FIGURE 3.1 Cost of Life Insurance per Year Compared with the Annual Premium in a Whole Life Contract
There are tax advantages associated with life insurance policies in many countries. If the policyholder invested the surplus premiums, tax would normally be payable on the income as it was earned. But, when the surplus premiums are invested within the insurance policy, the tax treatment is often better. Tax is deferred, and sometimes the payout to the beneficiaries of life insurance policies is free of income tax altogether.
Variable Life Insurance
Given that a whole life insurance policy involves funds being invested for the policyholder, a natural development is to allow the policyholder to specify how the funds are invested. Variable life (VL) insurance is a form of whole life insurance where the surplus premiums discussed earlier are invested in a fund chosen by the policyholder. This could be an equity fund, a bond fund, or a money market fund. A minimum guaranteed payout on death is usually specified, but the payout can be more if the fund does well. Income earned from the investments can sometimes be applied toward the premiums. The policyholder can usually switch from one fund to another at any time.
Universal Life
Universal life (UL) insurance is also a form of whole life insurance. The policyholder can reduce the premium down to a specified minimum without the policy lapsing. The surplus premiums are invested by the insurance company in fixed income products such as bonds, mortgages, and money market instruments. The insurance company guarantees a certain minimum return, say 4 %, on these funds. The policyholder can choose between two options. Under the first option, a fixed benefit is paid on death; under the second option, the policyholder's beneficiaries receive more than the fixed benefit if the investment return is greater than the guaranteed minimum. Needless to say, premiums are lower for the first option.
Variable-Universal Life Insurance
Variable-universal life (VUL) insurance blends the features found in variable life insurance and universal life insurance. The policyholder can choose between a number of alternatives for the investment of surplus premiums. The insurance company guarantees a certain minimum death benefit and interest on the investments can sometimes be applied toward premiums. Premiums can be reduced down to a specified minimum without the policy lapsing.
Endowment Life Insurance
Endowment life insurance lasts for a specified period and pays a lump sum either when the policyholder dies or at the end of the period, whichever is first. There are many different types of endowment life insurance contracts. The amount that is paid out can be specified in advance as the same regardless of whether the policyholder dies or survives to the end of the policy. Sometimes the payout is also made if the policyholder has a critical illness. In a with-profits endowment life insurance policy, the insurance company declares periodic bonuses that depend on the performance of the insurance company's investments. These bonuses accumulate to increase the amount paid out to the policyholder, assuming the policyholder lives beyond the end of the life of the policy. In a unit-linked endowment, the amount paid out at maturity depends on the performance of the fund chosen by the policyholder. A pure endowment policy has the property that a payout occurs only if the policyholder survives to the end of the life of the policy.
Group Life Insurance
Group life insurance covers many people under a single policy. It is often purchased by a company for its employees. The policy may be contributory, where the premium payments are shared by the employer and employee, or noncontributory, where the employer pays the whole of the cost. There are economies of scale in group life insurance. The selling and administration costs are lower. An individual is usually required to undergo medical tests when purchasing life insurance in the usual way, but this may not be necessary for group life insurance. The insurance company knows that it will be taking on some better-than-average risks and some worse-than-average risks.
3.2 ANNUITY CONTRACTS
Many life insurance companies also offer annuity contracts. Where a life insurance contract has the effect of converting regular payments into a lump sum, an annuity contract has the opposite effect: that of converting a lump sum into regular payments. In a typical arrangement, the policyholder makes a lump sum payment to the insurance company and the insurance company agrees to provide the policyholder with an annuity that starts at a particular date and lasts for the rest of the policyholder's life. In some instances, the annuity starts immediately after the lump sum payment by the policyholder. More usually, the lump sum payment is made by the policyholder several years ahead of the time when the annuity is to start and the insurance company invests the funds to create the annuity. (This is referred to as a deferred annuity.) Instead of a lump sum, the policyholder sometimes saves for the annuity by making regular monthly, quarterly, or annual payments to the insurance company.
There are often tax deferral advantages to the policyholder. This is because taxes usually have to be paid only when the annuity income is received. The amount to which the funds invested by the insurance company on behalf of the policyholder have grown in value is sometimes referred to as the accumulation value. Funds can usually be withdrawn early, but there are liable to be penalties. In other words, the surrender value of an annuity contract is typically less than the accumulation value. This is because the insurance company has to recover selling and administration costs. Policies sometimes allow penalty-free withdrawals where a certain percentage of the accumulation value or a certain percentage of the original investment can be withdrawn in a year without penalty. In the event that the policyholder dies before the start of the annuity (and sometimes in other circumstances such as when the policyholder is admitted to a nursing home), the full accumulation value can often be withdrawn without penalty.
Some deferred annuity contracts in the United States have embedded options. The accumulation value is sometimes calculated so that it tracks a particular equity index such as the S&P 500. Lower and upper limits are specified. If the growth in the index in a year is less than the lower limit, the accumulation value grows at the lower limit rate; if it is greater than the upper limit, the accumulation value grows at the upper limit rate; otherwise it grows at the same rate as the S&P 500. Suppose that the lower limit is 0 % and the upper limit is 8 %. The policyholder is assured that the accumulation value will never decline, but index growth rates in excess of 8 % are given up. In this type of arrangement, the policyholder is typically not compensated for dividends that would be received from an investment in the stocks underlying the index and the insurance company may be able to change parameters such as the lower limit and the upper limit from one year to the next. These types of contracts appeal to investors who want an exposure to the equity market but are reluctant to risk a decline in their accumulation value. Sometimes, the way the accumulation value grows from one year to the next is a quite complicated function of the performance of the index during the year.
In the United Kingdom, the annuity contracts offered by insurance companies used to guarantee a minimum level for the interest rate used for the calculation of the size of the annuity payments. Many insurance companies regarded this guarantee – an interest rate option granted to the policyholder – as a necessary marketing cost and did not calculate the cost of the option or hedge their risks. As interest rates declined and life expectancies increased, many insurance companies found themselves in financial difficulties and, as described in Business Snapshot 3.1, at least one of them went bankrupt.
3.3 MORTALITY TABLES
Mortality tables are the key to valuing life insurance contracts. Table 3.1 shows an extract from the mortality rates estimated by the U.S. Department of Social Security for 2009. To understand the table, consider the row corresponding to age 31. The second column shows that the probability of a man who has just reached age 31 dying within the next year is 0.001445 (or 0.1445 %). The third column shows that the probability of a man surviving to age 31 is 0.97234 (or 97.234 %). The fourth column shows that a man aged 31 has a remaining life expectancy of 46.59 years. This means than on average he will live to age 77.59. The remaining