Insurance and Risk Management
Lecture 5 : Life Insurance
Chapters 16 ~ 18 in Rejda (2011)
Ch. 16: Fundamentals of Life Insurance
Ch. 17: Contractual Provisions
Ch. 18: Purchase Decisions
I’m not afraid to die. I just don’t want to be there when it happens.
Life insurance protects against financial distress
due to unexpected premature death.
Based on Mathematical
Expectations of Life Span
Ability to predict how many
people of a particular
group will die in a given
period of time.
Allows companies to know how much to charge each individual.
Term vs. Whole Life
• Methods of providing life insurance
– Yearly renewable Term 2000
• Pure life insurance
– Level Premium Method 1500
(Cash value policies)
• Pure life insurance 1000
• Savings accumulation
• Examples 500
– whole life
– universal life
– variable life 0
age 20 age 30 age 40 age 50 age 60 age 70
• Why? Term Whole Life
Lines of Life Insurance
In individual lines, policies are sold directly to an individual.
That person then chooses his or her beneficiary.
Group policies are often
sold to people who are
employees of the same
company. Everyone is
insured under one
master policy. Each
person names his or
her own beneficiary.
Roughly half of all life insurance benefits are paid while the
policyholder is living.
Cash Value - Amount paid in premiums plus interest earned
minus expenses the company has incurred in providing
Borrow Money - Borrow from the insurance company using the
policy’s cash value to secure the loan.
Collect dividends - if the company makes a profit, some of the profit
is returned to the policyowners (of mutual companies only)
Options for benefit disbursement:
Lump Sum Payment. Face value of policy is paid at one time.
Installment payments for a specified period of time. Payments are
made for X number of years and automatically include interest.
Example: Payments for ten years from $100,000 benefit might pay
$11,796 a year.
Installment payments of a specified amount. Certain amounts will be
paid each year until money (including interest) runs out.
Example: Want payments for $1,500 per month from a policy with
$100,000 benefit. Payments might continue for 6 years and 2 months.
Life annuities guarantee income for life
• Purchased the same way as life insurance.
• Purchasers usually determine amount per month they
wish to receive.
• Size of payments depend on when payments start and
how much has been paid in to annuity.
• Provide tax advantages.
Fundamentals: Premature Death
• Meaning of premature death
• Costs of premature death (severity)
• Chance of Dying Prematurely (frequency)
• Economic Justification of Life Insurance
• Amount of Insurance to Own
• Human Life Value Approach
• Needs Approach
Probability of Death Prior to Age 65
How Much Life Insurance Do You Need?
Types of Life Insurance
There are worse things in life than death. Have you ever
spent an evening with an insurance salesman?
• Traditional Products:
– Term, Whole Life, and Endowment
• Product Innovation:
– Universal and Variable (investment-linked)
• Other Products:
– Modified Life Insurance, Second-to-Die Insurance,
Group Life, ……
• Death benefit = amount beneficiaries receive
• Cash value = amount of savings accumulation
• Death protection = amount of pure death protection
= death benefit - cash value
• Face amount = stated amount of coverage
= death benefit (for term, WL, and some UL)
= death benefit - cash value (for some UL)
– 1/4 of policies (4% in HK; WHY?)
– almost half of death protection purchased
==> Term Policies carry higher amount of insurance
• Guaranteed renewable
• May also be convertible
• Premium increases over time
Endowment Insurance (儲蓄壽險)
• Pays face amount
– if the insured dies
– if the insured survives the policy period
• Guaranteed Mutual Fund?
Cash Value Insurance
• Cash Value Policies
– Can obtain savings accumulation by
surrendering the policy
– Why bundle death protection & savings
• Tax advantaged method of saving
Whole Life Insurance
• Policy period ends when insured reaches
• Equivalent to endowment policy to 100
– single premium
– limited pay
– continuous premium
Examples of Different Payment Periods
Pay more in early years to avoid paying later
Whole Life Insurance
• Premiums generally do not increase over time
– But probability of dying increases over time
==> higher up-front premiums than with term
– Policyholder “prepays” part of the cost of future death
• entitled to prepayments if policy is surrendered
• this is the cash value (savings accumulation)
• If insured dies,
– beneficiaries receive face amount = death protection + cash value
• Structured so
– cash value over time
– death protection over time
Whole Life Insurance
Pattern of Cash Value and Death Protection for a
$100,000 Whole-Life Policy Issued at Age 30
Face Amount =
30 60 80 100
Participating Policies & Expense Loadings
• Participating means….
