BBMF2083 INSURANCE MANAGEMENT

CHAPTER 5 UNDERSTAND LIFE INSURANCE POLICY CONTRACTS (ANSWERS)

1. ASW:

a) Term insurance is appropriate in 3 situations:

 If the amount of income that can be spent on life insurance is limited, term insurance can
be effectively used. Substantial amounts of life insurance can be purchased for a
relatively modest annual premium outlay.

 Term insurance is appropriate if the need for protection is temporary. E.g. Decreasing
term insurance can be effectively used to pay off the mortgage if the family head dies
prematurely.

 Term insurance can be used to guarantee future insurability. A person may desire large
amounts of permanent insurance, but may be financially unable to purchase the needed
protection today. Inexpensive term insurance can be purchased, which can be converted
later into a permanent insurance policy without evidence of insurability.

b) Renewable: The policy can be renewed for additional periods without evidence of
insurability. The premium is increased at each renewal date & is based on the insured’s
attained age. The purpose of the renewal provision is to protect the insurability of the
insured,

Convertible: The term policy can be exchanged for a cash-value policy without evidence
of insurability.

c) No. Limitations of term insurance:

 Term insurance premiums increase with age at an increasing rate & eventually reach
prohibitive levels. Thus, term insurance is not suitable for individuals who need large
amounts of life insurance beyond age 65 or 70.

 Term insurance is inappropriate if you wish to save money for a specific need. Term
insurance policies do not accumulate cash values. Thus, if you wish to save money for a
child’s college education or accumulate a fund for retirement, term insurance is
inappropriate unless it is supplemented with an investment plan.

2. ASW:

a) Highest: Two-payment life policy

Lowest: 5-year renewable and convertible term policy (renewable until age 65)

b) 5-year renewable and convertible term policy (renewable until age 65)

c)

 Ordinary life policy

 Two-payment life policy

 Life-paid-up-at-age-65 policy

1
3.

a) Which of these policies would best meet the need for protection of Sharon’s son if she should
die prematurely? Discuss.

Because the amount of money available for life insurance is limited, the five-year renewable
and convertible policy should be purchased. A substantial amount of life insurance can be
purchased for a relatively small premium.

b) Which of these policies best meets the need to accumulate a college fund for Sharon’s son?
Discuss.

Universal life insurance can be used to accumulate a college education fund. Universal life
insurance permits cash withdrawals that can be used to pay college expenses.

c) Which of these policies best meets the need to accumulate money for a down payment on a
home? Discuss.

Universal life insurance can be used to accumulate a down payment on a home. Universal life
insurance permits cash withdrawals that can be used for a down payment on a home.

d) What major obstacle does Sharon face if she tries to meet all of her financial needs by
purchasing cash-value life insurance?

The major obstacle is that Sharon may be unable to pay the premiums necessary to meet all
of her financial needs. Because cash value life insurance is more expensive than term
insurance and the amount of income available for life insurance is limited, she may be
substantially underinsured. Thus the amount of cash value life insurance purchased may not
meet all of her financial needs.

e) Assume that Sharon decides to purchase the 5-year term policy in the amount of
RM300,000. The policy has no cash value. Identify a basic characteristic of a typical term
insurance policy that would help Sharon accumulate a fund for retirement.

Term insurance contracts are usually convertible. If the term policy is converted into an
ordinary life or universal life policy, Sharon would be able to accumulate a fund for
retirement.

2
4. Kathy, age 29, is married and has a son, age 3. She owns a RM100,000 ordinary life
insurance policy with a waiver-of-premium provision, guaranteed purchase option and
accelerated death benefits rider. Kathy has several financial goals and objectives for her
family. For each of the following situations, identify an appropriate contractual provision
or policy benefit that will enable Kathy to meet her financial goals. Treat each situation
separately.

a) If Kathy dies, she wants the policy proceeds to be paid in the form of monthly income to
the family until her son attains age 18.

The proceeds could be paid under the fixed period or fixed amount settlement option until
the son attains age 18.
b) Kathy is totally disabled in an auto accident when she failed to stop at a red light. After 6
months, she has not recovered and remains totally disabled. As a result, she cannot return
to her former job or work in any occupation based on her previous training and experience.
She finds that the premium payments for life insurance are financially burdensome.

