Principles of Insurance

Chapter 3: The Insurance Contract 3.1

Chapter 3

The Insurance Contract

Objectives
After studying this chapter, you should be able to
3A Distinguish between formal and informal contracts, bilateral and
unilateral contracts, commutative and aleatory contracts, and contracts
of adhesion and bargaining contracts, and identify which types
characterize an insurance contract
3B Explain the difference between a valid contract, a void contract, and a
voidable contract
3C Identify the four general requirements for the creation of a valid
informal contract and describe how each of these requirements can be
met in the formation of an insurance contract
3D Identify the property rights that a policyowner has in the insurance
policy he owns

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 3.2 Chapter 3: The Insurance Contract Principles of Insurance

Outline
Fundamentals of Contract Law The Policy as Property
 Types of Contracts  Right to Use and Enjoy Property
 General Requirements for  Right to Dispose of Property
a Contract

R
emember our point that life and health insurance products represent
promises—promises that, in some cases, could extend over decades?
This characteristic influences the form that such a product takes: in return
for an initial payment, an applicant typically receives an insurance policy, which
is a written record of the promise that the insurance company is making.
Recall that an individual insurance policy is an insurance policy that insures the
life or health of a named person. Some individual policies also insure the person’s
immediate family or a second named person. A group insurance policy insures the
lives or health of a specific group of people. For example, most group insurance
policies are purchased by employers to provide life or health insurance coverage to
their employees and, sometimes, to the dependents of covered employees.
Unless otherwise noted, the information presented in this chapter applies to
both individual and group insurance policies.

Fundamentals of Contract Law

Before an insurance policy is purchased, the applicant for insurance and the
insurance company must reach an agreement: the applicant must agree to buy
the insurance coverage from the company at the stipulated rate, and the company
must agree to issue that coverage under the offered terms. The insurance policy
describes the terms of their agreement.
An insurance policy represents a special kind of agreement known as a con-
tract. A contract is a legally enforceable agreement between two or more parties.
The two parties to an individual life or health insurance contract are the insurance
company that issued the policy and the individual who owns the policy, known
as the policyowner. The parties to a group insurance contract are the insurer that
issued the policy and the group policyholder, which refers to the person or orga-
nization that decides what types of group insurance coverage to purchase for the
group members, negotiates the terms of the insurance contract, and purchases the
group insurance coverage.
The fact that a contract is legally enforceable means that the parties are bound
to carry out the promises they made when entering into the contract. If a party
does not carry out its promise, then that party has breached the contract. Laws
provide innocent parties with remedies they can pursue to recoup losses resulting
from a breach of contract.

Types of Contracts
In Chapter 1, we described contracts of indemnity and valued contracts. As noted
LEARNING AID
in that chapter, health insurance policies typically are contracts of indemnity,

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Principles of Insurance Chapter 3: The Insurance Contract 3.3

and life ­insurance policies are valued contracts. Contracts may be categorized in
other ways—for example as either
„„ Formal or informal contracts

„„ Bilateral or unilateral contracts

„„ Commutative or aleatory contracts

„„ Bargaining contracts or contracts of adhesion

Formal and Informal Contracts

Contracts are either formal or informal. A formal contract is a written contract
that is enforceable because the parties met certain formalities concerning the form
of the agreement. Historically, a formal contract had to be stamped with a seal, but
that is no longer a requirement.
Life and health insurance contracts are informal contracts. An informal
contract is an oral or a written contract that is enforceable because the parties met
requirements concerning the substance of the agreement rather than requirements
concerning the form of the agreement.
As informal contracts, life and health insurance contracts could theoretically
be made in either written or oral form. However, laws in some jurisdictions require
insurance contracts to be in writing. Life and health insurance contracts typically
are expressed in written form—whether required by law or not—for practical rea-
sons. For example, a written contract provides a permanent record of the agree-
ment. Life insurance policies often remain in effect for many years. The memory
of someone’s oral promises made many years in the past may not be reliable, even
under the best circumstances. Putting the contract in writing helps prevent misun-
derstandings between the parties as to the terms and conditions of their agreement.

Bilateral and Unilateral Contracts

A contract between two parties may be either bilateral or unilateral. A bilateral
contract is one in which both parties make legally enforceable promises when
they enter into the contract.

Example:
Shi-Fay Cheng contracts with the Dependable Heating Company to have
the company install a heating system in her home for a mutually agreed-
upon price. Dependable promises to perform the work, and Shi-Fay
promises to pay a stated amount in exchange for the work.

Analysis:
This contract is bilateral—both Shi-Fay and Dependable have made legally
enforceable promises. If either Shi-Fay or Dependable fails to perform its
promise, the other party can take legal action to enforce the contract.

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 3.4 Chapter 3: The Insurance Contract Principles of Insurance

In contrast to a bilateral contract, a unilateral contract is one in which only one

of the parties makes a legally enforceable promise when entering into the contract.
Life and health insurance policies are unilateral contracts. The insurer promises
to pay a policy benefit if the insured dies, gets sick, or is injured. As long as the
premiums are paid, the insurer is legally bound by its contractual promises. The
purchaser of the policy, on the other hand, does not promise to pay the premiums
and cannot be compelled by law to pay them. In fact, the policyowner has the right
to stop paying premiums and cancel the policy at any time. Figure 3.1 illustrates
the difference between a bilateral and a unilateral contract.

Figure 3.1 Bilateral vs. Unilateral Contracts

Promise: Pay for Heating System

Promise: Install System

BOTH PARTIES HAVE MADE ENFORCEABLE PROMISES

Promise: Provide Insurance Coverage

ONLY THE INSURER MADE AN ENFORCEABLE PROMISE

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Principles of Insurance Chapter 3: The Insurance Contract 3.5

Commutative and Aleatory Contracts

Contracts may also be classified as either commutative or aleatory. A commutative
contract is an agreement in which the parties specify in advance the values that
they will exchange. Moreover, the parties generally exchange items or services
that they think are of relatively equal value. In the case of Shi-Fay Cheng and the
Dependable Heating Company, both parties essentially agreed that the installation
of the heating system and the price to be paid were of equal value. Contracts for
the sale of goods or services usually are commutative contracts.
In an aleatory contract, one party provides something of value to another party
in exchange for a conditional promise. A conditional promise is a promise to
perform a stated act if a specified, uncertain event occurs. If the event does not
occur, the promise will not be performed. Also, under an aleatory contract, if the
specified event occurs, one party may receive something of greater value than that
party gave.
Life and health insurance policies are aleatory contracts. A life insurance pol-
icy is an aleatory contract because the insurer’s promise to pay the policy benefit is
contingent upon the death of the insured while the policy is in force. The insured’s
death is an uncertain event because no one can say with certainty when the insured
will die.
A life insurance policy is also an aleatory contract because one of the parties
may receive something of greater value than that party gave. For example, a policy
may terminate prior to the death of the insured, and the insurer’s promise to pay
the policy benefit will never be performed—even if the insurer has received a
number of premiums. Conversely, death may occur soon after an insurer issues a
life insurance policy. In this case, the insurer must pay the policy benefit, which
will be more than the premiums the insurer received for the policy.

Bargaining Contracts and Contracts of Adhesion

Contracts may be further classified as either bargaining contracts or contracts of
adhesion. Suppose two individuals, Jean and Dylan, had the following conversation:

Jean: I will sell you my car for $3,000.

Dylan: I would like to buy your car but not for $3,000. How about $2,000?
Jean: I can’t sell you the car for $2,000; how about $2,500?
Dylan: Okay, I will buy your car for $2,500.

Jean and Dylan have entered into a bargaining contract, one in which both par-
ties, as equals, set the terms and conditions of the contract.
In contrast, life and health insurance policies are contracts of adhesion. A
contract of adhesion is a contract that one party prepares and that the other party
must accept or reject as a whole, generally without any bargaining between the
parties to the agreement. Although the applicant for individual life or health insur-
ance has choices about some of the contract provisions, generally he must accept
or reject the contract as the insurance company has written it. As a result, if any
policy provision is ambiguous, the courts usually interpret the provision in what-
ever manner would be more favorable to the policyowner or beneficiary. In contrast
to individual insurance policies, group insurance agreements often are subject to

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 3.6 Chapter 3: The Insurance Contract Principles of Insurance

some negotiation between the parties. Nevertheless, group insurance contracts are
contracts of adhesion. Figure 3.2 lists the various types of contracts and identifies
which types characterize life and health insurance contracts.

General Requirements for a Contract

According to the laws in most states in the United States and many other coun-
tries, an agreement must meet the following four general requirements to be a
LEARNING AID
valid informal contract:
1. The parties to the contract must express mutual assent, or agreement, to the
terms of the contract.

2. The parties to the contract must have contractual capacity.

3. The parties to the contract must exchange legally adequate consideration.

4. The contract must be for a lawful purpose.

Figure 3.2 Types of Contracts

Characterizes
Type of Contract Life and
Health
Insurance
Contracts

Contract is based on the form of the agreement No

(Formal contract)

Contract is based on the substance of the agreement Yes

(Informal contract)

Both parties make legally enforceable promises No

(Bilateral contract)

Only one party makes a legally enforceable promise Yes

(Unilateral contract)

The parties exchange things of equal value No

(Commutative contract)

One party provides something of value in exchange for a conditional promise Yes
(Aleatory contract)

Both parties set the terms No

(Bargaining contract)

One party sets the terms that the other party accepts or rejects Yes
(Contract of adhesion)

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Principles of Insurance Chapter 3: The Insurance Contract 3.7

In describing the legal status of a contract, the words valid, void, and voidable
are often used:
„„ Valid. A valid contract is one that is enforceable by law. Valid contracts sat-
isfy all legal requirements.
„„ Void. The term void is used in law to describe something that was never valid.
A void contract is one that does not satisfy one or more of the legal require-
ments to create a valid contract and, thus, is never enforceable.
„„ Voidable. At times, one of the parties to an otherwise valid contract may have
grounds to reject, or avoid, it. A voidable contract is one in which a party has
the right to avoid her obligations under the contract.
Let’s look at the four requirements in more detail.

