Introduction to Life Insurance and Endowment
What is Life Insurance?
Life Insurance is a contract between the policyholder and an insurer, where the insurer
promises to pay a sum of money (called the death benefit) to designated beneficiaries
upon the death of the insured person. In exchange, the policyholder agrees to pay regular
premiums.
Main Purpose: Financial security for dependents. The death benefit can be used to cover
living expenses, mortgages, loans, education costs, or other financial needs after the
policyholder's death.
Types of Life Insurance
There are two broad categories of life insurance:
Term Life Insurance:
Coverage: Only for a fixed period, such as 10, 20, or 30 years.
Death Benefit: Paid only if the insured dies during the policy term.
Premiums: Lower than whole life insurance because it doesn’t build cash value.
Example: A 35-year-old buys a 20-year term policy for $500,000. If they die
within those 20 years, their beneficiaries receive $500,000.
Whole Life Insurance:
Coverage: For the insured's entire life.
Death Benefit: Guaranteed payment upon death, regardless of when it occurs.
Cash Value Component: Whole life insurance builds up cash value over time.
The policyholder can borrow against this cash value or withdraw it during their
lifetime.
Premiums: Higher than term insurance due to the cash value and lifelong
coverage.
Example: A person buys a whole life policy with a $250,000 death benefit. They
pay premiums throughout their life, and the insurer pays $250,000 upon their
death, whether they die at age 50 or 90.
What is Endowment Insurance?
Endowment Insurance: This is a hybrid between life insurance and a savings plan. It
pays a lump sum either upon the insured’s death or at the end of a specified period (called
the maturity date), whichever comes first.
How it Works:
If the insured dies during the policy term, the death benefit is paid.
If the insured survives the term, they receive the policy’s maturity benefit, which
is often used for financial goals like retirement or paying for a child’s education.
Example: A person buys a 20-year endowment policy with a sum assured of $100,000. If
they die during the 20 years, the beneficiaries get $100,000. If they survive the 20 years,
they receive $100,000.
Life Insurance: Key Concepts
Premiums
Definition: The periodic payment made by the policyholder to keep the insurance policy
active.
How Premiums are Calculated:
Age: Younger policyholders pay lower premiums because they are less likely to
die soon.
Health: Healthier individuals get lower premiums because they are less risky to
insure.
Policy Type: Whole life insurance has higher premiums than term insurance due
to its cash value and permanent coverage.
Death Benefit
Death Benefit: The amount of money the insurer pays to the beneficiaries when the
insured dies. It can be a lump sum or an annuity (periodic payments over time).
Present Value of Future Benefits
In life insurance, actuarial present value (APV) is used to calculate the current value of
future payouts. It discounts future amounts to account for the time value of money and the
probability that the event (death) will occur in a certain time frame.
Formula for Actuarial Present Value:
𝐴𝑃𝑉 = 𝑣 𝑃(𝑇 = 𝑘)
Where:
𝑣= is the discount factor (based on the interest rate i).
𝑇 is the time until death for a person aged 𝑥.
𝑃(𝑇 = 𝑘) is the probability that a person aged xxx will die after 𝑘 years.
Example: Calculating Actuarial Present Value
Suppose a 30-year-old buys a life insurance policy that will pay $100,000 upon death.
The probability that they die in year 1 is 0.001, in year 2 is 0.0011, and in year 3 is
0.0012. The interest rate is 4%.
First, calculate the discount factor:
1 1
𝑣= = = 0.9615.
1 + 𝑖 1 + 0.04
The present value of future benefits is:
𝐴𝑃𝑉 = 100000 × (0.9615 × 0.001 + 0.9246 × 0.0011 + 0.8890 × 0.0012) = 304.53.
Thus, the actuarial present value of the death benefit is $304.53.
Life Tables and Mortality Rates
Life Table: A statistical table that shows the probability that a person of a given age will
die before their next birthday. These probabilities are denoted by 𝑞 , the probability of
death for someone aged 𝑥.
Mortality Rate: The proportion of individuals expected to die at a specific age. It is
derived from life tables and used to calculate premiums for life insurance.
Example: Using a Life Table
Consider a life table for a 30-year-old:
Probability of dying before 31: 𝑞 = 0.001.
Probability of dying before 32: 𝑞 = 0.0011.
To calculate the probability that a 30-year-old survives to age 32:
𝑃(30 → 32) = 𝑝 ∗ 𝑝 = (1 − 𝑞 ) ∗ (1 − 𝑞 ) = (1 − 0.001)(1 − 0.0011)
= 0.9979
Thus, the probability of surviving from age 30 to 32 is 99.79%.
Force of Mortality
Force of Mortality: The instantaneous rate at which individuals of a certain age die. It is
used in continuous-time models of mortality and is denoted by 𝜇 .
Example : Force of Mortality Calculation
If the force of mortality for a 30-year-old is 𝜇 = 0.0005, the probability that they
survive the next year is:
𝑃(𝑇 > 1) = 𝑒 = 0.9995.
So, the probability that the individual survives one more year is 99.95%.
Mathematical Formulation of Life Insurance
Single-Premium Life Insurance
Definition: A type of life insurance where the policyholder pays a one-time lump sum
(single premium) instead of periodic premiums. The insurer pays a death benefit when the
insured dies.
Actuarial Present Value (APV): The present value of the death benefit for single-
premium life insurance is calculated using:
𝐴 = 𝑣 𝑃(𝑇 = 𝑘)
Example : Single-Premium Life Insurance Calculation
A 40-year-old buys a single-premium life insurance policy with a death benefit of
$200,000. The interest rate is 5%, and the probability of death in each year is as follows:
𝑃(𝑇 = 1) = 0.003
𝑃(𝑇 = 2) = 0.0025
First, calculate the discount factor:
1
𝑣= = 0.9524.
1 + 0.05
Now calculate the APV:
𝐴 = 200,000 × (0.9524 × 0.003 + 0.9070 × 0.0025) = 1024.94
The present value of the death benefit is $1,024.94.
Level-Premium Life Insurance
Definition: A policy where the policyholder pays equal premiums over a period of time
(usually until death or a set number of years) in exchange for a guaranteed death benefit.
Endowment Insurance
Features of Endowment Insurance
Dual Benefits:
If the insured dies before the policy matures, the death benefit is paid to
beneficiaries.
If the insured survives the policy term, they receive the maturity benefit.
Example : Endowment Insurance
Consider a 10-year endowment policy with a sum assured of $100,000. If the insured dies
within the 10 years, their beneficiaries receive $100,000. If they survive, they receive
$100,000 at the end of the policy term.
Premium Calculation: The premiums for endowment policies are typically higher than
term life insurance because of the savings component.
