Module 5

The Need for lnsurance lntroduction "Life is like a box of chocolates...you just don't know what you're g:onna' get." Forrest Gump

Truer words have never been spoken. We can plan, and plan, and plan but we just do not know what is going to happen today, tomorrow or all the tomorrows thereafter. For those who favour procrastination (leave to Iomoffow what could be done today), this uncertainty is a good reason to do 1o11tittt.

However, most people have a need to plan. It gives them the confidence that comes from being prepared. Risks in life are just another factor

t'hich, when properly planned for, can be handled. The process of planning for risk is known as risk manegement. How one manages risk determines the need for insurance.

ln this module: The Fundamentals of Risk The Management of Risk Reducing Risk by Developing a Financial Plan Using lnsurance to Manage the Risk of Premature Death LESSON 5: Using Insurance to Manage the Risk of Disability LESSON 1: LESSON 2: LESSON 3: LESSON 4:

The Canadian Life Insurance Course

Some Key Terms to Know capital retention aqqroach:

to

the

personal income

needs

annual cash needs of the survivors.

approach.' identifies the needs of dependents and familY

Also known as the caPital

members that must be met in

caprtal required

Provide

the

needs

the event of the loss of

npproach.

a

major income stream.

capitalization of income: based on the calculation of the present value of the survivor's share of the income stream that the deceased

risk Jinancing:

includes

transferring risk and retaining risk.

person would have received had he

or she lived. Also known as the human life vqlue approach.

capitalized value: determines how much would have to be invested at a certain rate of return to equal the amount of money a Person would

risk management' the Process of planning for risk.

risk retention: when a

Person

accepts or retains all or Part a given risk.

risk transfer: shifting some or all of the cost of a Potential

earn in a year.

human lW value upproach: based on the calculation of the present value

survivor's share of the income stream that the deceased

of the

loss to a third party.

survivor life income needs: the period of time, which maY be

person would have received had he

life long, during which

or she lived. Also known as the

surviving spouse

c

apit al

iz

ation of

of

inc orne

.

the

requires

income.

For all the key terms for this, and all modules, please see the Glossary at the beginning of the book,

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The lr{eed for Insurance

LESSON 1: The Fundamentals of Risk Risk is defined as the probability of suffering harm or loss in the future. Losses can be emotional, physical or financial; this discussion focuses on managing

risk that leads to financial loss.

The goals of risk management are to minimize lhe cost of a parti.gular risk and

to do so in the most efficient manner. It is essential to understand the difference between severity and frequency of risk when dealing with risk management

.

Risk severity is the dollar cost

probability that a loss

will

of a loss.

Risk freqaency is the

occur.

High Severity/Iowfrequency risks are those risks that have a low likelihood of occurrence, but that would cause severe losses should they occur. Premature death is an example of a high severity/low frequency risk that is best managed through risk transfer,that is by shifting some or all of the cost of the potential loss to a third parfy. A life insurer is the third parly; it accepts the financial consequences of the risk in return for the premium paid.

Risk can be either specalative or pure. Both forms of risk may result in a loss

or in no change. Speculative risk, however, may also give rise to a

gain.

Hence, when someone speculates on the stock market by buying shares

of

company, those shares may decrease

in value (a loss), stay the

a

same (no

change), or increase (a gain).

Pure risk offers no chance ofgain.

It is categorized

as:

r'property risk

r'tability risk /fai1ntre of others

/personal risk

Property risk Property rislr is the risk faced by property owners of having their properly lost or damaged. A loss to property may be direct (that is, arising from theft, destruction, or physical damage), or indirect (that is, a financial loss created by

the loss of rental income that arises from the destruction, theft, or physical damage

to the properfy). Auto

and property insurance provide risk

management for most property risks.

5-3

The Canadian Life Insurance Course Remember,

liability risk

is

managed for

Liability risk

agents by E&0.

Liability risfts arise when a person intentionally or unintentionally inflicts personal injury on someone else, or causes damage to another's property. The person who has caused the injury is responsible for compensating the injured party.

Liability risks are of great concern to professionals (e.g., lawyers, financial planners and accountants), since the losses may be substantial. The professional cannot afford to lose future income or assets in order to pay damages awarded for negligence. Malpractice insurance and errors .and omissions insurance are forms of insurance that address liability risks.

Insurance agents are required to have errors and omissions insurance.

Failure of others When others do not fulfil obligations they have made to you, you face risk resulting from their inaction. This is known as failure of others. For example,

if your mechanic fails to fix a problem with your car, you risk the chance that the car may break down and you will incur out-of-pocket costs (the tow truck) and inconvenience (missing an important meeting).

Personal risk Personal risks are those that directly affect individuals and their dependents.

They include: the risk of premature death

-

dying earlier than one's anticipated life

expectancy and, thus, depriving dependents of a source of income

the risk of aging-where one outlives their money and

has

insufficient income during retirement the risk of disability or sicl*tess - experiencing a loss of income and the burden of medical expenses

Life and disability insurance provide unique solutions to these personal risks.

N.B. Unemployment is another form of personal risk that can be managed, in part,by the emergency fund equivalent to three months' family income all financial planners recommend to their clients.

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Module

5:

The lr{eed for Insurance

Risk of Premature Death: The risk of premature death, or death risk, is the risk of death occurring before the age of life expectancy (that is, before the tables of mortality indicate death should occur).

The costs of premature death can include:

-

loss of the income of the deceased

his or her funeral expenses estate settlement costs

medical expenses estate taxes

In addition, there are

dependents' income needs resulting from premature

death. Continuing expenses (e.g., mortgage and debt payments), and future expenses (e.g., education costs), can be expected.

Management of Premature Death Rls/r: The amount of insurance necessary to cover the risk of premature death depends upon the needs of each client.

It

is

determined.by completing a needs analysis as described later in this module.

Risk of Aging: The second form of personal risk, the risk of aging is the risk that one might outlive one's personal financial resources. This risk can be managed by retirement planning which considers all income and expenses that

n'ill be faced during

retirement. Age risk,

if

not addressed through proper planning, can diminish a retiree's standard of living significantly.

Risk of Disability: Disability is created by illness or accident; it is the last of the personal risks managed by life insurance. Disability intemrpts income and thus, can have a major financial impact on the disabled person and his or her dependents.

While the loss of income due to disability may be substantial, current and ongoing financial obligations continue. In addition, household expenses may increase due to personal care needs of the disabled. Health costs that are not covered by govemment health programs or private insurance plans, such as a prescription drug plan, can firther increase the risk the disabled person and his or her dependents face.

llanagement of Disability Risk: The frequency of occurrence is low for longterm disability and high for short-term disability. Therefore it is more probable a person will break a leg (short-term disability) than require an amputation rlong-term disability). Accordingly, the severity of loss ranges from low to 5-5

The Canadian Life Insurance Course

high. This means that disability risk might best be managed by using a combination of risk management techniques that include various forms of risk management, including some transference of the risk, some risk retentiofl, as well as loss prevention and loss reduction techniques.

The

Likelihood Of Disability

The likelihood of a person aged twenty-five, suffering a disability of a least six months' duration before the age of sixty-five, is one in three. One in seven will suffer from a disability that exceeds five years. The chances of long-term disability are much greater than premature death.

Disability Risk Management atWork Prudence Cavil has just been hired to work on the assembly line at Widgets R Us. Her job entails stamping out widgets, and dipping them in an acid bath. The human resources department informs her that she will be enrolled in their group disability income plan that pays disability benefits beginning 30 days after a disability occurs.

Disability benefits are paid in arrears. Thus, for the first 60 days of disability, Prudence runs the risks. At the end of the second 30-day period, her benefit is paid.

As a new member of the safety committee at Widgets R Us, Prudence uses a loss prevention strategy by convincing the company to install finger guards on the stamping machines and a loss reduction strategy by demanding installation of an acid splash rinse system at the acid dipping workstation. ln doing so, she has assisted the company in reducing the risk of injury by implementing a loss prevention plan.

