MGFC20 Ch10 more insurances

Insuring Against the Risk of Unacceptable Loss in Human Capital

Learning Objectives

• Evaluate the need for life insurance.

• Determine the appropriate amount of life insurance coverage.

• Understand the characteristics of common life insurance policies.

• Compare different life insurance policies.

• Comprehend the major features of typical disability insurance policies.

What Is Life Insurance?

• Life insurance is a method of financing the risk of death within a family.

• It is a contract between an insurance company and the insured, wherein the insured pays premiums
that the insurance company pools and invests.

• Beneficiaries receive the death benefit or face value, which is not taxable, upon the early death of the
insured.

More Life Insurance Terms

• Owner: The person who pays the premiums.

• Policy term: The period the insurance is in force.

• Rate: The cost per unit of insurance (e.g., $100).

• Insurability: Rules in the contract that determine who can be insured (e.g., passing a medical exam).

• Guaranteed insurability: Provision allowing the purchase of more insurance or policy changes without
requalifying.

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Who Needs Life Insurance?

• Evaluate the risk of premature death using a risk management model.

• Consider whether dependents need the insured's income to maintain a reasonable standard of living,
including the loss of services provided by the family member.

• Insurance can be bought before having dependents while it is easier to qualify.

Who Needs Life Insurance? (Continued)

• Should a parent buy insurance for their children?

• It depends. From a financial perspective, the answer would be "No" since the parent is not financially
dependent on the child.

• However, insurance might be worthwhile as a parent may need time off from work to grieve.

How Much Life Insurance?

• Three methods for determining the appropriate coverage amount:

1. Income approach: Replace the value of the human capital.

2. Expense approach: Estimate future family expenses and calculate the present value.
3. Human capital approach: Combines income and expense methods to provide a more accurate
assessment.

Income Approach

• Calculate the present value of the future earned income stream, including pension contributions and
benefits.

• Use real cash flows and a real risk-free interest rate.

• Consider that insured individuals may receive real raises or reductions, and adjust for taxation on
proceeds.

Income Approach — Adjustments

• Beneficiaries usually pay taxes at a lower rate than the insured, so reduce the calculated present value
to 70–80%.
• Account for tax by discounting the after-tax real income stream at the beneficiary’s expected after-tax
discount rate.

Expense Approach

• Prepare a balance sheet at the date of death.

• Estimate the expected future expenses of the dependents during the period of dependency in real
dollars.

• Discount the expenses net of income, considering tax implications.

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Expense Approach — Shortfall Calculation

• Estimate the family's annual expenses during the period of dependency.

• Calculate the supplementary income needed (dependents' income minus expenses).

• Determine the insurance needed to generate the after-tax income shortfall.

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Human Capital Approach

• Combines features of the income approach and the expense approach.

• Adjusts the income approach for unpaid income aspects (e.g., shared household duties) and reduction
of expenses after death.

• The resulted value will be higher than the expense approach, and the difference between human
capital and expense approach value equals the expected bequest.

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Types of Life Insurance

• Term Insurance: Pure insurance with no investment component.

• Policies with savings/investment features:

1. Whole life: Level premiums and coverage for life.

2. Endowment life: Pays the face value to the insured if they live to a certain age, in addition to the
death benefit for beneficiaries.
 3. Universal life: Minimum premium pays for term insurance, with optional extra payments
invested as in whole life.

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Tax Deferral on Permanent Policies

• The income in a permanent policy is tax-deferred until the cash surrender value is withdrawn.

• Tax is paid on the amount net of premium costs because premiums are contributed after-tax.

• Policyholders can use policy loans secured by the cash surrender value to defer tax even longer.

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Term vs. Non-Term Policy

• Term insurance costs less for the same coverage, making it better for risk management.

• Non-term policies provide enforced savings but are more expensive.

• Some individuals may prefer non-term policies to ensure a cushion for premium default.

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Secondary Policy Provisions

• Policies contain rules on various options, including:

1. Grace period for missed premiums.

2. Reinstatement time limits for lapsed policies.
3. Suicide time limits.
4. Loan provisions (for non-term policies).
5. Settlement options for beneficiaries to receive the payout.

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CPP Life Insurance

• The Canada Pension Plan (CPP) provides life insurance benefits:

1. A $2,500 non-indexed lump-sum death benefit.

2. Survivor pension to the spouse.
3. Qualified dependent children receive survivor benefits.

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Health Insurance

• Provincial health care plans provide basic medical care for free in Canada.
• Private plans offer supplements, often part of employer benefits, including coverage for semi-private or
private hospital rooms, dental care, eyeglasses, prescription drugs, and medical expenses outside
Canada.