CHAPTER OBJECTIVES
When you have finished this chapter, you should be able to
- Identify the exposures that arise in connection with an individual's income
- Explain the concept of present value and why it is important in measuring life values
- Explain the human life value concept
- Describe how various lifestyles affect the risk of loss from premature death
- Explain the process of needs analysis
- Identify the sources of protection that may be available to an individual as protection in the event of premature death
- Explain how the risk of disability differs from the risk of premature death
- Explain the relationship between the risk of premature death and longevity risk
We begin our study of specific types of insurance by looking at personal risks and insurance coverages designed to deal with them. As explained in Chapter 1, personal risks relate to the loss of the ability to earn income and include premature death, dependent old age (longevity or “superannuation”), sickness or disability, and unemployment.
We treat these risks first to follow the philosophy of risk management. This entire text is designed to develop concepts that should be used in dealing with risks the individual faces. We noted in Chapter 4 that losses with the greatest potential severity merit first attention. Following this principle, we turn first to the risk with the greatest potential severity for the individual and the family unit, the loss of income. A well-ordered personal insurance program should begin with protection of the individual's most valuable asset: income-earning ability. It is foolish to insure the property a person owns while neglecting to insure the asset that produces the property.
When designing a program to meet personal risks, individuals may have some protection from a number of sources. Social insurance programs, discussed in the next chapter, may provide an income in the case of death or disability. For example, Social Security provides some resources to meet the premature death, longevity, and disability exposures. Workers compensation plans pay benefits to disabled workers and dependents of deceased workers if the death or disability arose out of employment. Many individuals receive benefits from their employers. These may include employer-provided life insurance, pension plans, disability income plans, and medical expense insurance. Where government programs or employee benefits do not meet needs, the individual must make other arrangements through personal savings, insurance, or some combination.
This chapter will examine the exposures faced by the individual and family. The next chapter considers Social Security, workers compensation, and other social insurance programs that may provide some resources when an individual dies or becomes disabled or unemployed. Finally, in later chapters, we will look at insurance products designed to deal with these risks.
We begin by focusing on those risks that arise from uncertainty concerning the time of death. The individual faces two mutually exclusive risks that arise from the uncertainty concerning the time of death: premature death and longevity. Premature death occurs when the death takes place while others remain dependent on the individual's income. Longevity risk is the risk of outliving one's income, that is, the risk of retiring without adequate assets to cover living expenses during the period of retirement.
The risk of premature death and the risk of superannuation are, in a sense, competing and diametric needs. If the individual dies prematurely, he or she will have no need for funds that were being accumulated for retirement. If the individual lives until retirement, provision made for premature death will not be used.
As we will see when we look at life insurance, some types of life insurance include an accumulating fund that can provide funds for retirement. This means that although the basic function of life insurance is to provide protection against financial loss arising from premature death, it can be used to insure against premature death and as a vehicle for accumulating funds.
When no one is dependent on the individual and his or her death will not deprive anyone, there is no risk of financial loss, and protection against premature death is unnecessary. When protection against premature death is not needed, other approaches to accumulating funds for retirement will generally be more attractive than life insurance.
OBJECTIVES IN MANAGING PERSONAL RISKS
As in the case of risk management, the first step in managing personal risks is to establish objectives. Because personal risks involve the potential loss of income, the objectives in this area logically relate to the income that would be lost.
The first objective in managing personal risks is to avoid the deprivation of the individual and those dependent on him or her in the event of a loss that causes the termination of income. Achieving this objective means making arrangements to replace the income lost as a result of death, retirement, disability, or unemployment. Insurance is a common approach to replacing such income.
In addition to this risk management objective, other objectives may derive from personal financial planning. One such objective is sometimes the goal of transferring the maximum wealth possible to dependents. This second objective is fundamentally different from the goal of providing for those who are dependent and who would suffer deprivation if the income on which they are dependent were terminated. Eventually, offspring reach a point at which they are no longer dependent on their parents. The parents' concern for their children, however, may not end at this point. Usually, parents want to transfer wealth to their children (or other heirs) regardless of the children's need. To achieve this goal, they want to avoid the shrinkage that can occur as assets pass from generation to generation. Fortunately, measures can minimize the shrinkage of the estate and are referred to as estate planning.1
Finally, in addition to the objectives of protecting dependents from deprivation that would result from income producer's premature death and maximizing the wealth that is transferred to heirs, the individual may have other goals. These goals relate to the individual's plans for the future and things he or she hopes to achieve. They may include the education of children or grandchildren, charitable gifts, and other personal aspirations that might be frustrated by premature death.
OTHER STEPS IN MANAGING PERSONAL RISKS
The remaining steps in managing personal risks are the same as those discussed in Chapter 2: identifying the risks, measuring and evaluating those risks, selecting the risk management technique that will be used to address the risk, designing and implementing a plan to implement the decision, and evaluation and review. We have noted the perils that give rise to personal risks: death, superannuation, disability, and unemployment. Because the risks relating to the loss of income may differ depending on the peril that threatens income, we will discuss the remaining steps in dealing with personal risks separately for each of the perils that threaten income.
MANAGING RISKS ASSOCIATED WITH PREMATURE DEATH
Death can be a source of loss in two ways. The first is in triggering the expenses associated with death. These consist primarily of funeral costs, payment of debts owed by the individual, and death transfer costs such as the cost of probate and estate taxes. The second loss occasioned by death is the loss of income that would have been earned by the deceased.
Identifying Risks Associated with Premature Death
On first consideration, it might seem that the risk of income loss resulting from premature death is universal. After all, no one lives forever. But death does not automatically result in financial loss. The individual who dies does not suffer financial loss; the financial loss is sustained by others who are dependent on the income earned by the individual. The essential ingredient in the risk of income loss due to premature death is the existence of someone who would suffer deprivation as a result of the individual's death. The first step in determining whether the risk of lost income exists is to determine whether anyone will suffer deprivation as a result of the death. When no one will be deprived of income as a result of death, there is no risk of financial loss due to premature death.
The expenses that arise directly from an individual's death, such as burial expenses, can be funded out of assets owned by the individual at the time of death. If the deceased had no assets at the time of death, burial costs must be paid by survivors or by the state. Overall, however, the costs created by death, the so-called last expenses, are usually modest and seldom require significant measures.2 The loss of income that results from the individual's death may be greater, and it is the loss of one's income-earning ability that is the major risk management problem with which most people must deal.
Measuring Risks Associated with Premature Death
Two approaches have been suggested to evaluate the risk of premature death: human life value and needs analysis. The human life value concept focuses on the earnings of the individual that would have been lost in cases of premature death. Needs analysis focuses on the income and cash needs that must be met following an individual's premature death and compares those needs to resources already available.3
The Human Life Value The application of the concept of human life value to insurance purchase decisions is generally credited to S. S. Huebner.4 Simply stated, the human life value is based on the individual's income-earning ability; it is the present value of the income lost by dependents as a result of the person's death. Any attempt to measure the human life value must necessarily consider present value, a concept familiar to students who have studied finance. Because an understanding of this concept is essential to a meaningful measurement of income flows, we will pause for our discussion to review the concept for those readers who have not encountered it in their previous studies. (The student who is familiar with the concept of present value and the time value of money can flip forward through the pages to the point where we resume our discussion.)