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The lr{eed for Insurance

LESSON 2: The Management of Risk Risk management seeks to reduce the possibility of financial loss and personal harm. It is a six-step process:

/ / / /

identi&ing concerns in order to set risk management objectives identifying and evaluating risks developing risk management strategies

implementing plans y' monitoring and moditring plans

/

lnsurers manage risk

documenting plans

through the

ldentifying Concerns This part of the process identifies what must be protected against loss. For example, from a financial perspective, the income of a family's primary wageearner would be important to protect.

ldentifying and Evaluating Risks After determining what must be protected, it is essential to identify the ways in hich losses can be incurred and minimized. ',i

\

t'rnancial loss has various degrees of severity. It can be:

. o o

process

of undenvriting.

criticul: in which financial ruin is a possible result importsnt: inwhich financial adjustments are required that will reduce the standard of living muterial: in which financial adjustments are required

The frequency of risk, or the likelihood of occurrence, is classified as being 1s11,, rnediurn or high. It is coupled with the degrees of severity to indicate a ri-ide range of possible outcomes.

Risk Matrix Low frequency

Medium frequency

High frequency

critical degree of s everity

premature death

long-term disability

premature death resulting from dangerous hobby or

important degree of severity

fire

material degree of severity

robbery

short-teffn disability no longer than 6 months' duration short-term disability no longer than 4 weeks' duration

occupation

short-term disability no longer than 2 weeks' duration

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The Canadian Life Insurance Course

Ri s k M a n age me

nt Sfrafegies

Risk can be managed by:

risk control risk financing risk avoidance

N.B. Risk can be managed

in three ways.

Insurance is an important risk management technique since

it

transfers

the risk exposure to the insurer, and protects the current and/or future value of the accumulated assets of the insured.

Risk Control: Risk can be controlled by /oss prevention,which reduces the frequency of loss, and /oss reduction,which reduces the severity of loss.

Risk control may be used to manage some disability dsk. The frequency of loss can be reduced through the elimination of unsafe working conditions and

of safety rules at the place of employment, while the severity of loss may be reduced, for example, by the instillation of emergency response enforcement

equipment, and on-site medical treatment facilities.

Reducing loss can be achieved by:

-

safety measures

in which

safety techniques are employed to reduce the likelihood and severity of risk pooling risk with others who share similar risks, such as professionals who band together to obtain liability coverage at a lower cost than would be available to individual members of the group

-

segregating risk by separating risks, such as by ensuring that key executives from the same company travel separately

-

diversifying riskby not imperilling the group because of actions

of

one member

Risk Financing: Risk financing includes transferring risk and retaining risk.

N.B. Risk is transferred by shifting all or a portion of risk to another

party,

such as an insurer.

The risk of disability is effectively managed by risk transfer. Transferring all or a portion of the risk may be accomplished by enrolling in a group disabilify income insurance plan, and/or "topping up" the existing coverage in such a plan with an individual plan. In the absence of a group plan, it means acquiring an individual policy to cover the risk of disability.

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Module

5:

The Need

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Risk retention is when a person accepts or retains all or part of a given risk and may be used, in part, to manage disability risk. For example, an individual may decide that he or she does not wish to spend the amount required to purchase short-term disability coverage but will purchase a policy to cover long-term disability only. This means the person retains the risk of short-term disability while insuring against the risk of long-term disability.

N.B.

Risk retention is a risk management strategy in which the insured assumes risk.

Risk Avoidance: Avoiding risk is the easiest way of reducing risk: "I will not use my motorcycle to jump over Niagara Falls" is an example of risk

in real life it is difficult, if not impossible, to avoid all risk since it is not possible to predict with any certainty when, where, or how risk will be experienced. avoidance. However,

Risk Frequency, Severity, and Appropriate Risk Management Techniques Low frequency

Medium frequency

High frequency

transfer or retain loss

transfer loss

avoid loss

illiledium severity

transfer loss

transfer loss

reduce loss

-cw severity

retain loss

retain loss

retain loss

-t

iiig

h severity

Im

pl e me ntatio n and Mo

n ito ri ng

Once plans have been created, they must be implemented

to be effective.

Following implementation, they must be monitored on a regular, on-going basis to determine whether changes in the individual's life require a risk reassessment.

Documenting the Plan Keeping accurate and detailed records about the plan are essential. These records provide the rationale for the plan in case questions arise at alater date.

They can also be crucial for moving beyond the first set of plans into the future.

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The Canadian Life Insurance Course

LESSON 3: Reducing Risk by Developing a Financial Plan Financial planning involves the identification of the needs, goals, and objectives ofthe client in order to develop suitable strategies to achieve those objectives. Financial objectives (".g., anticipating retirement) are not quantifiable, but financial goals (e.g., $750,000 in a universal life account by age 65) can

be.

Such financial planning is how the risk of aging is addressed.

Information gathered from a client for financial planning purposes will be both quantitative and qualitative. The qaantitative information is necessary to set

financial goals. It includes a comprehensive list of assets, liabilities (debts), income, and expenses. It requires the preparation of a cash flow statement that shows cash

in and cash out, and

a balance sheet that illustrates the net worth

(assets less liabilities) of the client.

A client's qualitative information, used to set financial objectives, reveals his or her lifestyle choices, including those

decisions a person makes about how he or she lives that have a direct bearing

on income, cost and expenses, and also shed valuable light on the client's risk tolerance and preferred investments.

Developing a financial plan with a client can be fraught with obstacles, both personal and external. Personal obstacles reflect the emotions and the decisionmaking ability of the client and his or her personality traits.

External obstacles are those that are beyond the control of the individual. They include demographic trends, inflation, interest rate fluctuations, and income

tax changes. It is important to be aware of how these obstacles can affect the client.

The Financial Planning Process There are many similarities between the steps in the risk management process and the steps in the financial planning process. Financial planning requires:

/ / / / / /

5- 10

setting financial objectives gathering and analyzing financial information

developing strategies to meet objectives implementing plans monitoring and modifying plans documenting plans

Module

5

:

The Need

for Insurance

Setting financial objectives Setting financial objectives includes setting specific, realistic, yet challenging goals that require effort to achieve. They include short-term and long-term objectives that need to be prioritizedby the client.

Gathering and analyzing financial information Gathering financial information about the client is essential to understand his or her financial position. It clarifies the amount of money the client can invest, the debt obligations of the client, and whether his or her financial objectives

can realistically be met. A thorough review of the client's tax returns, insurance policies, wills and estate plans must be carried out. Financial planning means that the planner/agent must have a complete and thorough understanding ofthe client's life style and risk tolerance.

Developing sfrafegles Developing strategies will include: preparing a savings budget establishing registered andlor non-registered plans to meet shortterm and long-term goals a.s,ses,s

ing the need for insurance

devising plans to address other financial concerns, such as tax minimLzatton

lmplementing Plans Once the information has been gathered and analyzed and a plan has been formulated, implementation of that plan is essential if the client is to realize his or her objectives.

Atlonitoring and Modifying Plans

Monitoring the plan and making modifications should occur in a regular review that takes into account any change in the client's personal or financial situation.

Documenting Plans Documentation of the plan is essential for the agent in case the client becomes dissatisfied with results. Documentation of all six financial planning steps plus services provided

by others is part of the process called due diligence. Due diligence is being able to show that a reasonable basis exists for the recommendations given.

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The Canadian Life Insurance Course

Due diligence must be shown to have been in place by the agent to protect against liabil rty claims.

Failure to Plan

Your job as an agent

Selling the Goncept of Risk Transfer

includes making clients

An agent must be aware of the client's goals and the risks that they face before recommending any financial and./or insurance strategies.

understand that an insurance policy transfers some

How important is planning? Very important if you consider what happens when plans have not been made. A lack of planning would be indicated by a client without an emergency fund, a client who has to borrow to pay the entire cost of a child's education, or someone whose retirement date is pushed into the future because of inadequate financial resources.

or all of

their risk to the

It will be a person's perception that motivates his or her decision-making, and it is often difficult to convince a client that he or she needs insurance if that

insurer.

client believes that the probability of loss is low, or that the severity of the loss would not severely impact his or her financial security.

Risk comparison is one effective way to approach the concept of risk with a client. Try comparing the same risk between two time periods (e.g., risk of death today compared to the risk of death seven years from today), or comparing the risk to a benchmark (e.g., the risk of a long-term disability for a person of the same occupational classification as the client). Another approach involves comparing the risks of doing or not doing something (e.g., smoking or not smoking), or the risks that arise from one option compared to others (e.g., the risk of driving your car to work compared to the risk of public transportation).

