A Capital Budgeting Analysis of Life Insurance Contracts

Abstract

The standard options in the whole life insurance contract have values which are inadequately recognized in the controversy over the relative merits of whole life and term insurance plus direct investment. Capital budgeting techniques are here applied to that problem. The extended term option in the whole life contract is recognized and given an economic value. Consequently, the equilibrium rate of return that must be earned on any direct investments by an insured is found to be greater than in earlier studies. The pretax equivalent of this rate is also higher than the rates normally available to individual investors in instruments offering a high degree of safety of principal. Life insurance has long been recognized as a socially desirable technique for cushioning the economic losses associated with death, by transferring the uncertainty of the timing of economic loss from the shoulders of the individual to the collective shoulders of the group. This basic function was the initial motivation and is still its raison d'etre. In the process of fulfilling this function, the industry has also become the second largest financial intermediary for the investments of individuals.' J. R. Longstreet, Ph.D., is Professor of Finance and Chairman of the Department at the University of South Florida. He formerly was a member of the faculty of the University of California and of the Wharton School of Finance and Commerce. While at the Wharton School, Dr. Longstreet was a member of the Security Research Unit of the University of Pennsylvania for six years. Fred B. Power, M.Ed., is Assistant Professor of Finance at the University of South Florida. He also serves as Educational Consultant for State Farm Insurance Companies. The authors wish to acknowledge the criticisms and suggestions of their colleagues, Professors W. G. Modrow, R. J. Murphy, L. W. Small, and C. T. Smith. This paper was submitted in December, 1969. 1 Insurance reserves and insured pension reserves of individuals totalled $152.2 billion at the ,nrl of 1 R7 cnrAl wenhrer nxc,%u(l nhm.In recent years there has been increasing controversy over the desirability and appropriateness of the investment aspects of life insurance. Arguments have been advanced that the individual could obtain a more economic combination, or package of insurance and savings, if instead of buying ordinary level premium life insurance, he used a combination of term insurance, possibly decreasing term, and invested the difference in the premiums.2 Assumptions and Hidden Values Most articles discussing the relative merit of terms vs. whole-life insurance adopt a simplistic approach that overlooks a number of valuable options in the standard whole-life contract. The typical comparisons of term and whole-life policies assume that total death benefits are held constant by periodically reducing the term insurance to the point where the sum of the growing savings plus the term mercial and mutual savings banks as institutional investors of the savings of individuals in the United States. 2 For example, editors of Consumer Reports, The Consumers Union Report on Life Insurance, New York: Harper & Row, 1967. Mort and E. A. Gilbert, Life Insurance: Investing in Disaster, New York: Modem Age Book, 1938.