Chapter 2 : What Life Insurance involves
- The elements of life insurance business include asset, risk, principle of mutuality and the life insurance contract.
- Prof. Hubener devised the concept of Human Life Value (HLV).The HLV concept considers human life as a kind of property or asset that earns an income. It measures the value of human life based on an individual’s expected net future earnings.
- Net earnings means income a person expects to earn each year in the future, less the amount he would spend on self. It thus indicates the economic loss a family would suffer if the wage earner were to die prematurely. These earnings are capitalised, using an appropriate interest rate to discount them.
- Thumb rule to measure HLV: Divide the annual income a family would like to have, even if the bread earner was no longer alive, with the rate of interest that can be earned.
Example: Mr. Rajan earns Rs. 1,20,000 a year and spends Rs. 24,000 on himself. The net earnings his family would lose, were he to die prematurely, would be Rs. 96,000 per year. Suppose the rate of interest is 8% (expressed as 0.08). HLV = 96000/0.08 = 12,00,000
- Typical Risks faced by people are: dying too early, Living with disability, Living too long.
- General Insurance Policies are usually contracts of indemnity. Indemnity means that after the occurrence of an event like fire, the insurer can assess the exact amount of loss and pays compensation only to the amount of loss. No more or no less.
- Life Insurance contracts are known as Life Assurance Contracts. The amount of benefit to be paid in the event of death has to be fixed at the beginning itself. An assured sum is paid to the nominees of the insured when he dies.
- In General insurance contracts, the risk event protected against is uncertain. In Life insurance, the risk event protected, i.e. death is certain, but the time of death is uncertain. Thus it provides protection against the risk of premature death.
- In general insurance, the probability of happening of the event does not increase with time. In life insurance the probability of happening of the event (death) increases with age.
- Mortality is related to age and hence young people who are less likely to die are charged lower premiums as compared to old people.
- The level premium is a premium fixed such that it does not increase with age but remains constant throughout the contract period.
- This means that premiums collected in early years would be more than the amount needed to cover death claims of those dying at these ages, while premiums collected in later years would be less than what is needed to meet claims of those dying at the higher ages. The level premium is an average of both. This means that the excess premiums of earlier ages compensate for the deficit of premiums in later ages.
- Reserve: The Premiums collected in early years of the contract are held in trust by the insurance company for the benefit of its policyholders is called Reserves. An insurance company keeps this reserve to meet the future obligations of the insurer.
- Life Fund: The excess amount also creates a fund known as the “Life Fund”. Life insurers invest this fund and earn an interest.
- The level premium has two components. (1) term or protection component, premium needed to pay the cost of risk (2) cash value element that constitutes the saving element.
- Two ways to reduce risk in financial markets: Mutuality and diversification.
|Funds are spread out among various assets.||Funds of various individuals are combined (Placing|
|Placing eggs in different baskets.||all eggs in one basket.|
|Funds flow from one source to many destinations.||Funds flow from many sources to one.|
- Life insurance contracts involve both risk cover and a savings element. This makes it a financial product like other products in the financial market. Life insurance in fact has been less a protection product and more a way of holding wealth.
- Term insurance does not have a savings element associated with it.