Time Value of Money and Present Value The term time value of money refers to the fact that $1 today is worth more than $1 a year from now (or at some other time in the future).5 This is because $1 can be invested at some positive rate of return and will be worth more in the future. If $1 can be invested at 6 percent, $1.06 is the future value of a present dollar in one year at 6 percent. If we assume that the $1.06 is reinvested at 6 percent, the future value of $1 invested at 6 percent for two years is $1.00 times 1.06 times 1.06, or, $1.1236. Continuing the computation, we can determine the future value of $1 invested for any number of years; this is called compounding, reflecting the fact that interest is paid on the interest earned in previous periods.
Just as it is sometimes useful to know the future value of a present dollar, we sometimes want to know the present value of a future dollar. The present value of a future dollar is the amount that will be required, invested at a specified rate of interest, to equal a dollar in a specified number of years. The present value of a future dollar one year from now is computed by dividing the present value of a present dollar ($1) by the future value of a dollar at the specified rate of interest. For example, $1 invested at 6 percent for a year will be worth $1.06 at the end of the year. How much must we have, so that if we invest it at 6 percent it will equal $1 at the end of the year?
This $0.943396 is the present value of a future dollar or the discount factor. If we invest $0.943396 at 6 percent, it will equal $1 at the end of a year. We can divide the present value of a dollar in one year by the future value of a future dollar in one year to determine the present value of a dollar in two years:
Present value tables are available that indicate the present value of a future dollar for various numbers of years and at various rates. Table 10.1 indicates the present value of a future dollar at various interest rates from 1 to 40 years. It indicates the value of $1 to be received at the end of some number of years at various discount rates. It tells how much an individual would have to invest at a given rate of interest to receive $1 at some time in the future. Reading down the table, we can see that one must invest about $0.31 at 6 percent to have $1 at the end of 20 years.
Discounted Income Flows One of the most useful applications of the concept of present value is in discounting a flow of income to determine its present value. We can estimate the human life value by discounting the expected stream of income that would accrue to the dependents as a result of their breadwinner's continued employment. If we deduct the amount of the income that would be consumed by the producer personally and discount the remainder, we have a notion of the present value of the stream of income that would be lost.
Human Life Value Illustrated For the purpose of illustration, consider a 25-year-old person, who we will assume plans to work until age 65. If we estimate that his or her average earnings will be $60,000 annually and that two-thirds of the income will be consumed by dependents, the individual's economic value to dependents is $40,000 a year for 40 years. However, the life value at age 25 is not measured by this total figure, but by the amount that, invested at some conservative rate of interest, would yield an income of $40,000 per year for 40 years. We could compute this amount by discounting the $40,000 in each year by the appropriate rate for that year. Alternatively, we can consult a table such as Table 10.2, which indicates the present value of $1 each year for different numbers of years. Table 10.2 shows that a present investment of $15.046 will yield an income of $1 per year for 40 years, assuming a 6 percent interest rate. By multiplying $40,000 times $15.046, we obtain the sum that will yield $40,000 a year for 40 years, $601,840.6
TABLE 10.1 Present Value of $1 in N Years at Various Interest Rates
TABLE 10.2 Present Value of $1 Annually for N Years at Various Rates
TABLE 10.3 Economic Value of $10,000 Annual Income to Dependents
Other things being equal, the economic value of the individual generally decreases over time and disappears at retirement age. Table 10.3 indicates the declining economic value at different assumed rates of interest associated with an average annual income to dependents of $10,000. This table also illustrates the impact of the interest rate selected on the value indicated.
This method of calculating the economic value of a life is fraught with many difficulties, the chief of which is estimating future changes in income. These changes may be expected as the individual progresses in his or her career and are important determinants of the life value. Estimates of future earnings can at best be nothing more than a projection based on present earnings in the person's occupation. Furthermore, as noted, the human life value will change if future earnings are discounted at a different rate.7
Finally, the fact that the present value of an individual's income-producing ability is a given amount does not necessarily mean this is the sum for which it should be insured. If the loss of the individual's income would deprive no one, insurance is unnecessary. In addition, a part of the income lost through the person's death may be replaced by other sources, such as Social Security or life insurance available under a group insurance program in connection with employment.
The amount of life insurance that an individual should purchase is determined by the so-called needs approach, which determines the amount of life insurance required based on analysis of the needs that would have to be met by dependents should the income producer die. While Huebner's life value concept focuses on the income that would be lost, the needs approach attempts to identify the allocation of that income and to determine the purposes to which it would have been put.
The effect of the income loss occasioned by premature death depends on the circumstances. These circumstances include how important the income is to the survivors and whether it can be replaced from other sources. If the survivors were not employed at the time of the income producer's death, they may be able to find employment to replace the lost income. If the income is not replaced, the survivors' standard of living may decline. The basic function of life insurance, then, is to replace the income that is lost by dependents if the income producer on whom they are dependent dies. The primary reason for the purchase of life insurance is to prevent a decline in the standard of living of dependents and to permit the dependents to live in a manner that approximates the style they would have enjoyed if the income producer had not died.
Needs Analysis The needs approach attempts to determine the amount of life insurance that should be purchased based on analysis of the needs of those who would suffer financial loss. Needs analysis has three basic steps. The first step is to identify the needs that would arise or continue to exist following the death of the individual. Second, resources available to meet those needs must be identified. Potential resources at death might include savings, employer-provided life insurance, and various social insurance programs. Finally, the difference between needs and available resources represents unmet needs, and life insurance is one tool that may be used to meet this remaining need. Although the concepts are different, there is a relationship between the human life value idea and the needs approach to determining the amount of insurance needed in a particular situation. In summarizing the needs that would exist if the wage earner should die, we are looking at the other side of the income-expenditure equation. Whereas the life value concept focuses on the income that would be lost, the needs approach attempts to identify the allocation of that income and determine the purposes for which it would have been used. In addition, the needs approach attempts to recognize unusual or irregular expenditures that may result from the death of the individual and additional expenses that may accompany the period of readjustment following a wage earner's death.
For example, there may be a need to provide a source of funds to support the living expenses of surviving dependents. The amount of this need will vary, depending on marital status, the roles of husband and wife, the presence of children (or plans for children), and the employable skills of dependents. A variety of lifestyles are possible, each with different implications regarding the need for life insurance.
Lifestyles and the Needs Approach One way to illustrate the difference between the human life value approach and the needs approach to life insurance is to consider how different lifestyles affect the need for life insurance.
- Single individual The single individual without dependents usually has little need for death protection. Unless parents (or others) are dependent on a single person, replacing the income that might stop is unnecessary. Enough life insurance to cover any indebtedness and a fund for last expenses constitutes the extent of the need. However, a young single person may want to purchase life insurance because he or she may become uninsurable.
There are, of course, many single individuals who have dependents. These include widowed and divorced persons with children, single persons who support their parents, and single persons with other dependents. For these individuals, the need for death protection parallels that of the married couple with children.8
- Childless couple As with the unmarried person, the need of a childless couple for death protection is modest, particularly if both are employed. When both spouses are employed outside the home, the need for death protection on the part of the other is usually limited to an amount needed to meet any indebtedness and to cover final expenses. However, if the childless state is a temporary one and the couple intends to have children, they may need to buy life insurance to guarantee future insurability.
- Persons with children When children enter the picture, the problem becomes somewhat more complicated. Both parents may be employed outside the home, or one parent may act as homemaker while the other produces income. In the first case, in which both parents earn income, the standard of living may be threatened if either income is lost. Unless there is a willingness to reduce the family's standard of living in the event of a reduction in family income, the income of both spouses may have to be insured. When one parent works outside the home and the other acts as homemaker, the principal focus will be on insurance for the income-producing partner. The amount of insurance required in this case will depend, in part, on the ability and inclination of the homemaker spouse to obtain employment in the event of the income producer's death.
