owner has the right to name a “successor” or “contingent owner”, who then becomes the new owner if the current owner dies before the life insured  CFP Education Program Parties To The Contract cont. Life Insured – Under an individual life insurance policy, the person whose life is insured is commonly referred to as the life insured – Restrictions within Canadian insurance law require that an individual have an “insurable interest” before a contract of insurance can be issued and become valid Joint Life – A policy where there is more than one life insured is referred to as a “joint life policy”  Joint-Last-to-Die The policy is based on two or more lives and where the policy pays a death benefit upon the last death of the group of life insureds  Joint-First-to-Die The policy is based on two or more lives and where the policy pays a death benefit upon the first death within the group of life insureds  CFP Education Program Beneficiary Designation Revocable versus Irrevocable – There are two types of beneficiary designations available to a policy owner:  Irrevocable While the beneficiary remains alive, the policy owner may not alter or revoke the designation without the prior consent of the beneficiary The policy owner's control over the policy is limited and she requires the consent of the irrevocable beneficiary in order to do such things as alter or revoke the beneficiary designation or surrender the policy  Revocable The policy owner retains the right to alter the beneficiary designation without obtaining the prior consent of the beneficiary A revocable beneficiary has no legal right to any proceeds or decisions regarding the policy until after the death of the life insured  CFP Education Program Beneficiary Designation cont. Designating a Beneficiary  A Named Beneficiary – The policy owner has the opportunity to name a desired beneficiary in the insurance application, and this will appear on the actual policy – The following are the advantages of naming a specific beneficiary to receive the insurance proceeds: The insurance money is paid directly to the beneficiary and does not form part of the deceased person's estate Upon satisfactory proof of claim, the life insurance proceeds are paid promptly by the insurance carrier, which provides the beneficiary with a liquid asset The proceeds paid out under a life insurance policy are a private matter between the beneficiary and the insurance carrier, so when money is paid directly to a named beneficiary, it provides a high degree of privacy Upon the life insured's death, the named beneficiary is entitled to the proceeds, which are therefore protected from the policy owner's creditors Unlike wills, where other persons can contest the deceased's wishes, the proceeds paid to a named beneficiary are rarely subject to legal contest  CFP Education Program Beneficiary Designation cont.  Estate as a Beneficiary – Advantages: The payment of proceeds into the estate can provide a liquid asset that facilitates payment of the policy owner's debts and obligations, and can fund bequests Administration of an estate in receipt of significant cash will be easier, more flexible, and may allow for retention of valued family or business assets that might otherwise need to be sold to raise cash – Disadvantages: The potential for the policy owner's creditors to access the insurance funds through the estate The fact that assets passing through the estate, including life insurance proceeds, are subject to probate fees  CFP Education Program Beneficiary Designation cont.  Minor as a Beneficiary – Minors cannot provide a valid discharge to the insurance company – The policy owner can arrange for the appointment of a trustee to assume control of the life insurance proceeds on behalf of the minor child Contingent Beneficiary – The contingent beneficiary is entitled to the proceeds of the policy if the first-named beneficiary predeceases the life insured  CFP Education Program Settlement Options Most insurance policy proceeds are paid out as a lump-sum amount to the beneficiary, however the insurance policy also provides for different forms of payment known as “settlement options” These can include: – Payment of the full lump sum amount; – The money can be held on deposit; or – The moneys may be paid out as an annuity through instalments If settlement options are not pre-selected by the policy owner, the beneficiary has the option of selecting any of the settlement options offered in the insurance policy  CFP Education Program Contract Formation Void and Voidable Contracts  Void Contract  the contract is simply considered invalid and there is no opportunity for correction of the invalid issue (providing fraudulent medical evidence)  Voidable Contract  there is a fault with the contract but the fault can be corrected Policy Delivery (takes effect) – Where a contract has been issued as applied for, and where the first premium has been paid in full, it is possible to simply deliver the contract to the insured – Where the first premium has not been paid, the policy will not take effect until the first premium is paid  CFP Education Program Contract Formation cont. Rescission Right – Also known as the “10-day free look”, this is a 10-day period during which the policy owner has the opportunity to cancel the policy and receive a full refund of any premiums paid Incontestability Period – What an insurance contract becomes after the 2-year contestability period has expired Misstatement of Age – Special rules apply in situations where the correct age of the life insured, on the date of the policy application, exceeds a maximum age limit imposed by the carrier – Otherwise, an age correction can be made to an innocent misstatement of age  CFP Education Program Contract Formation cont. Grace Period – The period of time, generally 30 days, after which a premium payment has been missed, that insurance coverage remains in force, although the policy would be considered to be in an overdue position – If the premium remains unpaid after the grace period, the policy has “lapsed” and is no longer in effect Policy Reinstatement – If a policy lapses for non-payment of premiums, the insured has the right to request that the policy be reinstated at any time during the two-year period immediately following the date of the policy lapse. Along with a request for reinstatement, the insured must: pay all back premiums and any other indebtedness on the policy; and provide evidence of the good health and insurability of the life insured – The criteria for reinstatement of a policy differs by insurance carrier  CFP Education Program Contract Formation cont. Suicide Clause – Commonly, individual life insurance policies include an exclusion period for death by suicide, typically one or two years, during an initial period after the insurance policy is first issued – This is done to discourage the purchase of a life insurance policy in anticipation of committing suicide  CFP Education Program Premiums Life Expectancy – Refers to the average length of time a person is expected to live based on the person's prevailing age and specific death rates Life Expectancy at Birth by Sex, 1979-1999 Source: Health Canada Performance Report For the period ending March 31, 2003  CFP Education Program Premiums cont. Mortality – Given that the term “mortality” refers to death, the phrase “mortality rate” is used to describe the rate of death expected in the upcoming year based on prevailing age – Mortality rates can be measured based on a wide set of criteria, which normally includes age, sex and smoking status Premium Calculation – The three main factors used in pricing an insurance product are mortality cost, carrier operating expenses, and the expected investment return on the premiums or contributions into the plan Premium = Mortality Cost + Operating Expenses - Investment Return  CFP Education Program Premiums cont. This graph illustrates the pattern of mortality, where mortality increases year over year.  CFP Education Program Premiums cont. Age – On average, the risk of death increases the older one becomes, so as an individual ages, the probability of death in the next year increases Gender – Since, as the statistics indicate, on average, men are not expected to live as long as women, males have a higher mortality cost than females Smoking Status – Since smokers are more likely to contract an illness, they pay higher premiums, which is about 40 per cent higher – Each insurance carrier has its own definition of what constitutes a smoker; some may be more lenient when it comes to cigars, for example  CFP Education Program Premiums cont. Rating – When an insurance policy is issued based on “standard rates”, this suggests that the life insured is assessed as being similar to the average or expected, where standard is expressed as 100 per cent – Risk factors determine an individual’s “rating”, so, for example, a policy that has a 150 per cent rating would be one where the insurance carrier is willing to issue the contract but at a charge based on 150 per cent of the standard premium Uninsurable – The term used where the life insured's health or other factor considered material to the underwriting is judged to be at a level of risk greater than what the insurance carrier is willing to accept  CFP Education Program Premiums cont. Preferred Rates – Some insurance carriers have developed new rating approaches to premiums where they reward individuals whose personal risk profile is viewed as being superior to the expected average – For some products, the carrier is willing to offer preferred ratings where the individual pays a premium that is less than that charged for a standard risk profile – These enhanced premium structures are commonly referred to as “preferred premiums” or rates  CFP Education Program Underwriting Health – The life insured's current health and physical condition, as well as the health history, is a significant consideration in the underwriting process – The life insured's family health history is also a consideration Character, Occupation – Both are considered in the underwriting process Occupation  Where an individual's occupation places the life insured in a position of risk greater than the average, it may cause the carrier to adjust the insurance premium to reflect the increased risk, or may contribute to the carrier's decision that the risk is uninsurable Character  If there is a pattern of behaviour that could indicate an increased risk for the carrier, such as a history of speeding while driving, this would be a consideration in the acceptance and pricing of the risk  CFP Education Program Riders A “rider” is an endorsement or supplement that is added to the basic insurance policy to increase the features under the policy as part of the overall plan design o Waiver of Premium o Accidental Death and Dismemberment o Guaranteed Insurability o Cost of Living o Term Riders (additional insurance- term on top of permanent)  CFP Education Program Terminology Face Amount – The “face amount” of a policy is the stated amount of money on the face of the policy that is paid in the event of the life insured's death Beneficiary – The “beneficiary” of a life insurance policy is the person named in the policy as the individual who is to receive the life insurance proceeds upon the death of the life insured Adjusted Cost Basis – The “adjusted cost basis” (ACB) of a life insurance policy is the sum of all premiums paid less the sum of the net cost of pure insurance  CFP Education Program Terminology cont. Exempt and Non-Exempt Policies – “Exempt Policy”  One designed primarily to provide life insurance protection, allows for tax free growth until policy is terminated – “Non-Exempt Policy”  One that does not meet the required definition of exempt as established under the Act and as such it is deemed to be designed primarily as an investment, and not a life insurance policy, taxed on an annual basis  CFP Education