Chapter 11: Life Insurance

Premature Death 

• The death of a family head with outstanding unfulfilled financial obligations. (individuals who have unfulfilled financial obligations might need life insurance so those family members are met with financial instability) 

• What does "breadwinner" mean? 

It means you make more money than your partner.  

Costs of Premature Death (not exposing your family to that economic instability) 

• Future earnings are lost forever (would have produced more money if they were still working but can't because passed, for example, by a car accident) 

• 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 (family not really dependent on child for income) 

• Single person – no children (do not have dependents or someone they have financially obligated to but it still depends on the circumstance) 

• Single person with child(ren) (children dependent on the single person) 

• Married – no child(ren) (one spouse might not work and is dependent) 

• Married with children – both spouses work (might need insurance if they are struggling after one passes) 

• Married with children – one spouse works (one is dependent on the other spouse's income; insurance on the working spouse) 

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 (fallacies in this example = not considering that he might get a raise and assuming gets the paid the same each year; does not account for kids, needs, his financial goals; there are better ways to go about things to calculate) 

• 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 (needs – assets = life insurance amount) 

• 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) (readjustment means having a little extra life insurance just in case for that drop in income if someone passes and relying on only one income) 

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

  • Income for surviving spouse (if needed) 

  • Special needs (college education, mortgage, emergencies) 

  • Retirement needs 

Needs Approach Example (1 of 2) 

Needs Approach Example (2 of 2) 

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? (people believe life insurance is too expensive) 

• Belief that life insurance is too expensive to purchase 

• Difficulty is making the correct decisions about its purchase 

• Procrastination 

• They simply don't understand its importance 

• Opportunity cost (give up one thing to get another) 

Two General Types of Life Insurance  

• Term Life Insurance (provides protection for a limited period of time; temporary protection; if you die between the term you get cash back; if you outlive it, you do not get anything back) 

  • Death benefit only 

  • Temporary protection (10, 20, 30 years) 

• Cash-Value (Whole) Life Insurance (protection for your whole life; from when you buy it until you die as long as you continue to pay the premiums; permanent) 

  • Death benefit plus savings component (cash-value) 

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

• Death benefit = Both 

• Cash Value = Whole Life (only) 

Term Insurance (premiums are fixed during the term; renewal will bring premium cost go up; convert from term policy to whole life policy without having to go through another medical exam) 

• 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. 

Examples of Term Life Insurance Premiums 

Cash-Value (Whole) Life Insurance (you only get cash value if you surrender and do not want the policy anymore; you only get the death benefit) 

• 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) 

Life Insurance Comparison 

Group Insurance (not specific to life insurance; you get through employer or labor union; it covers you, your dependents, etc.; many people covered under that contract) 

• Differs from individual insurance. 

• Coverage of many persons under one contract. 

• Examples 

  • Health insurance through your employer. 

  • Life insurance through your employer. 

Group vs. Individual Insurance 

Advantages of Group Insurance (less expensive; paying a portion of your premium, for example, for your health insurance; just being a member) 

• 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 (really inflexible, may only have one option of insurance, you are stuck with it) 

• Inflexible for individuals. 

• Must be employed to get it. 

• Not always available. 

• May get insurance you wouldn't otherwise.