C. Decide on the best types of insurance for you
D. Decide whether you want a policy that pays dividends
1. Nonparticipating policy—guaranteed net cost and lower initial outlay
2. Participating policy—may be a better buy in the long run if interest rates remain high E. Shop around for a low-cost policy
F. Consider the financial strength of the insurer G. Deal with a competent agent
V. Appendix—Calculation of Life Insurance Premiums
Answers to Case Application
a.
Total premiums for 20 years $4,600
Subtract dividends for 20 years 1,613
Net premiums for 20 years $2,987
Subtract the cash value at the end of 20 years $3,620
Insurance cost for 20 years –$ 633
Net cost per year (–$633/20) = –$31.65 Net cost per $1000 per year (–$31.65/10) –$ 3.17 b.
Total premiums for 20 years each accumulated at 5% $ 7,985 Subtract dividends for 20 years, each accumulated at 5% 2,352
Net premiums for 20 years $ 5,633
Subtract the cash value at the end of 20 years 3,620
Insurance cost for 20 years $ 2,013
Amount to which $1 deposited annually will accumulate to in 20 years at 5% $34.719 For the interest-adjusted cost per year, divide $2013 by $34.719 $ 57.98 For the cost per $1000 per year, divide $57.98 by 10 $ 5.80 c.
Total premiums for 20 years, each accumulated at 5% $ 7,985 Subtract dividends for 20 years, each accumulated at 5% 2,352
Insurance cost for 20 years $ 5,633
Amount to which $1 deposited annually will accumulate to in 20 years at 5% $34.719 For the interest-adjusted cost per year, divide $5633 by $34.719 $162.25 For the cost per $1000 per year, divide $162.25 by 10 $ 16.22
Answers to Review Questions
1. The most glaring defect is that the traditional net cost method did not consider the time value of money. Interest that the policyholder could have earned on the premiums by investing them elsewhere was not considered. As a result, the true cost of insurance was understated.
2. (a) The interest-adjusted cost method is a more accurate cost method since the time value of money is taken into consideration by the application of an interest factor to each element of cost. (b) The surrender cost index is based on the assumption that the insured will surrender the policy at
the end of some time period. Under this method, the annual premiums and dividends are accumulated at 5 percent interest. The cash value at the end of the period is then subtracted from the net premiums, which results in an interest-adjusted cost for the time period under consideration. The final step is to convert the interest-adjusted cost for the entire period into an annual cost. This is done by dividing the interest-adjusted cost by the annuity due factor of $34.719, which is the amount to which $1 deposited annually will accumulate to in 20 years at 5 percent.
(c) The net payment cost index is useful if the insured intends to keep the policy in force and cash values are of secondary importance. The net payment cost index measures the relative cost of a policy if death occurs at the end of some specified time period, such as 10 or 20 years. The net payment cost index is calculated in a manner similar to the surrender index except that the cash value is not subtracted.
3. The negative returns during the early years can be explained by the heavy first-year acquisition and administrative expenses incurred when the policy is first sold. In recognition of the first-year load, cash value policies generally have little or no cash value at the end of the first year, and the cash values are relatively low during the first few years of the policy.
4. The Linton yield is the average annual rate of return on a cash value policy if it is held for a specified number of years. It is based on the assumption that a cash value policy is a combination of insurance protection and a savings fund. To determine the average annual rate of return for a given period, that part of the annual premium that is deposited into the savings fund must be determined. This can be done by subtracting the cost of the insurance protection for that year from the annual premium (less any dividend). The balance of the premium is the amount that can be deposited into the savings fund. Thus, the average annual rate of return is the compound interest rate that is required to make the savings deposits equal the guaranteed cash value in the policy at the end of a specified period. 5. The yearly rate of return is based on a formula developed by Joseph M. Belth (see text for formula).
Based on assumed benchmark prices per $1000 of protection for the various ages, the yearly rate of return on the saving component in a cash value policy can be calculated.
6. (a) Life insurance premiums paid in a lump sum to a designated beneficiary generally are received income tax free by the beneficiary.
(b) Dividends on life insurance policies generally are received income-tax free. However, interest on dividends retained under the dividend accumulations option is taxable to the policyholder. (c) The annual increase in a cash value policy is income-tax free. However, if the policy is
surrendered for its cash value, any gain is taxable as ordinary income.
(d) Life insurance proceeds paid in a lump sum to a designated beneficiary are generally received income-tax free by the beneficiary. If the proceeds are liquidated under a settlement option, the principal is received income-tax free, but the interest is taxable as ordinary income.
Chapter 13 Buying Life Insurance 83
7. If the insured has any incidents of ownership in the policy at the time of death, the entire proceeds are included in the gross estate of the deceased for federal estate-tax purposes. A federal estate is payable if the decedent’s taxable estate exceeds certain limits.
