Underinsurance in the UK

NAME

:

HANG PING CHER

STUDENT NO :110058177

SUPERVISOR :MR. DAVID SMITH

The dissertation is submitted as part of the requirements for theaward of the MSc in Actuarial Management.

August 2012

HANG PING CHER: UNDERINSURANCE IN THE UK

ABSTRACT`This paper investigates the problem of underinsurance in the United Kingdom.
We determine the monetary amount of the life assurance protection gap in UK
through an analytical study by considering various components of theresources needed and available to households to maintain their current
standard of living following the death of a breadwinner. Summing acrosshouseholds, we estimate that the UK protection gap is £3.77 trillion, or an
average of £194,455 per household. The average household protection gap islargest among younger households, at over £250,000. We also consider thecover needed for households to maintain a reasonable standard of living, andfind that there is still a substantial gap of £1.74 trillion. In general, we find thathouseholds need more cover but appear to have little spare cash. We alsopresent a case for decreasing term assurances as a superior form of cover interms of cost-efficiency. Finally, our model represents a viable method for anindividual to easily estimate his or her insurance needs. This allows people tobe more aware of the amount of cover that they require.

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ACKNOWLEDGEMENTS
I would like express my sincere gratitude and appreciation to my project
supervisor, Mr. David Smith, for his patience and insightful guidance
throughout the course of the project. This report would not have been possible
without his valuable advice and input.
I would also like to express my thanks to everyone who has contributed to thisreport in one way or another.

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Table of Contents
ABSTRACT ....................................................................................................... 2
ACKNOWLEDGEMENTS ............................................................................... 3
1.

INTRODUCTION ...................................................................................... 7
1.1 Research Objective ................................................................................... 8
1.2 Research Motivation ................................................................................ 92.

LITERATURE REVIEW ......................................................................... 113.

METHODOLOGY ................................................................................... 14
3.1 Assumptions ........................................................................................... 14
3.1.1 Inflation and Interest rates ............................................................... 14
3.2 Financial resources required................................................................... 15
3.2.1 Income replacement ......................................................................... 15
3.2.2 Outstanding debt .............................................................................. 20
3.3 Financial resources available ................................................................. 20
3.4 Examining the UK underinsurance gap ................................................. 20
3.4.1 Age bands ........................................................................................ 21
3.4.2 Household expenditure patterns ...................................................... 21
3.4.3 Outstanding debt .............................................................................. 21
3.4.4 Household income ........................................................................... 22
3.4.5 Household savings/Financial assets................................................. 22
3.4.6 Social security.................................................................................. 22
3.4.7 Life cover ......................................................................................... 24
3.5 Summary ................................................................................................ 24

4.

RESULTS ................................................................................................. 26
4.1 Expenditure patterns ............................................................................... 26
4.2 Individual cover held .............................................................................. 27
4.3 Protection gap ......................................................................................... 29
4.4 Sensitivity testing ................................................................................... 30
4.4.1 Discount rates .................................................................................. 30

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4.4.2 Children’s Expenditure .................................................................... 33
4.5 Additional analysis ................................................................................. 34
5.

DISCUSSION AND CONCLUSION ...................................................... 36
5.1 Discussion .............................................................................................. 36
5.2 Implications ............................................................................................ 37
5.2.1 A case for decreasing term assurances ............................................ 38
5.2.2 Estimating cover needed using our study ........................................ 40
5.3 Limitations ............................................................................................. 40
5.4 Avenues for Future Research ................................................................. 42

6.

REFERENCES ......................................................................................... 44

7.

LIST OF DATA SOURCES..................................................................... 48
APPENDIX A: Children Expenditure ......................................................... 49
APPENDIX B: Expenditure groups ............................................................. 51
APPENDIX C: Individual-level protection needs ....................................... 53

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List of Figures
Figure 1: Child expenditure scale .................................................................... 17
Figure 2: Flowchart for calculating UK protection gap ................................... 25
Figure 3: UK 10-year index-linked gilt yield .................................................. 31
Figure 4: Protection needs and gaps ................................................................ 36
Figure I: Calculation of individual-level protection needs .............................. 53

List of Tables
Table 1: Expenditure patterns by age of household reference person ............. 26
Table 2: Average in-force Sum Assured – Scottish Provident ........................ 28
Table 3: Protection gap analysis by age of household reference person ......... 29
Table 4: Sensitivity analysis: Discount rates ................................................... 32
Table 5: Sensitivity analysis: Children’s Expenditure ..................................... 33
Table 6: Additional analysis: Median income ................................................. 35
Table 7: Monthly premiums comparison ......................................................... 39
Table I: Cost of Raising a Child ...................................................................... 49
Table II: Deriving the Child expenditure scale ................................................ 50
Table III: List of variables under each expenditure group ............................... 51

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1. INTRODUCTION
Underinsurance refers to a scenario whereby an individual holds insufficient
insurance cover against a given risk. In this paper, we will be looking at
underinsurance under a life insurance context i.e. the “life assurance protectiongap”. This is the difference between the resources available to dependents
following a breadwinner’s death and that required to maintain their standard ofliving following the death event (Swiss Re, 2004).
Underinsurance appears to be a significant issue in the UK. According to
HSBC (2011), around half of UK parents do not own any life cover, a finding
echoed by Aviva’s (2012) study which found that more than half of UK
families did not have life insurance cover in place.
People who do not hold adequate life cover leave substantial risks to thefinancial wellbeing of their dependents. The death is likely to result in a
reduction in household income; however dependents still need to pay off any
outstanding mortgages or other debts. If the insurance payout is unable tocover these debt obligations, they will have to make adjustments to theirspending habits or face the risk of foreclosure. This is especially serious in UK
given that on average, the amount owed per UK adult is over 120% of average
earnings (Credit Action, 2012). In addition, underinsurance may disrupt thelifestyles of retirees, who may have to give up their retirement savings to plugthe financial gap in the household after the death (Goss, 2011).
Underinsurance can also lead to a reliance on government benefits, since itbrings about greater likelihood of financial difficulty for dependents and hence
more benefit claims. Meanwhile, with people not taking out sufficient cover,the insurance industry loses revenue. This translates to lost tax receipts for thegovernment, which will face greater financial burdens.

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There are several potential causes of underinsurance. Firstly, the presence ofsocial security benefits for dependents (Fitzgerald, 1987) and overestimationof the amount of cover held (Swiss Re, 2010) may cause people to perceive a
low need for insurance. Secondly, as households cut down on spending during
this period of poor economic outlook, life insurance may be treated as lower
priority expenditure. In addition, there may also be optimism bias. This iswhere people underestimate the chance of being affected by negative health
events (Dunning et al, 2004).
Finally, the various negative exposures in the media over the years could have
led to a poor perception and lack of trust towards the industry (Association of
British Insurers, 2011). Companies have been involved in mis-selling scandals,
where the benefits of an insurance policy are misrepresented or inappropriate
advice is knowingly given to consumers when selling policies, e.g. Equitable
Life 1 and Abbey Life 2 . Media coverage of rejected claims creates theimpression that insurers are unwilling to pay out claims, even though incertain instances the disputes occurred due to consumers failing tocomprehend or comply with policy terms and conditions. These events taintthe reputation of the entire insurance industry, causing consumers to even losefaith towards other life insurers that were not directly involved in theseincidents.
1.1 Research Objective
The objective of our study is to investigate the current underinsurance
situation in UK for life assurances. We will determine the monetary amount of1

Equitable Life was involved in the mis-selling of guaranteed annuity rate contracts. To offset
losses arising from investment guarantees, the company paid lower bonuses to policyholders
who exercised the aforementioned guarantees, even though the option appeared to be provided
without additional charges to consumers at the point of sale (Davis, 2004). This culminated in
the company having to pay £1.5 billion in customer compensation (BBC News, 2010a).
2
Abbey Life was judged to have made inappropriate recommendations to customers in thesale of mortgage endowments during the late 1990s. It was fined £1 million by the Financial
Services Authority, on top of customer compensation (Financial Services Authority, 2002).

