Insuring Your Life
Chapter 8
How Will This Affect Me?
Insurance should be used only to protect against potentially catastrophic losses, not for small risk
exposures. It should cover losses that could derail your family’s future. It balances the relatively
small, certain loss of ongoing premiums against low-probability, high-cost risks. This chapter
focuses on how to go about buying life insurance. Premature death is clearly a catastrophic loss
that could endanger your family’s financial future. We start by explaining how to determine the
amount of life insurance that is right for you. We also consider how to choose among key
insurance products, which include term life, whole life, universal life, variable life, and group
life policies. The key features of life insurance contracts are explained, and frameworks for
choosing an insurance agent and an insurance company are presented. The chapter will help you
prepare to make informed life insurance decisions.
Learning Objectives
8-1 Explain the concept of risk and the basics of insurance underwriting.
8-2 Discuss the primary reasons for life insurance and identify those who need coverage.
8-3 Calculate how much life insurance you need.
8-4 Distinguish among the various types of life insurance policies and describe their advantages
and disadvantages.
8-5 Choose the best life insurance policy for your needs at the lowest cost.
Choosing the best life insurance to fulfill the need is the second primary topic for this chapter.
Most likely term insurance will be the winner. [My bias, as a side note my wife says only buy
8-6 Become familiar with the key features of life insurance policies.
Financial Facts or Fantasies?
These may be used as “teasers” to get the students on the right page with you. Also, they may be
used as quizzes after you covered the material or as “pre–test questions” to get their attention.
• Term insurance provides nothing more than a stipulated amount of death benefits and, as a
result, is considered the purest form of life insurance.
Fact: Term insurance provides a given amount of life insurance (i.e., death benefits) for a
stipulated period of time and nothing more – no investments feature or cash value.
• Selecting an insurance company is the first thing you should do when buying life insurance.
Fantasy: The first thing you should do is determine the amount of life insurance you need and
then select the type of policy that is best for you. Only after you have taken these steps should
Financial Facts or Fantasies?
These may be used as a quiz or as a pre-test to get the students interested. The questions are the
same as above, just in the form of a quiz.
1. True False The best way to figure out how much life insurance you need is to
use a multiple of your earnings.
2. True False Social security survivor’s benefits should be factored into your life
insurance plans if you have a dependent spouse and/or minor
children.
3. True False Term insurance provides nothing more than a stipulated amount of
death benefits and, as a result, is considered the purest form of life
insurance.
4. True False Selecting an insurance company is the first thing you should do
when buying life insurance.
5. True False Because most life insurance policies are largely the same, you need
not concern yourself with differences in specific contract provisions.
Answers:
YOU CAN DO IT NOW
The “You Can Do It Now” cases may be assigned to the students as short cases or problems.
They will help make the topic more real or relevant to the students. In most cases, it will only
take about ten minutes to do, that is, until the student starts looking around at the web site. But
they will learn by doing so.
Shop for a Customized Life Insurance Policy
Let’s make life insurance more concrete and personal. You can easily get an insurance quote
online. Go to the popular Internet site noted in this chapter, http://www.insure.com/life-
insurance/, and provide the requested personal information. Then request a quote for a 20-year,
$200,000 term life insurance policy – you can do it now.
Check Out the Best Life Insurance Companies
The ratings of the best life insurance companies and an overall ranking, known as the Comdex
rank, are provided online at http://toplifeinsurancereviews.com/comdex-ranking-life-
insurance/. Go to the site and jot down the top five life insurance companies. Now you have a
great start when you are ready to shop for life insurance – you can do it now.
Buy term and invest the difference is a frequently stated plan. The “Financial Impact of Personal
Choices” below demonstrates this plan and can be used to discuss buy term and invest the
difference.
Financial Impact of Personal Choices
Amber and Josh Consider “Buying Term and Investing the Rest”
Amber and Josh Peterson have two young children and believe it’s time to buy a life insurance
policy to protect their family. They’ve both heard the life insurance advice to “buy term and
invest the rest.” In order to evaluate this advice, they’ve collected quotes for 20-year term and
whole life policies on Josh, both with a payoff of $250,000. The whole life policy premium is
$347 a month while the term policy premium is only $23 a month. In 20 years the whole life
policy will have a guaranteed cash value of $70,018 but at current rates would be worth
$105,721. The death benefit will have grown to $326,352. If the Petersons buy the term policy
and invest the $324 difference in monthly premiums at 8% for 20 years, they could have a
portfolio worth about $190,843!
