Chapter 5.

Life Insurance
Xiang Fang∗

University of Hong Kong

February, 2024

1 Introduction to Life Insurance

Starting from this chapter, we will discuss various insurance policies. In this chapter, we will
discuss life insurance policies.

1.1 What is Life Insurance and Why to Buy Life Insurance

We start by asking the very basic question: what is life insurance? Life insurance insures against
death — mostly unexpected death. In life insurance policies, the trigger of payment to the bene-
ficiary is the death of the insured.
Why do people want to buy life insurance? Everyone dies, so death is unavoidable. We know
that unavoidable risks are usually not covered by insurance policies, such as normal wear and tear.
It is true that death is unavoidable, premature death is not. Buying life insurance is protecting
the unexpected or premature death of the uninsured.

Example. Mr Chan is a 38-year-old successful lawyer in Hong Kong. His annual income is
5,000,000 HKD. His wife does not have a full-time paid job and he has two kids, a 4-year-old son
and a 1-year-old daughter.
If Paul buys a life insurance, he is protecting his family against his unexpected or premature
death. If he dies unexpectedly, his wife may not be able to support herself and the two kids at
the current standard of living. His kids are still very young and they need money for their future
education. A life insurance will at least pay his wife and kids a substantial amount of money either
to maintain their living standard or prepare for the kids’ future education.
Let’s summarize why people want to buy life insurance? The major reason is that one has
financial obligations. In the example, Paul has financial obligations to his wife and kids. If he
dies, he cannot fulfill his obligations. If someone does not have a partner or any kids, she may
∗
Contact: 818 KK Leung Building, The University of Hong Kong. Email: xiangf@hku.hk. These are notes for
FINA2342 Insurance: Theory and Practice. Comments welcome.

1
need to financially support her old-age parents. Her parents may lose their source of living if she
unexpectedly dies. She has financial obligations to her parents.
The financial obligations do not have to be with family members. If someone buys an apartment
with a mortgage, the owner may worry that if she dies, her family members cannot repay the
mortgage and thus the apartment will be lost. In that case, credit life insurance policies can
promise to repay the remaining unpaid mortgage.
Thanks to the better nutrition conditions and the development of medical conditions, the life
expectancy has increased significantly in the recent decades. How will the life insurance industry
be affected? If the insurers charge actuarial prices, the mortality rate does not matter, as both
the premium level and the claim costs are lower. However, as the probability of death becoming
lower, people may not treat the mortality risk as important a source of risk as before. Or it may
also be that people find mortality easier to manage and purchase more life insurance. It is an open
question how life expectancy change affects the life insurance industry.

1.2 Terminologies in Life Insurance

Before we get to the details of life insurance, I would like to introduce a few terminologies. We
already learned some of them in Chapter 1, such as the insured, policyholder, beneficiary. There
are a few more terminologies that are specific to life insurance.

• Death benefit: the amount of money that the beneficiary receives from the insurer when the
insured dies.

• Death protection: the amount of pure death protection coverage provided by the policy. We
will discuss later the difference between death benefit and death protection.

• Face amount (face value): the stated amount of coverage. However, the actual payment may
differ, which we will discuss later.

• Cash surrender value: the amount of money that the policyholder can withdraw if they
terminate the policy.

In general, there are two types of life insurance: term insurance and cash-value insurance.
Term life insurance provides temporary protection, whereas cash-value life insurance has a savings
component and builds cash values. In the next two sections, we introduce these two types of
insurance and their numerous variations.

1.3 Overview of Life Insurance Industry

The life insurance industry is an enormous industry. The following figure shows the basic statistics
of life insurance industry in the US in 2018. In the US, term life and whole life are similar in
number of policies and term life dominates whole life in the face amount.
Things look quite different in Hong Kong. In Hong Kong, whole life policies are much larger
than term life both in terms of number of policies and premium. If you want to know more about
the statistics about Hong Kong life insurance industry, check this website.

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 Figure 1: Basic statistics of life insurance in US

Table 7.2
Individual Life Insurance Purchases in the United States, by Plan Type, 2018
Policies in thousands/Amounts in millions
Policies Percent Face amount Percent

Term insurance
Decreasing 262 2.6 $5,404 0.3
Level 3,727 37.5 1,129,917 66.9
Decreasing other term1 NA NA 3,781 0.2
Level other term2 NA NA 70,795 4.2
Term additions NA NA 1,422 0.1
Total 3,990 40.2 1,211,320 71.8
Whole life and endowment 5,941 59.8 476,601 28.2
Aggregate total 9,931 100.0 1,687,921 100.0
Source: ACLI tabulations of National Association of Insurance Commissioners (NAIC) data, used by permission.
Notes: NAIC does not endorse any analysis or conclusions based on use of its data. Data represent U.S. life insurers; data for fraternal benefit societies
not included.
NA: Not available
1
Includes decreasing term insurance on spouses and children under family policies.
2
Includes level term insurance on spouses and children under family policies.

Table 7.3
Life Insurance Purchases, by Participating Status
Individual Group Credit Total
Face Face Face Face
amount amount amount amount
(millions) Percent (millions) Percent (millions) Percent (millions) Percent
2008
Nonparticipating $1,456,909 79.1 $1,027,759 95.8 $86,880 83.2 $2,571,548 85.2
Participating 384,756 20.9 45,514 4.2 17,603 16.8 447,873 14.8
Total 1,841,665 100.0 1,073,273 100.0 104,483 100.0 3,019,421 100.0
2017
Nonparticipating 1,173,763 70.1 1,236,592 94.0 49,002 97.4 2,459,357 80.9
Participating 499,731 29.9 79,058 6.0 1,301 2.6 580,090 19.1
Total 1,673,494 100.0 1,315,651 100.0 50,303 100.0 3,039,447 100.0
2018
Nonparticipating 1,196,400 70.9 1,163,579 93.5 47,025 97.5 2,407,004 80.8
Participating 491,540 29.1 80,750 6.5 1,227 2.5 573,517 19.2
Total 1,687,940 100.0 1,244,329 100.0 48,252 100.0 2,980,521 100.0
Source: ACLI tabulations of National Association of Insurance Commissioners (NAIC) data, used by permission.
Notes: NAIC does not endorse any analysis or conclusions based on use of its data. Data represent U.S. life insurers; data for fraternal benefit societies
not included.

68 American Council of Life Insurers

Source: US Life Insurance Factbook 2019.

3
 Figure 2: Basic statistics of life insurance in Hong Kong

長期保險業務
Long Term Insurance Business
表 L1 個人人壽業務
Table L1 Individual Life Business

表 L1a 有效個人人壽業務
Table L1a Individual Life In-Force Business
保單數目 保單保費
Number of Policies Office Premiums
保險種類
Type of Insurance 2015 2016 2017 2018 2019 2015 2016 2017 2018 2019
百萬元 百萬元 百萬元 百萬元 百萬元
$m $m $m $m $m
非投資相連:
Non-Linked:
終身
Whole Life 5,926,409 6,545,821 7,031,608 7,718,390 8,251,645 143,356.2 193,824.4 223,752.9 261,375.2 306,295.9
儲蓄
Endowment 1,164,031 1,205,652 1,109,798 936,257 907,580 43,135.9 68,443.6 65,200.0 39,217.5 50,954.1
定期
Term 894,707 845,041 810,848 839,071 894,947 4,840.0 4,103.9 4,026.8 4,418.4 4,834.2
其他
Others 1,828,868 1,890,584 2,225,360 2,377,800 1,915,068 59,174.2 70,735.1 74,197.4 72,463.7 37,165.2
9,814,015 10,487,098 11,177,614 11,871,518 11,969,240 250,506.3 337,107.0 367,177.1 377,474.8 399,249.4

投資相連:
Linked: 1,547,176 1,463,308 1,371,740 1,316,682 1,259,856 58,782.2 47,529.0 47,873.1 48,868.8 40,993.5