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the life assurance protection gap in the UK at a household level through ananalytical study. It will consider various components of the resources available
to and required by a household, to maintain their standard of living following
the death of a working member. It will then be summed across households in
UK to obtain the size of the UK protection gap.
At the same time, we investigate the various components of resources needed
and available to the household, the size of the protection gap, and how thesechange with age. Finally, we seek to produce a model that can be used by anindividual to estimate his or her life assurance protection needs.
In this study, we will mainly make use of household level data from the Officefor National Statistics, UK (ONS), as well as relevant data from other industry
sources.
1.2 Research Motivation
Underinsurance is a topic of interest due to its financial and social effects, as
we have stated above. Over the years, a number of studies had been carried out
to determine the level and impact of underinsurance in different countries,
using a variety of methods (Association of British Insurers, 2008; Auerbachand Kotlikoff, 1991; Bernheim et al, 2003; Kelly and Ngu, 2010; Swiss Re,
2004 and 2010). While the different models and approaches will each carrydifferent assumptions and will thus invariably produce different results, one
issue is how to make use of these results to help individuals to recognise theirown level of insurance needs, as opposed to just publishing a national-level
underinsurance

figureinthemedia.

Jones(2009)

suggeststhat“personalisation” (i.e. by presenting the numbers in a personal context) will
help individuals to relate better to these insurance needs. The media may be
publishing large national underinsurance figures, but the question that many
consumers really want to know is: how much does my family need?

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With this in mind, we seek to produce a method that can be adopted to
calculate an individual’s protection needs, which allows for such“personalisation”. At the same time, we try to keep the process simple, so as toincrease utilisation of the tool. We also hope that allowing people to better
understand their protection needs will contribute to closing the underinsurance
gap.
We also want to study the components of the protection needs and gaps, tounderstand the factors influencing the size of the protection gap. Finally, we
aim to provide a model that can be used over time. This will allow us to track
the changes in the protection gap over time by simply updating the inputs.

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2. LITERATURE REVIEWThe issue of underinsurance can be examined from several angles. In the past,various methods have been employed by different studies to quantify theextent to which a particular population is underinsured.
Blewett, Ward and Beebe (2006) examines a wide range of measures used tomeasure underinsurance in a health insurance context. They put forward three
dimensions of underinsurance: economic – impact of healthcare costs on theinsured after taking any insurance coverage into account; structural – where
the comprehensiveness of the health insurance is examined (in terms ofwhether cover is provided for certain procedures) or where one is uninsured
for a certain period of time; and attitudinal – one’s perception regarding theaccessibility of medical care, as well as how satisfied one is with the coverage
provided by his or her policy.
These dimensions of underinsurance can similarly be applied within a life
insurance context. The economic dimension could involve examining theimpact on household finances following a death event, as considered by
Auerbach and Kotlikoff (1991), Bernheim et al (2003), Kelly and Ngu (2010).
Analysis of the structural dimension could once again look at whether one isuninsured for certain time spells. An investigation into the attitudinal
dimension could consider perceptions towards life insurance as covered in
Swiss Re’s (2010) work, or the causes of consumers not renewing theirpolicies that Association of British Insurers (2010) investigated.
Given that our starting point is to gauge the amount of insurance required byan individual, we will be focusing on the economic aspect of underinsurance
for this study. We construct a model to determine the life insurance needs at ahousehold level, before applying it to examine the protection gap of UK. This
allows us to obtain a more accurate result as the needs of individual
households will be reflected more adequately.

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The measurement of the amount of protection needs is an art rather than ascience, given that there are many unknowns in the future that could affect thefinancial situation of a household. We discuss the methods used by otherstudies that look into the economic dimension of underinsurance, and how
they shape the development of our own model.
In their European Insurance Report, Swiss Re (2010) defines the protectionneeds of a country as ten times the average earnings of the working population
with dependents and 0.5 times for those without dependents. This is thenreduced by existing assets, social security and insurance cover to yield theprotection gap. Given that the study is making comparisons between European
countries at a macro level, this simplified approach may be justified as long as
the methodology is consistent. However, since we are working at a household
level, there is a need to tailor the calculations to the unique circumstances ofeach household, rather than just multiplying the earnings by a given factor.
A second Swiss Re (2004) protection gap study introduces the concept of an“income replacement multiplier”, which expresses the income replacement
component of the cover required as a multiple of income, under a set ofassumptions. It then determines the protection gap by considering otherexpenditure needs, debts, social security, savings held and current insurance
holdings. This is the methodology that provides the basic framework which
our model is built upon.
Auerbach and Kotlikoff (1991) examines life insurance adequacy for middleaged American households by converting all available resources into annuities
based on interest and mortality assumptions, using a Guass-Seidel iteration in
the case where annuities are not available. This is done for both before andafter the death event, with underinsurance defined as a situation where the sizeof the annuity falls by over 30% after the death of the spouse. However, such a
definition may overstate the degree of underinsurance, as a 30% fall in anannuity will have a larger impact on a household whose original equivalent

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annuity is £500 per week, as compared to one that has, say, £5,000 per week.
This is because the latter tend to set aside a higher amount for savings (Dynan,
Skinner and Zeldes, 2004), but this component does not need to be replaced.
When the income is reduced, the high earner can first reduce savings“expenditure” before having to cut back on other expenses, hence it
experiences a less significant fall in living standards. To take this into account,
our model needs to consider the allocation of household income, with the
expectation that households with higher income will allocate a greater
proportion of monthly income to savings.
Bernheim et al (2003) studies the life insurance holdings and risk of financial
consequences among couples. They include the consideration of economies ofscale of consumption within a household, when comparing a household’s
living standards before and following a death event. In terms of the treatmentof housing, they cite studies by Venti and Wise (2002) as well as Caplin(2002), culminating in the assumptions that survivors do not change
residences due to cost and inconvenience, and that they die with home equity
intact since they tend to preserve the equity of their homes. The economies ofscale of shared living will be taken into account in our model, and we also
assume that survivors will remain in their current residence following thedeath.
Rather than examining the protection gap as a whole, the Association of
British Insurers’ (2008) study looks at the protection gap of a household by
splitting it into three components: debt, essentials and lifestyle. It also
demonstrates how the size of the income gap for each component changes
over time. For our study, we modify this idea and take it one step further toconsider the expenditure patterns of each household when determining thecover required. Two other categories (Children, and Savings and investments)
are added to improve the model, and these are described in the next chapter.

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3. METHODOLOGYThis section presents the model employed to determine the amount of life
insurance cover required, as well as the application of the model to examine
the underinsurance gap in the UK.
3.1 Assumptions
3.1.1 Inflation and Interest rates
In order to express the protection needs of an individual as a current lump sum,
we need to discount the future streams of cash flows to obtain the present
value. In other words, the current lump sum is the amount required at present
to generate the future cash flow streams, given that interest is earned on themoney until the time of payment. The interest rate used to discount these cash
flows will depend on the returns that an individual can expect to earn on his or
her financial resources. At the same time, we assume that future household
expenses will rise in line with Consumer Price Index (CPI) inflation.
As such, the return on index-linked gilts represents a suitable discount rate forour future cash flows, given that it matches the nature and currency of our
cash flows. Here, we are essentially making use of the market’s expectations
for future inflation. The discount rate is the median of ten year index-linked
gilt yields for the past 24 months ending in June 2012, from the UK
instantaneous implied real forward curve (Bank of England, 2012). This has avalue of 1.21%.
We use the median value as a representation of the long term expectations ofinterest and inflation, as current values may be affected by short term market
fluctuations. The discount rate can be updated as the gilt yields change withtime, due to the changing economic conditions and other market factors.

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3.2 Financial resources required
This consists of two components: income replacement and outstanding debt.
3.2.1 Income replacement
Income replacement refers to the income streams that are required to sustain
the living standards of the household. Similar to other studies, (Auerbach andKotlikoff, 1991; Swiss Re, 2004 and 2010), we start off with the current
household income, since it directly influences the level of consumption andhence the amount of cover needed to replace any lost income.
The resources required for income replacement will be expressed in a form
similar to that used by Swiss Re (2004): an “income replacement multiplier”,
i.e. as a multiple of the deceased’s income3. This is derived by discounting
these future cash flows to obtain the lump sum that is required to generatethese cash flows at this point in time.
Meanwhile, household expenditure patterns are likely to differ depending on
the age of its members as well as the overall household income. For example,
a household with older members is likely to have lower expenditure on
mortgages or debts. To take into account these differences in the allocation ofhousehold income, we split the income into five expenditure groups anddetermine the resources required under each group as described below:
Essentials
This represents expenditure on basic necessities which tend not to decrease
after the death event, such as rental, social protection (e.g. home help,
residential homes) and maintenance for the accommodation. In terms of
housing outgoings, a household could be renting a property, or making
3

As an example, for one whose annual income is £20,000, an “income replacement multiplier”
of 10 implies that a lump sum of £200,000 is required to replace the lost income and maintainthe standard of living for dependents in the household.