– Mutuals always pay annual dividends; stock companies
often do so too.
– Why? - premiums based on conservative assumptions
– Illustrated versus actual dividends
– Dividend option: Cash payment; Reduction in next
premium; Paid-up additional life; Deposit; One-year
• Expenses loadings: Front-end expense charges
==> Cash value grows slowly at first
==> Implicit return on savings accumulation
initially low (see page 380 of the text).
Comparison of Cash Values in Whole Life
payments for life
A $50,000 20 Year Payments
L Single Premium
40 44 48 52 56 60 64 68 72 76 80 84 88 92 96
• Similar to whole life
• Main differences:
– Greater flexibility in premium payments
– Cash value does not follow a fixed schedule; it
• policyholder’s premium payments
• insurer’s expense and mortality charges
• rate insurer uses to credit interest to cash value
– minimum rate usually guaranteed
– rate often linked to short term interest rates
– Cash Withdrawal Permitted
WHY Universal Life?
Factors Affecting UL Cash Value
Cash value at beginning of period
Premium payments at beginning of period
Mortality charge at beginning of period
Expense charge at beginning of period
Interest credited at end of period
Cash value at end of period
Exhibit 17.3 Universal Life Insurance
Variable (Investment-Linked) Life
– Similar to whole life
– Main differences:
• Cash value does not follow a fixed schedule; it
– return earned on portfolio of mutual funds chosen by
• Death benefit
– minimum is guaranteed,
– varies with cash value
Summary of Features of Different
Types of Life Insurance Policies
Term Whole Variable Universal
Period of Temp. Perm. Perm. Perm.
Premium Fixed / Fixed Fixed Flexible
Flexibility increasing after 1st yr
Death Benefit Level Fixed Depends Level /
Cash Value None Scheduled Depends Depends
Life Insurance Comparison Chart
• Large and growing part of life insurance business
• Divide contract period in two
– Accumulation period
• Policyholder pays premiums
– Payout period
• Insurer makes payments
Use of Annuities
• Risk management perspective
– Protection against outliving resources (longevity risk)
• Savings perspective
– Tax advantaged method of saving
• Implicit returns are tax deferred
– Fixed annuities
• Return credited varies with interest rates
– Variable annuities
• Return credited varies with return on mutual funds
chosen by contract holder
Overview of Annuity Contracts
Premium payments (a) Single premium
(b) Fixed period, level premium up to an advanced age
(c) Flexible premium over time
Annuity benefits begin (a) Immediately
Annuity benefits end (a) Fixed number of years
(b) Death of one of more individuals
(c) Combination of (a) and (b)
Insurer payments (a) Fixed
(b) Vary with interest rates, with guaranteed minimum
(c) Vary with returns on stock and bond funds chosen by
Chapter 17: Contractual Provisions
Nearly every family buys life insurance; yet few policyholders ever
read a life contract with any effort to understand its provisions.
Mehr and Gustavson, Life Insurance, 4th edition.
• Standard Contractual Provisions
• Dividend Options
• Surrender Options
• Settlement Options
• Other Life Insurance benefits (Riders)
Standard Contractual Provisions
• Ownership clause
• Incontestable clause: 2 years
• Grace period: 30 or 31 days
• Cooling-down period:
• Exclusion and restrictions:
– Suicide clause, war exclusion, aviation exclusion
• Reinstatement clause (保單復效)
• Beneficiary designation (指定受益人)
Reinstatement (保單復效) Provision
• Due to nonpayment of premiums, a policy may
lapse, either deliberately or unintentionally.
• Reinstatement clause allows policyholders to
reinstate a lapsed policy so that it is restored to its
original status and its values are brought up to date.
• Insurers require:
– All back premiums must be paid
– Interest on past-due premiums may be required to be paid
– Insured may be asked to prove insurability.
– Must reinstate within 3 (or even 7) years after lapse.
• What is a beneficiary (受益人)?
–“a person, other than the insured or his personal
representative, to whom or for whose benefit
insurance money is made payable.”
• Who Makes the Designation?
–Insured (被保人)- UK
–Policyowner (保單持有人)- US
• Think of key employee life insurance
Priority of Entitlement
• Primary beneficiary
– Proceeds distributed in equal shares unless
otherwise specified (per capita)
• Secondary (Contingent) beneficiary
– multiple levels of contingent beneficiaries permitted
• Effects of Divorce
– (Common Law Jurisdictions) Divorce of insured
and named beneficiary does not automatically
revoke beneficiary designation
Example: Beneficiary Succession
• Debbie takes out a $150,000 life policy on her
life and establishes the beneficiary designations
as follows: her husband, Rob, is to receive the
full benefit; if he predeceases her, her two
children are to share equally in the benefit; if
her husband and both her children predecease
her, the benefit is payable to the Chinese
University of Hong Kong, her alma mater.
