Risk Management and Insurance

Q1
Annuities account for a great part of the protection one affords self against death. They do not follow the application of the law of large numbers as the law is traditionally utilized in life insurance. It has, therefore, been referred to as “upside-down life insurance.” When an annuitant passes away during the period of accumulation, their beneficiaries are paid a death benefit. The common treatment of annuities is to account for gross premium returns excluding interest or to account for the cash value, whichever is greater. The principle is for the principal sum to be liquidated over the annuitant’s lifetime regardless of the means of accumulation.
Q2
Annuities can fall under various classes. Traditionally, the following classifications have been used to differentiate annuities:
i. Individual vs. group annuity
ii. Fixed-dollar vs. variable annuity
iii. Deferred annuity vs. immediate annuity
iv. Installment annuity vs. single-premium annuity
v. Single life vs. joint life annuity
vi. Annuity certain vs. pure life annuity
In the case of specialized annuities, the contract options available include:
i. Single-premium deferred annuity (SPDA)
ii. Two-Tier Annuity
iii. Market-Value-Adjusted Annuities
iv. The Variable Annuity
v. Index Annuities
vi. The Contingent Deferred Annuity
vii. Survivorship or Reversionary Annuity
Q3
Investors have to account for inflation when projecting the future value of their investments. The Variable Annuity helps investors cope with the effects of inflation on investment portfolios. The underlying theory is that while the value of a dollar will change over time, a diversified investment portfolio will adjust to reflect the prevailing prices of commodities and services in the economy with inflation factored in. Common stocks represent the value of companies offering goods and services in the economy and their value will generally move in the direction of the general prices. Variable annuities have been consistent with this theory. The number of accumulation units credited to an investor’s account will reflect the current market value of the same units. This value is determined by dividing the current securities value accumulated by a client by the outstanding number of accumulation units.
Q4
Just like in life insurance, annuities’ earned investment income during the period of accumulation is not taxable. Taxation happens only when the income is disbursed. The disbursed amount is taxed on the basis that the payment made is in excess of the investment made in the contract. Further, an early withdrawal of an annuity attracts a premature penalty of 10 percent. However, this penalty is not applicable where the holder of the contract suffers a disability during the life of the contract.
Q5
In the case of the joint and last-survivor annuity, the contract is such that the insurance company makes payments until the death of the two annuitants. This makes the contract attractive to retired married couples. There are variations to the contract that may provide for the amount being paid out to be reduced after the passing of one annuitant with the reduced disbursement continuing until the passing of the second party.
In the case of joint life annuity, the contract is such that payments stop on the passing of the first annuitant. The second party does not get to benefit from the program after the first party passes. This arrangement is suitable where the joint parties have a reliable source of income that can reliably support one person but not two.
Q6
In a defined pension plan, the employee enters into a contract with the employer where the employer is to pay a specific amount in income when they retire. This amount in income is set using a benefit formula. The employer also covers the expenses associated with the plan. In a defined contribution pension plan, on the other hand, the contribution made by the employer to the pension plan is pegged on a percentage of the employee’s remuneration, e.g. 5% of wages. The amount due to the employee is the amount in contributions plus the investment earnings accruing from the contributions. Therefore, a defined contribution pension plan is a type of variable annuity.
Q7
When an employee is in a position to claim certain rights that accrue due to their employment even when their employment with an organization has ended, such a right is referred to as vesting. Vesting requirements vary by organization and may take the following forms:
i. Five years with no vesting, with 100% vesting at the end of the five years
ii. Three years with no vesting, with 100% vesting at the end of the three years
iii. 100% vesting applicable immediately
iv. 20% vesting at the end of three years, and then 20% vesting per year thereafter until fully vested
v. 20% vesting at the end of two years, and then 20% vesting per year thereafter until fully vested
Q8
The goal of the contribution limits is to limit tax advantages that may accrue to high-income individuals. The limits also reduce possible losses in federal revenue that may occur in the absence of such limitations. As per permitted disparity rules, an employer may provide higher benefits for higher wages. In the case of a defined contribution plan, the contribution the employer makes to the plan is reduced to comply with the Federal Insurance Contribution Act.
Q9.
In traditional IRA, the contributions made by an eligible person are tax-deductible. Further, the investment earnings do not attract an annual tax with the tax being deferred until when they withdraw the amount at age 59.5 years.
In Roth IRA, contributions made are non-deductible with the tax applied when a withdrawal is made within five years. The earnings on the contributions are compounded tax-free provided no withdrawal is made for at least five years. When the funds are finally withdrawn when the individual retires, they incur no tax liability.
Q10
Provisions are made as to the distribution of the funds to beneficiaries upon the death of the employee. In case of the death of the employee before the interest is paid in whole and there is no joint-and-survivor option in effect or where a beneficiary spouse dies before the interest is paid in full, the balance is distributed to beneficiaries within a period of five years.
In certain cases, provisions are made to cover disability. Where an employee suffers a permanent disability, disability benefits take effect. The plan may provide that the cost of such benefits, when factored into the life insurance given by the plan, should not cost more than half of the cost of the retirement benefits.
References
Vaughan, E. J., & Vaughan, T. (2007). Fundamentals of risk and insurance. John Wiley & Sons.