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mortgage payments on a purchased property. For the former, rental payments
will be considered in this section, since it represents an expense that isincurred at regular intervals over time. For a household with outstanding
mortgages, this is dealt with in the “Mortgage/Debt” expenditure group,
described in a later section.
We assume that this expenditure rises with price inflation, and will be fully
replaced until the household reference person reaches age 65 or for 25 years,
whichever occurs earlier. The former corresponds with the commencement ofgovernment pensions. The latter condition provides adequate support for
dependent children until they achieve financial independence as well as
caregiver’s expenses for any elderly dependents. As defined by the ONS, the“household reference person” refers to the head of the household, with thecondition that this person must be staying in the accommodation that was
surveyed (Office for National Statistics, 2011).
The full replacement assumption is due to the fact that social protection
expenses are unlikely to decrease significantly, if at all, following the deathevent. Housing related expenditures may fall as households have the option ofdownsizing, but this may be restricted by rental agreements that are in place.
Furthermore, as proposed by Bernheim et al (2003), emotional attachments totheir houses and the costs and effort required for moving houses means people
tend to remain in their current residence, at least in the short term.
ChildrenThis consists of expenditure relating to raising a child, such as education costs,
childcare costs, baby accessories, etc. This expenditure is assumed to berequired until the child reaches age 21. This implies that members will be costneutral to the household upon reaching the age of 21.

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The expenditure associated with raising a child is expected to vary with his or
her age, with higher costs expected at higher ages when he or she enters higher
education, due to associated costs such as tuition fees and living costs. Higher
expenses are also expected during early infancy years, possibly the result ofhigher susceptibility to illness, greater childcare costs and clothing expenditure
due to growth. This is supported by a study conducted by Liverpool Victoria(2012), which demonstrated that child raising costs were significantly higher
for children between ages 1 to 4 and 18 to 21.
To take this variation into account, we assume that the future expenditurestreams increase with inflation, and express the present value of the total costof raising a child until age 21 as a multiple of the current expenditure on thechild. This gives the advantage of being able to incorporate the fact that thecurrent amount spent on raising a child varies with each family, due to factors
such as household income and lifestyle. Using the Liverpool Victoria (2012)
study, we discount the future cost of raising a child using our discount rate of
1.21%, and express it as a multiple of the current annual spending on the child.
(Further details may be found in Appendix A.) The scaling factors are given in
Figure 1 below:
Figure 1: Child expenditure scale
Age Scaling factor Age Scaling factor Age Scaling factor
18.9
16.2
10.5
0
7
14
13.1
15.3
9.6
1
8
15
12.3
14.5
8.7
2
9
16
11.4
13.7
7.8
3
10
17
10.5
13.1
3.0
4
11
18
17.8
12.2
2.0
5
12
19
17.0
11.3
1.0
6
13
20
Note: The scaling factors represent the cost of raising a child until age 21, expressed as amultiple of the current annual spending on the child of a given age. As an example, for ahousehold currently spending 10% of their income on a child aged 8, the amount required toraise the child till age 21 is calculated as 10%×15.3 = 1.53 times current income.
Source: The table is constructed by discounting the total cost of raising a child until age 21
based on data from Liverpool Victoria (2012). Further details can be found in Appendix A.

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There is a sharp drop in scaling factor at age 18 which can be explained by thefact that the cost of raising a child until age 21 is obtained by multiplying thecurrent spending on the child and the scaling factor. The spending on a childaged 18 is expected to be significantly higher due to education fees, thus thetotal cost of raising a child until 21 will be a smaller multiple of this larger
amount. Similarly, the scaling factor at age 4 is smaller than that of age 5. Thisis because at age 4, there is relatively higher expenditure on clothing due togrowth, and higher childcare expenditure before the child begins receiving
formal education.
We assume that the Children Expenditure is distributed evenly among all
children, and calculate the replacement amount by multiplying the current
expenditure on each child with the corresponding scaling factor based on thechild’s age.
Mortgage/Debt
This includes repayment of mortgage, loans and other debts. Instead ofincluding this as part of income replacement, we will consider a lump sum thatallows the household to pay off any outstanding liabilities. This is because theamount of outstanding debt is known. Mortgages and debt are dealt with in the“Outstanding debt” section below (Section 3.2.2).
Savings and investments
The portion of income spent on savings and investments will not be replaced.
Rather, any accumulated savings and financial assets will be considered aspart of the resources available, which reduces the protection needs of thehousehold. This is discussed in Section 3.3.

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OthersHaving accounted for the four expenditure groups above, the remaining
portion of the income will be allocated to miscellaneous items for thehousehold, such as household goods or recreation expenses. These expenses
are assumed to increase with price inflation and the replacement period will be
until the household reference person reaches age 65 or for 25 years, whicheveris sooner.
When determining the amount of income replacement for these miscellaneous
expenses, we also need to consider economies of scale of shared living, i.e.
joint consumption. If there are more than two person living in a household, thecost of some resources are shared among members, e.g. central heating, which
reduces per head living costs. To account for this, we make use of factors fromthe Organisation for Economic Cooperation and Development’s (OECD)
modified equivalence scale (Office for National Statistics, 2011). This is
widely used across Europe and UK government departments to adjust
household income, so that standard of living comparisons can be made acrosshouseholds of different sizes and composition (Office for National Statistics,
2011).
Given that we already have a separate category for Children Expenditure, weonly consider the spending of members above 21, and members aged 18 to 21
who are not in full time education. We assign a factor of 1.0 to the first adultof the household and 0.5 for any additional adult. The factors are summed foreach household before and after the death event of the adult, and the ratio
provides the proportion of original expenditure (under “Others”) required tomaintain household living standards after the death.
Lastly, a single member household will be assigned a value of zero for income
replacement.

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3.2.2 Outstanding debt
As mentioned earlier, outstanding liabilities will be expressed as a lump sum,which will allow the household to fully fulfil any debt obligations following
the death. Debt obligations include mortgages, loans and other liabilities. This
entire amount will be added to the protection needs of the household.
Once again, in our treatment towards housing-related debts, we implicitly
assume that households do not move or downsize, even though this possibility
exists in real life.
3.3 Financial resources available
The financial resources available to a household following a death of an
income earner include savings and financial assets held by the deceased, life
insurance cover held by the deceased, as well as any social security paymentsthat the household is entitled to.
We only consider financial assets here, as it is assumed that the family will
want to hold on to any physical assets after the death event. Meanwhile, life
insurance cover held by the deceased include both individual and group life
cover, as well as any attaching spouse’s pension that is triggered on death. In
the UK, the government offers several bereavement benefits that are directly
triggered on death and they are considered in our study.
3.4 Examining the UK underinsurance gap
For the purpose of examining the UK underinsurance gap, we use data fromrecent UK household surveys conducted by ONS, as well as insurance datafrom Scottish Provident and Swiss Re. By basing our analysis on datacollected on a nationwide scale, we can minimise distortions from random
sampling errors.

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To determine the resources required by households, we utilise the 2010 Living
Costs and Food Survey conducted by the Office for National Statistics andDepartment for Environment, Food and Rural Affairs (2011). Data collected inthis survey is weighted to produce population-level figures, allowing for nonresponse and the population distribution (Office for National Statistics, 2011).
We will conduct our analysis taking these weights into account.
3.4.1 Age bands
We assign the households in the sample to four age bands based on the age ofthe household reference person. The four age bands are: Below 30, 30 to 39,
40 to 49 and 50 to 64. These age bands are selected such that they represent
different life stages with regards to career and family status, and as such wewill expect to see differences in their income and expenditure patterns.
3.4.2 Household expenditure patterns
The 2010 Living Costs and Food Survey also provides us with insights onhousehold expenditure patterns. Using expenditure data from the survey, we
calculate the percentage allocations to the various expenditure groups (namely:
Essentials, Children, Mortgage/Debt, Savings and investments, and Others) forthe household.
The full list of items that are allocated within each expenditure group can befound in Appendix B.
3.4.3 Outstanding debt
Outstanding debt includes outstanding mortgages and any outstanding credit
card bills. For each household, these are obtained directly from the 2010
Living Costs and Food Survey.

