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Life Insurance

Life Insurance

What It Means

A life insurance policy is a legal agreement between an insurance agency and the policyholder, according to which the insurance agency agrees to pay a predetermined amount of money to a person or to a group of people, such as the insured’s family, upon the death of the policyholder. Those who receive this money are called the beneficiaries of the life insurance policy. Most policies also state that the insured person, rather than the beneficiaries, becomes eligible to receive these funds if he or she lives to be a certain age, often 90, 95, or 100. In return for these benefits, the policyholder pays a fee called an insurance premium. Most policyholders pay this fee annually. Many people receive life insurance as part of the benefit package (the terms of employment contract including insurance coverage and other benefits) associated with their jobs.

For example, a life insurance policy identifies the policyholder’s wife as the beneficiary scheduled to receive $200,000 in the event of the policyholder’s death. The policyholder is required to pay a $90 premium annually. If the policyholder dies three years after buying the policy (having paid only $270), the insurance company will pay his wife $200,000. Assuming this is one of the most basic types of policies, the insurance company would be required to pay the same fee of $200,000 if the policyholder died 20 years after buying the policy, having paid a total of $18,000 in premiums to the insurance company. The policy also states that if the policyholder lives to be 95 years old, he will collect the $200,000. Over the life of the policy, the policyholder is free to change beneficiaries or to add beneficiaries to the policy. If the policyholder’s wife were to die before he did, he would be able to name one of his children as the new beneficiary. If the policyholder wishes to add a child to the policy, he is required to stipulate how the $200,000 should be divided among the beneficiaries.

When Did It Begin?

Life insurance dates back to ancient Rome, when groups of men formed burial clubs. Members pooled their money together, establishing a common fund. When one of the members died, the living members used the funds to pay the deceased’s funeral expenses and to provide financial support for the surviving members of his family. Life insurance more closely resembling the policies available today first appeared in sixteenth-century London. This life insurance was originally available only to merchants and shipowners who met with policy sellers at a place called Lloyd’s Coffee House to draft the terms of the policies. Out of these meetings grew Lloyd’s of London, one of the world’s best-known insurance firms.

In the United States life insurance was initially sold to plantation owners in the South who bought the policies for their slaves. According to some records, an insurance company called Nautilus sold more than 450 policies to slaveholders during a two-year period in the 1840s. Life insurance first appeared in the northern United States in the early 1760s, when Presbyterian churches in New York City and Philadelphia established the Corporation for Relief of Poor and Distressed Widows and Children of Presbyterian Ministers. Churches of other Protestant denominations followed suit later in the decade, and shortly thereafter many more life insurance companies appeared. From 1787 to 1837 nearly 30 new life insurance companies opened, but only a small fraction survived.

More Detailed Information

At first glance, it might seem insurance companies take an unwise financial risk when selling an insurance policy. There is a chance that any given client could die shortly after purchasing the policy, in which case the insurance company has to make a large payout to a beneficiary without having received much money from the policyholder. To minimize this risk and to maximize the probability that they will profit from the sale of the policy, insurance companies use a complex statistical system to establish premiums for each of their clients. The professionals who analyze mortality (death) rate statistics to determine the cost of a policy are called actuaries, whose practice is called actuarial science.

When establishing premiums actuaries consider a number of important variables, such as the age and gender of the client, the type of policy being purchased, and the number of dangerous lifestyle obligations, habits, or hobbies that the client maintains. Holding a life-threatening job, such as firefighting, or having a dangerous habit, such as smoking tobacco, or having a risky hobby, such as skydiving, increases the likelihood of an early death. Therefore clients who participate in such endeavors are required to pay higher premiums for their life insurance policies. Insurance companies also review the health history of a client’s family to determine the cost of the policy. If, for example, there is a history of cancer in his family, the client will be required to pay a higher premium. Evaluating risk and determining price through these exhaustive background checks, which include questioning both the client and his or her physician, is called “underwriting.” An insurance company pools the premiums it receives from individual clients and makes investments to cover losses incurred when a client dies.

Different types of life insurance are available; the most common are term insurance, whole life insurance, and universal life insurance. Term life insurance is the most basic and least expensive type of policy. It offers a predetermined payoff only in the event of the policyholder’s death. According to most term life insurance policies, the client begins by paying a small annual premium and gradually pays a higher rate as he or she gets older. Experts recommend term life insurance for young people in their early to mid-20s who do not receive some form of life insurance from their employers. Experts also recommend that these people obtain what is called a “guaranteed renewable policy,” since many life insurance companies retain the right to terminate the agreement if the condition of a policyholder’s life changes.

As with term life insurance, whole life insurance policies usually pay beneficiaries at the end of the insured’s life. However, with these policies the insured usually pays the same high premium throughout the policy. According to these policies, a specified portion of every premium is invested on the insured’s behalf in an interest-bearing account. The interest earned on the funds in this account increases the value of the payoff to the beneficiary upon the death of the client. There are many different types of whole life policies, each of which offer clients various options. According to some policies, clients can control the amount they invest and how the money is invested over the course of the policy. Clients can often borrow money against whole life policies. Despite these options, it has been shown that whole life insurance policies tend on average to yield relatively small returns. Universal life insurance policies were established in the 1980s to offer potentially higher returns than whole life policies. Such policies offer a wider range of investment choices and often guarantee fixed interest rates on investments for a year at a time.

Recent Trends

Reports from the first years of the twenty-first century indicated that more people worldwide purchase life insurance than any other form of insurance. In 2005 a total of $1.45 trillion was paid in life insurance premiums across the globe, while the combined premiums paid for all other types of insurance that year totaled $1.97 trillion. The ratio of life insurance premiums to all other nonlife premiums was nearly the same in the United States, where $517 billion in life premiums and $626 in nonlife premiums were collected in 2005. These figures made the United States the largest life insurance market in the world. Japan was the second largest market with $376 billion in life insurance premiums collected, and the United Kingdom was third with $101 billion.

Other data from 2005 indicate that excluding Japan, the rest of Asia was the largest growing life insurance market. The total in premiums collected in this geographic region increased 10.5 percent from the previous year. The growth, especially in China and India, has been attributed to three closely related factors. First, improvements in technology, namely the development of the Internet and data-management technologies, have allowed the world’s leading insurance firms to perform more sophisticated actuarial studies in emerging markets in the developing world. In other words, insurers now have the capacity to analyze a much broader customer base in more parts of the world. Second, rapidly developing economies in these areas have created a larger base of people able to afford life insurance policies. Third, governments in these markets have passed laws allowing major international firms to open branch offices there in order to compete with local insurance underwriters.

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