總數
Total 11,361,191 11,950,406 12,549,354 13,188,200 13,229,096 309,288.5 384,636.0 415,050.2 426,343.6 440,242.9
保額 淨負債
Sums Assured Net Liabilities
保險種類
Type of Insurance 2015 2016 2017 2018 2019 2015 2016 2017 2018 2019
百萬元 百萬元 百萬元 百萬元 百萬元 百萬元 百萬元 百萬元 百萬元 百萬元
$m $m $m $m $m $m $m $m $m $m
非投資相連:
Non-Linked:
終身
Whole Life 2,969,527.9 3,467,947.7 3,990,398.6 4,699,036.7 5,410,178.9 573,763.2 699,434.3 886,127.7 978,826.4 1,341,165.2
儲蓄
Endowment 293,580.3 357,820.3 384,056.6 353,164.1 368,992.1 228,661.4 259,587.4 294,763.0 287,212.5 307,221.2
定期
Term 386,582.8 359,450.3 382,163.7 412,842.6 449,591.4 13,807.7 7,928.7 8,607.0 9,404.8 10,019.2
其他
Others 692,215.8 845,692.8 1,086,364.5 1,267,902.6 985,218.2 240,162.3 279,919.2 329,120.2 382,686.7 134,345.9
- - - - - 9,470.0* 15,187.5* 17,962.8* 17,853.5* 23,433.7*
4,341,906.8 5,030,911.1 5,842,983.4 6,732,946.0 7,213,980.6 1,065,864.6 1,262,057.1 1,536,580.7 1,675,983.9 1,816,185.2

投資相連: 不適用 不適用 不適用 不適用 不適用

Linked: N.A. N.A. N.A. N.A. N.A. 226,959.6 269,530.1 313,213.6 271,738.7 303,987.4
- - - - - 133.7* 184.3* 103.8* 101.6* 91.7*
- - - - - 227,093.3 269,714.4 313,317.4 271,840.3 304,079.1

總數
Total 4,341,906.8 5,030,911.1 5,842,983.4 6,732,946.0 7,213,980.6 1,292,957.9 1,531,771.5 1,849,898.1 1,947,824.2 2,120,264.3
* 愛滋病及其他額外儲備。
* AIDS and other additional reserves.

表 L1b 新造個人人壽業務
Table L1b Individual Life New Business
保單數目 保單保費
Number of Policies Office Premiums
保險種類
Type of Insurance 2015 2016 2017 2018 2019 2015 2016 2017 2018 2019
百萬元 百萬元 百萬元 百萬元 百萬元
$m $m $m $m $m
非投資相連:
Non-Linked:
終身
Whole Life 673,363 807,268 828,053 830,572 744,901 71,583.3 100,230.5 92,537.8 92,918.4 102,949.2
儲蓄
Endowment 106,567 118,560 68,241 65,768 97,785 21,361.9 41,628.8 17,356.7 15,982.9 28,055.6
定期
Term 166,915 149,705 127,826 121,380 156,501 652.9 614.3 522.9 521.3 727.3
其他
Others 197,199 177,172 213,209 225,284 292,337 24,208.5 30,899.6 27,498.2 23,771.6 7,689.4
1,144,044 1,252,705 1,237,329 1,243,004 1,291,524 117,806.6 173,373.2 137,915.6 133,194.2 139,421.5

投資相連:
Linked: 24,079 14,855 33,739 46,812 28,672 10,303.3 5,704.7 12,730.2 17,406.8 11,758.8

總數
Total 1,168,123 1,267,560 1,271,068 1,289,816 1,320,196 128,109.9 179,077.9 150,645.8 150,601.0 151,180.3

4
2 Term Life Insurance

2.1 Term Life Insurance

The term insurance has a temporary period of protection, such as 1, 5, 10, 20, or 30 years.
Policyholder pays premium upfront. If the insured dies within the covered period, the beneficiary
gets the death benefit. Otherwise, the beneficiary gets nothing. Most term insurance policies are
renewable — the policies can be renewed for additional periods without evidence of insurability
and the premium is increased at each renewal date based on the age. Most renewable term policies
also allow the policyholder to covert to a cash-value policy with no evidence of insurability.
There are a wide variety of term insurance products sold today. They include: yearly renew-
able term, 5-, 10-, 15-, 20-, 25-, 30-year term, term to age 65, decreasing term, reentry term,
return of premium term insurance. The Rejda and McNamara textbook (Chapter 11) provides an
introduction to each variety, which we will not detail here.

The uses and limitations of term life. Term life is a pure protection against mortality risk.
It has no cash value. It is a good option especially when the resource is limited as the level of
premium is low. The option of renewal and convertibility provides additional benefits of future
insurability.
The uses of term life are also its limitations: term life has no saving function. If one wants to
save money for a specific need in the future, such as for kids’ education, term life is not the right
product. Moreover, the premium level can increase sharply with age.

Endowment life insurance. Endowment life insurance is similar with term insurance except
that the policy pays the face amount of the policy if the insured survives the policy term. Its
relative importance has declined in recent years.

2.2 The Mortality Table (Life Table)

We next study a very important tool used in life insurance, the mortality table (life table).
The most important parameter in insurance policies is the probability of death. The death
benefit is usually specified by the buyer, and the insurer can only figure out the expected payment
to the beneciary if knowing the death probability. Luckily, the death probability of people in each
age is relatively stable and is made into a table, called the “mortality table.”
The figure below is the 2014 Hong Kong life table for males. The most relevant columns are
columns 1-5. Column 1 is the age. Column 3 is the number of survivors at exact age x (suppose
there are 1 million people born at age 0). Column 4 displays the number of deaths in each age.
Column 2 is the ratio of column 4 and column 3, i.e., among the number of survivors (in column
3), what is the fraction of people that die in this year? Column 2 is the probability of death in
a single year at each age. Next, we study how to compute the probability of death over several
years, given the life table?
Let us look at an example, the probability of death in the next 3 years for a male of age 35.
We proceed from the total number of people (per 1 million newly born babies) at age 35, 990,192.

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 Figure 3: Hong Kong Mortality Table 2014, Male

人口生命表 Life Tables

表 2 2014 年香港男性人口生命表
Table 2 Hong Kong life table for males, 2014
確切年齡 確切年齡 確切年齡
x 歲和 x+1 歲之間的 確切年齡 x 歲的 x 歲和 x+1 歲之間的 x 歲和 x+1 歲之間的 確切年齡 x 歲以上 確切年齡 x 歲的
年齡 死亡概率 尚存人數 死亡人數 生存人年 總生存人年 平均預期壽命
Age Probability Number of Number of deaths Number of Total person-years Expectation
of dying survivors between exact person-years lived lived after of life
between exact at exact age x age x and age x+1 between exact exact age x at exact age x
age x and age x+1 age x and age x+1
x q(x) l(x) d(x) L(x) T(x) e(x)

0 0.00137916 1 000 000 1 379 998 809 81 160 693 81.16

1 0.00020509 998 621 205 998 519 80 161 884 80.27
2 0.00017421 998 416 174 998 329 79 163 365 79.29
3 0.00014693 998 242 147 998 169 78 165 036 78.30
4 0.00012326 998 095 123 998 034 77 166 867 77.31
5 0.00010328 997 972 103 997 921 76 168 833 76.32
6 0.00008714 997 869 87 997 826 75 170 912 75.33
7 0.00007488 997 782 75 997 745 74 173 086 74.34
8 0.00006692 997 707 67 997 674 73 175 341 73.34
9 0.00006369 997 640 64 997 608 72 177 667 72.35
10 0.00006558 997 576 65 997 544 71 180 059 71.35
11 0.00007282 997 511 73 997 475 70 182 515 70.36
12 0.00008536 997 438 85 997 396 69 185 040 69.36
13 0.00010253 997 353 102 997 302 68 187 644 68.37
14 0.00012326 997 251 123 997 190 67 190 342 67.38
15 0.00014581 997 128 145 997 056 66 193 152 66.38
16 0.00016870 996 983 168 996 899 65 196 096 65.39
17 0.00019067 996 815 190 996 720 64 199 197 64.40
18 0.00021093 996 625 210 996 520 63 202 477 63.42
19 0.00022920 996 415 228 996 301 62 205 957 62.43
20 0.00024545 996 187 245 996 065 61 209 656 61.44
21 0.00026048 995 942 259 995 813 60 213 591 60.46
22 0.00027593 995 683 275 995 546 59 217 778 59.47
23 0.00029244 995 408 291 995 263 58 222 232 58.49
24 0.00031060 995 117 309 994 963 57 226 969 57.51
25 0.00033001 994 808 328 994 644 56 232 006 56.53
26 0.00035057 994 480 349 994 306 55 237 362 55.54
27 0.00037254 994 131 370 993 946 54 243 056 54.56
28 0.00039689 993 761 394 993 564 53 249 110 53.58
29 0.00042483 993 367 422 993 156 52 255 546 52.60
30 0.00045833 992 945 455 992 718 51 262 390 51.63
31 0.00049877 992 490 495 992 243 50 269 672 50.65
32 0.00054691 991 995 543 991 724 49 277 429 49.68
33 0.00060328 991 452 598 991 153 48 285 705 48.70
34 0.00066783 990 854 662 990 523 47 294 552 47.73
35 0.00073943 990 192 732 989 826 46 304 029 46.76
36 0.00081673 989 460 808 989 056 45 314 203 45.80
37 0.00089815 988 652 888 988 208 44 325 147 44.83
38 0.00098341 987 764 971 987 279 43 336 939 43.87
39 0.00107265 986 793 1 058 986 264 42 349 660 42.92
40 0.00116510 985 735 1 148 985 161 41 363 396 41.96
41 0.00126134 984 587 1 242 983 966 40 378 235 41.01
42 0.00136333 983 345 1 341 982 675 39 394 269 40.06
43 0.00147276 982 004 1 446 981 281 38 411 594 39.12
44 0.00159162 980 558 1 561 979 778 37 430 313 38.17
45 0.00171720 978 997 1 681 978 157 36 450 535 37.23
46 0.00184971 977 316 1 808 976 412 35 472 378 36.30
47 0.00199225 975 508 1 943 974 537 34 495 966 35.36
48 0.00215004 973 565 2 093 972 519 33 521 429 34.43
49 0.00232959 971 472 2 263 970 341 32 548 910 33.50

