Professional Documents
Culture Documents
Babbel 1979
Babbel 1979
Babbel 1979
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ABSTRACT
A numberof methodologiesgenerallyused in comparinglife insurancecosts are
examined,andone is identifiedas appropriatefor measuringinflation'simpacton the
expectedcost of life insurance.The modelis used to demonstratethatanticipationsof
inflationare associatedwith higher(rationallyperceived)realcosts of life insurance
protectionwhen regulationimpedesinsurersfrom incorporatinghigherinterestrates
into nonparticipatingpolicy contractterms.
Introduction
Inflationis a problemthat has plaguedeconomies worldwide. Recently a
growingnumberof countrieshave experienceddouble-digitratesof inflation
which have affected basic institutionssuch as life insurance.The effects of
inflation on life insurance contractsare especially pronounceddue to two
factors:these contractsusuallyare specified in fixed, nominalcurrencyunits,
and most of them are designed to cover long periods of time. Because life
insurancevalues are specified in fixed nominal currencyunits, they do not
adjustto compensatefor the value erosionproducedby inflation, andbecause
the contracts are generally long-term, the accumulatederosive effects of
inflationon the insurancevalues can be substantial.Thus, while life insurance
productsaredesignedto provideprotectionagainstthe perilsof longevity and
prematuredeath, inflation and a rising cost of living can underminesuch
protection.
In this papera methodologyappropriatefor measuringlife insurancecosts
in an environment of inflation is developed. The model is then used to
examinetheoreticallythe effect of inflationon life insurancecosts. A number
of authorshave devised methodologiesby which the costs of life insurance
may be computed.1Nearly invariably,the methodologies have been devel-
oped and designed for use in comparing the costs of policies offered by
differing insurers. What is needed is a method appropriatefor measuring
425
TABLE 1
ConsumerApproachesto Life InsuranceValuation
Money Illusion
Consumers suffering from money illusion may realize that inflation is
occurring,but fail to recognize the impact of inflationon the real costs and
values of their life insurancepolicies.4 "'After all," they might remark,"the
size of my premium has not gone up in spite of inflation."
Moreover, if insurersare able to lower the premiumcharge due to higher
returnson investments from higher interestrates, consumerssufferingfrom
this degreeof money illusion mighteven believe thatthe cost of life insurance
is declining. Their focus is on the nominal costs and nominal levels of
protection,and unless inflation affects these nominal values, consumersdo
not recognize the impact of inflation on life insurance.
Such consumers might employ a numberof specific costing procedures
which may give rise to, or could serve to reinforce their illusion. One such
method,commonly called the "TraditionalMethod," which has long been in
use andwhich continues to be popularamongconsumersof life insurance,5is
used here for illustrative purposes. Its procedure is to add the insurance
premiumsfor a numberof years, usually 20, and to subtractthe sum of the
illustratedpolicy dividends for the period.6The cash value at the end of the
periodis subtractedfrom the resultingfigure, and the final amountis divided
by 20 (or by the length of the periodif otherthan20 years), andby the number
of thousands of the amount insured. The result, which may be positive or
negative, is the insurancecost per year per thousandcurrencyunits of life
insurance in force. The calculation procedure may be representedby the
following formula: k k
z P - E D -CV
NC = n=1 n=l (1)
k
4The features most often included in life insurancepolicies are premiums, death benefits,
cash values, dividends, and terminaldividends. The dividend featuresare available in "par-
ticipatingpolicies," but not in "nonparticipatingpolicies."
All life insurancepolicies contain one or more of the three basic kinds of insurance:term,
whole life, and endowment insurance.Term insurancefeaturespremiumsand deathbenefits,
with or without dividends. Whole life and endowment policies feature premiums, death
benefits, andguaranteedcash values, with or withoutdividends. Terminsurancepolicies offer
financial protectionagainst the peril of prematuredeath; whole life and endowment policies
offer protectionagainstthe peril of prematuredeath and also offer cash savings, which can be
used in providingprotectionagainst the peril of outliving one's earningcapacity. For further
details, see Pfeffer and Klock [33].
