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; hence, 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.