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We also consider any outstanding loans and hire-purchases. These are
estimated based on the household’s debt repayment expenditure and theprincipal amounts of these transactions.
3.4.4 Household income
The corresponding household income data is obtained from the sample in the2010 Living Costs and Food Survey. This also includes government
allowances and social security benefits, e.g. Job Seekers Allowance. The data
has been anonymised by top-coding the income of the top few percent ofearners, which will have the effect of understating the protection gap. On theother hand, this reduces the distortion to our results caused by households withextremely high incomes.
3.4.5 Household savings/Financial assets
This comprises of savings, shares, investment products and other financial
assets held by the household. As mentioned above, physical assets are notconsidered as we assume the family will continue to hold on to and make useof those assets after the death event – it forms part of the conditions tomaintain their current standard of living. To determine the amount of financial
assets held by households, we use data from the 2009-2010 Family Resource
Survey, conducted by the Department for Work and Pensions, National Centre
for Social Research and Office for National Statistics (2011).
3.4.6 Social security
In our analysis, we consider three such benefits:-

Bereavement payment: a lump sum of £2,000 claimable upon thedeath of a spouse.

-

Widowed Parent’s Allowance: a benefit payable to widowed parents
bringing up children, until the children reach a given age.

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Bereavement allowance: a weekly benefit paid to the surviving
spouse who is not bringing up children, for up to 52 weeks following
the death event. (Directgov, 2012)

Similar to our treatment of income replacement, these social security
payments are discounted to obtain the lump sum amount that is required togenerate these future cash flows. The discount rate used is 4.96%, which is themedian yield on ten year gilts over the last 24 months ending in June 2012
(Bank of England, 2012). Similar to the index-linked gilt yields, this is subject
to fluctuations over time, and can be updated accordingly.
Where the death event occurred as a result of serving in the Armed Forces,
dependents may be eligible for benefits under the Armed Forces
Compensation Scheme. This is a specialised benefit, and we do not consider
this due to a lack of household information on members serving in the Armed
Forces, which affects the eligibility to claim under the scheme. Furthermore,cases of death from serving in the Armed Forces are very rare.
There may be other means-tested benefits triggered on death, e.g. Funeral
Payments and Community Care Grants. The death event may also indirectly
affect eligibility of other benefits or financial support, if the occurrence of thedeath causes household income to fall below a certain level. For government
schemes, this is usually accompanied by a prerequisite that total capital of thehousehold is less than £16,000. The actual size of these benefits tends to be
determined on a case-by-case basis, depending on the circumstances ofindividual households and often also by any bereavement benefits being
claimed. Without detailed information on the characteristics and financials of
the household (e.g. tax payments, physical/mental disabilities amonghousehold members, household capital), we would not be able to identify or
estimate the resulting change in the current benefits received with any
certainty. As such, these benefits are excluded from our analysis.

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3.4.7 Life cover
To determine the total amount of life cover owned by households in the UK,
we consider both individual and group cover. The individual cover held isestimated using Scottish Provident’s (2012) data on the average life assurance
cover owned, broken down by gender and age groups. We take the average
life assurance cover from the relevant age group and weigh it according to thenumber of adult males and females in the household. This is then multipliedby the number of life assurance policies held by each household based on datafrom the 2010 Living Costs and Food survey. The life cover held by UK
households for each age group is derived by summing across all thehouseholds in the group.
Given that Scottish Provident has a substantial portfolio4, the numbers should
represent a suitable proxy to gauge current life insurance holdings in UK.
Nevertheless, we acknowledge that Scottish Provident may be focusing on
particular market segments, which may affect the numbers obtained. Thus, theresults should be interpreted with care, perhaps until our results can besubstantiated with improved household-level insurance data in future.
For the group cover, we use the total group cover data from Swiss Re (2011)
and apportion it to the households in the sample based on the wage and salary
income for each household, since death benefits within group schemes areusually linked to salary. The Swiss Re (2011) data also considers dependents’
death-in-service pension benefits by capitalising them using a factor of 30.
3.5 Summary
The methodology adopted for calculating the protection gap in this study canbe summarised in the flowchart below:

4

Royal London Group (Bright Grey and Scottish Provident) is among the top five in term
assurance sales for 2011, with more than 100,000 policies sold (Swiss Re, 2012).

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Figure 2: Flowchart for calculating UK protection gap

Note: Items in the black boxes represent input variables, the ovals represent adjustments, andthe other variables are derived from the inputs and assumptions.

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4. RESULTS
4.1 Expenditure patterns
Using data from the 2010 Living Costs and Food Survey, we calculate theproportion of total expenditure spent on the five expenditure groups. The
results are presented below:
Table 1: Expenditure patterns by age of household reference person
Age of household reference person
Expenditure split
Below 30 30 to 39 40 to 49 50 to 64
Essentials
19.9%
12.3%
9.7%
8.1%
Children
4.7%
3.8%
3.6%
1.6%
Mortgage/Debt
13.0%
20.8%
19.1%
14.3%
Savings and investments
0.7%
0.9%
0.9%
1.1%
Others
61.7%
62.2%
66.7%
74.9%
Total
100.0% 100.0% 100.0% 100.0%
Household income (£)
30,841 41,842 44,313 38,625
Note: The table shows the average expenditure patterns for households, based on the age ofthe household reference person, i.e. the head of the household that lives in the residence
surveyed. Household income includes wages and government social security benefits.
Source: This table is constructed using data from Office for National Statistics andDepartment for Environment, Food and Rural Affairs (2011). Further details can be found in
Appendix B.

Essentials account for almost 20% of expenditure for younger households andfalls over time. This is due to rental being included in the category and thelower household income of the Below 30 group. As such, Essentials represents
a large component of their expenditure. As the incomes of households increaseover time, the proportion of spending on Essentials falls. In addition, they start
to take out mortgages as they purchase their own properties. Thus, we see ashift in housing expenditure from Essentials to the Mortgage/Debt category.
This leads to the observation that Mortgage/Debt forms the largest proportionof expenditure at 30 to 39, a reflection of most mortgages being taken out
within that age group. For the 40 to 49 group, even though the proportion ofPage 26 of 53

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income allocated to Mortgage/Debt falls, we find that the actual amount spenton that category is greater, since households within this age band have higher
incomes. This may be due to households upgrading to bigger houses andtaking out new mortgages, led by greater affluence and perhaps increases infamily sizes. Finally, the expenditure allocated to Mortgage/Debt decreases forthe 50 to 64 group as more liabilities are paid off.
We find that the proportion spent on Children is highest in the lowest age
group. This observation can be explained by the lower income of the Below 30
group. In fact, we observe that the actual expenditure on Children for theBelow 30 group is lower than the 30 to 39 and 40 to 49 groups. This isreasonable, since the middle two groups are likely to contain more young
children and hence incur higher expenditures in that area.
Finally, we also note that the proportion spent on savings and investments
increases with age. This is in line with expectations since they have higher
incomes (Dynan, Skinner and Zeldes, 2004) coupled with the lower mortgage
expenditure for the oldest group. They are also likely to increase savings in
preparation for retirement, or perhaps as precautionary savings. However, theincrease is very slight, with values being generally low at around 1%.
4.2 Individual cover held
As at the end of first half of 2012, the average sum assured of all in-force life
cover for Scottish Provident is as follows:

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Table 2: Average in-force Sum Assured – Scottish Provident
Age bandBelow 30
30 to 39
40 to 49
50-64

Male
137,482
148,522
136,199
101,582

Female Total
130,593 133,676
135,845 141,865
113,341 125,164
79,787 92,091

Note: The sum assured values include joint life policies; the covers arising from such policies
are treated as being held by both males and females. Values are in British pounds (£).
Source: Scottish Provident (2012).

