Determining a policy’s valueThe value of an insurance policy being sold is based on the present value of the expected cash flows over the life of the investment.
When a life insurance policy is sold, the seller receives a cash payment. The buyer pays all future premiums and receives the death benefit upon the death of the insured.
There are four components to determining the “value of a life policy”:
1. Amount of the death benefit
2. Remaining expected life of the insured
3. The amount of premiums to be paid until the death benefit is paid
4. The discount rate or investor-required rate of return
The amount received from a policy is a mathematical determination of taking into account the impact that each of the factors has on the value. The higher the premiums, the longer the life expectancy and the higher the required investor’s return, the lower the value of the policy. Conversely, the lower the premiums, the shorter the life expectancy and the lower the investor’s required return, the higher the value of the policy.
Every case is different. In all cases, the death benefit is known, and, in most cases, the amount of annual premium payments can be determined within a reasonable probability. The expected remaining life of the insured is the factor with the greatest variability and therefore represents the greatest risk to the investor. Predicting how long any one individual will live is uncertain, based on one’s age, gender, health and lifestyle.
The discount rate required by an investor is based on the perceived risks and uncertainties associated with the policy cash flows as well as returns in the marketplace for investing in other assets.
The selling price of a life policy will always be greater than the cash surrender value but less than the death benefit.