8. The following rules should be followed when shopping for life insurance: (a) Determine whether you need life insurance
(b) Estimate the amount of life insurance needed (c) Decide on the best type of insurance for you
(d) Decide whether you want a policy that pays dividends (e) Shop around for a low-cost policy
(f) Consider the financial strength of the insurer (g) Deal with a competent agent
9. The policy illustration contains a narrative summary that describes the basic characteristics of the policy, the elements of the policy that are not guaranteed, federal tax guidelines, and interest-adjusted cost data. The policy illustration also has a numeric summary that shows the premium outlay, value of the accumulation account, cash surrender values, and the death benefit. Three policy values must be provided based on (1) the current interest rate credited to the policy, (2) the guaranteed minimum interest rate under the policy, and (3) midpoint interest. The illustration also shows the number of years the insurance protection will remain in force under the three sets of interest assumptions. 10. A low-load policy is a policy that life insurers sell directly to the public by using telephone
representatives or fee-only financial planners. The loading for expenses is lower than under policies sold by regular agents. The major advantage is that marketing expenses account for only 10 to 25 percent of the first year’s premium rather than 90 to 125 percent on policies sold by agents.
Answers to Application Questions
1. (a) Traditional net cost calculation:
Total premiums for 20 years (20 × 248.60) $4,972.00
Less dividends for 20 years –814.00
Net premiums for 20 years 4,158.00
Less cash value after 20 years 4,314.00
Insurance cost for 20 years –156.00
Net cost per year (–156./20) –7.80
Net cost per thousand per year (–7.80/20) –0.39
(b) Surrender cost index calculation:
Future value of the premiums $8,631.00
Less future value of the dividends –1,163.00
Net premiums for 20 years 7,468.00
Less cash value after 20 years –4,314.00
Insurance cost for 20 years 3,154.00
Interest-adjusted cost per year ($3,154.00/34.719) 90.84
Cost per thousand per year (90.84/20) 4.54
The surrender cost index is $4.54 per thousand per year. (c) Net payment cost index calculation:
Future value of the premiums $8,631.00
Less future value of the dividends –1,163.00
Net premiums for 20 years 7,468.00
Interest-adjusted cost per year: ($7,468.00/34.719) 215.10 Cost per thousand per year (215.10/20) 10.76
The net payment cost index is $10.76 per thousand per year. 2. (a) Traditional net cost calculation:
Total premiums for 20 years $45,600.00
Less dividends for 20 years 15,624.00
Net premiums for 20 years 29,976.00
Less cash value after 20 years 35,260.00
Insurance cost for 20 years –5284.00
Net cost per year (–5,284/20) –264.20
Net cost per thousand per year (–264.20/100) –2.64
The traditional net cost is a negative $2.64 per thousand per year. (b) Surrender cost index calculation:
Future value of the premiums $79,159.00
Less future value of the dividends 24,400.00
Net premiums for 20 years 54,759.00
Less cash value after 20 years 35,260.00
Insurance cost for 20 years 19,499.00
Interest-adjusted cost per year (19,499.00/34.719) 561.62 Cost per thousand per year (561.62/100) 5.62
Chapter 13 Buying Life Insurance 85
(c) Net payment cost index calculation:
Future value of the premiums $79,159.00
Less future value of the dividends 24,400.00
Net premiums for 20 years 54,759.00
Interest-adjusted cost per year (54,759.00/34.719) 1577.21 Cost per thousand per year (1577.21/100) 15.77
The net payment cost index is $15.77 per thousand per year.
3. John needs to consider the state of his health and the cost of obtaining the new policy. Based on his poor physical condition, he may be rated up. John should also consider that a new incontestable clause and suicide clause will apply to the new policy. He will also have to pay the acquisition costs and loading a second time. Without proper cost information, the replacement policy may be more expensive than his present policy.
4. (a) The lump sum payment of $50,000 is not taxable income. Death proceeds payable to a stated beneficiary are normally not taxable.
(b) The cash value increase of $380 is not taxable income.
(c) Life insurance premiums generally are not income-tax deductible.
(d) The dividend is largely a refund of a redundant premium. The $120 dividend is not taxable income.
Answer to Case Application in the Appendix to Chapter 13
a. Calculating the NSP for a Five-Year Term Insurance Policy, Male, Age 30
Age Amount of Insurance Probability of Death Present Value of $1 at 5½% Insurance Cost of
30 $1000 × 11,173 9,800,822 × 0.9479 = $1.08 (Year 1) 31 $1000 × 11,062 9,800,822 × 0.8985 = 1.01 (Year 2) 32 $1000 × 11,050 9,800,822 × 0.8516 = 0.96 (Year 3) 33 $1000 × 11,233 9,800,822 × 0.8072 = 0.93 (Year 4) 34 $1000 × 11,512 9,800,822 × 0.7651 = 0.90 (Year 5) NSP = $4.88
b. The net annual level premium (NALP) is determined by dividing the net single premium (NSP) by the present value of a life annuity due (PVLAD) of $1 for the premium paying period.
Age 30 $1 due immediately = $1.00
Age 31 9,789,650 9,800,822 × $1 × 0.9479 = 0.95 Age 32 9,778,587 9,800,822 × $1 × 0.8985 = 0.90 Age 33 9,767,537 9,800,822 × $1 × 0.8516 = 0.85 Age 34 9,756,305 9,800,822 × $1 × 0.8072 = 0.80 PVLAD of $1 = $4.50 NALP= PVLAD of $1 NSP = $4.88 4.50 = $1.08 c. No. A loading for expenses must be added to determine the gross premium.