Theory of Life Insurance

The Theory of Life Insurance encompasses the principles and structures behind life insurance products, which serve to mitigate the economic losses associated with life and death events. At its core, life insurance operates by pooling risks among a large group of individuals, allowing members to pay a predetermined premium in exchange for financial protection upon the death of the insured or at the end of a contract term. Various types of life insurance policies, including Whole Life, Term Life, Endowment, and Universal Life, are designed to address different financial needs and circumstances. Whole Life policies provide lifelong coverage with cash value accumulation, while Term Life offers coverage for a specific period without cash value. Endowment policies allow for benefits during the insured's lifetime, and Universal Life introduces flexibility in premium payments and benefits. Additionally, other forms, like Group and Industrial Life Insurance, cater to specific demographics or employment settings. Understanding these diverse options is crucial for individuals seeking to secure financial stability for their beneficiaries and manage potential economic risks related to life events.

Published in: 2021

By: Azria, Seth M.

Subject Terms

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

Overview

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.

Insurance Companies

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).

Life Insurance

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

• Annuities

• Universal Life Insurance.

Each of these policies is designed to address a particular set of circumstances that people may encounter.

Whole Life

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).

Term Insurance

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 and is therefore more likely to die. Insurers may also add a provision to the term policy that allows the insured to convert the term insurance policy to whole life or endowment life. Again, this conversion typically occurs without regard to the state of the health of the insured at the time of exercising the option.

From the point of view of the insured, term insurance serves a more limited function than whole life insurance because the savings aspect inherent in whole life is totally lacking. While whole life insurance is a common element of broad financial planning as well as protection, term insurance is generally used to protect against a specific economic harm that would occur if the insured died during a particular period of time. For example, a homeowner might purchase decreasing term insurance for the period of the mortgage on a home. This strategy would ensure that their survivors would be able to make the mortgage payments if the homeowner died. In this case, the amount of proceeds payable under the policy can be made to decrease annually so that in the event of death the proceeds will roughly equal the remaining mortgage debt. Similarly, a person may realize that death in the first 15 or 20 years of marriage before reaching financial security would have serious economic effects on the family. The term life insurance policy may be used to boost total coverage during those years without incurring the additional cost of a whole life insurance policy (Dobbyn, 2003).

Term life is less expensive than whole life insurance for a number of reasons; the possibility that the insurer will escape the payment of proceeds entirely if the insured's survives the term; longer life expectancy; lower premiums that reward healthy living; comparison shopping on the internet; and lower expenses for insurers. Sources report that in 1994, a 35 year old man might have paid $720 a year for $500,000 coverage on a 20 year term policy but in 2006 could likely get the same policy for approximately $335 per year (Wiener, 2006).

Endowment Insurance

Endowment life insurance differs from other forms of life insurance because the insured has a chance to reap the benefits while still alive. The usual policy provides for payments of proceeds either in the event of death during the specified period, or at the date of "maturity." Proceeds on maturity can be paid either in a lump sum or as an annuity, making this type of policy useful in retirement planning (Dobbyn, 2003).

Industrial Insurance

Industrial life insurance is named for the people for whom it is intended. This insurance is tailored to meet the needs of the blue collar urban industrial class. Industrial life insurance policies are essentially whole life, endowment, or term insurance with certain characteristics that set them apart in this category. It is generally written in modest amounts and frequently only in amounts necessary to cover burial expenses. To serve immediate needs resulting from burial expenses, the policies usually contain a clause that permits the insurer to make payment immediately upon death to the person appearing to the insurer to be entitled to the proceeds because they may have incurred medical or other expenses in connection with a deceased. These payments remove the delay that would result if an administrator or executor were required to collect the payment, or if a court was required to settle disputes between claimants to the estate. Additionally, most industrial life policies contain non-forfeiture benefits for the insured in the form of cash payments after the policy has been in effect for 2 to 5 years. This type of insurance is typically sold through individual solicitation and without the requirement of a physical examination. However, the insurer is usually protected by a clause that invalidates the policy if the insured "good health" at the inception date of the policy. Premiums are usually collected more frequently than other types of insurance; usually on a weekly basis. The high costs of solicitation per policy, lack of medical screening, and a higher than average death rate among low income groups, accounts for the fact that the price of industrial life insurance is higher than other types (Dobbyn, 2003).

