Chapter 11- Life Insurance
Principles of Risk Management and Insurance: Life Insurance Chapter Notes
Learning Objectives (1 of 2)
11.1 Explain the meaning of premature death as it applies to families and businesses.
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.
Learning Objectives (2 of 2)
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 (1 of 2)
Definition: Premature death refers to the death of a family head who has outstanding unfulfilled financial obligations.
Consequences:
Causes serious financial problems for surviving family members.
The deceased’s future earnings lost forever.
Incurred additional expenses (e.g., funeral expenses, estate settlement costs).
Possible reduction in the surviving family member's standard of living.
Non-economic costs incurred, such as grief.
Premature Death (2 of 2)
Trends: The economic problem of premature death has declined due to increased life expectancy.
Comparison: The United States lags behind many foreign countries due to factors such as:
Obesity
Sedentary lifestyle
Life Insurance Justification:
Purchase of life insurance is justified if the insured has earned income and dependents relying on those earnings for financial support.
Financial Impact of Premature Death on Different Types of Families
The requirement for life insurance varies across several family types, which include:
Single people
Single-parent families
Two-income earners with children
Traditional families
Blended families
Sandwiched families (those caring for both children and elderly parents).
Amount of Life Insurance to Own (1 of 5)
Estimation Approaches: Two approaches to estimate the necessary amount of life insurance:
Human Life Value Approach: Relies on the present value of the family’s share of the deceased breadwinner’s future earnings.
Amount of Life Insurance to Own (2 of 5)
Calculating Human Life Value:
Estimate the individual’s average annual earnings over their productive lifetime.
Deduct the following:
Taxes
Insurance premiums
Self-maintenance costs
Use a reasonable discount rate to determine the present value of the family's future earnings for years until retirement.
Amount of Life Insurance to Own (3 of 5)
Needs Approach: This approach considers the financial needs that must be met if the family head dies. Calculations should include:
An estate clearance fund (funds to settle the estate)
Income needed for a one or two-year readjustment period
Income needed until the youngest child reaches age 18 (dependency period)
Life income for the surviving spouse, which includes income during and after the blackout period.
Special needs, e.g., funds for college education, emergencies.
Retirement needs of the surviving spouse.
Amount of Life Insurance to Own (4 of 5)
Internet Calculators: Internet-based life insurance calculators lead to varied results but serve as a good starting point.
Underinsurance Trend:
Most families have insufficient life insurance.
Less than half of consumers aged 25-64 own life insurance policies.
The average coverage for U.S. adults in 2013 was $167,000, a decline of $30,000 from 2004.
Common beliefs include that life insurance is expensive, leading to procrastination and difficulties with decision-making.
Amount of Life Insurance to Own (5 of 5)
Opportunity Cost: Families often face high opportunity costs associated with purchasing life insurance, including:
Reduction in discretionary income for other expenditures.
Many families are in debt and have minimal savings.
After paying high-priority expenses (mortgage, food, utilities), little income remains for life insurance purchases.
Types of Life Insurance (1 of 11)
Categories of Life Insurance:
Term Insurance: Provides temporary protection.
Cash-Value Life Insurance: Includes a savings component and builds cash values.
Numerous variations are available today of both types.
Types of Life Insurance (2 of 11)
Term Insurance Characteristics:
Protection is temporary, expiring at the end of the policy period unless renewed.
Most term policies are renewable for additional terms with increasing premiums.
Many insurers implement an age limitation for renewal to minimize adverse selection.
Types of Life Insurance (3 of 11)
Convertibility of Term Policies:
Most term policies are convertible, allowing the exchange for a cash-value policy without insurability evidence:
Attained-Age Method: Premium based on attained age at conversion.
Original-Age Method: Premium based on original age at policy purchase.
A financial adjustment is required for conversion.
Types of Life Insurance (4 of 11)
Term Insurance Variants:
Yearly Renewable Term Insurance: Issued for one-year periods.
Long-Term Term Insurance: Issued for five or more years.
Term to Age 65: Provides coverage until age 65 before expiration.
Decreasing Term Insurance: Face value of the policy declines yearly.
Types of Life Insurance (5 of 11)
Reentry Term Insurance:
Policies renew at lower premiums based on acceptable evidence of insurability (good health).
Return of Premium Term Insurance: Returns paid premiums at the end of the term if insurance is still active.
Types of Life Insurance (6 of 11)
Appropriateness of Term Insurance: Beneficial when:
Limited income for life insurance spending.
Need for temporary protection.
Desire to guarantee future insurability.
Limitations: Premiums increase with age at an escalating rate, eventually reaching prohibitive levels; inappropriate for saving money for specific needs.
Types of Life Insurance (7 of 11)
Whole Life Insurance Overview:
A cash-value policy providing lifetime protection.
Provides a stated amount 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
Types of Life Insurance (8 of 11)
Ordinary Life Insurance Characteristics:
A level-premium policy that accumulates cash values and provides lifetime protection up to age 121.
Premiums remain level throughout the premium-paying duration.
Early excess payments supplement inadequate late premiums.
Insurer’s legal reserves must offset liabilities with sufficient assets.
The net amount at risk equals the difference between the legal reserve and face amount of insurance.
Types of Life Insurance (9 of 11)
Cash Surrender Value: Ordinary life insurance policies allow for accumulation of cash surrender values:
Overpaying in early years builds a legal reserve, leading to cash value accumulation.
Policyholders can borrow against cash values or exercise a cash surrender option.
