Principles of Risk Management and Insurance: Chapter 11 - Life Insurance
Principles of Risk Management and Insurance - Chapter 11: Life Insurance
Learning Objectives
11.1 Explain the meaning of premature death as it applies to families and business
11.2 Describe the financial impact of premature death on different types of families
11.3 Explain the needs approach for estimating the amount of life insurance to own
11.4 Describe the basic characteristics of term life insurance
11.5 Explain the basic characteristics of ordinary life insurance
11.6 Describe the following variations of whole life insurance:
Variable life insurance
Universal life insurance
Indexed universal life insurance
Variable universal life insurance
Current assumption whole life insurance and interest sensitive products
11.7 Identify and describe other types of life insurance:
Modified life
Home service life
Group life
Premature Death
Definition and Consequences (1 of 2)
Premature Death: The death of a family head with outstanding unfulfilled financial obligations.
Can cause serious financial problems for the surviving family members.
Loss of future earnings for the deceased, never to be recovered.
Additional incurred expenses such as:
Funeral expenses
Estate settlement costs
Potential reduction in the standard of living for surviving family members.
Encountering noneconomic costs such as grief and emotional distress.
Economic Trends (2 of 2)
The economic problem of premature death has declined due to increasing life expectancy.
The United States lags behind many other countries in terms of life expectancy due to factors such as:
Obesity
Sedentary lifestyle
Financial justification for life insurance exists if the insured has earned income dependent on others for financial support.
Financial Impact of Premature Death on Different Types of Families
Varied Needs
The required life insurance varies across different family structures:
Single people
Single-parent families
Two-income earners with children
Traditional families
Blended families
Sandwiched families
Amount of Life Insurance to Own
Estimation Approaches (1 of 5)
Two approaches to estimate the necessary amount of life insurance:
Human Life Value Approach:
Based on the present value of the family’s share of the deceased breadwinner’s future earnings.
Estimation Calculations (2 of 5)
Calculating the needed amount under the human life value approach involves:
Estimating the individual's average annual earnings over the productive lifetime.
Deducting taxes, insurance premiums, and self-maintenance costs.
Using a reasonable discount rate to determine the present value of the family's share of earnings until retirement.
Needs Approach (3 of 5)
Under the Needs Approach, the needed amount depends on the financial needs that need to be fulfilled if the family head should die.
Calculations should consider:
An estate clearance fund.
Income needed for a one- or two-year readjustment period.
Income needed for the dependency period until the youngest child reaches age 18.
Life income to the surviving spouse, including income during and after the blackout period.
Special needs such as funds for college education and emergencies.
Retirement needs.
Example Calculation - Total Life Insurance Needed (4 of 5)
Exhibit 11.1: How Much Life Insurance Do You Need?
What You Will Need
Cash needs:
Funeral costs: $15,000
Uninsured medical bills: $5,000
Installment debts: $12,000
Probate costs: $3,000
Federal estate taxes: $0
State inheritance taxes: $0
Total estate clearance fund: $35,000
Income needs:
Readjustment period: $24,000
Dependency period: $180,000
Life income to surviving spouse: $0
Retirement income: $0
Total income needs: $204,000
Special needs:
Mortgage redemption fund: $200,000
Emergency fund: $50,000
College education fund: $150,000
Total special needs: $400,000
Total needs: $639,000
Current Assets and Additional Insurance Needed (5 of 5)
Exhibit 11.1: Current Financial Situation
What You Have Today:
Checking account and savings: $10,000
Mutual funds and securities: $35,000
IRA: $20,000
Section 401(k): $40,000
Current life insurance: $60,000
Other financial assets: $0
Total assets: $165,000
Additional life insurance needed:
Total needs: $639,000
Less total assets: $165,000
Additional life insurance needed: $474,000
Types of Life Insurance
General Classification (1 of 11)
Life insurance policies fall into two main categories:
Term insurance: Provides temporary protection.
Cash-value life insurance: Contains a savings component that builds cash values.
Various adaptations of both types exist today.
Term Insurance Characteristics (2 of 11)
Temporary Protection: Coverage expires at the end of the policy period unless renewed.
Renewal: Most term policies can be renewed for additional periods, but premiums increase with each renewal.
Insurers may impose age limitations for renewal to minimize adverse selection.
Conversion Features (3 of 11)
Convertible Policies: Many term policies can be exchanged for a cash-value policy without providing evidence of insurability.
Two methods of conversion:
Attained-age method: Premium is based on the insured’s age at the time of conversion.
Original-age method: Premium is based on the insured's original age at policy purchase.
A financial adjustment is also typically necessary.
Types of Term Insurance Policies (4 of 11)
Yearly Renewable Term Insurance: Issued for one-year periods.
Multi-Year Terms: Can be issued for five or more years.
Term to Age 65: Protection to age 65, at which point the policy expires.
Decreasing Term Insurance: Face value gradually declines each year.
Special Term Types (5 of 11)
Reentry Term Insurance: Renewal premiums based on favorable evidences of insurability.
Return of Premium Term Insurance: Returns the premiums if the policy remains in force until the term ends.
Appropriateness of Term Insurance (6 of 11)
Suitable: When income for life insurance is limited and the need for protection is temporary.
Also suitable for those wanting to guarantee future insurability.
Challenges:
Premiums increase with age at an increasing rate, often becoming prohibitive.
Not suitable for saving for specific needs.
Whole Life Insurance (7 of 11)
A Cash-Value Policy: Lifetime protection is guaranteed; the stated amount is paid to a designated beneficiary upon death, regardless of timing.
