Basic Principles Of Life Insurance
Here’s where things get a little more complicated. Yes, I know this section is titled “basic principles.” “Basic,” in this context, involves taking some of the basic ideas of insurance (which are laced with jargon to begin with) and translating them into plain English.
I won’t blame you for backing out of this section.
But, I will applaud you if you stick with it and I promise it will help you later on down the road.
This section is here mostly for folks who want to dig into the nitty-gritty details of how life insurance works, how the industry works, and some of the technical jargon that makes up an insurance policy contract.
OK, let’s dig in…
Basic Principles Of Life Insurance
Why Does This Matter?
The tl;dr version:
- Principles give you a broader understanding of a subject, but also allow for a deeper understanding. A principle is a fundamental truth or statement upon which other truths or statements depend. Understanding the basic principles of life insurance allow you to know general truths about all life insurance policies, which in turn will help you make better decisions about the types of policies you buy and how you use your life insurance contract before you die. It can also help you make better decisions about how you save, spend, and invest your money.
- The ultimate or primary purpose of life insurance is to create certainty out of the greatest uncertainty confronting an individual. Namely, the fact that almost everything in life (and even life itself) is a speculation and difficult (or impossible) to predict accurately – When will you die? Will you die before you’ve accomplished everything you want to accomplish? Will your business succeed? Will you accumulate enough savings to retire comfortably? Will your investments pan out as you hope? Will you save enough money to send your child to college or get them into a trade school? Will you have enough money for a vacation next year? Will your computer last another year before dying? Will you get into a car accident (totaling your vehicle) before it’s paid off? Will you be able to afford your insurance deductibles? Will you become temporarily or permanently disabled and unable to work? Will you develop a degenerative disease and be unable to work? Will you … Life insurance levels these financial uncertainties by providing a guaranteed sum of money now and for your future.
- Life insurance is for any productive individual who values their earning potential, income, and savings and believes it’s worth protecting against loss, whether from disability, illness, or death.
Hey! How They Do That?
There is a somewhat famous saying in the life insurance industry:
There is no magic, only magicians.
Life insurance seems part magic, part science, and all mystery.
Turns out, the life insurance industry is not really all that mysterious. It exists to manage financial risks and does this using two principles:
- Risk Pooling (or spreading) and;
- The Law Of Large Numbers
Insurers don’t need to use illusions, tricks, or gimmicks to accomplish their risk-diminishing feats… just math.
Risk pooling or spreading is the process by which a large number of people come together to share the cost of a common risk. Instead of one person bearing a huge cost at some unknown time in the future, lots and lots and lots of people come together to pool or spread that risk around.
Each person in the group pays a very small amount to receive a larger amount later.
For example, assume 10,000 individuals of the same social group or class (i.e. farmers or industrial laborers or doctors or professors, etc.) come together and agree that if any one of them in the group dies, then all members of the group will pitch in and pay for the deceased individual’s funeral costs and also give some money to the surviving family to pay their living expenses for a certain number of years.
The cost of any one funeral might be $15,000, for example, and… well… that’s a lot of money for one person to shell out all at once. On top of that, maybe family members of each individual in the group needs some money to pay for ordinary living expenses for a few months or a few years.
Combined, each individual in the group would need to come up with $100,000 in savings if they were to take on the risk of death all by themselves.
No way, Jose.
So… each member of the group agrees to put $100 per month into a general account for the group. That account will be professionally managed on their behalf by competent managers and contracts will be drawn up for each member in the group. The manager’s job is to collect the funds, invest them, and make sure each contract is paid as promised when members die.
Each member of the group knows exactly what his or her family will get, when they will get it, and so on.
Coming up with $100,000 all at once, suddenly, and at a moment’s notice is pretty hard. But, coming up with $100 every month is pretty easy.
By sharing the burden of saving up so much money, and spreading the risk of death over all 10,000 group members, the most anyone pays is $100 per month, but everyone is entitled to $100,000 when they die.