'In a survey by the Instituteof Life Insurance[22], consumers of insurancein the United
States identified the TraditionalMethod as being the most "preferred"method.
'The calculationsuse an illustrativedividendscale; the scale does not representan estimate
of the amountthat the insurerwill pay, but ratherthe currentscale paid on existing policies.
where
Policy Illusion
A more subtle erroris made when consumersare myopic in theirperspec-
tive of life insuranceupon consideringthe net cost (in real or present value
terms)of a policy offeringa given numberof unitsof insurancein force. Their
focus is incorrectlyon the vehicle (i.e., the policy contract)ratherthanon the
design (i.e., the protection offered) of the life insurance purchase. This
misdirectedfocus is denoted "Policy Illusion" in this discussion, and is a
subset of money illusion.
In discussing this type of money illusion, attentionis given to an elabora-
tion of a capitalbudgetingprocedurefound useful in measuringthe impactof
inflationon the costs and benefits associated with life insurance.The model
developedalso is used in the subsequentsection of this paperafterundergoing
a slight modificationto remove the final element of money illusion from the
valuationprocedure.
A Capital Budgeting Approach
Several authorshave advocateda capital budgetingapproachto the prob-
lem of consumer valuation of life insurance.9While such an approachin
7The applicationof indices to insurancecontractswas first authorizedin Brazil by Decree-
Law No. 73 of November 21, 1966.
8The English translationof this quote from Chacel et al. 19, p. 255] is that of the author.
9Thefirst study known to the authorto treatthe purchaseof life insuranceas a purecapital
budgeting decision was one by Kensicki [24]. Readers unfamiliarwith capital budgeting
techniques should find Brigham [8, chs. 11, 12] helpful.
k
+ a+n-1 ($1,'0) + k DRa+n-1 (TD) (2)
n=1 /+1(1i ) n=1/i77 "
n_______-1
n 11 (1+i t- )
(1+i0) t=1 (1+i0) t=1
TD k k
k H (1-DR a+t1) cvk 1 (1-DRa+t 1)
t=1 t=t-1 a+-
+ + ~ ~k + k
t (t+i= (1+i
t=l t=l
where
E[NPVk] is the Expected Net PresentValue of the insurancepolicy, per
thousandunits of insurancein force, for the insuredwho plans
to surrenderthe policy in year k;
Pn is the premiumpayableat the beginningof yearn, per thousand
units of insurancein force;
CVk is the cash value at the end of year k, per thousandunits of
insurance in force;
k is the year of surrender;
DRa+n-I is the conditionalprobabilitythatan insuredwho survivesto age
a+n-l will die before reaching age a+n where the insured's
attainedage on the effective date of the policy is representedby
the letter a;
it (or in) representsthe opportunitycost for the time value of money in
year t (or year n) and serves as a basis for determiningthe
present value of any stream of future costs and benefits. In
operationalterms, it can be viewed as the after-taxinterestrate
selected by the individualrepresentinghis or herrisk-freerateof
returnin year t (or n);
Dn is the dividendpayableatthe end of yearn, perthousandunitsof
insurance in force; and
TDn is the terminal dividend payable at the end of year n, per
thousandunits of insurancein force.
Formula(2) shows the basic cash flows in a participatingwhole life policy:
premiums, death benefit, cash surrendervalue, and dividends. The first
expression representsthe expected present value of the premiumspayable.
This outflow is weighted at each step to reflect the possibility that the
premiumswill not be paiddue to the deathof the insured." Pnis discountedby
n
1
(1+i0)
n (1+i t1) because premiums are payable at the beginning of the
year.
