Chapter 8, Problem 3Q

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

Chapter
Section

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

A life insurance policy is a financial asset, with the premiums paid representing the investment’s cost. a. How would you calculate the expected return on a 1-year life insurance policy? b. Suppose the owner of a life insurance policy has no other financial assets–the person’s only other asset is “human capital,” or earnings capacity. What is the correlation coefficient between the return on the insurance policy and the return on the human capital? c. Life insurance companies must pay administrative costs and sales representatives commissions; henee, the expected rate of return on insurance premiums is generally low or even negative. Use portfolio concepts to explain why people buy life insurance in spite of low expected returns.

a)

Summary Introduction

To explain: The expected return on a life insurance policy.

The Expected return:

The expected return on an investment refers to the weighted average of estimated returns and estimation of occurrence of those returns.

Life Insurance Policy:

Life insurance policy is an agreement between two parties, the two parties are the insurance company and the policy buyer. The insurance company depicts to pay a predetermined amount to the policy holder in case of specified future events.

Explanation
• The expected return on the life insurance policy is that return which is gained or collected at regular intervals determined by that policy.
• An amount is invested in a life insurance policy and for that, small amounts are paid at regular intervals.
• The expected return on a 1-year life insurance policy is calculated in the same way as the return on the common stock is calculated.
• This will be more clear by the following example:

Assume,

The policy is a 1-year term policy which pays \$20,000 at death.

The probability of the death of policy holder is 2%.

The probability of zero return is 98%...

b.

Summary Introduction

To explain: The correlation coefficient between the return on the insurance policy and the return on the human capital.

Correlation Coefficient:

A correlation coefficient is a tool of statistical measure. This tool measures the relation between the two variables. It measures how the change in one value of variable affects the other.

c.

Summary Introduction

To explain: The reason for buying the life insurance in spite of low expected returns.

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