Chapter 6

Life Insurance
Definition of life insurance
Life insurance is a contract between an insurance
policy holder and an insurer, where the insurer
promises to pay a designated beneficiary a sum of
money (the benefit) in exchange for a premium,
upon the death of an insured person (often the
policy holder).
Depending on the contract, other events such as
terminal illness or critical illness can also trigger
payment.
The policy holder typically pays a premium, either
regularly or as one lump sum.
Other expenses, such as funeral expenses, can also be
included in the benefits.
• Insurance Vs assurance
• The specific uses of the terms “insurance” and
“assurance” are sometimes confused. In general, in
jurisdictions where both terms are used, “insurance”
refers to providing coverage for an event that might
happen (fire, theft, flood, etc.), while “assurance” is
the provision of coverage for an event that is certain
to happen.
• In the United States, both forms of coverage are
called “insurance” for reasons of simplicity in
companies selling both products.
• By some definitions, “insurance” is any coverage that
determines benefits based on actual losses whereas
“assurance” is coverage with predetermined
benefits irrespective of the losses incurred.
Features of Life Insurance Contract
• Followings are the features of life insurance
contract:
1. Nature of General Contract
2. Insurable Interest
3. Utmost Good Faith
4. Warranties
5. Proximate Cause
6. Assignment and Nomination
1. Nature of General Contract
• Since the life insurance contract is approved by
the Bangladesh Contract Act, it must have the
following essentialities:
• Agreement (offer and acceptance)
• Competency of the parties
• Free consent of the parties
• Legal consideration
• Legal objective
2. Insurable Interest
• Insurable interest is the pecuniary interest. The
insured must have insurable interest in the life to
be insured for a valid contract.
• Insurable interest arises out of the pecuniary
relationship that exists between the policy-
holder and the life assured so that the former
stands to loose by the death of the latter and/or
continues to gain by his survival.
• The loss should be monetary or financial. Mere
emotion and expectation do not constitute
insurable interest in the life of his friend or father
merely because he gets valuable advice’s from
them.
Insurable interest in life insurance may be divided
into two categories.
1. Insurable interest in own life and
2. Insurable interest in other’s life.
The latter can be sub-divided into two classes:
a. Where proof is not required and
b. Where proof is required
Again this insurable interest where proof is
required can be divided into two classes:
i. Insurable interest arising due to business
relationship, and
ii. Insurable interest in family relationship
2.1 Insurable interest in own’s Life
• An individual always has an insurable interest in his own
life. Its presence is not required to be proved.
• Bunyon says “Every man is presumed to possess an
insurable interest in his estate for the loss of his future
gains or savings which might be the result of his premature
death”.
• The insurable interest in own life is unlimited because the
loss to the insured or his dependents cannot be measured
in terms of money and, therefore, no limit can be placed to
the amount of insurance that one may take on ones own
life.
• Thus, theoretically, a person can take a policy of any
unlimited amount on his own life but in practice no
insurer will issue a policy for an amount larger than
amount seems suitable to the circumstances and means
of the applicant.
2.2 Insurable interest in other’s life
• Life insurance can be affected on the lives of third parties
provided the proposed has insurable interest in the third
party. There are two types of insurable interest in others
life. First where proof is not required and second, where
proof is required.
2.2.1 Proof is not required
• There are only two such cases where the presence of
insurable interest is legally presumed and therefore need
not be proved.
• Wife has insurable interest in the life of her husband: It is
presumed and decided by Reed vs. Royal Exchange (1795)
that wife has an insurable interest in the life of her husband
because husband is legally bound to support his wife. The
wife will suffer financially if the husband is dead and will
continue to gain if the husband is surviving.
• Husband has insurable interest in the life of his
wife: It was decided in Griffith vs. Fleming (1909)
that the husband has insurable interest in his
wife’s life because of domestic services
performed, by the wife. If the wife is dead,
husband has to employ other person to render
the domestic services and other financial
expenditures will involve at her death which are
not calculable. The husband is benefited at the
survival of his wife, so it is self proved that
husband has insurable interest in his wife’s life.
2.2.2 Proof is required
• Insurable interest has to be proved in the
following cases:
• Business Relationship: The policyholder may have
insurable interest in the life of assured due to
business or contractual relationship. In this case,
the amount of insurance depends on the amount
of risk involved. Example, a creditor may lose
money if the debtor dies before the loan is repaid.
The continuance of debtor’s life is financially
meaningful to the creditor because the latter will
get all his money repaid at the former’s survival.
Family Relationship: The insurable interest may
arise due to family relationship if pecuniary
interest exists between the policyholders and life
assured because mere relationship or ties of
blood and of affection does not constitute
insurable interest. The proposer must have a
reasonable expectation of financial benefit from
the continuance of the life of the person to be
insured or of financial loss from his death. The
interest must be based on value and not on mere
sentiments.
General Rules of Insurable Interest in Life Insurance:
• Time of Insurable Interest: Insurable interest must exist at
the time of proposal. Policy, without insurable interest, will
be wager. It is not essential that the insurable interest
must be present at the time of claim.
• Services: Except the services of wife, services of other
relatives will not essentially form insurable interest. There
must be financial relationship between the proposer and
the life-assured. In other words, the services performed by
the son without dependence of his father, will not
constitute insurable interest of the father in the life of his
son. Vice-versa is not essential for forming insurable
interest.