5-t2

Module

LESSON

4:

Using lnsurance

to

Manage

5:

The Need

for Insurance

the Risk of

Premature Death Transferring risks through insurance is an effective risk management technique. The contract of insurance transfers the pure risk to the insurer, rvhile risk reduction is achieved through pooling. ,A, prudent risk management strategy dictates that when the frequency of loss is unknown or low, and the severity of the loss is high, the risks should be transferred to an insurer. When considering the impact of severity and frequency of loss, severity must be _siven more weight because a single catastrophe could destroy the wealth base

of the entire family.

There are three classes ofinsurance products that address risk:

-

life insurance: risk of premature death disability insurance: risk of lost income due to accident or sickness health insurance: risk of increased costs due to health-related expenses

These products are available in a wide variety of policies. Policy benefits

will

will reflect the benefits provided

and

vary between insurers and premiums

operating cost charges ofeach company.

You may find in practice that producing a list of each client's needs, so that they can be easily compared against competing policy benefits, is an easy and effective way to present your "comparison shopping" efforts to your clients.

If you are not tied to one company, you will then want to obtain quotes from insurers based on exactly the same client information and policies with precisely the same features, to allow apple-to-apple comparisons. If some products are unavailable, it is better to tell your client and recommend another

tack. Also,

if

there is variance between quotes

based on exactly the same

policy feafures

the reason.

-

you

that is, two quotes are not must be prepared to explain

Once quotes are obtained from the insurer or insurers,

it is time to meet with

the client to present your findings and develop a go-forward strategy. This may

involve more research on your part

or setting a time when the policy

application can be completed.

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The Canadian Life Insurance Course

N.B. A client must understand

that the right policy provides the best balance

between risk retention by the client (to minimize premiums) and risk transfer to an insurer (to provide appropriate benefits).

Assessing lnsurance Needs An assessment of needs determines how much insurance a client should buy, that is the amount of the death benefit. of course, financial resources may limit how much can be afforded, but pure need is a good starting point for this analysis. o'How much coverage should I have?" will be the focus of many discussions with clients

Life insurance provides protection from the permanent loss of income arises from premature death. Income, for the purposes of a

that

life insurance needs

analysis, can be identified in terms of cash flow and income-in-kind (e.g., a spouse providing child care at home). The loss of income means dependents

-

the spouse and

children

faced with immediate, ongoing, and future

expenses without away to pay these costs.

Gosts Associated with Premature Death Immediate costs are known as last expenses. They include funeral expenses, probate fees (taxes), debt payments, including the mortgage since it is assumed that survivors will want to continue to live in their home without mortgage costs, and establishing a source of emergency funds for the survivors. ongoing expenses that must be addressed include providing an income for living expenses. Future expenses include funding offuture educational needs.

Remember: there are

three phases of financial dependency.

The three phases offinancial dependency are:

o

the readjustment period: This is the financial support needed by dependents while adjusting to a new standard of living after the death of the income earner (usually

1

to 2 years).

the dependency period during which time the surviving spouse must have sufficient income to provide care for the children. Especially in cases where the children are very young, it is impossible to know for certain at what age the children will no longer be dependent. To account for this uncert ainty, this period indefinite.

will be considered to be

survivor IW income needs: This is a period of time that may be life long for the survivittg spouse. This spouse may never have worked, or

5-14

Module

may not have worked for many years.

If

5:

The Needfor Insurance

so, financial support for the

duration of his or her life may be needed.

Determining the Right Amount of Life Insurance for a Glient In order to estimate the amount of life insurance that is required, an agent must be able to assess with the client, which of these costs would be incurred by the

survivors resulting from the premature death of the proposed life insured, and

their amounts. This can be determined in a fact-finding interview with the client that includes a needs analysis. Any group life coverage of the proposed life insured must also be taken into consideration, since many people acquire group life coverage in the amount of their mortgages. However, as will be seen in the discussion of group plans in module 9, group plans in and of themselves usually provide inadequate coverage.

There are many types of life insurance policies; this discussion focuses on the

rypical concerns of an individual policy owner. As you will see in upcoming modules, when life insurance is used for purposes other than replacing lost income

for

-

agreement

-

instance, when

it is used in business to fund a buy-sell

other variables must be considered.

Also, the needs analysis approach provides a dollar amount to answer the coverage question. However, a client may have other needs and these specific requirements can be addressed through the use of riders.

The three distinct methods used to determine the amount of life insurance that is appropriate for an individual client are:

/ / /

the capitalization of income (or human life value approach) the personal income needs approach

the capital retention approach (or capital needs approach)

Capitalization of lncome (Human Life Value Approach) This approach to determining how much insurance is needed is based on how much income the proposed insured earns. This income figure is divided by an assumed interest rate to give a lump sum amount; the lump sum is how much

would have to be invested now, at the assumed interest rate, to replace the income of the insured.

The formula is annual income + interest

rate: lump sum (the human life

value).

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The Canadian Life Insurance Course

if the annual income of the primary wage-earner is $30,000, the total amount of insurance needed would be (assuming a nominal rate of interest of 8o/o and a long-term inflation rate of 3o/o, the real rate of interest is For example:

5%):

$30,000 + .05 required)

If

:

$600,000 (human

$600,000 is invested at

5o/o,

life value : amount of insurance

the return

will be $30,000 annually. Thus, the

family of the insured has, in economic terms, replaced the income-earning value of the life lost through a policy with a $600,000 death benefit.

This approach has a number of drawbacks: it fails to consider other sources of income (e.g., business earnings), it is calculated by using a constant income stream over the life of the insured since it is difficult to know what increase in

it is diffrcult to separate self-maintenance income from income provided to the family unit, and it is not a true measure of the income is probable,

for clients who are not wage earners (for example, a This approach also ignores the number of years that income will

insurance required homemaker).

be required: aperson aged25 and aperson aged65 would appearto require the same amount of coverage.

Personal Income Needs Approach The personul income needs approach identifies the needs of dependents and family members that must be met in the event of the loss of a major income stream. These needs include income throughout the three phases identified previously: the readjustment period, the dependency period, and survivor life income needs.

This method is more accurate than the capitalization of income approach for determining the amount of insurance required since it is based on the objectives and needs of the family and dependents and considers all financial assets when determining the amount of insurance needed. Its disadvantages include the need for regular re-evaluation, it may ignore inflation, and not incorporate estate creation or preservation. It is not widely used.

it

does

Capital Retention Approach (Capital Needs Approach) In the capital retention approach (also known as the capital needs approach), the capital required to provide the annual cash needs of the survivors is determined and confirms the amount of insurance required.

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Module

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The Need

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It is based on the capitalized value of a person's life, that is, how much capital would have to be invested at a cefiain rate of return to equal the amount of money the person would earn in ayear. For example, the capitalized value of a person eaming $60,000 annually at a 4%o interest rate is $1,500,000 ($60,000 + 4Yo: $1,500,000).

If

the rate of interest is higher, the capitalized value is less. That is, $60,000 at 6Yo is $1,000,000. This is because less must be invested to yield the same annual amount (in this case $60,000).

The capital retention approach begins by putting a value on the assets of the individual's estate at death to determine whether needs can be met from existing resources and then, obligations are determined. obligations are of two tlpes: immediate (final expenses including funeral, legal fees, taxes, debts, and the mortgage) and on-going (continuing expenses for dependents including

food, medical and dental costs, and education funding).

A true picture of assets is best revealed by preparing a net worth statement of the proposed life insured that adds together all assets and subtracts all liabilities to arrive at"net worth". Then a needs analysis is prepared that uses some of the information from the net worth statement and additional information not reflected in the net worth since it pertains to the death of the proposed insured. This information determines financial position to see whether the client needs a term insurance or permanent insurance solution.

The needs analysis

will take into

consideration any mortgage-but not the

value of the real estate (usually the family home) represented by the mortgage because when dependents are

to be provided for, it is assumed that they will

want to continue to live in the home.

In order to apply the capital retention approach to a real-life scenario, first determine where each piece of information fits. Keep in mind the three phases of financial dependency when doing so. It is also important to note that, from time to time, there will be needs that will take place over a fixed period.

