A life insurance policy is a financial asset. The premiums paid represent the investment’s cost.
a. How would you calculate the expected return on a 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 lifetime earnings capacity. What is the correlation coefficient between returns on the insurance policy and returns on the policyholder’s human capital?
c. Insurance companies have to pay administrative costs and sales representatives’ commissions; hence, the expected rate of return on insurance premiums is generally low, or even negative. Use the portfolio concept to explain why people buy life insurance despite the negative expected returns.