Understanding Life Insurance Principles: How It Works

Life insurance operates on some basic principles common to many individuals. How the policy works is actually a function of the fact that many individuals come together as a group, and each person shares in the risk of death of the other people in the group. Life insurance companies manage this risk quantitatively and provide an organized structure for the transfer of risk from one individual to a large group of individuals.

Law of Large Numbers

All life insurance policies operate on the principle of the law of large numbers. Insurance companies must use a large sample size of the population to predict death rates. While no one single person's death can be predicted, the law of large numbers allows insurers to predict death rates by looking at a large group of people. A large sample size means that a probability can be predicted as a percentage of the population. Insurers have gotten to the point where they can predict death rates every year with very good accuracy.

Insurable Interest

Life insurance requires the principle of insurable interest. The person who is insured under the contract must have some kind of personal relationship to the policyholder. In order to purchase insurance on the life of another person, you must have a personal and economic interest in the other person's life. A person buying life insurance on the life of a stranger is doing nothing more than investing in the other person's death. Life insurance companies would not be able to accurately predict mortality rates if this was allowed to occur, and if their contracts were allowed to be used for unethical or illegal purposes, such as buying a life insurance policy on someone and killing them or having them killed.

Transfer of Risk

The transfer of risk is essential to life insurance. You do not retain the risk of death in your life insurance policy. Instead, this risk is spread out among all policyholders that the insurer does business with. All customers of the insurance company contribute money to the general account. This money is invested, and then claims are paid out when an individual from the group dies.

Perfected Savings

Jesus Huerta deSoto describes life insurance as a perfected savings. You purchase a death benefit for your family's future. However, the contract actually matures at a predetermined age, or after a preset time. With permanent insurance, this is most obvious. A whole life insurance policy, for example, matures at age 100. If you die prior to this age, the insurer pays the money to your family. But, the policy builds a cash reserve during your lifetime. If you live to age 100, the cash reserve equals the death benefit and the insurer pays out the death benefit to you.