Beneficiaries: Special Situations
• If the insured and the primary beneficiary
die in the same accident, it is presumed that
the insured died last.
• (Who gets the money?) Alex names his son Bob
the only beneficiary. Alex and Bob die in a car
accident. Alex’s wife claims that she should be
entitled the death benefit since she is the
deceased’s estate (遺產繼承人). Bob’s wife claims
the death benefits should be paid to her since she is
the beneficiary’s estate.
Beneficiaries: Special Situations
Common Disaster Provision
• The primary beneficiary should outlive the insured
by a definite period of time, such as 10 days, or it is
still assumed that the insured died last.
• Ex: (Who gets the money?) Alex and Betty, his wife by a
second marriage and primary beneficiary of his $100,000
life insurance policy, are both killed in a car accident. Betty
survives Alex by only 24 hours. Alex has a child Carl from
his first marriage. Betty also has a child David from her
– With Common Disaster Clause:
– Without Common Disaster Clause:
Standard Contractual Provisions
• Policy loan provision
– Nature: the policyowner can borrow the cash values.
– Advantages: a low annual percentage rate; no paperwork;
flexibility in repaying
– Disadvantages: heavy borrowing may cause policy to
lapse; the amount of protection is reduced.
• Automatic premium provision
– Nature: allows overdue premiums to be paid by borrowing
from the cash value at the end of the grace period
– Purpose: to prevent the policy from lapsing
– Main disadvantages: may be overused; amount of
protection is reduced.
Riders and Other Optional Benefits
• Disability income,
• Guaranteed insurability (purchase) option,
• Accidental death benefit,
• Accelerated death benefit,
• Cost-of-living rider
Riders: WP and Disability Income
• WP: inexpensive or even free
• Become total disabled before some stated age, such
as 60 or 65.
• Total disability: During the first 2 (or 5) years, it means
that the insured cannot perform all duties of his or her
occupation. After that, it means that the insured cannot
engage in any occupation reasonably fitted by education,
training and experience.
• Ex: Dr. Yeh is a chemistry professor who has throat cancer
and cannot teach. If he can find some other job for which
he is reasonably fitted by training and education, such as a
research scientist for a chemical firm, he would not
considered disabled after 2 years.
Rider: Guaranteed Purchase Option
• Permits the insured to purchase additional amounts of
life insurance at specified times in the future w/o
evidence of insurability.
• Ex: Paul, age 28, purchases a HK$200,000 life policy with
a guaranteed purchase option and becomes uninsurable after
the policy is issued. Assuming he elects to exercise each
option, he would have the following amount of insurance:
– Age 28 HK$200,000 (basic policy) +
– Age 31 HK$200,000
– Age 34 HK$200,000
– Age 37 HK$200,000
– Age 40 HK$200,000
– Total insurance at age 40 HK$1,000,000
Rider: Accidental Death Benefit
• Doubles the face amount of life insurance if death
occurs as a result of an accident.
• Also know as double indemnity.
• Additional premium is relatively low, but some
CFPs don’t recommend it, since:
– Economic value of a human life is not doubled if death
occurs from an accident.
– Most people will die as a result of a disease and not
from an accident.
– The insured may be deceived and believe that he or she
has more insurance than is actually the case.
Rider: Accelerated Death Benefit
• Also known as a living benefit rider.
• Allows insureds who are terminally ill to collect
part of all of their life insurance benefits before
– Terminal illness (24 months or less) rider; Catastrophic
illness rider; or long-term care rider
• Ex: Betty, age 59, who is terminally ill with cancer,
requests 50% of her $1,000,000 life policy. After the
benefit is discounted for interest, she receives $462,960.
After the payment is made, premiums are reduced to 50%,
and the face amount is reduced to $500,000.
Rider: Cost-of-Living Rider
• Allows the insured to purchase additional
insurance amount equal to the percentage
change in the consumer price index (CPI)
w/o evidence of insurability.
• Decline CPI?