Mutual Assent
Whether a contract is made when the parties sign a written agreement or shake
hands, the parties involved have agreed to do something. The requirement of
mutual assent is met when the parties reach a meeting of the minds about the
terms of their agreement.
For life and health insurance policies, as well as for other contracts, mutual
assent is expressed through a process of offer and acceptance. An offer is a pro-
posal to enter into a binding contract with another party. The party that makes
the offer is the offeror, and the party to whom the offer is made is the offeree.
An acceptance of the offer is the offeree’s unqualified agreement to be bound to
the terms of the offer. If an offer is accepted according to its terms, mutual assent
has occurred.

Example:
Denise Chung said to her neighbor, Graham Spader, “I will sell you my old
lawn mower for $100.” Graham replied, “I like your lawn mower, so I will
buy it for $100.”

Analysis:
Denise’s statement to Graham was an offer, and Denise was the offeror.
Graham was the offeree. Graham’s reply was an acceptance of the offer.
Through their offer and acceptance, Denise and Graham expressed their
mutual assent to the terms of the contract.

Contractual Capacity
For an informal contract to be binding on the parties, the parties must have
­contractual capacity—that is, they each must have the legal capacity to make a
contract. Individuals and insurance companies can enter into binding contracts,
but the criteria for determining contractual capacity are somewhat different for
individuals than for insurers and other corporations.

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3.8 Chapter 3: The Insurance Contract Principles of Insurance

Contractual Capacity of Individuals

Every individual is presumed to have the legal capacity to enter into a valid con-
tract. The law, however, has established some exceptions to this general rule to
protect certain individuals who may not understand the consequences of their
actions. In most jurisdictions, these individuals include (1) minors and (2) people
with diminished mental capacity.
Minors. The laws in nearly all jurisdictions establish a particular age, referred
to as the age of majority or age of maturity, at which people are considered adults
who are capable of managing their own affairs and accepting the legal obligations
created by their actions. A minor is a person who has not attained the age of major-
ity. In most countries and most states in the United States, the age of majority is 18.
Generally, a contract entered into by a minor is voidable by the minor.1 A minor
is usually permitted to reject a contract before reaching the age of majority or
within a reasonable time afterward.
Many jurisdictions have, by law, lowered the age of majority for the purpose of
entering into life insurance contracts. These laws permit younger people—gener-
ally those who are at least age 15 or 16—to purchase life insurance and to exercise
some of a policy’s ownership rights as though they were adults. In most such situ-
ations, the beneficiary of the life insurance policy must be a member of the minor’s
immediate family.
If an insurance company sells an insurance policy to a person who is younger
than the permissible age to purchase insurance, then the company is required
to provide the promised insurance protection as long as the premiums are paid.
The minor, however, could sue to avoid the policy, and the insurance company
would have to return the premiums the minor paid for the policy.

Example:
Caridad Mendoza, age 17, purchased a life insurance policy from Totem
Life Insurance Company and paid the initial premium. The minimum
permissible age to purchase life insurance in the jurisdiction in which
Caridad lives is 18 years.

Analysis:
Because Caridad is younger than the permissible age, this life insurance
policy is voidable by Caridad. She can reject the contract before she turns
18 or within a reasonable time afterward, and Totem must refund any
premiums she has paid. In contrast, as long as Caridad pays the premiums
for the policy, Totem is bound by the contract.

Mental Capacity. Two situations arise in which a person’s lack of mental

capacity affects her contractual capacity:
„„ A court declares the person to be insane or mentally incompetent. A contract
entered into by such a person is usually void.

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Principles of Insurance Chapter 3: The Insurance Contract 3.9

„„ The person’s mental competence is impaired, but a court has not declared her
to be insane or mentally incompetent. For example, the person can be mentally
impaired as a result of being intoxicated or mentally ill. Contracts entered
into by such a person are generally voidable by that person. If the person later
regains mental competence, she may either reject the contract or require that
it be carried out. In contrast, the other party to the contract does not have the
right to reject the contract and must carry out its terms if required to do so.

Contractual Capacity of Organizations

Corporations are generally presumed to have the contractual capacity of a men-
tally competent adult. Therefore, a corporation that was created in accordance
with the laws of the applicable jurisdiction has the contractual capacity to enter
into a contract, including a contract to purchase insurance.
An insurer acquires the legal capacity to issue an insurance contract by being
licensed or authorized to do business as an insurer by the proper regulatory author-
ity. A company that is neither licensed nor authorized as an insurance company
does not have the legal capacity to issue an insurance contract. Should an unau-
thorized insurer issue a policy to a person who is unaware of the insurer’s lack of
legal capacity, the policy may be enforceable against the insurer. The legal effect
of such a contract depends on the laws of the particular jurisdiction. In some juris-
dictions, the contract is void; in others, the contract is voidable by the policyowner.

Legally Adequate Consideration

For an informal contract to be valid, the parties to the contract must exchange
consideration, which means that each party must give or promise something that
is of value to the other party. In addition, the consideration exchanged must be
legally adequate. In general, consideration is legally adequate as long as it has
some value to the parties.
An applicant submits the application and the initial premium—the first pre-
mium paid for an insurance policy—as consideration for a life or health insurance
policy. The applicant gives this consideration in return for the insurer’s promise to
pay the policy benefit if the conditions stated in the policy occur. If the applicant
does not pay the initial premium, then no contract is formed, because the appli-
cant has not provided the required consideration. Renewal premiums, which are
premiums payable after the initial premium, are a condition for continuance of the
policy and are not consideration for the policy.
Figure 3.3 illustrates legally adequate consideration for an insurance policy.

Lawful Purpose
No contract can be made for a purpose that is illegal or against the public inter-
est—a contract is valid only if it is made for a lawful purpose. For example, all
jurisdictions have laws that make certain acts punishable as crimes. An agreement
between two parties to commit a criminal act, such as an agreement to kill an
individual in exchange for money, is not legally enforceable.
As we mentioned in Chapter 1, early life insurance policies were sometimes
used to gamble on an individual’s life. As a result, many jurisdictions enacted

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3.10 Chapter 3: The Insurance Contract Principles of Insurance

Figure 3.3 Legally Adequate Consideration for Insurance

Completed insurance application

Initial premium

Promise to pay policy

benefits if conditions
stated in policy occur

insurable interest laws as a matter of public policy to prevent such wagering.

The requirement that an insurable interest be present when a policy is issued pro-
vides assurance that a life insurance contract is being made for the lawful purpose
of providing protection against financial loss rather than for an unlawful purpose,
such as speculating on another person’s life in hopes of making a profit.
The requirement of lawful purpose in making an individual life insurance con-
tract is met if an insurable interest is present when the policy is issued. After
issuance, a continuing insurable interest is not required for the contract to remain
valid.

Example:
Harvey Atkinson purchased a life insurance policy insuring his wife, Lily.
Harvey and Lily divorced several years later.

Analysis:
As Lily’s spouse, Harvey had an insurable interest in her life when the
policy was issued. Therefore, the policy remains valid and in effect as
long as premiums continue to be paid even if Harvey no longer has an
insurable interest in Lily’s life.

An insurable interest usually is not required in a group insurance contract

because the group policyholder’s interest in the contract does not encourage
wagering as does a policyowner’s interest in an individual insurance contract.
For a group insurance contract, the lawful purpose requirement is met when the
group policyholder enters into the contract to provide benefits to covered group
members.
Figure 3.4 summarizes the requirements for a valid informal contract.

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Principles of Insurance Chapter 3: The Insurance Contract 3.11

Figure 3.4 Requirements for a Valid Informal Contract

Mutual Assent

Contractual Capacity

Legally Adequate Consideration

Lawful Purpose

The Policy as Property

In addition to being governed by contract law, insurance policies are a type of
property and, thus, are also subject to the principles of property law. In legal ter-
minology, property is defined as a bundle of rights a person has with respect to
something. In most countries including the United States, property is character-
ized as either real property or personal property. Real property is land and what-
ever is growing on or attached to the land. All property other than real property is
characterized as personal property and includes tangible goods such as clothing,
furniture, and automobiles, as well as intangible goods such as contractual rights.
An insurance policy is intangible personal property—it represents intangible legal
rights that have value and that can be enforced by the courts. The owner of an
insurance policy—rather than the insured or beneficiary—holds these ownership
rights in an insurance policy.
Ownership of property is the sum of all the legal rights that exist in that prop-
erty. The legal rights an owner has in property include the right to use and enjoy
the property and the right to dispose of the property.

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3.12 Chapter 3: The Insurance Contract Principles of Insurance

Right to Use and Enjoy Property

The right to use and enjoy property that one owns is an inherent feature of prop-
erty ownership. The owner of an insurance policy has the right to deal with the
policy in a number of ways. For example, the owner of an individual life insurance
policy has the right to name the policy beneficiary. The policyowner also usually
has the right to change the beneficiary designation at any time while the policy is
in force. We describe naming and changing the beneficiary of an individual life
insurance policy in Chapter 9. We describe the right to name the beneficiary of a
group life insurance policy in Chapter 13.

Right to Dispose of Property

The owner of property generally has the right to dispose of the property. For
example, if you own an automobile, you have the right to give it away or sell it.
Similarly, the owner of an insurance policy can dispose of it. The policyowner
may transfer ownership of the policy by making a gift of the policy to someone
else. We describe some of these aspects of policy ownership in later chapters. For
now, just remember that, as property, an insurance policy consists of a bundle of
ownership rights.

Key Terms
contract voidable contract
group policyholder mutual assent
formal contract offer
informal contract acceptance
bilateral contract contractual capacity
unilateral contract minor
commutative contract consideration
aleatory contract initial premium
conditional promise renewal premium
bargaining contract property
contract of adhesion real property
valid contract personal property
void contract ownership of property

Endnote
1. The general rule that a minor’s contract is voidable by the minor has some exceptions. One important
exception is that a minor’s contract for necessaries, which are goods and services that a minor requires
for her well-being, is valid and binding on both parties.

