Life Insurance is a private contract between a policy holder and an insurance company. The policy holder promises to pay specified amounts (called insurance premiums) and in exchange the insurance company will pay an amount of money when the policy holder dies. The money frequently is used for funeral expenses or to support the policy holder's family afterwards. For example, if a person has children and knows that they will need money for college, he could buy a life insurance policy in an amount that will cover their college costs if he dies before the children finish college.
How it works
People who study risks (called actuaries) determine the average life span of people and the risk that they will die. Some people will live longer than the average and others will die sooner than the average. Life insurance is a way of spreading the risk that the policy holder will die sooner than the average. The insurance company collects the premiums and invests the money. Because the insurance company sells policies to a large number of people, it sets the premiums at a level that will have enough money available to pay the death benefits as policy holders die. The insurance company will lose money if more people die sooner than the actuaries had predicted. The insurance company can also lose money if it spends too much on sales or administration or if its investments go bad. The insurance company will make a profit if it earns more money on its investments, if it keeps its costs low, or if people decide to cancel their insurance policies before they die.
Unlike most contracts, the customer will not be around to see that the deal is honored by the other party. So, life insurance is regulated by states. Most states will watch how the life insurance companies invest the money. In general, insurance companies must have "reserves" that they invested very conservatively in safe investments. Also, most states have laws that say who is allowed to buy a life insurance policy. (If any person could buy a life insurance policy on any stranger, then crooks could buy a policy, kill the stranger and collect the money.) Under the law, a person must have a legitimate reason for owning a life insurance policy on another person. This is called an "insurable interest." States also regulate insurance companies to make sure that they do not charge excessively high premiums or that they fail to pay out the promised benefits.
Life insurance companies are never legally required underwrite or to provide coverage to anyone, with the exception of Civil Rights Act compliance requirements. Insurance companies alone determine whether a person can be insured, and some people, for their own health or lifestyle reasons, are deemed uninsurable. The life insurance company can either decline to write any policy on a person, or can "rate" the policy (increasing the premium amount to compensate for a greater probability of a claim).
Types of policies
There are two basic types of life insurance:
- Protection policies – designed to provide a benefit in the event of specified event, typically a lump sum payment. A example is term life insurance.
- Investment policies – where the main objective is to facilitate the growth of capital by regular or single premiums. In the United States these are typically: whole life, universal life and variable life policies.