Types include:
Ordinary life
Limited-payment life
Endowment insurance
Variable life
Universal life
Variable universal life
Current assumption whole life
Indeterminate-premium whole life
Ordinary Life Insurance Details (8 of 11)
Level-Premium Policy: Accumulates cash values and provides coverage until age 121.
Premiums are fixed for the entire premium-paying term.
Early years' excess premiums supplement inadequate later years' premiums.
Insurer’s legal reserve must be offset by sufficient financial assets.
Legal and Cash Value Relations (9 of 11)
Net Amount at Risk: Difference between legal reserve and face amount of insurance.
Cash Surrender Values: Built up from early overpayment, giving policyholders borrowing rights or cash surrender rights.
Limited-Payment Life Insurance (10 of 11)
Provides lifetime protection with premiums paid for only a fixed number of years.
Common durations: 10, 20, 25, or 30 years.
Paid-Up Policy: At age 65 or 70, no further premiums are needed; matures either upon death or endowment.
Single-Premium Whole Life (11 of 11)
Offers lifetime coverage with just a single premium payment required.
Endowment Insurance: Pays the full amount if death occurs within a specified time frame; otherwise, the amount is paid to the policyholder if alive at the end.
Variations of Whole Life Insurance
Variable Life Insurance Characteristics (1 of 9)
Fixed-Premium Policy: Death benefits and cash values fluctuate based on investment performance in a separate account (similar to a mutual fund).
Premium remains level; entire reserve is held in this separate account.
Cash-surrender values are not guaranteed; no minimum cash values are assured.
Universal Life Insurance Overview (2 of 9)
Flexible Premium Policy: Provides lifetime protection; after the first premium, policyholders choose the amount and frequency of payments.
Charges are deducted for administrative expenses with remaining amounts credited to a cash-value account.
Offers significant flexibility in managing premiums and benefits.
Separation of Components (3 of 9)
In universal life insurance, death protection and cash savings are separate.
Target Premium: Suggested but not obligatory to pay.
Monthly mortality charges deducted from the cash-value for insurance costs.
Interest earnings depend on prevailing interest rates.
Two Options in Universal Life (4 of 9)
Two forms of universal life insurance options:
Option A: Level death benefit in early periods, increasing later to meet tax corridor tests.
Option B: Increasing death benefits equal to the net amount at risk plus accumulated cash value.
Flexibility and Limitations (5 of 9)
Universal life allows cash withdrawals and favorable tax treatment.
Limitations:
Risk of misleading returns advertised by insurers.
Cash value and premium projections may be invalid or misleading.
Policies may lapse without firm commitment on premiums.
Indexed Universal Life Features (6 of 9)
A variation of universal life with unique attributes:
Assures a minimum interest rate and additional interest based on the performance of a specified stock market index.
Crediting based on a capped formula.
Variable Universal Life Characteristics (7 of 9)
Policies marketed as investments/tax shelters.
Policyholders control the investment of premiums within specified range.
No guaranteed minimum return or cash value; substantial risk borne by policyholders due to high expense charges and unpredictable returns.
Current Assumption Whole Life Overview (8 of 9)
Non-participating policy with cash values depending on current insurer’s mortality, investment and expense outcome.
Vanishing Premium Life: Previously referenced models where the policy would pay up if non-guaranteed interest rates materialized; regulated against misleading terminology regarding premium disappearances.
Current Assumption Product Forms (9 of 9)
Two categories:
Low-Premium Products: Begin with low premiums, with redetermination provisions post-initial guarantee lifelong.
High-Premium Products: Allow cessation of premium payments after a designated period.
Comparison of Individual Life Insurance Policies
Key Differences
Exhibit 11.6 (1 of 2)
Feature | Term Insurance | Ordinary Life Insurance | Variable Life Insurance | Universal Life Insurance | Variable Universal Life Insurance |
|---|---|---|---|---|---|
Death Benefit Paid | Level or decreasing benefit | Level death benefit | Guaranteed with investment gain potential | Level or variable based on investment | Level or variable based on investment |
Cash Value | No cash value | Guaranteed cash values | Depends on investment performance (not guaranteed) | Guaranteed minimum plus excess interest | Depends on investment performance (not guaranteed) |
Premiums Paid | Increase at each renewal | Level premiums | Flexible premiums | Flexible premiums | Flexible premiums |
Policy Loans | No | Yes | Yes | Yes | Yes |
Partial Withdrawal | No | No | Permitted in some policies | Yes | Yes |
Surrender Charge | None | No stated explicit charge (reflected in cash values) | Yes | Yes | Yes |
Other Types of Life Insurance
Modified Life Policy (1 of 3)
Whole life policy with lower premiums in the initial 3-5 years, increasing afterward.
Advantageous for applicants who need permanent insurance but cannot initially afford regular whole life premiums.
Preferred Risk Policies (2 of 3)
Offers lower rates to individuals expected to have lower-than-average mortality (e.g., non-smokers).
Joint Life Insurance (3 of 3)
Policy insuring two or more lives, paying out upon the death of the first insured.
Second-to-Die Insurance: Insures multiple lives, pays the benefit upon the death of the last insured, frequently used for estate planning.
Savings Bank Life Insurance (S B L I)
Sold by savings banks as a type of life insurance.
Home Service Life Insurance
Evolved from Industrial life insurance, involving policies of small amounts where premiums are collected at the insured’s home.
Group Life Insurance
Provides coverage for a group of people under one master contract, often seen in employer-employee arrangements.