There is no gamble or risk because the managers of the general account promise to pay everyone’s family when their time comes.
This is the essential nature of risk pooling.
The Law of Large Numbers
Risk pooling alone doesn’t solve the problem of transferring, reducing, controlling, or eliminating financial risk.
In addition to spreading risk around, insurance relies on the principle of large numbers.
This principle says that the larger the number of individual risks in a group of people, and the more similar those people are to one another, the more certain the outcome is and the more reliable the prediction of death will be.
Without getting deep into the politics of insurance, it has been suggested that all you need to adequately spread risk around and predict an outcome is to group people by the communities they live in or… just offer everyone insurance without regard to any sort of formal medical underwriting or risk classification.
This. Does. Not. Work.
Simply grouping people together in a big “pool” gives insurance companies near-zero information content about how to price the risks they’re taking.
This is why life insurance companies use risk classes, which are determined (in part) by medical underwriting, which relies on the Law of Large Numbers to build accuracy into the underwriting process. It is an attempt to objectively quantify the risk an insurer is taking.
Life insurance companies do not know when you will die. But, they don’t need to know. All they need to know is how many people, on average, die within any given year.
They need to know what percentage of people in a given social club, group, or risk class die in any given year. For example, perhaps 2% of farmers die in any given year or maybe 5% of coal miners die in any given year or maybe 1.5% of office workers die in any given year.
Or… perhaps an insurance company knows that, on average, smokers die at twice the rate of non-smokers. Or… perhaps the insurance company knows that people, on average, with a high body mass index (BMI) and a waist circumference larger than 40 inches die at 5 times the rate of people with a lower BMI and smaller waist circumference.
Life insurance companies can calculate these percentages very precisely using the Law Of Large Numbers.
Over many years, and with enough groups of insured individuals who are similar to one another in some way, a life insurance company can predict (usually within a less than 1% error rate) the probability of death of not only the entire number of insureds on their books but also the percent of people who will die in every risk class and sub-group, for both males and females.
The number of deaths are counted and kept on file for many, many, years and… they become the basis for something called “mortality experience,” which is the number of insured individuals who die over a given period of time and the financial impact it has on the insurance company.
The Concept of Risk In Life Insurance
What Is Risk?
Let’s talk about risk, ba-by. Let’s talk about you and me. Let’s talk about…
Risk…is, always and everywhere, the measure of the uncertainty of loss (and only loss). Risk never measures the probability of gain.
I can’t tell you the number of times people have spouted nonsense on the Interwebs about how risk is equivalent to gambling.
no. No. NO.
Risk means “risk of loss.” There is no such thing as a “risk of gain.”
So, in life insurance, the primary risk being measured is the risk of losing one’s income due to death. Secondary risks that are measured include the risk of losing one’s income due to disability, chronic or terminal illness, and in some cases the risk of losing one’s savings (which is derived from your income).
In all cases, the risk measured is the risk of loss of your income.
Your income – which, in turn, is a measure of your current productive ability and future (earning) potential – is your most valuable asset. Losing it means losing, well, just about everything.
Which is why people buy life insurance.
But… people do not buy life insurance with the hope that they will gain more income (or savings) than they are capable of making through their own efforts.
And here is the crucial difference between gambling, investing, and insurance.
Speculative risk is a special type of risk in that it measures the risk of loss involved in gambling or investing. But because gambling and investing involve a possibility of gain, measuring speculative risk involves isolating the probability of loss within the wider context of an activity where there are both gains and losses.
The nature of speculative risk is that a loss may never materialize (thus, you may never get a chance to measure it or it may be very difficult to measure). Speculative risk is, generally, difficult (and sometimes impossible) to predict with a high degree of certainty.
For example, going to Las Vegas and betting it all on “red” is a type of speculative risk. You could lose everything. But, you could win a potentially unlimited amount of money (well, limited to whatever the house has in its vault and whatever the odds are on the bet).
