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 should
prepare you to make informed life insurance decisions.
Learning Goals
LG1 Explain the concept of risk and the basics of insurance underwriting.
Risk and underwriting is the focus of insurance. It will be useful to give some examples of
events that you definitely would insure v events that you would not insure. The first include
major fire in your house, major car accident, premature death of wage earner, and a major
surgical procedure. Examples of events you would not insure include the risk of a meteor falling
on your head, risk of having a cold, risk of a light bulb burning out, or the risk of tearing your
clothes while jumping over a fence. The insurance decision compares the expected value of an
event with the cost of insuring for that event.
LG2 Discuss the primary reasons for life insurance and identify those who need coverage.
The primary purpose of life insurance is to protect your dependents from financial loss in the
event of your untimely death. If you have no one dependent upon you for resources, you do not
need life insurance. You could ask the class if they have insurance. If yes, why? If no, why?
LG3 Calculate how much life insurance you need.
Need for life insurance is the first primary topic for this chapter. Worksheet 8.1 organizes the
information to be considered in the insurance or not decision. The multiple of earnings is a
general estimation of your need for life insurance. The rule of thumb is 5 to 10 times you annual
take-home pay. The needs analysis [of the worksheet] is more specific and gives a more
appropriate measure of the need for life insurance.
LG4 Distinguish among the various types of life insurance policies and describe their advantages
and disadvantages.
The material here is mostly definitional and description. The text presents the material well.
You could ask the students what some of the terms mean. You could copy the definition of
several of the terms [say ten] and randomize the terms to create a matching question which could
be a quiz to judge level of knowledge of these terms. The power point slides also cover this
material.
LG5 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. The various forms of whole life have their
purpose and may be best for some cases, but term is the easy sale. To paraphrase a sentence in
the chapter, “People buy term insurance; you have to sell whole life.”
Exhibits 8.2, 8.3, 8.5, 8.6 and 8.7 gives some illustrative costs of insurance. Exhibit 8.8
overviews the various types of life insurance.
LG6 Become familiar with the key features of life insurance policies.
Exhibit 8.10 lists the various rating companies and their ratings. The rule of thumb is to always
purchase life insurance from a company with one of the top two ratings. The text defines the
various terms well and is sufficient. Use class time elsewhere.
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.
• The best way to figure out how much life insurance you need is to use a multiple of your
earnings.
Fantasy: While the multiple earnings approach is probably the simplest procedure, it suffers
from a number of serious shortcomings. A better choice is the needs approach.
• Social security survivor’s benefits should be factored into your life insurance plans if you have
a dependent spouse and/or minor children.
Fact: Survivor’s benefits are paid to the dependents of eligible deceased workers and can be a
big factor in helping your family meet their annual income needs.
• 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
you address where you will buy the insurance.
• Because most life insurance policies are largely the same, you need not concern yourself with
differences in specific contract provisions.
Fantasy: All insurance policies are not the same. Thus, it is important to familiarize yourself
with the provisions of the contract, including the beneficiary clauses and settlement options.
Financial Facts or Fantasies?
These may be used as a quiz or as a pre-test to get the students interested.
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
Matt and Jan Consider “Buying Term and Investing the Rest”
Matt and Jan Horton 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 Matt, 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 Horton’s 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 Horton’s wonder about the financial consequences of their decision.
It looks like buying term and investing the difference leaves the Hortons better off. Yet the
financial consequences can only be fully evaluated in light of the Hortons’ 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
Horton’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 Hortons 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 Hortons. 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?”
http://www.nerdwallet.com/blog/finance/advisorvoices/difference-term-life-insuranc/.
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?
Insurance is intended to protect you and your family from the financial consequences of losing
assets or income when an accident, illness, or death occurs. By anticipating the potential risks to
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
c. loss control — Any activity that lessens the severity of loss once it occurs. Together Loss
d. risk assumption — The choice to accept and bear the risk of loss. Risk assumption can be an
e. insurance policy — A contract between the insured and the insurer under which the insurer
All of these are ways to handle risk that individuals [as well as businesses] handle risks that
8-3 Explain the purpose of underwriting. What are some factors that underwriters consider
when evaluating a life insurance application?
Underwriting — The process used by insurers to decide who can be insured and to determine
applicable rates that will be charged for premiums. Insurers are always trying to improve their
8-4 Discuss some benefits of life insurance in addition to protecting family members
financially after the primary wage earner’s death.