Program Temporary Versus Permanent An individual's need for insurance may be short-term or perhaps temporary, where the need is for a specific period of time In this case, it makes sense to purchase a product designed specifically to address the temporary or shorter-term need for insurance, such as Term insurance Permanent insurance is coverage designed to provide insurance coverage throughout the insured's lifetime, such as whole life, universal life, and Term-to-100  CFP Education Program Living Benefits When an individual is diagnosed with a terminal illness, it is becoming increasingly common for insurance carriers to allow a life insured, who is terminally ill, to receive a partial pre-payment of the death benefit, know as a “living benefit” This type of loan/advance is treated as an advance against the eventual payment of the life insurance proceeds CFP Education Program Term Life Insurance  CFP Education Program Introduction Term life insurance provides life insurance coverage for a limited time or period, which is reflective of the word “term” The period for the insurance coverage will vary, with the contract normally expiring at a maximum age such as age 65, 70 or 75 or 85 Term insurance is a type of insurance product developed to address a need that is temporary in nature, where there is no permanent need for life insurance coverage There are a variety of different term insurance products on the market, some of which simply expire at the end of a specified term and others that can be renewed for multiple terms  CFP Education Program Benefit Amount With the purpose of providing insurance for temporary needs or for a specific period of time, term insurance can be established with a fixed level of coverage throughout the term of the insurance contract or it can be designed with a decreasing level of coverage, such as insurance designed to cover a mortgage throughout an individual's lifetime  CFP Education Program Renewable Some of the more common forms of term insurance include: – One-year, annual renewable term, often referred to as yearly renewable term – Five-year, 10-year and 20-year term insurance – Term to age 65, where the premium is set at the point of issue and remains constant until the end of the term, at age 65 It is common for one, five, ten and twenty-year term insurance products to offer the insured the opportunity to renew the policy at the end of each successive term, up to a maximum age of the life insured CFP Education Program Renewable cont.  CFP Education Program Convertible “Convertible Feature”  Whereby the insured is given the opportunity to convert the term insurance product to a permanent insurance product offered through the issuing insurance carrier, without the need to provide evidence of insurability For affordability reasons, an individual might initially purchase term insurance to cover a financial need, knowing that at a future point she intends to convert the term insurance to a permanent policy  CFP Education Program Policy Expiration With term life insurance, the insurance carrier normally sets a maximum age with regard to the life insured, after which the policy completely terminates, with no opportunity to renew If the need for insurance coverage remains as a policy expiration date approaches, conversion of the policy to a permanent product may be a wise consideration Common ages at which a term insurance policy expires include age 65, age 70, 75 and 85  CFP Education Program Product Pricing and Premiums With term insurance, the insurance carrier's premium schedule takes into consideration the carrier's mortality costs and expenses Generally, premiums for term life insurance are relatively low in the early years and increase through each successive renewal An individual may decide to pay monthly, quarterly or semi- annually, depending upon which options the insurance carrier makes available CFP Education Program Whole Life Insurance  CFP Education Program Introduction Whole life insurance is the most traditional type of permanent insurance, which is intended to provide coverage for as long as the life insured lives The face amount of the insurance policy and the premium are established at the time that the policy is purchased and remain fixed throughout the time that the policy remains in force A whole life policy may also be known as a “straight life policy” or an “ordinary life policy”  CFP Education Program Plan Design Reserve – In simple terms, the reserve on a whole life policy is: Premiums paid to date plus Interest earned less Mortality and plan expense charges CFP Education Program Plan Design cont.  CFP Education Program Plan Design cont. Cash Value - The portion of the reserve that the insurance carrier is willing to “give back” to the policy owner as a non-forfeiture right Cash Surrender Value - If a policy owner terminates her whole life insurance coverage, the cash value in the plan would be paid to the plan owner less any surrender charges Participating Policy - A whole life policy where the owner of the policy shares in the profits of the insurance carrier through the receipt of dividends  CFP Education Program Plan Design cont. Non-Participating Policy – A “non-participating” whole life policy is a policy where the policy owner does not participate in any of the profits of the insurance carrier Dividends – A dividend paid to an owner of a participating policy is considered to be the equivalent of a refund of premium – There are generally five options available to the recipients of dividends:  CFP Education Program Surrender Charges The cost of issuing an insurance policy is quite substantial and it takes several years of insurance premiums for an insurance carrier to break even on the expenses associated with issuing the policy For this reason, permanent insurance policies often include a “surrender charge” when a policy is cancelled These tend to be quite high in the early years of the policy and reduce through time  CFP Education Program