In order to

a review of the Settlement Options as discussed on page 2-23 is useful. We will typically use the lump sum settlement option to deal with the readjustment period, those needs arising address those needs,

upon death. The interest only option is appropriate for the dependency period, those needs that occur when looking after the children. The instalment option

would be used when a fixed need arises over a fixed period. (As an example, a surviving spouse wishes to refurn to school for three years at a cost of $13,000 5-17

The Canadian Life Insurance Course

per year.) The life annuity option is generally only used in the retirement years, and will be examined in detail in Module 10b. For the time being, we

will

if there is enough income available to look after the children, after the children are gone will also be taken care of.

assume that,

that the needs

When calculating the insurance needs, it is useful to, after having analyzed the

financial information, determine which period each piece of information fits

into. In order to do so, we will look at the example of William

and Sophia

Gallo.

Practice the Capitalized Value Formula Calculation This worksheet gives you an opportunity to practice your math skills to ensure that you are comfortable making the capitalized value of a human life calculation. ln this case, William and Sophia Gallo have asked you to estimate

the cash needs of the family in the event of William's death. (All answers appear at the end of this module.)

Ihe objective of exercise is

to

this

determine

how much life insurance coverage the Gallos need according

to the capital

One of the calculations you might begin with is a Statement of Net

Worth. lt will list William's assets and liabilities. Liabilities are deducted from assets to determine net assets.

retention approach.

**

Check your answers at

the end of the module.

Net Worth Statement

Assets lnvestments Real Estate

22,1 1B

495,000

Cash

21 ,903

Art

17 ,000

Jewellery

29,000

Total

assets (student to complete)

!*iablllties Accournt with stockbroker l\4ortgages

Folicy loan Personal Line of Credit Total liabilities (student to complete) Net assets {sfude nt to complete)

s-18

$

$'r

8,601

257,667 14,623

5.248

Module

5

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The l{eed

for Insurance

Life lnsurance Needs

As described above, the value of the home real estate is not considered an asset because the home must be retained; however, the mortgage must be paid off.

Readjustment Period Last or Final Expenses

Assets

(use only assets available on (these are the one-time death. For example, life expenses that must be dealt

with in the

insurance death benefits would be included, whereas the value of the principal residence typically would not.)

Death Benefit of

$

period.

2,500

readjustment

)

Funeral

$

19,23G

CPP

22,118

lnvestments

Legal and

9,347

Accounting Fees Cash on Hand

21 ,903

Taxes

49,278

Debts

28,472

Mortgage

Total Assets (student to

Total Final Expenses

complete)

(student to

$

257,667 $

complete)

The difference between the total assets and the total final expenses represents the insurance need. lf there are more assets than expenses, then those excess assets can be used to offset the needs that arise in the dependency period.

Total Expenses - Total Assets =

Readjustment Period Need (student to complete)

5- 19

The Canadian Life Insurance Course

Dependency Period Continuing Income Continuing Expenses (add all sources of income (add all recurring expenses that that would continue despite would arise on the death of the life

the

absence

insured.

of the

life

insu red . )

)

Sophia's

Housing

3,026

Food

8,1 60

Clothing

5,200

Medical and Dental

3,400

Salary

:r,31S/month (student to complete) 18,220

Rental

lncome

Vehicle Expenses Entertainment and holidays

Total Income (student to complete)

$

11 ,844

8,200

Education Fund

4,170

Miscellaneous

8,700

Total Gontinuing Expenses

$

(student to complete)

Capitalization of lncome

lf there is more continuing income than continuing expenses, then we do not need to proceed. However, if the continuing expenses are greater than the continuing income, then we need to calculate how much money needs to be invested for the interest only settlement option to work. What will happen, then, is the surviving spouse will invest the portion of the death benefit that is required to deal with the dependency period and live off the interest provided, leaving the invested principal intact.

ln order to do this, we need a rate of return on investments. William and Sophia work with you to determine that, after taking into account inflation (which we will discuss in Module 10) and taxation (which we will discuss in Module 10b), they can expect a 3.5o/o rate of return.

5-20

Module

(Total Continuing Expenses

5:

The Need

for Insurance

- Total lncome) * Rate of Return = Dependency Period Need (student to complete)

Other Needs As previously discussed, if there are other needs of a fixed amount that

will take place over a fixed period, then those needs should be calculated on a case-by-case basis. Simply multiply the number of years times the amount of the need. For exam purposes, that calculation will suffice. Once you have mastered the financial calculator, you will find that this calculation can be done more precisely using that tool,

Readjustment Need + Dependency Need + Other Needs = Total lnsurance Requirements

ln this example there are no "other needs." Calculate the

total

insurance requirements for the Gallo family: Readjustment Need + Dependency Need = Total lnsurance Requirements (student to complete)

Most people think

LESSON 5: Using lnsurance to Manage the Risk of Disability

the risk of premature death

is great than the

The risk of being disabled is much greater than the risk of premature death.

risk of disability.

Disability income insurance is based on the concept of replacing salary or wages lost because the disability prevents work. Gainful employment is so fundamental to the concept of disability income insurance that this form of insurance is only available to those who work full-time.

They're mistaken!

While loss of income from a disability is usually temporary, such a loss can be financially and emotionally devastating if the disability is severe. Thus, disability income insurance provides an income in the form of monthly benefits to replace income no longer being provided by an employer. It both provides the means by which the bills are paid and the peace of mind that can hasten recovery.

5-21

The Canadian Life Insurance Course

The amount of disability income insurance that can be acquired through an individual policy is based primarily on the proposed insured's amount of earned income. Earned income

for most people consists of their

salary.

However, income from these sources must be considered in the earned income calculation: -salary or wages -commissions -net research grants -net business income Sources

of income that will continue despite disability, such

income,

will not enter into the calculation of benefit.

as investment

Disability policies have a number of variables by which the proposed insured can retain some risk. These will be discussed in more detail in module 8, but they include:

-

the definition of total disability adopted by the insured (own occ, any occ, regular occ)

-

the length of time benefits

-

the amount of benefit applied for (between 60% and70%)

will

be received (called the benefit period)

the length of time between being disabled and when benefits begin (called the elimination period or waiting period)

The disability

formula is earned

The amount of insurance available will be determined by the insurer; an amount of benefit equal to 50%-70% of eamed income (pre-tax) is customary.

High income earners may only receive a 50Yo benefit.

income-bued.

Therefore, the formula to determine how much

will

be received is:

earned income x 60o/" (assuming a 60oh benefit payment) + 12

:

disability

income benefit For example:

if

the annual salary of the proposed insured is $50,000, and there

were no other sources of eamed income and the amount of benefit was

600/o,

the amount he or she would receive is: $50,000 x 600/o: $30,000

: 12: $2,500.

Benefits are paid monthly, in arrears, so in this case, the benefit to be received would be $2,500.

5-22

Module

5:

The Needfor Insurance

The amount received is tax-free when the premiums are entirely paid by the insured; an important consideration when considering how much will be received in benefits.

However, in a group plan in which the employer was the policy owner, the employer might choose to pay the premiums for the employees. When this occurs, the employee will have to pay tax on the benefit.

As with a life policy, specific needs can be addressed through the use of riders to supplement or enhance coverage.

Practice the Disability Income Benefit Calculation Sources of income for William Gallo: Salary $92,644 Commissions 113,g8g lnvestment income 22,863

Assuming a benefit payment of 65%, William Gallo could qualify to tk receive $ asa monthly disability income benefit.

*

Do the calculation and check it against the answer provided

below.

Assessing Health lnsurance Needs Health insurance, sold through accident and sickness policies, reimburses outof-pocket expenses incurred by an insured. Thus, the amount of coverage will be determined by:

-

existing costs anticipated costs

There is no formula to determine amount of coverage, as there is with life and

disability; the decision on the amount of coverage to be provided in the policy is based (within reasonable limits) on how much coverage a person wants.

The insured will exercise risk retention by assuming a deductible or coinsurance factor, both of which reduce the amount of reimbursement. These factors will be covered in detail later in this book.

5-23

The Canadian Life Insurance Course

Capital Retention Approach Answers: Total assets = $46,521; total final expenses = $364,000; readjustment period needs = $317,479; total continuing

sources of income = $46,000; total continuing expenses = $52,700; dependency period needs = $191 ,428.57 [$6,700 + .035]i total insurance requirement = $508,907.57 [$tgt ,428.57 + $317,479]

Disability lncome Answer: Assuming a benefit payment of 65%, William Gallo could qualify to receive $1 1 ,463.45 ($21 1 ,633 x 65% = $137,561 .45 + 12) as a monthly disability income benefit.

s-24

Module

5

:

The lr{eed for Insurance

Module 5: Summary of Key Points Some

Life insurance can cover the costs of premature death and disability, and reimburse medical or dental expenses. lt, therefore, reduces the financial risk of the insured and his or

or all key points may be

on the exam.

of these

The risk of disability is much higher than the risk of premature death.