Premiums would be waived under the waiver-of-premium provision if Kathy satisfies the
definition of disability stated in the policy. In older policies, the first six months of
premiums paid would be refunded.

c) When she retires, Kathy would like to have the cash value in the policy paid to her in the
form of life-time income. She wants the payments to continue for at least 10 years.

The cash value could be placed under the life income option with 10 years of guaranteed
payments. She will receive income for life with at least 10 years of guaranteed payments.

d) Kathy is terminally ill from a serious heart condition. Kathy’s physician believes she will die
within 1 year. Kathy has no savings and health insurance, and her medical bills are soaring.
She needs RM50,000 to pay all medical bills and other financial obligations.

Under the accelerated death benefits rider, part or all of the death proceeds can be paid to
Kathy while she is still alive. She can use the funds to pay her medical bills and other
obligations.

e) 3 years after the policy was issued, Kathy was diagnosed with breast cancer. As a result,
she is now uninsurable. She would like to purchase additional life insurance to protect her
family.

She can exercise the guaranteed purchase option, which allows her to obtain additional life
insurance without evidence of insurability. The first option could be exercised three years
after the policy is purchased.

3
5. Endowment insurance is said to be a combination of two forms of insurance coverage.
Discuss.

ASW:

The ordinary life policy provides for the payment of the amount of the insurance to a
designated beneficiary upon the death of the insured.

The pure endowment reverses the process & pays the amount of the insurance only in the
event that the insured lives a specified term.

The amount of the insurance is paid to the insured himself if he is living at the end of the
period; otherwise, the company pays nothing.

Most endowment policies offered by insurance companies incorporate the features of a

term life insurance policy.

When so written, if the insured dies during the term, the amount of the insurance is payable
to a designated beneficiary. If he is living at the end of the period, he himself receives the
amount.

The usual endowment policy is thus a combination of pure endowment & term insurance.
E.g. In the case of a 10-year endowment policy, if the insured lives to the end of the term,
the face of the policy is paid under the pure endowment feature.

On the other hand, if the insured dies during the endowment term, the term feature of the
contract pays the face of the policy & the pure endowment feature pays nothing.

By combining the 2 features in a single plan, the insured guarantees the accumulation of a
fund over a given period if he lives & also guarantees the payment of a fund to his
beneficiaries if he dies.

6. A 15-year endowment contract with an initial sum assured of RM50,000 is expected to

provide an annual bonus rate of RM20 per thousand sum assured. The annual premium is
RM2,800.

a) Compute the maturity value expected if the terminal bonus rate is 10% of the accumulated
bonuses and the accumulated bonuses are compounded at a rate of 1.758% per annum.

b) Estimate the internal rate of return.

ASW:

a) Sum assured = RM50,000

Accumulated bonuses = RM17,293

Terminal bonus = 0.1 x RM17,293 = RM1,729

TOTAL = RM69,022

b) 5.9%

4
7. Legally and technically, life insurance is not a contract of indemnity. Discuss.

ASW:

While the idea of indemnity is emphasized in writing life insurance, strictly speaking one
cannot say that the contract is one of indemnity. In buying life insurance, an insured
undertakes to compensate his estate, dependents or others to whom he is obligated for the
loss occasioned in the event of his untimely death. However, when settlement is made, the
beneficiaries under the policy are under no obligation to demonstrate, as a condition
precedent to collecting the insurance, a direct pecuniary loss as a result of the decease of
the insured.

Because of the investment element of the policy, a principal sum accrues for the benefit of
the insured, his estate or beneficiary otherwise designated. It is quite possible & frequently
it is the case, that at the time the policy becomes payable because of the death of the
insured, his value as a producer has long since ceased. As a matter of fact, he may have
long been a dependent & a charge upon relatives. These circumstances have no bearing
whatever upon the right of the designated beneficiary to participate fully in the policy in
accordance with its terms.

The life insurance contract, therefore, provides for the payment of a definite sum regardless
of whether the death of the insured is the occasion of a pecuniary loss to the beneficiary. In
fact, quite the contrary may be the case without providing reasons for denying liability on
the policy / settling a claim for an amount less than the policy face. In its essence the
contract of life insurance is an undertaking to pay a certain sum of money on the death of
the insured person, without regard to monetary loss. “This species of insurance.” It has
been held, “in no way resembles a contract of indemnity.”