• Insurable Interest must be valuable: In business
relationship the value or extent of the insurable must be
determined to avoid wager contract of additional
insurance. Insurance is limited only up to the amount of
insurable interest.
• Insurable interest should be valid: Insurable interest
should not be against public policy and it should be
recognized by law. Therefore, the consent of life
assured is very essential before the policy can be
issued.
• Legal responsibility may be basis of insurable
interest: Since the person will suffer financially up to
the extent of responsibility, the proposal has
insurable interest to that extent.
• Insurable Interest must be definite: Insurable
interest must be present definitely at the time of
proposal. Mere expectation of gain or support will
not constitute insurable interest.
• Legal Consequence: Insurable interest must be there
to form legal and valid insurance contract. Without
insurable interest, it would be null and void.
3. Utmost Good Faith
• Life insurance requires that the principle of utmost good faith
should be preserved by both the parties. The principle of
utmost good faith says that the parties, proposer (insured)
and insurer must be of the same mind at the time of
contract because only then the risk may be correctly
ascertained. They must make full and true disclosure of the
facts material to the risk.
Material facts: In life insurance material facts are age, income,
occupation, health, habits, residence, family history and plan
of insurance. Material facts are determined not on the basis
of opinion, therefore, the proposer should disclose not only
those matters which the proposer may feel are material but
all facts which are material.
Duty of both parties: It is not only the proposer but the insurer
also who is responsible to disclose all the material facts which
are going to influence the decision of the proposer.
Full and True Disclosure: Utmost good faith says
that there should be full and true disclosure of all
the material facts. Full and true means that there
should be no concealment, misrepresentation,
half disclosure and fraud of the subject matter to
be insured.
Legal Consequence: In the absence of utmost good
faith the contract will be avoidable at the option
of the person who suffered loss due to non-
disclosure. The intentional non-disclosure
amounts to fraud and the unintentional non-
disclosure is voidable at the option of the party
not at fault.
4. Warranties
• In an insurance policy, a warranty is a promise. The definition of warranty
in an insurance is an agreement between the two parties (the insured
and the insurer) that must be carried out with full responsibility by the
insured.
• A warranty is a promise (assurance) that must be met by the insured in
regards to the risks to:
• Do or not do something.
• A fact that is deemed to exist or not to exist.
• Warranties are an integral part of the contract, i.e., these are the basis of
the contract between the proposer and insurer and if any statement,
whether material or non-material, is untrue, the contract shall be null
and void and the premium paid by him may be forfeited by the insurer.
The policy issued will contain that the proposal and personal statement
shall form part of the Policy and be the basis of the contract.
• 4.1 Breach of Warranty
• If there is breach of warranty, the insurer is not bound to perform his
part of the contract unless he chooses to ignore the breach. The effect of
a breach of warranty is to render the contract voidable at the option of
the other party provided there is no element of fraud. In case of
fraudulent representation or promise, the contract will be Void ab initio.
5. Proximate Cause
• The efficient or effective cause which causes the
loss is called proximate cause. It is the real and
actual cause of loss. If the cause of loss (peril) is
insured, the insurer will pay; otherwise the
insurer will not compensate.
• In life insurance the doctrine of Causa Proxima
(Proximate Cause) is not applicable because the
insurer is bound to pay the amount of insurance
whatever may be the reason of death. It may be
natural or unnatural.
6. Assignment and Nomination
• Assignment — a transfer of legal rights under, or interest in,
an insurance policy to another party. In most instances, the
assignment of such rights can only be effected with the
written consent of the insurer.
• The Policy in life insurance can be assigned freely for a
legal consideration or love and affection. The assignment
shall be complete and effectual only on the execution of
such endorsement either on the Policy itself or by a
separate deed. Notice for this purpose must be given to the
insurer who will acknowledge the assignment. Once the
assignment is completed, it cannot be revoked by the
assignor because he ceases to be the owner of the Policy
unless reassignment is made by the assignee in favor of
the assignor.
• The life policies are the only Policies which can be
assigned whether the assignee has an insurable interest
or not.
• Nomination is the process by which the policyholder
appoints a person or persons to receive policy benefits in
case of a death claim. So in case of an eventuality, the life
insurance company pays the policy proceeds to the
appointed person - called Nominee.
• The holder of a policy of life insurance on his own life may,
either at the time of affecting policy or at any subsequent
time before the Policy matures, nominate the person or
persons to whom the money secured by the policy shall be
paid in the event of his death. A nomination can be
cancelled before maturity, but unless notice is given of any
such cancellation to the insurer, the insurer will not be
liable for any bonafide payment to a nominee registered in
the records. When the policy matures, or if the nominee
dies, the sum shall be paid to the Policy-holder or his legal
representatives.
Amount of Life Insurance to Own
• Once you determine that you need life insurance,
the next step is to calculate the amount of life
insurance to own. Some life insurers and financial
planners recommend that insureds carry life
insurance equal to some multiple of their earnings,
such as 5 to 10 times annual earnings. Such rules,
however, are meaningless because they do not take
into account that the need for life insurance varies
widely depending on family size, income levels,
existing financial assets, and financial goals.
• Three approaches can be used to estimate the
amount of life insurance to own:
■■ Human life value approach
■■ Needs approach
■■ Capital Retention Approach
Human Life Value Approach
• The family’s share of the deceased breadwinner’s
earnings is lost forever if the family head dies
