Insurance and Investing: Terms, Concepts, and Differences - Prof. John C. Easterwood, Study notes of Corporate Finance

Download Insurance and Investing: Terms, Concepts, and Differences - Prof. John C. Easterwood and more Study notes Corporate Finance in PDF only on Docsity! AAEC 3104: Financial Planning for Professionals Exam 2: Study Guide The following list is in no way a comprehensive review of what you need to study for the exam….the following is a minimum or baseline knowledge. Chapter 8: Intro to Insurance & Risk Management pp. 299-304 Basic terms and principles of insurance which should be familiar from class discussion For example, with valuation (replacement, ACV, agreed-upon value)…..consider how agreed-upon value is used with scheduled personal property endorsements Chapter 9: Life Insurance What is: Premium: Grace period Face value Cash value In general, what are the different methods to estimate the amount of life insurance needed? What factors are typically considered for each? You will not have to do a calculation but you should be able to describe the factors typically considered. - Human Life Value (HLV): uses projected future earnings as the basis for measuring life insurance needs. 1. calculate the families share of earnings (FSE) a. Take annual salary and subtract personal consumption and taxes to find FSE. 2. calculate work life expectancy 3. Determine human life value using FSE as PMT, a interest rate, and the work life expectancy. - Financial Needs Approach: evaluates the income replacement and lump sum needs of survivors in the event of an income producer’s untimely death. o Affect of inflation is taken into account. 1. Calculate the family’s income (cash flow) needs for each period. a. Readjustment, child ages and the cash flow till last kid is 16, blackout period, and till retirement – find the PV of the sum. 2. Calculate the family’s lump sum funding needs a. final expenses and debts b. education fund needed (today’s dollars) c. emergency fund 3. Calculate the life insurance death benefit needed a. Total need = family’s income + lump sum b. Less life insurance already in place c. Less liquid assets - Capital Retention Approach: provides a death benefit amount that, along with the families other assets, is sufficient to provide a level of investment income that covers the projected needs of the family without having to invade the death benefit principal. 1. Prepare a balance sheet – list all of the assets and liabilities to arrive at a projected balance sheet at death. Assets include: life insurance, existing personal policies, coverage through employers, death benefits. 2. Calculate the capital available for income – subtract liabilities, cash needs, and non- income producing capital from total assets. 3. Determine the amount of additional capital required – compare the family’s income objectives with other sources of income available. Such as SS. What are the fundamental differences in term and whole life insurance? Who would be a good candidate for a term, whole life, universal policy, VUL life insurance policy? Term insurance: “pure insurance” because it provides nothing more than death benefit protection for a temporary or limited period, and the death benefit is paid only if the insured dies during the period. - No cash value - Renewable, gives the policyowner the right to continue coverage for an additional period without evidence of the insurability at a premium based on the insured’s current age. - Convertible, can be exchanged for a cash value life insurance policy without evidence of insurability. - Convertibility and Renewability protect the policyowner against the loss of insurability. Whole life insurance: pays a death benefit during the lifetime of the insured, as long as the premiums are paid according to the policy contract. - cash value - level premium What are the advantages and disadvantages of each type of policy: term, whole, universal, VUL? Term Advantages: - Term insurance is less expensive and more affordable policy dollar for dollar - Ideal for temporary protection - Protects insurability, can later be converted into a cash value permanent policy. Disadvantages: - Increase of premiums based on the aging of the insured - No savings feature - No lifetime coverage Whole Advantages: - Fixed premiums - Tax-deferred accumulation - Lifetime coverage Disadvantages: - Inflexible premiums - Inadequate coverage - Low IRR - Surrender charges Universal Advantages: - Flexible premium - Flexible death benefit - Current assumptions: better cash value, lower morality charges Disadvantages: - Flexible premiums, no fixed commitment: polices lapse - Misleading rates of return and long term illustrations 2 apply? Recall whenever you have “earnings” either form policy proceeds or a bank savings account, taxes are due!  Interest only: insurance company retains the death benefit and pays the primary beneficiary interest on that sum.  Fixed amount: specifies that s designed amount of the income will be provided to the beneficiary on a regular basis until the proceeds and accumulated interest are depleted.  