If you lose, that loss can be measured. But, it cannot be measured beforehand. You can only analyze the risk you took after the fact. In other words, you can know what your risk was in the past, but not what it will be in the future.
And, if you win, there is no actual loss and thus nothing to protect against. Not only is there no loss to measure… you have experienced a gain. You have something you did not have (and could not get) before.
Something similar happens in the stock market. You may buy a mutual fund or a common stock of a publicly-traded company. The stock price may increase over time or… you may lose your entire investment.
What is the risk of loss there?
It can certainly be measured after the fact and in some cases, you can get a general idea of the risk you take beforehand, but… if you make money, the risk of loss evaporates. There is nothing to measure at that point. Again, not only is there no loss to measure… you have experienced a gain. You have something you did not have (and could not get) before.
This is why speculative risks cannot be insured against.
Pure risk involves only the risk of loss. Seems an awful lot like speculative risk but it’s different – way different. With pure risk, the probability of profit or investment gain is impossible.
For example, the risk of you being injured only measures the probability of losing your income due to the injury. There is no opportunity for you to gain or profit if you do not become injured. If you’re not injured, you would just go about your day as you normally would. You do not get something that you did not have before.
Similarly, the risk of you dying measures the probability of losing your income due to your death. If you don’t die, you do not experience a gain or profit over and above what you had before dying. You simply live your live the way you would have lived it. You don’t get something you did not have before.
What about the cash value of permanent life insurance policies, like whole life, universal life, and variable life insurance? Surely these represent a gain, don’t they?
It is true that whole life and universal life (and especially variable life) insurance cash values earn interest. And, it is possible to experience a real gain on the cash value of a life insurance policy.
However, in the Life Insurance Policy Basics section of this guide, I discussed the nature of death benefit and cash values. To reiterate, death benefits are comprised of both pure insurance and cash value. In other sections of this guide, I discuss how cash values grow relative to the death benefit of a policy.
Even when there is a gain in cash values, the death benefit is still a multiple of that cash value, and there is an insurance amount associated with the policy, thus… the principle of pure risk still applies – there is no gain on the insurance component of the policy.
The insurance is explicitly designed to make your beneficiaries whole for a loss of your income. In some cases, this insurance amount is adjusted for inflation or some other interest factor to reflect the time value of money. In the case of dividend-paying whole life, the insurance amount grows as dividends buy additional paid-up life insurance to reflect an increasing need or want for insurance protection.
When the cash value of a policy equals the death benefit, the policy is said to have “endowed” and the insurance ends. The insurance company is obligated to offer you payment of the cash value (which has now fully replaced the insurance amount).
So, again, the essence of “pure risk” is that there is no opportunity for profit or gain if the insured event does not occur (i.e. if your death does not occur).
This is why only pure risk is insurable.
Ways To Deal With Risk
Do you have to buy a life insurance policy?
No, of course not.
There are many ways to deal with risk.
You can avoid it. You can try reducing your risks. You can retain risk and plan for it. Or, you can transfer risk away from you and have someone else deal with it.
Risk avoidance is where you try to get rid of risk by avoiding risky behavior. For example, you can become a hermit and not drive or own an automobile, never fly, don’t go outside for a walk or run, and never interact with people. This eliminates a lot of risk.
Is it practical?
Another way to deal with risk is to try reducing risky behavior or activities in your life (sounds boring already, doesn’t it?).
Risk reduction methods would include installing smoke detectors in your home to reduce the financial risk (and even the absolute risk) of a fire burning down your home. You might buy a low-powered vehicle with extra safety features to reduce your risk of being injured in an automobile accident. Or, you might install a security system in your vehicle or home to reduce the risk of theft.
Sometimes, risk reduction makes sense. Sometimes, it doesn’t.