香港人口生命表 2014–2069 10 Hong Kong Life Tables 2014–2069

6
 Figure 4: Hong Kong Mortality Table 2014, Male, cont’ed

人口生命表 Life Tables

表 2 （續） 2014 年香港男性人口生命表

Table 2 (Cont’d) Hong Kong life table for males, 2014
確切年齡 確切年齡 確切年齡
x 歲和 x+1 歲之間的 確切年齡 x 歲的 x 歲和 x+1 歲之間的 x 歲和 x+1 歲之間的 確切年齡 x 歲以上 確切年齡 x 歲的
年齡 死亡概率 尚存人數 死亡人數 生存人年 總生存人年 平均預期壽命
Age Probability Number of Number of deaths Number of Total person-years Expectation
of dying survivors between exact person-years lived lived after of life
between exact at exact age x age x and age x+1 between exact exact age x at exact age x
age x and age x+1 age x and age x+1
x q(x) l(x) d(x) L(x) T(x) e(x)

50 0.00253948 969 209 2 461 967 979 31 578 569 32.58

51 0.00278633 966 748 2 694 965 401 30 610 590 31.66
52 0.00307482 964 054 2 964 962 572 29 645 189 30.75
53 0.00340926 961 090 3 277 959 452 28 682 617 29.84
54 0.00379158 957 813 3 632 955 997 27 723 165 28.94
55 0.00422111 954 181 4 028 952 167 26 767 168 28.05
56 0.00469416 950 153 4 460 947 923 25 815 001 27.17
57 0.00520404 945 693 4 921 943 233 24 867 078 26.30
58 0.00574930 940 772 5 409 938 068 23 923 845 25.43
59 0.00632921 935 363 5 920 932 403 22 985 777 24.57
60 0.00691105 929 443 6 423 926 232 22 053 374 23.73
61 0.00748580 923 020 6 910 919 565 21 127 142 22.89
62 0.00806801 916 110 7 391 912 415 20 207 577 22.06
63 0.00868319 908 719 7 891 904 774 19 295 162 21.23
64 0.00936916 900 828 8 440 896 608 18 390 388 20.41
65 0.01018436 892 388 9 088 887 844 17 493 780 19.60
66 0.01117747 883 300 9 873 878 364 16 605 936 18.80
67 0.01238736 873 427 10 819 868 018 15 727 572 18.01
68 0.01384035 862 608 11 939 856 639 14 859 554 17.23
69 0.01554486 850 669 13 224 844 057 14 002 915 16.46
70 0.01743055 837 445 14 597 830 147 13 158 858 15.71
71 0.01944873 822 848 16 003 814 847 12 328 711 14.98
72 0.02157218 806 845 17 405 798 143 11 513 864 14.27
73 0.02383313 789 440 18 815 780 033 10 715 721 13.57
74 0.02629252 770 625 20 262 760 494 9 935 688 12.89
75 0.02903787 750 363 21 789 739 469 9 175 194 12.23
76 0.03215474 728 574 23 427 716 861 8 435 725 11.58
77 0.03571500 705 147 25 184 692 555 7 718 864 10.95
78 0.03978512 679 963 27 052 666 437 7 026 309 10.33
79 0.04440614 652 911 28 993 638 415 6 359 872 9.74
80 0.04959361 623 918 30 942 608 447 5 721 457 9.17
81 0.05535432 592 976 32 824 576 564 5 113 010 8.62
82 0.06168350 560 152 34 552 542 876 4 536 446 8.10
83 0.06856975 525 600 36 040 507 580 3 993 570 7.60
84 0.07600078 489 560 37 207 470 957 3 485 990 7.12
85 0.08414048 452 353 38 061 433 323 3 015 033 6.67
86 0.09304203 414 292 38 547 395 019 2 581 710 6.23
87 0.10276034 375 745 38 612 356 439 2 186 691 5.82
88 0.11335172 337 133 38 215 318 026 1 830 252 5.43
89 0.12487347 298 918 37 327 280 255 1 512 226 5.06
90 0.13738334 261 591 35 938 243 622 1 231 971 4.71
91 0.15093897 225 653 34 060 208 623 988 349 4.38
92 0.16559718 191 593 31 727 175 730 779 726 4.07
93 0.18141322 159 866 29 002 145 365 603 996 3.78
94 0.19843985 130 864 25 969 117 880 458 631 3.50
95 0.21672643 104 895 22 734 93 528 340 751 3.25
96 0.23631787 82 161 19 416 72 453 247 223 3.01
97 0.25725355 62 745 16 141 54 675 174 770 2.79
98 0.27956617 46 604 13 029 40 090 120 095 2.58
99 0.30328064 33 575 10 183 28 484 80 005 2.38
（註釋 Note）
100+ 1.00000000 23 392 23 392 51 521 51 521 2.20

註釋： 這數字是指 100 歲的平均預期壽命。 Note : This figure refers to the expectation of life at age 100.

香港人口生命表 2014–2069 11 Hong Kong Life Tables 2014–2069

7
Over the next three years (from age 35 to 38), in total there are 732 + 808 + 888 = 2, 428 deaths.
2,428
Therefore, the probability of death over the next three years is 990,192 = 0.00245. The probability
of surviving the next three years is 1 − 0.00245 = 0.99755.
The following formula is useful for us to understand the mortality table.

P r(A) = P r(A|B) × P r(B) + P r(A|not B) × P r(not B)

The probability of event A can be decomposed into the weighted average of the two conditional
probabilities on whether event B happens. To be concrete, let A be the probability of a 35-year-
old to die between 36 and 37, B the probability of a 35-year-old to survive until 36. What the
mortality table shows about death probability between 36 and 37 is P r(A|B), the probability of
death between 36 and 37 conditional on the person survives age 36. The probability of the
person surviving age 36 P r(B) is shown in the mortality table as 1 minus the death probability
between 35 and 35. Note that P r(A|not B) = 0, as not B indicates the person dies between 35
and 36, he cannot die again between 36 and 37.
Therefore, the probability of a 35-year-old to die between 36 and 37 is equal to the product
of (1 − p35 )p36 , where p35 and p36 are probabilities of death at age 35 and 36 shown in mortality
tables.
Alternatively, if we only have information given in column 2, the probability of death in each
year, how can we calculate the probability of death in the next three years? There are three
possibilities if a person dies in the next three years: die between 35 and 36, between 36 and 37,
and between 37 and 38. So, what are their probabilities, respectively?

• The probability of death between 35 and 36: 0.00073943.

• The probability of death between 36 and 37. First, the person needs to survive until 36
(not die at 35); second, the person dies at 36. The probability of death at 36 is equal to
808
(1 − 0.00073943) × 0.00081673 = 0.000816. You can check this is equal to 990,192 .

• The probability of death between 37 and 38. It is equal to the probability of surviving until
37 and death at 38, i.e., (1 − 0.00073943) × (1 − 0.00081673) × 0.00089815 = 0.00089680.
888
Again, you can check this is equal to 990,192 .

The sum of the three probabilities, 0.00073943 + 0.000816 + 0.00089680 = 0.00245. Note that the
probability of death over the next three years does not equal to the sum of the death probability in
the subsequent three years — death at 36 first requires survival through the age 35, so the death
rate at age 36 should be multiplied by the probability of survival through 35.

Exercise: Consider a Hong Kong male of age 40. Compute the probability of this person to die
between 40 and 41, between 42 and 43.

Answer: The probability of death between 40 and 41 is 0.00116510. The probability of death
between 42 and 43 is (1 − 0.00116510) × (1 − 0.00126134) × 0.00136333 = 0.00136002.