Fixed period: the beneficiary will receiver the maximum periodic payments that the death benefit proceeds will purchase for a specified period.  Life income: allows the beneficiary to receive a specified periodic payment, usually for his lifetime.  Life income and period certain: provides an income to the beneficiary for her lifetime or a specified period, if longer.  Life income with refund: the life insurance company agrees that f the primary beneficiary dies before the total amount paid under the option equals the proceeds of the policy, the life insurance company will pay the difference to a contingent beneficiary.  Joint and survivor income: provides joint beneficiaries a stated amount of income during their lives, and a continuation of the original or reduced amount for the remaining beneficiaries lives. What is the purpose of an annuity? What are the differences in a fixed, variable and EI annuity? Annuity: is a contract designed to provide payment to the holder at specified intervals, usually for a fixed period, for the annuitant’s life, or for the lives of two or more joint annuitants. - Fixed: those in which the insurer agrees to credit a specified interest rate over a stated period.  Insurer can guarantee a certain annuity payment amount upon annuitization  Provides more security of principal than a variable but has limited upside potential - Variable: the annuity owner chooses to allocate funds among one or more subaccounts. o Subaccounts: portfolios of stocks and/or bonds professionally managed.  Gains and losses are credited and debited to the annuity using what are known as accumulation units.  Accumulation units: units of measurement that, when combined, equal the total account value of a variable annuity. o Owner expects more short-term volatility o Does not guarantee specific annuity payments, but potential for greater returns. - Equity Indexed Annuities (EIAs): concept of returns that are equal to a percentage, or participation rate, of a popular market index (i.e. S&P 500) o Credited rate is capped at a percentage of the increase in the index, which limits the upside. o You can enjoy features and benefits of both fixed and variable annuities. What are the different methods of receiving payments or benefits from an annuity? • Straight life: provides a lifetime income to the annuitant regardless of how long the annuitant lives. • Life with period certain (e.g., 10 or 20 years): guarantees the greater of a life income to the annuitant or a minimum number of payments to the annuitant’s beneficiary. • Installment refund: continues periodic payments after the annuitant has died until the sum of all annuity payments equals the purchase price of the annuity. • Cash refund: In cases where an annuitant dies before periodic payments equal or exceed the price paid for the annuity. The insurer pays a lump sum equal to the difference btw the price paid and the total payments received by the annuitant to the beneficiary of the annuity. • Joint and survivor: is based on the lives of two or more annuitants, most often the husband and wife. Annuity payments are made until the last annuitant dies. Nothing on 1035 exchange, except to recognize the definition. 5 - Can provide new opportunities for flexibility and tax deferred accumulation without paying taxes on the cash value growth. 1035 exchanges of life insurance policies or annuities are not subject to tax – the cost basis transfers. What is hospital, surgical, physicians expense and major medical insurance? Give an example of an expense covered by each. - Major Medical Insurance: designed to provide broad coverage of all reasonable and necessary medical expenses associated with an illness or injury. (i.e. covers hospitalization charges, physician and surgeon’s fees). - Hospital Expense: provides payment for expenses incurred by the insured while in the hospital. (i.e. room and board charges). - Surgical Expense: provides for the payment of surgeon’s fees, even when surgery is not performed in a hospital. - Physicians Expense: pays for fees charged by physicians who provide the insured with nonsurgical care. What is the difference between an indemnity policy and managed health care (PPO, HMO)? HMO: provides comprehensive health services to its members for a fixed prepaid fee. - not allowed to use non-HMO providers - must use a contract provider or no benefits are paid PPO: arrangement btw the insured, the insurer, and the health care provider that allows the insurer to receive discounted rates from service providers. - members are allowed to use non-PPO providers o pay higher deductibles and coinsurance, although some benefits are still paid - greater choice of health care providers than HMOs How does an HSA and HDHP work? What features of a HSA are like an IRA? A 529 plan? - Health Savings accounts (HSAs): special accts used to pay for current and future medical expenses in conjunction with a high deductible health plan (HDHP). - High Deductible Health Plan (HDHP) o HMO, PPO, or indemnity plan o