Premiums Premiums for whole life insurance are paid in advance of the coverage period The premium schedule can be developed as an integral part of the plan design, and can be paid annually, quarterly, or even monthly  CFP Education Program Policy Loans General – As a whole life policy ages, the build-up of cash value begins to accumulate and many policies offer the policy owner the ability to borrow funds from the cash value in the policy, within defined limits – If a policy is surrendered when a policy loan is outstanding, any loan balance and interest indebtedness is repaid from the cash surrender value  CFP Education Program Collateral Assignment “Collateral Assignment”  A policy owner can assign the policy itself, or the policy's cash value, which has built up over the years, as security for a loan, where the creditor is someone other than the life insurance carrier With a collateral assignment, the policy owner offers the policy as security for the loan  CFP Education Program Death Benefit The death benefit paid under a life insurance policy is comprised of the policy's face amount plus any enhancements When a death benefit is paid out under the policy, any indebtedness, such as a policy loan or outstanding premium, will reduce the total amount of benefit paid to the beneficiary  CFP Education Program Non-Forfeiture Options The contract for a permanent life insurance policy sets out the options available to the policy owner if she should decide to discontinue premium payments on a life insurance policy that has an accumulated cash value, known as “non-forfeiture options” These include: o Cash Surrender Value (take the cash) o Automatic Premium Loan (keep the insurance, until cash runs out) o Extended Term Insurance (Use cash to buy as much term as possible) o Reduced Paid-Up Insurance (Buy as much permanent as cash will let you) CFP Education Program Universal Life Insurance  CFP Education Program Introduction Relatively new, having first become popular in the early 1980s, when traditional insurance products did not seem to meet the changing needs of consumers Soaring interest rates combined with consumers' interest in managing their own investments created the demand for a new insurance product A universal life policy is a type of permanent insurance, designed to address long-term needs, and includes various components that provide choices for the consumer Features  Varying amount of coverage, payment flexibility, interest-sensitive investments  CFP Education Program Product The three main factors used in pricing an insurance product include: – Mortality cost – Expenses – Expected rate of return on the premiums or contributions into the plan With a universal life policy, the words “contributions” or “deposits” are often substituted for the word “premium” The three components identified under each UL policy include: – Mortality charges under the policy – Expenses charged by the carrier for the policy – Investment earnings within the policy  CFP Education Program Product cont. Mortality Charges – At the time of purchase, the policy owner decides the type of mortality charges that will apply under the policy – There are a variety of options to choose from, but the most common are yearly term rates and level term-to-100 rates “Yearly term rates”  Based on the probability that death will occur in the upcoming year “Level term rates”  Consider the increasing cost associated with an increasing probability of death each year Expense Charges – The policy generally includes: Monthly administration fee Possibly transaction fees related to administrative services  CFP Education Program Product cont. Investments – Universal life policies provide the policy owner with a range of investment options that generally include fixed-interest options such as: Simple savings account Guaranteed term deposits Equity options Index options  CFP Education Program Cash Surrender Value = Cash Value - (Sum of any policy loan outstanding + Any applicable surrender charges) The surrender charges tend to be very high in the early years of the policy and decrease through time as the policy ages  CFP Education Program Death Benefit Options Level Face (least expensive) – Provides a fixed, level amount of insurance, using which, the insurance carrier's cost of insurance (mortality cost) decreases over time as the policy's accumulated value increases Level Face Plus Deposits – Combines the face amount of the policy and the gross amount of the deposits made into the plan Level Face Plus Account Value – Pays the beneficiary the face amount of the policy plus the value held within the policy account Indexed Death Benefit (Most expensive) – Policy owner may select to index the death benefit on an annual basis  CFP Education Program Non-Forfeiture Options Non-forfeiture options provide the policy owner with alternatives if she chooses to discontinue premium payments Under a universal life policy, the mortality and expense charges must be covered annually for the policy to remain in force For those plans that build up cash value in the accumulating account, the annual mortality and expense charges are withdrawn from the accumulating account  CFP Education Program Policy Loan and Illustration Policy Loan – Any amount up to the cash surrender value of the policy is available to the policy owner as a policy loan CFP Education Program Term-To-100  CFP Education Program Introduction Term-to-100 insurance is a type of permanent insurance product that provides insurance coverage to age 100 In many situations, the coverage remains in force after the life insured reaches 100, but there are no further premium payments required Generally, premiums for the term-to-100 policy are level and guaranteed The term-to-100 policy is non-participating  CFP Education Program Product Design The design of a term-to-100 policy can differ by carrier While some plans require premiums until age 100, other carriers may establish a premium schedule based on a limited