Suitable when lifetime protection is essential, but many remain underinsured post-purchase.
Types of Life Insurance (10 of 11)
Limited-Payment Life Insurance:
Provides lifetime protection but requires level premiums paid only for a specified period (common tenures: 10, 20, 25, or 30 years).
Paid-Up Policies: Mature at a specific age when no further premiums are due.
Types of Life Insurance (11 of 11)
Single-Premium Whole Life Insurance:
Provides lifetime protection with a single premium payment.
Endowment Insurance: Pays the face amount if the insured dies within a fixed period; alternatively, pays the face amount at end of the period if insured is alive.
Accounts for less than 1% of life insurance in force.
Variations of Whole Life Insurance (1 of 9)
Variable Life Insurance:
A fixed-premium policy wherein the death benefit and cash values fluctuate according to a separate account's investment performance (similar to a mutual fund).
Premiums are level with entire reserves held in a separate account for investment.
Cash-surrender values lack guarantees; no minimum guaranteed cash values.
Variations of Whole Life Insurance (2 of 9)
Universal Life Insurance:
Offers a flexible premium policy providing lifetime protection.
Post-first premium, policyholders decide amounts and frequency of payments.
Premiums, minus explicit expense charges, contribute to a cash-value (accumulation fund).
Monthly administrative expenses deducted from the policy.
Variations of Whole Life Insurance (3 of 9)
Universal Life Insurance Components:
Separates protection and savings components.
Target premium exists but is not mandatory.
Monthly mortality charges deducted from cash-value account for insurance costs.
Insurers usually deduct 5-10% of each premium for expenses; cash-value interest earnings fluctuate based on interest rates.
Variations of Whole Life Insurance (4 of 9)
Types of Universal Life Insurance:
Option A: Pays a level death benefit during early years, increasing later to meet Internal Revenue Code corridor test.
Option B: Provides an increasing death benefit comprising constant net amount at risk plus accumulated cash value.
Variations of Whole Life Insurance (5 of 9)
Universal Life Flexibility Limitations:
Permits cash withdrawals, favorable tax treatment.
Acknowledges limitations:
Advertised rates of return may be misleading.
Cash-value and premium projections could be invalid.
Insurers might increase mortality charges.
Risk of policy lapses due to inconsistent premium payments.
Variations of Whole Life Insurance (6 of 9)
Indexed Universal Life Insurance:
Variation offering a minimum interest rate guarantee.
Additional interest credited based on specific market index investment gains, typically capped by a formula.
Variations of Whole Life Insurance (7 of 9)
Variable Universal Life Insurance:
Considered pivotal among whole life insurance variations.
Typically marketed as investment vehicles or tax shelters.
Policyholders control premium investments; no guarantees on minimum interest or cash value.
Carries higher expense charges (e.g., front-end loads, back-end surrender charges, management fees); holders bear significant investment risk.
Variations of Whole Life Insurance (8 of 9)
Current Assumption Whole Life Insurance:
Non-participating whole life where cash values hinge on the insurer’s mortality, investment, and expense performance.
Vanishing Premium Life: Previously sold with illustrations suggesting it might become paid-up at projected interest rates; N A I C prohibits misleading “vanish” terms.
Variations of Whole Life Insurance (9 of 9)
Current Assumption Whole Life Products:
Low-premium products: low initial premium with a premium recalculation post-guarantee period.
High-premium products: permit premium cessation after a certain period.
Comparison of Individual Life Insurance Policies (1 of 2)
Comparison Factors include:
Death Benefit:
Term Insurance: Level or decreasing.
Ordinary Life: Level.
Variable Life: Guaranteed minimum plus investment returns.
Universal Life: Level (Option A) or variable (Option B).
Variable Universal Life: Level (Option A) or variable (Option B).
Cash Value:
Term Insurance: No cash value.
Ordinary Life: Guaranteed cash values.
Variable Life: Variable cash dependent on performance.
Universal Life: Min. interest rate with excess potential.
Variable Universal Life: Cash value based on performance.
Comparison of Individual Life Insurance Policies (2 of 2)
Premiums:
Term Insurance: Increases at renewals.
Ordinary Life: Level premiums.
Variable Life: Fixed-level premiums.
Universal Life: Flexible premiums, as well as Variable Universal Life.
Policy Loans & Withdrawals:
Term Insurance: No loan provisions.
Ordinary Life: Loans permitted.
Variable, Universal & Variable Universal Life: Allow different types of loans and partial withdrawals.
Surrender Charges:
Term Insurance: None.
Ordinary Life: No explicit charges, reflected in cash values.
Variable, Universal & Variable Universal Life: Surrender charges applicable.
Other Types of Life Insurance (1 of 3)
Modified Life Policy: A whole life policy with lower premiums for the first three to five years, followed by higher premiums. Beneficial for those who cannot afford regular whole life premiums initially.
Preferred Risk Policies: Offered at lower rates to individuals expected to have lower-than-average mortality (e.g., non-smokers).
Other Types of Life Insurance (2 of 3)
Joint Life Insurance: A policy insuring two or more individuals, payable upon the first person's death.
Second-to-Die Life Insurance: Insures two or more lives, with benefits due upon the last insured death; commonly used in estate planning.
Other Types of Life Insurance (3 of 3)
Savings Bank Life Insurance (S B L I): Sold by savings banks.
Home Service Life Insurance: Evolved from industrial insurance where small policies are collected at the insured's home.
Group Life Insurance: Provides coverage for a group under a master contract.