On average, the Below 30 group holds £133,676 of life cover. This increases
to £141,865 for the 30 to 39 group, which holds policies with the highest
average sum assureds. Life assurance policies are used to protect the financial
well-being of dependents by providing resources to replace the income lost in
the event of death, and its demand tends to increase with greater affluence andthe presence of children (Diacon and Mahdzan, 2008). Therefore, this higher
sum assureds for the 30 to 39 group is expected, given higher incomes andgreater likelihood of households containing children. Consumers may alsopurchase life insurance to provide cover for mortgages that are taken out, andwe have observed that Mortgage/Debt expenditure is higher for this age group.
In spite of this, we will see in the following section that the increase in coveris insufficient to meet the actual needs of the household.
The amount of cover held then falls with age. This effect could be caused by
the some of the policies being decreasing term assurances that provide coverfor mortgages, where the sum assureds fall over time as the mortgages arebeing paid off.
In general, males tend to have more cover than females, in terms of higher
sum assureds. This may be due to the fact that males tend to have higher
earnings than females (BBC News, 2010b) and thus have more income thatneeds to be replaced. The difference in sum assured widens with age, possibly

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due to more women switching to part-time work or becoming housewives
upon childbirth.
4.3 Protection gap
Based on the methodology described earlier, we set out to determine theprotection gap for UK:
Table 3: Protection gap analysis by age of household reference person

Household incomea
Income replacement
multiplierb, cIncome replacement
amountOutstanding debtd
Total lump sum needed
Savings/Financial assetse
Social securityf
Total cover required
Individual life coverg
Group life coverh
Protection Gap perhouseholdWeighted number ofhouseholds ('000)i
Protection Gap (UK)Age of household reference person
Below 30
30 to 39
40 to 49
50 to 64
30,841
41,842
44,31338,625
9.5

8.7

7.9

3.3

322,492
31,838354,330
3,031
6,633
344,665
45,84534,250403,390
68,972472,362
9,025
19,755443,582
94,41949,165

388,793
64,324453,117
17,66915,634
419,813
113,681
51,622

160,367
28,597
188,965
27,424
6,383
155,158
61,87137,136

264,571299,998

254,51156,1502,811
0.74 trn

4,406
5,138
7,019
1.32 trn
1.31 trn
0.39 trn
Total protection gap 3.77 trillion

Note: The values above are averages of the sample households. Except for the income
replacement multiplier, values are in British pounds (£).
Sources: a, b, d, f, i) Office for National Statistics and Department for Environment, Food andRural Affairs (2011); c) Liverpool Victoria (2012); e) Department for Work and Pensions,
National Centre for Social Research and Office for National Statistics (2011); g) Scottish
Provident (2012); h) Swiss Re (2011).

The cover required starts out at £344,665 for the Below 30 group andincreases to £443,582 for the 30 to 39 group, due to higher incomes that

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require replacement. Having peaked at the 30 to 39 group, it then falls as age
increases. The reason for this is a decrease in replacement period offsetting theincrease in income, coupled with older households owning more financial
assets. Finally there is a sharp drop between the 40 to 49 and 50 to 64 groups
due to a significantly shorter replacement period, as shown by the income
replacement amount.
The magnitude of the income replacement multiplier figures appear consistent
with Swiss Re’s (2004) analysis of several countries.
4.4 Sensitivity testing
Our model makes use of several assumptions with regards to interest rates andhousehold characteristics, which influence the amount of cover required. We
use best estimates as our model input; however these values can and dochange with time, and the actual outcome may thus differ from expected.
Therefore, sensitivity tests are conducted to examine how the calculated valueof the protection gap changes when these assumptions are varied. By using
alternative parameter values to re-run our model, we can observe the potential
deviations from our calculated results. This also allows us to understand therelative importance of the assumptions that are driving our results.
4.4.1 Discount rates
The following graph shows the yield curve for ten year UK index-linked gilts,
which we use as the discount rate to value the amount of resources required
for replacement of future income lost:

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Figure 3: UK 10-year index-linked gilt yield

Yield (%)

UK instantaneous implied real forward
curve
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00

UK instantaneous
implied real
forward curve

Note: This is the change in ten year index-linked gilt yields for the past 15 years, up to 30
June 2012.
Source: Bank of England (2012).

The gilt yield has remained near the 2% level since 1998, before falling
towards the end of 2003. For the past seven years, the gilt yield tended to vary
between 0.5% and 1.5%. Depending on future market conditions and theamount of success in controlling price inflation, the yield might move backtowards the 2% level in the long term. However, this cannot be known withcertainty.
Thus to see the effect of potential future changes in gilt yields on thecalculated protection gap for both the short-term and long-term, we conduct asensitivity test on our discount rate with 0.25%-point variations. This is shownin the following table:

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Table 4: Sensitivity analysis: Discount rates
Discount rate (based on index-linked gilt yields)

Change inProtection gap
per household(£)
Change inProtection gap
per household

0.71%-0.50%

0.96%-0.25%

1.21%
Original basis

1.46%+0.25%

1.71%+0.50%

Below 30

+19,163+9,376

264,571-8,985-17,599

30 to 39

+23,471+11,484

299,998-11,005-21,555

40 to 49

+18,824+9,238254,511-8,906-17,493

50 to 64

+4,230+2,091-2,045-4,046

Below 30

+7.2%

+3.5%

56,150
N/A

-3.4%

-6.7%

+3.8%

N/A

-3.7%

-7.2%

+3.6%

N/A

-3.5%

-6.9%

+7.5%

+3.7%

N/A

-3.6%

-7.2%

4.05

3.91

3.77

3.63

3.5

+7.53%+3.69%

N/A-3.55%-6.97%

30 to 39
40 to 49

50 to 64
Total UK protection gap(£ trillion)% change

+7.8%
+7.4%

Note: The original basis used in our model is given in the middle column. The values above
are averages of the sample households.

In terms of absolute change in the protection gap per household, a change inthe discount rate will have a larger impact on groups with longer income
replacement periods as well as groups with larger income replacements. The
30 to 39 group experiences the largest change in protection gap due to a
combination of its long replacement period and a relatively higher income
compared to the Below 30 group.
When the size of the absolute change is compared to the original protection
gap in percentage terms, the 30 to 39 group again experiences the largest
impact. The Below 30 group experiences the smallest percentage change inprotection gap, due to the large size of its original protection gap. Overall, theUK protection gap changes by around 3.6% for every 0.25%-point variation indiscount rate in the opposite direction.
Given the results above, the discount rate is an important assumption.
However, it is difficult to predict it with certainty, since interest rates are

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constantly changing with market conditions. Nevertheless, the value chosen is
felt to be appropriate for our cash flows.
4.4.2 Children’s Expenditure
In this analysis, we consider the effect on our results when we ignore theadjustment for the variation of Children Expenditure with age. In effect, thismaintains the Children Expenditure at the current level and it is only affectedby price inflation. This expenditure will be replaced until the child is age 21.
Table 5: Sensitivity analysis: Children’s Expenditure

Incomereplacement
amount (£)

Below 30
30 to 39
40 to 49

Original
basis
322,492
403,390388,793Children adjustment
removed324,406
404,947
385,539%change
+0.6%
+0.4%
-0.8%

Protection gap
per household(£)

50 to 64
Below 30
30 to 39
40 to 49

160,367
264,571299,998
254,511

159,231
266,485
301,555
251,256

-0.7%
+0.7%
+0.5%
-1.3%

50 to 64
UK protection gap

56,150£3.77 trn

55,013£3.75 trn

-2.0%
-0.3%

Note: The “Children adjustment removed” column shows the effect of removing theadjustment for the variation of Children Expenditure with age. The values above are averagesof the sample households.

