Lecture Twelve ： Fundamentals and Types of Life Insurance

Lecture Twelve ：

Fundamentals and Types of Life Insurance

Learning ObjectiveLearning Objective

Explain the different health risks in a person’s life. Describe the financial impact of premature death

on different types of family.Describe the economic justification of life insurance. Methods for providing life insurance protection. Explain the types of life insurance. Explain the major characteristics of different types

of life insurance.

Main Contents The financial impact of premature death on

different types of family Three approaches to estimate the amount of life

insurance to own Methods for providing life insurance protection Types of life insuranceThe major characteristics of term insuranceThe major features of ordinary life insuranceThe basic characteristics of variable life insuranceThe basic characteristics of universal life insurance

Risks in a person’s life

Thinking about the following questions

• What risks does a man or woman face in his or her life?

• What’s the financial impact of premature death on different types of family

Risks in a person’s life

In people’s life, however, there are different kinds of health risk. Such as: Illness premature death injury

Kelly, age 32, is the sole support for her disabled husband and two small children. She earns $30,000 annually and has $40,000 of life insurance and $10,000 in savings. If Kelly dies suddenly, could her family survive on the $50,000 left to them? Probably not. Although Social Security survivor benefits may be available, other financial factors must be considered, such as payment of the mortgage, the children-college education, and financial support for her disabled husband. Clearly, $50,000 will not go far. Kelly premature death will create financial insecurity for the surviving family members. She can, however, purchase life insurance to restore the family share of her lost earnings.

Case

Probability of Death Prior to Age 65Age Within

a year Prior to age 65

Age Within a year

Prior to age 65

0 0.0100 0.21 35 0.0017 0.18

5 0.0003 0.20 40 0.0022 0.17

10 0.0002 0.20 45 0.0032 0.16

15 0.0006 0.20 50 0.0050 0.14

20 0.0011 0.19 55 0.0081 0.12

25 0.0012 0.19 60 0.0126 0.07

30 0.0014 0.18

Premature Death

• Meaning of premature death –Premature death can be defined as the death of a family head with outstanding unfulfilled financial obligations, such as dependents to support, children to educate, and a mortgage to pay off.–Costs of Premature Death premature mature death can cause serious financial problems for the surviving family members.

• Family earning lost• additional expenses (such as funeral expenses, medical bills, estate

settlement costs, and federal estate taxes for large estates )• reduction in living standard • certain noneconomic costs ( such as emotional grief, loss of a

parental role, etc.)

Premature Death

• Financial Impact of Premature Death on Different Types of Families:Single peopleSingle-parent families Two-income earners Traditional families Sandwiched families Part F: General Provisions

Three approaches to estimate the amount of life insurance to own

Human life value approach Needs approach Capital retention approach


Human life value approach

Be defined as the present value of the family’s share of the deceased breadwinner’s future earnings.

It can be calculated by the following steps:


• Estimate the individual’s average annual earnings over his or her productive lifetime.

• Deduct federal and state income taxes, Social Security taxes, life and health insurance premiums, and the costs of self-maintenance. The remaining amount is used to support the family.


•Determine the number of years from the person’s present age to the contemplated age of retirement.

• Using a reasonable discount rate, determine the present value of the family’s share of earnings for the period determined in step 3.


Needs approach

• The various family needs that must be met if the family head should die are analyzed, and the amount of money needed to meet these needs is determined.


•The most important family needs are the following:

Estate clearance fundIncome during the readjustment periodIncome during the dependency periodLife income to the surviving spouseSpecial needs

• Mortgage redemption fund• Educational fund• Emergency fund

Retirement needs

How Much Life Insurance Does An American Need?

• An Illustration of the Needs Approach for estimating the amount of life insurance

• Example (Exhibit 16.2. p120) cash needs income needs special needs


Capital retention approach • (Also called capital needs analysis) , it preserves the

capital needed/income-producing assets to provide income to the family

• The amount of life insurance needed based on the capital retention approach can be determined by the following steps: Prepare a personal balance sheet listing all assets and liability Determine the amount of income-producing capital Determine the amount of additional capital needed (if any)

How Much Life Insurance Does An American Need?