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Principles of Insurance Chapter 4: Life Insurance Premiums 4.1

Chapter 4

Life Insurance Premiums

Objectives
After studying this chapter, you should be able to
4A Define policy reserves and explain the premises of the legal reserve
system
4B Define premium rate and calculate the annual premium amount for a
given life insurance policy
4C Explain how actuaries account for the cost of benefits, operating
expenses, and investment earnings in developing premium rates
4D Explain how insurers use mortality tables in pricing products and
describe the effect that mortality rates have on the cost of benefits and
the premium rate for a block of policies
4E Describe the effect of compound interest on investment earnings and
calculate the amount of interest earned on a given sum of money
4F Explain the purpose of using conservative values in financial models
4G Explain how the level premium system operates

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4.2 Chapter 4: Life Insurance Premiums Principles of Insurance

Outline
The Legal Reserve System The Level Premium System
Establishing Premium Rates
 Cost of Benefits
 Operating Expenses
 Investment Earnings
 Financial Models

S
uppose you have just purchased a life insurance policy and made your ini-
tial premium payment. How did the insurance company decide what the
policy’s premium would be? And assuming that your policy has renewal
premiums, how did the company come up with an amount for those as well?
To determine the proper premiums to charge, insurers employ specialists
known as actuaries. An actuary is an expert in financial risk management and
the mathematics and modeling of insurance, annuities, and financial instruments.
In insurance companies, actuaries are responsible for ensuring that products are
financially sound and profitable. Actuaries accomplish this dual objective by
establishing for every product a premium rate that will enable the company to
both cover its costs of developing and administering the product and generate a
reasonable profit for the company and its owners.
Unlike previous chapters, which applied to a broader spectrum of life and
health insurance products, this chapter focuses on life insurance products.

The Legal Reserve System

The system that insurers use to set financial values for life insurance products is
generally known as the legal reserve system. The legal reserve system derives its
name from legal requirements that apply to insurers in the United States and many
other jurisdictions. Insurers are required by law to establish policy reserves, some-
times referred to as contractual reserves, legal reserves, or statutory reserves.
These reserves represent the amount an insurer estimates it needs to pay future
benefits.
Of all the terms used in the insurance industry, reserves is one of the most
important and also one of the most easily misunderstood. In our everyday lives,
we use the term reserves to mean something extra, something that is available in
addition to our usual supply. For example, in a broad sense, people use the term
reserves to refer to a sum of additional money that is put aside in case a special
need arises. Used in this sense, a reserve fund is an asset.
In the insurance industry, however, reserves are not assets. Rather, they are lia-
bilities representing the amount of money an insurer estimates it will need to pay
its future obligations. Policy reserves represent the largest portion of an insurer’s
total liabilities. By law, the insurer is required to maintain assets that are at least
equal to the amount of its policy reserve liabilities. Accordingly, the insurer must
price its life insurance products so that it can meet its policy reserve requirements
at all times.

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Principles of Insurance Chapter 4: Life Insurance Premiums 4.3

The legal reserve system is based on the following premises:

„„ The amount of benefits payable should be specified or calculable in advance
of the insured event.
„„ Companies should collect in advance the money needed to fund a policy
reserve so that they will have sufficient funds available to pay claims and
expenses as they occur.
„„ The premium an individual pays for a life insurance policy should be directly
related to the amount of risk the insurance company assumes for the policy.

Establishing Premium Rates

In pricing life insurance products, actuaries do not determine the exact premium
amount that each policyowner pays. Rather, they establish premium rates for
blocks of policies. A block of policies is a group of policies issued to insureds who
are all the same age and sex and in the same risk classification.

Example:
An insurer may classify into one block all term life insurance policies to
be issued to male tobacco nonusers, age 35, with no significant medical
history.

A premium rate is a charge per unit of insurance coverage. In most cases,

premium rates for a block of policies are based on a $1,000 life insurance cover-
age amount, known as a coverage unit. Thus, the premium rate for an individual
life insurance policy is typically expressed as the rate per thousand per year. An
annual premium amount for a policy is calculated by multiplying the premium rate
by the number of coverage units.

Example:
The annual premium rate for a $500,000 life insurance policy is expressed
as $4 per $1,000 of coverage.

Analysis:
The annual premium amount for the policy is $2,000, which is calculated
as follows:
LEARNING AID
Annual Premium
Premium Rate Amount
Number of Units
(Payment per Unit × ($1,000 of Coverage)
=
(Customer’s Annual
per Year)
Payment)
500, found as
$4 × ($500,000 ÷ $1,000)
= $2,000

Note that other factors, such as the application of policy fees and policy dividends,
may affect the premium amount actually charged to a policyowner.

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 4.4 Chapter 4: Life Insurance Premiums Principles of Insurance

Actuaries consider many variables as they perform the calculations necessary

to establish premium rates. In performing these calculations, actuaries seek to
ensure that premium rates are
„„ Adequate. Adequate premium rates are high enough so that the insurer will
have enough money to pay policy benefits as well as operating expenses.
Because most insurance companies operate for a profit, their premium rates
should be high enough to provide a reasonable profit as well.
„„ Equitable. Equitable premium rates ensure that each policyowner is charged
a premium that reflects the degree of risk the insurer assumes in providing
the coverage. Insureds who represent similar degrees of risk to the company
should be charged similar rates.
„„ Not excessive. If an insurer’s premium rates are too high, potential custom-
ers may instead purchase policies from competitors that offer lower premium
rates. In addition, sales producers may prefer to represent other insurers that
offer lower premium rates.
The three most important factors that actuaries consider in the calculation of
life insurance premium rates are (1) the cost of benefits, (2) operating expenses,
LEARNING AID
and (3) investment earnings.

Cost of Benefits
The cost of benefits, sometimes known as the cost of insurance, is the value of
all the contractually required benefits a product promises to pay. For a given life
insurance product, the projected cost of benefits generally equals the sum of all
the potential benefit payments under the product multiplied by the probability that
each benefit will be payable. We can express the projected cost of a given benefit
as follows:
Projected cost of a Potential benefit Probability that the
given benefit = amount payable × benefit will be payable

The primary policy benefit payable by an insurer when an insured dies while
the policy is in force is the death benefit. Insurers determine the probability that
death benefits will be payable in a given year by referring to mortality tables,
which estimate the mortality rate for a given group of insureds.
The cost of benefits for a group of insureds depends in part on the mortality rate:
„„ In general, the higher the mortality rate for a group of insureds of the same age
and sex, the higher the cost of benefits and, thus, the higher the premium rate.
„„ Conversely, the lower the mortality rate for a group of insureds of the same
age and sex, the lower the cost of benefits and the lower the premium rate.
Because life expectancy and mortality rates vary widely from one country to
another, insurers usually rely on mortality tables developed for use in a particular
country. Figure 4.1 illustrates a portion of a mortality table.

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Principles of Insurance Chapter 4: Life Insurance Premiums 4.5

Figure 4.1 Sample Mortality Table—Male

Mortality Rate
Age Number Living Number Dying
per 1,000
59 100,000 1,100 11
60 98,900 1,200 12
61 97,700 1,300 13

The group of males age 59 begins the year with 100,000 members. During the year, 1,100 of the
men are expected to die. The mortality rate during the year is 11 per 1,000, calculated by dividing
the number dying at age 59 by the number living at age 59 at the beginning of the year.

1,100 ÷ 100,000 = 0.011

According to this mortality table, 11 out of every 1,000 men are expected to die after attaining age
59 but before attaining age 60.

We can check this number—the 1,100 dying during their 59th year—by subtracting it from 100,000,
the number of men expected to be alive at the beginning of their 59th year. This calculation should
give us the number of men expected to be alive at the beginning of their 60th year:

100,000 – 1,100 = 98,900

Most mortality tables are known as sex-distinct mortality tables because they
contain separate statistics for males and females. In contrast, other mortality
tables, known as unisex mortality tables, show a single set of mortality rates to be
used for both males and females.
Mortality statistics show that, at nearly all ages, females have lower mortality
rates than males of the same age. To reflect this difference, most insurers set lower
life insurance premium rates for equivalent coverage for women than for men of
the same age and underwriting risk. Figure 4.2 shows the differences in average
life expectancies at birth by country and by sex, as of 2013.
Most mortality tables that insurers use to price products divide the mortality
rates into two additional categories: tobacco users and tobacco nonusers. In other
words, sex-distinct mortality tables often show mortality rates for four catego-
ries of people: male tobacco users, male tobacco nonusers, female tobacco users,
and female tobacco nonusers. A mortality table that does not show separate mor-
tality rates for tobacco users and tobacco nonusers is referred to as a composite
mortality table. For the purpose of setting premium rates, mortality tables in some
countries, such as the United States and Canada, are also divided into even more
categories, such as preferred, standard, and substandard risk classifications.

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 4.6 Chapter 4: Life Insurance Premiums Principles of Insurance

Figure 4.2 Average Life Expectancy by Country, 2013

Male Life Female Life

Expectancy at Expectancy at
Birth Birth
Australia 80 85
Brazil 72 79
Canada 80 84
China 74 77
Indonesia 69 73
Japan 80 87
Mexico 73 78
Spain 80 86
United States 76 81

Source: From Global Health Observatory Data Repository: Life expectancy—Data by country. http://apps.who.int/gho/data/node.
main.688?lang=en Chapter 4. Figure 4.2. displayed as a chart showing Male and Female Life expectancy at Birth for countries
Australia, Brazil, Canada, China, Indonesia, Japan, Mexico, Spain, United States

Operating Expenses
For life insurance companies, operating expenses are the costs of operations other
than expenses for contractual benefits, or the cost of benefits. In setting a premium
rate for a product, the insurer must estimate the expenses associated with develop-
ing the product, selling it, and supporting it over the years it is expected to remain
in force. Examples of these expenses include
„„ Product development costs
„„ Distribution and promotion costs
„„ Payroll costs for staff, as well as employee benefit costs
„„ The costs of providing customer service to policyowners, such as producing
and mailing account statements and answering customer service phone calls
„„ The costs associated with maintaining the company’s offices and its computer
systems
In general, insurers spend considerably more on benefit payments to customers
than on their operating expenses. Figure 4.3 shows the typical portion of insurance
company expenses that was attributable to paying benefits and the portion that was
attributable to operating expenses.
A significant risk associated with an insurer’s operating expenses is that custom-
ers will terminate or reduce the value of a life insurance policy before the policy
becomes profitable. During the policy’s early years, the insurer incurs substantial
product expenses. Underwriting expenses and other expenses are incurred when
an insurer issues a policy. For example, insurers often pay a substantial portion of a
policy’s initial premium as a commission to the producer who sold the policy. Thus,
a policy generally must remain in force for several years for it to be profitable.