When income alone is the basis for determining how much insurance coverage is needed (called the Capitalization of Income Approach), the formula is: annual income + real rate of interest When capital invested to equal income lost is the basis for determining how much insurance coverage is needed, the Capital Needs/Retention Approach is used.

is key to

with the

LLQP depends on your knowledge

her dependents.

Earned income

Success

determine how much will be

received as a monthly disability benefit. The formula is: earned income x benefit amount + 12

5-2s

subjects.

5b THE NEED FOR

'NSURANCE: Case Studies ln this module: LESSON'I: The Mathematical Calculations of lnsurance LESSON 2: Ratios, Gompounding and the Rule of 72 LESSON 3: The Time Value of Money LESSON 4: Matching Needs to Products LESSON 5: lntegrating Financial Planning with Life and Health lnsurance

Some Key Terms to Know fuctor: is

expressed as percentage of an insurance claim that is

modul factor: arr additional

paid by the insured.

additional costs associated with the processing of insurance premiums that are

coinsurunce

con

pounding.' occurs when an

person

reinvests distributions from an investment

charge

factored into the premium cost to reflect

paid monthly or quarterly, rather than rn

a

single payment.

(e.g. interest), so that he or she is earning

growth

on growth (e.g. interest on

interest).

present value of u single sum: a formula used to illustrate how much money must be invested presently, in order to grow to a

heulth insurunce: sold through accident and sickness policies, it reimburses the insured

desired amount, at a specified time in the future.

for out-of-pocket expenses.

rule of insurance deductible: the amount of a claim that the insured pays before payment for

how long it takes for an investment portfolio to double in size 72.' illustrates

when its income is reinvested.

that claim is received from the insurer.

Make sure you practice the calculations

in this

module

as you work your way through.

time value of money.' is the difference between a sum that is invested, and the sum to which it will grow over time.

The Canadian Life Insurance Course

LESSON 1: The Mathematical Calculations of lnsurance An agent requires a certain amount of mathematical skill in order to properly assess client insurance needs, explain premium costs, various coverage options, and to complete insurance applications.

Insurance Premiums Perhaps the most important and frequent question facing an agent is how much will the product cost, and is there a difference if premiums are paid once a year or more often.

While these calculations are usually computer-generated by insurers, the agent should be able to calculate them from the insurer's rate book, using the following three-step method.

Step One: Calculate the basic rate per $1,000 of coverage in the policy. For example, the rate book may indicate a premium rate of $1 .90 per thousand dollars of coverage for a 32year-old female, non-smoker. lf the coverage is $100,000, the initial premium cost is $1 .90 x 100 = $190 per year.

Step Two: Add to this figure a fixed annual policy fee, set by the insurer, called a policy factor.

Assume, for example, that the policy factor is $45, the annual premium for the above example is calculated as $190 + $45 = $235 per year.

Step Three: The third calculation arises only when the premium payments are to be made monthly or quarterly. The premium determined through the first two steps must be adjusted by an additional fee (set out in the rate book), called a modalfactor. This figure is then divided by the number of payment to be made throughout the year.

The modal factor is a charge based on the time value of money over the period, and additional costs associated with processing a number of payments, rather than a single payment. lf the modal factor in the example above is .08, the annual premium, payable on a

monthly basis is calculated as $235 x 1.08 = $253.80 + 12 = $21.15 per month.

5b-2

Module 5b: The Needfor Insurance

Insurance Deductibles and Go-insurance The calculation of deductibles and co-insurance factors is important when advising a client about the benefits payable for accident and sickness claims.

The deductible is subtracted from the claim.

The co-insurance calculation is applied to the net claim (i.e. the claim less the deductible).

For example, Sasha has a prescription drug plan with a co-insurance factor of 85%, a single deductible of $35, and eligible expenses of $385.

The expenses covered by the plan are calculated as: ($sas - $ss) x 85% = $297 .50 lf Sasha was a member of a group plan, she might have a single deductible and a family deductible.

Her single deductible might be $50 and the family deductible, $200. lf she first claims $100 in prescription costs for herself, her reimbursement will be $100 - $50 = $50. lf her next claim is another $100 in prescriptions for herself, her reimbursement will be $100.

lf, however, Sasha's first claim in a year is $300 in prescriptions for her husband and two children, she will receive $300 - $200 = $100. Her family claims for the balance of the year will have no deductible applied since the deductible has already been paid.

Finally, if Sasha's first claim in a year is $50 for herself, she will receive no reimbursement because her deductible equals her claim. lf her next claim is $200 for her family, the deductible is reduced by the amount Sasha has already paid. Thus, the claim will be:

$200-($zo0-$50) =$so

5b-3

The Canadian Life Insurance Course

LESSON 2= Ratios, Gompounding and the Rule of 72 Ratios are used to compare or relate quantities, amounts, or sizes between two or more things. They are used frequently by agents in the financial planning process (e.9. the ratio of liquid assets to current liabilities), and by financial institutions (e.9. approving credit or loans based on the debt service ratio).

Compounding is a great selling feature of many of the products offered by a life agent. lt occurs when an investor reinvests distributions from an investment, such as interest, so that the investor is earning growth on growth.

The thought of doubling one's investment over time makes saving and investing attractive even to the uninitiated investor. The Rule of 72 reveals how long it takes for a portfolio to double in size when income is reinvested. lt is calculated by dividing the rate

of return into 72. So, for example, someone earning a return of portfolio can expect its value to double in 6 years.

12o/o

on their investment

72+12=6 The same rule may be used if the number of years during which one wishes the value to double is known; the number 72is divided by that number of years to produce the rate required to double the value within that time. For example, if the number of years in which the person wishes to double the value is 9, the rate of return required in order to double the value is 8%

72+ 9 = B LESSON 3: The Time Value of Money The time value of money is simply the difference between a sum that is invested, and the sum to which it will grow over time. Understanding this concept and its related calculations are essential tools for financial planners and life agents. lt allows clients to make decisions on the amount and results of their savings and on the amount of money that will be available to them in the future as a result of these investments and savings.

The future value of money is greater than today's value because of interest earned on the money and the power of compounding. Compounding means the money grows at a

faster rate since interest is earned on interest.

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Module 5b: The Needfor Insurance

Please Note: The time value of money and the future value of money are important concepts to understand. However, you will not be required to do these mathematical questions on the exam as a financial calculator is not permitted.

This is illustrated in the formula for the future value of a single sum:

futurevalue (FV; = presentvalue (PV) (1 + interest rate [])

N(thenumberorcompoundinsperiods)

For example, if you deposited $2,000 today in a GIC that was paying 4.5% interest annually, how much money would you have in ten years?

* ==?:"'1'l;L-'?,' = 3,106.00 The result may be achieved using a financial calculator* as follows:

Key

Touch

Display

2,000 4.5 10

PV

2,000

i

4,5

n

10

FV

$3,1 05 .94

CPT

(comp)

*Note: A Sharp brand financial calculator has been used to illustrate these calculations.

Consult the manufacturer's instructions when using another make.

The present value of a single sum begins with determining how much money is required at a future date. lt shows how much must be invested now to grow to that amount. Working backwards from a future date is called discounting. The present value of a single sum is illustrated by the following formula: present value (PV;

=

future value (FV) (1 + interest rate [l])

N (the numberof discountins periods)

For example, how much would you need to invest today in order to have $100 in two year's time? Current two-year interest rates are 6,25% connpound anRually.

PV

100

(l + .0625)2

= - 1Q0 = $AA.5B 1.1289

sb-5

The Canadian Life Insurance Course

The result may be achieved using a financial calculator as follows:

Key 1OO 6.25 2n CPT

Touch

Display

FV

100

i

6.25 2

(comp)

PV

$BB.58

A higher interest rate with more discounting periods will produce a smaller present value number. Conversely, lower interest rates and/or fewer discounting periods produce a larger present value number.

The calculation of the future value of an asset (e.g. the future value of an annuity), that is accumulated through periodic payments or savings is important; it can prove an incentive for clients to systematically save today, for future use. ln order to calculate the future value of the asset through such accumulation, the savings or investment payments must be of regular frequency and equal value. The calculation is made using a financial calculator.

