Chapter 4 Life insurance

Why do we need life insurance?

Economic justification of life insurance
 Premature death: the death of a family head with outstanding unfulfilled financial
obligations

 The purchase of life insurance is economically justified if the insured has earned income, and
others are dependent on those earnings for their financial support. Life insurance can be used to
restore the family’s share of the deceased breadwinner’s earnings.

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
 Term insurance

Traditional
life Endowment
insurance
insurance
products Whole life
insurance
Term insurance
Term insurance
 A term insurance provides a death benefit over a fixed term
 The period of protection is temporary and up to only a certain period of time
 Most term insurance policies are renewable
 The premium is increased at each renewal date and is based on the insured’s attained age
 Most term insurance policies are convertible
 The term insurance policy can be convertible to a whole-life policy without evidence of
insurability
 Types of term insurance
 Yearly renewable term
 5-, 10-, 15-, 20-, 30-year term
 Term to age 65
 Decreasing term
 Return of premium term insurance Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th
Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 Edition. McGrawHill.
nd
Types of term insurance
 Yearly renewable term
 Issued for a one-year period
 Policyholder can renew for successive one-year periods to some stated age without evidence of insurability
 Premiums increase with age at each renewal date
 Term insurance issued for 5, 10, 15, 20, 30 years
 Premiums paid during the term period are level
 Premiums increase when the policy is renewed
 Term to age 65
 Provides protection to age 65
 The policy can be converted to a whole life insurance, but the decision to convert must be exercised before age
65

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Types of term insurance
 Decreasing term insurance
 The coverage or death benefit gradually declines each year
 Premiums are usually level throughout the policy period
 The principle behind decreasing term insurance is that when people get older, the liabilities that they have
and the corresponding need for a large amount of insurance decrease
 However, decreasing term insurance does not provide for changing needs, such as birth of a child, nor does it
provide an effective hedge against inflation
 Return of premium term insurance
 Returns the premiums at the end of the term period provided that the insurance is still in force
 Some people may think that the insurance is free if the premiums are returned at the end of the term period,
but actually the insurance is not free when the time value of money is considered
 This kind of insurance is expensive, which can result in a serious problem of underinsurance

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Simple calculation of term insurance
 John, age 27, purchases a one-year term insurance with a face amount equal to $100,000. Suppose
that the probability that John would die at the end of each year is 0.001. Given an annual interest
rate of 5%, how much should the premium be for this one-year term insurance?
 Expected payment at the end of 1-year period =
 Present value of the payment =
 Therefore, the premium for this one-year term insurance is $95.2381.
Simple calculation of term insurance
 Suppose that now John decides to purchase a three-year term insurance with a face amount equal to
$100,000. What would be the single premium for this three-year term insurance?
 Single premium
Simple calculation of term insurance
 Exercise: A man, age 35, has the following probability of death in each of the coming three years:
Age Probability of death at the end of year
35-36 0.001
36-37 0.0015
37-38 0.002

 Assume an annual interest rate of 10%. Calculate the single premium of a three-year term insurance
with $500,000 face amount for this man.
Uses and limitations of term insurance
 Term insurance is appropriate in the following situations:
 The amount of income that can be spent on life insurance is limited
 The need for protection is temporary
 Used to guarantee future insurability

 However, term insurance has the following limitations:

 Term insurance premiums increase with age at an increasing rate and may reach prohibitive levels
 Term insurance is inappropriate if you wish to save money for a specific need, e.g. save money for a
child’s college education, accumulate a fund for retirement
How to determine the appropriate amount
of term life insurance coverage?
Endowment insurance
Endowment insurance
 Endowment insurance pays the face amount of insurance if the insured dies within a
specified period; if the insured survives to the end of the endowment period, the face
amount is paid to the policyholder at that time
 For example, if Stephanie purchases a 5-year endowment policy with a face amount equal to
$100,000, the insurer will pay $100,000 to the beneficiary if Stephanie dies in the subsequent
5 years. If Stephanie survives the 5-year period, then the insurer will pay $100,000 to
Stephanie at the end of this period
 Endowment insurance would require a relatively large premium than term insurance because
the insurer will have to pay the face amount regardless of whether Stephanie dies
 Since either Stephanie or her beneficiary will receive $100,000 sometime in future, an
endowment policy is similar to a savings account

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Calculation of endowment insurance
Ann, age 25, purchases a three-year endowment policy with a face amount equal to $100,000.
Suppose that the probability that Ann would die in each year is 0.001. Given an annual interest
rate of 5%, how much should the net premium be for this endowment insurance?

Net premium

86,396.93
Whole life insurance
Whole life insurance
 A whole life insurance policy 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
 It is just like an extension of endowment policy (a very long-term endowment policy)

 Common types of whole life insurance

 Ordinary life insurance
 Unit-linked life insurance (alternatively named as variable life insurance)
 Universal life insurance

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Ordinary life insurance
 A level premium policy that provides cash values and lifetime protection

 The policyholder needs to pay premium as long as he/she is alive and the face amount
will be paid to the policyholder’s beneficiary when the policyholder dies

 There is cash value for the policy, which is the amount paid to the policyholder when
he/she chooses to surrender the policy

 Life insurance with cash values is sometimes also sold as a saving or investment
vehicle, however, it has two limitations as an appealing investment: 1) the effective
rate of return is not guaranteed; 2) the loading for expenses when compared to
competing investments is relatively high

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Unit-linked insurance (alternatively named as variable life insurance)