For example, not everyone can afford to live in gated communities, or buy the most expensive (and safest) vehicles, or attend the best colleges. Lifting weights, doing some cardio, and eating a healthy, balanced, diet might reduce your risk of certain diseases, but not everyone is willing to go through the effort of working out and eating healthy.
This is where risk retention comes into play.
Risk retention means you take on the risk yourself, but you plan for it by establishing some kind of savings fund designed specifically to deal with the risk you want to take on.
For example, if you were to retain the risk of getting into a car accident by saving up enough money to repair or replace your vehicle, you could avoid buying collision insurance. However, you would have to dedicate your savings for this purpose and would not spend it on something else (otherwise, you are not retaining the risk).
Some people call this “self-insurance.” Black’s Law Dictionary is very specific on this issue. While “self-insurance” is sort of a “layman’s term,” there is technically no such thing as “self-insurance,” since insurance means transferring risk away from you and onto someone (or something) else.
Which brings us to risk transference.
Risk transference is the process of transferring risk away from you. The most common way to do this is to buy insurance.
Transferring the risk of your death away from you doesn’t mean you’re reducing your risk of dying. It simply means you’re transferring the financial risk of loss away from you. You are paying the insurance company to deal with this financial risk.
You are trading an unknown future risk (your death) for a known premium payment.
Sweet! I Can Haz Insurance Now?
Hold your ponies.
Before you can get life insurance, the insurance company needs to know that the risk you want to insure is actually insurable.
Some risks aren’t insurable.
Remember when I said that insurance companies only insure “pure risk” Life insurance companies want to make sure they’re able to insure your life before they agree to anything.
Even though insurers can only insure pure risks, not all pure risks are insurable.
No, that’s not a typo and no it’s not a contradiction… though I admit it can be a little confusing to understand… at first.
You see, insurance companies look for certain characteristics or elements before they agree to underwrite and insure you.
First of all, the loss to them cannot be catastrophic. So… while you might want to buy $50 trillion of life insurance, that might be a catastrophic loss to an insurer and they’ll tell you to go pound sand.
The risk of death also has to be due to chance. No suicides (at least not in the first 2 years of the policy).
And… your health. You must be healthy enough to be insurable. No terminal illnesses or chronic illness which would make it impossible for the insurer to underwrite your life.
Insurance companies constantly battle something called “adverse risk selection.” Meaning, there is a tendency for sick people (or people with poor general health) to try to get insured or keep their existing life insurance policies (even term insurance after the level premium period is over) because they know they cannot qualify for a new policy.
Fortunately, insurers are good at controlling for adverse risk selection.
All this to say… you need to be underwritten before you can haz life insurance. And, there are different ways to be underwritten and… different types of companies you can be underwritten by.
Types of Life Insurance Companies That Will Underwrite You
There are basically two different types of insurance companies you can buy life insurance from.
Stock companies are the most common form of insurance company. A stock company is a publicly-owned insurance company. Like any other private organization that’s publicly-owned, stock life insurers issue shares of stock, which you can buy on most major stock exchanges.
It’s structured the same as any other corporation in the U.S. Stock holders of a publicly-held insurer may or may not also be policyholders. Generally, there is no strong correlation between the owners of the company (the stockholders) and the customers of the insurer (the policyowners).
When a stock company declares a dividend, it is paid to the company’s owners – the shareholders (just as it is with any other publicly-traded company). The primary responsibility of the directors and officers of the insurance company is to the owners of the company – the shareholders.
Policyholder interests have to be balanced with the wants and needs of the shareholders, but… in any dispute between shareholders and policyowners, the shareholders’ interests take priority.
A mutual insurance company is also incorporated but has no shareholders. Instead, the mutual insurance company is wholly-owned by its policyowners. The officers and directors of the company have a single responsibility to policyowners and no one else.
When you purchase insurance from a mutual insurance company, you become both a customer and owner of the company. As such, you are entitled to vote for members of the board of directors and thus… you can influence the direction of the company and its management for your benefit.
