Consumer Valuation of Life Insurance. A Capital Budgeting Approach

Abstract

The Capital Budgeting Approach has been suggested as a method whereby the consumer may estimate the cost of his life insurance, by several authors. Many cost methods include parts of a formal capital budgeting model. But none to date has treated the purchase of life insurance as a pure capital budgeting decision. This article takes the consumer's viewpoint. Assumptions of lapse are not relevant to the consumer because he faces a lapse rate of one or zero in each year depending on whether he pays his premium. For life companies, lapse rates are vital to calculate an asset share accurately. The result of the Capital Budgeting Approach is a cost method that is more easily understood by both the consumer and the agent and that fairly reflects company decisions relative to high early cash values and dividends. The value of a life insurance policy to the consumer has been a difficult concept for years. This paper analyzes the life insurance policy as a series of cash and opportunity cash flows. Capital budgeting techniques are applied to the flows in the life insurance contract to reveal for insureds a comparative value of insurance in terms of rates of return and net present values. Requisites For Cost Method Any system of life insurance cost (value) comparisons should be simple. The primary method of dissemination of cost information to the public is through life insurance agents. Agents acquire information from trade sources. In order that accurate information may be transmitted, it must be simple to survive the round-about communication process from calculation to consumer. A second goal in a cost comparison system is to reflect the time value of money. From the consumer's viewpoint, a life insurance policy is a conPeter R. Kensicki, D.B.A., C.L.U., is Assistant Professor of Finance at Ohio University. Formerly with the Georgia Department of Insurance, Dr. Kensicki is a Trustee of the Griffith Foundation for Insurance Education and is Chairman of the Board of Trustees of the Institute for Research Studies, Inc. This paper was submitted in September, 1973. The author wishes to thank the many people who have contributed their time and talent to reading and suggesting changes in this paper. While there are too many to list all, a special thanks is given to Harry Blythe, Professor of Finance, Ohio State University.