The protection gap obtained is £3.75 trillion, slightly lower than our original
result. For the two youngest age groups, removing the adjustment for Children
Expenditure increases the income replacement and the associated protection
gaps.
This is because households in these two age groups are more likely to containyoung children aged 1 to 4. The lower scaling factors for children aged 1 to 4compensates for the relatively higher expenditure experienced during thisperiod, since expenditure is expected to fall as the child grows older. Without
this adjustment, expenditure on Children is assumed to remain at this higher

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level and replaced for each year until the child is 21. This leads to larger
calculated income replacement amount for households with children of ages 1
to 4. Nevertheless, the magnitude of the change on each of the four age groups
is small.
4.5 Additional analysis
It can be argued that instead of having a target replacement income that allows
a household to maintain its current living standards, which may be above
average, what a household realistically need is an income that allows it tomaintain a reasonable standard of living. We take the median income, i.e. thelevel of income earned by the household in the middle of the sample whenarranged in ascending order of income, as our definition of “reasonable”.
We then re-run our model by setting an upper limit to the income being
replaced. This maximum corresponds to an equivalised income equal to theequivalised median income of our sample, calculated on the original OECD
scale used by the Office for National Statistics (2011)5. In other words, thissets the maximum replacement income to be the level that allows thehousehold to have a standard of living comparable to a single adult household
earning the median income of our sample. This has the value of £332 per week,or £17,323 per annum (Office for National Statistics, 2011). Our findings arepresented below:

5

In the OECD scale used by the Office for National Statistics (2011), a factor of 1.0 is
assigned to the first adult of the household, 0.5 for any additional adult or child aged 14 andabove, and 0.3 for a child below 14. For the adapted scale we use in Section 3.2.1, we
excluded dependent children from the analysis to avoid double-counting.

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Table 6: Additional analysis: Median income
Original basis Median income
322,492
232,650
Below 30
403,390
251,11430 to 39
Income replacement amount (£)
388,793
251,480
40 to 49
160,367
98,88350 to 64
264,571
174,729
Below 30
299,998
147,72230 to 39
Protection gap per household (£)
254,511
117,198
40 to 49
50 to 64
UK protection gap% change

56,150£3.77 trn
N/A

£1.74 trn-54%

Note: The table compares the resources required by households to maintain a reasonable
standard of living, given in the “Median income” column, with that required to maintaincurrent living standards. The values are averages of the sample households.

In this case, the protection gap shrinks to £1.74 trillion. This figure signifies
the minimum amount of additional cover required by UK, which ensures that
dependents have a reasonable standard of living following a death event. A
protection gap does not exist for 50 to 64 group, which holds £99,007 of life
cover on average. This is more than the £93,673 required after outstanding
debts and other resources available are taken into account. For the younger
households, significant gaps still exist.

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5. DISCUSSION AND CONCLUSION
5.1 Discussion
The results from Table 3 above can be summarised in the following figure:
Figure 4: Protection needs and gaps

Protection needs and gaps
500,000
Outstanding debt
400,000
Income replacement
amount299,998
254,511Amount (£)

300,000

200,000

Protection gap

264,571Social security
56,150100,000
30,841

41,842

44,31338,6250Below 30 30 to 39 40 to 49 50 to 64

Savings/Financial
assetsLife cover held
Household income

Age of Household Reference Person

Note: In the figure, the numbers on the red columns indicate the size of the protection gaps,
whereas the numbers on the grey line indicate the household income for the given age groups.

The protection gap is the biggest for the group aged 30 to 39, due to highlevels of income and debt. The protection gap then falls with age, ashouseholds build up more assets and take out more cover, with acorresponding reduction in cover required.
The fall in protection needs between the 30 to 39 and 40 to 49 groups is small
compared to the reduction between the 40 to 49 and 50 to 64 groups. For the
first two groups, outstanding debt has not fallen substantially, possibly due toPage 36 of 53

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households upgrading to larger properties and taking out new mortgages. The
decrease in the income replacement amount is small, with higher incomes andthe presence of more dependents as households become larger.
Relative to the amount of life cover held, the size of the protection gaps for theage groups below 50 is large. Households in these age groups need more thandouble their present life insurance holdings to maintain their current standardof living following a death event. The figure also shows that the amount ofsocial security benefits that are typically triggered on death represent only asmall proportion of the actual household needs.
5.2 Implications
The results of our study signal a need for households to increase theirexpenditure on insurance. However, this is a tough ask considering that theamount spare cash available is generally low, as demonstrated by the fact that
UK households are spending a high proportion of their income, reflected in the
low savings rates in Table 1. This is especially so for the lower income groups,
which may have little or no savings.
In particular, the large sizes of the protection gaps for the younger age groups
imply that younger households appear to be substantially underinsured and asignificant amount of risk exists within that segment of the population. Given
that the probability of death is low at younger ages, optimism bias may cause
consumers to underestimate the likelihood of death (Dunning et al, 2004). As
they deem it to be an event that is unlikely to happen to them, they do not feelthe need to purchase life insurance, resulting in the large protection gaps
observed. This segment of the population represents a potential target market
for insurers, and the government may also focus on this group in terms ofeducation and promoting awareness.

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At the moment, there are no tax reliefs provided on purchases of life assurance
products in UK. The Life Assurance Premium Tax Relief and tax reliefs for
Pension Term Assurances were abolished in 1984 and 2007 respectively. The
government may consider implementing tax reliefs to increase life assurance
purchases, since it results in a lower effective cost to consumers. This can betargeted at certain groups, e.g. parents with children below 16, through the useof eligibility criterion. However, a tax relief scheme will involve running costs
on top of the direct cost of providing the benefits itself, i.e. lost tax revenues,
which the government may be unable or unwilling to meet. Also, the UK
government may be placing greater importance on reducing public debt
(Wheatcroft and Bale, 2010).
Meanwhile, even though low income households with little assets may obtain
additional financial support, we see that the amount of social security benefits
triggered after a death event is low compared to the amount required tomaintain a household's current lifestyle. The high cost of providing social
security plus the fact that overall government expenditure is forecasted to
exceed tax receipts for the next few years (HM Treasury, 2011) suggest thatthese benefits are unlikely to be increased significantly in the near future.
Therefore, there is a need for consumers to take personal steps to safeguard
their dependents’ financial wellbeing.
5.2.1 A case for decreasing term assurances
Given the way we specified the protection needs of an individual, where themain purpose of a term assurance is to convert one’s survival-contingent
income stream into a lump sum paid in the event of death (Auerbach andKotlikoff, 1991), there is a case for the purchase of decreasing term assurances.
These are policies where the sum assureds decrease over the term of thecontract. This is because income replacement, which tends to form the bulk of
the cover required, generally falls over time as one approaches retirement anddependent children grow up. The other major component of resources required

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is the outstanding mortgage, where a decreasing term assurance is a natural
match.
The advantage of a decreasing term assurance is that it allows the “correct”
targeting of benefits, i.e. to avoid purchasing unnecessary cover. Similar to theamount of life cover required, the sum assured of the policy decreases overtime. Because of this, the cost of such policies is lower than a level term
assurance, where the sum assured remains constant throughout the duration of
the contract. An example is shown in the table below:
Table 7: Monthly premiums comparison

Age 35, policy term 25 years
Age 35, policy term 30 years
Age 40, policy term 25 years

Level Term
Assurance£13.48£15.32£19.53

Decreasing
Term Assurance£ 9.79£10.97£13.22Costsavings
27%
28%
32%

Note: The values are monthly premiums, based on the average of quotes from Legal &General, Liverpool Victoria and Aviva. The policy offers £200,000 of life cover (without
critical illness) for a male non-smoker.
Source: Quotes are obtained from Confused.com, an online price comparison site:
http://www.confused.com/life-insurance [Accessed: 14 August 2012].

Compared to a level term assurance, a decreasing term assurance issignificantly cheaper. Even though the sum assured of the typical decreasing
term assurance policy (used to generate the quotes above) may not decrease inexactly the same way as the cover required according to our model, it takes ona similar form, and Table 7 highlights the potential for significant cost savingsto the consumer. This is important given that cost appears to be a key barrier
among consumers when taking out life insurance products, especially in thecurrent economic climate (Association of British Insurers, 2009).
Currently, level term assurances account for a majority of term assurance sales– in 2011, sales volumes for level term assurances are 60% higher thandecreasing term assurances (Swiss Re, 2012), with a tendency for decreasing
term assurances to be associated with mortgage-related cover.

