Friday, 25 June 2010

Life Insurance Basic Principles (Part III) - Risk Pooling

The Basic Principles of Life Insurance (Part III)

Risk Pooling

Life insurance is based on a mechanism called risk pooling, or a group sharing of losses. People exposed to a risk agree to share losses on an equitable basis. They transfer the economic risk of loss to an insurance company. Insurance collects and pools the premiums of thousands of people, spreading the risk of losses across the entire pool. By carefully calculating the probability of losses that will be sustained by the members of the pool, insurance companies can equitably (fairly) spread the cost of the losses to all the members. The risk of loss is transferred from one to many and shared by all insureds in the pool. Each person pays a premium that is measured to be fair to them and to all based on the risk they impose on the company and the pool (each class of policies should pay its own costs). If all insureds contribute a fair amount to the mortality fund held by the insurance company, there will be sufficient dollars in the fund to pay the death benefits of those insureds that die in the coming year. Individually, we do not know when we will die, but statistically, the insurer can predict with great accuracy the number of individuals that will die in a large group of individuals. The insurance company has taken an uncertainty on any individual’s part, and turned it into a certainty on their part.

Illustration of the risk-pooling Concept

The simplest illustration of risk pooling involves providing life insurance for one year, with all members of the group the same age and possessing similar prospects for longevity. The members of this group agree that a specified sum, such as $100,000, will be paid to the beneficiaries of those members who die during the year, the cost of the payments being shared equally by the members of the group. In its simplest form, this arrangement might involve an assessment upon each member in the appropriate amount as each death occurs. In a group of 1,000 persons, each death would produce an assessment of $100 per member. Among a group of 10,000 males aged 35, 21 of them could be expected to die within a year, according to the 1980 Commissioners Standard Ordinary Mortality Table (more on this later). If expenses of operation are ignored, cumulative assessments of $210 per person would provide the funds for payment of $100,000 to the beneficiary of each of the 21 deceased persons. Larger death payments would produce proportionately larger assessments based on the rate of $2.10 per $1,000 of benefit.

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