Fundamentals
of
Life Insurance
The economic problem of
premature death
Premature death means that a person dies
with outstanding unfulfilled financial
obligations, such as children to support or a
mortgage to be paid off.
Several costs are associated with premature
death.
The family's share of the deceased
breadwinner's income is lost forever;
additional expenses are incurred because of
funeral costs and other expenses;
some families may experience a decline in
their standard of living because of insufficient
income;
and there is the emotional grief and loss of a
role model for the children.
Life insurance is economically
justified if:
-someone earns an income, and
-others are financially dependent on
that income for at least part of their
financial support.
Three approaches that can be used to
estimate the amount of life insurance
to own
The human life value is defined as:
the present value of the family's share
of the deceased breadwinner's
earnings.
This approach crudely measures the
economic value of a human life.
The human life value can be measured by
the following steps:
a. Estimate the individual's average
annual earnings over his or her productive
lifetime.
b. Deduct federal and estate income
taxes, Social Security taxes, life and
health insurance premiums, and the costs
of self-maintenance.
c.
Determine the number of years from
the person's present age to the
contemplated age of retirement.
d.
Using a reasonable discount rate,
determine the present value of the
family's share of earnings for the period
determined in step c.
The use of a lower discount rate in
calculating the human life value will
produce a higher human life value for the
individual.
The needs approach can be used to
determine the amount of life insurance to
own.
After considering other sources of
income and financial assets, the various
family needs are converted into specific
amounts of life insurance.
The most important family needs are as
follows:
a. estate clearance fund
b. income during readjustment period
c. income during dependency period
d. life income to the widow
e. special needs
- mortgage redemption fund
- education fund
- emergency fund
f. retirement needs
The advantages of the needs approach
are as follows:
a. It is a reasonably accurate method
for determining the amount of life
insurance to own after family needs are
recognized.
b. Other sources of income and
financial assets are considered.
c. Possible inadequacy of present life
insurance is quickly recognized.
d. The needs approach can also be
used to recognize needs during a period
of disability or retirement.
The disadvantages of the needs
approach are as follows:
a. The family head is assumed to die
immediately, which is unrealistic.
b. Life insurance planning is required,
which may be complex and difficult to
understand.
c. The family needs must be periodically
evaluated to determine if they are still
appropriate as family circumstances
change.
d. The needs approach ignores inflation
in its simplest version.
The capital retention approach is based on
the assumption that the capital needed to
provide income will not be liquidated.
Three steps are involved.
First, prepare a personal balance sheet that
includes all death benefits from life insurance
and other sources.
Second, determine the amount of incomeproducing capital.
Finally, determine the amount of additional
capital (if any) that is needed.
The two basic methods of paying
premiums
Under the yearly renewable term method, life
insurance protection is provided for only one
year.
The policy can be renewed for successive
one-year periods with no evidence of
insurability.
The yearly renewable term method is not
suitable for lifetime protection because
premiums increase with age until they reach
prohibitively high levels.
Under the level premium method, premiums
are level and do not increase with age.
The insured has lifetime protection to age
100.
Under this method, premiums paid during
the early years are higher than is necessary
to pay current death claims, while those paid
in the later years are inadequate for paying
death claims.
The redundant premiums paid during the
early years are invested and used to
supplement the inadequate premiums paid
during the later years.
The legal reserve
The legal reserve reflects the redundant
premiums paid during the early years of the
policy.
It steadily increases until it reaches the face
of the policy by age 100.
The fundamental
purpose of the legal reserve is to
provide lifetime protection.
Because a legal reserve is necessary for
lifetime protection, cash values become
available.
However, cash values are the by-product of
the level premium method.
Since the insured has paid in more than is
actuarially necessary during the early years
of the policy, he or she should receive
something back if the policy is surrendered.
One in Four U.S. Households Now Has No
Life Insurance
Relationship between the Net Amount
at Risk and Legal Reserve