Some mutual life insurers sell participating insurance policies. These policies participate in the insurer’s investment activities and policyowners receive a share of the company’s earnings each year. This is done through a dividend payment, which can be paid in cash or used to purchase more insurance (thus increasing ownership rights in the company).
Legally, dividends are defined as a refund of the portion of premiums which are left over after the company deducts operating expenses and expenses related to claims and sets aside money for policy reserves.
But… dividends also include a share of the company’s operating profits, investment gains, and mortality savings. In the early years of the policy, dividends received are typically less than the premium paid. However, eventually, dividends can exceed total premiums paid into the policy.
Mutualization and Demutualization
Occasionally, a mutual life insurer will choose to demutualize and… a stock company might decide to mutualize. In other words, mutual companies can become stock companies and stock companies can become mutual companies.
One of the most famous examples of this is MetLife. MetLife used to be a mutual insurance company which demutualized in 2000. In some cases, there is a risk that an insurer will stop paying dividends to whole life policyholders because the company is no longer necessarily owned by its policyholders. Although MetLife demutualized, it continued to pay dividends to its whole life insurance policyholders.
That being said, it is very unusual for a mutual life insurer to demutualize. There is some evidence, and at least one study, which shows mutualization (moving from a stock company to a mutual company) improves operational efficiency (Ownership structure and control: The mutualization of stock life insurance companies, David Mayers and Clifford W. Smith, Financial Review 16(1):73-98 · June 1984).
Executives, and the board of directors for most insurance companies, are also reluctant to back out on previous promises made under a mutually-owned company. Not only can it create a PR nightmare, it tends to hurt business. Perhaps more so than most corporations, life insurers continue to build their business on trust and by building long-term relationships with their policyholders (since it generally takes an insurer 10 to 15 years to profit from most life insurance policies, it makes little sense for the company to risk the trust of its customers).
Insurance For Your Insurance: The Reinsurance Net And State Guaranty Associations
Reinsurance companies are a special group of insurers which do not sell to the general public. Instead, they sell insurance to other insurance companies. Reinsurance is a special arrangement where an insurance company transfers some of its risk to another insurer.
In essence, life insurance companies are, themselves, spreading risks around to reduce the risk to any one company. This creates a “reinsurance net,” which acts as a natural industry-created safety net of sorts.
In addition to reinsurance, every state maintains a State Guaranty Fund or Association. Life insurance companies contribute to the state fund. If an insurer is unable to pay its claims, the State Guaranty Fund will pay the unpaid claims.
Basic (But Obscure) Life Insurance Jargon And What It Really Means
What The Heck Does All This Jargon Mean?
Jargon no good.
So, let’s break this down like a fraction and get a handle on some of the terms you might run into at some point.
Offer and Acceptance
All contracts, and especially life insurance contracts, have to be made with an offer by one side and an acceptance of the contract’s exact terms by the other side.
The offer is usually made by the policyholder when he or she submits an application for insurance to an insurance company. The insurance company then either accepts or rejects the offer. I know it seems like the other way round. I can assure you, it isn’t.
An application for life insurance is like asking, “I can haz life insurance?”
You are offering the company some money in exchange for a bunch of promises.
If the company accepts the offer, then it issues the policy as applied for.
Sometimes, the insurer will reject the initial offer and make a counter-offer. This usually happens when the policyholder (technically, it’s when the person insured under the contract) has some kind of health condition that the insurers cannot underwrite without an additional charge. The insurer then has to change the terms of the contract and tell the policyholder that those terms must be amended to include an additional charge or charges.
The policyholder then has the right of refusal, meaning, the policyholder can reject the company’s counter-offer.
In plain English, let’s say you apply for an insurance policy. The insurer can accept or reject the application or it can accept it on the condition that you pay a little more than what was originally agreed upon.
