Chapter 11

Life Insurance

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Agenda

• Premature Death
• Financial Impact of Premature Death on
Different Types of Families
• Amount of Life Insurance to Own
• Types of Life Insurance
• Variations of Whole Life Insurance
• Other Types of Life Insurance

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11-2
Premature Death

• Premature death can be defined as the death

of a family head with outstanding unfulfilled
financial obligations
– Can cause serious financial problems for the
surviving family members
– The deceased’s future earnings are lost forever
– Additional expenses are incurred, e.g., funeral
expenses and estate settlement costs
– Some families will experience a reduction in their
standard of living
– Noneconomic costs are incurred, e.g., grief
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11-3
Premature Death (Continued)
• The economic problem of premature death
has declined because life expectancy has
increased
• The United States lags behind many
foreign countries. Some reasons for this
include:
– Obesity
– Sedentary life style
• The purchase of life insurance is financially
justified if the insured has earned income
and others are dependent on those
earnings for financial support
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11-4
Financial Impact of Premature
Death on Different Types of Families
• The need for life insurance varies across
family types:
– Single people
– Single-parent families
– Two-income earners with children
– Traditional families
– Blended families
– Sandwiched families

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Amount of Life Insurance to Own

• Two approaches can be used to estimate the

amount of life insurance to own
• The human life value approach
– The amount needed depends on the insured’s
human life value, which is the present value of
the family’s share of the deceased breadwinner’s
future earnings

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11-6
Amount of Life Insurance to Own
(Continued)

• To calculate the amount needed under the

human life value approach:
– Estimate the individual’s average annual
earnings over his or her productive lifetime
– Deduct taxes, insurance premiums and self-
maintenance costs
– Using a reasonable discount rate, determine the
present value of the family’s share of earnings
for the number of years until retirement

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11-7
Amount of Life Insurance to Own
(Continued)
• Under the needs approach, the amount
needed depends on the financial needs that
must be met if the family head should die
• The calculation 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, e.g., funds for college education
and emergencies
– Retirement needs
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11-8
Exhibit 11.1
How Much Life
Insurance Do
You Need?

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11-9
Amount of Life Insurance to Own
(Continued)
• Internet-based life insurance calculators
produce widely varying results, but may be a
good starting point
• Most families own an insufficient amount of
life insurance
– Less than half of consumers aged 25-64 own life
insurance policies
– The average amount of coverage for U.S. adults
in 2013 was $167,000, down $30,000 from 2004
– Consumers believe life insurance is expensive.
They procrastinate, and have difficulty in making
correct decisions about the purchase of life
insurance 11-10
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Amount of Life Insurance to Own
(Continued)
• The opportunity cost of purchasing life
insurance may be too high for many
families
– The purchase of life insurance reduces the
amount of discretionary income available for
other needs
– Many families are in debt and have little savings
– After payment of high priority expenses, such
as a mortgage, food and utilities, many families
have only a limited amount of income to
purchase life insurance

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Types of Life Insurance

• Life insurance policies can be classified in

two general categories:
– Term insurance provide temporary protection
– Cash-value life insurance has a savings
component and builds cash values
– There are many variations of both types
available today

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Types of Term Life Insurance

• Under a term insurance policy, protection is

temporary; protection expires at the end of
the policy period, unless renewed
• Most term policies are renewable for
additional periods
– Premiums increase at each renewal
– To minimize adverse selection, many insurers
have an age limitation beyond which renewal is
not allowed

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Types of Term Life Insurance
(Continued)
• Most term policies are convertible, which
means the policy can be exchanged for a
cash-value policy without evidence of
insurability
– Under the attained-age method, the premium
charged for the new policy is based on the
insured’s attained age at the time of conversion
– Under the original-age method, the premium
charged for the new policy is based on the
insured's original age when the term insurance
was first purchased
– A financial adjustment is also required

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Types of Term Life Insurance
(Continued)
• Yearly renewable term insurance is issued for
a one-year period
• Term insurance can also be issued for five or
more years
• A term to age 65 policy provides protection to
age 65, at which time the policy expires
• Under a decreasing term insurance policy,
the face value gradually declines each year