Mutual Insurance

Mutual Life Insurance accounts for a large proportion of the life insurance rate in the US. Mutual, or participating, life insurance requires the insured to pay a fixed premium somewhat more than the estimated cost of the insurance. Depending on the extent of losses, the amount of expenses, and the amount of interest earned on the reserve during the year, the insured receives a dividend from the insurer each year. The dividend is a return of the unused part of the premium previously paid. Although the insurer generally pays a higher premium of the participating policy that on a nonparticipating policy; if conditions are favorable, the insured may receive a dividend that will make the net cost less for the participating policy. The decision as to the amount of the annual premium, if any, is in the discretion of the insurer's board of directors (Dobbyn, 2003).

Group Insurance

Group Insurance refers to a method of marketing standard forms of insurance, such as life insurance. Under a group insurance policy, a master policy is issued to the party negotiating the contract which the insurer, usually an employer. Subsequently, certificates of participation are issued to the individual insured members of the group, frequently employees. The master policy sets forth all the terms and conditions of the insurance, while the certificates of participation serve merely to inform the individual members of the major features of the insurance but are not considered part of the insurance contract itself. This form of marketing is feasible from the point of view of the insurer because the factors influencing insurability and premiums, particularly for life or health insurance, are fairly homogeneous for a group such as the fulltime employees of a particular company. The mere fact that all the members are employed full time is a strong positive indication of insurability. Therefore, the usual physical examination and other methods of screening applicants for life or health insurance can be dispensed with. Membership in the group is a necessary and sufficient condition to insurability under the group plan. In this way, the savings to the insurer on cost of administration can be passed along to the group in reduced premiums (Dobbyn, 2003).

Universal Insurance

Universal life insurance is a modern variation on the theme of whole life insurance and has been created to combine features of an investment program at competitive rates with the tax and protection advantages of traditional whole life insurance. The major characteristic of universal life insurance is the continuing flexibility of three figures that are rigidly fixed at the inception of the ordinary whole life policy: The premium, the death benefit, and the interest rate on accumulated cash values. As with whole life insurance, universal life insurance involves an element of investment based on the fact that the cash value of the policy accumulates interest and ultimate payment of the cash value is guaranteed (Dobbyn, 2003).

Annuities

An Annuity, unlike the life insurance already discussed, protects against the economic problems that may arise from a long life rather than an early death. An annuity provides for a fixed annual, or more frequent, benefit beginning at specified date and continuing for the life of the insured. It is a guaranty against living to an age at which one's income producing capacity would not be sufficient to meet ones needs. Many annuities also provide for a refund of part of the premiums paid in the event of an early death. The variable annuity, an innovation on the fixed benefit annuity, whereby the insured buys the units of ownership in a portfolio of common stocks. When the period of payment begins, the insurer makes payment of a certain number of units per year; the number of units being an actuarial determined on the basis of a life expectancy of the insured. The benefit of this type of annuity is that the value of the units rises as the market value of the common stocks in the portfolio rises, thereby protecting the insured against the effects of inflation (Dobbyn, 2003).

Conclusion

Insurance companies may offer affordable coverage because of the principle of risk distribution, which spreads out the risk of loss to as many parties as possible. Buying insurance makes sense for many people to avoid the possibility of a catastrophic loss in exchange for a fixed and predictable premium. Life insurance, in some form, is often used meet several different individual needs that arise from a person's death. It can be employed to meet burial and other final expenses, to replace income of the deceased for family or loved ones, pay off a mortgage, and invest money, among others. Different types of insurance are designed to serve each individual need circumstances. A person who wants to save money and provide insurance for future beneficiates may purchase whole life. A person concerned about the cost of living a long life may purchase an annuity. A term policy may be useful to meet potential financial challenges that would arise if death occurred during a specific period of time.

