How Does a Life Insurance Policy Work?

The Purpose of Life Insurance

Life insurance may seem like a concern of only modern society, but the idea has been around in some form since the days of ancient Rome. The reason for the concept's longevity is that in any society where people work and raise a family, death can be a dramatic financial, as well as emotional, setback. In those early Roman days, people actually collected money to help pay for the deceased's funeral expenses. Today, we purchase a life insurance policy that will cover those costs, as well as many other expenses, including medical bills and a home mortgage.

Choosing & Buying Life Insurance

Life insurance has become more complicated over time. You can find a variety of insurance options and must contend with complex legal jargon in most policies. The basics, however, are fairly straightforward. Life insurance comes in two primary groups: whole life or term. If you choose whole life insurance, the policy is expected to cover the rest of your life. If you choose term life insurance, the policy will cover a smaller period, such as 5 to 10 years. After the policy term ends, you will need to renew it or purchase a new policy for coverage. When you purchase a policy, you are expected to pay ongoing premiums. The premium is paid once a month, once every three months or once every year. As long as the premiums are kept current and your policy has not expired, your beneficiary will receive the stated amount of benefits in your policy upon your death. For example, if you purchase a $100,000 policy, your beneficiary will receive that amount after your death.

The Principles behind Life Insurance

To understand life insurance thoroughly, you also need to understand some of the underlying ideas on which the current insurance system is based. For example, shared risk is one of the biggest of those principles. When a larger group of people share a risk, the risk is minimized for everyone involved. With insurance, that risk is financial. By lumping together the premiums for thousands of people and wisely investing them, the company minimizes its risk of financial loss when someone dies before paying into his policy for very long. Another principle is known as predicted mortality. This idea is that we can determine approximate life expectancy for people based on hundreds of years of medical record-keeping on health and lifestyle factors. By being able to make a life expectancy determination, life insurance companies can determine the financial risk they face when offering a policy to someone. That level of risk is the basis for determining premiums.

How Risk Affects Premiums

Edmund Halley, the person who identified Halley's Comet, was the first to create risk assessment charts for life insurance premiums. Although he is not as well known for this feat, this has more impact on most of us than his comet findings. When you attempt to purchase life insurance, the company will ask you questions and may require you to complete a brief medical examination. These factors include your health, your occupation, your age, your lifestyle and your hobbies. Once your risk has been assessed, you will be placed in a specific underwriting class: preferred or preferred plus policy holders pay the lowest premiums, standard is the class where about 75% of the population ends up, and special rating applicants must pay higher premiums. Smokers and people who have only recently quit smoking will pay higher premiums than nonsmokers. Also, some people will be rejected for life insurance policies because they are considered too high-risk. This category would be people with prior serious medical conditions (a heart attack or cancer, for example). Of course, your premiums will also be higher based on the amount of financial coverage you want. The lower your risk factors, however, the more coverage you will be able to purchase.

Resources

• Basics of Life Insurance