Insurance description
Life insurance (Life Assurance in
British English) is a type of insurance. As in all
insurance, the insured transfers a risk to the insurer.
The insured pays a premium and receives a policy in
exchange. The risk assumed by the insurer is the risk of
death of the insured.
How life insurance works
There are three parties in a life insurance transaction;
the insurer, the insured, and the owner of the policy
(policyholder), although the owner and the insured are
often the same person. For example, if John Smith buys a
policy on his own life, he is both the owner and the
insured. But if Mary Smith, his wife, buys a policy on
John's life, she is the owner and he is the insured. The
owner of the policy is called the grantee (he or she
will be the person who will pay for the policy).
Another important person involved is the beneficiary.
The beneficiary is the person or persons who will
receive the policy proceeds upon the death of the
insured. The beneficiary is not a party to the policy,
but is designated by the owner, who may change the
beneficiary unless the policy has an irrevocable
beneficiary designation. With an irrevocable
beneficiary, that beneficiary must agree to changes in
beneficiary, policy assignment, or borrowing of cash
value.
The policy, like all insurance policies, is a legal
contract specifying the terms and conditions of the risk
assumed. Special provisions apply, including a suicide
clause wherein the policy becomes null if the insured
commits suicide within a specified time for the policy
date (usually two years). Any misrepresentation by the
owner or insured on the application is also grounds for
nullification. Most contracts have a contestability
period, also usually a two-year period; if the insured
dies within this period, the insurer has a legal right
to contest the claim and request additional information
before deciding to pay or deny the claim.
The face amount of the policy is normally the amount
paid when the policy matures, although policies can
provide for greater or lesser amounts. The policy
matures when the insured dies or reaches a specified
age. The most common reason to buy a life insurance
policy is to protect the financial interests of the
owner of the policy in the event of the insured's
demise. The insurance proceeds would pay for funeral and
other death costs or be invested to provide income
replacing the deceased's wages. Other reasons include
estate planning and retirement. The owner (if not the
insured) must have an insurable interest in the insured,
i.e. a legitimate reason for insuring another person’s
life.
The insurer (the life insurance company) calculates the
policy prices with an intent to recover claims to be
paid and administrative costs, and to make a profit. The
cost of insurance is determined using mortality tables
calculated by actuaries. Actuaries are professionals who
use actuarial science which is based in mathematics
(primarily probability and statistics). Mortality tables
are statistically based tables showing average life
expectancies. The three main variables in a mortality
table are age, gender, and use of tobacco. The mortality
tables provide a baseline for the cost of insurance. In
practice, these mortality tables are used in conjunction
with the health and family history of the individual
applying for a policy in order to determine premiums and
insurability. The current mortality table being used by
life insurance companies in the United States and their
regulators was calculated during the 1980s. There is
currently a measure being pushed to update the mortality
tables by 2006.
The current mortality table assumes that roughly 2 in
1,000 people aged 25 will die during the term of
coverage. This number rises roughly quadratically to
about 25 in 1,000 people for those aged 65. So in a
group of one thousand 25 year old males with a $100,000
policy, a life insurance company would have to, at the
minimum, collect $200 a year from each of the thousand
people to cover the expected claims.
The insurance company receives the premiums from the
policy owner and invests them to create a pool of money
from which to pay claims, and finance the insurance
company's operations. Contrary to popular belief, the
majority of the money that insurance companies make
comes directly from premiums paid, as money gained
through investment of premiums will never, in even the
most ideal market conditions, vest enough money per year
to pay out claims. Rates charged for life insurance
increase with the insured's age because, statistically,
a people are more likely to die as they get older.
Since adverse selection can have a negative impact on
the financial results of the insurer, the insurer
investigates each proposed insured (unless the policy is
below a company-established minimum amount) beginning
with the application, which becomes part of the policy.
Group Insurance policies are an exception.
This investigation and resulting evaluation of the risk
is called underwriting. Health and lifestyle questions
are asked, and the answers are dutifully recorded.
Certain responses by the insured will be given further
investigation. Life insurance companies in the United
States support The Medical Information Bureau, which is
a clearinghouse of medical information on all persons
who have ever applied for life insurance. As part of the
application, the insurer receives permission to obtain
information from the proposed insured's physicians.
Life insurance companies are never required by law to
underwrite or to provide coverage on anyone. They alone
determine insurability, and some people, for their own
health or lifestyle reasons, are uninsurable. The policy
can be declined (turned down) or rated. Rating means
increasing the premiums to provide for additional risks
relative to that particular insured.
Many companies use four general health categories for
those evaluated for a life insurance policy. These
categories are Preferred Best, Preferred, Standard, and
Tobacco. Preferred Best means that the proposed insured
has no adverse medical history, is not under medication
for any condition, and his family (immediate and
extended) have no history of early cancer, diabetes, or
other conditions. Preferred is like Preferred Best, but
it allows that the proposed insured is currently under
medication for the condition and may have some family
history. Most people are in the Standard category.
Profession, travel, and lifestyle also factor into not
only which category the proposed insured falls, but also
whether the proposed insured will be denied a policy.
For example, a person who would otherwise be in the
Preferred Best category will be denied a policy if he or
she travels to a high risk country.
Upon the death of the insured, the insurer will require
acceptable proof of death before paying the claim. The
normal minimum proof is a death certificate and the
insurer's claim form completed, signed, and often
notarized. If the insured's death was suspicious and the
policy amount warrants it, the insurer may investigate
the circumstances surrounding the death, before deciding
whether there is a legal obligation to pay the claim.
Proceeds from the policy may be paid in a lump sum or as
an annuity paid over time in regular recurring payments
for either for the life of a specified person or a
specified time period.
Insurance vs. assurance
The specific uses of the term "insurance" and
"assurance" are sometimes confused. In general, the term
insurance refers to providing cover for an event that
might happen while assurance is the provision of cover
for an event that is certain to happen.
When a person insures the contents of their home they do
so because of events that might happen (fire, theft,
flood, etc.) Insurance is a way of spending a little
money to protect against the risk of having to spend a
lot of money. The point is, when a person insures their
home contents they do so to provide protection against
something that might happen. They hope their home will
never be burgled, or burn down but they want to ensure
that they are financially protected if the worst
happens.
When a person insures their life they do so knowing that
one day they will die. Therefore a policy that covers
death is assured to make a payment. The policy offers
assurance on death; even if the policy has a prescribed
termination date the policy is still assured to pay on
death and therefore is an assurance policy. Examples
include Term Assurance and Whole Life Assurance. An
accidental death policy is not assured to pay on death
as the life insured may not die through an accident,
therefore it is an insurance policy.
A policy might also be assured for other reasons. For
example an endowment policy is designed to provide a
lump sum on maturity. Under certain types of policy the
lump sum is guaranteed. Therefore, this may also be
called an assurance policy.
The test of whether a policy is assurance or insurance
is that with an assurance policy the insured event will
definitely occur (at some point) whereas with an
insurance policy there is a risk the insured event might
occur.
With regard to Whole Life policies, the question is not
whether the insured event (in this case death) will
occur, but simply when. If the policy has nonforfeiture
values (or cash values) then the policy is assured to
pay.
During recent years, the distinction between the two
terms has become largely blurred. This is principally
due to many companies offering both types of policy, and
rather than refer to themselves using both insurance and
assurance titles, they instead use just the one. |