8. ASW:

a) Traditional net cost method

Total premiums for 20 years (248.60 x 20) RM4,972

(Subtract) Dividends for 20 years (814)
Net premiums for 20 years RM4,158
(Subtract) Cash value at the end of 20 years (4,314)
Insurance cost for 20 years RM156
Net cost per year (-RM156 ÷ 20) (RM7.80)
Net cost per RM1,000 per year [-RM7.80 ÷ (20,000 / 1,000)] (RM0.39)

b) Surrender cost index

Total premiums for 20 years, each accumulated at 5% RM8,631

(Subtract) Dividends for 20 years, each accumulated at 5% (1,163)
Net premiums for 20 years RM7,468
(Subtract) Cash value at the end of 20 years (4,314)
Insurance cost for 20 years RM3,154
Amount to which RM1 deposited annually at the beginning of each year will RM34.719
accumulate to in 20 years at 5%
Interest-adjusted cost per year (RM3,154 ÷ RM34.719) RM90.84
Cost per RM1,000 per year [RM90.84 ÷ (20,000 / 1,000)] RM4.54

5
c) Net payment cost index

Total premiums for 20 years, each accumulated at 5% RM8,631

(Subtract) Dividends for 20 years, each accumulated at 5% (1,163)
Insurance cost for 20 years RM7,468
Amount to which RM1 deposited annually at the beginning of each year RM34.719
will accumulate to in 20 years at 5%
Interest-adjusted cost per year (RM7,468 ÷ RM34.719) RM215.10
Cost per RM1,000 per year [RM215.10 ÷ (20,000 / 1,000)] RM10.76

9. ASW:

a) Traditional net cost method

Total premiums for 20 years (2,280 x 20) RM45,600

(Subtract) Dividends for 20 years (15,624)
Net premiums for 20 years RM29,976
(Subtract) Cash value at the end of 20 years (35,260)
Insurance cost for 20 years RM5,284
Net cost per year (-RM5,284 ÷ 20) (RM264.20)
Net cost per RM1,000 per year [-RM264.20 ÷ (100,000 / 1,000)] (RM2.64)

b) Surrender cost index

Total premiums for 20 years, each accumulated at 5% RM79,159

(Subtract) Dividends for 20 years, each accumulated at 5% (24,400)
Net premiums for 20 years RM54,759
(Subtract) Cash value at the end of 20 years (35,260)
Insurance cost for 20 years RM19,499
Amount to which RM1 deposited annually at the beginning of each year RM34.719
will accumulate to in 20 years at 5%
Interest-adjusted cost per year (RM19,499 ÷ RM34.719) RM561.62
Cost per RM1,000 per year [RM561.62 ÷ (100,000 / 1,000)] RM5.62

c) Net payment cost index

Total premiums for 20 years, each accumulated at 5% RM79,159

(Subtract) Dividends for 20 years, each accumulated at 5% (24,400)
Insurance cost for 20 years RM54,759
Amount to which RM1 deposited annually at the beginning of each year RM34.719
will accumulate to in 20 years at 5%
Interest-adjusted cost per year (RM54,759 ÷ RM34.719) RM1,577.21
Cost per RM1,000 per year [RM1,577.21 ÷ (100,000 / 1,000)] RM15.77

6
10. ASW:

a) Net single premium

Age Amount of Probability of PV of RM1 at 5.5% Cost of

Insurance Death Insurance
30 RM1,000 x 11,173 x 0.9479 = RM1.08 (year 1)
9,800,822
31 RM1,000 x 11,062 x 0.8985 = RM1.01 (year 2)
9,800,822
32 RM1,000 x 11,050 x 0.8516 = RM0.96 (year 3)
9,800,822
33 RM1,000 x 11,233 x 0.8072 = RM0.93 (year 4)
9,800,822
34 RM1,000 x 11,512 x 0.7651 = RM0.90 (year 5)
9,800,822
NSP = RM4.88

b) Net annual level premium

Age 30 RM1 due immediately RM1.00

Age 31 9,789,650 x RM1 x 0.9479 0.95
9,800,822
Age 32 9,778,587 x RM1 x 0.8985 0.90
9,800,822

Age 33 9,767,537 x RM1 x 0.8516 0.85

9,800,822
Age 34 9,756,305 x RM1 x 0.8072 0.81
9,800,822
PVLAD of RM1 RM4.51

NALP = NSP = RM4.88 = RM1.08

PVLAD of RM1 RM4.51

c) No. A loading for expenses must be added to determine the gross premium.