prematurely. This loss is called the human life
value. Human life value can be defined as the
present value of the family’s share of the
deceased breadwinner’s future earnings.
• In its basic form, the human life value can be
calculated by the following steps:
1. Estimate the individual’s average annual earnings
over his or her productive lifetime.
2. 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.
3. Determine the number of years from the person’s
present age to the contemplated age of
retirement.
4. Using a reasonable discount rate, determine the
present value of the family’s share of earnings for
the period determined in step 3.
• For example, assume that Richard, age 27, is married
and has two children. He earns $50,000 annually and
plans to retire at age 67. (For the sake of simplicity,
assume that his earnings remain constant.) Of this
amount, $20,000 is used for federal and state taxes,
life and health insurance, and Richard’s personal
needs. The remaining $30,000 is used to support his
family. This stream of future income is then
discounted back to the present to determine
Richard’s human life value. Using a reasonable
discount rate of 5 percent, the present value of 40
annual payments of $1 at the end of each year is
$17.16. Therefore, Richard has a human life value of
$514,800 ($30,000 * $17.16 = $514,800).
However, the basic human life value just described has
several limitations.
• First, other sources of income are ignored, such as
Social Security survivor benefits, as well as the
income from individual retirement accounts (IRAs),
and private pension death benefits.
• Second, in the basic model, occupations are not
considered, work earnings and expenses are assumed
to be constant, and employee benefits are ignored.
• Third, the amount of money allocated to the family
can quickly change because of divorce, birth of a
child, or death of a family member. Also, the longrun
discount rate is critical; the human life value can be
substantially increased by assuming a lower rate.
• Finally, the effects of inflation on earnings and
expenses are ignored.
Needs Approach
• The second method for estimating the amount of
life insurance to own is the 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 total amount of existing life
insurance and financial assets is then subtracted
from the total amount needed. The difference, if
any, is the amount of new life insurance that
should be purchased.
The most important family needs are the following:
■■ Estate clearance fund
■■ Income during the readjustment period
■■ Income during the dependency period
■■ Life income to the surviving spouse
■■ Special needs
– Mortgage redemption fund
– Educational fund
– Emergency fund
– Mentally, emotionally, or physically challenged family
members
■■ Retirement needs
Estate Clearance Fund
• An estate clearance fund or clean-up fund is
needed immediately when the family head dies.
Immediate cash is needed for burial expenses;
uninsured medical bills; installment debts; estate
administration expenses; and estate, inheritance,
and income taxes.
Income During the Readjustment Period
• The readjustment period is a one- or two-year
period following the breadwinner’s death. During
this period, the family should receive
approximately the same amount of income
received while the family head was alive.
Income During the Dependency Period
The dependency period follows the readjustment
period; it is the period until the youngest child
reaches age 18. The family should receive income
during this period so that the surviving spouse
can remain at home, if necessary, to care for the
children.
Life Income to the Surviving Spouse
Another important need is to provide life income to the
surviving spouse, especially if he or she is older and
has been out of the labor force for many years. Two
income periods must be considered: (1) income
during the blackout period and (2) income to
supplement Social Security benefits after the
blackout period. The blackout period refers to the
period from the time that Social Security survivor
benefits terminate to the time the benefits are
resumed. Social Security benefits to a surviving
spouse terminate when the youngest child reaches
age 16 and start again when the spouse attains age
60.
Special Needs
• Families should also consider certain special needs, which
include the following:
■■ Mortgage redemption fund. The amount of monthly income
needed by surviving family members is greatly reduced when
monthly mortgage payments or rent payments are required.
■■ Educational fund. The family head may wish to provide an
educational fund for the children. If the children plan to attend a
private college or university, the cost will be considerably higher
than at a public institution.
■■ Emergency fund. A family should also have an emergency fund.
An unexpected event may occur that requires large amounts of
cash, such as major dental work, home repairs, or a new car.
■■ Mentally, emotionally, or physically challenged family
members. Additional funds may be needed for educating,
training, and caring for children or adult family members who
are mentally, emotionally, or physically challenged.
Retirement Needs
• Because the family head may survive until
retirement, the need for adequate retirement
income should also be considered. Most retired
workers are eligible for Social Security retirement
benefits and may also be eligible for retirement
benefits from their employer. If retirement
income from these sources is inadequate, you
can obtain additional income from cash-value life
insurance, individual investments, a retirement
annuity, or an individual retirement account
(IRA).
Capital Retention Approach
• Unlike the needs approach, which assumes
liquidation of the life insurance proceeds, the capital
retention approach preserves the capital needed to
provide income to the family. The income-producing
assets are then available for distribution later to the
heirs.
• The amount of life insurance needed based on the
capital retention approach can be determined by the
following steps:
■ Prepare a personal balance sheet.
■ Determine the amount of income-producing capital.
■ Determine the amount of additional capital needed
(if any).
Prepare a Personal Balance Sheet
• The first step is to prepare a personal balance sheet
that lists all assets and liabilities. The balance sheet
should include all death benefits from life insurance
and from other sources.
Determine the Amount of Income-Producing Assets
• The second step is to determine the amount of
income-producing assets. This step is performed by
subtracting the liabilities, cash needs, and