It is also important to recognize the contribution of the homemaking spouse. Such a spouse makes an economic contribution to the family, and the loss of the services he or she provides would create a financial burden for the family. When funds are available, this exposure should be insured, but such coverage ranks below coverage on an income-producing spouse.9
In the case of a single parent with children, the situation is essentially the same as for the family with a single working spouse but without the “cushion” of a potentially employable surviving spouse. In addition, some plan should exist for the guardianship and care of the surviving children.
Divorce and Income Needs Divorce is a traumatic experience for the participants for a variety of reasons, one of which is the dramatic change in the financial situation of both parties. When one of the parties has been dependent on the income of the other, the divorce settlement may provide for continued support of that party through alimony, the money paid to a former spouse under a divorce or separation settlement. When there are minor children, the court will likely order child support payments. In such cases, the recipient of the alimony or child support payments faces the same risk associated with the premature death of the payer as before the divorce. The need for life insurance on the payer is, therefore, as great, if not greater, as in the case of the married couple. Insurance and annuities may be used to secure the obligations under a qualified domestic relations order or divorce decree.10 Although income planning in a divorce situation involves many of the same considerations as income planning for the family unit, it differs in the sense that the decisions are often dictated by the court. Many of the decisions relating to needs are made for the parties, and the court may specify the manner in which these needs will be met. Further, the arrangement may have tax implications for the parties. The tax ramifications relating to insurance in divorce proceedings are discussed in Chapter 16.
Classification of Needs The question often arises, How does one anticipate the amount that will be needed to replace the wage earner's income? Two approaches exist. The first is to deduct from current expenditures the portion of family income consumed by the wage earner. The remainder is the amount the family will require should the wage earner die. This approach, however, ignores the changes in expenditures that may occur as a result of the wage earner's death. The second approach, which seems more logical, is to construct a household or family budget summarizing the required expenditures. A family budget is a plan through which one establishes spending goals and monitors how well the household is doing in meeting these goals. Most budgets are based on historical expenditures and will include provisions for weekly, monthly, quarterly, and annual expenditures. Many individuals have never constructed a budget for their day-today living and have, therefore, given little thought to the amounts that would be needed following the death of the wage earner. For those individuals who do not currently budget, constructing a needs-oriented insurance program may be the first attempt at budgeting. Although a family budget is the starting point for determining needs, it may be classified in various ways; the traditional approach includes the following:
| Cash Needs | Income Needs |
| Fund for last expenses and debts | Funds for readjustment |
| Dependency period income | |
| Emergency funds | |
| Mortgage payment funds | Life income for spouse |
| Educational funds |
The first group, cash needs, represents those needs for which a lump-sum amount is desirable at death. The nature of the fund for last expenses, also called the cleanup fund, is obvious. Death may be accompanied by high medical expenses, funeral costs, and other unplanned outlays, and the fund for last expenses is intended to cover these. Ideally, medical expenses will be covered by a well-planned health insurance program. Whether specific funds should be provided for the payment of debts depends on the circumstances, but the planner should consider whether such funds should be provided as a part of the life insurance proceeds. Assuming that medical expenses associated with the last illness are covered by health insurance, something in the range of from $10,000 to $15,000 is usually adequate for the fund for last expenses.
The purpose of emergency funds is to provide the survivors with a cushion for unexpected expenses that may arise as the family makes its transition to life without the deceased and thereafter. Although the selection of the amount for an emergency fund is somewhat arbitrary in any case, a typical allowance is $5000 to $10,000.
The mortgage payment fund may be a particularly effective way of reducing the amount of income needed during the dependency period. If the mortgage permits prepayment without penalty, substantial savings in future interest payments can be gained by paying off the loan at the death of the income producer. Conversely, if the mortgage is not paid off, the payments may be met by providing a higher income during the years it has to run.
Although educational needs are typically listed as a separate need, this is arbitrary, and parents may differ in attitude regarding the obligation to help finance a child's college education. Some parents provide considerable assistance, but many students finance their own college education through loans and part-time employment. If the parents plan to assist their children with college expenses, the income protection plan should specifically recognize these expenses as part of the income need. Provision for college expenses can take one or two forms: A specific lump sum can be made available to each child to help defray the cost of college, or the income of the dependency period can be extended to provide income throughout the college years.
The remaining three needs represent income needs. The need for continued income to support the family's lifestyle may be greater than immediate cash needs, and it is the loss of one's income-earning ability that is the major risk management program with which most people must deal.
The income needs are classified into three groups, representing three different periods in the family's life cycle. Many experts recommend a separate readjustment period following the death of the wage earner, during which the family's income is higher than it will ultimately be. They believe that the family will have certain nonrecurring expenditures as it adjusts to its new way of life immediately following the death. When the family will suffer a decline in standard of living following the death of an income earner, the readjustment period provides some time to accomplish that readjustment.
Income needs during the dependency period are the largest in most programs and consist of income required during the period for which others, for example, the children, would be dependent on the wage earner. The length of the dependency period income will usually depend on the number of children, their ages, and the relative contribution of the income producer to total family income. When both spouses are employed outside the home, the specifics of the situation will determine the percentage of each income that should be insured. The contribution of each income to family needs and the continuing needs that would have to be met will dictate whether both incomes or a part of both should be insured. When one spouse produces all of the family income, it will usually be necessary to insure a high percentage of that income. In either case, the important factor is the income producer's contribution to family welfare and the family needs that will have to be met from some other source if he or she dies. As we will see in the next chapter, the children and surviving spouse may be eligible for Social Security benefits following the death of the wage earner. (Typically, children are eligible for benefits as long as they are under age 18, and the surviving spouse is eligible until the youngest child reaches age 16.) By themselves, however, Social Security benefits are rarely sufficient to allow the family to maintain its previous standard of living.
The ability of a homemaker spouse to obtain employment in the event of the death of the income-producing spouse is also a factor. However, the net gain from such employment is generally less than the received wages. First, the spouse must pay taxes, including Social Security and income taxes, on the earnings. Second, the spouse may lose Social Security benefits to which he or she was otherwise entitled because earnings in excess of certain amounts allowed reduce the Social Security benefits.11 Additional costs will be incurred by working, including clothing, transportation, lunches, and child care. If life insurance provides adequate income, the surviving spouse may elect to work outside the home. Without it, he or she is compelled to do so.
Finally, when the children are grown, the spouse may still need to replace a part of the wage earner's income. This is true if the surviving spouse is not employed outside the home and has few employment opportunities if the income-producing spouse should die. Based on the structure of Social Security benefits, the spouse's life income may be conveniently divided into two parts. The first starts when the youngest child reaches 18, at which time Social Security benefits cease, and continues until the spouse's Social Security benefits resume again at age 60 or 62. Because the spouse receives no Social Security benefits during this time, it is sometimes called the blackout period. During this period, the entire income must come from life insurance, employment, savings, or some other source. After the blackout period, Social Security benefits will resume, and a lesser amount of supplementary income will become necessary.
FIGURE 10.1 Needs Analysis Chart
Under the needs approach, these income requirements of the family are usually listed on a monthly basis over time. The presentation indicates the amount of income needed, the amount available from Social Security and other sources, and the extent of the unfilled need. This information may be summarized in graphic form, as shown in Figure 10.1. The chief benefit of this graphic analysis is that it helps the individual visualize the amounts needed as a flow of income. The perceptive student will note, however, that the needs presented in the chart are measured in constant dollars. Because actual needs will increase with inflation, the ideal approach is one in which the effects of inflation can be recognized. Various approaches have been used to address the problem of inflation in needs analysis with varying degrees of success. Today, with financial calculators and computer spreadsheets, factoring inflation into the measurement of future income needs is much easier.
