How Life Insurance Works

Sean Jameson is the marketing manager of a large toy manufacturer. He is a family man of 40. His wife Cindy is a part-time assistant at a local supermarket. Their children Cheryl (14), Adrienne (12) and Bart (6) are enrolled at a private school.

The Jamesons own two cars, a modern home and have some savings. The house is mortgaged to the bank and the cars have been financed through the bank's Motor Finance division.

Sean was already running late for the regular Monday morning management meeting when he received a call from the bank's broker. He hastily agreed to a meeting with the broker.

The meeting took place at the Jameson's home in the early evening. Sean and Cindy were brought face to face with the bare facts. If anything happened to Sean, the family would be all but destitute. Their savings would last a year at most and Cindy would probably lose the house and cars. The private school would have to go.

This huge risk could be covered by a life insurance policy. The needs analysis' revealed that a capital sum of at least $1 million will be required as an investment to ensure that the family could maintain their lifestyle in the event of his death. The broker's plan will provide the required capital. A part investment, part life cover mix. In just 25 years the premium of $1000 per month will have turned into an illustrated $1 million and the family will be protected. The premium will increase by 5% each year. In addition, the policy would include disability cover at no charge! The broker completes the form, Sean signs and undergoes the required medical tests.

The policy is known as a 'universal life' policy. At the beginning, a significant portion of the premium is used to cover life insurance, and the remainder (after expenses) is invested. As the investment portion grows, the requirement for life cover diminishes.

The life insurance company uses mortality tables to calculate the risk of Sean dying within the next year. These tables show the proportion of people that die at each age. Between the ages of 40 and 41, roughly 0.2% or 2 out of every 1000 people of that age die. The statistics vary from country to country, by gender and by race. For a white male the risk is 0.25% or 2.5 per 1000. Females have a much lower chance of dying! As the age increases, so does the risk.

Being healthy, Sean's risk of dying is actually less than that of the general population.

The risk of death for the first year is 0.25% or 1 in 400. The cost of $1m life cover for the year is $2,500 or $208.33 per month. The insurance company need to do more than simply break even. So the odds are changed to favour the insurance company. Life cover is charged at 0.4% - $4000 for the first year. Broker's commission is paid at 85% of the first year's premium - $10,200. Expenses are calculated at an additional $134 per month. So the first year's costs amount to $15,808 (Risk Cover $4,000 + Commission $10,200 + expenses $1,608) from the $12,000 premium. At the end of year 1, the policy shows a shortfall of $3808. In the second year some funds will become available for investment. Commission, expenses and the margin on life insurance may vary according to the company and the country, but the principle is the same.

5 years later Cindy has a shock visit from the police. Sean has been killed in a terrible motor accident. The family are devastated. The life company are informed and a claim initiated. But the family are in for another shock. Under huge stress at work, Sean had taken to smoking a few months earlier. He did not think of telling the insurance company. The insurance company discovered this and refuted the claim on the basis of non-disclosure. Sean had been covered as a non-smoker.

Non-disclosure refers to anything that could materially affect the risk but is not disclosed to the insurer. Smoking is one of these risks. Others would be undisclosed health history. Had Sean told the life company, the family would have been paid the $1m. Had Sean lived, the investment portion would have grown.

Life insurance can be seen as a wager. The premium is the bet. The risk-cover the prize. As long as the premium is paid, the cover will remain. The client wins if he dies as long as he has disclosed everything.