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Types of Term Life Insurance
(Continued)
• Under a reentry term insurance policy,
renewal premiums are based on select
(lower) mortality rates if the insured can
periodically demonstrate acceptable
evidence of insurability (i.e., good health)
• Return of premium term insurance is a
product that returns the premiums at the
end of the term period provided the
insurance is still in force

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11-16
Uses and Limitations of Term Life
Insurance
• 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
• However,
– Term insurance premiums increase with age at an
increasing rate and eventually reach prohibitive
levels
– Term insurance is inappropriate if you wish to
save money for a specific need

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Exhibit 11.2 Examples of Term Life
Insurance Premiums

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Types of Whole Life Insurance

• Whole life insurance is a cash-value policy

that provides lifetime protection
– A stated amount is paid to a designated
beneficiary when the insured dies, regardless of
when the death occurs
– Types include:
• Ordinary life • Universal life
• Limited-payment life • Variable universal life
• Endowment insurance • Current assumption whole life
• Variable life • Indeterminate-premium whole life

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11-19
Types of Whole Life Insurance
(Continued)
• Ordinary life insurance is a level-premium
policy that accumulates cash values and
provides lifetime protection to age 121
– Premiums are level throughout the premium-
paying period
– The excess premiums paid during the early years
are used to supplement the inadequate premiums
paid during the later years of the policy.
– The insurer’s legal reserve is a liability that must
be offset by sufficient financial assets
– The net amount at risk is the difference between
the legal reserve and the face amount of
insurance
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11-20
Exhibit 11.3 Relationship Between the Net Amount
at Risk and Legal Reserve (2001 CSO Mortality Table)

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Types of Whole Life Insurance
(Continued)
• Another characteristic of ordinary life
insurance policies is the accumulation of cash
surrender values
– A policyholder overpays for insurance protection
during the early years, resulting in a legal reserve
and the accumulation of cash values
– The policyholder has the right to borrow the cash
value or exercise a cash surrender option
• An ordinary life policy is appropriate when
lifetime protection is needed and can be used
to save money
– A major limitation is that some people are still
underinsured after the policy is purchased
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11-22
Types of Whole Life Insurance
(Continued)
• Under a limited-payment life insurance
policy, the insured has lifetime protection,
and premiums are level, but they are paid
only for a certain period
– The most common limited-payment policies are
for 10, 20, 25, or 30 years
• A paid-up policy at age 65 or 70 is another
form of limited-payment life insurance
– A policy is paid up when no additional premium
payments are required; it matures when the face
amount is paid as a death claim or endowment

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11-23
Types of Whole Life Insurance
(Continued)
• A single-premium whole life policy provides
lifetime protection with a single premium
• Endowment insurance pays the face
amount of insurance if the insured dies
within a specified period. If the insured is
still alive at the end of the period, the face
amount is paid to the policyholder
• Endowment insurance accounts for less
than one percent of the life insurance in
force
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11-24
Variations of Whole Life Insurance

• Variable life insurance is a fixed-premium

policy in which the death benefit and cash
values vary according to the investment
experience of a separate account, which is
similar to a mutual fund maintained by the
insurer
– The premium is level
– The entire reserve is held in a separate account
and is invested in common stocks or other
investments
– Cash-surrender values are not guaranteed and
there are no minimum guaranteed cash values

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11-25
Variations of Whole Life Insurance
(Continued)

• Universal life insurance is a flexible premium

policy that provides lifetime protection
– After the first premium, the policyholder decides
the amount and frequency of payments
– Premiums, less explicit expense charges, are
credited to a cash-value account, also called an
accumulation fund
– Policies typically have a monthly deduction for
administrative expenses
– The policies have considerable flexibility

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Variations of Whole Life Insurance
(Continued)

• In a universal life insurance, the protection

and savings components are separated
– Most policies have a target premium, but the
policyholder is not obligated to pay it
– A monthly mortality charge is deducted from
the cash-value account for the cost of the
insurance protection
– Insurers typically deduct 5-10 percent of each
premium for expenses
– Interest earnings credited to the cash-value
account depend on the interest rate
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11-27
Variations of Whole Life Insurance
(Continued)

