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FundamentalsFundamentals

ofof

Life InsuranceLife Insurance

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Premature death means that a person dies

with outstanding unfulfilled financial

obligations, such as children to support or amortgage 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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Three approaches that can be used toestimate 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'searnings.

This approach crudely measures theeconomic value of a human life.

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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 perioddetermined in step c.

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The use of a lower discount rate in

calculating the human life value willproduce 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 specificamounts 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 periodd. 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 approachare as follows:

a. It is a reasonably accurate method

for determining the amount of lifeinsurance 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 needsapproach are as follows:

a. The family head is assumed to dieimmediately, which is unrealistic.

b. Life insurance planning is required,

which may be complex and difficult tounderstand.

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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 toprovide income will not be liquidated.

Three steps are involved.

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First, prepare a personal balance sheet thatincludes all death benefits from life insurance

and other sources.

Second, determine the amount of income-

producing capital.

Finally, determine the amount of additionalcapital (if any) that is needed.

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The two basic methods of payingpremiums

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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 ofinsurability.

The yearly renewable term method is not

suitable for lifetime protection becausepremiums 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 duringthe 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 tosupplement the inadequate premiums paid

during the later years.

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The legal reserve

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The legal reserve reflects the redundantpremiums paid during the early years of the

policy.

It steadily increases until it reaches the faceof the policy by age 100.

The fundamentalpurpose of the legal reserve is to

provide lifetime protection.

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Because a legal reserve is necessary for

lifetime protection, cash values becomeavailable.

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 yearsof 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 NoOne in Four U.S. Households Now Has No

Life InsuranceLife Insurance

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Relationship between the Net AmountRelationship between the Net Amount

at Risk and Legal Reserveat Risk and Legal Reserve