The Petersons wonder about the financial consequences of their decision. It looks like buying
term and investing the difference leaves the Petersons better off. Yet the financial consequences
can only be fully evaluated in light of the Peterson’s objectives and attitude towards risk. The
whole life insurance policy provides a guaranteed cash value in 20 years while the invested
difference produces a higher expected but risky, unguaranteed payoff. And the Peterson’s must
consider whether they will have the discipline to keep “investing the difference” over the next 20
years. Once the whole life policy’s cash value builds up, they could stop paying the premium by
accepting some trade-offs in the value of the policy. In 20 years the term life insurance coverage
will go away, which might be fine if the kids are gone and the mortgage is paid off. In contrast,
the Petersons could stop paying the whole life policy premiums then and accept a reduced paid-
up amount of coverage.
The personal financial consequences of “buy term and invest the rest” suggest the advice may
well work for the Petersons. But the best decision depends on their objectives, discipline, and
attitude towards the risks of “investing the rest.”
Source: Adapted from Chris Arnold, “Life Insurance: Is Buying Term and Investing the
Difference Your Best Approach?”
Financial Planning Exercises
Planning Exercises
1. Deciding if additional life insurance is needed and, if so, appropriate type. Use Worksheet
8.1. Harvey Cook, 45, is a recently divorced father of two children, ages 10 and 7. He
currently earns $95,000 a year as an operations manager for a utility company. The divorce
settlement requires him to pay $1,500 a month in child support and $400 a month in
alimony to his ex-wife. She currently earns $35,000 annually as a schoolteacher. Harvey is
now renting an apartment, and the divorce settlement left him with about $100,000 in
savings and retirement benefits. His employer provides a $75,000 life insurance policy.
Harvey’s ex-wife is currently the beneficiary listed on the policy.
What advice would you give to Harvey? What factors should he consider in deciding
whether to buy additional life insurance at this point in his life? If he does need additional
life insurance, what type of policy or policies should he buy? Use Worksheet 8.1 to help
answer these questions for Harvey.
See Worksheet 8.1 below.
In 11 years, both kids will be in college. The funds for college will be available from savings
and not need life insurance. Also, child support payments stop. So when reaches 56 [45 + 11]
Date
a. $ 1,900
$
400 $
b.
c. 11 22
d.
1. Income
TOTAL FINANCIAL RESOURCES NEEDED (add right column)
566,400.00$
Other loans
Total debt (4 a + 4 b)
5. Other financial needs
Children’s college fund
Other needs
3. Final expenses (funeral, estate costs, etc.)
Period 2
Period 3
Period 1
a. $ $
b.
c.
d.
e.
f.
Step 1: Total financial resources needed
Other life insurance
Step 3: Additional Life Insurance needed
566,400.00$
Total period income (d × e)
Step 2: Total financial resources available
ADDITIONAL LIFE INSURANCE NEEDED
g. TOTAL INCOME
391,400.00$
175,000.00$
–$
Annual Social Security survivor’s
benefits
Surviving spouse’s annual income
Other annual pensions and Soc. Sec.
benefits
Annual income
Number of years in time period
Total living need per time period (b × c)
TOTAL LIVING EXPENSES (add line d for each period):
2. Special needs
356,400.00$
4,800.00$
105,600.00$
Period 2
Net yearly income needed
(a × 12)
Number of years in time period
LIFE INSURANCE NEEDS ANALYSIS METHOD
Insured’s Name
Step 1: Financial resources needed after death
1. Annual living expenses and other needs:
20-Sep
Harvey Cook
–$
Monthly living expenses
–$
22
2. Estimating life insurance needs. Use Worksheet 8.1. Sophie Lopez is a 72-year-old widow
who has recently been diagnosed with Alzheimer’s disease. She has limited financial assets
of her own and has been living with her daughter Felicity for two years. Her only income is
$850 a month in Social Security survivor’s benefits. Felicity wants to make sure her mother
will be taken care of if Felicity should die prematurely. Felicity, 40, is single and earns
$55,000 a year as a human resources manager for a small manufacturing firm. She owns a
condo with a current market value of $100,000 and has a $70,000 mortgage. Other debts
include a $5,000 auto loan and $500 in various credit card balances. Her 401(k) plan has a
current balance of $24,500, and she keeps $7,500 in a money market account for
emergencies.