payment period such as 20 or 25 years, or to age 65 While older term-to-100 plans do not normally have a build up of cash value, some carriers may offer a guaranteed value if a plan remains in force for a specified period  CFP Education Program Premiums The premium schedule for a term-to-100 plan will appear higher in the early years of the policy when compared with a five or 10-year term policy because the premium schedule is level throughout the term-to-100 policy payment period The cost of the term-to-100 plan is generally less than for a comparable whole life policy because the term-to-100 plan does not normally have the traditional build-up of cash value If a policy owner misses a premium payment, the standard grace period applies, but because there is generally no cash value, there are no options for any automatic premium payment from within the value of the policy  CFP Education Program Exempt and Non-Exempt Given that the term-to-100 policy is designed with the primary purpose of providing insurance protection only, the plan remains exempt with no income tax reporting required CFP Education Program Group Life Insurance  CFP Education Program Introduction It is common for employers to provide group benefits as an integral part of an employee's total compensation program; the scope of group benefits is quite wide and can include life insurance, dependant life insurance, health and dental as well as disability benefits. While group life insurance is commonly part of an employee's benefit package, it is also fairly common for associations to offer group life insurance to participating members There are variations in the types of group insurance plans available to individuals, but the general principles remain consistent across the plans  CFP Education Program Basic Principles o Policy Owner o Life Insured o Actively at Work o Coverage o Premiums  CFP Education Program Product Design Basic group life insurance, offered through an employer plan, is normally designed as a flat amount, or as a multiple of the plan member's annual earnings Most insurance carriers offer coverage for as long as the individual is employed, up to age 65 Group life insurance is one-year renewable term insurance that provides temporary insurance protection only, such as: – Employer-provided group life insurance – Creditor insurance – Association-provided group life insurance  CFP Education Program Beneficiary The life insured has the opportunity to designate a beneficiary to receive the proceeds upon her death By naming a beneficiary, other than an individual's estate, the proceeds paid at the time of death pass directly from the insurance carrier to the beneficiary and do not form part of the life insured's estate  CFP Education Program Evidence of Insurability Smaller-size group insurance plans may provide a very basic level of group insurance without any evidence of insurability by the plan members For larger-size group insurance plans, it is common to offer basic amounts of coverage, including group life insurance, without any evidence of good health from the plan members  CFP Education Program Conversion When a plan member terminates employment and therefore loses entitlement to the group life insurance, she is given the opportunity to convert lost coverage, up to a $200,000 maximum, to an individual life insurance policy without providing evidence of insurability Other events where an individual may be eligible to convert her coverage to an individual life insurance policy without providing evidence of insurability, include: – A plan member's loss of coverage upon reaching the maximum age covered by the plan – Termination of the whole group insurance plan  CFP Education Program Disability Provision Many group life insurance plans include a disability waiver of premium provision whereby the premium for the plan member's group life insurance is waived if she is assessed as being disabled within the definition of disability under the contract provision This can be a valuable benefit when a plan member requires protection, but due to a disability, may no longer be able to afford the ongoing premium  CFP Education Program Premiums When an employer purchases a group insurance plan, the composition of the group of covered employees has a direct impact on the calculation of the insurance premiums for each of the benefits With life insurance, the age, sex and occupation of the plan members within the employer's group will directly affect the premium A new premium rate is set each year based on the composition of plan members within the group  CFP Education Program Taxation of Group Life Insurance Premiums for group life insurance paid by the employer create a taxable benefit for the employee The group life insurance premium is a tax-deductible expense for the employer The death benefit is paid tax-free to the beneficiaries  CFP Education Program Appropriateness Group life insurance is the primary source of insurance protection for a significant number of Canadians because they are very common and group life insurance tends to be a core benefit within most employers' group plans When group insurance plans offer coverage amounts that are based on two or three times an individual's salary, for some people this may appear to be a substantial amount of coverage; however, because the coverage is dependent on continued employment, and the employer's continuation of the group plan, the coverage could disappear rapidly When an individual changes jobs, there may be a period during which she has no group insurance coverage CFP Education Program Disability Insurance  CFP Education Program Overview While life insurance provides protection for an individual in the event of premature death, disability insurance provides financial protection to an individual who becomes unable to work because of a health impairment Disability insurance pays a benefit during the insured individual's lifetime, and is commonly referred to as a living benefit