8
2.3 Term Life Pricing
Next, we discuss term life pricing. For now, we abstract away all premium loadings and only
consider the actuarial pricing. We start with the simplest case, the one-year life policy.

One-year term life. Consider a policy of $100,000 coverage for a 35-year-old Hong Kong male.
Discount rate is 5%. The expected claim cost is 100, 000 × 0.00073943 = 73.943. The present value
is 73.943
1+5%
= 70.42. We assume that the premium is paid at the beginning of the year, and the death
benefit is paid at the end of the year.

Two-year term life. We next consider a slightly complicated case, a policy of $100,000 coverage
that covers two years. The expected claim cost in the first year is 73.943, the expected claim cost
in the second year is 81.600. The present value of expected claim cost is 73.943
1+5%
81.6
+ (1+5%) 2 = 144.44.

Again, we highlight here that the probability for this person to die between 36 and 37 is
0.000816, instead of 0.00081673.

Two payments. In previous cases, we assume all premiums are paid in a single time. In most
cases, premiums can be collected over several years. For the two-year term life policy, suppose the
premium is paid at the beginning of the first and second year, in the same amount. Let it be P ,
it should satisfy:
(1 − 0.00073943)P
P+ = 144.44.
1 + 5%
We solve for P = 73.783. Note that only those who survive the first year need to make the second
payment, so the payment in the second year needs to be multiplied by the fraction of buyers that
survive the first year.

Summary. The pricing of term life insurance mainly involves specifying the probability of death
from the mortality table and calculate the present value. Reminder:

• When you calculate the death probability in the second year, remember that you should not
directly use the number of death rate in the mortality table. Rather, you should consider
the probability of survival until that age.

• If there are multiple payments, you should remember that only the survived make the pay-
ments.

3 Whole Life Insurance

Different from the term life policies that only cover death for a given period, whole life insurance
covers the death of the insured for the whole life. “Whole life insurance” is used as a generic name
for a cash value policy that provides lifetime protection, and we will discuss the traditional whole
life insurance as well as many of its variants in this section.

9
 There are several basic types of whole life insurance. Ordinary life insurance policies have
their premiums payable throughout the lifetime of the insured, and limited payment life in-
surance policies have premium paid over a period. A stated amount (face value) is paid to a
designated beneficiary when the insured dies.
Everyone dies, so anyway the beneficiary will someday get the payment from the insurer. This
defines the long-term nature of whole life policies. Intuitively, the whole life policy is like a saving
instrument with am unknown maturity — when the insured dies. As we have studied, money has
its time value and the whole life policy has cash value accumulation. You might think whole life
policies are similar to a deposit account — buyers of the whole life policies simply give their money
to the insurer and interest accrues as time goes. Whenever the insured dies, the beneficiary gets
repaid. This is not true — if so, why is it an insurance?
The fallacy of the reasoning is that it ignores whole life policies’ protection function. In the
pool of buyers, a certain fraction will sadly experience unmature death. The basic function of
insurance is risk pooling — all buyers contribute their portion to support those who suffer a loss.
In this case, the logic is the same. A fraction of the premium paid by every buyer goes to the
deceased buyer.

3.1 The Cash Value Accumulation

In this section, we use an example to illustrate how cash value accumulates for a whole life policy.
We consider a very simple environment, where we assume zero premium loading and the interest
rate is constant. The pool of buyers is large enough that the law of large numbers holds.

Example. Suppose a pool of 10,000 30-year Hong Kong male purchase a whole life insurance
with face value 1 million HKD, which means whenever the insured dies, the beneficiary will get
1 million HKD from the insurer. Suppose the single premium level is 60,000 HKD. Assume the
interest rate is 5%.
After a year, according to the mortality table, the probability of death in the first year is
0.00046 so there are 4.6 buyers that die in the year. The insurer needs to pay 4.6 million HKD.
This amount is burdened by all buyers. The burden on each buyer is

(1, 000, 000 − 60, 000) × 4.6/(10, 000 − 4.6) = 432.60

Among the 4.6 million HKD payment to the beneficiaries, 60, 000 × 4.6 comes from these deceased
policyholders’ premium payment. The remaining part needs to be shared by the survived 10, 000 −
4.6 policyholders.
After a year, the cash value of each remaining buyer’s policy is (60, 000 − 432.60) × (1 + 5%) =
62, 548 HKD. Here we are assuming that the mortality cost does not earn interest and is provisioned
at the start of the year.
Now let’s try to understand what the cash value means. As the whole life insurance protects
against death for the remaining life of the buyer, the premium can be divided into two parts: one
part covers the expected mortality cost in the coming year, and the other covers the mortality cost
in the future that does not realize in the year and earns interest. The second part is called the
“cash value.” In the above example, the 432.6 HKD is the mortality cost in the first year.

10
 We display the formula for the cash value accumulation with slight generalization, which allows
for multiple premium payment. Note that only if the insured is alive, the premium needs to be
paid.

Cash valuet = Cash valuet−1 + Premiumt − Mortality costt + Interest creditedt

The cash value of a life policy equals the cash value in the last period, plus the newly paid premium
and accrued interest, net of the expected mortality cost.

3.2 Death Benefits and Death Protection

In this section, we are going to introduce two related but different concepts: death benefits and
death protection. We start with understanding the dual functions of whole life insurance: death
protection and saving.
As we show in the previous example, the 30-year-old policyholder’s premium contribution is
divided into two parts: death protection (432.6 HKD) and saving (the remaining). The 432.6 HKD
is the actuarial price for a one-year death coverage while the remaining is equivalent to a saving
instrument.
The death benefit is equal to the amount that the beneficiary will get upon the death of the
insured. In a traditional whole life policy, the death benefit is equal to the policy’s face value. In
some variations of whole life policies, the death benefit can vary and exceed the policy’s face value,
as we will discuss later.
The death protection is defined as the difference between the face value and the cash value.
The Rejda and McNamara textbook also calls it “the amount at risk.” Use the above example as an
illustration (assume premium loading is zero). In the inception of the policy, the death protection
is equal to the death benefit of 1 million HKD as cash value has not started to accumulate. After
one year, the cash value accumulates as (62,548), after the deduction of the expected mortality cost
in the first year. Suppose the insured dies in the second year, the insurer returns the cash value
of 62,548 to the beneficiary, plus an additional amount of 1, 000, 000 − 62, 548 = 937, 452 HKD.
The additional amount is called the “death protection,” as this part is the actual payment that is
financed by everyone in the pool. In the next year, another (10, 000−4.6)×0.00050 = 5 buyers will
die. The remaining 937, 452 × 5 HKD is shared by all 10, 000 − 4.6 = 9995.4 people. Each person’s
expected mortality cost is (1,000,000−62,548)×5
(9995.4−5)
= 469.18 HKD. For those policyholders that survive the
next year, at the end of the year, their cash value grows to (62, 548 − 469.18) × (1 + 5%) = 65, 183.
In Exercise 1, you are asked to calculate the cash value of the policy if the premium of 60,000
is paid in three consecutive years when the insured is 30, 31, and 32, 20,000 paid in each year.
The figure below shows a typical pattern of the cash value and death protection for a given
face amount of the policy. In the early life of the policy, cash value is low and the death protection
is large. That means in the early life of the policy, most of the claim cost at the death of the
insured needs to be financed from all policyholders in the same pool. As time goes and the cash
value accumulated, the amount of death protection declines as a larger fraction of the death benefit
comes out of the cash value. 1
1
This figure is taken from Harrington and Niehaus, Chapter 15.

11
 Figure 5: Cash value and death protection

3.3 Front-end Premium Loading

There is an important part that is missing in the cash value accumulation above, the premium
loading. This section will include the premium loading charge and illustrate an important feature
of whole life insurance policies’ cash value: the front-ended premium loading.
As we have illustrated in chapter 4, insurers incur administrative cost and profit loadings, which
are charged on the buyers of policies. We amend the formula to include premium loading as

Cash valuet = Cash valuet−1 +Premiumt −Mortality costt +Interest creditedt −Premium loadingt .

Typically, the insurance premiums are front-end-loaded. Front-end-loaded premium means that
the insured is overcharged during the early years. In the previous example, the mortality cost
for the age 30 is 432.6 per buyer. Suppose the total expense related to the policy is 5,000. The
insurer may deduct 2,000 in that year, which exceeds the mortality cost plus the average expense
(for a 10-year holding period). In later years , the premium loading will decline and the amount
deducted from the cash value can be even less than the mortality cost.
At any moment, the policyholder can choose to surrender the policy. We call the amount
paid to a policyholder who surrenders the policy the cash-surrender value. With the premium
front-end-loaded, policyholders are incentivized not to surrender the policy in its early life (say,
within 5 years). If a policyholder surrenders the policy early, she will be overcharged.