Determining future income needs combines the processes of compounding and discounting. First, to estimate future income needs, present needs are projected at an estimated inflation rate. Social Security benefits, which are subject to automatic adjustment for inflation, are projected at the same rate of inflation. If the spouse is employed, his or her income is also projected at an assumed rate for wage increases. The difference between the inflation-adjusted gross need and the inflation-adjusted sources of income represents the unfilled need. To determine the present value of this unfilled need, the projected deficiency is discounted using a discount rate that represents the anticipated earnings on the funds that will be purchased to meet the unfilled need. Table 10.4 illustrates this process.
The current value of the remaining unmet needs in Table 10.4 is $153,768. This $153,768 amount summarizes the difference between projected income needs and the projected sources of funds to meet these needs. It is the present value of the difference between needs and available resources. To determine the portion of this amount that must be insured, existing resources should be considered. Suppose the individual has $50,000 in life insurance available from his or her employer and a savings of $20,000. This leaves a remaining unmet need of $83,768 ($153,768 minus $70,000) that may be covered by the purchase of additional life insurance.12
Capital Liquidation versus Capital Conservation Once future income needs have been estimated and combined, the remaining question concerns the funding to meet the needs. There are two basic strategies, capital conservation and capital liquidation. The preceding illustration uses a capital liquidation approach since it assumes the principal will be consumed in meeting the projected income needs. Under the capital conservation approach, sufficient funding is provided so investment earnings alone will supply the income stream without depleting the capital. Under this approach, also called capital needs analysis, the amount of funding required is an amount that is sufficient, together with other assets, to provide investment income that will cover the projected needs of the family. A capital conservation approach will require a greater amount of capital than the capital liquidation approach, but the difference in the amount required for the two approaches will depend on the period for which the income stream must be provided and the return earned on the capital. The longer the period and the higher the investment return, the smaller the difference in the principal required under the capital conservation and capital liquidation approaches.13
TABLE 10.4 Present Value of Inflation-Adjusted Future Income Needs
The choice between the capital liquidation and capital conservation strategies relates to objectives. The capital liquidation approach is designed to meet the single risk management strategy of protecting dependents against deprivation that might result if the income stream on which they depend is interrupted. The capital conservation strategy seeks to meet the personal financial planning objective of transferring wealth to heirs.
A Continuing Task The principal defect of the life value and the needs approaches is they rely on static analysis, determining the amount of insurance at a specific point in time. This results in the purchase of an insurance amount that may be correct at that time but will become inaccurate as time goes by. Because the life value of the individual decreases over time as the end of the income-earning years approach, the fixed amount may be excessive. The needs of each individual will vary, depending on the age, the number of children, and financial assets. In addition, the wants of the individual may change over time because, during each period of life, different needs appear more crucial.
The Estate Liquidity Need
As previously noted, one of the objectives in managing the risk of premature death may be the goal of transferring the maximum wealth possible to dependents. One of the impediments to achieving this objective arises because estates shrink as they pass from one individual to another. Several factors are responsible for this. First, there is the shrinkage that results from the debts of the decedent, for all debts must be paid before the estate may be passed on to the heirs. In addition, the costs involved in probate and administration generally amount to between 4 percent and 5 percent of the estate. Finally, and frequently the most burdensome, there are the federal estate tax and the state inheritance tax.14 Although risk control measures such as estate planning can reduce the amount of these costs, the need for liquidity in the estate to meet death costs that cannot be reduced represents a need that can be met with life insurance.
Estate Planning
Minimizing estate shrinkage is an area in which risk control measures, generally referred to as estate planning, can be effective in reducing potential losses. Estate planning is the process through which one arranges one's affairs so as to yield the most effective accumulation, management, and disposition of capital and income. It involves decisions regarding how an individual's financial affairs will be managed following his or her death and who will do the managing. A major goal of estate planning is to reduce the shrinkage of an estate as it passes from one generation to the next. The greatest shrinkage of the estate has historically come from the federal estate tax, a tax that is imposed on the transfer of a taxable estate.
Federal Estate Tax The federal estate tax, also known as a death tax, is a tax imposed on wealth transfers made at the holder's death. From the time it was enacted in 1916, there has been pressure for repeal of the federal estate tax.15 Congress passed legislation repealing the estate tax in 2000, but President Clinton vetoed it.
The basic features of the estate tax today were adopted by the Tax Reform Act of 1976 (TRA-76), which unified the tax on three types of transfers: transfers at the time of death, gifts made prior to death, and generation-skipping transfers. The law required that taxable gifts made during the lifetime of the deceased be combined with the decedent's estate to compute the taxable estate. The generation-skipping transfer imposes a tax on wealth that “skips” a generation (e.g., a bequest by a grandparent to a grandchild). This tax is intended to ensure that taxes are paid at each generational level and cannot be avoided by using a trust or other means to transfer wealth.
Between 2001 and 2012, the structure of federal estate taxes was uncertain. Laws enacted in 2001 and 2010 made changes to the federal estate tax law but provided that the changes would sunset at some point in the future.16 This bizarre scenario created challenges for estate planners. The American Taxpayer Relief Act of 2013 (ATRA-2013) rectified the situation, creating a permanent structure for federal estate taxes going forward and allowing for a more certain planning environment.
The federal estate tax applies to one's entire taxable estate, meaning the gross estate minus allowable deductions, but any tax payable is subject to a unified credit that reduces the actual tax payable. The unified credit was $220,550 in 2001, which exempted $675,000 from the estate tax. Estates in excess of the exempt amount were taxed at rates from 37 percent to 55 percent (applicable to estates in excess of $3 million), and a 5 percent surtax was applied to estates from $10 million to $21 million. Today, the estate tax exemption is $5 million, increased for inflation, or $5.25 million in 2013. Estates above that level are taxed at 40 percent. Like the estate tax, the generation-skipping transfer tax rate is 40 percent with an exemption of $5.25 million in 2013.
Gift Tax Prior to TRA-76, estates and gifts were subject to separate taxes, each with its own exemption and progressive tax rates. TRA-76 combined these into a single unified estate gift tax with the previously indicated unified credit. Gifts during one's lifetime that exceed $10,000 per donee per year (adjusted for inflation) are combined with the taxable estate and subject to a single credit and tax rate schedule.
Certain gifts are not subject to the gift tax however. These include gifts that are less than the annual exclusion ($14,000 in 2014), tuition or medical expenses paid directly to a medical or educational institution, and gifts to a spouse, political organization, or charity.
Basis of Inherited Property Heirs who receive property from a decedent are generally not required to carry over the decedent's income tax basis for that property for income tax purposes. Rather, their basis for the property is equal to the fair market value at the date of the decedent's death (or six months after death in some cases). Thus, any appreciation that occurs from the time the decedent acquired the property until his or her death is permanently shielded from the capital gains tax.
Portability ATRA-2013 provides for portability of the estate and gift tax exemption between spouses. Portability was first introduced in the Job Creation Act of 2010, and it was made permanent in 2013. Portability allows a surviving spouse to use the decedent's unused exclusion. So, for example, if a husband dies in 2013 and uses only $3 million of his available exclusion, the wife is allowed a total exclusion of $7.5 million (her original $5.25 million exclusion plus the remaining $2.25 exclusion from the husband's estate). To claim the additional exclusion, an estate tax return must be filed at the death of the first spouse.