• An Illustration of the Capital Retention Approach for estimating the amount of life insurance

• Example (p122-124) financial needs current assets additional life insurance

Methods for Providing Life Insurance Protection

Two basic methods can be used to provide life insurance to individuals:

Yearly Renewable Term Method Level-Premium Method


Yearly Renewable Term Method (YRT，年度续保的定期保险）provides life insurance protection for only one

year. The insured is permitted to renew the policy for successive one-year periods with no evidence of insurability.

The pure premium is determined by the death rate at each attained age.


Premium increases as the individual gets older. The premium increase is gradual during the early

years, but it rises sharply during the later years.Because premium increases with age, yearly

renewable term insurance leads to Adverse Selection against the insurer.

Life-time protection cannot be provided to most insureds under the yearly renewable term methods;


Level-Premium Method ( 均衡保费保险） premiums do not increase from year to year but

remain level throughout the premium paying period, and the insured has lifetime protection to age 100.

premiums paid during the early years of the policy are higher than is necessary to pay current death claims, while those paid in the later years are inadequate for paying death claims.


the excess premiums paid during the early years are invested at compound interest, and the accumulated funds are used to supplement the inadequate premiums paid during the later years of the policy.

The method of investing and accumulating the fund is regulated by law, it is referred to as a Legal Reserve.

One i n f our U. S Househol ds Now Has No Li f eI nsurance

0

10

20

30

40

50

60

70

80

90 Any Li f eI nsuranceI ndi vi dualGroup

1976 1984 1992 1998

Reasons Why Peopl e Don' t Have MoreI nsurace

81%

58%

48%

43%

33%

28%

22%

It's too expensive

I don's know enough

Worry about making wrong decision

I haven't gotten around to it

I prefer to put my money elsewhere

No one has approached me

Don't like to think about dying


the net amount at risk represents the pure insurance portion of the policy. It declines over time as the legal reserve increases.

The death claim consists of two elements: • A legal reserve (saving element)

• The net amount at risk (protection element)

• As the legal reserve increases, the net amount at risk declines.

• by the level-premium method, the insurer can provide the insured with lifetime protection.


Cash Values VS Legal Reserve Under the level-premium method, a legal reserve results. The policy-owner may no longer want the insurance, and the policy can be surrendered for its cash surrender value.Cash values and the legal reserve are not the same thing and are computed separately. The cash values are below the legal reserve for several years, but after the policy has been in force over an extended period, the cash surrender value will equal the full reserve.

Relationship between the net amount at risk and legal reserve

$0

$500

$1, 000

$1, 500

1 2 3 4 5 6 7 8 9

Types of Life Insurance

From a generic viewpoint, life insurance policies can be classified as either term insurance or cash-value life insurance. Term insurance provides temporary protection, while cash-value life insurance has a savings component and builds cash values. Numerous variations and combinations of these two types of life insurance are available today.


Term Insurance ( 定期寿险）Whole Life Insurance （终身寿险）Endowment Insurance( 两全保险） Variation of Whole Life Insurance Other Types of Life Insurance


Term Insurance ( 定期寿险）• Provides temporary protection, such as 1, 5,

10, or 20years. The protection expires at the end of the period.

• Most policy are renewable without evidence of insurability （可保性） .

• The premium is increased at each renewal and is based on the insured’s attained age.

• The renewal provision results in adverse selection against the insurer.


Term Insurance( 定期寿险）• Has no cash-value or savings element• Can be exchanged for a cash-value policy• Types of Term Insurance

Yearly renewable term5-, 10-, or 20-year termTerm to age 65Decreasing term (the face amount gradually

declines each year, but the premium is level throughout the period)

Reentry term (renewable premiums are based on select (lower) mortality rates if the insured can periodically demonstrate the evidence of insurability)


Term Insurance( 定期寿险）•Users of term insurance

Relatively lower premium, especially at younger ages. More selection under the keen price competition.

appropriate if the need for protection is temporary.can be used to guarantee future insurability

•Limitations of Term Insurancepremiums increase with age and eventually reach

prohibitive levels. (e.g. Exhibit 17.1 P135) Not suitable for people beyond 65.

inappropriate if you wish to save money for a specific need.