Terms & Concepts

Annuity: A type of insurance that protects against economic problems that may arise from a long life; provides payments after a certain age.

Actuary: A person who computes premium rates, dividends, risks, etc., according to probabilities based on statistical records.

Beneficiaries: The people designated in an issue policy to receive the proceeds of the policy.

Cash Surrender Value: The amount available in cash upon cancellation of an insurance policy, usually a whole life.

Covered Economic Losses: Losses suffered that an insurance company will pay for at the rate or in the amount determined by the terms and conditions of the insurance contract.

Endowment Life Insurance: A type of life insurance that may allow the insured to receive benefits while still alive upon the maturity of the policy.

Group Insurance: A method for marketing insurance whereby a master policy is issued to one party and that party subsequently issue certificates of participation to others; usually arises in the employer-employee context.

Industrial Life Insurance: Insurance of several types designed for and marketed to urban blue collar workers.

Insured: A person protected or covered by an insurance policy.

Insurer: The party obligated to pay proceeds of a policy upon the happening of a covered event or the insurance company.

Mutual Life Insurance: A type of life insurance also called participating, that may refunds part of the premiums pays in the form of a dividend.

Premium: The payment made under an insurance policy.

Reinsuring: Sharing the risk by insurance companies; part or all of the insurer's risk is assumed by other companies in return for part of the premium paid by the insured.

Term Life Insurance: A policy that last for only for a specified and only pays only if the insured dies during that period. It does not accumulate a cash value. This type of insurance is cheaper that whole life insurance.

Whole Life Insurance: An insurance policy that last for an insured's entire life that accumulates a cash value and is guaranteed to pay out, unless cancelled or lapses due to nonpayment. Considered and investment vehicle in addition to insurance protection.

Universal Life Insurance: A variation of whole life insurance that includes flexibility as to premiums, interest rates and death benefit.

Bibliography

Dobbyn, J.F. (2003) Insurance law in a nutshell, (4th ed.). West Publishing: St. Paul, Minn.

Hezzelwood, W.L. (2013). Managing life insurance policies: an analytical approach built on standard actuarial techniques. Journal of Financial Planning, 26, 60-66. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=90536792&site=ehost-live

Katt, P.C. (2013). One life insurance size doesn't fit all estate planning situations. Journal of Financial Planning, 26, 38-39. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=88935253&site=ehost-live

Keeton, R.E. & Widiss, A.I. (1988) Insurance law: A guide to fundamental principles, legal doctrines and commercial practices. Practitioner's Edition, West Publishing: St. Paul, Minn.

Love, T., & Miller, W. C. (2013). Repercussions of a sustained low-interest-rate environment on life insurance products. Journal of Financial Service Professionals, 67, 44-52. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=85802247&site=ehost-live

Oglesby, D. (2007). Life insurance. Concise encyclopedia of investing, 40. Retrieved September 18, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=23701996&site=ehost-live

Oglesby, D. (2007). Term life insurance. Concise encyclopedia of investing, 71. Retrieved September 18, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=23702047&site=ehost-live

Stevick Jr., G. (2006). The case for whole life. Advisor Today, 101, 28-30. Retrieved September 22, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=22653753&site=ehost-live

Wiener, L. (2006). Is it time to get a new lease on term life? U.S. News & World Report, 141, 67-67. Retrieved September 18, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=22208795&site=ehost-live

Theory of Life Insurance

On this Page

Subject Terms

Theory of Life Insurance

Overview

Practice of Insurance

Insurance Companies

Life Insurance

Whole Life

Term Insurance

Endowment Insurance

Industrial Insurance

Mutual Insurance

Group Insurance

Universal Insurance

Annuities

Conclusion

Terms & Concepts

Bibliography

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