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However, it could be worth exploring the possibility of offering decreasing
term assurances as a cheaper and more efficient way of ensuring one has
adequate cover, even under a situation where there is no mortgage
consideration. That being said, there may be a lack of consumer awareness orunderstanding with regards to decreasing term assurance products. One
solution to improve consumer understanding of products is to create summary
sheets of key technicalities and explaining them using layman terms ordiagrams.
5.2.2 Estimating cover needed using our study
Given that cost is main barrier to seeking advice from independent financial
advisors (Association of British Insurers, 2011), our model provides a quick
and simple way of estimating the desired level of an individual’s insurance
needs (Appendix C). This helps in a situation where consumers know that theyneed cover, but are not sure how much cover to purchase.
Even though it may not entirely replace professional advice, it can provide
individuals with a rough idea of how much cover is required, and signal when
there is a need to review the amount of life cover held. The individual can thendecide whether he or she needs to seek advice from independent financial
advisors, based on the estimates obtained. While we may not expect the gap tobe fully closed, hopefully this will spur people to adjust their insurance
holdings to better match their needs.
5.3 Limitations
Due to a lack of household-level insurance data, we use average figures when
considering financial assets and insurance holdings. The protection gap will be
understated if these holdings are skewed, since we are assuming that any
surplus resources and cover that households own will offset the protection
gaps of other households.

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The protection gap may also be understated due to the effects of InheritanceTax. In UK, Inheritance Tax is payable when an estate exceeds the thresholdof £325,000. However, an estate that is left to a surviving spouse in UK is
exempted from paying Inheritance Tax regardless of its size, also known as“spouse or civil partner exemption”. At the same time, the unused InheritanceTax threshold is transferred to the surviving spouse, which increases thethreshold to up to £650,000, to be applied upon the second spouse’s death.
Since the tax applies only to very large inheritances received by non-spousal
members of the household, it is likely to only affect a small proportion of the
population who amass a large amount of assets as they get older. Thus, we do
not expect the effect to be significant, and exclude Inheritance Tax from ouranalysis.
On the other hand, some social security benefits for a household are income
dependent. When an earner dies, the benefits receivable may increase as
household income falls below a given level. As mentioned earlier, the actual
increase in such benefits takes into account several other household
circumstances and is hard to ascertain. Hence, this is not taken into account inour calculations, and will have the effect of overstating the protection gap.
Finally, there are certain expenses where the amount of consumption
attributable to the children in the household cannot be established withcertainty. Rather than allocating an arbitrary portion of these expenses toChildren, they have been categorised under Others. Examples include
household items such as appliances, groceries or holiday trips. When
allocating these Children Expenditure to Others, only a portion of these
expenses will be replaced, albeit usually for a longer period of time. The
overall effect on household protection gaps depends on the relative length of
the replacement period for the two categories, and other characteristics of eachhousehold.

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On balance, we feel that the model is likely to understate the protection gap.
Furthermore, we exclude households where the household reference person isaged 65 or above. The presence of any unmet protection needs within thatgroup will mean that the actual protection gap is larger than our calculated
figure.
5.4 Avenues for Future Research
Other ways to expand on our current work in life insurance include tracking ofresults over time, repeating the investigation using updated figures to see how
the size of the gap has changed. Future studies into the UK protection gap canalso include other means-tested social security benefits, perhaps using microsimulation models similar to that used by Kelly and Ngu (2010) for theirresearch in Australia6, for a more comprehensive analysis.
In the absence of household level data with regards to life insurance ownership,
we estimated the protection gap by aggregating the average sum assured of life
assurance policies across households that own such policies. However, thisfails to reflect the actual insurance holdings of households in different
circumstances. The level of life insurance ownership may be dependent on theamount of mortgage outstanding, since a common use of life insurance
policies is to repay a mortgage in the event of death. It is also dependent onhousehold income, where wealthier households could be more than adequately
covered while low income households find themselves lacking protection.
The large amounts of sum assured held by these wealthy households will leadto higher average figures, even though some of them may own surplus cover
above that required to cover a protection gap. Using these average figures willcause the surplus cover to be included among the insurance held by the6

Kelly and Ngu (2010) makes use of STINMOD, an enhanced micro-simulation model whichassesses the change in the disposable income of a base hypothetical family following different
insurance events, including death and disability of either husband or wife. Tax and othertransfer income are also incorporated into the model.

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population, causing the protection gap to be understated. Future studies may
conduct the analysis by using household-level insurance data containing sum
assureds of life cover held, to obtain a more accurate reflection of the size ofthe protection gap.
Lastly, future research may look into the protection needs of households where
the household reference person is age 65 and above. The retired segment of
the population may still be paying off mortgages or loans, or may wish toleave an inheritance for dependents in the event of death. The cost of obtaining
long term care will also be among their consideration. At the same time,government pensions and financial support from dependents will affect theamount of cover required. With a different set of post-retirement needs, ourcurrent model is a poor fit to their requirements. However, there is still a needfor them to hold life cover and a further protection gap may yet exist.

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6. REFERENCES
Association of British Insurers (2008) Coping with Crises: HouseholdProtection Needs [Online]. Available:
http://www.abi.org.uk/content/contentfilemanager.aspx?contentid=25011 [20February 2012]
Association of British Insurers (2009) Q3 2009 ABI Savings and Protection
survey Research Brief [Online]. Available:
http://www.abi.org.uk/content/contentfilemanager.aspx?contentid=44520 [16February 2012]
Association of British Insurers (2010) Q1 2010 ABI Savings and Protection
survey Research Brief [Online]. Available:
http://www.abi.org.uk/Publications/47971.pdf [16 February 2012]
Association of British Insurers (2011) ABI Quarterly Consumer Survey Q32011 [Online]. Available: http://www.abi.org.uk/Publications/59192.pdf [16February 2012]
Auerbach, A. J. and Kotlikoff, L. J. (1991) The Adequacy of Life Insurance
Purchases, Journal of Financial Intermediation, 1(3), pp. 215-241.
Aviva (2012) The Aviva Family Finances Report – January 2012 [Online].
Available: http://www.aviva.com/data/mediauploads/news/File/Family%20Finances%20Report%205%20January%202012.pdf [20 February 2012]
Bank of England (2012) Yield Curves [Online]. Available:
http://www.bankofengland.co.uk/statistics/Pages/yieldcurve/archive.aspx [02August 2012]
BBC News (2010a) Equitable Life: Timeline of key events [Online]. Available:
http://www.bbc.co.uk/news/business-10725923 [15 May 2012]

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HANG PING CHER: UNDERINSURANCE IN THE UK

BBC News (2010b) Pay gap between men and women narrows, says ONS[Online]. Available: http://www.bbc.co.uk/news/business-11947127 [25 July2012]
Bernheim, B. D., Forni, L., Gokhale, J. and Kotlikoff, L. J. (2003) The
Mismatch Between Life Insurance Holdings and Financial Vulnerabilities:
Evidence from the Health and Retirement Study, The American Economic
Review, 93(1), pp. 354-365.
Blewett, L. A., Ward, A. and Beebe, T. J. (2006) How Much Health Insurance
Is Enough? Revisiting the Concept of Underinsurance, Medical Care Researchand Review, 63(6), pp. 663-700.
Caplin, A. (2002) Turning Assets into Cash: Problems and Prospects in the
Reverse Mortgage Market, in Bodie, Z., Hammond, B., Mitchell, O., andZeldes, S., eds., Innovations in retirement financing. Philadelphia, PA:
Pension Research Council, The Wharton School, University of Pennsylvania,
2002, pp. 234-253.
Credit Action (2012) Debt Statistics February 2012 Edition [Online].
Available: http://www.creditaction.org.uk/assets/PDF/statistics/2012/february2012.pdf [25 February 2012]
Davis, E. P. (2004) Is there a Pensions Crisis in the U.K.? The Geneva Papers
on Risk and Insurance, 29(3) pp. 343-370.
Diacon, S. and Mahdzan, N. S. A. (2008) Protection insurance and financial
wellbeing.
Directgov (2012) Bereavement Benefits [Online]. Available:
http://www.direct.gov.uk/en/MoneyTaxAndBenefits/BenefitsTaxCreditsAndO
therSupport/Bereaved/index.htm [2 July 2012]

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HANG PING CHER: UNDERINSURANCE IN THE UK

Dunning, D., Heath, C. and Suls, J. M. (2004) Flawed Self-Assessment,
Psychological Science in the Public Interest (Wiley-Blackwell), 5(3), pp. 69106.
Dynan, K. E., Skinner, J. and Zeldes, S. P. (2004) Do the Rich Save More?
Journal of Political Economy, 112(2), pp. 397-444.
Financial Services Authority (2002) Abbey Life fined 1m for endowment misselling and other failings [Media release], 04 December 2002. Available:
http://www.fsa.gov.uk/library/communication/pr/2002/118.shtml [15 May
2012]
Fitzgerald, J. (1987) The Effects of Social Security on Life Insurance Demandby Married Couples, The Journal of Risk and Insurance, 54(1), pp. 86-99.
Goss, K. (2011) Underinsurance risks unravelling the best laid retirement
plans, Money Management [Online]. Available:
http://www.moneymanagement.com.au/opinion/underinsurance-risksunravelling-the-best-laid-ret [21 February 2012]
HM Treasury (2011), Budget 2011.
HSBC (2011) British families left vulnerable by retirement shortfall [Online].
Available:
http://www.newsroom.hsbc.co.uk/press/release/british_families_left_vulnerab[20 February 2012]
Jones, M. (2009) It’s time you made protection personal, Mortgage Strategy,June 29 2009, pp. 14.
Kelly, S. and Ngu, V. Q. (2010) The Lifewise/NATSEM Underinsurance
Report: Understanding the social and economic cost of underinsurance.