• There are two forms of universal life

insurance:
– Option A pays a level death benefit during the
early years, and the death benefit increases in
later years to meet the corridor test required by
the Internal Revenue Code
– Option B provides for an increasing death benefit
which is equal to a constant net amount at risk
plus the accumulated cash value

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Exhibit 11.4
Two forms of
Universal Life
Insurance
Death Benefits

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Exhibit 11.5
$100,000
Universal Life
Policy, Level
Death Benefit,
Male, Nonsmoker,
Age 25

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Exhibit 11.5 $100,000 Universal Life Policy, Level
Death Benefit, Male, Nonsmoker, Age 25 (Continued)

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Variations of Whole Life Insurance
(Continued)
• Universal life provides considerable
flexibility
– Cash withdrawals are permitted
– Policies receive favorable tax treatment
• Limitations include:
– Insurers advertise misleading rates of return
– Cash-value and premium-payment projections
can be misleading and invalid
– Insurers can increase the mortality charge
– A policy may lapse because some policyholders
do not have a firm commitment to pay
premiums
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11-32
Variations of Whole Life Insurance
(Continued)
• Indexed universal life insurance is a
variation of universal life insurance with
certain key characteristics:
– There is a minimum interest rate guarantee
– Additional interest may be credited to the policy
based on investment gains of a specific stock
market index
– The amount credited is based on a formula
which is usually capped

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11-33
Variations of Whole Life Insurance
(Continued)
• Variable universal life insurance is an
important variation of whole life insurance
– Most are sold as investments or tax shelters
– The policyholder decides how the premiums are
invested
– The policy does not guarantee a minimum interest
rate or minimum cash value
– These policies have relatively high expense
charges, including front-end loads for sales
commissions, back-end surrender charges, and
investment management fees
– The policyholder bears substantial investment risk

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11-34
Variations of Whole Life Insurance
(Continued)
• Current assumption whole life insurance is a
nonparticipating whole life policy in which the
cash values are based on the insurer’s
current mortality, investment, and expense
experience
– A nonparticipating policy does not pay dividends
– An accumulation account reflects the cash value
under the policy
– If the policy is surrendered, a surrender charge is
deducted from the accumulation account
– A guaranteed interest rate and current interest
rate are used to determine cash values
– A fixed death benefit and maximum premium level
at the time of issue are stated in the policy
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11-35
Variations of Whole Life Insurance
(Continued)

• There are two forms of current assumption

whole life products:
– Low-premium products, with a low initial
premium and a redetermination provision that
allows the insurer to recalculate the premium
after the initial guaranteed period expires
– High-premium products, with a provision that
allows the policyholder to discontinue paying
premiums after a certain time period.

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Exhibit 11.6 Comparison of Individual Life
Insurance Policies

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Other Types of Life Insurance

• A modified life policy is a whole life policy

in which premiums are lower for the first
three to five years and higher thereafter
– One advantage is that applicants can purchase
permanent insurance immediately even though
they cannot afford the higher premiums for a
regular whole life policy
• Preferred risk policies are sold at lower
rates to individuals whose mortality
experience is expected to be lower than
average (e.g., a nonsmoker)

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Other Types of Life Insurance
(Continued)
• Joint life insurance is a policy written on
the lives of two or more people and is
payable at the time of death of the first
person to die
• Second-to-Die life insurance insures two or
more lives and pays the death benefit upon
the death of the second or last insured
– The insurance is usually whole life, but it can be
term
– This form of life insurance is widely used in
estate planning

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11-39
Other Types of Life Insurance
(Continued)
• Savings Bank Life Insurance (SBLI) is a type
of life insurance that is sold by savings banks
• Industrial life insurance is a type of insurance
in which the policies are sold in small
amounts and an agent of the company
collects the premiums at the insured’s home
• Group life insurance provides life insurance
on a group of people in a single master
contract

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