Sometimes, the insurer will accept your application with a reduced premium. This happens more often than you might think. While most people are rated standard and pay the premium they were quoted by their agent or broker (assuming it was the “normal” rate for the policy), some insurance companies have such good underwriting practices that they’re able to approve 75% or more of approved applications at a better-than-quoted premium. In other words, if the insurer accepts the application and issues the policy, then it tends to approve that policy at better-than-standard rates.
Of course this also means that the insurer probably has higher-than-normal rejection rates or is very picky about who they underwrite for insurance.
Either way, both you and the insurance company must agree on the terms. Even if you send in the premium before the policy is issued, you can still reject the offer and the insurance company has to return your premium, in full.
If the insurer says, “Yo! Cool offer bro, but we’ll only insure you if you give us an extra $30 per month” then you can accept or reject that offer (called a “counter-offer”) or… if the insurer accepts your initial application, then you send the insurance company the first premium and the insurance company puts the policy in-force. “In-force” means the policy is nice and legal, it will pay out as long as premiums are paid in-full, and you’re good-to-go.
Terms And Consideration
Before the insurance policy can be legally enforceable, the promises in the contract must be supported by something called “consideration.” Consideration is something you give the insurance company… something valuable – cash-money-bling, baby!
More specifically, the insurance company charges a “premium” in exchange for the promises in the insurance contract. The premium, as you will recall from the Life Insurance Policy Basics section of this guide, is a charge or fee that you pay every year, twice per year, every quarter, or monthly.
The Principle Of Legal Purpose
The goal of the policy and the reason you buy it (and the reason the insurance company agrees to do business with you) must be legal.
For example, you cannot take out a life insurance policy on your annoying and idiotic neighbor Joe, and then run him down with your Humvee, pretending to be Batman in The Tumbler, and then collect on the death benefit. Even if Joe kicked your dog in the ribs last Tuesday and you think he deserves epic retribution, you cannot take out a contract on his life.
The Rule Of Competent Parties
This probably goes without saying, but you have to have all your marbles upstairs to enter into a life insurance policy. You can’t be insane or have dementia and the life insurance company must be an actual company. It can’t be some pretend insurance business your brother-in-law runs out of his basement.
Minors cannot enter into contracts. The mentally ill cannot enter into contracts. Anyone under the influence of alcohol or drugs cannot enter into contracts. You get the idea.
The principle here is that some people are incapable of understanding the (and thus agreeing to) the contract.
Business entities, trusts, and estates can, however, buy life insurance policies even though they are not “individuals.”
A small side note: beneficiaries and the person being insured in the contract (assuming they are different from the policyholder) are not actually parties to a contract. So, you can take out a policy on your newborn child and name your other 8-year-old child the beneficiary. It may not be the wisest move ever, but you can do it, if you want to.
An Aleatory Contract
An alien what?
No, this is not the latest installment of a Ridley Scott sci-fi horror movie.
An aleatory contract is a special type of contract which is contingent upon some kind of uncertain event taking place… like, you know, dying. Life insurance policies are aleatory in nature. Meaning, there is an element of chance involved for both you and the insurance company. On the insurer’s side, it has to honor the promises of the contract, even if it receives less premium than what it has to pay out as a death benefit or if it has not made a profit before it has to pay a death claim.
On your side of this contract, you do not know when you will die. If you buy a term life policy, and it lapses before the death benefit is paid, your beneficiaries do not receive a death benefit. If you buy a whole life or universal life policy and you outlive the contract (you live to the contract’s maturity date), the insurer has to offer you the death benefit as a cash payment and no further death benefits are payable after that.
A Contract Of Adhesion
Adhesion, like glue or… really strong tape.
Life insurance policies get “stuck” to you, in a manner of speaking. Meaning, they are prepared by the insurance company and the terms and conditions aren’t the result of negotiation (you cannot normally negotiate the costs of a life insurance policy) so… you must adhere to the terms as though you did negotiate them even though you did not.
On the bright side, in contract law, and especially with life insurance policies, the contract is to be viewed or interpreted in a court of law in a way that is most favorable for you (the party that did not write the contract) and not the insurance company (who did write the contract).
