RECOMMENDING AN INSURANCE POLICY (Chapter 11)

Question 1

REVIEW

What is a Term Policy ?

Answer 1

Insurance contract that promises to pay a death benefit in exchange for a premium if the life insured dies within a fixed term of the contract.

Question 2

REVIEW

Explain Term-100

Answer 2

• Provides lifetime coverage with a maturity date at age 100.
• Premiums are no longer payable after age 100.
• DOES NOT have Cash Surrender Value.

Question 3

REVIEW

Define Universal Life

Answer 3

• Provides lifetime coverage with a investment component.
• Savings from excess premiums can accumulate tax sheltered funds.
• Builds cash value and it’s known for flexibility.

Question 4

REVIEW

Simplify Limited Payment T-100

Answer 4

Policy with premiums payable for a specific period of time (10 or 20 years) or to a specific age ( 65 or age100). Policy then becomes “Paid-Up”.

Question 5

REVIEW

What are the FOUR non-forfeiture Benefits in a Whole Life Policy?

Answer 5

(Easiest way to remember is “CARE”)

1. C - Cash Surrender Value
2. A - Automatic Premium Loan
3. R - Reduced Paid-up Insurance
4. E - Extended Term insurance

Question 6

REVIEW

In a whole life policy, what are the 5 dividend payment options for Participating Policies?

Answer 6

1. Cash
2. Premium Reduction
3. Accumulation
4. Paid-Up Additions (PUAs)
5. Term Insurance

Question 7

REVIEW

What are the Non-forfeiture options in a UL policy?

Answer 7

1. Surrendering the policy
2. Policy withdrawals (partial surrender)
3. Premium offsets
4. Policy loans
5. Collateral for third-party loans
6. Leveraging
7. Distribution upon death

Question 8

REVIEW

Probability of Death

Answer 8

Statistical Probability that a person within a certain group will pass away before their next birthday.

Question 9

REVIEW

Life Expectancy

Answer 9

Average number of years that a person can expect to live from that age forward.

Question 10

Chapter 11 - Recommending an insurance policy

The probability of death in terms of odds helps a client visualize how real the risk of death is. How do you calculate the odds of death?

Answer 10

• Odds are simply calculated by dividing 1 by the probability of death.
• (Example) according to the general statistics for all Canadians, a man who just turned 30 has a probability of dying before his next birthday of 0.104%
• To many people, that seems to be a very low number. However, when expressed as odds, this means that one out of every 962 men who have just turned 30 years old will die before their 31st birthday. (1 ÷ 0.1045%)

Question 11

A person’s lifestyle choices can also influence his probability of death, such as…

Answer 11

• Smoking;
• Having a stressful job;
• Drinking excessively;
• A history of driving infractions;
• Frequent travel, particularly to developing countries;
• Engaging in hazardous activities or hobbies.

Question 12

The life agent also needs to determine how long the client’s risk of death will be a concern from a financial standpoint Illustrate a client’s duration of risk

Answer 12

Most of Derek’s financial obligations have a limited duration:

• His spousal support obligation of $500 per month will continue until his ex-wife Susan reaches age 65, and she is currently 44 years old;
• His child support obligation for Jordan is $1,000 per month until Jordan reaches age 19, and he is currently 8 years old;
• Derek and Becky’s mortgage has a balance of $318,120, with payments of $1,800 per month over the next 18 years;
• Derek’s car loan will be paid off in 6 years
• (The tax liability resulting from the cottage transfer will only arise upon
  his death, and because the timing of that death is unknown, the risk could
  continue to be a concern for 40 or 50 years or even longer. Furthermore, while the amount of the other financial risks related to supporting his family decrease over time, the tax liability is likely to increase over time as the cottage continues to appreciate)

Question 13

There are two types of insurance needs analysis, what are they ?

Answer 13

• Income replacement approach
• Capital needs approach

Question 14

Chapter 11 - Recommending an insurance policy

The agent should consider other risks to which the client may be exposed, other than the risk of death, particularly those that could be covered under a life insurance rider or that could interfere with the ability to pay the policy premiums. Name two other risk factors that the client should be aware of

Answer 14

• Risk of illness or disability
• Risk of unemployment

Question 15

Explain the income replacement approach

Answer 15

• Income replacement approach is reflected by the loss of employment income that would result from the death of an income earner.
• This approach strives to replace that lost income and it assumes that as long as this income can be replaced, the surviving family will not experience a reduction in their standard of living.