After talking with her mother’s doctor, Felicity believes that her mother will be able to
continue living independently for another two to three years. She estimates that her mother
would need about $2,000 a month to cover her living expenses and medical costs during
this time. After that, Felicity’s mother will probably need nursing home care. Felicity calls
several local nursing homes and finds that it will cost about $5,000 a month when her
mother enters a nursing home. Her mother’s doctor says it is difficult to estimate her
mother’s life expectancy but indicates that with proper care some Alzheimer’s patients can
live 10 or more years after diagnosis. Felicity also estimates that her personal final
expenses would be around $5,000, and she’d like to provide a $25,000 contingency fund
that would be used to pay a trusted friend to supervise her mother’s care if Felicity were no
longer alive.
Use Worksheet 8.1 to calculate Felicity’s total life insurance requirements and recommend
the type of policy that she should buy.
Step 2: Total financial resources available
ADDITIONAL LIFE INSURANCE NEEDED
Other life insurance
Other resources
TOTAL FINANCIAL RESOURCES AVAILABLE (1g + 2
Step 3: Additional Life Insurance needed
189,100.00$
189,100.00$
Date
a. $ 2,000
$
5,000 $
b.
c. 3 10
d.
a. $
b. $
TOTAL FINANCIAL RESOURCES NEEDED (add right column)
House mortgage
Other loans
Total debt (4 a + 4 b)
5. Other financial needs
Other needs
3. Final expenses (funeral, estate costs, etc.)
4. Debt liquidation
Annual Social Security survivor’s
Period 2
Period 3
Period 1
b.
c.
d.
e.
f.
2. $ 32,000.00
Total period income (d × e)
g. TOTAL INCOME
Savings and investments
132,600.00$
benefits
Surviving spouse’s annual income
Other annual pensions and Soc. Sec.
benefits
Annual income
Number of years in time period
1. Income
Step 2: Financial resources available after death
Spouse education fund
Children’s college fund
Total living need per time period (b × c)
TOTAL LIVING EXPENSES (add line d for each period):
2. Special needs
24,000.00$
72,000.00$
672,000.00$
60,000.00$
600,000.00$
Period 1
Period 2
Net yearly income needed
(a × 12)
Number of years in time period
LIFE INSURANCE NEEDS ANALYSIS METHOD
Insured’s Name
Step 1: Financial resources needed after death
1. Annual living expenses and other needs:
20-Sep
Felicity
10,200.00$
Period 3
–$
–$
Monthly living expenses
102,000.00$
10
–$
30,600.00$
3
–$
0
10,200.00$
3. Appropriateness of whole life insurance. Martha and Louis Mitchell are a dual-career
couple who just had their first child. Louis age 30, already has a group life insurance
policy, but Martha’s employer does not offer a life insurance benefit. A financial planner is
recommending that the 27-year-old Martha buy a $250,000 whole life policy with an annual
premium of $1,670 (the policy has an assumed rate of earnings of 5 percent a year). Help
Martha evaluate this advice and decide on an appropriate course of action.
4. Appropriateness of variable life insurance. While at lunch with a group of coworkers,
one of your friends mentions that he plans to buy a variable life insurance policy because it
provides a good annual return and is a good way to build savings for his 5-year-old’s
college education. Another colleague says that she’s adding coverage through the group
plan’s additional insurance option. What advice would you give them?
A variable life insurance policy goes further than whole and universal life policies in
combining death benefits and savings. The policyholder decides how to invest the money in the
5. Choosing among types of life insurance. Camila Rodriguez, a 38-year-old widowed
mother of three children (ages 12,10, and 4), works as a product analyst for a major
consumer products company. Although she’s covered by a group life insurance policy at
work, she feels, based on some rough calculations, that she needs additional protection.
Leon Thompson, an insurance agent from Insurance Advisers, has been trying to persuade
her to buy a $150,000, 25-year, limited payment whole life policy. However, Camila favors
a variable life policy. To further complicate matters, Camila’s father feels that term life
insurance is more suitable to the needs of her young family.
a. Explain to Camila the differences between (i) a whole life policy, (ii) a variable life
policy, and (iii) a term life policy.
