How Exactly Does Life Insurance Work?

Few financial instruments are as complex as life insurance, but it doesn’t have to be a mystery as to how it works.  For most people, life insurance is the single most important part of their financial life as it may provide the only source of capital that will be needed to sustain a family’s financial security when one of the breadwinners dies.  It represents a substantial obligation on the part of a life insurer which is why it is issued as a contract that binds both the insurer and the policyholder to very specific provisions.  Being that it is a contract, the basic working components of the life insurance policy are often buried amidst the nearly indecipherable legalese, so here, we strip away the legal jargon for a simple explanation of how life insurance works.

A Simple Concept

The basic concept of life insurance is simple: a person (insured) contracts with a life insurance company (insurer)to provide a specified amount of money to people (beneficiaries)he or she designates in the event of the insured’s death.  The insured agrees to pay a specified amount of premium to the insurer to cover its costs of insurance.  That’s it, as far as the basic concept.  Like a watch that appears so clean and simple on the face, there is an intricately designed machine inside the cover that makes it tick.

Life Insurance Fundamentals Exposed

Death Benefit

The death benefit is the amount of insurance that the insured and the insurer agree will be paid upon the insured’s death.  The amount is determined by the insured but the insurer must determine that there is an insurable interest – individuals or an entity that would suffer a financial hardship as a direct result of the death of the insured.

Premium Payment

In return for the insurers promise to pay a death benefit, the insured agrees to a premium payment amount and schedule. As long as the premiums are paid on time, the insured remains obligated.  The primary pricing component of the premium amount is the cost of insurance which the insurer uses to cover its risk.  The insurer uses actuarially based statistics and mortality tables to determine how much risk it will assume to insure a person’s life. Factors such as the person’s age, health, lifestyle, and medical history are weighed against the actuarial assumptions to arrive at the cost of insuring the person’s life.  The insurance costs increase each year as the person ages. 

Term Policy Premiums: The amount of premiums can vary widely from one type of policy to another. For term policies, which have only a death benefit component, the premiums are low because the insured is paying only for the cost of insurance along with some small administrative expenses. It’s a straightforward exchange of premium for death benefit.  If the need for life insurance is only temporary, these can be the most effective form of protection. If, however, the need for life insurance extends beyond 20 or 30 years, term insurance premiums can become very expensive.

Cash Value

Permanent insurance policies contain both a death benefit component and a cash value component.  The cash value serves two main purposes. It is a savings element that enables the insured to accumulate funds, on a tax-deferred basis, that can be used for a future need. It is also risk modifier that enables the insurer to keep the cost of insurance lower as the insured ages thereby creating a level premium payment that is affordable later in life.  Premiums may start out much higher than an equivalent term policy, however, over time, permanent policies can turn out to be more cost effective due to the cash value accumulation.

Essentially, the insurer prices the premium payment so that a certain amount is applied to the cash values. As the cash values accumulate it decreases the risk to the insurer because the cash value becomes a part of the death benefit.  For example, a life insurance policy that starts out with a $500,000 death benefit obligates the insurer to that total amount. Over time, the cash value accumulates to, say, $100,000 which reduces the insurer’s obligation to $400,000.

If the cash value growth exceeds the insurer’s assumptions it may be possible for the insured to reduce the amount of the premium payment or stop it altogether by using the cash values to make the payments.

How Insurers Can Deliver on their Promise

The fact that, in the history of life insurance in the United States, there has never been a failure to pay a death benefit should instill confidence in anyone concerned with the financial security of their family.  Life insurance companies have been the bed rock of our financial industry for over a century. For those who may need additional assurances, the life insurance industry is heavily regulated and closely scrutinized by state insurance departments that impose extremely strict reserve and capital surplus requirements on all insurers. Insurers who fail any aspect of an annual audit are required to immediately increase their surplus and raise their reserve levels so that they can meet 100% of their financial obligations.  That’s how they have been making life insurance work for nearly 200 years.