nonincome-producing assets from total assets.
• Unless the home is sold or rented, it ordinarily does
not produce cash income for the family. Thus, the
home is considered to be part of non-income-
producing assets, which is subtracted from total
assets to arrive at the amount of liquid assets that
can produce income for the family.
Determine the Amount of Additional Capital
Needed
• The final step is to determine the amount of
additional capital needed. This step involves a
comparison of the income objective with other
sources of income, such as Social Security survivor
benefits.
• 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, whereas 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
• Term insurance has several basic characteristics. First,
the period of protection is temporary, such as 1, 5,
10, 20, or 30 years. Unless the policy is renewed, the
protection expires at the end of the period.
• Most term insurance policies are renewable, which
means the policy can be renewed for additional
periods without evidence of insurability.
• Most term insurance policies are also convertible,
which means the term policy can be exchanged for a
cash-value policy without evidence of insurability.
• Finally, term insurance policies have no cash value
or savings element. Although some long-term
policies develop a small reserve, it is used up by the
contract expiration date.
• Types of Term Insurance
• A wide variety of term insurance products are sold
today. They include the following:
■■ Yearly renewable term
■■ 5-, 10-, 15-, 20-, 25-, or 30-year term
■■ Term to age 65
■■ Decreasing term
■■ Reentry term
■■ Return of premium term insurance
• Yearly renewable term insurance is issued for a
one-year period, and the 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 can also be issued for 5, 10, 15,
20, 25, or 30 years. The premiums paid during the
term period are level, but they increase when the
policy is renewed.
• A term to age 65 policy provides protection to age
65, at which time the policy expires. The policy
can be converted to a permanent plan of
insurance, but the decision to convert must be
exercised before age 65.
• Decreasing term insurance is a form of term
insurance where the face amount gradually declines
each year. However, the premium is level throughout
the period. In some policies, the premiums are
structured so that the policy is fully paid for a few
years before the coverage expires.
• Reentry term is a term insurance policy in which
renewal premiums are based on select (lower)
mortality rates if the insured can periodically
demonstrate acceptable evidence of insurability.
Select mortality rates are based on the mortality
experience of recently insured lives. However, to
remain on the low-rate schedule, the insured must
periodically show that he or she is in good health and
is still insurable.
• Uses of Term Insurance
• Term insurance is appropriate in three general situations.
• First, if the amount of income that can be spent on life
insurance is limited, term insurance can be effectively used.
• Second, term insurance is appropriate if the need for
protection is temporary. For example, decreasing term
insurance can be used to pay off the mortgage if the family
head dies prematurely, or provide income during the
dependency period.
• Finally, term insurance can be used to guarantee future
insurability. People may desire large amounts of
permanent insurance, but may be financially unable to
purchase the needed protection today. Inexpensive term
insurance can be purchased, which can be converted later
into a permanent cash-value policy without evidence of
insurability.
Limitations of Term Insurance
• Term insurance has two major limitations.
• First, term insurance premiums increase with age at
an increasing rate and eventually reach prohibitive
levels. For example, in one insurer, a male, age 30,
would pay an annual premium of $140 for a
$500,000, 10-year term insurance policy. At age 70,
this same policy would cost $4,400 annually.
• Second, term insurance is inappropriate if you wish
to save money for a specific need. Term insurance
policies do not accumulate cash values. Thus, if you
wish to save money for a child’s college education or
accumulate a fund for retirement, term insurance is
inappropriate unless it is supplemented with an
investment plan.
Whole Life Insurance
• If the insured wants lifetime protection, term
insurance is impractical because the coverage is
temporary, and the premiums are prohibitive in
cost at older ages. In contrast, whole life
insurance is a generic name for a cash-value
policy that provides lifetime protection. Whole
life insurance is called ordinary life insurance if
premiums are payable throughout the lifetime of
the insured and limited payment life insurance if
the premium period is less than the insured’s
lifetime. A stated amount is paid to a designated
beneficiary when the insured dies, regardless of
when the death occurs.
Ordinary Life Insurance
• Ordinary life insurance is a level-premium policy
that accumulates cash values and provides lifetime
protection to age 121. Age 121 is the end date of the
mortality table, and premiums are paid throughout
the insured’s lifetime.
Ordinary life insurance has several basic
characteristics.
• First, as stated earlier, premiums are level
throughout the premium-paying period. As a result,
the insured is actuarially overcharged during the early
years and undercharged during the later years. The
excess premiums paid during the early years are
accumulated at compound interest and are then used
to supplement the inadequate premiums paid during
the later years of the policy.
• A second characteristic is the accumulation of
cash-surrender values, which is the amount paid
to a policyholder who surrenders the policy. As
noted earlier, under a system of level premiums,
the policyholder overpays for the insurance
protection during the early years, which results in
a legal reserve and the accumulation of cash
values.
Uses of Ordinary Life Insurance
• An ordinary life policy is appropriate when
lifetime protection is needed.
• Ordinary life insurance can also be used to save
money. Some policyholders wish to meet their
protection and savings needs with an ordinary life
policy.
Limited-Payment Life Insurance
• A limited-payment policy is another type of
traditional whole life insurance. The insurance is
permanent, and the insured has lifetime protection.
The premiums are level, but they are paid only for a
certain period. For example, Shannon, age 25, may
purchase a 20-year limited payment policy in the
amount of $25,000. After 20 years, the policy is