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Principles of Insurance Chapter 4: Life Insurance Premiums 4.7

Figure 4.3 Distribution of U.S. Life Insurance Company Expenditures, 2014

Operating
expenses
13%
Investment
expenses
1%
Taxes
3%

Additions to
policy reserves
17% Benefit
Payments
66%

Source: Adapted from ACLI, Life Insurers Fact Book 2015, Copyright © 2015 American Council of Life Insurers, Washington, DC,
(November 2015, 19,) 50 https://www.acli.com/Tools/Industry%20Facts/Life%20Insurers%20Fact%20Book/Documents/FB15_All.pdf
(15 February 2016). Used with permission.

An example of a situation in which an insurer may lose money on a product is

when the product’s actual lapse rate exceeds the rate built into the product’s pre-
mium rate. The termination of an insurance policy for nonpayment of premium is
known as a lapse. Therefore, the lapse rate is the percentage of a specified group
of policies in force at the beginning of a specified period, such as a year, that are
terminated by the end of that period for reasons other than the death of the insured.

Example:
The Reliable Insurance Company had a block of 10,000 life insurance
policies in force at the beginning of last year. During the year, 1,000 of the
policies lapsed.

Analysis:
For last year, the actual lapse rate for this block of policies was 10%, found
as follows:
1,000 lapses ÷ 10,000 policies in force = 10% lapse rate

If this 10% lapse rate exceeded the rate that Reliable’s actuaries built into
the product’s premium rate, Reliable may have lost money on this product.

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4.8 Chapter 4: Life Insurance Premiums Principles of Insurance

Investment Earnings
In setting a product’s premium rate, an insurer must take into account investment
earnings—the money the insurer earns from investing the funds it receives from
customers. Many life insurance policies remain in force for a number of years
before benefits become payable. During that time, the funds paid for these policies
are available for the insurer to invest. The earnings on these investments allow
insurance companies to charge policyowners less than if companies relied solely
on the premiums and charges that policyowners paid.
As financial intermediaries, insurance companies invest the funds received
from customers in many different ways—in government and corporate bonds,
mortgages, real estate, and corporate stock. In fact, insurance companies can place
money in any safe investment that is likely to provide good earnings and is not
prohibited by government regulation.

How Investments Create Earnings

Many investments earn money in the form of interest payments. Interest is a pay-
ment for the use of money. The rate of interest is expressed in terms of a percent-
age, such as 10 percent. The principal is the sum of money originally invested,
loaned, or borrowed.
Simple interest is interest on the principal only. Consider an example of
a ­simple-interest loan. In such a transaction, the lender is considered to be the
investor. A 10 percent interest rate on a loan indicates that the borrower must pay
the lender the amount originally borrowed, plus an additional 10 percent of that
amount each year.

Example:
Casper O’Hare loaned Riley Nugent $1,000 for two years at an annual
interest rate of 10%. Riley did not repay any of the principal or interest on
the loan for two years.

Analysis:
At the end of one year, Riley owed Casper $1,100, calculated as
$1,000 principal + ($1,000 principal × 0.10)

At the end of two years, Riley owed Casper another $100 in interest,
calculated as
$1,000 principal × 0.10 = $100

Therefore, at the end of the second year, Riley owed Casper a total of
$1,200, calculated as
$1,100 + $100

Calculating interest on both the principal and the accrued interest is called
compounding, and the interest in this case is called compound interest.
Today, the interest on most loans and investments is compound interest. When
interest is compounded, the interest earned each investment period is equal to the

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Principles of Insurance Chapter 4: Life Insurance Premiums 4.9

accumulated balance at the beginning of the period multiplied by the interest rate.
The amount of interest earned that period is then added to the accumulated bal-
ance to determine the beginning balance on which interest will be paid during the
next period. In this way, interest is earned on both the original principal and on all
accumulated interest.

Example:
Olivia Sandoval loaned Shu-Ling Lee $1,000 at an interest rate of 10%,
compounded annually. Shu-Ling did not repay any of the principal or
interest on the loan for two years.

Analysis:
At the end of the first year, Shu-Ling owed Olivia $1,100, calculated as

$1,000 principal + ($1,000 principal × 0.10)

At the end of the second year, Shu-Ling owed Olivia $110 in interest,
calculated as

($1,100 accumulated balance) × 0.10

Therefore, at the end of the second year, Shu-Ling owed Olivia a total of
$1,210, calculated as

$1,100 + $110

The interest in this example was compounded annually. However, interest can be
compounded with any frequency—quarterly, monthly, or daily, for example.
Although the additional $10 earned by compounding interest in the previous
example may seem small, over a long period of time, compounding interest has a
dramatic effect on the total amount of interest that is earned.

Example:
Kalinda Patel deposited $1,000 in a bank account that pays 5% simple
interest. She made no other deposits for the next 25 years.

Analysis:
After 25 years, Kalinda’s account earned $1,250 in simple interest ($50
× 25). Had her account paid compound rather than simple interest, she
would have earned a total of $2,386 in compound interest at the end of
the 25-year period.

The example of the bank account shows how much money a single amount
can earn over time. Many insurance policies require annual premium payments,
which usually allow the insurer to invest an additional amount from premiums
every year the policy remains in effect. Figure 4.4 shows the amount of money that
can be earned over various periods of time by investing $1,000 a year at 5 percent
interest, compounded annually.

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 4.10 Chapter 4: Life Insurance Premiums Principles of Insurance

Figure 4.4 Value of $1,000 Annual Investment at 5% Interest,

Compounded Annually

$60,000
Principal +
 Compound Interest

 Principal
$50,000 
Value of Investment

$40,000


$30,000


$20,000




$10,000 



$0



1 5 10 15 20 25

Number of Years

Value of Investment
1 year Principal $1,000 Interest $50 Total $1,050
5 years Principal $5,000 Interest $802 Total $5,802
10 years Principal $10,000 Interest $3,207 Total $13,207
15 years Principal $15,000 Interest $7,657 Total $22,657
20 years Principal $20,000 Interest $14,719 Total $34,719
25 years Principal $25,000 Interest $25,113 Total $50,113

For the sake of simplicity, we illustrated investment earnings in terms of an

interest rate earned on a loan and on a bank account. However, companies can
receive investment earnings from many other types of investments. For example,
insurance companies invest money by buying stock in other companies. While an
insurance company owns the stock, the company may collect dividend payments
on that stock. In addition, the insurer might be able to sell the stock for more than
it paid. In both instances, the insurer’s investment earnings can be expressed as a
rate of return, which is the investment earnings expressed as a percentage of the
principal.

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Principles of Insurance Chapter 4: Life Insurance Premiums 4.11

Example:
Reliable Insurance Company purchased stock in the Mimosa Corporation
for $100,000. One year later, Reliable sold the Mimosa stock for $120,000.

Analysis:
Reliable earned a return of $20,000 on its investment ($120,000 - $100,000).
The percentage rate of return on the investment was 20% ($20,000 return
÷ $100,000 = 0.20 or 20%).

Financial Models
Actuaries need to be able to establish premium rates for products that will satisfy
the company’s objectives over the many years that the products are expected to be
in force. Product outcomes can vary, however, based on economic conditions, the
insurer’s claim experience, policy terminations, and other factors. Companies can
evaluate the potential effects of various future conditions on a product’s financial
values by using financial models. In general, a financial model is a computer-
based mathematical model that approximates the operation of real-world financial
processes. Companies use product development software that simulates the poten-
tial financial processes likely to occur over the time that a product is expected to
remain in force.
Examples of financial values that insurers use in modeling are values for inter-
est rates, mortality rates, expenses, and lapses. A typical financial model runs hun-
dreds or even thousands of scenarios, with each scenario representing a different
set of financial values that the product is likely to experience.
Insurers build into their financial models the risk that they will face unexpected
outcomes. One way they do this is by using projections that are designed to be
more than adequate; such projections are said to be conservative.
Conservative values for specific life insurance product elements generally take
the form of
„„ Mortality rates that are higher than expected

„„ Investment earnings that are lower than expected

„„ Operating expenses that are higher than expected

Example:
An insurer may project mortality rates that are 10% higher than expected
to ensure that the premium rate for a product will be more than adequate.

In calculating premium rates, actuaries use conservative values to provide a

buffer against adverse product results.

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4.12 Chapter 4: Life Insurance Premiums Principles of Insurance

The Level Premium System

If insurers always charged policyowners the amount it cost to provide coverage at
the insured’s current age, the mortality expense would be low when the insured
LEARNING AID
was young and increase as the insured grew older. Most people would not be able to
afford the cost of insurance in their later years when mortality rates and expenses
are high. Therefore, insurers developed the level premium system, which is a life
insurance premium system that allows a policyowner to pay the same premium
amount each year a policy is in force. Insurers use the level premium system to
price many types of cash value life insurance, term life insurance that provides
coverage for more than one year, and endowment insurance.
Level premiums are possible because, in the early policy years, premium rates
for level premium policies are higher than needed to pay claims and expenses.
Relatively few insureds will die during those early policy years, and few claims
will be payable. The insurer can invest the premium dollars that are not needed to
pay claims and expenses in those years.
As people insured under a block of level premium policies grow older, the
insurer expects to receive an increasing number of death claims each year. Under
a level premium system, the insurer uses premium dollars from the early policy
years, plus the investment earnings, to help pay the increased number of death
claims in the later years. Thus, the premium rate on any of these policies can
remain level throughout the duration of the policy. Figure 4.5 illustrates the dif-
ference between the premiums required for a level premium policy and those
required for a series of similar one-year term life policies. We discuss term life
insurance in Chapter 5.

