Chapter 11: Life Insurance

Premature Death

The death of a family head with outstanding unfulfilled financial obligations.

Costs of Premature Death

• Future earnings are lost forever

• Additional expenses incurred 

  • Funeral expenses 

  • Uninsured medical bills 

  • Higher childcare costs 

  • Estate settlement expenses 

  • Outstanding debts 

• Possible reduction in standard of living 

Which of the following needs life insurance?

• Child

• Single person – no children

• Single person with child(ren)

• Married – no child(ren)

• Married with children – both spouses work

• Married with children – one spouse works

How much life insurance is needed? 

• Depends on family size, income levels, existing financial assets and financial goals.  

• Human Life Value Approach 

  • Present value of the family's share of the deceased breadwinner's future earnings. 

• Needs Approach 

  • Amount needed depends on the financial needs that must be met if the family head should die. 

 

Human Life Value Approach 

1. Estimate the individual's average annual earnings over his/her productive lifetime. 

2. Deduct taxes and self-maintenance costs. 

3. Using a discount rate, determine the present value of the family's share of earnings for the number of years until retirement. 

Human Life Value Approach Example

Phil Dunphy, age 30, is married and has three children. Phil plans to retire in 35 years. 

1. Earns $80000 per year 

2. Of that, $30000 spent on taxes and personal needs. 

3. Using a discount rate of 5%, the remaining $50000 per year for 35 years has a present value of $818700. 

Disadvantages of Human Life Value Approach 

• Ignores assets and other sources of income (Social Security, retirement plans). 

• Earnings and expenses assumed to be constant (most people get a raise each year). 

• Based on income rather than need. 

• Effects of inflation on earnings and expenses are ignored. 

Needs Approach

Calculation should consider: 

• Estate clearing fund (burial, medical bills, debts, attorney's fees, taxes)

• One- or two-year readjustment period (same income as prior to death)

• Dependency period for children (until youngest is at least 18) 

• Income for surviving spouse (if needed) 

• Special needs (college education, mortgage, emergencies) 

• Retirement needs 

Disadvantages of Needs Approach  

• Difficult to estimate the cost of future needs (what will college cost in 20 years?) 

• Assumptions can be construed in different ways causing a large range of values. 

• Needs may be different (what if spouse remarries?) 

Why might someone not purchase (enough) life insurance?

• Belief that life insurance is too expensive to purchase 

• Difficulty in making the correct decisions about its purchase 

• Procrastination 

• They simply don't understand its importance 

• Opportunity cost

Two General Types of Life Insurance  

• Term Life Insurance

  • Death benefit only 

  • Temporary protection (10, 20, 30 years) 

• Cash-Value (Whole) Life Insurance

  • Death benefit plus savings component (cash-value) 

  • Policy period is lifetime of insured, doesn't expire

Term Insurance

• Term insurance can be provided for 5, 10, 15, 20, 25, or 30-year periods (terms). Premiums paid during the term are level, but increase if renewed. 

• Most policies are renewable, meaning the policy can be renewed without evidence of insurability. 

• Most policies are convertible, meaning the term policy can be exchanged for a cash-value policy without evidence of insurability. 

Term Insurance is Appropriate When:  

• The amount of income that can be spent on life insurance is limited. 

• The need for protection is temporary. 

• The insured wants to guarantee future insurability. 

Limitations of Term Insurance 

• Renewal premiums increase with age at an increasing rate and eventually reach prohibitive levels. 

• Inappropriate if you wish to save money for a specific need. 

Cash-Value (Whole) Life Insurance

• Provides lifetime protection 

• A stated amount is paid to a designated beneficiary when the insured dies, regardless of when the death occurs. 

• Accumulates a cash-surrender value, which is the amount paid to a policyholder who surrenders the policy early. 

• The policyholder has the right to borrow the cash value. 

• Options include Whole Life, Universal Life, and Variable Life 

Advantages of Cash-Value Life Insurance  

• Maintain coverage for your entire life (vs. a certain time period with term) 

• Accumulate savings (cash-value) 

• Policyholder can borrow cash-value 

• Some policies allow withdrawal of cash-value 

 

Disadvantages of Cash-Value Life Insurance  

• Do you really need life insurance when you are 70? 

• Annual premiums are higher than term insurance 

• If you borrow from it, 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

• Differs from individual insurance. 

• Coverage of many persons under one contract. 

• Examples 

  • Health insurance through your employer. 

  • Life insurance through your employer. 

Advantages of Group Insurance

• May be less expensive. 

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

• Employer may pay all/part of premium. 

• No evidence of insurability 

• May get insurance you wouldn't have bought otherwise. 

Disadvantages of Group Insurance

• Inflexible for individuals. 

• Must be employed to get it. 

• Not always available. 

• May get insurance you wouldn't have bought otherwise.