The second expressionrepresentsthe presentvalue of the dividendsthatare
expected to be received by the insured,weighted accordingto the probability
thatthe insuredwill surviveto receive them. This expressionis discountedby
n
11 (1+id) as dividends are receivable at the end of each policy year.
t=1
The thirdexpression representsthe death benefit, which is the amountof
insurancein force (one thousandunits) multipliedby the probabilitythat it is
received (i.e., the probabilitythat the insuredwill die). The death benefit is
,,1+1 n
n
discountedby + H (1+i -l due to the availabilityof the deathbenefit
0 t=1
E a-1) (I a
E[NPCk]
E[NPC = (I-DR_a t- n-i a+t-1) k DR n-1
. ($1000)
n=I (i+i) n=I (l+i)
(3)
k
CVk HI (I -DR +t-1
(i+i)k
k (5)
cvk TI (1-DR at-)
t=1
k k
(1+r) G(+j)
To determinethe likely impactof a change in the expected rateof inflation
on the cost of life insurance, the method of differential calculus may be
employed such that
dE [NPCk]
dE [NPCk] - dj dj.
Returning to the level premium whole life policy (equation 15]) and differ-
entiating16
1 k 1-n -n n-i
dE[NPCk] [P (1-DR 1) (l+r) (1-n) (l+j) n (1-DR )
a-i n=Itt1
-k -k-i k
CVk(1+r) (-k) (+j) - l (1-DR ) ]dj
Here it is seen that for k= 1,2,3,... the first term will be a nonpositive
expression while the second and third terms (including their preceding signs)
will be positive. The sum of these three expressions, whether positive or
negative, specifies the direction of the impact of a change in the expected rate
of inflation on the expected net present cost of a given amount of life insurance
coverage. If the sum is positive (negative), an increase in the expected rate of
inflation will produce a rise (decline) in the expected net present cost of the
policy. It can be shown that for the insured who plans to surrender at the end of
the first policy year, an increase in the expected rate of inflation unambigu-
ously will lead to an increase in the expected net present cost of a term policy.
It also can be shown that if insurance is priced fairly (where present values of
expected costs and benefits are equal), the same pattern will hold true for an
insured who plans to surrender at the end of the second policy year.17 In
general, however, determining the impact of expected inflation on the cost of
life insurance will require more information with regard to the levels of costs
in relation to benefits, the time horizon, and the mortality rates. When such
information is provided, it was found in several cases [4] that the expected net
present cost of life insurance increases with anticipated inflation for surrender
in year one, but decreases with anticipated inflation for surrender thereafter.
At first blush these cost patterns may seem counter-intuitive, but can be
explained readily through examining the interaction of two opposing forces
deriving from the timing of cost and benefit flows, and the magnitudes of
these flows. The timing of cost and benefit flows leads to an increase in the
expected net present cost of a life insurance policy, when inflation is intro-
'6In addition to assuming independence between the real requiredrate of returnand the
expected inflationrate, the model implicitlyassumes that(1) mortalityratesare independentof
the inflation rate, and (2) policy terms are independentof the inflation rate. While the first
assumptionmay be a close approximationto reality (except, perhaps, in the case of the fixed
income recipient, whose anxiety level increases with inflation, therebycontributingto earlier
death), the second assumption may not hold if markets are free to adjust policy terms in
accordancewith the ratesof inflation. Inthe countriesstudiedby the author,policy termseither
were slow to incorporateor did not adjustto the higherinterestratesaccompanyinginflation.
'7The proof of these assertions is available to the reader upon request to this author.
duced into the model. It will be noted that the benefit flows are always
discountedat higher rates than the premiumflow, because they occur later
within each time period leading to a higher expected net present cost of the
policy.
If costs exceed benefits (the usualcase), the relativemagnitudesof the cost
andbenefit flows tend to reducethe expected net presentcost of an insurance
policy when inflation is introducedinto the model. An example illustratesthis
point. If two unequalquantitiesare discountedequally in percentageterms,
the largerof the two quantitieswill decline more in absolute terms. Thus, as
costs are of larger magnitudethanbenefits, their discounted values will fall
more rapidly in absolute terms with inflation, thereby decreasing the net
present cost.