For example, a client wishes to know the future value of an annuity to which $100 monthly contributions are made over a 10 year period (120 months), when the interest rate is 12o/o annually (1o/o per month).

Key

Touch

Display

1OO

PMT

100

n

120

120 (10

x 12)

1i

1

CPT (comp) FV

$23,003.88

The determination of the interest rate required to turn a present value of money into a future value is another essential time value of money calculation. For example, suppose a client has $50,000 in an RRSP and wants to have $200,000 in 20 years without putting any more money in the plan. What rate of interest must the investor earn in order to achieve this financial goal? Once again, this is computed using a financial calculator as follows:

sb-6

Module 5b: The l{eedfor Insurance

Key

Touch

Display

50,000

(*/-)PV

-50,000

20

n

20

200,000

FV

200,000

CPT(comp)

i

7.18

The interest rate required is 7.18o/o over the period.

LESSON 4: Matching Needs to Products As the following case study illustrates, risk management techniques can be applied to all aspects of the financial planning and life insurance needs planning, including: premature death

-

disability

businesscontinuation tax planning investment planning retirement planning estate planning

Mavis Clarke is an architect and a partner in the firm at which she works. She is 39, childless, and married to Gregory, a freelance web designer.

Mavis's passion in life is horse riding and, particularly, amateur show jumping.

Unfortunately, at her last show she took a fall and broke her wrist. lt is not her first accident while jumping; all riders fall on a fairly regular basis and consider themselves lucky if they just have a sprain.

One of the partners at Mavis's firm has recently died and his widow is anxious to have the partnership settle his interest in the firm. ln fact, the remaining partners will each have to come up with $100,000 in the next six months to meet this obligation.

Mavis is an only child. She is the executrix of her one surviving, critically ill, parent's estate and expects in the immediate future to inherit the only estate asset: a rambling old house loca"ted in the downtown core of the city.

Mavis manages all of her family household finances, pays all the bills, and recently supervised the renovations to the home she and Gregory own. The home is valued at $350,000 and is encumbered by two mortgages that total $275,000. sb-7

The Canadian Life Insurance Course

When Mavis turns 40, she will inherit the capital from a trust fund established for her by her maternal grandmother. lt will be $250,000. Her total annual income is about $150,000; it is comprised of salary and partnership benefits from the firm at $138,000 and income from the trust at $12,000.

The income derived by Gregory covers the rent and related expenses for his studio, hardware, and software. His total income is between $7,500 and $10,000 per year.

Mavis has a small RRSP; Gregory has no RRSP. Gregory has neither the time nor the inclination to discuss any sort of financial plan, has very little interest in the concept of retirement, and has insisted that the house be registered in Mavis's name since he sees that it was her money that paid for it.

Mavis convinces Gregory to meet with a life agent and seek some advice on insurance and related matters for his own good, since if Mavis was to die unexpectedly, or is hurt or becomes sick, Gregory would be in dire financial straits.

Risk of Death and Disability Like most people, the risk of disability is greater for Mavis and Gregory than the risk of premature death especially given Mavis's hobby as an equestrian.

The agent and the couple begin by reviewing sources of income that would continue if one dies, and liabilities. Their largest liability is their mortgage and each would want to continue living in their home if the other died. Therefore, insurance in an amount to cover their mortgage is essential. The amortization period of the mortgage is 15 years. The Clarkes can clearly see that a renewable and convertible 1O-year term policy on each of

their lives for $250,000 will cover this need and at the end of the term, can be reduced to the size of the mortgage at that point for another term. They also agree that the addition of an ADD rider is prudent.

The agent points out some ideas to Mavis about risk reduction and avoidance since there would be serious financial repercussions if Mavis was to have a serious fall while jumping. Mavis considers that one way she could maintain her interest in the sport would be to train youngsters and ease back on her own activities.

Although Mavis's most recent accident did not impact her ability to work, her investigation of the potential effect of disability has revealed a gap in her disability coverage: the group disability plan only provides $2500 per month as a maximum benefit. lf Mavis became totally disabled, a monthly income of $5,500 would be required to maintain her current standard of living. Accordingly, she decides to top-up her own coverage by purchasing an additional $3,000 of individual disability insurance. ln the sb-8

Module 5b: The Needfor Insurance

event of an accident or serious illness, the policy will ensure Mavis's incomefundamental to family finances-continues.

Needs identified, faced and addressed by these solutions: - the need for the mortgage to be paid off if Mavis's income should cease - the need to reduce the risk of injury from Mavis's hobby - the need for income greater than that provided by the group plan

Business Continuation The death of one of Mavis's partners has, in the absence of life insurance, proved very onerous for the surviving partners. ln order to avoid another cash call that would result from the death of any of the remaining partners, Mavis should insist that all partners enter into a criss-cross agreement wherein all of the remaining partners insure the lives of each other equally. Because of the financial strain on the partners from their outstanding obligation, the purchase of term insurance would be more appropriate at this time compared to a permanent life insurance solution in which the premiums would be much greater initially. However, if the partners opt for whole life, the partners should be designated as irrevocable beneficiaries to ensure that no one partner can erode the value of the policy by securing a loan against the CSV in the policy.

To relieve the financial burden of the premiums, it is recommended that the insurance be funded by the "split-dollar" method in which both the ownership and the funding of the policies is shared equally between the partnership and the individual partners.

A/eeds identified, faced and addressed by these solutions:

-

the need to continue the partnership in the event of the death of a remaining partner and, hence, the need for life insurance on their lives the need to have a means of buying out a partner's interest if the partner should die, retire, or become disabled

Tax Planning The Clarkes risk loss of wealth accumulation if they do not take appropriate measures to reduce their taxes. They consult with a tax specialist who recommends this plan.

When Mavis receives the capital from her trust fund, $'150,000 of those funds should be used to reduce the mortgage. This will increase the equity in the home to $225,000. The home equity can then be used as collateral for a loan that will be used to buy ol"rf Mavis's share of the deceased partner's interest in the firm. The interest on that loan becomes tax deductible to Mavis because it is an investment in which it is reasonable to expect growth.

5b-9

The Canadian Life Insurance Course

The family home is suitable for Gregory's studio and when a portion of the home is used for the purpose of generating income, it is possible to pro-rate many home expenses as tax write-offs. This will reduce Gregory's taxable income, which although low now, may grow in the future as he establishes a reputation in his business. However, to deduct a percentage of mortgage interest, Gregory must have an ownership interest in the home.

An additional portion of the trust capital should be put towards Mavis's unused RRSP contribution room, and she should make a commitment to contribute towards the RRSP in future years to use all unused room. Mavis can also enjoy considerable tax deductions by opening a spousal RRSP in Gregory's name, to which Mavis contributes. The RRSP should not be self-directed, since Gregory has no interest in investments, but should be a managed plan using long-term investments, such as mutual funds, that will grow for use in his retirement.

When Mavis inherits the house from her parent, she intends to rent it and retain it to allow the area in which it is located to maximize the potentialfor resale. Accordingly, when she receives the inheritance, she should immediately gift it to Gregory. Such a transfer can be made at the same market value at which she received it. There are no capital gains on the property because it was the principal residence of the parent. When the home is in Gregory's name, he can bring the rental income into his taxable income at a lower rate than Mavis and when the house is eventually sold, the taxes on the capital gain will be substantially less when incurred in his name.

Needs identified, faced and addressed by fhese solutions: the need to maximize tax deductions by use of RRSPs

-

the need to split income to reduce tax the need to assert income in the hands of the spouse with the lowest marginal tax rate

Investment Planning The Clarkes face numerous risks without an investment planning strategy; these include loss of capital growth, loss of capital preservation, and correspondingly, a loss of purchasing power due to inflation.

Gregory's spousal RRSP and its investment in mutual funds is a solid beginning towards an investment strategy. ln his case, it is also suitable because the managed plan is ideal for someone who is uninterested in the investment process and does not have immediate cash needs.

While Mavis's RRSP has now been topped up, the question arises as to how her plan should be managed. She has the business acumen to manage her plan, but she does sb-10

Module 5b: The Needfor Insurance

not have sufficient time, and therefore like Gregory, chooses a managed plan. Like Gregory, there is no need for liquidity, and therefore a plan with long-term investments seems appropriate.

