How Life Insurance Works

Total life insurance in force in this country exceeds $10 trillion, reports the American Council of Life Insurance. That is $10,000 multiplied by one billion, or more than $40,000 for every man, woman and child in the United States.

We buy life insurance for a multitude of reasons: to protect our family's lifestyle, to make sure our children have the funds for a college education; to buy peace of mind for ourselves. Primarily, however, we buy life insurance because we care about our loved ones and want to protect their futures. That is why, last year alone, Americans paid insurance companies more than $215 billion in life insurance premiums.

What did we buy? What exactly is life insurance? How does it work? For instance, how can a company issue a product (the guarantee of future dollars) worth a stated sum of money, collect payments each year equal to just a few pennies on the dollar and then pay the full death benefit amount -- whether the insured dies the next day, the next decade or well into the next century?

A detailed, technical explanation of life insurance is neither necessary for most people nor possible to present in less than a hundred pages. However, the fundamental principles of life insurance are fairly simple. As an informed consumer -- who very likely pays hundreds, perhaps thousands, of dollars each year for life insurance protection -- you will benefit from a better understanding of the fundamentals of this unique product.

What is Life Insurance?

Life insurance is a financial product designed to provide a pre-determined sum of money at the exact moment it is needed most. In return, the policyowner agrees to pay significantly smaller sums over a period of time. The purpose of life insurance is to replace uncertainty (when a person will die) with guarantees (that specified funds will be there to alleviate financial loss, regardless of when death occurs).

Most important of all, the life insurance agreement between the company and the policyowner guarantees that those future dollars will be paid. This is not a thought or a hope; it is a promise.

The Scientific Principles Upon Which Life Insurance is Built

Insurers have been able to keep that promise because life insurance is based on sound scientific principles. These include:

1. The concept of shared risk
2. The law of large numbers
3. Predictable mortality
4. Invested Assets
5. Fair and accurate risk selection

1. Shared Risk

Members of our earliest societies understood the benefits of pooling their resources, talents and, yes, risks. Whether hunting for food or defending against common enemies, people found that sharing the risk among the group minimized the risk to the individual.

This is how the workers guilds of the Middle Ages attempted to protect families of members against another common enemy: financial hardship caused by death. Members would contribute small amounts each year into a common "widows and orphans" fund. Though the system was flawed, it did provide basic protection for families of members who died during the year. This idea was still used as late as the Nineteenth Century in this country by immigrant groups; it later became the basis for the hundreds of fraternal life insurance companies still flourishing today, as well as for association group insurance plans, including those offered by the American Academy of Family Physicians.

2. The Law of Large Numbers

The principle of shared risk only works when the law of large numbers is also applied. Under this scientific principle, the larger the group, the less impact the death of one member has on the group as a whole. A group with just ten, a hundred, even a thousand members would not work. The base would be too fragile, too susceptible to mortality "blips" due to situations and events that lead to unexpected deaths (such as a flu epidemic or earthquake that took thousands of lives in a certain geographic location).

This is one reason groups and individuals today transfer the risk to insurance companies, in effect forming new groups consisting of hundreds of thousands, very often millions, of members.

3. Predictable Mortality

A third principle of life insurance is predictable mortality. It is not possible to tell when a given individual will die. But due to more than a century of tracking and recording data about health, lifestyle and mortality trends, insurers can project life expectancies. This data is recorded in mortality tables.

A mortality table is a chart summarizing the life span of a large number of people. Specifically, it projects (1) the number of deaths that will occur per 1,000 individuals at a given age and (2) the life expectancy of an individual at any age. The 1980 Commissioner's Standard Ordinary Mortality Table (1980 CSO) is the official mortality table in use by all insurers today. It charts a representative sample of 10 million lives and follows them to age 100, when, for insurance purposes, the last person is presumed to have died.

Once the insurance company can reasonably predict how many people of a given age will die in a given year, it can project mortality experience. Subsequently, the insurer can then project costs and premium rates. For instance, as life expectancy has climbed dramatically in this century, the cost of life insurance has decreased.

4. Invested Assets

When the company receives premiums, that money is not just put into a vault. It is invested. It may be years before a claim is made against the policy, so the impact of investment experience can be significant. The projected return is factored into premium and other costs. At the same time, a percentage of assets is set aside in company reserves to reduce the impact of unexpected events.

5. Fair and Accurate Risk Selection

A life insurance contract is an aleatory contract: It is based on the possibility of a chance occurrence and, in all likelihood, one side will benefit more than the other. However, for life insurance to work, the insurer needs to remove as many variables as possible. This brings us to the final principle of insurance, which is fair and accurate risk assessment. Especially with individual insurance policies, coverage is issued based on the assumption of reasonable risk. This means insuring people who are generally in good health at the time of application. This is also why medical exams and blood samples are sometimes required.

Once insured, policyowners are protected if they become ill. That's the reasonable risk the company assumes, that a certain percentage of insureds will die prematurely. However, were the company to issue policies on seriously ill applicants, life insurance would become prohibitively expensive.

Risk Selection Criteria

A number of factors are considered when evaluating a risk for insurance and establishing an equitable premium for coverage. Primary among these are:

1. Health and medical history: Insurers consider an applicant's current health and past medical records, and remain alert for a history of impairments in other family members.
   
   
2. Occupation: Some occupations -- such as fire fighting or those involving the use of heavy machinery -- carry greater risks than others.
   
   
3. Amount of insurance: The dollar amount of insurance must be in proportion to the applicant's income and apparent need. This helps reduce the danger to the insurance company of high risks attempting to "load up" on large amounts of coverage. This is also why amounts in excess of certain limits require additional medical evidence of insurability.
   
   
4. Age: A younger applicant is generally a better risk than an older one, simply because mortality is higher at older ages. This is reflected in lower rates for younger applicants. Many insurers will not issue new policies above a certain age.
   
   
5. Sex: Women as a group have longer life expectancies than do men. This is often reflected in lower rates for women; however, many insurers have gone to unisex mortality tables in recent years.
   
   
6. Lifestyle: Experience has shown that certain activities -- especially smoking and alcohol and drug abuse -- dramatically increase insurance risk. This is why smokers generally pay a higher premium than their nonsmoking counterparts.
   
   
7. Hobbies & avocations: Some hobbies, such as mountain climbing and piloting private aircraft, are considered to be high-risk avocations that must be considered in the selection process.

The above are the key criteria in risk selection. They determine whether you will be accepted for coverage and, if so, the rate you will pay. Many group plans, including your Academy's, provide a degree of pre-qualification of the individual; the insurer evaluates the risk of the group as a whole and, as a result, is able to simplify the process of determining the insurance risk of the individuals within that group.

The Role of Life Insurance in Your Life

Life insurance is a unique financial product. In some respects, it is an oxymoron in that it deals scientifically and precisely with variables that are emotional and, within the context of our own individual lives, completely unpredictable.

Perhaps the most important factor about life insurance is simply that it works. Since the 1850s, when the modern life insurance policy was created, insurance companies have consistently kept their contractual "promise to pay." This in turn has made it possible for millions of men and women in this country to keep their promises to their families, building a plan of financial security on the foundation of life insurance protection.