Life insurance is a complex financial instrument designed to create a sum of money upon someone’s demise.
Just as a savings account is used for accumulation, a stock for growth, a bond for income and a loan for leverage, so a life insurance policy is used to provide a lump sum of money to someone (the beneficiary) when someone else (the insured) dies. Like the other financial products, it is a tool to help you accomplish specific objectives.
Like all other types of insurance, life insurance is designed to offset the effects of an economic loss. However, instead of an economic loss due to property damage, illness or lawsuit, life insurance is used to offset the economic loss caused by the death of someone.
Like all other types of insurance, life insurance offsets the economic loss by sharing the loss with a large group of people. A small “loss” (the premium) is voluntarily incurred so as to prevent a financial disaster should an uncertain large loss occur. (With life insurance however, it isn’t the event that is uncertain – we all will die – it is the timing of the event.)
An example of economic loss that life insurance can offset is burial/cremation costs that create a financial obligation for someone; there could also be additional expenses related to a final illness or accident. However, the biggest economic loss is often the loss of future earnings of the deceased, if the death occurs during working years. The loss of future earnings concept will be discussed in detail in a future email.
While there is evidence of property and maritime insurance several thousand years BCE, and even basic attempts to create something akin to burial insurance, the concept of economic loss due to death did not really come on the scene until around the time of the Industrial Revolution. Since then, it has been improved, refined, and fine-tuned, leaving us with the dizzying array of products available today.
Now that life insurance has been defined, future missives will address when it is appropriate, the different types that currently exist, formulae for determining an appropriate amount of coverage (if any is needed or desired), the parties to a life insurance policy, dividends, loans, taxation, and many other topics.