Mavis also needs advice regarding investing the balance, $60,000, of the capital from the trust. She thinks she would like to "take a flyer" on the stock market. The agent agrees that the potential returns from the market may exceed those in her RRSP, she lacks the time to actively monitor such investments, and she has insufficient knowledge about the market generally.

Mavis's lack of time and investment knowledge also rule out a segregated fund as an appropriate investment. However, the agent points out an alternative that might accomplish Mavis's desire for higher returns while filling a noticeable gap in the insurance needs of the couple. The agent recommends using the $60,000 to purchase a joint and last survivor universal life policy with a face value of $500,000 which will adequately provide for one in the event of the death of the other.

Choosing a level death benefit plus account value allows them to take advantage of an anticipated growth in the investment account over the life of the policy. The inheritance means they can pay for the policy using the $60,000 as a single premium, with some limitations as to policy taxation issues.

The U.L. policy will allow Mavis to select from a wide number of products offered by the insurer, and will satisfy her desire for a more aggressive approach to growth within the policy when she opts for a higher weighting of equity index funds. The cash value can grow on a tax-deferred basis and the Clarkes have the option of a partial surrender should the need arise.

Needs identified, faced and addressed by these solutions:

need to match investments with client risk tolerance need to match investments with client objectives need to match investments with client investment style need for liquidity need to know your client

Retirement Planning The Clarkes risk outliving their money if they do not begin to plan for retirement soon.

While retirement planning per-se may not be a priority for either of the Clarkes at this point in their life, the agent will have stressed the advantages of compounding within the RRSPs and the universal life policy. The agent will have provided cost illustrations with a 5b-1 I

The Canadian Life Insurance Course

primary and secon dary rate of return that will show the amount of income that will be generated and available for Mavis when she is 60 and 65.

The agent will also stress the importance of continuing to make RRSP contributions, and the need for a comprehensive retirement plan when the Clarkes are readY to contem plate reti rement.

Needs identified, faced and addressed by fhese so/uflons: - need to begin to address retirement planning when younger instead of older to

-

benefit from comPounding need for income at retirement

Estate Planning Since Mavis and Gregory do not have wills, the agent must stress the importance of the wills as they relate to the cost effective settlement of their respective estates. Without heirs, their estate planning will not focus on bequeathing their estates but on avoiding probate fees.

The agent will have explained the effect of the joint survivor aspect of the universal life policy: it will ensure probate fees are avoided. Probate fees on their home will also be avoided when their home is held in joint tenancy.

The Clarkes should be made aware that naming each other as beneficiary of their RRSPs affords creditor protection, avoids probate fees, and allows for tax-free roll-over at death.

Finally, both should name a power of attorney to manage their financial affairs in the event of incapacity. rVeeds identified, faced and addressed by these solutions:

need for a will need to structure affairs to minimize probate fees

sb-12

Module 5b: The I{eed.fo, Insurance

LESSON 5: lntegrating Financial Planning with Life and Health lnsurance Owen and Eileen Doherty are 46 and 44 years old respectively. Owen works for Bamco, a toy distributor, where he is Manager of Marketing. He hopes when the current Vice-

President of Marketing leaves the company, he will be promoted into that position.

Eileen works as an office assistant in a legal firm. She does not have her diploma to allow her to progress to be a law clerk, though in practice she does almost all the same

work as the law clerks in the office. Owen and Eileen have three children: Kate who is 16, Kimberly who is 13 and Josh who is 9.

Owen and Eileen have just bought a new home. lt is the second home they have owned; their first was a condo apartment just after they were married. When Kate was born, they moved to a townhouse and rented at that location until they found the house of their dreams.

The Dohertys do not live extravagantly but they find that by the time they have paid for the extra-curricular activities of the kids (horseback riding, ballet, and hockey respectively), their mortgage, all the bills, car payments, and a two-week camping holiday every summer, that there is not a lot of cash left over. They are concerned because their home is extremely important to them, both emotionally because it is exactly the type of house they always wanted, and financially because the equity in the home will be an important source of retirement income-someday.

Owen has an RRSP that he started five years ago when he received an income tax refund that year. He has a self-directed plan that he monitors quarterly. lt is invested in a GIC and a "new technology" mutual fund. The mutual fund has lost 70% of its value in the last two years. Owen is not particularly concerned because he sees the money sitting in the plan for another 20+ years and he gets a great deal of pleasure out of checking out the individual stocks that comprise the holdings of the fund on the internet

at home.

They have no life insurance because they do not trust the product and do not understand what it can do for them. Owen's employer provides a group policy with basic dental and prescription drug benefits. Eileen's employer provides the same benefits.

sb- 13

The Canadian Life Insurance Course

You have been Jack and Theresa Doherty's agent for the past eight years. They are Owen's parents. They suggest you give Owen a call because they feel that Owen and Eileen are living paychequeto-paycheque, and they know that because Owen and Eileen are both heavy smokers, some planning for the future is a good idea.

Your first meeting with Owen and Eileen is a tentative one. They are highly defensive of their finances and financial practices. Eileen is particularly sensitive to mention of her income because she realizes she makes about half of what the law clerks make, despite the fact that she feels she often has to cover for them and fix their mistakes.

Setting Goals You explain to them that everyone has goals; whether they like to spend time thinking about them, or they seem achievable or not. Owen volunteers that his goal is to become Vice President of Marketing and Sales at Bamco; he feels he could increase sales by 20o/o by implementing a few changes. You point out that keeping their home for the foreseeable future is an objective and they agree. Their agreement is the first step in compiling quantitative information about the Dohertys. You suggest another meeting in a weeks'time to give them some time to think about objectives.

At your second meeting, you are bombarded by a veritable wish list of objectives Eileen and Owen have identified. They include spending two weeks in Paris next school break, buying a new car, having sufficient tuition funds for all three kids, putting in a swimming pool, topping up their RRSPs, retiring at 55, setting Eileen up as an independent legal consultant to fill in for absences at all the lawyer's offices in their town, saving $20,000 to pay for weddings for the two girls, and so on.

Your first job is to prioritize these objectives into what can be accomplished in the shortterm and the longterm. You point out that they have not included keeping and ultimately owning outright their home as an objective; their view is that "of course" that is a goal, just as maintaining their current standard of living is a given. These choices both have costs attached that must be reflected in the planning worksheet.

The breakdown of objectives looks like this: Shortterm: continuing to live in their home saving tuition fees for Kate who will go to college in two years maintaining their current standard of living increasing their level of saving in an RRSP

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5b-14

buying a new car installing a swimming pool

Module 5b: The lr{eedfor Insurance

Long-term: paying off the mortgage enjoying a luxurious 2 week holiday each year having funds available to pay for weddings saving tuition fees for Kimberly and Josh retirement at age 55

Turning Objectives into Goals To quantify these objectives, a dollar value for each objective must be established.

Owen and Eileen must also prioritize their objectives because even they realize they cannot afford everything they wish.

Short-term:

Priority

Objective

Most important

continuing to live in their home

Most important

maintaining their standard of living

Most important

saving tuition for Kate

$5,000

lmportant

lncreasing savings in RRSP

$13,500

Over next two years and $t 0,000 for each of next three years 23 years

Less

Buying a new car

$6,600

5 years

lnstalling a swimming pool

$2q,000

3 years

Annual expense $gt ,200 for

Duration of expense 1B years

Notes

mortgage and taxes $48,000

15 years

Once Josh has graduated, annual expenses will decline Total need is $40,000

important Least important

This goal only assumes Owen has a RRSP Assumes purchase of a new car lnterest charges on the loan to do this are 17.2%

5b- 1s

The Canadian Life Insurance Course

An analysis of long-term objectives looks like:

Priority

Objectives

Annual expense

Duration of expense

Notes

Most important

paying off the mortgage

N/a

N/a

saving tuition fees for Kimberly and Josh

$5,000

Most important

Kimberly's tuition will begin in 5 years; Josh's in 9 years

While definitely a long term goal, the cost of this goal is covered under short term obiectives.

There will be no overlap with two kids in college at the same time

enjoyrng a luxurious holid ay 2 weeks each year retirement at age 55

$t s,000

15 years

To be determined by funds available

It is only 9 years until Owen retires, if he retires at 55

having funds available to pay for weddings

To be determined by funds available

lmportant

lmportant

Least important

This is a nice frill that may have to be sacrificed.

