Life Assurance / Life Insurance

Life Assurance or Life Insurance, is a type of insurance policy where the insured element is contingent upon human life.

The term life insurance is common in the US, where the term life assurance is common in the UK. Although these terms are often used interchangably there is a difference in meaning which is discussed below.

Life based contracts tend to fall into two major categories:

Protection policies - designed to provide a benefit in the event of specified event, typically a lum sum payment.
Investment policies - where the main objective is to facilitate the growth of capital by regular or single premiums.

What is Life Assurance/Insurance?

As with all most insurance polices, life assurance is a contract between the insurer and the policy owner (policyholder) whereby a benefit is paid to the policy owner if an insured event occurs which is covered by the policy. To be a life policy the insured event must be based upon life (or lives) of the people name in the policy.

Insured events that may be covered include:

death,
diagnosis of a terminal illness,
diagnosis of a critical illness,
disability due to ill health,
permanent disability,
accidental death or
requirement for long term care. (This list is not exhaustive).
Life policies are typically presented as types legal contracts and the terms of the contract describe the limitations of the insured events. Specific exclusions are often written into the contract to limit the liability of the insurer; for example claims relating to war, riot and civil commotion.

Underwriting

The insurer will collect pertinent information about the life (lives) to be insured and have an underwriter assess the information to establish if the likelihood of a claim for a given individual is above average. The information is typically a series of facts relating to age, lifestyle habits and medical history. The likelihood of death is referred to as mortality the likelihood of ill health is referred to as morbidity.

It is a general principle that life contracts are written on the basis of utmost good faith. That is, the proposer and the insurer both accept that the other is acting in good faith. In practice this means the proposer can assume the contract offers what is shown prima facie without having to fine comb the small print and the insurer assumes the proposer is being honest when providing details to underwriter.

When does Insurance become Assurance?

When a person insures the contents of their home they do so because of events that might happen; fire, theft, flood etc. Insurance is a way of spending a little money to protect against the risk of having to spend a lot of money. The point is, when a person insures their home contents they do so to provide protection against something that might happen. They hope their home will never be burgled, or burn down but they want to ensure they are financially protected if the worst happens.

When a person insures their life they do so knowing that one day they will die. Therefore a policy that covers death is assured to make a payment. The policy offers assurance on death; even if the policy has prescribed termination date the policy is still assured to pay on death and therefore is an assurance policy. Examples include Term Assurance and Whole of Life Assurance. An accidental death policy is not assured to pay on death as the life insured may not die through an accident, therefore it is an insurance policy.

A policy might also be assured for other reasons. For example an endowment policy is designed to provide a lump sum on maturity. Under certain types of policy the lump sum is guaranteed. Therefore, this may also be called an assurance policy.

The test of whether a policy is assurance or insurance is that with an assurance policy the insured event will definitely occur (at some point) whereas with an insurance policy their is a risk the insured event might occur.

Definition of Insurance

Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of potential financial loss. Insurance is defined as the equitable transfer of the risk of a potential loss, from one entity to another, in exchange for a premium and duty of care.

Principles of insurance
The timing or occurrence of the loss must be uncertain.

The rate of losses must be relatively predictable: In order to set premiums (prices) insurers must be able to estimate them accurately. If the coverage is unique, the insured will pay a correspondingly higher premium. Lloyd's of London often accepts unique coverages. (e.g., the insuring of Tina Turner's legs and Jennifer Lopez's behind)

The losses must be predictable on a macro level: Insurers need to know how much they would be required to pay when the insured-for event occurs. Most types of insurance have maximum levels of payouts, but not all do, notably health insurance.

The loss must be significant: The legal principle of De minimis dictates that trivial matters are not covered. Furthermore, rational insurance uses existing insurance when the transaction costs dictate that filing a claim is not rational.

The loss must not be catastrophic: If the insurer is insolvent, it will be unable to pay the insured. In the United States, there exists a little-known system of Guaranty Funds to reimburse insured people whose insurance companies have become insolvent.This program is run by the National Association of Insurance Commissioners (NAIC).

