Sometimes, it’s good to go back to the basics. What is insurance and how does it work? By really understanding these two questions, we can make better decisions when choosing term life insurance or any insurance for that matter. So let’s go back to the basics and understand how insurance works and more importantly, how it can work for you.

Insurance has been around centuries in one form or another and has really exploded into so many variations and types that it can be overwhelming. From Property and Casualty to Health to the one most relevant to our decision, life insurance…insurance can be bought on most things and situations these days. Before we become overwhelmed with the options, let’s go to the heart of how insurance functions.

Insurance is based on the premise that a given situation, whether it’s the death of a financial provider (life), a catastrophic illness/injury (medical), or a tragic house fire (property and casualty), would so adversely affect a person or group of people financially, they would be unable to recover. It is a catastrophic loss that any given individual cannot financially survive. How do we do deal with that. Life insurance typically involves a great deal of money as we may need to replace the potential income from an earner over decades. Health insurance bills can run hundreds of thousands….even millions of dollars. The total destruction of a person’s house can also be hundred’s of thousand or millions of dollars. These are big numbers and society needs a tool to somehow offset these situations which although rare, do occur to individuals within a group. The answer is insurance.

Insurance, whether it’s term life or some other type has a simple premise and promise. If we can group many individuals together (the more the better), then we can spread an individual’s risk of a catastrophic situation occurring among the whole group. We never know for certain which individual it might happen to which is why we need insurance in the first place. There is however, a probability or percentage chance for any one individual based on historical data. If for a given population, 1 person out of 1000 dies from age 40-45 each year, we now can calculate how much to charge each individual in that group of 1000 people for a certain level of benefit. Let’s say for $100,000 of benefit to paid out in the even that a person dies, we know we can divide the $100K by 1000 (number of people) and then charge each individual $100/per year. 999 of the people will pay $100 and not receive a benefit but the one person who passes away will be able to pass $100,000 down to their beneficiaries. This in a nutshell, is the core functioning of life insurance and indeed, insurance itself.

The more people we have in the pool, the better. Let’s say there is a really bad year where five people in that “risk pool” die. The premium would become $500 or five times the original amount. That’s too much volatility. Or let’s say 1 person in a risk pool of 10 individuals dies. The premium then becomes $10,000. That doesn’t work either. The way to address either situation is to have 100,000’s or millions of people in the risk pool. This way, the odd years or spikes in probability are smoothed out for a more stable premium.

The life insurance carriers in this situation try to best estimate risk, probability, and premium so that they attract as many people as possible into the pool. If they can successfully do this, they are able to add a small percentage to the premium to both operate their business and have a profit (if they are a Stock Company model). The carriers have also taken this core design and tweaked it over the years with add-ons such as Riders or certain Exclusions that either augment or protect the original risk assessment.

Why is it important to go back to the basics? Well for one, you now will have a better understand of why term life insurance might be a better or more pure form of insurance than whole life or annuities. Insurance is about risk…not investment. There are better ways to invest than through life insurance as we discuss in detail at our Term versus Whole life insurance article.

We hope this helps give you a core understanding of insurance. You can now compare and choose the right for you through our term life quoting engine as a final test!

About the author

Dennis Jarvis is a licensed insurance agent concentrating on term life insurance. Shop, compare, and instantly quote multiple carriers with professional guidance and resources.