A frequently asked question. You may wonder whether the mortality cost and expenses need
to be deducted before or after calculating interest. Both are ok depending on the assumption. If
we assume that the mortality cost and expenses are paid at the end of the period, they will earn
interest. If we assume the mortality cost and expenses are provisional at the beginning of the
year, they need to be deducted and should not earn interest. The reality is certainly somewhere

12
in between. As our calculation is only for conceptual and pedagogical purpose, we do not need to
take a strong stand on which assumption we prefer.
In the answer to exercise 4, you will find that it when calculating the mortality cost in the
first year, it directly uses the face value of the policy multiplying the death probability, without
substracting the premium contributed by the deceased. It is not right when we assume all premium
loadings are zero. But usually, thanks to front-ended premium loading, the first year premium
payments are used to cover expenses, so we make a simpler calculating by directly multiplying
the face value of policy by the death probability. You will find that actually the two ways of
calculating have tiny difference — so we also accept the calculation of the first-year mortality cost
as the product of face value and death probability.

Why do whole life insurance policies have their premiums front-loaded? Straightforwardly, if
the insurer splits the expenses evenly into a long period of time, say, 20 years, it will suffer a loss
if the buyer surrenders it after five years. In that case, the expense (e.g.,underwriting) is incurred
but the insurer only recovers a quarter of the expense. Therefore, front-ended premiums enable
the insurers to recover the expenses in a relative short period of time.
Moreover, as we see, whole life policies are long-term policies in nature. Most buyers will
survive at least 10-20 years after the inception of the policy, so that the insurer can use the
collected premium to make some long-term investment. The insurers use front-loaded premium
to disincentivize policyholders to surrender the policy early. Alternatively, you can understand
the front-end-loaded premium as a surrender charge. Even with front-ended charges, life insurers
typically suffer a loss on new policies written in the first year, known as the “new business loss.” 2

3.3.1 Policy Surrender

Why do policyholders want to surrender their policies? There are several possible reasons. First,
the policyholders lose their bequest motive — they no longer want their beneficiaries to get their
death benefit and decide to stop the premium payment (for term life) or surrender the policy
and receive the cash surrender value (for whole life). Second, there may be income, health, and
liquidity shocks to the policyholders. For example, if the policyholders are in a sudden need of cash,
they may choose to surrender the policy. Studies show that insurers will take into consideration
the possible surrenders and consider surrender charge when they set the premium level. If they
predict that 10% of the buyers will surrender the policy early and they expect to receive 10%
buyers’ surrender charge, competition will drive the insurers to lower the premium level for all
buyers. Essentially, the buyers who surrender the policy are cross-subsidizing those who do not.
2
In the Rejda and McNamara textbook, Chapter 11, pp. 231, it states “The insured is actuarially overcharged
during the early years and undercharged during the later years. The premiums paid during the early years are higher
than is actuarially necessary to pay current death claims, whereas those paid in the later years are inadequate for
paying death claims.” This is different from “front-end-loaded premium” in our context. The textbook statement
refers to the policy that charges a constant premium level over the whole life of the insured. In early years, the
premium exceeds the mortality cost since the death probability is low. In later years, the premium is lower than
the mortality cost. “Front-ended premium loading” emphasizes the slow accumulation of cash value in the early
life of the policy to recover the expenses and disincentivize policyholders’ surrender.

13
3.4 Whole Life Pricing
In this section, we study the pricing of whole life insurance policies. In practice, the insurers
need to consider many factors to determine the premium level, including the mortality cost, front-
end premium loading, macro environment, industry competition, etc. This section is only an
illustration of the very fundamental aspect of whole life pricing, which involves the mortality cost
and the time value of money. We abstract away the premium loading in this section and assume
a constant interest rate of 5%. 3
The table below (Figure 7) is a 1980 standard mortality table for males in the US. As we have
explained, the probability of dying is equal to the number of deaths divided by the number of
people. We consider a whole life policy with a face value of $100,000 sold to a 40-year-old male.
As a first step, we need to calculate the probability of death for the 40-year-old in each age.

• The death probability at age 40 (between 40 and 41): 0.00302.

• The death probability at age 41 (between 41 and 42): (1 − 0.00302) × 0.00329 = 0.00328.

• The death probability at age 42 (between 42 and 43): (1−0.00302)×(1−0.00329)×0.00356 =

0.003538.

• ...

Figure 7 gives the probability of death at each age for this 40-year-old male. Why is the probability
of death at age 90 very low? Because this is the probability of a 40-year-old male to die at age 90,
not the probability of a 90-year-old male to die in the next year. It is very hard for the 40-year-old
to live until 90, so the probability for him to die at age 90 is low.

Single premium. Suppose the premium is paid all at once at age 40. We simply need to
calculate the present value of the future expected claim cost (assume paid at the end of each year)
as in Figure 8. The single (actuarial) premium is 22, 373, calculated as

302/1.05 + 328/1.052 + ... = 22, 373.

Continuous level premium. For most whole life policies, the premium can be paid in multiple
years. Here we consider the case in which premium is paid throughout the life of the insured.
Again, note that only the survived policyholders make the payment. Let the annual premium be
P . In each year, we need to multiply P with the probability of survival until that year. The
calculation is shown in Figure 9.
The present value of expected premium payment should equal to the present value of the
expected claim cost. We can solve 16.30P = 22, 373 for P = 1, 372.58.
3
This section references Harrington and Niehaus, Chapter 15.6.

14
Figure 6: The textbook mortality table

15
 Figure 7: Death probability

Figure 8: Single premium whole life

16
 Figure 9: Continuous level premium whole life
Present Value
Probability of
40- -Year-Old Living Expected of Expected
Premium Payment Claim Costs
Age until Specified Age

40
1x P $p

41 0,996980 0,996980 XP (0.996980 x P)/1.05 =$0.9524P

42 0,993700 0,993700 XP (0.993700 x P)/1.05
2

0,9013P

43 0,990162 0,990162 XP (0.990162 X P)/1.05

3

0.8553P

44 0,986330 0.986330 XP (0.986330 x P)/1.05

4

0.8115P

96 0.010484 0,010484 XPp (0.010484 x P)/1.05

56
0,0007P
97 0.006452 0,006452 X P (0.006452 x P)/1.05
57
0,0004P
98 0.003354 0,003354 X P (0.003354 x P)/1.05
58
0.0002P
99 0.001147 0,001147 X P (0.001147 x P)/1.05
59
0.0001P
Total $16.30P

3.5 Variations of Whole Life

In the previous section, we introduce the basics of whole life policies, particularly, the cash value
accumulation, front-end premium loading, and the pricing of whole life. In this section, we will
introduce variations of the whole life policies.4

3.5.1 Variable Life Insurance

Variable life insurance is defined as a fixed-premium policy in which the death benefit and
cash values vary according to the investment experience of a separate account. This is similar
to a mutual fund maintained by the insurer, except that it is only available within a variable
life insurance policy. The policyholder has the option of investing the cash value in a variety of
investments, such as common stock fund, bond fund, investment fund, etc.
The variable life insurance differs from the traditional whole life policy that the rate of return the
cash value accures is not predetermined. Rather, the return depends on the investment experience.
For example, the return may track the benchmark stock market index (say, the Hang Seng index
in Hong Kong, or the S&P500 index in the US). If the benchmark index rises, the accrued return
is higher, and vice versa.

3.5.2 Universal Life Insurance

The universal life insurance is a life insurance with flexible premium arrangement. Except
for the first premium, the policyholder determines the amount and frequency of payments. Most
policies have a target premium, but the policyholder is not obligated to pay the target premium.
4
This section references Rejda and McNamara, Chapter 11, “Variations of Whole Life Insurance.”

17
As long as the minimum premium is paid, the policy will remain in force. Typically, a universal
life insurance has a guaranteed minimum interest rate.
For the universal life insurance, the policyholder receives an annual statement that shows the
premiums paid, death benefit, and value of the cash-value account. The statement shows the
mortality charge and interest credited to the cash-value account.