Indemnification

An entity seeking to transfer risk (an individual, corporation, or association of any type) becomes the 'insured' party once risk is assumed by an 'insurer', the insuring party, by means of a contract, defined as an insurance 'policy'. This legal contract sets out terms and conditions specifying the amount of coverage (compensation) to be rendered to the insured, by the insurer upon assumption of risk, in the event of a loss, and all the specific perils covered against (indemnified), for the term of the contract.

When insured parties experience a loss for a specified peril, the coverage entitles the policyholder to make a 'claim' against the insurer for the amount of loss as specified by the policy contract. The fee paid by the insured to the insurer for assuming the risk is called the 'premium'. Insurance premiums from many clients are used to fund accounts set aside for later payment of claims - in theory for a relatively few claimants - and for overhead costs. So long as an insurer maintains adequate funds set aside for anticipated losses, the remaining margin becomes their profit.

How an Insurance Company makes money

A customer might pay one or more premium payments over time. The company collects these payments from one or more customers. If something happens which triggers a claim, the company then pays out a certain amount of money. If, during the lifetime of all of the company's insurance contracts, it pays out less than it has taken in, it makes what is known as an underwriting profit. One measure of an insurance company's performance is their loss ratio (incurred losses and loss-adjustment expenses divided by net earned premium). The loss ratio is added to the expense ratio (underwriting expenses divided by net premium written) to determine the company's combined ratio. The combined ratio is a reflection of the company's overall underwriting profitability. A combined ratio of less than 100 percent indicates a profit, while anything over 100 is a loss. One company that is famous for achieving underwriting profit is American International Group. Berkshire Hathaway, by contrast, is famous for making its money on "float" rather than underwriting profit. Float is the concept that as insurance premiums are collected up front, and claims paid over time (sometimes up to periods of 10 years or more), the insurance companies are able to collect investment income on the money they have reserved for claims that have not occured yet, or have not yet been paid. Over time, this interest is compounded into significant dollars, particularly for a company as large as Berkshire Hathaway.

In many cases a company's combined ratio is greater than 100 percent, however the company still manages to make money. This is because in between the time the company collects premiums and when it pays out claims, it can invest that money. The return from these investments may offset an underwriting loss resulting in profit. For example, if a company has to pay out 10 percent more than it took in, but made a 20 percent return on its investment, then it made a 10 percent profit. However, since most insurance companies consider it only prudent (and may be mandated to do so by laws controlling insurance businesses in the territory in which they operate) to invest in risk-free government bonds, or other lower risk and lower return forms of investments, it's important that the extra amount it has to pay out compared to what it has to take in is less than the percent return of these investments. If it isn't, the company loses money. The extra amount that a company has to pay out can be considered a "cost of funds" and be compared to an interest rate of the same company borrowing money. Because of this, most insurance companies don't have a goal just to have any amount of profit over the cost of funds, but rather to have this cost of funds to be lower than what they would have been able to get by borrowing somewhere else. If this isn't the case, the insurance company does not add any value to their owners, who theoretically could have borrowed money from somewhere else and made the same investments themselves.

Determination of Insurance Rate Structures

The insurer uses actuarial science to quantify the risk they are willing to assume. Data is generated to approximate future claims, ordinarily with reasonable accuracy. Actuarial science uses statistics and probability to analyze the risks associated with the range of perils covered, and these scientific principles are used by insurers, in conjunction with additional factors, to determine rate structures.

For example, many individuals purchase homeowner's insurance policies by signing a contract paying a premium to an insurance company. If a covered loss occurs, the insurer is obliged by the terms of the contract to honor the insured's claim. For some policyholders, the amount of insurance benefits received from their insurer will greatly exceed the expense of premiums paid. Others may never make a claim or receive any benefit other than the peace of mind rendered by the security of an insurance policy. When averaged, the total claims expense paid by an insurer should be less than the total premiums paid by their policyholders, with the difference allocated to overhead and profit.

Insurance companies also earn investment profits. These are generated by investing premiums received until they are needed to pay claims. This money is called the 'float'. The insurer may make profits or losses from the value change in the float as well as interest or dividends on the float. In the United States, the underwriting loss of property and casualty insurance companies was $142.3 billion in the five years ending 2003. But overall profit for the same period was $68.4 billion, at the result of float. Some insurance industry insiders, most notably Hank Greenberg, do not believe that it is forever possible to sustain a profit from float without an underwriting profit as well.