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Principles of Insurance Chapter 4: Life Insurance Premiums 4.13

Figure 4.5 Level Premiums Contrasted with One-Year Term Life Premiums

One-Year Term Policy Cost

Level Premium Policy Cost

Premium

Age

Key Terms
actuary investment earnings
legal reserve system interest
policy reserves principal
block of policies simple interest
premium rate compounding
cost of benefits compound interest
death benefit rate of return
operating expenses financial model
lapse level premium system
lapse rate

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Principles of Insurance Chapter 5: Term Life Insurance 5.1

Chapter 5

Term Life Insurance

Objectives
After studying this chapter, you should be able to
5A Identify the common personal and business needs that life insurance
can meet
5B Describe the coverage provided by level term, decreasing term, and
increasing term life insurance policies, and explain when the premium
charged for term life insurance coverage may increase
5C Describe renewable term life insurance and convertible term life
insurance
5D Describe the operation of a return of premium (ROP) term policy

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5.2 Chapter 5: Term Life Insurance Principles of Insurance

Outline
Needs Met by Life Insurance Term Life Insurance
 Personal Needs  Characteristics of Term Life
 Business Needs Insurance Products
 Plans of Term Life Insurance
Coverage
 Features of Term Life Insurance
Policies

I
n this chapter, we describe various types of term life insurance products. Term
life insurance is distinct in that it remains in force for a specific period of time,
rather than for the entire life of the insured. Why would a person choose to be
covered for only a portion of her life? It depends on what her needs are.
Many products, life insurance included, meet different needs for different peo-
ple. One clear example is the automobile. One person might purchase a vehicle
with four-wheel drive and high ground clearance to carry heavy loads over dirt
roads. Another may need a small, fuel-efficient vehicle for an urban commute—
until she starts a family, when she decides a larger vehicle with comprehensive
safety features is more important. Financial products such as life insurance also
cover a wide variety of needs. A person’s financial needs can be very different
from his neighbor’s. They can even be very different from what his needs were
when he was younger, or what his needs will be in the future.

Needs Met by Life Insurance

Recall that life insurance policies pay a policy benefit following the death of the
insured. The beneficiary can use this benefit for a variety of purposes, including
both pre-existing needs and needs that arise upon a person’s death. Individuals and
businesses both have needs life insurance can meet.

Personal Needs
People’s needs for life insurance coverage vary greatly, but most buyers share a
number of common reasons to purchase life insurance. Among the most common
of these needs are dependents’ support, paying debts and final expenses, and estate
planning.

Dependents’ Support
If a person who supports or helps support a family dies, the surviving dependents
may face serious problems after the person’s death. Household expenses persist;
rent or mortgage payments still come due; utility bills continue to arrive; food and
clothing remain necessities. The death may create additional expenses, such as the
need to provide child care or household upkeep. To make matters worse, surviving
family members often must make difficult financial decisions while they are still
coping with the emotional effects of the loss of a loved one.

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Principles of Insurance Chapter 5: Term Life Insurance 5.3

Many people save money for unexpected expenses. But relatively few have
sufficient funds to pay their usual expenses for an extended period of time if the
regular family income is reduced substantially or ceases altogether. Even those
who possess sufficient savings may worry that using those savings to pay house-
hold expenses will make it more difficult for them to meet future financial needs,
such as providing for retirement.
Life insurance can provide funds to support dependents until they obtain new
methods of support or adjust to living on a lower income. It also can fund the edu-
cation of the insured’s dependents.

Example:
Derek Chau purchased a $250,000 life insurance policy. At the time of
his death, he had a wife, Kelly—the policy beneficiary—and two teenage
children.

Analysis:
The policy was in force upon Derek’s death, so the insurer paid $250,000
to Kelly. Kelly used $15,000 of the proceeds to pay Derek’s final expenses
and put $100,000 toward college funds for the children. She placed the
remaining $135,000 in the bank to help her make mortgage payments
and cover household expenses for the next few years.

In many jurisdictions, when an insurer pays the death benefit of a life insurance
policy in a lump sum to a beneficiary following the death of the insured, that ben-
efit usually is not considered taxable income to the beneficiary. Regulators provide
this tax benefit to encourage people to protect their dependents with life insurance.
By doing so, they hope to lessen potential reliance on government aid.

Debts and Final Expenses

When a person dies, he often leaves a variety of debts, such as mortgage loans,
educational loans, personal loans, credit accounts, and automobile loans. Some
expenses arise as a result of the person’s death itself, such as doctor and hospital
bills that are not covered by insurance, and of course funeral expenses. Further-
more, various taxes may come due. Balanced against these debts and taxes are the
individual’s assets. These assets may include cash, bank and investment accounts,
real estate, personal possessions, and possibly ownership interests in a business.
The accumulated assets that an individual owns when she dies are referred to
as that person’s estate. When the individual dies, her estate is distributed in an
orderly manner according to the law.
In general, an individual can determine who will receive the assets in her estate
by executing a will, which is a legal document that directs how the individual’s
property is to be distributed after her death. If an individual does not execute
a valid will during her lifetime, the law determines how the property is to be
­distributed.

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5.4 Chapter 5: Term Life Insurance Principles of Insurance

When a person dies, a personal representative typically is appointed to settle

the deceased person’s estate. The personal representative is known as the executor
if the person died with a valid will, or the administrator if the person died without
a valid will. The responsibilities of settling an estate include identifying and col-
lecting the deceased’s property, filing any required tax forms, collecting all debts
owed to the deceased, and paying all outstanding debts that the deceased owed.
The personal representative then distributes the remaining property according to
the deceased person’s will or the applicable law.
To ensure that her estate is distributed properly, a person should have an estate
plan, which is a plan that considers the amount of assets and debts that a person is
likely to have when she dies and how best to preserve those assets so that they can be
distributed as she desires. An estate plan is particularly important because a person’s
death generally does not extinguish her debts. Instead, the debts must be paid from
the deceased’s estate before her heirs can receive any assets from the estate.

Example:
Monica LeBeau died with a will in place and an estate worth $600,000,
including a home worth $200,000. She also had $120,000 in final expenses,
mortgage debt, and credit card debt. Her will specified that her oldest
child, Reba, would receive the family home, and the remainder of her
estate would be divided between her two younger children, Ben and Luke.

Analysis:
Monica’s executor paid off her debts from her estate. After the debts
were settled, the remaining estate was worth $480,000, including the
home. Reba received the home, and Ben and Luke divided the remaining
$280,000 worth of Monica’s estate between them.
If Monica’s final expenses and debt had been $420,000, the executor
would not have been able to pay them out of her estate without selling
the family home, and Monica would not have been able to leave the home
to Reba.

However, if a life insurance policy is included in the deceased’s estate plan, the
proceeds can help pay those remaining debts. The personal representative then can
distribute the deceased’s assets in accordance with the deceased’s wishes.
In some cases, other people, such as a spouse or parent, may be personally
liable for a particular debt of the deceased. For example, a spouse or parent may
have co-signed a loan with the deceased and be jointly liable with the deceased
for its repayment. Insurance benefits can help pay off any such debts, easing the
burden on the deceased’s loved ones.
Figure 5.1 describes some methods for determining how much life insurance an
individual should purchase.

Business Needs
Businesses also have needs that life insurance can meet. Two common reasons for
a business—or an individual who owns a business—to purchase life insurance are
(1) to provide funds to ensure that the business continues in the event of the death
or disability of an owner, partner, or other key person, and (2) to provide benefits
for its employees.

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Principles of Insurance Chapter 5: Term Life Insurance 5.5

Figure 5.1 How Much Life Insurance Is Enough?

Without the ability to predict the future, it’s impossible to

know exactly how much life insurance a person will need.
But life insurance companies are specialists at making ­educated
estimates. They also try to teach customers how to make
­informed estimates on their own. A very simple method is to use
a ­formula based on the person’s current income. For e­ xample, an
insurer’s formula might recommend that p ­ eople purchase at least
five times their current income in life ­insurance. Thus, a person
who earns $60,000 a year would be ­advised to ­purchase at least
$300,000 of life insurance. These multiples vary widely, depend-
ing on the person or institution making the ­recommendation,
and of course are very general estimates.
A more exacting method requires the person to develop a comprehensive picture of her ­financial
situation and future financial needs by evaluating her debts, savings, expenses, and family ­situation.
Insurance companies and financial advisors make this task easier by offering various software
programs and mobile applications designed to help organize the required information. These
programs, usually called life insurance needs calculators or simply life insurance calculators, are
generally available at no charge on an insurer or financial publication’s website. Some non-profit
organizations, such as Life Happens (www.lifehappens.org), were founded with the intention of
educating the public on the benefits of owning life insurance and related products. Providing free
access to life insurance needs calculators is an integral part of this strategy.

Business Continuation Insurance

A business continuation insurance plan is an insurance plan designed to ensure
the continued financial viability of a business when faced with the death or dis-
ability of the business owner or other key person. A key person is any person or
employee whose continued participation in the business is vital to the success of
the business and whose death or disability would cause the business to incur a sig-
nificant financial loss. A business continuation insurance plan often includes key
person life insurance or a buy-sell agreement.