completely paid up, and no additional premiums are
required even though the coverage remains in force.
A paid-up policy should not be confused with one
that matures. A policy matures when the face amount
is paid as a death claim or as an endowment. A policy
is paid up when no additional premium payments are
required.
• The most common limited-payment policies are
for 10, 20, 25, or 30 years. A paid-up policy at age
65 or 70 is another form of limited-payment
insurance.
• An extreme form of limited-payment life
insurance is single-premium whole life insurance,
which provides lifetime protection with a single
premium. Because the premiums under a limited-
payment policy are higher than those paid under
an ordinary life policy, the cash values are also
higher.
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 beneficiary at that time.
• For example, if Stephanie wants to provide a basic
college fund for her 1-year-old daughter, she may
take out a $20,000 15-year endowment policy.
The funds will be available whether Stephanie
lives or dies.
Variations of Whole Life Insurance
• Important variations of whole life insurance
include the following:
■■ Variable life insurance
■■ Universal life insurance
■■ Indexed universal life insurance
■■ Variable universal life insurance
■■ Current assumption whole life insurance
Variable Life Insurance
• Variable life insurance can be defined as a fixed-
premium policy in which the death benefit and
cash values vary according to the investment
experience of a separate account, which is
similar to a mutual fund maintained by the
insurer. The death benefit and cash surrender
values will increase or decrease with the
investment experience of the separate account.
• Although there are different policy designs,
variable life policies have certain common
features. They are summarized as follows:
■■ A variable life policy is a permanent whole life
contract with a fixed premium. The premium is level
and is guaranteed not to increase.
■■ The entire reserve is held in a separate account and
is invested in common stocks or other investments.
The policyholder has the option of investing the cash
value in a variety of investments, such as a common
stock fund, bond fund, balanced fund, money market
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, but it can
never fall below the original face amount.
■■ There are no minimum guaranteed cash values.
The actual cash values depend on the investment
experience.
Universal Life Insurance
• Universal life insurance is another important variation
of whole life insurance. Universal life insurance (also
called flexible premium life insurance) can be defined
as a flexible premium policy that provides protection
under a contract that separates the protection and
saving components. Except for the first premium, the
policyholder determines the amount and frequency
of payments. The premiums, less explicit expense
charges, are credited to a cash value account (also
called an accumulation fund) from which monthly
mortality charges are deducted and to which monthly
interest is credited. In addition, universal life policies
typically have a monthly deduction for administrative
expenses.
Universal life insurance has certain characteristics, which
include the following:
■ Unbundling of protection and saving component
■ Two forms of universal life insurance
■ Considerable flexibility
■ Cash withdrawals permitted
■ Favorable income-tax treatment
Unbundling of Component Parts
A distinct characteristic of universal life insurance is the
separation or unbundling of the protection component and
the saving component. The policyholder receives an
annual statement that shows the premiums paid, death
benefit, and value of the cash-value account. The
statement also shows the mortality charge and interest
credited to the cash-value account.
Two Forms of Universal Life Insurance
There are two forms of universal life insurance.
• Option A pays a level death benefit during the early
years.
• Option B provides for an increasing death benefit.
Considerable Flexibility
Compared to traditional whole life products, universal
life insurance provides considerable flexibility, which
includes the following:
■ The policyholder determines the frequency and
amount of premium payments.
■ The face amount of insurance can be increased with
evidence of insurability. However, the face amount of
insurance can be reduced with no evidence of
insurability.
■ The policy can be changed from a level death
benefit to a death benefit equal to a specified
face amount plus the policy cash value (with
evidence of insurability).
■ The policyholder can add cash to the policy at any
time, subject to maximum guideline limits that
govern the relationship between the cash value
and the death benefit (tax law limitations).
■ Policy loans are permitted at competitive interest
rates.
■ If the policy permits, additional insureds can be
added.
Cash Withdrawals Permitted
• Part or all of the cash value can be withdrawn.
Interest is not charged, but the death benefit is
reduced by the amount of the withdrawal.
Favorable Income-Tax Treatment
• Universal life insurance enjoys the same favorable
federal income tax treatment as traditional cash-
value policies. The death benefit paid to a named
beneficiary is normally received income-tax free.
Indexed Universal Life Insurance
• Indexed universal life insurance is a variation of
universal life insurance with certain key
characteristics.
• First, there is a minimum interest rate guarantee,
which is usually lower than the minimum interest
rate guarantee on a regular universal life policy.
• Second, additional interest may be credited to the
policy based on the investment gains of a specific
stock market index, such as the S & P 500 Index.
• Third, there is a formula for determining the amount
of enhanced (additional) interest credited to the
policy; the formula usually places a cap on the
maximum upper limit of additional interest credited
to the policy; the formula may also place a limit on
the participation rate that applies to the index.
• Fourth, there is often considerable consumer
misunderstanding and unrealistic performance
expectations under this type of policy.
• Finally, consumers find that policies regulated
under Federal Securities laws, as well as state
insurance regulation, provide more complete
disclosure than policies not federally regulated.
Variable Universal Life Insurance
• Variable universal life insurance is an important
variation of whole life insurance. These policies are
often sold as investments or tax shelters. Variable
universal life insurance is similar to a universal life
