CFP

By Investopedia AAA

Insurance Selection and Annuities - Cost Benefit Analysis

Once a person/client has determined which policy they would like to purchase it is necessary to analyze the cost versus the overall benefit. When determining the cost of the policy a person must include the opportunity cost as well as the actual out-of-pocket expense. There are two methods used to analyze the cost/benefit.

  • Surrender Cost Index- This analysis is useful if a person is considering surrendering the policy 10 or 20 years in to the contract.
  • Net Payment Cost Index- This analysis is useful if a person is concerned with the death benefits and would like the policy compared to the death benefits of similar policies.

Generally, the smaller the index numbers, the more beneficial the policy. For the index to be accurate a person has to compare similar policies. Also, the analyses are only useful in comparing new policies.

How to calculate the surrender cost index:
1. Calculate the Future Value of the following...
  • Assume that premiums are paid at the beginning of the year on an annual basis (payment). The account they are paid into will grow at a specified interest rate, i.e. 5%. (interest) Assume that this will be done for a specified number of years. The present value should be zero. Write down the Future Value
  • Assume that the dividends paid are paid at the end of the year (payment) and placed into an account earning a specified interest rate, i.e. 5% (interest). Assume that this will be done for the same number of years used in the previous step. Again, the present value should be zero. Write down the future value.
  • Assume an expected cash value for the number of years used in the previous step.

2. Subtract the expected cash value (step c) and the future value of dividends paid (step b) from the future value of premiums paid (step a). example (step a - step c - step b = cost)

3. Discount the results of step 3 back at 5% for the number of years used in the previous steps to determine a beginning year annuity. (compute the payment, not the present value)

4. Divide the results of step 3 by the number of thousands of dollars of the death benefit. Example: if the death benefit is $500,000, step 3 would be divided by 500. This gives you the estimated annual cost. The lower the number the better. Net Payment Cost Index

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