Question

How can life insurance and annuity products be used to create a steady stream of cash disbursements and payments so as to avoid either the payment or receipt of a single lump sum cash amount? (LG 15-2)

Answer 1

answer

A life insurance policy (whole life or universal life) requires regular premium payments which then entitle the beneficiary to a single lump sum. Upon receipt of such a lump sum, a single annuity could be obtained which would generate regular cash payments until the value of the insurance policy is depleted.

Annuities vs. Life Insurance

Life insurance companies and investment companies are the two primary types of financial institutions offering annuity products. For life insurance companies, annuities are a natural hedge for their insurance products. Life insurance is bought to deal with mortality risk—that is, the risk of dying prematurely. Policyholders pay an annual premium to the insurance company who will pay out a lump sum upon their death.

If the policyholder dies prematurely, the insurer will pay out the death benefit at a net loss to the company. Actuarial science and claims experience allow these insurance companies to price their policies so that on average insurance purchasers will live long enough so that the insurer earns a profit.

Annuities, on the other hand, deal with longevity risk, or the risk of outliving one's assets. The risk to the issuer of the annuity is that annuity holders will survive to outlive their initial investment. Annuity issuers may hedge longevity risk by selling annuities to customers with a higher risk of premature death.

Example of an Annuity and Life insurance policy

A life insurance policy is an example of a fixed annuity in which an individual pays a fixed amount each month for a pre-determined time period (typically 59.5 years) and receives a fixed income stream during her retirement years.

An example of an immediate annuity is when an individual pays a single premium, say $200,000, to an insurance company and receives monthly payments, say $5,000, for a fixed time period afterward. The payout amount for immediate annuities depends on market conditions and interest rates.