Min. annual deductibles and max. out-of-pocket limits (both inflation indexed) must apply  $1100 individual; $2200 family (2008)  $5600 individual; $11,200 family (2008) HSA: IRA/529 for health care • Contribution is adjustment to income or if through a cafeteria plan are pre-tax • One-time transfer from IRA • Same investment options as IRAs • Annual limits & catch-ups apply  $2900 individual; $5800 family; $900 catch-up; $1,000 catch-up 2009+ • Income limits or earned income requirement do not apply • Employer, employee, or both may contribute • Contributions stop with Medicare enrollment What is the difference/similarity in an HSA, a FSA and a HCRA? Who funds each? Pre- or post-tax funding? What happens at year end? HSA: • Employer, employee, or both may contribute • Contribution is adjustment to income or if through a cafeteria plan are pre-tax • No “use it or lose it” unspent balances remain in accounts until spent. • Annual limits & catch-ups apply 6  $2900 individual; $5800 family; $900 catch-up; $1,000 catch-up 2009+ • Contributions to their HSAs through a salary reduction arrangement within a cafeteria plan (section 125) can changed on a monthly basis unlike salary reduction contributions to an FSA. FSA: typically funded by employee salary reductions that allows employees the benefit of paying for their benefits with pre-tax income. • Employer established savings plan funded with pre-tax dollars: medical OR dependent care • Max. applies • “Use it or lose it” annually: 2.5 month period • Pay for unreimbursed medical expenses, copays, deductibles, etc. • Some restrictions apply: elective cosmetic surgery, OTC meds, insurance premiums HCRA: employer sponsored health spending accounts that allow employees to accumulate funds for health expenses. • Employer sets up an HCRA on behalf of a covered employee and deposits a certain amount of money into the plan each year. • Funds accumulate tax-free • Unlike HSA all contributions into HCRAs are made by the employer. What happens to an HSA when the individual (1) enrolls in Medicare; or (2) dies. 1. Enrolls in Medicare: Contributions made by an employer, individual, or both must stop once an individual enrolls in Medicare. 2. Dies: a. If the spouse is the beneficiary, the spouse inheriting the HAS is treated as the owner. b. If the spouse is not the beneficiary, the account will no longer be treated as a HSA. Instead, the account will become taxable to the decedent in the decedent’s final tax return if the estate is the beneficiary, or it will be taxable to the recipient. What is long term care (LTC) insurance? What policy features are important to consider when purchasing LTC insurance. LTC: provides coverage for nursing home stays and other types of assistance with activities of daily living that are not covered by other health insurance. Types of Coverage:  Skilled nursing care: dr. supervised; highest level of medical care  Intermediate nursing care: dr. supervised, bur occasional care only  Home health care: Skilled medical care or nonmedical care  Custodial care: Nonmedical assistance  Assisted living: Housing, medical and nonmedical support  Adult day care: On-site supervision  Hospice care: Terminally ill care; location varies Policy Features: • Defined period approach: provides coverage for a defined following an elimination period of up to 180 days or more. • Pool-of-money approach: the insured is covered up to a specific dollar amount regardless of the period. Rules of Thumb, If client has:  a net worth between $250,000 and $1.5 million, excluding the home, consider LTC.  a net worth in excess of $1.5 million, excluding the home, should consider self-insuring.  a net worth less than $250,000, excluding the home, should consider self-insuring. What are ADLs and how to they relate to LTC or disability insurance? Elimination or waiting period? Chronically ill individual 7 3. Lightning 9. Riot 4. Smoke 10. Theft 5. Windstorm 11. Aircraft 6. Vandalism 12. Volcano Open perils Policy: is designed to protect against all perils expect those specifically excluded from coverage Excluded:  Movement of ground  Ordinance or law  Damage from water: surface, below surface, sewer/drain  War or nuclear hazard  Power failure  Intentional act (fraud)  Neglect: failure to protect after loss or threatened by loss What is the difference in ACV and replacement cost coverage on contents? Which requires the higher $ amount of coverage? What would be the ACV of an item costing $400 with a 10-year life, destroyed or stolen after two years? Ans: $320 Replacement cost coverage: covered losses are paid on the basis of what it costs to replace the property without a deduction for depreciation.  