Whole Life Insurance （终身寿险）• is a cash-value policy that provides lifetime

protection. • From a historical or traditional perspective,

the following two types merit some discussion:Ordinary life insurance （普通终身寿险）Limited-payment life insurance （限期缴费终身寿险）

Types of Life Insurance Ordinary life insurance （普通终身寿险）•（ Also called straight life and continuous premium whole life) ， provides lifetime protection to age 100, and the death claim is a certainty.• premiums remain level throughout the premium paying period. •Has an investment or saving element called cash surrender value(现金价值，退保金）•cash value can be borrowed under a loan provision. The cash values are small during the early years, but increase over time. •Contains cash surrender value, nonforfeiture options, dividend options, and settlement options.

Types of Life Insurance Uses of Ordinary life insurance

Ordinary life insurance is appropriate in two general situations:

– be appropriate when lifetime protection is needed

– be used to save money when additional savings are desired

Limitation of ordinary life insurance -some persons are still underinsured after the

policy is purchased due to the insurance agent’s persuasion.

Types of Life Insurance Limited-payment life insurance （限期缴费终身寿险） •provides lifetime protection •premiums remain level ,but paid only for a certain period （ 20,20, 25, 30 years). An extreme is single-premium whole life insurance. •The premiums under is higher than under an ordinary life policy.•Should be used with caution, especially for a person with a modest income to insure his or her life.

Percent Owni ng any l i f e i nsuance

0%10%20%30%40%50%60%70%80%90%

1984 1992 1998

Househol dsI ndi vi dual s

Average coverage, 1992 dol l ars

$0

$50, 000

$100, 000

$150, 000

$200, 000

$250, 000

1984 1992 1998


Endowment Insurance ( 两全保险）• Another traditional form of life 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 policyowner at that time.

Types of Life Insurance Variation of Whole Life Insurance （现代终身寿险）

• Life insurance have experienced keen competition in recent years from commercial banks, mutual funds, and other financial institutions.

• Traditional whole life insurance have been criticized by the consumers due to relatively lower return on savings component.

• To become more competitive, insurers have developed a wide variety of whole life products that combine insurance protection with an investment element.


Variation of Whole Life Insurance （现代终身寿险）Some important variations of whole life insurance include the following:

Variable life insurance(变额寿险）Universal life insurance(万能寿险）Variable Universal Life Insurance(变额万能寿险）

Types of Life Insurance Variable life insurance(变额寿险）

• Appeared in US market in 1976.

• be defined as a fixed-premium policy in which the death benefit and cash surrender values vary according to the investment experience of a separate account maintain by the insurer.

• Although there are different policy designs, variable life policies have certain common features as the following:

Types of Life Insurance Variable life insurance(变额寿险）

• A permanent whole life contract with a fixed premium.

• the entire reserve is held in a separate account and is invested in equities or other investments.

• The policyhowner has the option of investing the cash values in a variety ways, such as common stock fund, bond fund, balanced fund, money market fund, or international fund.

• cash surrender values are not guaranteed, and there are no minimum guaranteed cash values.

Types of Life Insurance Universal life insurance(万能寿险）• Appeared in US market in 1979.

•be defined as a flexible premium policy that provides protection under a contract that unbundles (分类） the protection and saving components.•The policyowner determines the amount and frequency of the premium payments, which can be monthly, quarterly, semiannually, annually, or a single payment. •The premium less a monthly mortality charges, administrative expense charge, and credited to a cash-value account .•Universal life insurance has certain characteristics as the following:


•Universal life insurance has certain characteristics as the following:

– Unbundling of component parts （ protection component, saving component, expense component)

mortality charge; Expense charges; Interest rate

– Two forms of universal life insurance (Death Benefit =pure insurance protection + cash value. Option A pays a level death benefit during the early policy years.; Option B provides for an increasing death benefit)