Key Person Life Insurance

Key person life insurance, or key employee life insurance, is individual life insur-
ance that a business purchases on the life of a key person. When a business pur-
chases key person life insurance, the business owns, pays the premiums on, and is
the beneficiary of the insurance policy. If the key person dies, the business receives
the death benefit.
Key persons typically include a company’s owners, executives, and manag-
ers—those who have the knowledge, experience, and expertise to manage the
company successfully. However, other people also may be vitally important to the
continued success of the business. For example, a top salesperson or an employee
with important business contacts may be responsible for a large portion of the com-
pany’s income. Similarly, a lead engineer might be the only person with enough
technical expertise and familiarity with the company’s equipment to maximize
manufacturing efficiency.

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 5.6 Chapter 5: Term Life Insurance Principles of Insurance

The loss of a key person’s expertise and services may seriously affect the com-
pany’s earnings. During the period following the death of a key person, sales may
drop off, and morale and productivity can decline. Creditors, customers, and sup-
pliers may become uneasy. The business almost certainly incurs the cost of finding
or training a replacement for the key person. Key person life insurance helps offset
those costs. In addition, if the company’s creditors, customers, and suppliers know
that the business has protected itself by insuring the lives of its key employees,
they may be more confident about the company’s future.

Example:
Electric Galaxy Software Solutions considers its owners and executives to
be key persons. It also identifies its lead software engineer, Rebecca Sloe,
as a key person. Rebecca is well-known in the industry for her innovative
work. The business purchases key person life insurance on Rebecca as well
as on its owners and executives.

Analysis:
If Rebecca were to die, the proceeds from her policy would provide a
source of cash to supplement the company’s earnings while it searches for
and trains a replacement for her. In addition, if Electric Galaxy’s customers
and suppliers know about the key person life insurance, they may be more
confident about the company’s future and may agree to continue their
business relationships with Electric Galaxy on the same basis as before
Rebecca’s death.

Buy-Sell Agreements
The owner of a small business may want to ensure that the business can continue
to operate under new ownership after his death. A buy-sell agreement is an agree-
LEARNING AID ment in which (1) one party agrees to purchase the financial interest that a second
party has in a business following the second party’s death, and (2) the second party
agrees to direct his estate to sell his interest in the business to the purchasing party.
One or more of the parties to a buy-sell agreement often purchase life insurance
to fund the buy-sell agreement. Life insurance can be used to fund buy-sell agree-
ments for sole proprietorships, partnerships, or corporations with a small number
of shareholders.

Example:
Emmett Jackson is the sole owner of Reliable & Timely Services. Emmett
entered into a buy-sell agreement with one of his employees, Kareena
Singh. Under the agreement’s terms, Kareena agreed to buy the business
for $1,000,000 in the event of Emmett’s death. She purchased a $1,000,000
life insurance policy on Emmett’s life, naming herself as the beneficiary.

Analysis:
Should Emmett die, the proceeds of the life insurance policy would be
paid to Kareena. Kareena could use the proceeds to purchase Reliable &
Timely Services from Emmett’s estate, which has been directed to sell the
business to Kareena in this situation.

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Principles of Insurance Chapter 5: Term Life Insurance 5.7

Employee Benefits
Many businesses provide various financial products, including life insurance, for
their employees as an employee benefit. These compensation packages enable
businesses to attract and retain qualified personnel. Many employers provide
health insurance and retirement plans, which we’ll explore later in the text; group
term life insurance is also very common, as we’ll discuss below.

Term Life Insurance

All life insurance policies provide for the payment of a benefit upon the death of
the insured while the policy is in force. Therefore, all life insurance policies help
individuals and businesses meet the needs we discussed earlier. But the more fea-
tures a policy has, and the more needs it meets, the more expensive it tends to be.
Term life insurance is usually the least expensive plan of life insurance available.
Therefore, individuals and businesses often choose term life insurance to meet
their needs. In 2014, 39 percent of new individual life insurance policies purchased
in the United States were term life policies, for a total face amount of $1.1 trillion.1
A life insurance policy’s face amount is the amount of life insurance benefits for
which an individual applies and that the insurer approves. Group term life policies
are also the most common form of group life insurance purchased.

Characteristics of Term Life Insurance Products

Term life insurance is life insurance that provides coverage only if the insured
dies during the period specified in the policy; that specified period is known as
the policy term. The death benefit is payable only if (1) the insured dies during
the policy term, and (2) the policy is in force when the insured dies. If the insured
lives until the end of the specified term, the policy may give the policyowner the
right to continue some form of life insurance coverage. If the policyowner does not
continue the coverage, then the policy expires and the insurer has no obligation to
provide further insurance coverage.
The length of the policy term varies considerably from one policy to another.
For example, some insurers issue travel insurance policies that provide a policy
benefit only if the insured dies during a specified trip. Insurers also sell policies
that cover a term of a specified number of years, such as 1 year, 5 years, 10 years,
20 years, or 30 years.
When term life policies were first introduced in the United States, the vast
majority purchased were for a one-year term. Over time, longer terms have grown
more popular, to the point that now 20-year term policies are the favorite choice
with customers. Figure 5.2 shows how this change has occurred over time.
Term life policyowners typically must pay annual renewal premiums on the
policy anniversary to keep the coverage in force. The policy anniversary gener-
ally is the anniversary of the date on which coverage under the policy became
effective. Both the policy date—the date on which the policy’s coverage begins—
and the expiration date—the date on which the policy’s coverage ends—are usu-
ally stated on the face page of the policy.

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 5.8 Chapter 5: Term Life Insurance Principles of Insurance

Figure 5.2 Term Insurance Sales Over Time

20 Year 1990 1995 1999 2001 2005 2008 2010 2012 2014 2015
1 Year 62 37 13 9 5 7 6 7 6 6
10 Year 9 14 21 23 20 18 16 19 20 21

20 Year 1 3 18 35 38 41 36 39 37 38

Other 28 46 48 33 37 34 42 35 37 35

100% 100% 100% 100% 100% 100% 100% 100% 100% 100%

Source: LIMRA’s U.S. Individual Life Buyer Study and Quarterly Individual Life Sales Survey.

Another common type of term insurance policy covers the insured until she
reaches a specified age, usually age 65 or 70. For example, a term insurance policy
that covers an insured until age 65 is referred to as term to age 65. However, the
policy does not expire on the actual date when the insured reaches the specific age.
Instead, the policy’s coverage expires on the policy anniversary that falls either
closest to, or immediately after, the insured person’s 65th birthday, depending on
the terms of the policy.

Example:
Twin brothers Alex and Byron Freeman were born on September 4, 1980.
Both purchased term to age 65 policies, effective on the same day, July 7,
2011. Alex’s coverage expires on the policy anniversary closest to his 65th
birthday, while Byron’s expires on the policy anniversary immediately after
his 65th birthday. Both plan to pay all renewal premiums as they come
due.

Analysis:
Alex’s policy will expire on July 7, 2045, the anniversary date closest to his
65th birthday of September 4, 2045. Byron’s policy will expire on July 7,
2046, the first policy anniversary immediately after his 65th birthday.

Another distinctive characteristic of term life is that it does not accumulate a

cash value. We discuss cash value insurance in more detail in the next chapter.

Plans of Term Life Insurance Coverage

The amount of the benefit payable under a term life insurance policy usually
remains the same throughout the term of the policy. To meet specific customer
needs, term life policies are also available with benefits that either increase or
decrease over the policy’s term. Figure 5.3 illustrates the differences in these plans.

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Principles of Insurance Chapter 5: Term Life Insurance 5.9

Figure 5.3 Term Life Insurance Plans

Level Term Decreasing Term Increasing Term

erm
Level Term De c in gT
r ea r eas
sing I nc
Ter
$

$
m

Year Year Year

Benefit Premium

Level Term Life Insurance

By far, the most common plan of term insurance is level term life insurance,
which provides a death benefit that remains the same over the policy term. Level
term policies also usually feature level premiums, where the amount of the ini-
tial premium and each renewal premium remains the same throughout the stated
policy term. However, some level term policies provide for renewal premiums that
may increase during the policy term, although the death benefit remains the same.

Example:
Andrea Kovachev owns a 10-year level term policy that provides $250,000
of coverage. The initial premium was $500, and the policy features level
premiums.

Analysis:
The insurer agrees to pay $250,000 if Andrea dies at any time during the
10-year period that the policy is in force. Each renewal premium also will
be $500 throughout the policy term.

Decreasing Term Life Insurance

Decreasing term life insurance provides a death benefit that decreases in amount
over the policy term. The death benefit begins at a specific amount and then
decreases over the policy term according to a method described in the policy. For LEARNING AID
example, assume that the benefit during the first year of coverage for a 10-year
decreasing term policy is $100,000 and that the benefit then decreases by $10,000
on each policy anniversary. The coverage is $90,000 for the second policy year,
$80,000 for the third year, and so forth, down to $10,000 for the tenth year. At the
end of the 10th policy year, the coverage expires.

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5.10 Chapter 5: Term Life Insurance Principles of Insurance

The renewal premiums for a decreasing term policy usually remain the same
throughout the policy term. However, they are usually less than the renewal pre-
miums for a comparable level term policy.
Decreasing term policies are typically designed to meet specific needs that
decrease over a period of time. For example, many people borrow money to pur-
chase houses or cars, and as they repay those loans, their liabilities decrease. Sim-
ilarly, a family’s expenses decrease as children grow up and move away from
home. A decreasing term policy usually is specifically intended to shield depen-
dents from inherited debts such as a mortgage, car payments, or credit card debts.
Three common plans of decreasing term insurance are mortgage life insurance,
credit life insurance, and family income insurance.

