FIN 502 Study Guide - Disability Insurance

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21 Apr 2012
CHAPTER 10 life, health and disability insurance
Life insurance: financing the risk of the premature and untimely death of a family member
Insupportable risk: loss of income due to the unanticipated death of a family member
Insured: the person upon whose death and death benefit (or the face value) of the insurance policy will
be paid
Beneficiary: the person(s) who receives the death benefit or face value of the policy upon the death of
the insured
Death benefit or face value: the dollar amount that will be paid to the beneficiary if the insured dies
Premium: dollar amount that must be paid to the insurance company. The premium may be payable in
one lump sum, or periodically
Owner: the person who pays the premiums. If you buy life insurance for your son, you are the owner, and
your son is the insured
Policy term: the period during which the insurance is in force
Rate: cost of each unit of insurance
Insurability: qualifications for the insured to be insurable. There are certain requirements that the insured
may have to meet before an insurance policy can be bought (EX. Passing a medical examination)
Guaranteed insurability: provision that allows the insured to buy additional life insurance at certain
specific future dates without proof of insurability
Income approach: estimates the face value of the life insurance by calculating the present value of the
insured’s expected future income
o Present value of the insured expected future income is conceptually the insured’s human capital
o Use the real rate of interest to calculate present value
Real rate of interest = nominal rate of interest expected rate of inflation
o Lifetime earnings stream is risky and one may want to use a higher discount rate than the real
rate of interest
o Basic benchmark present value of the insured’s lifetime earnings assuming no growth in real
earnings and using real rate of interest as the discount rate
o Assumes that the beneficiary pays income tax on the receipts at the same rate as the insured
paid on the original income
Face amount of life insurance policy is not taxable income for the beneficiary, because
the premiums are not tax deductible
Interest earned on face amount is taxable; therefore the principle amount is less than
the amount calculated by the basic benchmark method
o Rule of thumb rather than insuring 100% replacement of the insured’s income, families may
want to insure only 70% or 80% of the insured’s future income
Expense approach: a life insurance face value amount that the family needs is the amount that will
provide enough funds to pay those expected expenses of the beneficiaries that are not covered by
government transfer income or other income
o If insurer dies, life insurance death benefit is invested and used as the expenses occur
o Calculates the present value of the beneficiaries’ future expenses
o Basic benchmark present value of the insured’s expected income shortfall, from now until
retirement; if there is no shortfall, there is no need to buy life insurance under the expense
o Can use the approximate method to estimate the amount of life insurance
Life Insurance = (Average annual income / discount rate) x adjustment factor
o Six steps to expense approach:
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