How Does Insurance Work?
Through the centuries, people have pursued financial security for themselves and those who depend on them. We all have a compelling need for security; security is peace of mind and freedom from worry. Most economic actions we take are to satisfy some need and thus attain some degree of security.
Unfortunately, complete financial security has been elusive, in part because of certain problems: death, sickness, accidents, and disability. These problems can strike at any time and without any warning. The emotional stress these problems bring is increased by the financial hardships that are almost certain to follow.
Insurance evolved to produce a practical solution to such economic uncertainties and losses. The true significance of insurance is its promise to substitute future economic certainty for uncertainty, and to replace the unknown with a sense of security.
Insurance works by pooling risk, which means that a large group of people who want to insure against a particular loss pay their premiums into what we will call the insurance bucket, or pool.
Because the number of insured individuals is so large, insurance companies can use statistical analysis to project what their actual losses will be within the given class. They know that not all insured individuals will suffer losses at the same time or at all. This allows the insurance companies to operate profitably and at the same time pay for claims that may arise.
For instance, most people have auto insurance but only a few actually get into an accident. You pay for the probability of the loss and for the protection that you will be paid for losses in the event they occur.
Fundamentals of Life Insurance
Types of Risks Covered
1. Loss of Earning Capacity
2. Lack of Liquidity
3. The Expense of Replacing Key Skills
Types of Life Insurance
1. Term: Term life insurance is the simplest type of life insurance. It provides insurance protection for a specified period of time (or term) and pays a benefit only if the insured dies within that term.
a. Annual Renewable Term: this insurance provides a level amount of protection for one year and is renewed annually but at a higher rate each year as the likelihood of the insured’s death increases.
b. Level Premium Term: this insurance covers a period of several years, such as 5-year term, 10-year term, or 20-year term. The premiums stay the same during the length of the contract.
c. Decreasing Term Insurance: this insurance is characterized by benefit amounts that gradually decrease over the term of protection. These are often marketed as mortgage protection insurance or credit life, with the death benefit corresponding to the balance of a mortgage or other loan. Often they are sold by the bank or other lender.
2. Cash Value Insurance: Unlike term insurance, which provides only death protection, cash value insurance combines insurance protection with a savings or accumulation element. This accumulation is commonly referred to as the policy’s cash value.
a. Whole Life: this insurance provides protection for the insured’s whole life, from date of issue to the insured’s death, provided the premiums are paid. Typically the death benefit and the premiums remain level during the life of the policy.
b. Universal Life: this insurance is a variation of whole life insurance, characterized by considerable flexibility. Universal life allows the policy
owner to determine the amount and frequency of premium payments and to adjust the policy face amount up or down to reflect changing circumstances.
c. Variable Life: Unlike traditional whole life policies in which the accumulation amounts are guaranteed, this insurance ties the return on the
accumulation element to returns on stock market indexes or a specific bundle of stock investments. Thus the policyholder assumes the risk, with the hope that higher than average returns will increase the cash value within the policy.
Financial Factors in Insurance Policies
The cost of a life insurance policy is based on a combination of all these factors:
1. Mortality factor: the actuarial likelihood the insured will die at any given time
2. Cost of sales factor: the expense of paying for the creation of the policy
3. Administrative expenses factor: the cost of operating the insurance company and paying its overhead
4. Profit factor: earning by the insurance company payable to its stockholders
5. Investment factor (Reserves) (not applicable in term policies): the return on money held and invested by the company, which adds to its overall revenue
Other Life Insurance Concepts
1. Insurability: the determination of the health of the potential insured, more specifically the likelihood that the insured will suffer a premature death, which may dissuade the company from accepting the policy or may cause it to offer coverage only on the condition that the policyholder pay higher premiums.
2. Convertibility: a policy option that allows the insured to convert a term policy into a cash value policy at the end of the term, without proof of insurability.
3. Group Life Insurance: a policy covering an entire group of people such as a group of employees. These policies are usually offered as a fringe benefit by employers. They tend to be less expensive than individual policies and allow an otherwise uninsurable employee to obtain coverage.
4. Financial Soundness of Company: the financial stability of the company is critically important because it will determine if the company can pay the benefits promised to policyholders when those benefits become due.
At Personal Asset Advisors, we want our clients to fully understand what insurance is and how it works. We’re happy to review your existing policies and explain them to you. That’s the first step to knowing if you have the right kind of insurance and if you have too much or not enough.
Here are some fundamental principles of this important component of your financial peace of mind.