policy with two major exceptions:
■■ The policyholder determines how the premiums are
invested, which provides considerable investment
flexibility.
■■ The policy does not guarantee a minimum interest
rate or minimum cash value. One exception, however,
is that the policy may have a fixed-income account,
which may guarantee a minimum interest rate on the
account value.
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. A
nonparticipating policy is a policy that does not
pay dividends.
Other Types Of Life insurance
• Modified Life Insurance
• A modified life policy is a whole life policy in
which premiums are lower for the first 3 to 5
years and higher thereafter. The initial premium
is slightly higher than for term insurance, but
considerably lower than for a whole life policy
issued at the same age.
• Preferred Risks
• Most life insurers sell policies at lower rates to
individuals known as preferred risks. These
people are individuals whose mortality experience
is expected to be lower than average.
• Joint Life Insurance
• Joint life insurance (also called a first-to-die
policy) is a policy written on the lives of two or
more people and is payable at the time of the
death of the first person to die. For example, this
policy can be used to insure a husband and wife,
where each is the beneficiary of the other spouse.
• Second-to-Die Life Insurance
• Second-to-die life insurance (also called
survivorship life) is a form of life insurance that
insures two or more lives and pays the death
benefit at the time of the death of the second or
last insured.
• Group Life Insurance
• Group life insurance is an important type of
insurance that provides life insurance to
members of a group in a single master contract
between the insurer and employer, or other
group sponsor. Physical examinations are not
required, and certificates of insurance are issued
as evidence of insurance.
Determining The Cost Of Life Insurance
• The cost of life insurance is a complex subject. In general,
cost can be viewed as the difference between what you
pay for a life insurance policy and what you get back. If
you pay premiums and get nothing back, the cost of the
insurance equals the premiums paid.
• However, if you pay premiums and later get something
back, such as the cash value and dividends, your cost will
be reduced. Thus, in determining the cost of life insurance,
four major factors must be considered: (1) annual
premiums, (2) cash values, (3) dividends, and (4) time value
of money.
• Two cost methods that consider some or all of the
preceding factors are the traditional net cost method and
the interest-adjusted cost method.
Traditional Net Cost Method
• From a historical perspective, life insurers previously
used the traditional net cost method to illustrate the
net cost of life insurance. Under this method, the
annual premiums for some time period are added
together. Total expected dividends to be received
during the same period and the cash value at the
end of the period are then subtracted from the total
premiums to determine the net cost of life
insurance. For example, assume that the annual
premium for a $10,000 ordinary life insurance policy
issued to a female, age 20, is $132.10 (paid at start of
policy period). Accumulated dividends over a 20-year
period are $599, and the cash-surrender value at the
end of the twentieth year is $2,294 (see Exhibit 13.1).
The average cost per year is minus $12.55 (- $1.26
per $1,000).
• Traditional Net Cost Method
• Total premiums for 20 years (132.20X20) $2,642
• Subtract accumulated dividends for 20 years -599
• Net premiums for 20 years $2,043
• Subtract the cash value at the end of 20 years -2,294
• Insurance cost for 20 years - $251
• Net cost per year (- $251 /20) - $12.55
• Net cost per $1,000 per year (- $12.55/10) - $1.26
• The traditional net cost method has several
defects and is misleading.
• The most glaring defect is that it does not
consider the time value of money.
• In addition, the insurance illustration often
showed the insurance to be free (to have a
negative cost). This is contrary to common sense,
because no insurer can provide free insurance and
remain in business.
Interest-Adjusted Cost Method
• The interest-adjusted cost method developed by the
National Association of Insurance Commissioners is a
more accurate measure of life insurance costs. Under
this method, the time value of money is taken into
consideration by applying an interest factor to each
element of the cost calculation.
• There are two principal types of interest-adjusted
cost indexes: the surrender cost index and the net
payment cost index.
• The surrender cost index is useful if you believe that
you may surrender the policy at the end of 10 or 20
years, or some other time period.
• The net payment cost index is useful if you intend to
keep your policy in force, and cash values are of
secondary importance to you.
Surrender Cost Index
• The surrender cost index measures the cost of life insurance
if you surrender the policy at the end of some time period,
such as 10 or 20 years, and takes compound interest into
account. Exhibit shown in the next slide provides an
illustration of the surrender cost index.
• The annual premiums of $132.10 are accumulated at 5
percent interest, which recognizes the fact that the
policyholder could have invested the premiums elsewhere.
Therefore, the true accumulated value is $4,586, not
$2,642 as shown in the traditional method. Although the
schedule of dividends for each year is not shown here, it is
assumed that the dividends in the hypothetical schedule
are accumulated at 5 percent interest , at the end of 20
years which would be $824. Using the same policy as
before, the net premiums for 20 years adjusted for interest
are $3,762.
• The next step is to subtract the cash value at the end
of 20 years from the net premiums, which results in a
total insurance cost of $1,468.
• The final step is to convert the total interest adjusted
cost for 20 years into an annual cost. This is done by
dividing the total interest-adjusted cost for 20 years
by an annuity due factor of 34.719.
• By dividing the total interest-adjusted cost of $1,468
by $34.719, you end up with an annual interest-
adjusted cost of $42.28, or $4.23 for each $1,000 of
insurance.
• As you can see, the interest adjusted cost is positive,
which means that it costs something to own life
insurance when forgone interest is considered. In this
case, the average annual cost is $42.28 if the policy is
surrendered after 20 years.
Surrender cost index
Total premiums for 20 years, each accumulated at 5% $4,586
(131.20x FVIFA due at 5% for 20 years or 131.20x 34.719)