Nonforfeiture (Surrender) Options
• Take cash value
– Surrender of the policy
– Not a good option for cash needs
• Use cash value as a single premium for
– Reduced paid up whole life
• Appropriate option for a retiree with limited income
who still has some life insurance needs
– Extended term insurance policy
(Dollar Amount for Each $1,000 of Ordinary
Life Insurance Issued at Age 21)
• One lump sum cash payment
• Interest option
• Installment option
• Life income option
– Life income with period certain
– Life income with a refund
(Minimum Monthly Income Payments per
$1,000 Proceeds, 3 Percent Interest)
Life Income Options
(Minimum Monthly Income Payments per
$1,000 Proceeds, 3 Percent interest)
Example: Settlement Option
• Which settlement option should be selected?
• (A) Helen, a childless registered nurse in good health,
has just become a widow at the age of 24. She is the
beneficiary of a HK$400,000.
• (B) Mary, 57, is a housewife with 2 dependent college-
age children whose husband died last week. She is the
beneficiary of a HK$1.2 million life insurance policy.
• (C) Walter, 87, is a widower with few financial resources
who lives in a retirement home and is the beneficiary of a
HK$4 million policy insuring his late daughter.
Chapter 18: Buying Life Insurance
When you buy life insurance, it’s relatively easy to compare
first-year premium. But that figure tells you nothing about
what the policy will cost over the long run.
---- Consumers Union
• Insurance costs comparisons
• Taxation of Life Insurance
• Shopping for Life Insurance
– How to be a savvy consumer?
Term Insurance Cost Comparisons
• Traditional net cost method:
t - CV20
• Adjusted cost index 20
– Idea: calculate accumulated future value of all costs
• accumulate premiums (P) per $1,000 of coverage
• less policyholder dividends (D)
• for 20 years
• at a 5% interest rate
– 20-year Accumulated Cost (AC20):
AC20 = å Pt (1.05) - å D t (1.05)20-t
t =1 t =1
Whole Life Cost Comparisons
• Another approach: use adjusted cost index again
– but subtract cash value (CV) at end of 20 years
– AC20* = AC20 - CV20
– In practice adjust cost indices are scaled to get interest
adjusted cost (IAC):
• Net payments index
(assuming not terminate the policy) IAC = AC /
20 20 1.05 t
= t =1
• Surrender cost index 20
(take cash value into account) IAC 20 = AC 20 /
å 1.05 t
Example: Cost of Life Insurance
• Assume a US$10,000 ordinary life insurance
policy issued to a female, age 20, is $132.10.
Estimated dividends over a 20-year period are
$599, and the cash surrender value at the end of
twentieth year is $2,294.
• The annuity due factor at 5% interest rate is 34.719. ($1
deposit at the beginning of each year at 5% interest will
be accumulate to 34.719 at the end of 20 years.)
• What is the average cost per year according to the
three methods mentioned above?
Exhibit 18.1 Traditional Net Cost Method
Exhibit 18.2 Surrender Cost Index
Exhibit 18.3 Net Payment Cost Index
Universal Life Cost Comparisons
• More complex
• One approach:
– Use interest adjusted cost index subtracting an
estimate of cash value
• under common assumptions(across policies being
compared) about premiums and interest rates
• No consensus exists
Exhibit 18.4 Comparison of Life
Insurance Costs for Selected Companies
Rate of Return on Saving Component
• The annual rate of return earned on the
savings component of a policy is an
important consideration if you intend to
invest over a long period of time
• The Linton yield is the average annual rate
of return on a cash value policy if it is held
for a specified number of years
– Current information is not readily available to
consumers, so the method has limited use
Rate of Return on Saving Component
• The yearly rate of return method is based on a
amount available in the policy assumed price of the
at the end of the policy year + protection component
amount available in the policy
at the beginning of the policy year
• The information needed for the calculation is
readily available to consumers
Exhibit 18.5 Average Annual Rates of Return for
109 Cash-Value Policies by Year of Policy
Shopping for Life Insurance
• Determine whether you need life insurance
• Estimate the amount of insurance needed
• Decide on the best types of insurance for you
• Decide whether you want a policy that pays dividends
– Nonparticipating policy: guaranteed net cost and lower initial outlay
– Participating policy: better buy in the long run if interest rates are high
• Shop around for a low-cost policy
• Consider the financial strength of the insurer (rating)
• Deal with a competent agent
Exhibit 18.6 Benchmark Prices
Causes of Insolvency
• Non-life insurance
– Premiums too low
– Catastrophic losses
• Life Insurance
– Drop in asset values
– Bank run
No. of insolvencies
In the U.S. (Non-life)
No. of insolvencies in the US (Life)