Meaning, if there any ambiguities in the policy, they will be interpreted in a way most favorable to you or your beneficiary and not the insurer.
A Unilateral Contract
Unilateral contracts mean that only one party to the contact (the insurance company) makes any kind of enforceable promise. The insurance company must make good on its promises. However, you are not legally required to keep making premium payments. You can quit at any time. You’ll lose the insurance policy, obviously, but the insurer cannot come after you for any unpaid premiums – even if your contract was a 20, 30, or 50+ year contract.
A Non-Personal Contract
How can life insurance not be personal, you say?
The answer is quite simple, but not at all intuitive.
In a legal sense, the life insurance policy is an agreement between the insurance company and the insured, with the policyholder or policyowner taking ownership over the contract. The policyowner does not need to be the insured person in the contract. And, even if they are (which, to be fair, most policyowners are also insured under the contract), they can give away the ownership of the contract (which is called “assignment”).
Because of this, life insurance is not considered a personal contract because the insured and the policyowner do not need to be one and the same.
For example, you can take out an insurance policy on your own life, and then transfer ownership of that policy to your spouse or sell it to an investor (which is what happens with a life settlement or viatical settlement company). You are still the insured person in the contract, but someone else owns the contract on your life and can make decisions about how premiums are paid, who the beneficiaries are, and so on.
Or… you can insure your children’s lives and be the policyowner. In this example, your children are insured, but you are the contract owner and can make decisions about how premiums are paid, who the beneficiaries are, and so on.
A Conditional Contract
The insurance company promises to love you.. conditionally. If you satisfy the condition, your life insurance policy pays out.
Meaning, your insurance policy will pay out but… it is entirely dependent on you paying your premiums and the insurable event happening. “Insurable event happening” in the life insurance biz is code for… you have to die for the policy’s insurance amount to pay off.
Some life insurance policies have non-forfeiture options and cash surrender values which do not require you to buy the farm, kick the bucket, or engage in any other cliché. This is covered in greater detail in other sections of this guide.
A Valued Contract
In life insurance, it’s all about stated value.
Meaning, the contract pays a fixed or stated sum of money, regardless of the actual loss incurred. And in fact, the insurance company never attempts to calculate the actual loss.
So, for example, if you have an insurance policy worth $10,000 when you die, that is what your beneficiaries get. If your funeral expenses are $25,000, your beneficiaries still only get $10,000 and owe the funeral home $15,000.
But, if your policy is worth $1,000,000 and your beneficiaries only “need” $300,000 to pay off all debts, they still get the $1,000,000.
“Valued,” does not mean the life insurance policy’s face amount of insurance is fixed forever. Some policies have changing death benefit amounts, which allow death benefits to increase or decrease over time.
What’s important is the stated value of the contract when you die. That’s what is paid out to your beneficiaries.
A Contract Of Utmost Good Faith
This is going to be hard for some people to accept, but life insurance is a contract of something called “utmost good faith.”
Both the insurance company and the policyowner must know all material facts and relevant information. Neither you nor the insurance company is legally allowed to conceal facts, disguise important information, or otherwise deceive one another.
When you buy a policy, and you tell the insurance company that you’re not a smoker, and you really are, that is a misstatement of a material fact because if the insurer had known that beforehand, it would affect how they would have priced your policy. It might have also affected whether or not they issued a policy if you had other health problems. In some cases, misstatements of material facts will result in the insurance company rejecting your application or canceling your policy (even after it’s issued) as long as they do it in a timely manner. More on that in just a moment.
Likewise, if an insurance company promises to pay a death benefit of $1 million, they must have enough to cover your death benefit claim as soon as the policy is issued. It cannot lie about or conceal any financial trouble or problems with its surplus or reserves. It cannot misrepresent what is in the insurance contract. It cannot conceal terms and conditions of the contract itself.