 A permanent whole life policy with a fixed premium

 The premium is level and is guaranteed not to increase
 The death benefit and cash values vary according to the investment experience of a
separate account maintained by the insurer
 The policyholder has the option of investing the cash value in a variety of
investments, such as a common stock fund, bond fund, or international fund
 If the investment experience is favorable, the face amount of insurance is increased.
If the investment experience is poor, the amount of life insurance could be reduced.
 Cash-surrender values are not guaranteed

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Universal life insurance
 Premium flexibility
 A flexible premium policy
 Except for the first premium, the policyholder determines the amount and frequency of payments,
sometimes subject to annual minimum and maximum amounts
 Unbundling of death protection and saving component
 The interest rate credits to the policy’s cash value can vary monthly, depending on current market
interest rates, but usually there will be a guaranteed minimum interest rate

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Universal life insurance
 Death benefit options
 With a universal life policy, the policyholder generally has a choice between two death benefit
options
 The first option pays a level death benefit during the early years
 The second option provides for an increasing death benefit

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Universal life insurance
 Loans and partial surrenders

 Policyholders can take out loans on some universal life policies

 Any unpaid interest on the loan is automatically deducted from the policy’s cash value.

 Instead of loan provisions, some universal life policies allow partial surrenders. The policyholder can
simply remove a portion of the cash value without terminating the policy. In these cases, no interest
is credited on the portion of the cash value that is surrendered.

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
An example of universal life insurance illustration

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Limitations of Universal Life
 Misleading rates of return

 Decline in interest rates

 Interest rates have declined significantly over time
 The earlier cash-value and premium payment projections based on high interest rates can be
misleading and invalid

 Right to increase the mortality charge

 Insurers can increase the current mortality charge for the cost of insurance up to some maximum
limit

 Lack of firm commitment to pay premiums

 Some policyholders do not have a firm commitment to pay premiums

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13th Edition.
Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2nd Edition. McGrawHill.
Some other forms of life insurance
Some other forms of life insurance

 Second-to-die life insurance

 Insures two lives and pays the death benefit upon the death of the second insured
 Also called survivorship life insurance
 Widely used in estate planning

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Some other forms of life insurance
 Group life insurance as employee benefits
 Employee benefits are employer-sponsored benefits other than wages, which enhance the economic
security of individuals and families and are partly or fully paid for by the employers
 A master contract is formed between the group policyholder (the employer) and the insurer for the
benefit of the individual members (the employees)
 Most group life insurance in force today is group term life insurance
 The amount of term insurance on an employee’s life can be based on the worker’s earnings and position,
which is typically some multiple of the employee’s salary or earnings
 If employees leave the group because of termination of employment or retirement, they can convert
their term insurance to an individual life insurance policy
 Most group plans also allow a modest amount of life insurance to be written on the employee’s spouse
and dependent children

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Group life insurance
Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
nd
What are different types of life insurance?
 Life insurance
contractual provisions
Life insurance contractual provisions
 Life insurance policies contain a lot of contractual provisions, here we discuss some
common contractual provisions that life insurance consumers should understand
 Ownership clause
 Owner of a life insurance policy can be the insured, the beneficiary, a trust, or other party
 Under the ownership clause, the policyholder possesses all contractual rights in the policy
while the insured is living
 Beneficiary designation
 Primary and contingent beneficiary: 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
 Revocable beneficiary: Most beneficiary designations are revocable. A revocable beneficiary
means that the policyholder reserves the right to change the beneficiary designation without
the beneficiary’s consent

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Life insurance contractual provisions
 Change-of-plan Provision
 Allows policyholders to exchange their present policies for different contracts
 The purpose is to provide flexibility to policyholders as the original policy may no longer be
appropriate if family needs and financial objectives change
 Exclusions
 Suicide clause
 War clause
 Some undesirable activities may be excluded, e.g. auto racing, skydiving, travel or residence
in a dangerous country
 Assignment clause
 A life insurance policy is freely assignable to another party. For example, the policyholder
may donate a life insurance policy to a church, charity, or educational institution

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Life insurance contractual provisions
 Dividend options
 Life insurance policies frequently contain dividend options
 A policy that pays dividends is known as a participating policy, which give policyholders the
right to share in the divisible surplus of the insurer
 The dividend represents a refund of the premium if the insurer has favorable experience with
respect to mortality, interest, and expenses
 Several ways in which dividends can be taken: cash, reduction of premiums, dividend
accumulations, paid-up additions
 Settlement options
 There are various ways that the policy proceeds can be paid
 The policyholder can elect the settlement option prior to the insured’s death, or the
beneficiary may be granted that right
 Common settlement options: cash, interest option, fixed-period option, fixed-amount option,
life income options
Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Additional life insurance benefits
 Rider
 A life insurance rider can be added to a life insurance policy to provide additional benefits
 Most riders require the payment of an additional premium
 Waiver-of-Premium provision rider: if the insured becomes totally disabled from bodily injury
or disease before some stated age, all premiums coming due during the period of disability
are waived
 Guaranteed purchase option rider: Policyholders have the right to purchase additional
amounts of life insurance at specified times in the future without evidence of insurability
 Accidental death benefit rider: Doubles the face amount of life insurance if death occurs as a
result of an accident

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Additional life insurance benefits
 Accelerated death benefits
 Allow part or all of the life insurance face amount to be paid to a chronically or terminally ill
policyholder before he or she dies

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Additional life insurance benefits
 Life settlement
 A life settlement is a financial transaction by which a
policyholder who no longer needs or wants to keep a life
insurance policy sells the policy to a third party for more than its
cash value
 The purchaser, who is typically an investor group, becomes the
new beneficiary and is responsible for all subsequent premium
payments
 Life settlement has its downside: the policies are sold to parties
who do not have an insurable interest in the insured’s life;
regulation of life settlements may be inadequate

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Explaining life insurance settlements
Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.