Ch. 11: Life Insurance

premature death

death of a family head with outstanding unfulfilled financial obligations

costs of premature death

• loss of future earning

• possible reduction in standard of living

• expenses:

  • funeral

  • estate settlement

  • outstanding debts

  • uninsured medical bills

  • higher childcare costs

who needs life insurance?

if the loss of the individual would result in a reduction in standard of living tied to financial reasons

human life value approach

estimates present value of family’s share of earnings for the number of years until retirement and deducts taxes and self-maintenance costs

disadvantages of human life value approach

ignores assets and other income sources (social security, retirement plans)

earnings and expenses assumed to be constant

ignores effects of inflation

based on income rather than need

needs approach

based on expenses that will be incurred in the event of death and needs of the family

• estate clearing fund

• dependency period for children 

• income for surviving spouse if needed

• special needs (mortgage, college savings for kids)

• retirement needs

• one- or two-year readjustment period

disadvantages of needs approach

difficult to estimate the cost of future needs

assumptions can be construed in different ways causing a large range of values

needs may be different later on (like if spouse gets remarried)

term life insurance

main type of life insurance that provides a death benefit only and temporary protection

• provided for terms

• premiums are level during the term but increase if renewed

• most policies are renewable - the policy can be renewed without evidence of insurability

• most policies are convertible - can be exchanged for a cash-value policy without evidence of insurability

term life insurance is appropriate when

person has limited income to spend on life insurance

need for protection is temporary

insured wants to guarantee future insurability

limitations of term insurance

renewal premiums increase with age at an increasing rate each renewal period and eventually reach prohibitive levels

• leads to adverse selection issue where healthy individuals drop insurance but unhealthy individuals keep it (age limitation helps correct this)

not appropriate if you want to spend money for a very specific need

cash-value (whole) life insurance

main type of life insurance providing lifetime protection

• stated amount is paid to a stated beneficiary whent he insured dies, regardless of when the death occurs

• the policyholder accumulates a cash-surrender value, the amount paid if they surrender the policy early

• policyholder has the right to borrow the cash value

advantages of cash-value life insurance

coverage for lifetime instead of a term period

accumulate savings (cash-value)

policyholder can borrow the cash-value, some policies allow withdrawal

Disadvantages of cash-value life insurance

• Do you really need life insurance when you get fairly old? 70? 80?

• Annual premiums are higher than term insurance

• If you borrow the cash-value you have to pay it back

• Cash-value stays with insurance company when the policyholder dies

• Cash-value may not be guaranteed (depending on type)

Group insurance

employee benefits; coverage of many people under one contract

health and life insurance often group insurance

group insurance differs from individual bc

• Contract between insurer and employer (not individual)

• current/former employees, maybe dependents as well

• Same rate for everyone under the policy

• Underwriting based on the average risk of the group

• Insurable if you’re a member of the group - the insurer can’t exclude individuals from the policy

• High adverse selection due to asymmetric information

advantages of group insurance

• May be less expensive (employer pays for all or a portion of the premium)

• Tax benefits to employees (costs are usually pre-tax)

• No evidence of insurability

• May get insurance you wouldn’t have bought otherwise (can’t be excluded from the group)

disadvantages of group insurance

• Inflexible for individuals (have to wait for certain period to get insurance or change your policy)

• Must be employed to get it (lose insurance if you lose your job)

• Not always available

• May get insurance you wouldn’t otherwise (if insurance is packaged you may not be able to exclude certain kinds of insurance so you’d be paying for coverage you don’t need)