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Life insurance contract from terminally ill client

P3-46. The viatical industry offers a rather grim example of present value concepts. A firm in this business, called a viator, purchases the rights to the benefits from a life insurance contract from a terminally ill client. The viator may then sell claims on the insurance payout to other investors. The industry began in the early 1990s as a way to help AIDS patients capture some of the proceeds from their life insurance policies for living expenses.

Suppose a patient has a life expectancy of 18 months and a life insurance policy with a death benefit of $100,000. A viator pays $80,000 for the right to the benefit, and then sells that claim to another investor for $80,500.

a. From the point of view of the patient, this contract is like taking out a loan. What is the compound annual interest rate on the loan if the patient lives exactly 18 months? What if the pa-tient lives 36 months?

b. From the point of view of the investor, this transaction is like lending money. What is the compound annual interest rate earned on the loan if the patient lives 18 months? What if the patient lives just 12 months?

Solution Preview

a. 80,000 = 100,000/(1+r)^1.5
r = 16%, if the patient lives 18 ...

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