If a loss occurs, the insured will receive the greater of: • actual cash value (ACV) of the part of the dwelling damaged • (amount of insurance ÷ coinsurance) × loss = Amount of coverage – Deductible ASSUMING coverage = to at least 80% of the replacement cost What is the 80% rule? The 100% rule? How is each applied? Understand the component parts and application of an auto policy. PAP  Physical damage  Medical payments  Liability coverage  Uninsured or underinsured motorists protection No-fault insurance  Co. repairs insured, regardless of fault  Limits right to sue other drivers for damages, but can sue for “pain & suffering”  Policy Definitions:  Part A—liability  Part B—medical payments  Part C—uninsured motorists  Part D—damage to your auto  Part E—duties after an accident or loss  Part F—general provisions What is umbrella or excess liability insurance? “When” is it needed? How is this determination made? Personal Umbrella Policy: PUP is designed to provide a catastrophic layer of liability coverage on top of the individuals homeowners and automobile insurance policies.  Standard coverage amount at least $1 million  Self-insured retention (SIR), or deductible, required for any losses associated with coverage’s beyond HO or PAP, e.g. false arrest, defamation of character 10  Exclusions apply, but vary by policy Chapter 12, Investments and Supplements A (pp. 552-562), Supplement B (pp. 588-607) How are the following important when investing? Taxes Time Risk (market, investment, and investor risk tolerance: define each) Diversification Market efficiency What are the (1) common goals of investing and the (2) common prerequisites to investing? (1) Goals  Capital accumulation • Reason for investing  Preservation of capital • Inflation protection for accumulated wealth at minimal risk  Maximizing returns • Greater returns generally require greater risk  Minimizing risk • Balanced with goals to meet investor’s specific goals (2) Prerequisites to investing  Save money from current budget to achieve financial goals  Limit short-term credit to amount easily paid off each month  Manage income and expenses monthly  Increase savings by reducing expenditures  Put a safety net in place – buy insurance  Maintain adequate emergency funds – keep a proper level of liquidity Compare/contrast ownership and lending investments. What do you earn from each? What are the implications, advantages, and disadvantages for taxes?  Lending investments  Default risk – but still paid first  Interest rate risk • Rate changes effect bond price • Rate changes effect reinvestment rates  Ownership investments in business  Common stock • Appreciation • Earnings -- dividends  Preferred stock: bond + stock features • Fixed payment – preferred stock dividend • Valued similar to bonds, similar risks  Ownership investments in real estate  Cash flow: rent vs. raw land  Depreciation deduction  Low correlation with other assets  Derivatives  Options contracts • Puts – option/right to sell • Calls – option/right to buy 11  Futures contracts  Direct versus indirect investing What are the sources of risk when investing? Compare/contrast systematic and unsystematic risk. Investment Risk:  Uncertainty of future outcomes  Probability of adverse result  Investors expect higher returns for higher levels of risk à • Higher the risk, the higher the return • Lower the risk, lower the return:  Inflation, interest rate risk ALWAYS are problems  Is there risk in being TOO safe? • Longer the time horizon, the higher the risk Systematic Risk  Risks affected by broad macroeconomic factors  Cannot be eliminated 1. Purchasing power risk • Risk that inflation will erode real value of investor’s assets • Bonds held to maturity 2. Reinvestment risk • Risk that earnings distributed cannot be reinvested at a rate of return equal to the expected yield of current investments • Zero-coupon bonds—free of such risk 3. Interest rate risk • Risk that interest rates will affect the value of securities • Interest rates are inversely related to value of bonds and stocks 4. Market risk • Associated with changes in economic environment 5. Foreign Currency Risk (exchange rate risk) • Risk that a change in relationship between value of dollar and value of foreign currency will occur Unsystematic Risk:  Risks unique to single security, company, industry, or country  Can be eliminated through diversification – 10 stocks 1. Business risk  Speculative nature of business, management, and philosophy  Uncertainty of operating income  Utilities are less risky than cyclical companies 2. Financial risk  Risk created by leverage of firm  Use of debt magnifies return on equity (ROE) 3. Default risk  Associated with the inability of a business to service its debt  US government securities are default-risk free 4. Country (regulation) risk  Associated with the potentially adverse effect of changes in a country’s laws or political situation What is asset allocation and why does it change over the life cycle? What 3 components make up a portfolio -- stocks, bonds, cash equivalents -- why? Generally, how might the % allocated to each asset class change over the life cycle? 12  Date of declaration: date that a dividend payment has been declared  Date of record: date at which shareholders are entitled to receive the dividend payment  Ex-dividend date: the date on which the market reflects the dividend payment  Date of payment: the date the dividend will actually be paid Capital Appreciation: form of return the investor receives when a company chooses to retain the earnings and invest in additional projects, appreciation of the stock.  