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Contrast the different kinds of life insurance policy.

FRM® Part I · Financial Markets and Products · Insurance Companies and Pension Plans · FRM1.FM.2.e

The idea

Term life pays only if death occurs within a stated term, has no savings element and is the cheapest cover. Whole life covers the insured for life with level premiums, so early premiums exceed the cost of cover and build a cash value. Because payment is certain, it costs more than term. Endowment pays on death within the term or a lump sum if the insured survives to the end. Variable life lets the policyholder direct the cash value into investment funds and bear the investment result. Universal life allows flexible premiums and death benefit, with interest credited by the insurer. Variable-universal life combines both flexibilities. Group life covers employees under one contract, usually without individual medical underwriting. Annuities pay while the holder lives. The exam usually describes a need and asks for the matching contract.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which description matches term life insurance?

  1. It pays only if the insured dies within a stated period, and builds no cash value - correct
  2. It pays a lump sum on death or on survival to the end of the termWhy not: This describes an endowment policy.
  3. It lets the policyholder invest the cash value in funds of the holder's choiceWhy not: This describes variable life insurance.
  4. It pays a death benefit whenever the insured dies, however late, and builds a cash valueWhy not: This describes whole life insurance.

Term cover is pure protection for a defined period, so it is the cheapest per unit of cover and has no savings component.

A harder one

A firm wants to give all its staff life cover under one contract, with no individual medical examinations and a lower cost per person. Which policy type fits best?

  1. Universal life insuranceWhy not: Universal life is an individual policy with flexible premiums, not a master contract for a workforce.
  2. Variable life insuranceWhy not: Variable life gives individuals a choice of investments; it is not a workforce contract.
  3. Endowment insuranceWhy not: Endowment policies pay on survival to the end of a term as well as on death; they are individual contracts.
  4. Group life insurance - correct

Group life covers many people under one master contract with little or no individual underwriting, which reduces costs, subject to participation rules.

The hardest tier

Two 30-year-olds each buy USD 500,000 of cover: one a 20-year term policy and the other a whole life policy, both with level premiums. Why is the whole life premium much higher?

  1. Whole life carries a lower discount rate since the cover is shorterWhy not: The cover is longer, not shorter, and the discount rate does not explain the savings element.
  2. Term policies carry higher mortality risk than whole life, so the insurer reduces the term premiumWhy not: The term policy is cheaper because it may never pay; it is not due to differing mortality risk.
  3. The benefit is certain to be paid, and the level premium also funds a growing cash value - correct
  4. Whole life premiums are set at the annual cost of cover each year, which rises with ageWhy not: This describes yearly renewable term; whole life premiums are level and overpay in early years.

A term policy pays only if death happens in the term, whereas whole life pays for certain, so the expected claim is far larger. Level premiums also exceed the early-year cost of cover, building a reserve.

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