Subtract dividends for 20 years, each accumulated at 5% -824

Net premiums for 20 years (interest adjusted) $3,762

Subtract the cash value at the end of 20 years -2,294

Insurance cost for a total of 20 years (interest adjusted) $1,468

Amount to which $1 deposited annually at the beginning $34.719

of each year will accumulate to in 20 years at 5%
Interest-adjusted cost per year ($1,468 /$34.719) $42.28

Cost per $1,000 per year ($42.28 /10) $4.23

Net Payment Cost Index
• The net payment cost index measures the relative
cost of a policy if death occurs at the end of some
specified time period, such as 10 or 20 years. It is
based on the assumption that you will not surrender
the policy. Therefore, it is the appropriate cost index
to use if you intend to keep your life insurance in
force.
• The net payment cost index is calculated in a manner
similar to the surrender cost index except that the
cash value is not subtracted (see Exhibit 13.3).
• If the policy is kept in force for 20 years, the policy
has an annual cost of $108.36 ($10.84 per $1,000)
after interest is considered.
Net Payment cost index
Total premiums for 20 years, each accumulated at 5% $4,586

Subtract dividends for 20 years, each accumulated at 5% -824

Insurance cost for 20 years $3,762

Amount to which $1 deposited annually at the beginning $34.719

of each year will accumulate to in 20 years at 5%
Interest-adjusted cost per year ($3,762 /$34.719) $108.36

