Life Insurance Decoded
A Sense for Money
After talking about debts at great length in the past weeks, this week we are going to take a closer look at life insurance: What life insurance is, how it works, who needs it and who does not need it. In our next post on insurance, we’ll look at the different types of life insurance policies available, how they can be best used and which type provide the best value.
Essentially, life insurance is a contract with an insurance company to pay out a cash sum when we die within a defined period of time. The insurance company will calculate the risk of any one individual dying during the agreed time period (length of cover), and charge money (the premium) to cover that risk. For a basic life insurance policy, if the person insured doesn’t die then they have paid their premium for the sole benefit of having the peace of mind they had, but if they do die, the insurance company will normally pay out far more than the premium they have received from the insured to his or her beneficiaries.
So, why do we need life insurance? Well, to be blunt, we all know that we are going to die at some time. It’s just that we just don’t know when that time will be. If we knew when we were going to die, there would be no need for life insurance (or savings for that matter). We’d simply arrange our affairs so that on the date of death, we had no liabilities and probably no savings, as we wouldn’t be around to spend the money. Therefore, we can use a life insurance policy to prevent the financial shocks caused by our untimely death.
An interesting question then, is how does an insurance company calculate how much to charge for a life insurance policy? Well, they will compile a “mortality table,” which is a statistical record of many items including the age that people die, their occupation and the cause of death. From this table, the company will be able to calculate the statistical chances of any individual dying at a given age. From the table, the insurance company will see that smokers tend to die earlier than non-smokers and that certain occupations are more dangerous than others.
For example, the insurer will see that a non-smoker who works in an office is likely to live longer than a construction worker who smokes and works on a building site. Therefore, the premium for insuring the construction worker will be more than the premium for the office worker for the same amount of insurance benefit.
Another interesting concept is called “insurable interest.” This states that one individual can only insure the life of another individual if they have some financial “interest” in the individual staying alive and therefore some financial loss if they were to die. Without the need to have an insurance interest, there would be too much temptation to insure the life of a complete stranger and claim on the policy when they met with an unfortunate “accident.” So, a wife can insure her husband or a businessman can insure a business partner as they both are financially dependent upon the husband and business partner staying alive and making a financial contribution to the home and the business.
Let’s look at an example of a family where the husband and wife both work and generate the family’s income. They have two children at school hoping to go to university, a mortgage on their home, a loan on a car and all the usual household expenditures. They manage to pay all the bills, but they don’t have any savings. So, if either the husband or the wife were to have an accident or health problem that resulted in their death, the family would suffer in some way, as on a single income they couldn’t pay all the bills and something would have to be sacrificed; maybe the car, or the house or even the university education.
For this family, buying a life assurance policy makes a great deal of sense. If either of the parents died, the insurance company would pay a lump sum of cash that could be used to either repay some of the loans and so reduce the need for income, or be used to replace the lost income. The devastation of losing a partner/parent is clearly terrible in itself, without the need to have to then find additional money to pay the family’s bills. In this case, the small premium to pay for a life insurance policy is probably money well spent.
If you don’t have anyone who is financially dependent upon you, no children, no brothers or sisters or spouse relying on you, and your parents have made their own financial arrangements, it’s still worthwhile to think about your own wellbeing and how you will provide for yourself. Insurance is one option and there others as well. We will discuss this in more detail in the next post.