Two forms death benefit. There are two forms of death benefit for universal life insurance.
The first form is called “the level death benefit.” In the early life of the policy when cash value
low, the death benefit is equal to the face value of the policy. As the cash value accumulates, it
may exceed the face value. It may be due to the excessive premium payment. It may be due to the
unexpected return change accrued to the cash value. Recall that the death protection (amount at
risk) is the difference between the death benefit and cash value. Since the death protection must
be nonnegative, the death benefit starts to rise with the cash value when the cash value exceeds
the face value. The upper figure below shows the death benefit of this form.
The second form of death benefit features a constant death protection, called “increasing death
benefit.” As the cash value increases, the death benefit increases with the cash value of the policy.
The lower figure shows the death benefit of this form.

Figure 10: Two forms of death benefit

The universal life insurance has considerable flexibility. First, the policyholder can determine
the frequency and amount of premium payments. Second, the face amount of insurance can be
increased. The policy can be changed from a level death benefit to an increasing death benefit
with a specified face amount. Cash can be added to the policy subject to a cap. Cash withdrawal
are permitted, sometimes subject to a fee charge.

3.5.3 Variable Universal Life Insurance

The variable universal life insurance, as its name suggests, is a combination of universal life and
variable life. It shares similar features with a universal life policy except that the policyholder can

18
determine how premiums are invested and there is no minimum cash value guaranteed. Typically,
variable universal life insurance involves higher expense charges and substantial investment risk.
It is not possible to exhaust the existing types of whole life insurance policy variations in the
market. In this section, I list the major ones and hopefully give you a sense of what variations are
possible. If you encounter a new variation of the whole life policy, what you have learned in this
section should enable you to understand the policy after reading the policy’s brochure.

4 Contractual Provisions
Life insurance policies contain numerous contractual provisions. In this section, we discuss the
major contractual provisions in life insurance. Note that the contractual provisions might change
with the time and with the place where policies are issued. What is introduced here should only
serve as a reference. 5

4.1 Dividends
If a life insurance policy pays dividends, it is known as a participating policy. Through divi-
dends, policyholders share the divisible surplus of the insurer. The source of surplus includes: the
lower mortality cost than expected, higher return than anticipated, lower expense loading than ex-
pected. On the other hand, a policy that does not pay dividends is known as a nonparticipating
policy.
The amount of dividends is determined by the insurer regularly (say, once a year). The actual
dividends can be different from the projected values provided in the brochure. Typically, the
insurer will smooth dividend accumulation based on past experience and future outlook to provide
a stable dividend.
The dividend can be either cashed out, or added to the next coming due premium, or used
to purchase an increment of paid-up additions. Dividend earns an interest rate if not withdrawn.
The best use of dividends depends on the buyer’s financial status and financial goals.

4.2 Settlement Options

The settlement options refer to the various ways that the policy proceeds can be paid. The common
settlement options are as follows.

• Cash. The policy proceeds can be paid in a lump sum to a designated beneficiary.

• Interest option. The policy proceeds are retained by the insurer, and interest is periodically
paid to the beneficiary. The beneficiary can be given withdrawal rights.

• Fixed-period option. The policy proceeds are paid to a beneficiary over a fixed period of
time.
5
This section references Rejda and McNamara, Chapter 12.

19
 • Life income option. Under the life income option, the policy proceeds are paid to the ben-
eficiary in the form similar with an annuity (we will discuss annuities in the next chapter).
For example, installmenet payments can be paid until the beneficiary’s death. Alternatively,
there can a guaranteed period of installment payments or a guaranteed total amount.

4.3 Other Contractual Provisions

Ownership clause. The policyholder possesses all contractual rights in the policy while the
insured is living, including changing the beneficiary, surrendering the policy for its cash value,
borrowing the cash value, receiving dividends, and electing settlement options. The policyholder
can designate a new owner as well.

Entire-contract clause. Life insurance policy and the attached application constitute the entire
contract between the parties. No statement can be used by the insurer to void the policy unless
it is a material misrepresentation and is part of the application. The insurer cannot change the
policy terms unless the policyholder consents to the change.

The incontestable clause. The insurer cannot contest the policy after it has been in force 2
years during the insured’s lifetime. After the policy has been in force for 2 years during the insured’s
lifetime, the insurer cannot later contest a death claim on the basis of a material misrepresentation,
concealment, or fraud when the policy was first issued. Some extreme fraudulent situations are
excluded, such as the beneficiary taking out a policy with the intent of murdering the insured.

Suicide clause. If the insured commits suicide within two years after the policy is issued, the
face amount of insurance will not be paid and there is only a refund of the premium paid.

Grace period. A life insurance policy contains a grace period during which the policyholder
can pay an overdue premium.

Reinstatement clause. It permits the owner to reinstate a lapsed policy if certain requirements
are met (mostly because the policyholder forgets to pay the premium or because the policyholder
has a temporary financial problem).

Beneficiary designation. The policyholder can designate a primary beneficiary and a contin-
gent beneficiary. A primary beneficiary is the beneficiary who is first entitled to receive the policy
proceeds on the insured’s death. A contingent beneficiary is entitled to the proceeds if the primary
beneficiary dies before the insured.
Most beneficiary designations are revocable. The policyholder reserves the right to change the
beneficiary designation without the beneficiary’s consent.

Change-of-plan provision. It allows policyholders to exchange their present policies for differ-
ent contracts.

20
Exclusions and limitations. Certain situations are excluded, such as suicide and war.

Premium payment. It specifies how premium should be paid and the associated charge in
difference scenarios.

Policy Loans. The policy loan provision allows the policyholder to borrow the cash value and
the interest rate is stated in the policy. Moreover, under the automatic premium loan provision,
an overdue premium is automatically borrowed from the cash value after the grace period expires,
provided the policy has a loan value sufficient to pay the premium.

Assignment clause. Under an absolute assignment, all ownership rights are transferred to a
new owner. Under a collateral assignment, the policyholder temporarily assigns a life insurance
policy to a creditor as collateral for a loan, while only certain rights are transferred.

5 Practical Issues in Life Insurance

In this section, we are going to discuss two practical questions: how much life insurance is needed
and how to select the most appropriate policies?

5.1 How Much Life Insurance Is Needed?

• The first thing we should consider when deciding on purchasing life insurance is the purpose:
do you want a tool of saving and investment, or do you want to protect against the mortality
risk? In the later section, we will discuss life insurance as a saving and investment tool. In
this section, we focus on mortality risk protection as the main function of life insurance.

• Figure out the beneficiary’s needs. For example, if one wants to buy a life insurance policy
for his wife and kids, he needs to consider the amount of money his wife and kids need for a
certain life quality. Moreover, there can be specific needs such as kids’ education, mortgage
payment, etc.

• Figure out the financial capacity without the insured. The buyer should also take into
consideration how much the dependent (such as the wife of the buyer) can earn. You might
wonder why we do not buy excessive life insurance for the dependents — insurance is costly
and one needs to pay premium. It will be more economical to purchase the appropriate
amount of insurance and one may use the remaining of income/wealth on other uses, such
as investment in stocks, real estates, or consumption.

• Figure out the duration of support. This is especially applicable if there are kids to support.
One may want to support the kids until they finish their education.

21
Approaches for needs calculation. There are different approaches to calculate the needs,
while they share a similar idea. The first approach uses the insured’s income as a benchmark.
The buyer asks himself: how much income could be spent on the dependents if he were alive? He
needs to subtract his own expenses from the income. The present value of his income during the
duration of support will be the amount needed. Alternatively, he might sum up the expenses for
different needs and calculate the present value over the duration of support. There is considerable
uncertainty in our estimates long into the future — so one may leave some room for possible extra
needs.

5.2 How to Compare Different Policies?

In this section, we will discuss how to compare different policies. We start with comparing different
types of life policies, say, term life policies, whole life policies and variants, and more specific life
policies such as credit life policies.

Term life policies. The advantage of term life policies is they are cheap. These policies are
purely for death protection and does not have a cash surrender value. The premium level simply
reflects the probability of death and premium loading. The disadvantage of term life policies is
that the premium payment does not gain value and nothing is repaid unless the insured dies.

Whole life policies. Whole life policies both protect against death and have a saving compo-
nent. For traditional whole life policies, interest rates are stable and premium payments are fixed.
The path of cash value is quite predictable. But whole life policies have front-end-loaded premium,
so that savings in whole life policies are highly illiquid. The buyer will suffer a large loss if the
policy is lapsed in the early life of the policy.

Whole life policy variants. The variants of whole life policies introduce more flexibility to the
policies, such as choosing return benchmark and premium flexibility. As you can imagine, these
policies grow out of the demand from the market but everything comes at a cost. For example,
more flexibility may involve higher premium loading. Choice of investment benchmark can bring
additional risk in the accumulation of cash value.