Question 16

Explain the capitalization of lost income and it’s calculation

Answer 16

The insurance need is determined by calculating the amount of capital that would have to be invested to generate the lost income.

• Annual income ÷ rate of return = Capitalized value
  ($8,400/month × 12 months) ÷ 5% = $2,016,000)
• This suggests that he should have about $2 million in life insurance.

Question 17

Name a DISADVANTAGE of the capitalization of lost income approach

Answer 17

The approach so far fails to consider the impact of income taxes or inflation on income.

Question 18

Why do we need to account for income taxes when using a capitalization of income approach?

Answer 18

• While life insurance proceeds are not taxable when received, if the proceeds are invested, the resulting investment income is taxable.
• If the lost income is expressed as an after-tax amount, the interest rate used when calculating the capitalization of income should also be an after-tax amount, using an appropriate tax rate.

Question 19

What are the calculations for an after tax rate using a capitalization of income approach?

Answer 19

Rate of return × (1 – tax rate) = After-tax rate of return
5% × (1 – 25%) = 3.75%

• (This means that, using the replacement of income approach, adjusted for
  income taxes, Derek would need $2,688,000 in life insurance, calculated as):

($8,400/month × 12 months) ÷ 3.75% $2,688,000

Question 20

Why do we need to account for inflation when using a capitalization of income approach?

Answer 20

In reality an individual’s employment income usually increases over time, at least at a rate to keep pace with inflation.

Question 21

What are the calculations for inflation using a capitalization of income approach?

Answer 21

(1 + return) ÷ (1 + inflation rate) - 1 = Inflation-adjusted rate of return

• If the inflation rate is 2% per year and the investment return is 5% per year, the
  inflation-adjusted rate of return is 2.94% calculated as:
• 1. (1 + 0.05) ÷ (1 + 0.02) – 1 = 0.0294
• 2. ($8,400/month × 12 months) ÷ 2.94% = $3,428,571

Question 22

Why do we need to account for income taxes and inflation simultaneously using the capitalization of income approach?

Answer 22

In most occasions, the amount of capital needed will be affected by both income taxes and inflation.

Question 23

What are the calculations for income taxes and inflation simultaneously using the capitalization of income approach?

Answer 23

(1 + after-tax return) ÷ (1 + inflation rate) -1= After-tax, after inflation rate of return

• (example) was determined that if the investment return is 5% per year and taxes are 25%, the after-tax rate of return is 3.75%. If the inflation rate is 2%,
  the after-tax, after-inflation rate of return is 1.71%, calculated as:
• 1. (1 + 0.0375) ÷ (1 + 0.02) – 1 = 0.0171
• 2. ($8,400 per month × 12 months) ÷ 1.71% = $5,894,737

Question 24

What is the weakness of the income replacement approach?

Answer 24

• It fails to address what the survivors actually need, as well as how long the lost income would have been generated if the life insured had not died.
• The income replacement approach also fails to address the life insured’s desire to create or protect an estate.

Question 25

Explain the capital needs approach

Answer 25

• It identifies all of the income and
  capital needs arising as a result of death, and converts them to a capitalized amount at death.
• This approach starts by listing the surviving family’s sources of income, then comparing them with their expenses, to determine if a shortfall exists.

Question 26

Income earned by the surviving family could take the form of employment income, pension or investment income, or government benefits. Illustrate this example.

Answer 26

• Becky does not currently work, and she does not expect to return to work for at least 6 years, at which time she believes that her take-home pay would be about $4,500 per month.
• However, Derek would feel better if he knew that she could manage the household financially without working until Robbie turns 18.
• Neither of them currently earns investment or pension income. If Derek dies, Becky would be eligible for a Canada Pension Plan (CPP) survivor benefit of about $675 per month, and Anya and Robbie would be eligible for a CPP benefit of about $265 per month as children of a deceased CPP contributor.
• Derek wants to ignore any potential benefits his family could receive under his province’s Workers’ Compensation Board, because there is no guarantee that his death will be work-related.
• Derek’s non-registered investment portfolio currently produces after-tax income of $7,200 annually, but because these assets may be needed to meet estate expenses, this income is not being included at this point.