Cost per $1,000 per year ($108.36 /10) $10.84

Shopping for Life Insurance/ Steps follows in
developing a sound life insurance program
1. Determine whether you need life insurance.
2. Estimate the amount of life insurance you need.
3. Decide on the best type of life insurance for you.
4. Decide whether you want a policy that pays
dividends.
5. Shop around for a low-cost policy.
6. Consider the financial strength of the insurer.
7. Deal with a competent agent.
1. Determine Whether You Need Life Insurance
• The first step is to determine whether you need
life insurance. If you are married or single with
one or more dependents to support, you may
need a substantial amount of life insurance. You
may also need life insurance if you have a
temporary need, such as paying off the mortgage
on your home.
• However, if you are single and no one is currently
dependent on you for financial support, you do
not need life insurance, other than a modest
amount for burial purposes.
2. Estimate the Amount of Life Insurance You Need
• The needs approach is a practical method for
determining the amount of life insurance to
purchase. Persons with dependents often need
surprisingly large amounts of life insurance. In
determining the amount needed, you must
consider your family’s present and future financial
needs, potential survivor benefits from Social
Security, and other financial assets currently
owned.
3. Decide on the Best Type of Life Insurance for You
• The next step is to select the best type of life
insurance policy for you. The best policy is the one
that best meets your financial needs.
4. Decide Whether You Want a Policy That Pays
Dividends
• Both stock and mutual insurers issue participating
policies, which give policyholders the right to share in
the divisible surplus of the insurer by payment of a
dividend. A dividend is a refund of part of the gross
premium if the insurer has favorable experience with
respect to mortality, expenses, and interest.
5. Shop Around for a Low-Cost Policy
• One of the most important suggestions is to shop
carefully for a low-cost policy. There is enormous
variation in the cost of life insurance. You should not
purchase a life insurance policy from the first agent
who approaches you. Instead, you should compare
the interest- adjusted cost of similar policies from
several insurers before you buy.
6. Consider the Financial Strength of the Insurer
• In addition to cost, you should consider the
financial strength of the insurer issuing the policy.
Some life insurers have become insolvent and
have gone out of business. Thus, it is important to
buy life insurance only from financially sound
insurers.
7. Deal with a Competent Agent
• You should always deal with a professional agent
or financial planner when you buy life insurance.
A professional agent is one who has the
competence to understand your needs and to
match them with the right plan.
Problem 1
• Richard, age 45, is married with two children in
high school. He estimates that his average annual
earnings over the next 20 years will be $60,000.
He estimates that one-third of his average annual
earnings will be used to pay taxes, insurance
premiums, and the costs of self-maintenance. The
remainder will be used to support his family.
Richard wants to calculate his human life value
and believes a 6 percent discount rate is
appropriate. The present value of $1 payable for
20 years at a discount rate of 6 percent is $11.47.
Calculate Richard’s human life value.
Problem 2
Kelly, age 35, is a single parent and has a one-yearold
son. She earns $45,000 annually as a marketing
analyst. Her employer provides group life insurance in
the amount of twice the employee’s salary. Kelly also
participates in her employer’s 401(k) plan.
She has the following financial needs and objectives:
■ Funeral costs and uninsured medical bills $ 10,000
■ Income support for her son $2,000 monthly for 17
years
■ Pay off mortgage on home 150,000
■ Pay off car loan and credit card debts 15,000
■ College education fund for son 150,000
Kelly has the following financial assets:
■ Checking account $ 2,000
■ IRA account 8,000
■ 401(k) plan 25,000
■ Individual life insurance 25,000
■ Group life insurance 90,000
a. Ignoring the availability of Social Security survivor
benefits, how much additional life insurance, if any,
should Kelly purchase to meet her financial goals
based on the needs approach? (Assume that the rate
of return earned on the policy proceeds is equal to
the rate of inflation.)
b. How much additional life insurance, if any, is needed
if estimated Social Security survivor benefits in the
amount of $800
Problem 3
• Nicole, age 25, is considering the purchase of a $20,000
participating ordinary life insurance policy. The annual
premium is $248.60. Projected dividends over the first 20
years are $814. The cash value at the end of 20 years is
$4314. If the premiums are invested at 5 percent interest,
they will accumulate to $8631 at the end of 20 years. If the
dividends are invested at 5 percent interest, they will
accumulate to $1163 at the end of 20 years. A $1 deposit at
the beginning of each year at 5 percent interest will
accumulate to $34.719 at the end of 20 years.
a. Based on the traditional net cost method, calculate the cost
per $1000 per year.
b. Based on the surrender cost index, calculate the cost per
$1000 per year.
c. Based on the net payment cost index, calculate the cost per
$1000 per year.
Problem 4
Todd, age 40, is considering the purchase of a $100,000
participating ordinary life insurance policy. The annual
premium is $2280. Projected dividends over the first 20
years are $15,624. The cash value at the end of 20 years is
$35,260. If the premiums are invested at 5 percent interest,
they will grow to $79,159 at the end of 20 years. If the
dividends are invested at 5 percent interest, they will
accumulate to $24,400 at the end of 20 years. A $1 deposit
at the beginning of each year at 5 percent interest will
accumulate to $34.719 at the end of 20 years.
a. Based on the traditional net cost method, calculate the cost
per $1000 per year.
b. Based on the surrender cost index, calculate the cost per
$1000 per year.
c. Based on the net payment cost index, calculate the cost per
$1000 per year.
Thank You