Specific policies. There are specific policies that satisfy particular needs. For example, the
credit life policies repay the mortgage if the insured dies. The policyholder can protect his depen-
dents from the mortgage burden through credit life policies.
Once one specifies the type of policy she wants to purchase, she needs to compare different
policies provided by different insurers. For term life policies, the interest adjusted cost index
can be used. The interest adjusted cost index is defined as
20
X 20
X
20−t+1
AC20 = Pt (1.05) − Dt (1.05)20−t
t=1 t=1

Pt is the premium paid at the beginning of year t and Dt is the dividend at the end of year t. The
index is calculated based on a duration of 20 years and an interest rate of 5%. To annualize the

22
index, we define the interest adjusted cost index as
AC20
IAC20 = P20
t
t=1 1.05

The IAC index is a measure of the cost of a policy taking into consideration of dividend and time
value of money.
For whole life policy, the cost is slighted amended by subtracting the cash value at the end of
year 20. Specifically, the IAC index for a whole life policy is defined as
AC20 − CV20
IAC20 = P20
t
t=1 1.05

where CV20 is the cash value of the policy at the end of year 20.
An alternative metric to evaluate a whole life policy (and its variants) is to compute its internal
rate of return. For the variants, the comparison of IRR should take into consideration the difference
of risks in these policies.

6 Understanding a Life Insurance Plan

In this section, I am going to walk you through an insurance plan and apply what we have learned
in this chapter. The policy is in a separate pdf file “BOC1.” This policy is slightly different from
the whole life policies we have discussed in the course — usually the whole life policy only pays
the death benefits when the insured dies. In this policy plan, there is an additional benefit if the
insured gets one of the illnesses listed on Page 8 and 10. This policy is a combination of health
insurance and whole life insurance. We mainly discuss page 4 to page 5 (shown in Figure 11 and
12).
Page 4 lists the basic information of the insured and the policy. The policy requires a premium
of 20 years, each year 4,822 USD until the end of year 20. In total, without calculating the time
value of money, premium payment equals 96,439. Columns 2-5 list the accumulation of cash value
and dividends. Column 2 lists the guaranteed cash value in the end of each year. Column 3 lists
the accumulated annual dividends, which are the profits shared with buyers. Column 4 is the
terminal dividend, which is payable upon policy surrender, death of the insured, or the payment
of the major illness benefit or policy maturity (explained on page 7 of the policy). Both columns
of dividends are not guaranteed and thus can change. The terminal dividend starts to be payable
at least after the policy is in force for 10 years.
Column 5 is the sum of columns 2-4. Column 2 is guaranteed while columns 3-4 are not
guaranteed. Some policies may provide more detailed scenario analysis to show the accumulated
dividends in a optimistic scenario and a pessimistic scenario.
Column 6 is the agreed death/major illness benefit. Before the age 61, the death benefit is
153,000. After the age 61, the death benefit is 128,000. This is because the policy provides
additional death benefit in the event of death of the insured under the age 61 while the policy is
in force (explained on page 7 of the policy). Column 7 lists the total death benefit, which is equal
to the major illness/death benefit, plus the accumulated annual dividends and terminal dividend.
At the maturity of the contract when the insured is 100, the guaranteed cash value is equal to

23
the major illness benefit/death benefit. The last column lists the cumulative premium payment,
without taking into consideration the time value of money.

Figure 11: A sample whole life plan

BOC GROUP LIFE ASSURANCE COMPANY LIMITED '1>W. 'ifil!(#:lniH, fl/¾01'i!Mlfli!ill4

A subsidiary of BOC Hong Kong (Holdings) Limited

HUNDRED LIFE CRITICAL ILLNESS INS PLAN

Illustration Summary - Details of Basic Plan (Full Illustration)

Proposed Life Insured :MR Benefit Term : To Age 100
Sex : M (Non-smoker) Premium Payment Term : 20 Years
Age : 44 Initial Sum Insured : 128,000
Policy Currency : USD Initial Annual Premium : 4,821.96

IMPOR TANT: THIS IS A SUMMARY ILLUSTRATION OF THE BENEFITS OF YOUR POLICY AND IN NO WAY AFFECTS THE TERM S AND
CONDITIONS STATED IN THE POLICY DOCUMENT.
Total Major
End of Accumulated Major Illness Illness Benefit/
Policy Guaranteed Annual Terminal Total Benefit/ Total Total
Year Cash Value Dividends* Dividend Cash Value Death Benefit Death Benefit Premiums Paid
1 0 0 0 0 153,600 153,600 4,822
2 256 42 0 298 153,600 153,642 9,644
3 1,152 129 0 1,281 153,600 153,729 14,466
4 2,688 264 0 2,952 153,600 153,864 19,288
5 5,376 451 0 5,827 153,600 154,051 24,110
6 8,448 694 0 9,142 153,600 154,294 28,932
7 12,288 997 0 13,285 153,600 154,597 33,754
8 15,744 1,363 0 17,107 153,600 154,963 38,576
9 19,584 1.798 0 21,382 153,600 155,398 43,398
10 23,936 2,305 6,378 32,619 153,600 162,283 48,220
11 28,160 2,890 7,384 38,434 153,600 163,874 53,042
12 32,640 3,557 8,470 44,667 153,600 165,627 57,864
13 37,376 4,313 9,641 51,330 153,600 167,554 62,685
14 42,624 5,162 10,903 58,689 153,600 169,665 67,507
15 48,128 6,110 12,262 66,500 153,600 171,972 72,329
16 52,864 7,163 13,728 73,755 153,600 174,491 77,151
17 58,112 8,332 15,249 81,693 128,000 151,581 81,973
18 63,616 9,622 16,881 90,119 128,000 154,503 86,795
19 69,376 11,043 18,627 99,046 128,000 157,670 91,617
20 75,392 12,602 20,495 108,489 128,000 161,097 96,439
21 77,312 14,262 21,444 113,018 128,000 163,706 96,439
22 79,232 16,028 22,450 117,710 128,000 166,478 96,439
23 81,024 17,905 23,516 122,445 128,000 169,421 96,439
24 82,944 19,899 24,646 127,489 128,000 172,545 96,439
25 84,864 22,015 25,847 132,726 128,000 175,862 96,439
26 86,656 24,259 27,123 138,038 128,000 179,382 96,439
27 88,576 26,637 28,484 143,697 128,000 183,121 96,439
28 90,368 29,154 29,935 149,457 128,000 187,089 96,439
29 92,160 31,818 31,483 155,461 128,000 191,301 96,439
30 94,080 34,633 33,134 161,847 128,000 195,767 96,439

Explanation:
1. This summary should be read in conjunction with the Glossary of this proposal when interpreting the values in the above table.
2. The above is only a summary illustration of the major benefits of your policy. You should refer to your Insurance Intermediary or the Company for
more information or, if appropriate, a more detailed proposal.
3. The projected Annual Dividends values and Terminal Dividend included in the above are based on the Company's current dividend scales and
are not guaranteed. The actual Annual Dividends and Terminal Dividend paid may change with the values being higher or lower than those
illustrated.
4. It assumes that all premiums are paid in full when due, with no policy loan during the Benefit Term. The Total Cash Value will be reduced if the
above A nnual Dividends have been withdrawn or Minor Illness Benefit has been claimed.
5. Total Premiums Paid is calculated by annual payment mode and is less than the actual premium paid if premium mode is other than annual
payment.

The above accumulated amount includes interest accrued thereon at the current interest rate of 4.50% per annum, which can be changed from
time to time.

Unless otherwise specified, the above projected figures are neither guaranteed nor estimated values for future. The premium(s) may differ slightly
from the premium(s) payable in the policy due to rounding differences.

This is an illustration document which is not a contract and Is for reference only. Please refer to the policy provisions for details (including full tem1s, conditions and exclusions) of the plan.
The premiums in this proposal are calculated based on standard rates. The actual premium(s) will be detem1ined by us upon polic y approval.
This proposal is valid for 30 days from the print date and is distributed in Hong Kong only.
Prop osal No. 103HK0120140227150501 Print Date Page 4 of 9
Insurance Agent : Bank of China (Hon g Kong} Limited /012397 Contact No. ·

How to evaluate this whole life policy? Here we introduce four methods.

1. IRR assuming the insured is alive. We can easily calculate the IRR at each age assuming
the insured is alive through
19
X 4822 CVt
i
=
i=0
(1 + r) (1 + r)t

24
Figure 12: A sample whole life plan, cont’ed

25
 where CVt is the cash value at the end of year t. You may choose whether or not to include
the dividends. Exercise 6 asks you to calculate the IRR at different ages.
You will find that the IRR for this plan is very low. After including the accumulated annual
dividends and terminal dividends, the IRR at 80 years old is around 3 percent. However,
this is an unfair statement because it completely ignores the insurance function of the plan,
i.e., providing protection against death.