Question 27

Ongoing expenses are going to be after the death of the life insured. It is important to consider that certain expenses will…

Answer 27

• Increase (childcare.
• Decrease (food, clothing).
• Be unaffected (home heating).
• Be eliminated entirely (the life insured’s golf membership, or mortgage payments)

Question 28

What is an income shortfall?

Answer 28

If the income is less than the expenses, then an income shortfall exists

expenses – income = shortfall

• Factoring in the CPP survivor benefits ($675 monthly for Becky and $265 monthly for each Anya and Robbie, if Derek dies, the family would experience a shortfall of $2,945 per month, calculated as:
  $2,945 = $4,150 – ($675 + $265 + $265)

[Ref. 11.3.3]

Question 29

TRUE OR FALSE?

Ideally, the investment return used in capitalization of income shortfall should be the after-tax inflation adjusted rate of return.

Answer 29

TRUE

Question 30

Explain the capital drawdown method

Answer 30

A Practical approach for needs that have a limited duration by multiplying the
annual shortfall by the number of years the shortfall is expected

Question 31

Illustrate a scenario where the capital drawdown method applies

Answer 31

• Derek has indicated that he would prefer that Becky would not have to return to work until Robbie turns 18.
• At that time, she could find work and likely take home enough money to cover all of her expenses.
• Using the capital drawdown method, the capitalized value of the family’s shortfall over 18 years would be $636,120, calculated as:
• $636,120 = ($2,945/month × 12 months) × 18 years

Question 32

Explain capital needs analysis

Answer 32

Lump sum needs that may arise as a result of death, to insure that the estate has enough liquidity to meet these needs.

Question 33

Name Some examples of capital needs

Answer 33

• Final expenses
• Tax liabilities
• Debt elimination
• Estate expenses
• Emergency fund
• Education fund
• Estate equalization
• Charitable bequests and legacies
• Assets available upon death (assets that are already in the form of cash or cash
  equivalents)
• Existing Insurance
• Total capital needs (including the capitalized income shortfall)

Question 34

How do you calculate a shortfall in capital?

Answer 34

Total capital needs at death – available assets – existing life insurance = Capital shortfall

• This shortfall represents the amount of additional insurance that should be acquired. It is normally rounded up to the nearest $10,000 or $50,000 amount.
• Using a capital needs approach with the capital drawdown method, Derek’s
  capital shortfall is $754,240, calculated as:
  $754,240 = $1,506,990 – $402,750 – $250,000 – $100,000
• Derek should therefore consider acquiring an additional $760,000 in life
  insurance.

Question 35

Explain where the capital needs may be suited to term insurance.

Answer 35

• Need to pay off the mortgage with the insurance; (only for the duration of the mortgage, usually 25 years or less);
• Children’s needs (when most will eventually be financially independent, say within 20 or 25 years);
• Employment income; (usually extends only until retirement age around age 55
  to age 65).

Question 36

Explain where the capital needs may be suited to PERMANENT insurance.

Answer 36

• Special needs children who may never outgrow their need for financial support;
• Tax liability that only arises upon death;(may not be realized for 30, 40 or even 50 years into the future, and it may also increase by that time);

Question 37

There are only a few situations where the agent might recommend an irrevocable beneficiary designation, such as when…

Answer 37

• It is a requirement of a spousal or child support court order;
• There is a need to protect the insurance proceeds from creditors;
• It is being used to implement a tax strategy in connection with charitable giving.

Question 38

TRUE OR FALSE?

When an estate is subject to probate, the contents of the estate and the terms will become public knowledge.

Answer 38

TRUE

• Naming the estate as the beneficiary of an insurance policy means that the death benefit becomes a matter of public record.
• This increases the chance that someone might contest the distribution of the death benefit to its intended beneficiary

[Ref. 11.5.4.3]