Theory of Life Insurance
Insurance protects people from economic loss. Economic loss may arise from any number of misfortunes and without insurance either the party causing the loss or the party that suffered the loss would be forced to bear the full economic impact. While there is no way to transfer the pain, inconvenience, or sorrow that mat accompany a particular misfortune, insurance acts to distribute the risk of economic loss among as many as possible. Life insurance, is its various forms, provides protection from economic loss associated with life and death. This article discusses the theory of insurance generally and reviews some major types of life insurance and the situations they were designed to address.
Keywords Actuary; Annuity; Beneficiaries; Cash Surrender Value; Covered Economic Losses; Endowment Life Insurance; Group Insurance; Industrial Life Insurance; Insured; Insurer; Mutual Life Insurance; Premium; Reinsuring; Term Life Insurance; Universal Life Insurance; Whole Life Insurance
The word theory, when used in non-technical contexts, means an untested idea or opinion. However, in a technical or scientific sense, a theory is a verified or established explanation of known facts or phenomena; for example, Einstein's Theory of Relativity. This discussion is geared toward the technical meaning. The fact is that life insurance exists and in various forms. To explain the fact of life insurance, we will look to the nature of insurance generally, a description of some popular types of life insurance, and explore their value to people that opt for one insurance policy over another.
Practice of Insurance
Insurance, generally, protects people from economic loss. Economic loss may arise from any number of misfortunes and without insurance, either the party causing the loss or the party that suffered the loss would be forced to bear the full economic impact. While there is no way to transfer the pain, inconvenience, or sorrow that may accompany a particular misfortune, insurance acts to distribute the risk of economic loss among as many as possible within a given category. Each member of the protected category, that is each insured, makes a predetermined payment called a premium. The premiums are collected into a fund out of which payment is made for covered economic losses of an insured in the group. In effect, each member contributes a small amount to compensate other members of their group for losses they suffered. In general, no member will know in advance whether they will receive more compensation than the premiums paid or whether they will merely be paying for the losses of others in the group. Despite this feature of insurance, it make sense to purchase insurance because the typical goal for the insured is to avoid the gamble of going it alone. The gamble of going it alone of either is to potentially escape all loss or be forced to bear the full impact of a potentially devastating economic loss. Insurance replaces that gamble with the opportunity to pay a defined premium that fixes the maximum possible economic loss associated with a particular type of risk. Sharing economic risk in this fashion is called the principle of risk distribution and is fundamental to understanding insurance coverage generally. For example, businesses routinely insure against losses to merchandise and other property and the premium is considered a cost of doing business. The amount of that premium is added into the price charged to the public for products or services. This is an example of the distribution of risk spread out widely through the entire community.
It may appear that an insurance company has merely agreed to assume the liability of another in the event that liability materializes. However, there is a major difference between an insurance policy and a contract whereby one party assumes the liability of another. A plan of insurance includes a substantial number of members and distributes the risk among them. When fixing the premium rates paid by each member to cover all the losses for the period as well as administrative and other costs, the insurer must predict the number and size of losses likely to occur during that period. Just as in flipping a coin where the number of heads and tails becomes increasingly more even and predictable as the number of flips increases. The impact of unanticipated losses on the predicted total losses will lessen as the number of insurance policies issued increases. This relationship is called the law of averages and this predictability permits an insurer to fix rates that are low enough to make the insurance marketable, and yet high enough to allow the insurer to weather all losses and still cover administrative and other costs. In the event an insurance company does not sell enough of a particular type of policy to be comfortable under the law of averages, it can distribute its risk by reinsuring with other insurance companies (Dobbyn, 2003).
Given the fundamental principles of insurance, it would be theoretically possible to evaluate and insure against any risk associated with any lawful activity. However, this article is focused on life insurance and the associated economic risks of life and death. Life Insurance is essentially a contract to make specific payments upon the death of the person whose life is insured. Stated another way, life insurance guarantees a sum of money to designated beneficiaries upon the insured's death or perhaps to the insured if he or she lives beyond a certain age. The cast of characters involved with a life insurance policy other than the insurer include: The owner of the policy, the person whose life is being insured and the beneficiaries who are paid under the policy. The owner of the policy has the power to name or change the beneficiary, the right to assign the policy, cash it in it for its surrender value, or use it as collateral in obtaining a loan, and also the obligation to pay the premiums. The same person may occupy all three positions by naming their estate as beneficiary, or each of the three positions may be held by a separate person.
Just as insurance is broken down into several categories, life insurance also contains various subcategories. Some common forms of life insurance policies are:
• Whole Life
• Term Life
• Endowment Life Insurance
• Industrial Life Insurance
• Mutual Life Insurance
• Group Insurance
• Universal Life Insurance.
Each of these policies is designed to address a particular set of circumstances that people may encounter.
As the name suggests, coverage under a whole life insurance policy is intended to run for the entire life of the insured. Proceeds are paid upon the death of the insured and payment of the proceeds is as certain as death itself, unless the policy is canceled by the owner or it lapses for nonpayment of premiums. Additionally, a whole life policy has the possibility of a cash surrender value, which is generally available at any time after the policy has been in force for or three years and prior to the death of the insured. Because the whole life policy accumulates cash surrender value, as well as the certainty of ultimate payment in some form, it acts as an investment vehicle in addition to insurance. In addition, the cash value which may be accessed upon surrender or used as collateral for a loan, the whole life policy provides a fixed premium for life. Because life insurance premiums are calculated according to the risk of death, such premiums may be prohibitive as a person ages; whole life tends to alleviate that problem with fixed and level premiums for the life of the policy. As an investment strategy, whole life insurers typically invest the premiums conservatively based on a diversified portfolio to ensure that the funds will weather economic downturns. This strategy can provide security and peace of mind to the policy owner (Stevick, 2006).
As opposed whole life, term life insurance coverage lasts only for a specified term, for example one month, 10 years, or 20 years. The insurer only pays the specified amount of proceeds if the insured dies within that term. In contrast to the whole life policy, the term life policy generally does not accumulate a cash surrender value upon surrender or lapse of the policy. As a result, it is uncertain that the insurer will be obligated to pay anything in proceeds under the policy because the insured may outlive the term. Because payment under term life insurance is uncertain, it does not have an element of investment. Occasionally, term insurance policies are made more marketable by making them renewable for additional term or terms. This renewal feature is usually offered without regard to the state of health of the insured at the time of renewal. However, rates for subsequent terms are typically substantially higher than for the initial term because the insured has aged...
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