2. Compare the NPV of the insurance part of the plan. Here we ignore the dividends and
only look at the insurance part. It is similarly to the example we analyzed in the previous
sections. Define suri = Πij=1 (1 − p44+j ) the probability of surviving until year i and deai =
Πij=1 (1 − p44+j−1 )p44+j the probability for the person to die at age i.
20
X 4822 × suri
P Vcost =
i=1
(1 + r)i−1

Note that we define p0 = 1 and pi is the probability of death in each age 44+i, taken from the
mortality table. Since this policy also covers critical illness, this number should be higher.
56
X DB44+i × deai
P Vbenefit =
i=1
(1 + r)i

where DB44+i is the death benefit that the insured can get after i years. The NPV of the life
insurance plan is P Vbenefit − P Vcost . For given r, we can compare whether N P V is positive
or negative, or we can solve for the IRR of the plan. Since the premium payment is equally
distributed, the net cash flow in early years is negative so we desire a higher IRR.
The limitation of such approach is it completely ignores the dividend. Approach 3 below
takes into consideration the dividend.

3. Assume accumulated annual dividends are cashed out upon death. The PV of benefit is
revised to be
56
X (DB44+i + div44+i ) × deai
P Vbenefit =
i=1
(1 + r)i
Note that div44+i is cumulative dividend (including accumulated annual dividend and termi-
nal dividend) when the insured dies. We may choose to include the dividend or not when we
assess the policy, depending on whether we trust the insurer’s projection.

4. Buyers may not want to hold the insurance until death. They may want to choose surrender
the policy at a certain age, say, 85. In this case, the PV of benefit is revised to be
41
X (DB44+i + div44+i ) × deai (CV85 + div85 ) × sur85
P Vbenefit = +
i=1
(1 + r)i (1 + r)41

Comparing to the IRR calculation when we simply assume the buyer survives until 85, there
are two differences. First, it adjusts for the PV of cost by the survival probability. Second
and more importantly, it includes the PV of expected death benefit before 85. Note that the

26
 death benefit is much higher than cash value in early life of the policy, the PV of benefit will
be greater than if we assume the insured survives.

7 Life Insurance as Wealth Management Tools

In this section, we are going to discuss one question related to the recent development of life
insurance, especially in Hong Kong. While term life policies are still popular in the US, more and
more insurance policies are mainly serving for the purpose of saving and investment. For example,
this is a plan provided by AIA, one of the leading insurers in Hong Kong. Turn to page 3, you
find that the plan states, “If the worst should happen, the death benefit will include: (i) 105% of
the total premiums paid for the basic plan; or (ii) the guaranteed cash value of the policy plus the
face values of any reversionary bonus (accumulated dividend) and any terminal bonus (dividend)
in the policy. We know that in the early life of the policy, the cash value of the policy is very low
and dividend does not accrue much, so the death benefit is only 105% of the total premiums paid.
Basically, the death protection function of this plan is very tiny. This 105% total premiums paid
enables the policy to be sold as an insurance policy. Once the cash value exceeds 105% of the total
premiums paid, the death benefit equals to the cash value. We might view this type of policies
purely for saving and investment purposes.
Why do we turn to insurance companies for investment? The limitations are obvious.

• Life insurance policies are long-term policies. Investing through life insurance sacrifices
liquidity. The policyholder needs to wait for at least 20 years to cash out for a reasonable
rate of return.
• Insurers are not specialized in investment. The most professional investment advisors and
portfolio managers should be working mostly in mutual funds, hedge funds, etc, where gener-
ating returns for customers is their utmost important goals. Insurers are best at pooling and
assessing risks, underwriting, etc. Although they also hire professional portfolio managers,
this is not their expertise.

Is there any reason that argues for the wealth management through insurers?

• Easy for inheritance. If a parent wants to pass his wealth to his kids, life insurance is very
convenient. Simply specify the kid as the beneficiary. If the parent dies, the kid automatically
inherits the wealth as death benefits. It avoids the complicated procedures of inheritance
and can avoid the high inheritance taxes in some places.
• In early years, purchasing insurance in Hong Kong used to be a way for people in mainland
China to avoid capital controls. At that time, credit cards can be directly used to purchase life
insurance in Hong Kong, which is not restricted by the limit of capital outflows for individual
accounts. This has changed in the recent years. The past year of 2020 has witnessed a sharp
decline of mainland business due to the travel restrictions. From January to September in
2020, mainlanders spent a total of 6.5 million HKD on life and annuity policies in Hong
Kong, and this is an 82-percent decline from the same period a year ago.
• Saving for specific needs. Insurance salespersons often market their policies as suitable for
certain purposes, such as kids’ education. For example, they might say, your kids need to get

27
 education in 15 or 20 years. If you purchase a life insurance today with a specific premium
payment, after 20 years, you will have a fund to support your kids’ education.
This argument is true for many people, especially for those who have limited access to
the complicated financial tools. However, one could always find other institutions or more
professional portfolio managers to manage their money.

• Is the long-term nature beneficial? This is my conjecture and you may agree or disagree.
The long-term nature of insurance company investment is a disadvantage, but it may also be
an advantage. For typical mutual funds, their clients constantly evaluate their performance,
say, at quarterly frequency. In every quarter, they should reveal their performance and if it
is less satisfactory, the clients will pull their money out. In that case, the fund managers
should always work very hard to satisfy the short-term goal of high returns and it might
cost the fund manager some good long-term investment opportunities. For insurers, their
investors are long-term and the front-end-loaded premium guarantees that most investors
will not surrender the policy in the early life of the policy, they might be able to take some
long-term opportunities that are not affordable by mutual fund managers.

8 Exercises
1. Suppose a 30-year-old Hong Kong male purchases a whole life insurance policy with face
value 1 million HKD. Premiums of 20,000 are paid when he is 30, 31, and 32. Calculate the
cash value of the policy when he is 31 and 32 (assume he is still alive at 32). Use the life
table for Hong Kong male 2014 and assume interest rate is 5%.

2. (HN 15.3) The following table provides information about a universal life policy. Fill in the
table.

Year 1 Year 2 Year 3

Cash value at beginning of year 10,000
Premium payments made at beginning of year 1,000 1,000 1,500
Mortality cost 550 600 675
Expense cost 100 50 50
Interest rate 6% 5% 5%
Credited interest
Cash value at the end of the year

Questions 3 through 5 are based on the textbook mortality table in Figure 6.

3. (HN 15.6) What is the net single premium for a $1,000 face amount three-year term policy
for a 50year-old male, assuming an interest rate of 5%?

4. (HN 15.8) Calculate the net level premium for a two-year endowment policy for a 50-year-old
with an interest rate of 5 percent. Ignoring expenses what would the policy’s cash value equal
after one year?

5. (HN 15.10) Insurer testing for HIV provides a good example of how the cost of gathering
information about mortality risk can sometimes cause insurers not to gather information.

28
 Insurers commonly use blood tests to identify HIV (if permitted by law). However, since
blood tests are not free, insurers only use blood tests if the expected costs of misclassification
exceed the cost of the test. Suppose that the cost of the blood test is $100 and the prob-
abilities of death for HIV-infected males is 20 times the probability listed in the mortality
table.

(a) What are the expected claim costs for a 30-year-old male applying for $100,000 of
one-year term insurance if he is HIV negative? HIV positive?
(b) Suppose that 1, 000 30-year-old males apply for insurance. The insurer knows that 2
percent of them are HIV positive but needs the blood test to identify those specific
applicants. Should the insurer give all applicants a blood test?

6. Consider the policy we discuss in Section 6. Calculate the IRR for the policyholder at each
age (45,50,55,60,65,70,75,80,85,90,95,100) under the following scenarios.

(a) The insured is alive and the policy is surrendered. The policyholder gets the guaranteed
cash value (ignore the uncertain accumulated annual dividends and terminal dividend).
(b) The insured is alive and the policy is surrendered. The policyholder gets the guaranteed
cash value plus the projected dividends (keep in mind that the dividends are uncertain).
(c) The insured dies/gets one of the major diseases and the beneficiary gets the major
illness/death benefit. Ignore the uncertain accumulated annual dividends and terminal
dividends.
(d) The insured dies/gets one of the major diseases and the beneficiary gets the total major
illness/death benefit. Include the uncertain accumulated annual dividends and terminal
dividends.
(e) How can these calculations help you evaluate whether this policy is an appropriate
policy for the policyholder.

29