(i) Whole life policy: Policy provides insurance and many options such as single premium, paid
b. What are the major advantages and disadvantages of each type of policy?
Exhibit 8-8 lists the major advantages and disadvantages of the various types of life insurance.
Type of Policy
Advantages
Disadvantages
Term
Low initial premiums
Simple, easy to buy
Provides only temporary coverage for a set
period
May have to pay higher premiums when
policy is renewed.
Whole Life
Permanent coverage
Savings vehicle: cash value
builds as premiums are paid
Some tax advantages on
accumulated earnings
Cost: provides less death protection per
premium dollar than term
Often provides lower yields than other
investment vehicles
Sales commissions and marketing expenses
can increase costs of fully loaded policy.
Universal Life
Permanent coverage
Flexible: lets insured adapt
level of protection and cost
of premiums Savings
vehicle: cash value builds at
current rate of interest
Savings and death protection
identified separately
Can be difficult to evaluate true cost at time
of purchase; insurance carrier may levy
costly fees and charges
Interest rate changes may adversely affect
future cash values or expected premium
payments, which may even cause the policy
to lapse
Variable Life
Investment vehicle: insured
decides how cash value will
be invested
Higher risk
c. In what way is a whole life policy superior to either a variable life or term life policy? In
what way is a variable life policy superior? How about term life insurance?
d. Given the limited information in the case, which type of policy would you recommend
for Camila? Explain your recommendation.
6. Life insurance premiums and comparison of types. Using the premium schedules
provided in Exhibits 8.2, 8.3, and 8.5, how much in annual premiums would a 25-year-old
male have to pay for $100,000 of annual renewable term, level premium term, and whole
life insurance? (Assume a five-year term or period of coverage.) How much would a 25-
year-old woman have to pay for the same coverage? Consider a 40-year-old male (or
female): Using annual premiums, compare the cost of 10 years of coverage under annual
renewable and level premium term options and whole life insurance coverage. Relate the
advantages and disadvantages of each policy type to their price differences.
Policy is $100,000, for 10 years
Insured
Annual renewable term
Level premium term
Whole life insurance
25-yr male
$164 * 5 + $167 * 5 =
$1,655
$120* 10 = $1,200
$1,057 * 5 + $1,218 *
5 = $11,375
25-yr female
$143 * 5 + $150 * 5 =
$1,465
$108* 10 = $1,080
$956 * 5 + $1,099 * 5
= $10,275
40-yr male
$188 * 5 + $228 * 5 =
$2,080
$144* 10 = $1,440
$1,749 * 10 =
$17,490
40-yr female
$178 * 5 + $225 * 5 =
$2,015
$135* 10 = $1,350
$1,499 * 10 =
$14,990
7. Using Insurance policy illustrations. Describe the key elements of an insurance policy
illustration and explain what a prospective client should focus on in evaluating an
illustration.
Test Yourself Questions
8-1 Discuss the role that insurance plays in the financial planning process. Why is it
important to have enough life insurance?
8-2 Define (a) risk avoidance, (b) loss prevention, (c) loss control, (d) risk assumption, and (e)
an insurance policy. Explain their interrelationships.
a. risk avoidance — Avoiding an act that would create a risk. Risk avoidance is an attractive
way to deal with risk only when the estimated cost of avoidance is less than the estimated cost of
8-3 Explain the purpose of underwriting. What are some factors that underwriters consider
when evaluating a life insurance application?
8-4 Discuss some benefits of life insurance in addition to protecting family members
financially after the primary wage earner’s death.
8-5 Explain the circumstances under which a single college graduate would or would not
need life insurance. What life-cycle events would change this initial evaluation, and how
might they affect the graduate’s life insurance needs?
8-6 Discuss the two most commonly used ways to determine a person’s life insurance needs.
You can use one of two methods to estimate how much insurance is necessary: the multiple-of–
earnings method and the needs analysis method. The multiple-of-earnings method takes your
1. Estimate the total economic resources needed if the individual were to die.
8-7 Name and explain the most common financial resources needed after the death of a
family breadwinner.