The following is an excerpt from Questions and Answers on Life Insurance: The Life Insurance Toolbook.
Life insurance is a type of insurance that pays money when someone passes away. That’s simple. However, to understand what life insurance is today you should look at how life insurance originated. Life insurance is one of the very oldest types of insurance/financial products in existence. It stems from the old principle that if a villager’s house burned down, the other villagers would help to rebuild the house.
The first life insurance came from this concept. Then a concept known as the tontine annuity system was founded in Paris by the 17th century Italian-born banker Lorenzo Tonti. Although essentially a form of gambling, this system has been regarded as an early attempt to use the law of averages and the principle of life expectancies in establishing annuities. Under the tontine system, associations of individuals were formed without any reference to age, and a fund was created by equal contributions from each member. The sum was invested, and, at the end of each year, the interest was divided among the survivors. The last remaining survivor received both the year’s interest and the entire amount of the principal.
However, as the amount of money that people wished to be insured for increased, and the risk potential for violent fluctuations for those involved increased as well.To minimize this effect,it was necessary that the law of large numbers be applied to this situation.This is where we see the first roots of the actuarial practice. An actuary is a mathematician employed by an insurance company to calculate premiums, reserves, dividends, and insurance, pension, and annuity rates, using risk factors obtained from experience tables. These tables are based on the company’s history of insurance claims as well as other industry and general statistical data.
This is an example of the principle known as the Law of Large Numbers. This principle states that the greater the number of similar exposures (in this case—lives insured) to a peril (e.g. death), the less the observed loss experience will deviate from the expected loss experience. Basically, the more people that the risk is spread out over, the more money (premiums) will be coming in. So, when a person does die, it will not be as big of a burden to the rest of the insureds. Of course, in certain circumstances, there will not be much that can be done.
The function of insurance is to safeguard against misfortunes by having the losses of the unfortunate few paid for by the contributions of the many that are exposed to the same peril. This is the essence of insurance—the sharing of losses and, in the process, the substitution of a certain small “loss” (the premium payment) for an uncertain large loss. (Reference—Black, H. and Skipper, K.; Life Insurance, Twelfth Edition, Prentice Hall (Englewood Cliffs, NJ), p. 18)
Life insurance, like any other financial product, is a tool to assist you in accomplishing a specific goal (or goals). As such, it will assist the beneficiary when there is an economic loss, due to the death of the insured that extends well beyond just funeral or final medical expenses. The loss of future income, due to the death of a breadwinner, can have a severe impact on the lifestyle of the surviving family members. Debt owed by the deceased may become due and payable as well as possible estate or inheritance taxes. Life insurance can create an immediate source of funds to enable the payment of these expenses and to provide a source of future income.
Benjamin Franklin helped found the insurance industry in the United States, in 1752, with the Philadelphia Contributionship for the Insurance of Houses from Loss by Fire.The current state insurance regulatory framework has its roots in the 19th century, with New Hampshire appointing the first insurance commissioner in 1851. Insurance regulators’ responsibilities grew in scope and complexity as the industry evolved. Congress adopted the McCarran-Ferguson Act in 1945 to declare that states should regulate the business of insurance, and to affirm that the continued regulation of the insurance industry by the states was in the public’s best interest.
The purchasing of life insurance is an uncomfortable task for many people, and the image of most life insurance advisors leave something to be desired with examples such as Bill Murray in Groundhog Day and Mel Brooks in High Anxiety.Typically, there is recognition of an obligation to protect one’s dependents from the financial hardship of an untimely death, but no one likes to think about the fact that they will die someday. This is another reason—aside from the potential discomfort of dealing with a life insurance advisor—that can make it easy to delay and put off the decision to purchase life insurance.
Keep in mind as you go through this process that life insurance is not for you, it is for your survivors. Therefore, you typically will only have a need for life insurance when you are leaving behind someone or some entity that is dependent on your income.
Great summary of life insurance. Seems like this must be an excellent book.
Posted by: Doug Warshauer | September 09, 2010 at 07:29 AM
"Therefore, you typically will only have a need for life insurance when you are leaving behind someone or some entity that is dependent on your income."
While the entirety of the article is interesting and informative, the idea quoted above is pervasive and, in my opinion, results in way to many housewives and stay at home moms or dads who are uninsured or underinsured. Those men and women are contributing so much to their families and even though it is not traditional income, the work they do is something that would have to be paid for by the family if that person passed away. I think it would be a mistake to read this article and walk away thinking that if you don't have income, you don't need insurance.
Posted by: Jen | September 09, 2010 at 08:50 AM
Jen --
I think you are correct. But I think a stay-at-home mom or dad fits into their line of thinking. After all, families are dependent on the "income" of the one who stays at home (even though there is no actual income -- they are dependent on their work.) This is why we have life insurance on both me AND my wife.
Posted by: FMF | September 09, 2010 at 09:08 AM
For those who have maxed the traditional retirement accounts (IRA's, 401K's, SEP's, etc) and have no consumer debt and more income to invest for a LONG PERIOD of TIME (caveat), there are SEVERAL types of permanent insurance that ALSO are EXCELLENT investment vehicles to compliment the traditional ones above. In the past 10+~ years, life insuranc investments have typically WAY outperformed traditional equity invetments. Glad I've owned permanent life insurance since 1987! Surprised that LI as a investment alternative often isn't talked much here but, if the audience isn't the market (high earning professionals -typically), LI often gets passed by, that's too bad as permanaent whole life insurance was the first "type" of life insurance sold. Many companies have been around almost 200+~ years!
Posted by: JeffinwesternWa | September 09, 2010 at 11:55 AM
If one buys a life insurance, here are some additional tips that can be very useful:
1. Do some research prior to purchase ( do your homework)
2. Check company’s financial health
3. Company size, time in business
4. Company’s history of complaints
5. Seek assistance from Insurance professional
Posted by: California Casualty | September 09, 2010 at 03:31 PM
The above reference to California Casualty is incorrect and needs to be removed. The url referenced does not belong to California Casalty and we do not sell life insurance. If you are the author of this post please remove.
Posted by: California Casualty | September 14, 2010 at 04:48 PM
This is an interesting post on the origins of life insurance. Like the author says, many consider buying life insurance a morbid task because of its implicit connection to one’s death. But purchasing a life insurance policy is one of the most crucial financial decisions of an individual’s life as it secures the future of those who survive him or her.
If you have people who depend on your income to provide for them, just think of the impact on their lives if you’re no longer around. The more your financial obligations, the greater is your need for a life insurance policy so your loved ones are taken care of should something happen to you.
Denise at AccuQuote
Disclaimer: I work for AccuQuote and this is my personal opinion.
Posted by: [email protected] | September 20, 2010 at 10:16 AM