The Taxable Estate The taxable estate is determined by deducting certain allowable exemptions from the gross estate. The gross estate includes the fair market value of all real and personal property owned by the individual at the time of death, including the individual's interest in any property that is owned jointly with another. In addition to other assets, the gross estate includes the proceeds of life insurance policies on the individual's life, no matter how payable, if the deceased possessed any incidents of ownership in the policies. Incidents of ownership means such ownership rights as the right to change beneficiaries, to borrow against the cash value of the policies, or to collect the cash values. Inclusion of life insurance proceeds in an estate can be avoided if proceeds are payable to a named beneficiary such as a spouse, child, or friend and if the insured avoids incidents of ownership in the policy at death (and at any time within three years before death). If the insured has no incidents of ownership, the proceeds will be excluded from the taxable estate even though the insured may have paid the premiums on the policy. The premium could be considered a gift to the beneficiary and subject to the $10,000 annual exclusion from the gift tax. Some individuals avoid incidents of ownership by having their spouses own policies on their lives and by giving up the right to change beneficiaries or to exercise any of the policy options.17
Deductions The gross estate is subject to certain deductions in determining the taxable portion. These include, for example, death taxes paid to the states, charitable contributions, and foreign death taxes. Prior to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA-2001), a state death tax credit was available; however, this was gradually phased out between 2001 and 2004. In 2005, the state death tax credit was completely repealed and replaced by a deduction for death taxes paid to any state or to the District of Columbia.
The most important deduction from the gross estate is the marital deduction. Since 1982, an unlimited marital deduction has been allowed for estate and gift tax purposes. This means that an individual may give his or her spouse gifts in any amount without gift tax liability, and property passing from one spouse to the other is not subject to the federal estate tax. However, the estate tax marital deduction applies only to the part of the estate that passes from the deceased to a surviving spouse.
Trusts
A common tool for implementing estate planning strategies and for the administration of an estate is a trust. A trust is an arrangement under which the holder (called the trustee) undertakes the management of another's property (called the corpus of the trust), for the benefit of designated persons. The person establishing the trust is called the grantor, trustor, or the creator of the trust. Those who receive income from the trust are known as beneficiaries, and persons to whom the corpus of a trust will pass at the death of the beneficiary or beneficiaries are called remaindermen.
The most widely used trusts are the testamentary trust, which is a part of the will and, as its name implies, takes effect after death, and the living or inter vivos trust, which is established during the lifetime of the creator and which may be revocable or irrevocable in nature.
Testamentary Trust A testamentary trust will not reduce estate taxes upon the death of the testator and will not lighten estate settlement costs. The potential trust property remains in the estate of the testator until distribution after the will has been probated. It is handled and taxed like all other property. However, it can reduce taxes and administration costs when the trust beneficiary dies. An individual who wishes to leave property to heirs other than a spouse to maximize the impact of the tax credit, but who wants at the same time to provide for a surviving spouse, may establish a testamentary trust with the spouse as the beneficiary of the trust and the other heirs as remaindermen. For estate tax purposes, the property in trust is not subject to the marital deduction but instead uses all or part of the unified credit. Although the surviving spouse enjoys the income from the trust, the property will be excluded from his or her estate at the time of death. This permits full use of the tax credit by the trust grantor while simultaneously providing an adequate level of income to the surviving spouse.
Living Trusts Living trusts, or inter vivos trusts, may be revocable or irrevocable. A revocable inter vivos trust is one in which the creator reserves the right to terminate the trust and acquire the property. The creator can reduce estate administration costs if the trust remains in force after his or her death for the property to pass outside the will. The beneficiaries will not have to wait until the will is probated to receive their allotted income and principal. The revocable trust does not, however, reduce the estate tax liability.
An irrevocable inter vivos trust is one in which the creator relinquishes the right to terminate the trust and acquire the property. An absolute and irrevocable trust takes the property out of the grantor's estate, thereby eliminating certain administrative costs. In addition, estate taxes may be reduced to the extent that the trust is established through gifts subject to exclusion from the federal gift tax (e.g., the annual $10,000 exemption per donee or the spouse gift exemption). Since such gifts are excluded from the gift tax, they are not subject to unification in computing the estate tax.
Irrevocable Life Insurance Trust One type of living trust that deserves special note is the irrevocable life insurance trust (ILIT), which is used to avoid the incidents of ownership in a life insurance contract that makes the insurance proceeds taxable under the federal estate tax. (If the policy beneficiary is a surviving spouse, the proceeds can escape estate taxation because of the unlimited marital deduction but will be subject to tax in the estate of the surviving spouse.) An ILIT avoids incidence of ownership that would otherwise make the life insurance benefits taxable.
Under an ILIT, life insurance is purchased and managed by a trustee subject to the instructions provided in a life insurance trust agreement. The trustee purchases a life insurance policy on the person to be insured, normally with the trust named as the beneficiary. At the insured's death, the life insurance proceeds are paid to the trust and distributed from the trust to the trust beneficiaries. The premiums are paid from funds transferred to the trust as gifts. Although the Internal Revenue Code (IRC) exempts $12,000 in gifts per donee annually, the exemption applies to gifts of a present interest, while gifts to an irrevocable trust represent future interest gifts and usually do not qualify for the exemption. However, the annual gift tax exemption will apply if beneficiaries are given the right to withdraw amounts that are placed in the trust on a yearly, noncumulative basis.18 Instead of making the gift directly to the beneficiaries, the grantor contributes funds to the trust for their benefit. The trustee then notifies each trust beneficiary a gift has been received on his or her behalf, and unless the beneficiary elects to receive the gift now, the trustee will use the contribution to pay the premium on the life insurance policy. Obviously, a key feature of the ILIT is the willingness of the beneficiaries not to withdraw the gift, which they must have the right to do if it is to qualify as a gift.
In addition to addressing the issue of incidence of ownership, an ILIT allows one to leverage the funds passed to family members as gifts through the purchase of insurance, the proceeds of which are an effective way to pay any estate taxes that remain after the maximum gifting has occurred.
LONGEVITY RISK
Longevity risk, the risk of living too long, is probably less threatening than the threat of premature death. Still, it is a risk that deserves attention. The retirement risk is influenced by the increased hazard of physical disability as one grows older and also by societal conventions. Many people consider age 65 the “normal” retirement age, but this is a recent notion in human history. In earlier periods, people worked until they died or until they became physically incapable of working.
Today, retirement is a significant event in a person's life. Indeed, it may be said that people spend their entire lives preparing for retirement. As in the case of the biblical famine of ancient Egypt, resources are accumulated during the income-fat years to be consumed during the income-lean years. The amount that must be accumulated during the income-fat years depends on a variety of circumstances and is influenced by the standard of living the individual wishes to maintain after retirement and the rate of inflation. A part of the risk associated with retirement is that the individual will not have accumulated sufficient assets by the time retirement arrives to afford an adequate standard of living. The second part is that the assets that have been accumulated will not last for the remainder of the individual's lifetime.
The Risk of Outliving the Retirement Accumulation
Before turning to the subject of accumulating funds for retirement, let us address the second part of the retirement risk, which is the easier of the two risks to manage: the risk that once funds have been accumulated, the individual may outlive those funds.
Except in unusual cases, the funds accumulated for retirement will be limited. Some strategy is needed to guarantee that the individual will not outlive the assets that have been accumulated. The conventional tool for this problem is a life annuity, under which a capital sum is converted into a stream of income over the individual's remaining life. An annuity may be defined as a periodic payment that continues for an individual's entire lifetime. The person whose life governs the duration of the payments is called the annuitant.