Mortgage Life Insurance

The largest debt that many people owe is the mortgage loan on their homes. Under
the terms of a typical home mortgage loan, a borrower makes equal monthly pay-
ments for a period of time, usually either 15 or 30 years. Each payment the bor-
rower makes on a mortgage loan consists of both principal and interest on the
loan. The amount of the outstanding principal balance owed on the mortgage loan
gradually decreases over the term of a mortgage, although initially the decrease
is fairly slow.
Mortgage life insurance, sometimes referred to as mortgage redemption
­insurance, is a plan of decreasing term insurance designed to provide a benefit
amount that corresponds to the decreasing amount owed on a mortgage loan.2
If the borrower purchases mortgage life insurance, the amount of the death ben-
efit payable at any given time generally equals the amount the borrower owes on
the mortgage loan at this time. The term of a mortgage life policy is based on the
length of the mortgage. Renewal premiums payable for mortgage life insurance
are generally level throughout the term.
Often, the beneficiary of a mortgage life policy is a family member of the
insured, and the beneficiary uses the death benefit to pay off the mortgage. Typi-
cally, however, the beneficiary is not required to pay off the mortgage; she may
choose to invest the benefit instead, or use it for other purposes. Because the insur-
ance policy usually is independent of the mortgage, the mortgage lender is not a
party to the insurance contract.
In some cases, a mortgage lender may require the borrower to purchase mort-
gage life insurance as a condition for obtaining a mortgage loan. The policy names
the lender as beneficiary, and the lender requires the borrower to maintain the
coverage throughout the mortgage term. If the borrower dies during the mortgage
term, the lender receives a benefit equal to the remainder due under the mortgage
loan. The insurance company is not a party to the mortgage loan contract. Its only
obligation is to carry out its duties under the mortgage life policy. In Canada, the
beneficiary of a mortgage life policy is automatically the mortgage lender.

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Principles of Insurance Chapter 5: Term Life Insurance 5.11

Example:
When Hector Ruiz purchased his home, he also bought a mortgage life
insurance policy from Enduring Life Insurance Company. Hector named
his wife, Alisa, as beneficiary.
Anna Zolkozky purchased a house at the same time and applied for
a mortgage loan from Grandiose Banking. As a condition of the loan,
Grandiose required Anna to purchase a mortgage life insurance policy
naming Grandiose as the beneficiary, and to maintain the coverage during
the mortgage term. Anna purchased her policy from Enduring Life.
Seven years later, both Hector and Anna died, and the death benefit on
each of their mortgage life insurance policies was $120,000.

Analysis:
In both cases, Enduring Life was obligated to pay the $120,000 to the
beneficiary. In Hector’s case, his beneficiary, Alisa, could use the benefit
to pay off the remaining balance on the mortgage loan or put it toward
another purpose, such as a college fund for their children. As the
beneficiary of Anna’s policy, Grandiose used the benefit to pay off her
mortgage.

Many mortgage loans are obtained jointly by two people, both of whose
incomes are required to make the monthly mortgage payments. For that reason,
insurers offer joint mortgage life insurance, which provides the same benefit as
a mortgage life insurance policy except the joint policy insures the lives of two
people. If both insureds survive until the end of the policy term, the joint mortgage
life policy expires. But if one of the insureds dies while the policy is in force, the
insurer pays the death benefit to the beneficiary, who typically is the surviving
insured. Again, the beneficiary is not required to use the benefit to pay off the
mortgage.

Example:
Kofi and Jenna Morant purchased a joint mortgage life policy soon after
buying their house. Kofi named Jenna as his beneficiary, and Jenna named
Kofi as hers.

Analysis:
If Kofi dies while the policy is in force, the insurer will pay an amount equal
to the mortgage loan’s balance to Jenna. If Jenna dies instead, the insurer
pays the amount to Kofi. Either one would be free to use the benefit
amount to pay off the remaining balance on the mortgage loan or to use
it for other purposes.

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5.12 Chapter 5: Term Life Insurance Principles of Insurance

Credit Life Insurance

Life insurance also is available to ensure the repayment of other types of loans
besides mortgages. Credit life insurance is a type of term life insurance designed
to pay the balance due on a loan other than a mortgage if the borrower dies before
the loan is repaid. Like mortgage life insurance, credit life insurance usually is
decreasing term insurance. Unlike mortgage life insurance policies, credit life
insurance policies always provide that the death benefit is payable directly to the
lender, or creditor, if the insured borrower dies during the policy’s term. Credit life
insurance guarantees the lender that the insured’s outstanding debt will be paid if
the insured borrower dies before the loan is repaid. Generally, the loan must be a
type of loan that can be repaid in 10 years or less.
Credit life insurance is available for automobile loans, furniture loans, and
other personal loans. Insurers typically issue credit life policies through lenders
such as banks, finance companies, credit unions, and retailers. As with mortgage
life insurance, the amount of the benefit payable under a credit life insurance pol-
icy is usually equal to the amount of the unpaid debt. Thus, as the amount of the
loan decreases, the amount of credit life insurance provided decreases. In addition,
some credit card holders are covered by credit life insurance for the amounts they
owe on their accounts. In such cases, the amount of life insurance coverage in
force at any given time may increase or decrease depending on the amount of the
outstanding debt.
Premiums for credit life insurance may be level over the duration of the loan or,
in cases in which the amount of the loan varies, may increase or decrease as the
amount of the outstanding loan balance increases or decreases. In most cases, the
insured pays the premium to the lender, and the lender then remits the premium
to the insurer.

Family Income Coverage

Family income coverage (called survivor income benefit in Canada) is a plan of
decreasing term life insurance that pays the beneficiary a stated monthly income
benefit amount if the insured dies during the policy term. Monthly income benefits
continue until the end of the term specified when the coverage was purchased.
Family income coverage is a form of decreasing term life insurance because the
longer the insured remains alive during the term of coverage, the shorter the length
of time over which the insurer is required to pay monthly income benefits and the
smaller the total amount of benefits the insurer will pay out. The beneficiary of
family income coverage typically is the insured’s surviving spouse. This form of
term insurance can meet the need of providing for a family until the children can
support themselves.
Under some family income coverages, the insurer promises to pay the income
benefit amount for at least a stated minimum number of years if the insured dies
during the policy’s term.

Example:
Arnold Kim purchased 10-year family income coverage that provides for
a $1,000 monthly income benefit payable to his wife, Nari. His coverage
specifies that the income benefit will be paid for at least 3 years if he dies
during the 10-year term of coverage.

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Principles of Insurance Chapter 5: Term Life Insurance 5.13

Analysis:
If Arnold dies 2 years after buying the family income coverage, the insurer
will pay to Nari a total of $96,000 in monthly income benefits ($1,000 x
8 years x 12 months). If he dies 8 years after buying the coverage, the
insurer will pay the monthly income benefit for 3 years, for a total of
$36,000 ($1,000 x 3 years x 12 months). If he dies 11 years after purchasing
the coverage, no monthly income benefit would be paid because the
coverage expired a year before his death.

Family income coverage is most commonly purchased as a policy rider to a

cash value life insurance policy, a type of policy that we describe in the next chap-
ter. A policy rider, also known as an endorsement, is an amendment to an insur-
ance policy that becomes part of the insurance contract and changes its terms.
A policy rider is as legally effective as any other part of the insurance contract.
Riders commonly provide some type of supplementary benefit or increase the
amount of a policy’s death benefit.
When a family income coverage rider is added to a life insurance policy, the
beneficiary is entitled to receive the death benefit of the policy if the insured dies
while the policy is in force. If the insured dies within the term of the family income
rider, the beneficiary will receive both the death benefit and the monthly income
benefit for as long a period as the rider provides. A cash value life insurance policy
with a family income coverage rider is referred to as a family income policy.3

Increasing Term Life Insurance

Increasing term life insurance provides a death benefit that starts at one amount
and increases by some specified amount or percentage at stated intervals over the
policy term. For example, a policy may provide coverage that starts at $100,000
and then increases by 5 percent on each policy anniversary date throughout the
policy term. Alternatively, the death benefit may increase according to increases
in the cost of living, as measured by a standard index such as the Consumer Price
Index (CPI).4 If the CPI has increased by 2 percent since the last policy anniver-
sary date, for example, the death benefit also would increase by 2 percent.
People often purchase increasing term insurance as a rider to a life insurance
policy, and usually just for a limited time to meet a specific need, such as provid-
ing funds for a child’s education.

Features of Term Life Insurance Policies

Term life insurance provides only temporary protection; at the end of the stated
term, the policy expires. A policyowner who wants to maintain insurance cover-
age after the policy expires must apply for a new policy. However, the new policy
must be underwritten, and the premium will be higher to take into account the
increased age of the insured. If the insured’s health has declined during the pol-
icy term, the insured may now be a substandard risk—raising premiums even
higher—or even no longer insurable. To meet this customer need to continue life
insurance coverage, insurers include renewability and convertibility features in
some term life insurance policies.

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5.14 Chapter 5: Term Life Insurance Principles of Insurance

Renewable Term Insurance

A renewable term insurance policy is a term life insurance policy that gives the
policyowner the option to continue the coverage at the end of the specified term
LEARNING AID
without presenting evidence of insurability—proof that the insured person con-
tinues to be an insurable risk. The provision in the policy that gives the insured
the option to continue coverage for an additional policy term without present-
ing evidence of insurability is called the renewal provision. In order to continue
coverage at the end of the specified term, the insured is not generally required to
undergo a medical examination or to provide the insurer with an updated health
history. Often, all the policyowner must do to renew the policy is pay the renewal
premium.

Example:
Ten years ago, Maria Donato purchased a ten-year renewable term policy
from Wellbeing First Insurance Company. Eight years ago, she began
smoking again, and three years ago she was placed under observation for
cardiac arrhythmia.

Analysis:
Maria may renew her term insurance policy by paying the required renewal
premium. Ordinarily, Wellbeing First would have declined an application
for insurance from an applicant with Maria’s health history at the time of
renewal. But the renewal provision of Maria’s policy gives her the right to
renew without proof that she continues to be an insurable risk.