This was a lot of information to go through with the Dohertys. As part of your due diligence, you record the details of this meeting and prepare to gather and analyze the financial information that you now require to move forward.

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h

Module 5b: The Needfor Insurance

Gathering and Analyzing Financial lnformation For your next meeting with the Dohertys you have requested that they gather together the relevant financial information for you to determine their cash flow, and hence resources available to start meeting some of their objectives.

Annual lncome: all sources Eileen's T4 for last year:

$ 68,500 $ 37,900

Total

$106,400

Owen's T4 for last year:

After Tax lncome Owen: $68,500

- 37.16%

Eileen: $37,900

-

31 .24%

Total funds available

$ 43,045 $ 26,060 $

69,1 05

Annual Expenses Mortgage

$28,600

Property taxes

$ 2,600

Utilities

$ 1,600

Food

Clothing

$ $

Telephone, cellphone, internet

$ 1,800

Car (insurance, gas, maintenance) Credit cards

$ 5,200 $ 2,500 $ 5,300

Children's activities

$t t ,000

Total annual expenses

$02,500

Entertainment and vacation

5,900 3,000

lnvestments Savings

$

RRSP. Owen

$4,300

Total

$5,200

Funds available

$1,605

e00

sb-r7

The Canadian Life Insurance Course

Developing Strategies You begin by addressing the risks the Doherty's are currently running given their lack of insurance and savings. lf Owen's income was lost, they would have to sacrifice all their goals.

You point out to them that they must have insurance, at a minimum, that covers the mortgage on their house and other final expenses if one or the other should die prematurely.

A needs analysis based on Owen's life shows their actual insurance requirement:

Assets on Death Death Benefit of CPP $ lnvestments

$

Total Assets 303,41 1 (Total Expenses) -

7]00

Readjustment Period Last or Final Expenses 2,500 5,200

T,Too

Funeral Legal and Accounting Fees lncome Tax and Capital Gains Tax Debts (credit cards , car loan) Emergency Fund (Owen's salary x 3 months) Mortgage Total Final Expenses

(Total Assets)= $2gS,7

jl

$

5,ooo 2,000 350

5,300 10,761

$

280,000 303 ,411

Readjustment Need

Dependency PerioC Continuing lncome (yearly) Gontinuing Expenses (yearly)

$

Eileen's Salary Government Benefits

2,400

$

Total lncome (Total Continuing Expenses

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:'

26,060

-

$

Housing Clothing Telephone Car (insurance, g?s, maintenance) Entertainment and vacation Education Fund (for all 3 children)

2B,4Go

4,200 5,900 3,000

Food

Total Gontinuing Expenses

Total lncome) + Rate of Return

=

1,800

5,200 2,500 15,000

$

3T,Goo

Dependency Need

Module 5b: The lr{eed-fo, Insurance

Given a 4o/o interest rate: (37,600

- 28,460) + 4o/o = $228,500 Dependency Need

295,711 (Readjustment Need) + 228,500 (Dependency Need)

= $524,211 Total lnsurance Requirements

They are discouraged to see how much insurance they require since they believe they cannot afford the premiums.

However, you point out to them the following:

.

acquiring a 10-year renewable and convertible term policy to cover mortgage and last expenses based on Owen's life will catry a $386. annual premium; this is affordable

2.

they could increase their level of income if Eileen was to become qualified as a law clerk. This is not a stated objective because Eileen did not feel she had any way to cover the tuition expense but through the Lifelong Learning Plan and Owen's RRSP, Eileen can access enough for tuition. She can provide off-hours services to real estate offices and storefront legal shops to maintain near her same level of income. ln two years, her salary can increase to $71,000.

They can establish an RESP for Kate; depositing $2,000 this year and next will enable them to receive $400 each year from the government education savings grant program, bringing their total savings for her tuition to $4,800; shy of their goal but a significant contribution to first-year tuition.

Saving for retirement must begin immediately. With their current available funds, a properly-funded universal life policy will begin to satisfy their objective of having funds available for retirement, while meeting an unstated objective of leaving a bequest to each of the three children; something neither Owen or Eileen had thought of. A U.L. policy with a $250,000 face value will provide a cash surrender value of $100,000 when Owen is 65. They can use the CSV to provide them with a loan against the policy or withdraw the ACB of the policy in a lump sum or as periodic payments.

1

3.

4.

lmplementing Plans The Doherty's are disheartened because their long-term goals remain largely unavailable. However, they realize they must begin somewhere and follow your suggestions.

5b- 19

The Canadian Life Insurance Course

Monitoring and Modifying Plans On the first year anniversary of both policies, you find Eileen in school and the family struggling while she carries two parttime jobs, and Owen works at his full-time job and one part-time job to replace Eileen's lost income. You stress the importance-especially

now-of not letting the policies lapse because on Eileen's graduation, their financial stresses will be eased and they will have the benefit of having acquired both policies at a younger age. You are able to review with them all the reasons they purchased their policies because you have the documentation of their decision-making process.

On the second anniversary of both policies, Eileen has graduated as a law clerk and is hired by a new firm at $86,000 annually. Owen has achieved his goal: he has been appointed Vice-President and now earns a base salary of $98,000 plus bonuses and commission. His anticipated earnings this year are $108,000. His goal of retiring at 55 has changed; he loves his new job and cannot imagine life without his work.

This is the time to address long-term goals, and point out that the Doherty's can now afford to cover themselves for the risk posed by disability to either of the incomeearners. While Owen is covered by his employer with key person disability insurance, Eileen has no coverage and both Owen and Eileen agree that her salary is essential to meet their long-term objectives.

You thus begin the process of determining: the amount of disability income benefit the benefit period the waiting period the definition most suitable to Eileen's circumstance The amount of disability income benefit Eileen can receive is directly linked to her income. Since her income consists of her salary only, Eileen can receive 60-65% of her salary as a benefit. Based on her salary of $86,000 annually, Eileen qualifies for $51,600-$55,900 in benefits.

Eileen is classified as close to the top for her occupational classification. This high rating means a lower premium; she is deemed less likely to make a claim than a lower classification. Therefore, she selects a longer benefit period, five years.

Given Owen's current level of salary, the Dohertys feel they can manage a slightly longer waiting period. Eileen chooses a six-month waiting period.

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Module 5b: The I{eedfor Insurance

Eileen chooses the regular occupation definition of disability because she is able to undertake her duties for her employer or another even if she is restricted to home.

Eileen sees the risk she could face if she suffered a dismemberment and she was unable to use her hands or arms, since she spends 80% of her time at a computer.

Therefore, she adds to her disability policy an accidental death and dismemberment

rider specifying coverage for her eyesight and her arms.

A sensitive issue that must be addressed is that the Dohertys have made a lifestyle choice that puts their financial and physical health at serious risk: they are both heavy smokers.

It will be your job to introduce the idea of critical illness insurance that includes a

definition for all cancers directly related to smoking: lung, oesophagus, mouth, stomach, and so on. With such a policy, if either Owen or Eileen was diagnosed with a cancer covered in the policy, he or she would receive a lump-sum payment. They could use this money to take one of the trips they have dreamed of as a long-term goal. lf they add a return of premiums rider, they will receive their premiums back if a claim has not been made within the specified period of time.

To meet their goal of retirement, they must start saving more money in RRSPs and they will have to accept some risk in order to get a better return.

You present segregated funds held in an RRSP as an option. The Dohertys can pick funds that are growth-oriented and hence catry a greater risk but they can limit their losses lo 25% of deposits. The maturity date on the contract will come up in ten years, thereby giving them lots of time to maximize growth in the fund in its early years and allow for compounding in the years to follow.

When the term policy expires, Owen will be 56 and Eileen 54. Their mortgage on their home will be reduced to $165,000. Owen's income is now $170,000 annually and Eileen's is $98,000. Kate and Kimberly have graduated from university and are independent; Josh is completing his first-year of university.

Due to their ages and their smoking status, the renewal premium on the term policy would have been $6,400 annually. The Doherty's allow the policy to lapse; the death benefit on the seg fund will help to reduce the mortgage if one should die, and the death benefit on the U.L. policy will reduce the mortgage further. Thus, the survivor can continue to live in the home. They use the funds that were directed towards education expenses for the children to make regular, large deposits to their U.L. policy to build the cash values in the account for their retirement years. sb-21