Annuities have been called “upside-down life insurance,” and in a sense they are a reverse application of the law of large numbers as it is used in life insurance. The function of a life annuity is to liquidate a principal sum, regardless of how it was accumulated, over the lifetime of the annuitant. It may involve the liquidation of a sum derived from a person's savings (including the annuity itself) or the liquidation of life insurance cash values or death benefits in the form of a life income to the owner or beneficiary of the policy.
Under the annuity principle, the law of averages operates to permit a guaranteed lifetime income to each annuitant. Some people who reach age 65 will die before they reach age 66. Others will live to be 100. Those who live longer than average will offset those who live for a shorter period than average, and those who die early will forfeit money to those who die later. Every payment the annuitant receives is part interest and part principal. In addition, each payment is part survivorship benefit in that it is composed in part of the funds of group members who have died.19
Estimating the Accumulation Need
As with the premature death exposure, the individual may have a number of resources available to meet the longevity exposure. Employer provided retirement plans and Social Security benefits are two important sources for most individuals. These benefits are usually payable over the lifetime of the individual, commencing at retirement. The individual must usually supplement these plans with personal savings or life insurance policies that include a savings element.
The need for retirement income can be measured in a way similar to that used in measuring death needs. The individual's income needs during retirement are projected at some assumed rate of inflation, together with Social Security benefits, which are deducted from the needs. If pension benefits will be available, they are also deducted in determining the postretirement need that must be met from savings. The remaining retirement income need may be met by purchasing a life annuity beginning at retirement age. In this case, sufficient funds must be accumulated by retirement age to cover the purchase price of the annuity.
In measuring the life insurance need, we discount future income needs to determine the present value of future needs. Because the retirement need is a deferred need, the time value of money serves a different function in planning for retirement. In this case, we determine the amount that will be needed in the future and calculate the contributions required to reach the target accumulation, given some assumed rate of return. We can compute the future value of $1 contributed each year to an accumulating fund and invested at a specified rate and, thereby, determine the annual or monthly contribution that will be required to meet a specific accumulation goal in a specified number of years at some assumed rate of return. We will defer our discussion of this process until Chapter 19 when we discuss the various options available to meet income needs during the retirement period.
THE RISKS ASSOCIATED WITH DISABILITY
In discussing the need for life insurance, there may be instances in which no one would suffer financial deprivation in the event of a person's death and there is no need for life insurance. The disability income need is fundamentally different. In the case of the disability exposure, the absence of dependents does not eliminate the need for income since the disabled person will need income during a period of disability. The income need may be greater in the case of an individual without a spouse. When a disabled person has a spouse, the domestic partner may be able to provide some income for the couple. In addition, the nondisabled spouse will serve as a care provider. The single individual does not have the cushion of a spouse's income and will have to hire a care provider. This means the percentage of a single person's income that must be replaced in the event of disability may be higher than of a person with a spouse.20
For the individual with dependents, if the wage earner becomes disabled, the family's income needs will be as great as they would be if he or she died. In fact, they will probably be greater. As in the case of life insurance, the needs vary with the number of children in the family and with other responsibilities the insured may have. As in the case of death, benefits available under employer provided plans and social insurance plans should be considered in determining the need for other protection.
Some authorities argue that loss-of-income protection should come even before life insurance. When a wage earner is disabled, his or her earnings stop as surely as if death had occurred. This “living death” of disability can be economically more severe than actual death. If the breadwinner of the family dies, the family's income stops; if he or she is disabled, the income stops and expenses remain the same and usually increase. A disabled person, by definition one whose ability to work is impaired, must depend on sources other than employment for income. When persons other than the disabled individual were supported by the lost income, the problem became worse.
TABLE 10.5 Probability of Death and Disability at Various Ages
In addition to disability being more burdensome financially to the individual and dependents than is usually supposed, the chance of loss at most ages is greater than the chance of death. Table 10.5 indicates the probability of death and disability at various ages.
As indicated by the data in the table, the probability of disability of at least 90 days is higher at every age during the individual's working years than is the probability of death. Nearly half the people who reach age 35 will be disabled for at least three months before reaching age 65, and the average length of the disability will be more than five years.
Needs Analysis for the Disability Risk
A needs analysis for the disability risk is much like the needs analysis for premature death. First, income needs for each year are projected by examining the amount required to maintain the family in the event of disability. Usually, the income needs of the family will not diminish much if the wage earner is disabled. There may be a modest reduction in some expenses associated with employment, such as the cost of commuting, business lunches, and perhaps a part of the clothing budget, but the reduction will probably be small. Although there may be an increase in medical expenses, adequate medical expense insurance should be available to meet the increased medical care costs.
In determining disability income needs, the need to continue to plan for the retirement years must be considered. In our discussion of disability income contracts, we will see that most insurers will provide coverage for disability arising out of accident for the individual's entire lifetime but limit coverage for disability arising out of sickness until age 65. How, one may ask, do we provide for income beyond age 65 for the individual who is disabled as a result of sickness? The answer is that the income need after age 65 is treated as a part of the individual's retirement needs. The need for income after age 65 will exist whether or not the person is disabled, and prudent individuals accumulate funds to supplement Social Security benefits. Because insurers do not offer lifetime disability coverage for illness, a disability protection program should provide benefits in an amount that will permit the disabled person to continue making contributions to his or her retirement program. In this way, the accumulation of funds intended for retirement will be there at age 65 whether or not the individual is disabled.
Resources Available to Meet the Disability Risk
After determining the needs, the next step is to identify any benefits available from existing sources. Several sources may provide protection against lost income during disability. For disability that arises out of and in the course of employment, most injured workers are entitled to benefits under their state workers compensation law. The amount of these benefits depends on the worker's earnings at the time of the injury and is specified by law. In addition, workers in California, Hawaii, New Jersey, New York, Rhode Island, and Puerto Rico are covered for nonoccupational disabilities by compulsory programs under which the benefits are prescribed by law. Finally, workers who are totally and permanently disabled and who meet special eligibility requirements qualify for disability benefits under the Social Security program. The eligibility requirements under this program are strict, and benefits are payable only if the individual is unable to engage in any “substantially gainful employment.” This is more strict than the typical group or individual disability income plan, and individuals can commonly be eligible for private disability benefits but not for Social Security disability benefits. In 2013, average earnings of $1,040 or more were considered substantial and would result in the discontinuation of the benefits under Social Security.21
Besides these government-sponsored or supervised programs, the most common source of recovery is through group or individual disability income policies. In some instances, employers self-insure a program of disability benefits for their employees, providing cash benefits or paid sick leave. In others, the paid sick leave plans are integrated with disability income insurance purchased from commercial insurers.
Addressing Unmet Disability Income Needs
Unmet needs are determined by subtracting available resources from the needs that have been identified. Disability insurance may then be purchased to cover the unmet needs. The most important disability income need is long-term disability coverage for occupational and nonoccupational disabilities to supplement Social Security. In addition, most people will need short-term disability coverage for disabilities not covered under Social Security (including the Social Security waiting period). A properly coordinated disability income program provides coverage for occupational and nonoccupational injuries in an amount that meets the family's need for income during the entire period of disability. The coverage for occupational disability should supplement workers compensation benefits so the combined workers compensation and disability income insurance provide the same level of coverage as for nonoccupational disabilities. Disability insurance is discussed in more detail in Chapter 20.