– Considerable flexibility

– Cash withdrawals permitted

– Favorable income-tax treatment

OPTI ON ALevel Death Benefi t

$0$20, 000$40, 000$60, 000$80, 000

$100, 000$120, 000$140, 000$160, 000

35 40 45 50 55 60 65

Death benefi t

Pure i nsurance

Cash Val ue

OPTI ON BLevel Net Amount at Ri sk

$0

$50, 000

$100, 000

$150, 000

$200, 000

$250, 000

35 40 45 50 55 60 65

I ncreasi ng death benefi t

Pure i nsurance

Cash val ue

Age


•Limitation of Universal Life Insurance– Misleading rates of return– Incomplete disclosure– Decline in interest rates– Right to increase mortality charge– Lack of firm commitment to pay premiums.


Variable Universal Life Insurance( 变额万能寿险）•This policy is similar to the universal life policy but with two major exceptions:

– The policyowner has a variety of investment options for investment of the cash values.

– There is no minimum guaranteed rate of interest.

– The investment risk falls entirely on the policyowner.

Types of Life Insurance Variable Universal Life Insurance(变额万能寿险）•Current Assumption Whole Life Insurance

– Current assumption whole life insurance (also called interest-sensitive whole life) is a nonparticipating whole life policy in which the cash values are based on the insurer’s current mortality, investment, and expense experience.

•Indeterminate-Premium Whole Life Insurance– An indeterminate-premium whole life policy is

a generic name for a nonparticipating policy that permits the insurer to adjust premiums based on anticipated future experience.

Types of Life Insurance Other Types of Life InsuranceA wide variety of additional life insurance products are sold in US today. Some policies are designed to meet special needs or have unique features. Others combine term insurance and cash-value life insurance to meet these needs.

• Modified Life Insurance• Preferred Risks• Second-to-Die Life Insurance• Juvenile Insurance• Savings Bank Life Insurance• Industrial Life Insurance

Summary

• In people’s life there are different kinds of health risk, such as illness, premature death, injury, etc.

• Premature death means that a family head dies with outstanding unfulfilled financial obligations. Great financial insecurity may result if a family head dies prematurely.

• At least four costs are list with premature death: human life value, additional expenses, noneconomic costs.

• The purpose of life insurance can be economically justified if a person has an earning capacity.

Summary

• From a generic viewpoint, life insurance policies can be classified as term insurance or cash-value life insurance.

• Term insurance provides temporary protection, while cash-value life insurance has a savings component and builds cash values. The purpose of life insurance can be economically justified if a person has an earning capacity.

Review Questions

I. Explain the meaning of premature death and identify the costs associated with it.

2. Explain the economic justification for the purchase of life insurance.3. Define the human life value. How is the human life value measured?4. Describe the needs approach for determining the amount of life insurance

to own.5. Explain the yearly renewable term method for providing life insurance to

individuals.7. Explain the level-premium method for providing life insurance to

individuals.9. Describe the purpose of the legal reserve in cash value life insurance.10. Describe the basic characteristics of term insurance.11. When is the use of term insurance appropriate?12. Describe the basic characteristics of ordinary life insurance13. Under what situations can an ordinary life policy be used?14.Describe the basic features of a variable life insurance policy.15. Explain the major characteristics of universal life insurance.

Case application

1. a. "The financial impact of premature death is uniform for all families." Do you agree or disagree with this statement? Explain your answer. b. Do single people need life insurance? Explain your answer.

2. Jose, age 30, is married and has one child. He has been told that he should purchase life insurance to protect his family. a. Describe each of the basic family needs for which Jose may need life insurance. b. Explain the limitations of the needs approach as method for determining the amount of life insurance to own.

Search For Information资料查询：查阅自己感兴趣的我国保险市场上任一家人寿保险公司的寿险产品。

现实问题思考：从转嫁人身风险的角度分析我国寿险保险产品市场的优劣势。

Preview•Readings : Text: Life Insurance Contractual Provisions (P351-365); Buying Life Insurance (374-383)

•Assignments /Questions

Documents

Lecture Twelve ： Fundamentals and Types of Life Insurance