Concept Of Warranty
Warranty is a statement you make to the insurer that is guaranteed to be true. If you tell the insurer you don’t have cancer, you must not have cancer at the time of the application. It becomes part of the contract (yet really) and is part of the pricing of your premiums.
If the insurer finds out you lied, it can revoke the contract.
Concept Of Representation
Representation is anything you state on an application that you believe to be true. It’s used by the insurance company to figure out whether or not it wants to issue you a policy. A representation isn’t the same as a warranty because it doesn’t become part of the contract.
The practical distinction between a representation and warranty here basically that if a representation is untrue, then the insurer has the right to cancel the policy but only if it was material to the creation of the contract. Usually the insurance company is on the hook to prove that what you told them caused them to make a decision that they wouldn’t ordinarily make. If a warranty is false, then the insurer can just go ahead and cancel the contract. Bam. Done. No other reason or explanation necessary.
Some of this comes down to the severity of the misstatement and whether it would have seriously impacted the underwriting of the insurance contract. For example, if you told the insurer your cancer was in remission and it wasn’t, then the insurer would probably be able to cancel the policy since this is a misrepresentation – the insurer would have not issued the policy or would have seriously altered the terms if they had known about this condition before agreeing to sell you the policy.
But… if you tell the insurer that your mother died when she was 71 and she actually died when she was 73, then the insurer probably would not be able to cancel the policy. Your dad, however, will probably have a long talk with you about it.
Concept Of Concealment
Concealment is basically when a person fails to disclose a known material fact then applying for life insurance… especially if the intent is to defraud the insurance company.
I think this is pretty self-explanatory. Tell the truth. Always. Don’t try to defraud the insurer.
For some reason, this is one of those obvious-but-not-so-obvious provisions in a life insurance contract.
Insurable interest means that the person applying for life insurance has to be negatively affected… they must suffer a loss if the person being insured in the contract were to die, become sick, or become disabled.
If you are the policyowner and the insured person (which is usually the case), you are assumed to have an unlimited insurable interest in your own life.
Sounds kinda “duh,” but I’d rather state the obvious than risk someone being oblivious to this fact.
The insurance company also assumes you have a high insurable interest in close family members like your spouse, kids, and also your siblings. You might also have an insurable interest in other relatives like a close uncle or maybe your grandparents.
You have an insurable interest in business partners, key employees of a company you own, and maybe rank-and-file employees.
If you are the policyowner, but someone else is being insured in the contract, the insurer will verify insurable interest and must obtain consent from the person you want to insure.. even if it’s your spouse.
Insurable interest only needs to exist at the time the contract is being taken out. If you later divorce your spouse, for example, you do not have to give up your insurance policy where you are the owner and he or she is the insured person in the contract.
The Incontestable Clause
Speaking of fraud…
There is a little-known provision buried in every life insurance policy which probably will surprise even the haters. If you do happen to lie to the insurance company, and you do it intentionally to defraud the company, the company usually only has 2 years to discover the concealment or misstatement.
If they do not discover the concealment within 2 years, he contract cannot be voided, canceled, or revoked on the grounds of concealment or misstatement of material facts.
In essence, you can legally defraud the insurance company if you somehow make it past the incontestability period. This is unlike most contracts, where fraud always… always… results in a voided contract. Not so with life insurance.
Now… let me be absolutely clear. I am not advocating you defraud the life insurance company. I hope we can both agree that doing this is morally wrong.
I bring this up because there is this weird idea floating around that insurance companies are these big behemoth financial institutions which run over and trample policyowners whenever they get a chance… that they have impenetrable contracts which always favor the insurer and the customer is at their mercy.
People love to hate insurance companies. Everyone has a story about how their best friend’s brother’s former roommate once got raked over the coals by an insurance company. I’m not saying it doesn’t happen.
But… the reality is, insurers are not invulnerable and their business model is heavily dependent on them trusting you.
With great power comes great responsibility.