EVALUATING THE MEDICAL EXPENSE EXPOSURE
No personal risk management program is complete without some protection against medical expenses. The major consideration in the area of medical expense coverage should be protection against the catastrophic loss. A variety of plans are available, ranging from plans covering a specific class of medical expenses with a small deductible to plans covering a broad array of expenses with a larger annual deductible. Because of the variety of plans available and that most individuals are covered for these expenses under employer-provided plans, we defer discussion to Chapter 21.
MANAGING THE RISK OF UNEMPLOYMENT
We have addressed three of the perils that threaten income: premature death, longevity, and disability. It seems appropriate that we recognize the existence of the fourth peril and comment on the risk management alternatives available with respect to unemployment.
Although the techniques used in managing the unemployment risk are essentially the same as those used in managing the risk of other perils that threaten income, the range of alternatives is more limited. With respect to risk transfer, for example, there are limited options. State unemployment insurance programs exist in all states and most individuals will have some protection from this source. These programs are designed to provide protection against involuntary unemployment when the individual is available for work but is temporarily unemployed. The protection from this source is limited in duration and in amount.
In addition to the protection available under the state unemployment insurance programs, unemployment insurance is available on a limited basis in connection with installment credit. Usually, the coverage is overpriced.
State Unemployment Insurance Programs
The U.S. system of unemployment compensation was created by the Social Security Act of 1935, which gave states a financial incentive to create state unemployment insurance programs.22 Each state has enacted separate legislation and operates a separate program, and the programs differ in many respects. Nonetheless, some similarity exists given the requirements of federal law.23
Eligibility for Benefits The eligibility requirements vary from state to state, but all call for previous employment in a covered occupation and continued attachment to the labor force as a prerequisite for benefits. In most states, the worker must have earned a certain minimum income during the preceding year, referred to as the base period. Some states require that the worker must have been paid a stated dollar minimum during the base period, and a few demand a specified number of weeks of employment with a minimum amount of earnings each week. Most states require the employee to have earned some multiple of the weekly benefit amount that he or she will receive (e.g., 30 times).
Continued attachment to the labor force is required. The basic philosophy of the unemployment compensation program is only those workers who are legitimate members of the labor force are eligible for benefits. Therefore, unemployment must be involuntary before the worker can collect benefits, which means the worker must be willing and able to work. This is the principal reason that benefits are payable through the state employment offices. The worker desiring to draw benefits must present himself or herself at the employment office to collect the money and must be willing to accept suitable work if it is offered.24 The question of what constitutes suitable employment can be thorny, but normally the administrative staff of the state employment office decides whether the work is appropriate. The worker who feels he or she has been unfairly treated is entitled to a hearing. Following the philosophy that only those who are involuntarily unemployed are entitled to benefits, most state laws deny or limit benefits to workers who quit without sufficient reason or who are discharged for misconduct.25
Benefits under State Unemployment Laws The worker who meets the requirements of previous employment and involuntary unemployment is entitled to certain benefits as a matter of right, without the necessity of meeting a needs test. There is no uniformity among the states in the amount of benefits to which the qualified worker is entitled, and the benefits payable in some states are higher than those in others.
In all states, the amount of the benefits to which the worker is entitled is related to previous earnings. In most states, the method of determining benefits is to take some percentage or fraction of the worker's wages during the quarter of highest earnings in his or her base year. One of the most commonly used fractions is 1/26. If the worker was fully employed during the quarter, the 1/26 benefit provides a weekly benefit equal to approximately 50 percent of his or her normal full-time earnings. The amount of the benefit is subject to a state weekly maximum and minimum. Most states now provide for an automatic adjustment of the benefit maximum to coincide with changes in the state's average weekly wage of those in covered employment. A few provide for a sliding maximum based on the number of dependents the unemployed worker has. The maxima under effect in the various state laws in January 2013 varied from $235 a week (in Mississippi) to $1011 a week (in Massachusetts). Most states provide for a one-week waiting period before benefits begin, but 9 states do not require a waiting week.
In addition to imposing limits on the amount, all states stipulate a maximum period for which benefits are payable. In most states, this is 26 weeks. However, Massachusetts has a 30-week maximum. In periods of high and rising unemployment in a state, benefits are payable for up to an additional 13 weeks under the federal Extended Unemployment Compensation Program.26 Furthermore, the federal government has occasionally created federally funded programs of supplemental benefits during periods of national recession. For example, during 2013, the federal government provided up to an additional 47 weeks of benefits, depending on the state, through an Emergency Unemployment Compensation Program.
Retention and Risk Reduction
The limited range of transfer alternatives means that for most people, the alternatives for managing the risk of unemployment are retention and reduction. Unfortunately, the risk of unemployment is one of those involuntarily retained risks. As in the case of other retained risks, recognizing the risk is a first step in dealing with it. The individual should do two things to address the risk of involuntary unemployment. The first is to recognize it as a retained risk and provide a cushion to cover the loss if it should occur.
Most authorities recommend an emergency or contingency fund equal to the amount of three to six months' expenses. The purpose of this fund is to cover expenditures during a period of reduced income or unemployment. With an emergency fund of this type, the involuntary retention of the unemployment exposure is at least partially funded. The emergency fund, combined with the benefits available from unemployment insurance, will provide a cushion for unemployment losses if they occur.
In addition to maintaining adequate funding for the retention of this risk, it also makes sense to reduce the likelihood that the loss will occur. In the real world, a comprehensive education and specialized work skills remain the most effective loss-prevention measures against the peril of involuntary unemployment. For students, this means selecting a career that is relatively immune to fluctuations in employment.
IMPORTANT CONCEPTS TO REMEMBER
longevity risk
human life value
time value of money
present value discounting
needs approach
capital needs analysis
insurance programming
fund for last expenses
cleanup fund
emergency fund
dependency period
capital liquidation strategy
capital conservation strategy
readjustment expense fund
premarital period
pre-child years of marriage
child-raising years
years approaching retirement
blackout period
estate planning
intestate
federal estate and gift tax rates
incidents of ownership
gross estate
taxable estate
trust
living trust
life insurance trust agreement
life annuity
retirement risk
disability risk
unemployment risk
QUESTIONS FOR REVIEW
1. Briefly explain how the human life value approach differs from the needs approach in determining the amount of life insurance an individual should purchase. What is the relationship between the two approaches?
2. What, if any, are the defects in using the human life value concept in determining the amount of life insurance an individual should purchase?
3. The need for life insurance varies with the individual's lifestyle. How does this need differ for single individuals, childless couples, and persons with children?
4. Identify the “needs” traditionally considered in determining the amount of life insurance required for a family.
5. Identify the sources other than life insurance that might provide resources to meet needs in the case of premature death.
6. One tool for dealing with the risk of outliving one's income is a life annuity. Briefly explain how a life annuity is able to do this.
7. Identify the resources that might be available to address the retirement risk.
8. Explain why the disability needs for a particular individual are likely to be even greater than the needs in the case of premature death.
9. How should one deal with the dilemma created because disability resulting from sickness may extend beyond age 65, but insurers are generally unwilling to provide coverage for such disabilities beyond age 65?
10. Identify the resources that may be available for an individual who experiences a disability.
QUESTIONS FOR DISCUSSION
1. The changing lifestyles of many Americans have modified some of the traditional principles of insurance buying. With an increase in the number of two income families, do you think that the overall need for life insurance has (a) increased or (b) decreased? Why?
2. It is often stated that one of the most neglected areas in the life insurance field is that of insurance on the homemaker spouse. In facing the risk management decision regarding life insurance for the family, where do you think that life insurance on a spouse who is not employed outside the home should fit?
