Tie-in arrangements of life insurance and savings: an economic rationale

Abstract

Cash-value life insurance contracts can be viewed as tying life insurance with savings. The main purpose of this article is to provide an economic rationale for this widespread practice. It is assumed that there is an asymmetry of information between the insurers and insureds, where the latter know better their probability of death, and hence adverse selection may cause a market failure. To overcome this problem, a multiperiod (for exposition purposes a three-period model is used) contract and a single-period contract are offered. The multiperiod contract specifies a savings element which may be received by the insured at his or her discretion if the insured lives at the end of the second period. lt is shown that by the right choice of the savings element and the return on this element, the insurers can induce insureds to self select. Insureds with lower probabilities of death will choose the multiperiod conitract whereas insureds with higher mortality rates will choose successive single-period contracts. It is therefore shown that tie-in arrangements of savings and insurance may help solve the problem of adverse selection and hence an economic rationale is provided for their existence. Cash-value life insurance contracts tie savings and risk of death insurance. Many researchers tried to explain the popularity of such tie-in arrangements, and whether they can dominate a strategy of buying risk insurance (i.e., term insurance) and savings separately (see, e.g., Ferrari, 1968; Fortune, 1973;