Dividends • Qualified, special tax treatment of 15% if 25% MTB or higher or 0% for those in 10% or 15% MTB in ‘08 • Non-qualified, taxed as ordinary income  Capital appreciation (gains/losses) • Long-term: Year + 1 day, 15% or 28% for collectibles • Short-term: taxed as ordinary income or max. of 35% • Capital losses carried forward, up to $3,000 offset current income annually but carry forward can continue - Capital gains income is preferred over dividend income from a tax standpoint, making capital appreciation preferred, but many investors still like dividends. - Price appreciation of capital appreciation is much less reliable, however, than dividend income. There is more risk associated with gain from the sale of stock verse dividend income. o Long term investors prefer capital appreciation, more able to control the recognition and taxation of the gain. o Investors needed current income cannot afford the risk of whether a stock will appreciate enough to cover living expenses during the given year, are more comfortable with dividend income. Be able to identify the basic stock classifications and match to examples. What are the risks, characteristics of each type?  Size • Large cap: valued at >$5 billion  ExxonMobil, General Electric, Microsoft • Mid cap: $1-5 billion  Bed, Bath & Beyond, Monsanto, Hilton Hotels • Small cap: <$1 billion  Earthlink, FirstFed Financial, Vintage Petroleum Common stock  Ownership in the company Preferred stock  Hybrid security with features of common stock & bonds Foreign securities  Companies outside of the US, often with a low correlation to US common stock Defensive stocks also know as counter-cyclical stocks  Steady growth, increased demand during down markets and less demand during up markets  Utilities (also known as income stocks)  Household staples (groceries, pharmaceuticals)  Sins (gambling, alcohol, tobacco)  Low beta relative to the market Cyclical stocks  Demand consistent with the economic cycle –up or down  Autos, cement, steel, heavy equipment, airlines 15  Higher beta relative to the market Blue-chip stocks  Industry leaders with consistent dividend payment (regardless of profit/loss) and relatively consistent growth  GE, GM, ExxonMobil, Wal-Mart, IBM Income stocks  Moderate growth, consistent dividends, ex. utilities Growth stocks  Above average price appreciation, with little or no dividend payment  Emerging growth stocks – younger companies with significant potential and risk Interest-sensitive stocks  Companies whose economic cycle is inversely tied to interest rates b/c of the product produced or the debt load carried  Housing: building supplies, furnishings, equipment  Insurance companies, banks/S&Ls, telephone, utility Value stocks  Undervalued companies expected to “come back”  High-quality companies with low PE ratios New economy stocks  Technology-related companies related to the Internet  Sellers, Amazon  Access providers, phone, cable  Hardware provides, Cisco “Tech bubble” of 2000/01 Market dropped with 60% losses Why own common stock, preferred stock, foreign/international securities? What are the general definition and features of each? How purchased? For what purpose? Common Stock: - Ownership interest in a company. Preferred Stock: - Type of stock that has characteristics of both fixed income investments and of common stock in that dividend payments must be paid each year before paying a dividend to the common shareholders. - Features: o Cumulative o Participating preferred o Convertible preferred Foreign/international securities: - Foreign = Securities issued by non-us firms. - Global = securities issued by us firms and other firms around the globe. What systematic and unsystematic risks are commonly associated with equities? Why? Systematic risks  Market risk  Interest rate risk • Increased borrowing costs • Attractiveness of other investments • Value of equities fall as rates rise  Exchange rate risk Unsystematic risks  Business risk  Financial risk 16  Country risk 4 markets….not detailed explanation, just by definition……what is each? (see Powerpoint slide)  Primary market—where new issues of securities are first offered to the public  Secondary market—where investors can buy and sell securities with other investors: NYSE  Third market—over-the-counter (OTC) trading of equity shares listed on an exchange  Fourth market—institutional traders that trade without the help of brokers What are market indexes? What do they represent? How do they relate to the NYSE, the AMEX, or the NASDAQ (in other words, the four markets)? Why are they important? pp. 611—615, Purchasing Equities, basic definitions ONLY….nothing on determining the margin call Long positions: - The purchase of stock in hopes that it will appreciate over time Short Position: - A type of position investors take by selling borrowed shares in hopes that the stock price will decline over time. 17