Chapter 16 Fundamentals of life Insurance

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Fundamentals of Life Insurance
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The economic problem of premature death
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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.
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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.
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• 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.

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Three approaches that can be used to estimate the
amount of life insurance to own
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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.
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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.
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• 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.

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The use of a lower discount rate in calculating
the human life value will produce a higher human
life value for the individual.
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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.
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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
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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.
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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.
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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.
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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.
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The capital retention approach is based on the
assumption that the capital needed to provide
income will not be liquidated. Three steps are
involved.
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First, prepare a personal balance sheet that
includes all death benefits from life insurance
and other sources. Second, determine the amount
of income-producing capital. Finally, determine
the amount of additional capital (if any) that is
needed.
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The two basic methods of paying premiums
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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.
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Under the level premium method, premiums are
level and do not increase with age. The insured
has lifetime protection to age 100.
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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.
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The legal reserve
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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.
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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.
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One in Four U.S. Households Now Has No Life
Insurance
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Relationship between the Net Amount at Risk and
Legal Reserve