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HANG PING CHER: UNDERINSURANCE IN THE UK

Liverpool Victoria (2012) Cost of a Child: From cradle to college [Online].
Available: http://www.lv.com/upload/lv-rebrand2009/pdfs/other/11665_LV_COAC.PDF [8 May 2012]
Office for National Statistics (2011) Family Spending 2011.
Swiss Re (2004) Mortality protection: the core of life, Sigma, 4 [Online].
Available: http://media.swissre.com/documents/sigma4_2004_en.pdf [19February 2012]
Swiss Re (2010) European Insurance Report 2010.
Swiss Re (2011) Group Watch 2011.
Swiss Re (2012) Term and Health Watch 2012.
Venti, S. F. and Wise, D. A. (2002) Aging and Housing Equity, in Bodie, Z.,
Hammond, B., Mitchell, O., and Zeldes, S., eds., Innovations in retirement
financing. Philadelphia, PA: Pension Research Council, The Wharton School,
University of Pennsylvania, 2002, pp. 254-281.
Wheatcroft R. and Bale, S. (2010) Too big to ignore: protection andperception gaps, CII thinkpiece, 33 [Online]. Available:
http://www.knowledge.cii.co.uk/system/files/TP33_Wheatcroft_Bale_Too_Bi
g_to_Ignore_Jan2010.pdf [15 February 2012]

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HANG PING CHER: UNDERINSURANCE IN THE UK

7. LIST OF DATA SOURCES
Bank of England (2012) Yield Curves [Online]. Available:
http://www.bankofengland.co.uk/statistics/Pages/yieldcurve/archive.aspx [02August 2012]
Department for Work and Pensions, National Centre for Social Research andOffice for National Statistics (2011). Social and Vital Statistics Division,
Family Resources Survey, 2009-2010 [computer file]. Colchester, Essex: UK
Data Archive [distributor], November 2011. SN: 6886,
http://dx.doi.org/10.5255/UKDA-SN-6886-1 [5 June 2012]
Liverpool Victoria (2012) Cost of a Child: From cradle to college [Online].
Available: http://www.lv.com/upload/lv-rebrand2009/pdfs/other/11665_LV_COAC.PDF [8 May 2012]
Office for National Statistics and Department for Environment, Food andRural Affairs (2011). Living Costs and Food Survey, 2010 [computer file]. 2nd
Edition. Colchester, Essex: UK Data Archive [distributor], July 2012. SN:
6945, http://dx.doi.org/10.5255/UKDA-SN-6945-2 [17 July 2012]
Scottish Provident (2012).
Swiss Re (2011) Group Watch 2011.

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APPENDIX A: Children Expenditure
According to Liverpool Victoria (2012), the cost of raising a child in UK is asfollows:
Table I: Cost of Raising a Child
Age
Cost per year
0£10, 261
1 to 4£14, 140
5 to 10£7, 679
11 to 17£7, 536
18 to 21
£17, 459
Note: The table shows the annual cost of raising a child based on his or her current age.
Source: Liverpool Victoria (2012).

To obtain the scaling factors that we use in our analysis, we first discount the
total cost of raising a child until age 21 based on the values above. The
discount rate used is the median yield on 10 year index-linked gilts over thelast 24 months ending in June 2012, and has a value of 1.21%. This is also thediscount rate used for calculating the present value of the other income
replacement components, and is in line with our assumption that Children
Expenditure increases with inflation.
This is then divided by the cost required to raise the child in the current year
based on his or her age, so that the amount needed to raise a child until age 21
is expressed as a multiple of the current annual expenditure on the child. Thisis shown below:

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Table II: Deriving the Child expenditure scale
Cost per
Total discounted
Age yearcost of raising child Scaling factor
0
10,261
193,53418.9
114,141
185,49013.1
2
14,141
173,42312.3
3
14,141
161,20911.4
4
14,141
148,848
10.5
5
7,679
136,337
17.8
6
7,679
130,214
17.0
7
7,679
124,018
16.2
8
7,679
117,746
15.3
9
7,679
111,399
14.5
10
7,679
104,975
13.7
11
7,536
98,473
13.1
12
7,536
92,037
12.2
13
7,536
85,523
11.3
14
7,536
78,931
10.5
15
7,536
72,2589.6
167,536
65,5058.7
177,536
58,6707.8
18
17,45951,7523.0
1917,45934,7092.0
20
17,45917,4591.0
Note: The annual cost of raising a child is based on Liverpool Victoria (2012). The discountrate used is 1.21%. This is the median yield on ten year index-linked gilts over the last 24
months, ending June 2012. The scaling factor is obtained by dividing the total discounted cost(third column) with the current annual cost (second column).

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APPENDIX B: Expenditure groups
The 2010 Living Costs and Food Survey (Office of National Statistics andDepartment for Environment, Food and Rural Affairs, 2011) provides details
on household expenditure patterns for the UK. The following presents the listof variables used to derive the values for the various expenditure groups forour study. This is based on the survey’s Specification documents (Volume F:
Derived Variable User guide, and Volume G: Derived Variable Flowcharts),
which are used by the Office for National Statistics in producing the Family
Spending 2011 report (Office for National Statistics, 2011). These documents
are provided as part of the data file.
Table III: List of variables under each expenditure group
Expendituregroup
Essentials7

Children

Description

Variable (as found in the survey)

Residential homes
Home help
Net rent
Second dwelling – rent
Maintenance andrepair of dwelling
Water supply andmiscellaneous services
relating to thedwelling
Children’s clothing
and footwear
Education

CC4111t
CC4112t
B010, B020
C41211t
B102, B104, B107, B108,
C43212c, C43111t, C43112t
B050, B053p, B056p, B060, B159,
C44211t

C31231t, C31232t, C31233t,
C31234t, C31313t, C32131t
B160, B164, CA1111c, CA1112c,
CA2111c, CA2112c, CA3111c,
CA3112c, CA4111c, CA4112c,
CA5111c, CA5112c, CA1113t,
CA2113t, CA3113t, CA4113t,
CA5113t

7

Household expenditure for “Water Supply – Second dwelling” and “Council tax, mortgage”
is estimated using national average figures, amounting to an average of £1.74/week.

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Mortgage/Debt

Savings andinvestments

School meals
Baby toiletries andaccessories(disposable)
Baby equipment(excluding prams andpushchairs)
Prams, pram
accessories andpushchairs
Nursery, crèche,playschools
Child care payments
Money, cash gifts
given to children
Interest on credit cards
Capital repayment ofmortgage
Loan/Hire Purchase ofvehiclesPurchase of motor
caravan (new andsecond-hand) loan/HP
Housing: mortgage
interest payments,
council tax etc.
Pay off loan to clear
other debt
Savings andinvestments

B260t
CC1317t

CC3222t

CC3223t

CC4121t
CC4122t
CK5212t, CK5213t, CK5214t,
CK5215t, CK5216t
B237
B200, B203, B204, B150
C71112t, C71122t, C71212t
C92114t, C92116t

B130, B150, B2081, B030, B038p

CK5316t
CK5111t, CK5113t, CK2111t

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APPENDIX C: Individual-level protection needs
Based on our sensitivity testing on the Children category above, we find thatthe protection need results are close to that calculated by our original modeleven when the adjustment to Children Expenditure is removed. Hence, apossible simplified method that can be used by an individual to calculate his or
her protection need is shown below:
Figure I: Calculation of individual-level protection needs

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