Investment Life Insurance versus Term Insurance and Separate Investment: A Determination of Expected-Return Equivalents

Abstract

The purpose of this paper is to analyze the provocative proposition of substituting for investment life insurance a program of term insurance and separate investment. The approach is to calculate an expected-return equivalent, that is, the rate of return net of taxes and investment expenses that one would have to expect from a separate investment fund plus term insurance over some duration, such as twenty or thirty years, in order to attain at least the equivalent of the performance of investment life insurance, taking into account the probability of persisting in either scheme and the time value of money. In the current environment of aggressive competition for the individual's savings dollar, one is frequently confronted with comparisons between investment life insurance and other investment media. The extent to which investment in life insurance is discouraged by proponents of other media is epitomized in the expression buy term and invest the difference. The slogan implies that one is better off if, instead of buying investment life insurance, he uses the same financial outlay to purchase an equivalent amount of term insurance protection at a lower J. Robert Ferrari, Ph.D., C.L.U., A.C.A.S., is Assistant Professor of Insurance in the Wharton School of Finance and Commerce of the University of Pennsylvania. Dr. Ferrari is co-author of Life Insurance and/or Mutual Funds and of The Private Insurance of Home Mortgages. The author gratefully acknowledges that the bulk of the research for this paper was financed by a summer research grant from the National Science Foundation. The author is indebted also to Howard Simkowitz and James O'Grady, graduate students at the University of Pennsylvania, who performed much of the computational work for this paper, and to Joseph M. Belth, Indiana University, who offered much helpful criticism. A draft of this paper was presented at the 1967 Risk Theory Seminar in Philadelphia, Pa. premium and invests the remainder (the difference) in a separate investment. This proposition is well-recognized by anyone familiar with life insurance and it has stimulated a great deal of interest in the relative investment merits, or demerits, of life insurance. However, the generally accepted of analyzing the relative investment return in life insurance is subject to a number of shortcomings. Accordingly, the three-fold purpose of this paper is: (1) to describe and analyze the traditional Linton method for determining the investment return that an investor must expect to earn if a plan of term insurance and separate investment is to be at least as favorable as an equivalent financial outlay in investment life insurance; (2) to describe an alternative that alleviates many of the shortcomings of the traditional approach; and (3) to present the results of the application of this new to a number of modern life insurance plans.