8-3 A life insurance policy is a financial asset, with the premiums paid represe

Question

8-3 A life insurance policy is a financial asset, with the premiums paid representing the investment’s cost. a. How would you calculate the expected return on a 1-year life insurance policy? b. Suppose the owner of a life insurance policy has no other financial assets—the person’s only other asset is “human capital,” or earnings capacity. What is the correlation coeffi- cient between the return on the insurance policy and that on the human capital? c. Life insurance companies must pay administrative costs and sales representatives’ commissions, hence the expected rate of return on insurance premiums is generally low or even negative. Use portfolio concepts to explain why people buy life insurance in spite of low expected returns

Explanation / Answer

a. How would you calculate the expected return on a 1-year life insurance policy?

Answer: I would calculate the expected return on a 1 year life insurance policy using life expectancy.The expected return on a life insurance policy is calculated just like we are calculating for common stock. Each outcome is multiplied by its probability of occurrence, and then these products are summed.

b. Suppose the owner of a life insurance policy has no other financial assets—the person’s only other asset is “human capital,” or earnings capacity. What is the correlation coeffi- cient between the return on the insurance policy and that on the human capital?

Answer: The return on human capital and the return on the insurance policy has a perfect negative correlation.The events like death and future lifetime earnings capacity are mutually exclusive.

c. Life insurance companies must pay administrative costs and sales representatives’ commissions, hence the expected rate of return on insurance premiums is generally low or even negative. Use portfolio concepts to explain why people buy life insurance in spite of low expected returns.

Answer: People are generally risk averse. Therefore, they are willing to pay a premium to decrease the uncertainty of their future cash flows.As the portfolio concept tells us, people buy life insurance more for the have an internal peace,that an insurance policy give them - not the expected returns that theywould like to get.  A life insurance policy guarantees an income which is the face value of the policy, to the policyholder’s beneficiaries when the policyholder’s future earnings capacity will zero.Because of this people buy insurance policy in spite of low expected return.

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