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The Concept Of Insurance Defining Life Insurance A working definition of life insurance begins with understanding why the concept of insurance originally developed. In all lives, uncertainty exists about what will happen tomorrow, next month, next year. The future holds unknown events, some that will be positive, others, negative. Negative events include the possibility of loss. Insurance is specifically concerned with financial loss. For example, because most people own and rely upon the availability of cars, they can envision the financial loss that will occur if the car is damaged in an accident. As a result, people buy auto insurance to protect themselves against the uncertainty - the risk they take by driving - that they will suffer a financial loss if an accident occurs. Back to top How Insurance Helps Insurance is the answer to this uncertainty because it produces a substantial sum of money that becomes available precisely when it is needed - when the financial loss occurs. If all people could personally generate and accumulate enough wealth to cover financial losses, there would be no need for insurance. Since most people are not wealthy, insurance was devised as a way of having a large number of people share in the loss. Suppose, for example, you and 999 other adults each agreed to pool a certain amount of money each year - let's say $500 each. Then, if one of this group of 1,000 people dies, his or her family would receive $100,000 from that pool of funds. Most people wouldn't hesitate to pay $500 for a guarantee of $100,000. This spreads the financial loss among 1,000 people rather than the loss being assumed by any one individual. Back to top Spreading and Transferring the Risk of Financial Loss Life insurance works in the same way. Instead of pooling money with private parties, people who purchase life insurance make small payments to an insurance company in return for the guarantee of a substantial sum of money if death occurs. The financial loss is still spread among many others who also purchase insurance from the same company, but it is the insurer who accumulates the funds and is responsible for paying for losses. In this way, the financial risk is transferred from one person to a group through an insurance company. Back to top The Law of Large Numbers Insurance companies are able to provide this service at a reasonable cost by relying on the so-called "law of large numbers," which refers to the development of statistics from a large population. The more cases studied, the more reliable the statistical probabilities that are assumed as a result of the study. Insurers carefully accumulate and analyze factors that affect how long people as a group live - factors such as life expectancy at birth, health conditions, sex, place of residence, and others. This information is developed into mortality tables that show the probability of death occurring at certain ages. For example, a table might show that of 95,000 people who are age 30, 200 will die within the year. From the large body of information gathered, insurers are able to establish how much to charge for insurance to be certain reserves are available to pay the guaranteed amounts when a death occurs. Back to top The Fundamental Purposes of Life Insurance Paying Death Benefits The best understood and most obvious purpose of live insurance is to pay a certain amount of money to survivors when the insured person dies. Paying death benefits was the original purpose of life insurance policies and continues to be the major reason people buy life insurance. Life insurance paid at the time of death can be used for many purposes, including: • Ongoing living expenses for survivors. • Retiring a mortgage on the survivors' home. • Establishing a fund for children's future college costs. • Paying off debts existing when the insured person dies. • Paying death expenses, such as medical and funeral costs. • Buying out a surviving partner's interest in a business. • Replacing income lost by the death of a key employee. Back to top Cash Accumulation As life insurance policies evolved, more emphasis was placed on the cash values that accumulated in policies as premiums were paid. Certain policies have features allowing cash accumulation that may be used by the inured person who does not die. For example, a policy might accumulate cash values that would be payable to the policy owner when she or he reaches a certain age or after the policy has been in force for a specified number of years. Later in this chapter you will learn more about the features of policies that provide for cash accumulation and the specific ways different policies handle such accumulations. Back to top Permanent vs. Term Insurance A basic distinction to be made about life insurance policies is whether the insurance is permanent or term. Permanent insurance, which is also called cash value life insurance, is permanent only insofar as the policy language is concerned. Originally, "permanent" meant that the policy was in force until the insured person died or lived to age 100, whichever came first. If the insured was still alive at age 100, the policy would pay its full amount of insurance to the insured instead of continuing until the insured person died. More recent policies often have earlier payoff dates. In addition, permanent policies typically build some type of cash value that is available while the insured person is living. For example, the cash value may be borrowed or used to help pay premiums. In more contemporary policies, cash values can grow significantly to provide retirement income. While the more appropriate terminology for these policies is "cash value life insurance," they are still often called permanent insurance. Term insurance, conversely, does not build cash values and does not continue "permanently." Instead, a term policy is written to pay a specified amount of insurance only if the insured dies within a specified "term" or period of time. When the term ends, so does the insurance coverage. In the past, if the insured wanted to continue coverage, a new term policy usually was required. In recent years, however, most term policies are written with an automatic renewal feature. You will learn how this works later in this chapter when we discuss term insurance in depth. Back to top Traditional Policies Whole Life Policies: Historically, the most common traditional type of permanent insurance was whole life insurance. The name of the policy describes how long it is effective - for the insured's whole life (until death) or age 100 if the insured does not die. Apparently presuming that someone age 100 has lived a whole lifetime, insurers who write these policies agree to pay the amount of the policy to the living insured person rather than continue to wait for the insured to die. Instead of the age 100, some insurers pay the policy proceeds to the insured at age 95 or 98. In fact, insurers may use whatever age they believe is appropriate actuarially, that is, based upon statistical calculations. Back to top Fixed, Level Premium Payment: "Whole life" also refers to the premium-paying period. Premiums are paid for the entire period the insurance is in force, again either until the insured dies or reaches age 100 (or other age the insurer selects). The advantage of making premium payments for a long period is that each payment will be relatively small for the benefit provided. At the time the policy is purchased, each payment is determined and "fixed" so that it never changes during the policy lifetime. This is called a fixed level premium. Back to top How Cash Values Accumulate: Because whole life policies are permanent insurance, cash values build during the policy period. In the early years of a whole life policy, typically while the insured person is young, more premium money is paid in than is required based upon the mortality tables for a younger person. The insurer accumulates, as cash values, the difference between the premium actually required to cover mortality costs and the premium the policy owner pays. Cash values grow not only from the excess premium payments, but also from interest paid on the cash value. At some point, as the insured ages, the level premium that is still being paid no longer covers the mortality risk, but the larger premiums paid in the earlier years balance the cost. Back to top Cash Value Guarantees: Whole life policies guarantee that specific amounts will accumulate each year the policy is in force and will be available to the policy owner as cash values. A table included in the policy itself shows the guaranteed cash values. The rate of interest is typically low simply because it is guaranteed rather than tied to anything going on in the financial world that might otherwise affect interest rates. While relatively low, these guaranteed rates help the cash values grow over the years of a whole life policy. Back to top An Owner Dies When a business owner dies, one of three basic consequences results: 1. The business is dissolved. 2. The business owner's heirs take the place of the deceased in the business, operating either as a new proprietorship, partnership or corporate stockholder, or under a different form of ownership. 3. The business owner's heirs sell the deceased person's business interest. The desirability and viability of each option depend on a number of factors, not the least of which are the financial obligations Uncle Sam and the individual states extract-yes, even unto death. Let's look briefly at factors that complicate the viability of each option, beginning with the immediate financial needs that arise when someone dies. Back to top Cash Needs Any individual's death creates some immediate cash needs, including those discussed in the next paragraphs. Back to top |