3. What reasons can you suggest for providing a lifetime income to a spouse after any children have been raised? Under what circumstances would you recommend against providing such a lifetime income?
4. “On first consideration, it might seem that the risk of income loss resulting from premature death is universal. After all, no one lives forever. But death does not automatically result in financial loss.” Explain why you agree or disagree with this statement.
5. “The effect of the income loss occasioned by premature death depends on the circumstances.” Describe a combination of circumstances in which the effect of income loss occasioned by premature death is insignificant.
SUGGESTIONS FOR ADDITIONAL READING
Aponte, J. B., and Herbert S. Denenberg. “A New Concept of the Economics of Life Value and the Human Life.” Journal of Risk and Insurance, vol. 35, no. 3 (Sept. 1968).
Bajtelsmit, Vickie L. Personal Finance: Planning and Implementing Your Financial Goals. Hoboken, N.J.: John Wiley and Sons, 2005.
Black, Kenneth Black, Jr., Harold D. Skipper, and Kenneth Black III, Life and Health Insurance, 14th ed., Lucretian, LLC, 2013.
Glover, Ryan. Preparing for Retirement: A Comprehensive Guide to Financial Planning. Tarheel Advisors LLC, 2013.
Hallman, G. Victor and Jerry Rosenbloom. Private Wealth Management: The Complete Reference for the Personal Financial Planner, 8th ed. McGraw-Hill, 2009.
Hofflander, A. E. “The Human Life Value: A Historical Perspective.” Journal of Risk and Insurance, vol. 33, no. 3 (Sept. 1966).
Langon, Thomas P., and William J. Ruckstahl. Financial Planning Applications. Bryn Mawr, Pa.: The American College, 2006.
WEB SITES TO EXPLORE
| American Council of Life Insurance | www.acli.com |
| Certified Financial Planner Board of Standards, Inc. | www.cfp.net |
| Institute of Certified Financial Planners | www.icfp.org |
| Internal Revenue Service | www.irs.ustreas.gov |
| Life Insurance Marketing and Research Association, Inc. | www.limra.com |
| Life Office Management Association (LOMA) | www.loma.org |
| Society of Financial Services Professionals | www.financialpro.org |
| The American College | www.theamericancollege.edu |
1Like the risk of income loss to dependents, premature death can cause estate shrinkage. In the case of the estate, death is premature if it occurs before the individual has taken the appropriate steps to minimize the shrinkage of the estate. Although the process of estate planning is beyond the scope of this text, we will address those facets of the estate shrinkage exposure that have implications for life insurance purchases.
2Debts owed by the individual at the time of death represent a unique exposure. If an individual dies with debts that exceed assets, the loss falls on the creditors. Some people may feel a moral obligation to provide funds for payment of debts that exist at the time of their death, but there is no legal obligation.
3We cannot place a value on human life. What we attempt to measure is the income-producing capacity of the individual, which is different.
4Huebner, S. S. The Economics of Life Insurance, 3rd ed. (New York: Appleton-Century-Crofts, 1959), p. 5.
5The expression “A bird in the hand is worth two in the bush” expresses the time value of birds, and suggests a discount rate of 0.5 as the present value of a future bird. Here we are doing the same thing with money.
6The calculation can be performed on many calculators that include financial functions.
7The difficulties involved in the calculation do not, however, invalidate the concept. Even though considerable guesswork is required, this is still the most acceptable method of calculating the economic value of a human life. Although it is probably a defective technique for determining the amount of life insurance that should be purchased, it is widely used in determining the amount of damages payable in wrongful death and injury cases.
8Specific insurance applications relating to divorced persons will be discussed shortly.
9In addition to the loss of homemaking and child care services provided by the homemaking spouse, death causes other losses. One seldom recognized loss is the increase in income taxes to the surviving spouse resulting from the inability to use the joint return in filing federal income taxes.
10A qualified domestic relations order is a judgment or order that relates to the provision of child support, alimony, or property rights to a spouse, a former spouse, or a child and which is made under a state's community property or other domestic relations law.
11The exact amount of Social Security benefits that would be lost depends on the circumstances. Loss of Social Security benefits is discussed in the next chapter.
12Our calculations have various assumptions, any one or all of which may not be fulfilled. It should be recognized that despite the illusion of precision implied by the multidecimal calculations of our computers, the projections are a guess.
13For a discussion of the capital needs analysis concept, see Thomas Wolff, J., Capital Needs Analysis—Basic Sales Manual (Vernon, Conn.: Vernon Publishing Services, 1977)..
14The estate tax is a tax on the right to transmit property at death; the inheritance taxes are levied by the states on the right of an heir to receive a bequest.
15The current federal estate tax was enacted in 1916 to help finance World War I. The pressure for repeal stems, in part, from historical precedent. A death tax has been imposed as a temporary expedient on three previous occasions, and repealed when the target funding had been raised. A death “stamp” tax was enacted in 1797 to pay for a naval buildup and abolished just five years later in 1802. The federal death tax was again enacted in 1862 to raise revenue for the Civil War. After the war ended, Congress repealed the tax in 1870. The third federal death tax was enacted in 1898 to finance the Spanish-American War. As before, the estate tax was abolished after the war in 1902. With the advent of World War I, the estate tax was reintroduced in 1916 and has existed in various forms since.
16In 2001, Congress passed and President Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA-2001). Among numerous other changes, EGTRRA-2001 contained provisions under which, beginning in 2002, the federal estate tax would be gradually reduced until January 1, 2010, when it would terminate. Then, on January 1, 2011, unless a future Congress passed another law, the estate tax would automatically revert to the system that existed in 2001 at the time EGTRRA-2001 was enacted. In December 2010, Congress passed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. This reimposed the estate tax but provided for a $5 million exemption that was scheduled to sunset on December 31, 2012.
17When incidents of ownership exist, they may be transferred to another party, such as a spouse or child. If the transfer occurs within three years of the individual's death, the insurance proceeds may be brought back into the estate as a gift that was made in contemplation of death.
18The right to withdraw gifts to a trust is called “Crummey powers,” after the individual involved in the case in which the principle was established. Crummey v. Commissioner, 397 F.2.d 82 (9th Cir. 1968).
19Annuities are discussed in Chapter 18.
20In this sense, marriage represents a risk-sharing technique and the treatment of risk by combining a small number of exposure units.
21Disabled workers who are blind are allowed to earn up to $1,740 per month. Eligibility requirements for Social Security disability income benefits and workers compensation are discussed in Chapter 11.
22Federal law imposes a tax on employers of 6 percent on wages up to $7000 per year paid to an employee but permits a tax credit of 5.4 percent if the employer participates in a state-approved unemployment compensation program and pays taxes on a timely basis.
23The student will no doubt want to look at the unemployment compensation act of his or her own state. The U.S. Department of Labor Web site contains current information on state unemployment compensation laws.
24For example, students unavailable for work while attending school and women who quit their jobs because of pregnancy or to get married are ineligible for benefits. However, since 1978, states are prohibited from automatically disqualifying women from unemployment benefits solely on the basis of pregnancy.
25In such circumstances, benefits may be completely or partially forfeited. For example, under the Iowa law a worker discharged for misconduct forfeits from four to nine weeks of benefits. A worker who voluntarily quits a job forfeits all benefits for which he or she had accumulated credit in that particular job, but the benefits given up are those accumulated only during the job that was quit.
26Extended benefits are triggered when the unemployment rate in a state averages 5 percent or more over a 13-week period and is at least 20 percent more than the rate for the same period in the two preceding years. The federal government funds approximately 50 percent of the cost of extended benefits.