The major benefits are financial protection for dependents, protection from creditors [with proper
planning, life insurance benefits can be excluded from an estate], tax benefits [generally, benefits
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?
Life insurance should be considered if you have dependents counting on you for financial
support. Thus, it is possible that parents or other relatives are relying on the college student to
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
A more detailed approach is the needs analysis method. This method considers both the
financial obligations and financial resources of the insured and his or her dependents; it involves
three steps, as shown in Exhibit 8.1:
8-7 Name and explain the most common financial resources needed after the death of a
family breadwinner.
From Exhibit 7.1: Total economic needs include:
Income needed to maintain an adequate lifestyle
Extra expenses if the income producer dies: Included here would be the end of life
8-8 What are some factors that underwriters consider when evaluating a life insurance
application? Which, if any, apply to you or your family members?
Life insurance underwriting begins by asking potential insureds to complete an application
designed to gather information about their risk potential. In other words, underwriters consider
the likelihood that the insured will die while the life insurance policy is in effect. Underwriters
8-9 What is term life insurance? Describe some common types of term life insurance
policies.
Term life insurance is the simplest type of insurance policy. You purchase a specified amount of
insurance protection for a set period. If you die during that time, your beneficiaries will receive
the full amount specified in your policy. Types of term life insurance policies include:
8-10 What are the advantages and disadvantages of term life insurance?
Advantages are the cost and options like renewability and convertibility.
Disadvantages include the requirement that you are insurable when the policy expires which is
8-11 Explain how whole life insurance offers financial protection to an individual
throughout his or her life.
In addition to death protection, whole life insurance has a savings feature (called cash value) that
8-12 Explain how the “paid-up insurance” component of a whole life insurance policy
works.
Paid-up insurance is a single premium whole life policy that is purchased with one cash premium
payment at the inception of the contract, thus buying life insurance coverage for the rest of your
8-13 Describe the different types of whole life policies. What are the advantages and
disadvantages of whole life insurance?
Three major types of whole life policies are available: continuous premium, limited payment,
and single premium.
With a limited payment whole life policy, you’re covered for your entire life, but the premium
payment is based on a specified period—for example, so-called 20-pay life and 30-pay life
A single premium whole life policy is purchased with one cash premium payment at the inception
Advantages include the ability to have insurance protection your entire life regardless of your
insurability in later years.
Ability to borrow against the cash value of the policy with repayment deferred until death.
8-14 What is universal life insurance? Explain how it differs from whole life and variable
life insurance.
Universal life insurance is another form of permanent cash-value insurance that combines term
insurance, which provides death benefits, with a tax-sheltered savings/investment account that
pays interest, usually at competitive money market rates. Universal life is a form of “buy term,
8-15 Explain how group life insurance differs from standard term life insurance. What do
employees stand to gain from group life?
Under group life insurance, one master policy is issued and each eligible group member
receives a certificate of insurance. Group life is nearly always term insurance, and the premium
8-16 Why should the following types of life insurance contracts be avoided? (a) credit life
insurance, (b) mortgage life insurance, (c) industrial life insurance (home service life
insurance).
8-17 Briefly describe the steps to take when you shop for and buy life insurance.
Several factors should be considered when making the final purchase decision:
(1) comparing the costs and features of competitive products, [Exhibit 8.8 gives major
(2) selecting a financially healthy insurance company [Private rating agencies have gather
(3) choosing a good agent [When seeking a good life insurance agent, try to obtain
8-18 Briefly describe the insurance company ratings assigned by A. M. Best, Moody’s,
Fitch, and Standard & Poor’s. Why is it important to know how a company is rated? What
ratings would you look for when selecting a life insurance company? Explain.
These agencies use publicly available financial data from insurance companies to analyze their
debt structure, pricing practices, and management strategies in an effort to assess their financial
8-19 What characteristics would be most important to you when choosing an insurance
agent?
Competent, as indicated by the agent’s education and certifications. Also you want an agent who
will listen to your needs and answer your questions, regardless how stupid they may be. When
8-20 What is a beneficiary? A contingent beneficiary? Explain why it’s essential to designate
a beneficiary for your policy.
The beneficiary is the person who will receive the death benefits of the policy on the insured’s
death. If the primary beneficiary does not survive the insured, then the insurer will distribute the