According to the provisions of a typical renewable term insurance policy,

the policyowner has the right to renew the coverage for the same term and face
amount that the policy originally provided. For example, a policyowner usually
can renew a $250,000 10-year renewable term policy for another 10-year period
and for $250,000 in coverage. Most insurers also allow the policyowner to renew
the policy for a smaller face amount or a shorter period than provided by the origi-
nal contract, but not for a larger face amount or a longer period.
Many renewable term policies place limits on the policyowner’s right to renew.
The most common limitations are that the coverage may be renewed only (1) until
the insured reaches a stated age or (2) a stated maximum number of times. For
example, the renewal provision of a policy may specify that the coverage is not
renewable after the insured has reached the age of 75. Another policy may state
that the coverage is renewable no more than three times. Such restrictions exist to
minimize antiselection.
When a policyowner renews a term life insurance policy, the policy’s premium
rate increases because the insured is older than when the policy was issued. The
renewal premium rate is based on the insured person’s attained age—the age the
insured has reached (attained) on a specified date, which in this case is the renewal
date. Usually, the renewal premium rate remains level throughout the new policy
term.

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Principles of Insurance Chapter 5: Term Life Insurance 5.15

Example:
Douglas Woo purchased a 10-year renewable term life insurance policy
on his wife Ellen, age 36. The policy states that coverage is not renewable
after the insured has reached the age of 65. The policy’s annual premium
is $260.

Analysis:
On the policy anniversary at the end of the first 10-year term, Douglas
has the right to renew Ellen’s coverage without Ellen having to provide
evidence of insurability. The coverage will be for the same face amount
as the original policy and for the same 10-year term. The new premium
amount, however, will increase to reflect Ellen’s attained age at the time of
renewal—age 46. Douglas will pay this higher premium each year during
the 10-year renewal period. At the end of the second 10-year period,
he will have the option to renew the policy again, but the premiums will
increase a second time to reflect Ellen’s attained age of 56. At the end of
the third 10-year period, he will no longer be able to renew this policy, as
it will be the policy anniversary date after her 65th birthday.

The renewal feature can lead to some antiselection; insureds in poor health are
more likely to renew their policies because they may not be able to obtain other life
insurance. Because of this risk, the premium for a renewable term life insurance
policy usually is slightly higher than the premium for a comparable nonrenewable
term life insurance policy.
Most one-year term insurance policies and riders are yearly renewable term
(YRT) insurance or annually renewable term (ART) insurance, which means they
are renewable each year for a stated number of years. Yearly renewable term poli-
cies typically are renewable for periods of 10 to 30 years, depending on the age of
the insured. As the insured ages, however, the renewal premiums for YRT cover-
age can become considerably more expensive than premiums for comparable 5- or
10-year level premium policies. For that reason, most renewable term insurance
policies sold today have policy terms of from 5 to 30 years. Figure 5.4 illustrates
the difference in premium costs between a YRT policy, a 5-year term policy, and
a 30-year term policy as an insured ages.

Convertible Term Insurance

Younger people often purchase term insurance because of the lower premium
cost, but they may want cash value insurance later, when they can afford it.
A ­convertible term insurance policy gives the policyowner the option to convert LEARNING AID
the term policy to a cash value life insurance policy without providing evidence of
insurability. Convertible term insurance policies contain a conversion privilege,
which allows the policyowner to change—convert—the term insurance policy
to a cash value policy without providing evidence of insurability. Some policies,
known as renewable/convertible term insurance policies, are both renewable and
convertible.

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 5.16 Chapter 5: Term Life Insurance Principles of Insurance

Figure 5.4 Relative Premium Costs of a YRT Policy, a 5-Year Term Policy,
and a 30-Year Term Policy

YRT Policy Cost

$1,600
Five-Year Term Policy Cost

30-Year Level Premium Term Policy Cost

1,400

1,200

1,000
Premium

800

600

400

200

35 40 45 50 55 60 65
Age

When a term insurance policy is converted to a cash value policy, the new
premium rate is higher than the premium rate the policyowner paid for the term
insurance policy. This increase is required because the premium charged for a
cash value life insurance policy is higher than the premium charged for a compa-
rable term insurance policy. However, the premium a policyowner is charged for
the cash value policy cannot be based on any increase in the insured’s mortality
risk, except with regard to an increase in the insured’s age.
Insurers can use two different types of conversions. The more common conver-
sion is known as an attained age conversion, in which the premium rate for the
cash value policy is based on the insured’s age at the time the policy is converted.
Alternately, under an original age conversion, the premium rate for the cash value
policy is based on the insured’s age when the original term policy was issued.
The renewal premium rate charged for cash value insurance is lower under an
original age conversion than under an attained age conversion. This difference
occurs because the premium rate is based on a younger age. For that reason, you
would think that a policyowner would always prefer an original age conversion to

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Principles of Insurance Chapter 5: Term Life Insurance 5.17

an attained age conversion. However, under an original age conversion, the poli-
cyowner also must pay an additional lump sum at the time a policy is converted.
The lump sum is based on the difference between the lower premiums the
­policyowner actually paid for the term insurance policy and the higher premiums
that he would have paid if he had purchased a cash value policy originally. This
lump sum can be substantial, and as a result, attained age conversion is much more
common than original age conversion.

Example:
Henrik Swenson bought a convertible term life policy at age 35 and
converted it to a cash value policy at age 39, using an attained age
conversion. Constance Braddock also bought a convertible term life policy
at age 35, and converted it to a cash value policy at age 39, but her policy
used an original age conversion.

Analysis:
At conversion, the insurer charges Henrik the same premium it would
charge a 39-year-old man for a comparable cash value policy. Constance’s
insurer charges her the same premium rate it would charge for a
comparable cash value policy issued to a 35-year-old woman. However,
her insurer also requires a lump sum payment based on the difference
between the premiums she paid for the last four years and the premiums
she would have paid if she had purchased a cash value policy.

Like the renewal feature, the conversion privilege can lead to some antiselec-
tion. Insureds in poor health are more likely to convert their coverage because
they may not be able to obtain other life insurance, or the premium rate for a new
policy would be prohibitively expensive. As a result, insurers usually charge a
higher premium rate for a convertible term policy than they charge for a compa-
rable nonconvertible term policy. In addition, insurers usually limit the conversion
privilege in some way. For instance, some policies do not permit conversion after
the insured has attained a specific age, such as 55 or 65, or after the term policy has
been in force for a specified time. For example, a 10-year term policy may permit
conversion only during the first 7 or 8 years of the term. In many cases, insurers
place additional limits on original age conversions. Under a 20-year term policy,
an insurer might permit an attained age conversion for the first 10 years of the
policy term, but permit an original age conversion only during the first 5 years of
the policy term.

Return of Premium Term Insurance

Some people are reluctant to purchase term insurance because they see it as a
financial risk. If they are alive when the policy expires, they will receive no mon-
etary benefits from the insurer despite having paid premiums for a number of
years. Some insurers now offer return of premium (ROP) term insurance, which
is a form of term life insurance that provides a death benefit if the insured dies
during the policy term and promises a return of premiums if the insured does not
die during the policy term.

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5.18 Chapter 5: Term Life Insurance Principles of Insurance

Example:
Helene Nikos, age 38, is the policyowner-insured of a $500,000 30-year
ROP term policy from Azure Insurance. Helene paid all the required annual
premiums of $1,150 and was alive when the policy expired.

Analysis:
Azure would return to Helene the premiums she has paid for the coverage,
a total of $34,500 ($1,150 x 30 years).

Some ROP term policies provide a partial return of premiums if the policy is
kept in force for a stated period of time but then canceled before the end of the
term. The longer these policies are kept in force, the greater the percentage of the
premium that is returned. Under such a policy, if the insured dies during the policy
term, the beneficiary receives the death benefit only; there is no additional partial
return of premiums.
Most insurers offer ROP term policies for terms of only 15 years or longer. The
premium for an ROP term policy varies by insurer. The premium is usually more
than 25 percent higher than for a comparable term policy without a return of pre-
mium feature, and sometimes as much as three times as high.
Renewability, convertibility, and return of premium features are of obvious
potential value to the policyowner, but they also are of value to the insurance
company. Most policyowners who renew or convert their term life insurance poli-
cies do so not because they are in poor health, but because they want to continue
their insurance protection. Regulatory changes have led to fewer insurers in the
United States carrying the return of premium feature, but this feature also gives
policyowners substantial motivation to keep a policy in effect.

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Principles of Insurance Chapter 5: Term Life Insurance 5.19

Key Terms
estate family income coverage
will policy rider
estate plan family income policy
business continuation insurance plan increasing term life insurance
key person renewable term insurance policy
key person life insurance evidence of insurability
buy-sell agreement renewal provision
face amount attained age
policy term yearly renewable term (YRT) insurance
policy anniversary convertible term insurance policy
level term life insurance conversion privilege
decreasing term life insurance attained age conversion
mortgage life insurance original age conversion
joint mortgage life insurance return of premium (ROP) term
credit life insurance insurance

Endnotes
1. ACLI, Life Insurers Factbook 2015 (Washington, DC: American Council of Life Insurers, 2015), 64,
https://www.acli.com/Tools/Industry%20Facts/Life%20Insurers%20Fact%20Book/Pages/RP15-010.
aspx (30 August 2016).
2. The term “mortgage insurance” is sometimes used to refer to a type of property/casualty insurance
more commonly referred to as private mortgage insurance (PMI) or lenders mortgage insurance
(LMI). PMI is insurance that pays the lender if the borrower fails to make mortgage payments as
required. PMI is not a form of life insurance.
3. Some insurers offer an alternative to the family income policy called a family maintenance policy,
which is a cash value life insurance policy that contains a level-term monthly income benefit rider.
If the insured dies during the term of the monthly income benefit rider, the beneficiary receives
monthly income payments for a fixed number of years. For example, assume that an insured pur-
chased a family maintenance policy with a 10-year term that provides for $1,000 monthly payments.
If the insured dies during that 10-year term, the beneficiary would receive both the death benefit and
a $1,000 monthly benefit for a total of 10 years, regardless of whether the insured dies in the first year
or the 10th year of the policy. If the insured dies after the 10-year term expires, no monthly benefits
are payable, but the beneficiary still receives the death benefit, as long as the policy remains in force.
4. The Consumer Price Index (CPI) measures the change in the price of a fixed list of items (a “basket
of goods”) bought by a typical consumer. The goods included in the CPI include food, transportation,
housing, utilities, clothing, and medical care.

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