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FIN 200: Personal Finance Topic 14-Life Insurance Lawrence Schrenk, Instructor 1 (of 28) Learning Objectives 1. 2. Explain the features of life insurance policies. ▪ Explain and calculate the effect of inflation on financial decision-making.▪ 2 (of 28) Life Insurance 3 (of 28) Do you need life insurance? Death Expenses Ongoing Financial Obligations Funeral Expenses Others Dependent on your Income Others Dependent on your Service Investment/Savings Vehicle Bequest 4 (of 28) How much do you need? Goal: Maintain Current Standard of Living Income Method Budget Method Rule of Thumb: 7-8 Times Annual Income Life Insurance Needs Estimator Be Conservative; More is Better Adjust for Inflation 5 (of 28) Terminology Primary Beneficiary Contingent Beneficiary Face Amount/Death Benefit Cash/Surrender Value 6 (of 28) Types of Life Insurance Term (Fixed Period) Life Insurance Permanent Life Insurance Annual Renewable Fixed-Rate (Lock-In Premium) Decreasing Term Whole Life Universal Life Variable Life Free (Employer Provided) Life Insurance 7 (of 28) Term Life Insurance Cost Factors Coverage Time Coverage Amount Age Gender Medical History 8 (of 28) Permanent Life Insurance Insurance + Savings Vehicle Whole Life Universal Life Zero Risk Policy Low (but Guaranteed) Return More Flexible Variable returns Possible Increase in Premium Variable Life Various Investment Possibilities 9 (of 28) Comparison Whole Universal Variable Mortality Costs Fixed Variable Fixed or Variable Expenses Fixed Variable Fixed or Variable Cash Value Fixed Variable Variable Investment Risk None Yes Yes Vary Premium No Yes Usually Change Death Benefit No Yes Usually 10 (of 28) Sources Agent Can be necessary for permanent life insurance Find a good agent E.g, Certified Life Underwriter (CLU) Multiple Policy Agent Financial Planner Internet Insure.com 11 (of 28) Life Insurance as Investment Rate of Return Flexibility of Disbursement ‘Forced Savings’ Life Insurance Dividends 12 (of 28) Other Issues Other Forms of Life Insurance Mortgage Insurance Credit Life Insurance Travel Accident Insurance Financial Stability of Issuer Ratings Agencies Rate Insurers Insure.com Ratings 13 (of 28) Ratings Example 14 (of 28) Project Note 15 (of 28) Ethical Dilemma Steve had a whole life insurance policy that provides $10,000 in life insurance protection and accumulates a cash value of twice his current annual income by age 65. Two years later, after Steve's marriage, he bought a second policy. His agent told him each policy would have a cash value double his annual income. At 65 he was appalled to see that the cash value on the older policy was $17,000 and on the newer policy was only $15,000. a. Was the agent being unethical in now showing Steve the potential impact of inflation on the policies' cash value? b. How much does an insurance agent need to reveal to potential clients? c. What ‘informational’ responsibilities does the buyer have? 16 (of 28) Inflation 17 (of 28) Example Your dream car costs $50,000 and you plan to buy it in 10 years. You save $273.30/month at 8%, so that you have $50,000.00 at the end of ten year. What happens to your dream? ▪ You don’t get it. If inflation were 5%, in 10 years the car would cost $82,350.47. You are $32,000.00 short! ▪ 18 (of 28) Another Example You want to be a millionaire by age 50. You save $546.23/month at 9%, so that you have $1,000,000 at the end of 30 years. ▪ You are technically a millionaire since you do have $1,000,000 in your investment account. But, in today’s dollars, that million is only worth $301,795.87 if the inflation rate is 4%. ‘In Today’s Dollars’–$1,000,000 in 30 years will allow you to buy the same goods that $301,795.87 buys today.▪ 19 (of 28) Real versus Nominal Inflation–Rise in the General Level of Prices Nominal Values ‘Money of the Day’ Not Adjusted for Inflation The Dollar Value You Actually Pay Real Values Adjusted for Inflation ‘Current’ Dollars/Today’s Dollars Constant Consumption Value 20 (of 28) Historical Inflation 21 (of 28) Simple Example A can of soda costs $1.00 today and $1.05 next year. What is the inflation rate? $1.50 $1.05 5% $1.00 At this rate of inflation, what will a can of soda cost in 5 years? $1.00 1.05 $1.28 5 22 (of 28) Simple Example with Calculator At 5% inflation, what will a $1.00 can of soda cost in 5 years? 1. 2. 3. 4. Input 5, Press N (This is annual so N = 5) Input 5, Press I/Y Input 1, press +/-, press PV Press CPT, FV to get $1.28 Do you recognize this pattern? ▪ The following two questions are identical: At 5% inflation, what will a $1.00 can of soda cost in 5 years? $1.28 At a 5% interest rate, what will be the future value of $1.00 5 years? $1.28 ▪ 23 (of 28) Another Example (Revisited) You save $546.23 per month at 9%, so that you have $1,000,000 at the end of 30 years. Inflation is 4% ▪ How much is that amount worth in today’s dollars? 1. 2. 3. 4. 5. Change P/Y to 12 Input 360, Press N (30 x 12 = 360 monthly payments) Input 4, Press I/Y (use inflation not the interest rate) Input 1,000,000, press +/-, press FV Press CPT, PV to get $301,795.87 24 (of 28) Real versus Nominal Rates Nominal Interest Rate Real Rate of Interest This is what we have been using It does not adjust for inflation. The nominal rate adjusted for inflation. Relationship (Approximation) Real Rate = Nominal Rate – Inflation 25 (of 28) Another Example (Revisited, Again) How much do you need to save monthly at 9% to have $1,000,000 (in today’s dollars) in 30 years, if inflation is 4%? Use the real rate for your calculation 1. 2. 3. 4. 5. Real Rate of Interest = 9% - 4% = 5%. Change P/Y to 12 Input 360, Press N (30 x 12 = 360 monthly payments) Input 5, Press I/Y (use the real interest rate) Input 1,000,000, press +/-, press FV Press CPT, PMT to get $1,201.55 (NOT $546.23) 26 (of 28) Getting your Dream Car! How much do you need to save monthly at 8% to have $50,000 (in today’s dollars) in 10 years, if inflation is 5%? Use the real rate for your calculation 1. 2. 3. 4. 5. Real Rate of Interest = 8% - 5% = 3%. Change P/Y to 12 Input 120, Press N (10 x 12 = 120 monthly payments) Input 3, Press I/Y (use the real interest rate) Input 50,000, press +/-, press FV Press CPT, PMT to get $357.80 (NOT $273.30) 27 (of 28)