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Quatloos! > Investment Fraud > Financial Planning > Guide to Insurance > Insurance Principles

Basic Insurance Principles

Ever wonder how an insurance company can charge a 30 year old person $25 per month for a $200,000 term life insurance policy? That sounds incredible. The insurance company is looking at the odds of anything happening to that 30 year old person and betting that before they have to pay out the death benefit the insured will cancel the policy, convert it to a whole life policy, pay higher premiums as the insured ages, or any number of other options. The insurance company also assumes there will be enough other policyowners that paying the death benefit, in the event the 30 year old dies during the policy period, will make a small dent in the funds the insurance company has reserved for such events.

Insurance is based on two principles: risk transference and the law of large numbers.

Risk transference, sometimes called ‘pooling’, involves the transfer of risk from the individual to a pool of the insurance company’s policyholders. The insurance company charges a fee, the premium (or part thereof), for accepting the risk and ‘pools’ the premiums from a group of policyholders into a general fund to fund the death benefits under contract.

For example, if 10,000 policyowners in the pool pay $1,000 each in annual premiums, the pool would amass $10,000,000 each year to cover claims resulting from losses. Should 500 members of the pool have losses during the year of $10,000 each, the pool would be able to reimburse the members for their losses and still accumulate a large amount of funds for later claims. In this particular case, new members would be brought into the pool and the remaining members would pay their next annual premiums to replenish and grow the pool of funds.

Keep in mind that a 30 year old person would pay a far less premium than a 60 year person for the same amount of insurance and the $1,000 figure above is only for demonstrating how the reserve for claims would grow.

The law of large numbers basically relies on the principle that the larger the pool, the more predictable the amount of losses will be in a given period. Since not all members of the pool are the same age or in the same health condition, we can assume not all of them will be making a claim at the same time.

In fact, by recording and studying the number of claims over a very large population, the number of 62 year old men, for example, who will die in a particular year can be fairly predicted. This is not to say the year a particular person will die can be predicted. It only says that in a given year there is a high probability that X number of men who are 62 will die at that age.

Accordingly, with enough data, a statistician can comfortably predict the number of persons of a given age who will conceive a serious illness in a given year. With enough data, the statisticians can assemble all of this information into tables. For deaths, the tables are called mortality tables and for sicknesses they are called morbidity tables.

All insurance is based on these two principles. A teenager commands a higher auto insurance rate because the statistical history has shown they have more accidents and the accidents are more serious than for a 40 year old driver. Homeowners located on the eastern seaboard of Florida have a higher incidence of losses than a homeowner located in Idaho and, statistically, should pay a higher insurance premium. It would not be fair to charge the Idaho homeowner additional fees to cover the costs of hurricanes in Florida, would it? A 40 year old man with two heart by-passes and who smokes statistically has less of a chance of living to age 70 than a 40 year old man who runs marathons. Again, this is not to say there will not be instances of a 40 year old marathon runner dying from heart problems or other causes but, statistically, those incidences will be less for the marathon runner than for the heart patient who smokes. Should both 40 year old men pay the same premium for the same amount of insurance coverage?

The application submitted by an applicant is extremely important to the insurance company. The application not only becomes essentially a legal document for purposes of recording what the insurance company knew about the applicant when the insurance company assumed the risk it is very important to the underwriter in rating the insurability of the applicant(s). There are generally rules within the policy to address errors, omissions or falsehoods provided on the application.

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This material contains only general descriptions and is not a solicitation to sell any insurance product or security, nor is it intended as any financial or tax advice. For information about specific insurance needs or situations, contract your insurance agent. Our articles are intended to assist in educating you about insurance generally and not to provide personal service. They may not take into account your personal characteristics such as budget, assets, risk tolerance, family situation or activities which may affect the type of insurance that would be right for you. In addition, state insurance laws and insurance underwriting rules may affect available coverage and its costs. If you need more information or would like personal advice you should consult an insurance professional. You may also visit your state’s insurance department for more information.

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