The problem encounteredin comparingexpected (net) present costs of a
life insurancepolicy underdifferinginflationrate assumptions,as performed
in the analysis of this section, is that not only do the costs change, but the
productalso changes. Therefore,any comparisonyields aboutas muchuseful
informationas comparingthe cost of apples underone inflationrateassump-
tion with the cost of peanutsunderanotherinflationrateassumption,hoping
therebyto infer the effect of inflationon the cost of apples. Under inflation,
the realprotectionachievedthrougha life insurancepolicy purchasedeclines,
while indemnificationvaries in real terms accordingto the date of death. As
the nominalterms of the policy remainthe same, it is temptingto comparethe
effects of inflation on the cost of the policies ratherthan on the life insurance
protection. However, the policy is merely the vehicle through which the
objective (i.e., protection)is sought. Thus attentionmoreproperlyis centered
upon the effects of inflation on the cost of protection.
To demonstrate more concisely the problem associated with using the
ExpectedNet PresentCost model in determiningthe effect of inflationon the
cost of life insurance,the formulais given in simplified notationas follows:
F [PV(C)] -
E[NPCI/per 1000 units /per 1000 units E[PV(B)]/per 1000 units (7)
ins. in force ins. in force ins. in force
In the foregoing formula, C and B representthe cost and benefits associated
with each one thousandcurrencyunitsof insurancein force. The E and PV are
expectations and present value operators, respectively. Unfortunately,the
numeraireto which the benefits and costs are attachedis a poor choice. The
one thousandnominal units of insurancein force representdifferentlevels of
protectionunderdiffering inflationrateassumptions.Hence, such a model is
inappropriatefor use by a consumerfree from policy illusion in determining
the cost of life insurance.
Many of the life insurance cost computation methods presently in use
incorporateelements thattend to inducepolicy illusion on the partof the user.
For example, the "Interest-AdjustedMethod," which was developed to
overcomedefects in the "TraditionalMethod" andwhich was recommended
by the JointSpecial Committeeon Life InsuranceCosts [23] and requiredby
law in some states of the United States, makes explicit use of a nominally
valued numeraire(one thousandunits of insurancein force). Accordingly,
No Illusion
If consumersare befuddledwith money illusion, partialmoney illusion, or
policy illusion, they are likely to view the influence of inflationas producing
life insurancecosts that are unchanged, higher, or lower, respectively.
To arriveat a costing methodology in which money illusion, in any of its
forms, is absent, a good startingpoint is formula(7), reproducedbelow for
convenience.
E[NPC] E
E[PV (C)] E
E[PV(B)]I
/per 1000 units /per 1000 units /per 1000 units
ins. in force ins. in force ins. in force
The nominalnumeraire,which gives rise to policy illusion, can be eliminated
in alternativeways. For the Expected Net PresentCost method, considered
earlierin the chapter,a simple andeffective approachis to divide each termin
the foregoing formulaby the last termthatappearson the right-handside. The
resulting equation is
/per 1000 units E[PV(C) /per 1000 units E[PV(B) /per 1000 unit
ins. in force ins. in force ins. in force (8)
E[P(B) /per 1000 units [P(B)]/per 1000 units [P(B) /per 1000 units
ins. in force ins. in force ins. in force
which simplies tQ
E[NPV] = E[PV(C)] 1. (9)
E[PV(B)] E[PV(B)]
"8Examplesof this approachcan be found in [5, 6, 15, 26, 27, 34, 35].
'9Whetheror not differing discount rates may be properly applied to separate cash flow
streams that are part of a "package" is debatable. Arditti [1] has demonstratedthat the
procedureof using a differentdiscountfactorfor cash flows exhibitingcomplete certaintyfrom
that applied to uncertain flows is appropriate.Other cash flows, he contends, should be
discounted by a similar risk-adjustedrate, because they are not separable. Whether these
conclusions areapplicableto the life insuranceproductis debatable.The policy can be arranged
to include any desirable cash flow provisions, and is cancellable by the policyowner at any
moment.
23The magnitude of the increased net real cost of life insurance under inflation can be
dramatic. Examples have been provided elsewhere [4].