What is Life insurance all about?

By C.T.A. Schaffter

The average person has probably heard a great deal about Life insurance and its importance to the citizens of this country. They may have a vague idea that money is paid out by the insurance company when somebody dies – but beyond that most people know very little about what Life insurance is actually about.

This article is meant to explain, in as simple a manner as possible, what Life insurance is and why it is so important.

How did Life insurance begin? Life insurance is said to have started in the United Kingdom over than 300 years ago, when there was a need to protect the families of the worker in the event of his untimely death. If the worker was very poor, and he died leaving a young family, the entire family, mother and children went to the “poor house,” where they were treated shabbily, had to work hard all day and were given grubby food to eat.

Mutual societies and mutual companies

In order to prevent this from happening, groups of workers got together and agreed to contribute a fixed sum each week out of their wages into a common pool. The pool was used to pay a fixed sum of money to the families of those who died before they gave up work. The amount was small, but it was something, and perhaps helped to keep the “wolf from the door” and obviate the necessity for the family to go into a poor house.

Unfortunately, this simplistic method of Life insurance did not quite work out. More people died than was expected so the fund was used up quickly, and there was no money left for those who had contributed but died later.

This was also largely because the groups of workers were too small, and there was no “spread” in numbers. In order to overcome this some organisations got together and formed what was known as a “mutual society” into which much larger groups of people paid their contributions, which amounted to what was then considered an adequate premium. From the proceeds of this pool, death claims were met. The policyholders were the owners of the pool and sometimes had to make good the shortfall, but this was in many ways a better system and one from which mutual companies arose.

As time went on private organisations also realised that there was money in Life insurance, and they began to raise capital, start a company, and then accept risks which the mutual societies were carrying. These companies, however, were profit oriented. They competed with one another, but the customer got a good deal at the end of it all.

Duties of actuaries

It must be remembered that to conduct this type of insurance in the early days, the modus operandi was very simple. All premiums went into a pool and if you survived the year, the money remained in the pool. If you died, the pool paid the agreed sum.

As long as the monies put into the pool were more than what was paid out, there was no problem, and in order to achieve a proper balance people known as actuaries were employed to work out the prospective mortality and the interest which could be earned on the monies entrusted to them. With a combination of these two factors the actuaries were able to say roughly how much premium had to be collected from each person to cover the risk in normal situations.

The companies, of course, added something more to cover their expenses and their profits, and this is how Life insurance premiums came to be calculated and the system continues to this day. The actuary plays a very important part in the running of a Life insurance company, ensuring that it charges the right premium so that it does not make a loss.

Types of Life insurance policies

Life insurance has several variations. The simplest form is called Term Insurance. This provides for a premium to be paid, and the sum insured (which is the promised amount) becomes payable if the policyholder dies. If he survives, however, he does not receive anything and his money goes into the pool, contributing to paying the claims of those who died during that year.

An improvement on this was what is called Endowment Insurance. Here the company promises not only to pay a certain sum of money at death, but also in many instances the same sum of money is given at the end of a specified period. So the policyholder is guaranteed to receive a certain sum of money either at death or at maturity/retirement. Naturally this type of policy was far more expensive than the term insurance policy.

The actuary calculates what premium is to be charged to cover not only the risk that the company carries, but he also calculates the additional premium required as a saving which will give the same amount at the end of the agreed period of say 15, 20, 25 or 30 years.

The actuary is very important because unless these calculations are done properly and accurately, the insurer will stand to lose or he will be charging far more than he needs to charge.

For many years the endowment policy was the most popular type of policy, and was used for a variety of needs, especially when people were taking out mortgages on property. When a person bought a house he usually went to the insurance company for a loan. The insurance company gave him the loan and also sold him an endowment policy which would give the capital back at the end of 20 years or so. If the policyholder died in the interim the same amount became payable, and the loan was repaid, with any balance paid to the policyholder’s heirs.

All that the policyholder had to do was to pay the premium on the policy each year as well as the interest on the loan, which was usually fixed in those days. This made it easy for an individual to buy a house and the system, in many ways, worked very well. In the UK and many developed countries it is this form of insurance which gave the thrust to home owning and mortgage business.

However, the primary purpose of insurance is to provide protection to your dependents – but how do you decide which policy to take? The cardinal rule is that you take a policy to fulfil your needs. There has to be a balance as well, because if your needs exceed your ability to pay, you must cut down on the size of the policy. If, however, you have adequate money to meet your needs and the needs of your family in the event of your untimely death, then you should take out a policy for the full value required.

A simple rule to follow is to insure for 100 times your monthly salary. It will leave something adequate to look after your family. But the important factor is that you should be able to pay for it.

Matters to consider when taking out insurance

One important factor to be considered when taking out a policy is your state of health, apart of course from your age. Those who are older pay more because their likelihood of dying is greater than that of those who are young. More important, however, is your state of health. Whether you are old or young, you may have suffered from some disease/illness which can shorten your life span, which is to the detriment of the insurer. It is important, therefore, that when you take out a policy, you disclose all ailments, because that is the only fair manner in which insurance business can be transacted.

You must not conceal your ailments, and hope that the insurer will give you better terms than he would otherwise have given. If you do that, and you are found out, you will lose all the premium you have paid, and your dependents will get nothing under the policy on your death.

The principle of “uberima fide,” which means utmost good faith, is paramount in the transaction of insurance contracts, and should be remembered by the person who is insuring, because it is he who is in full possession of all the facts about his own health, and he should not conceal these facts in an effort to get the better of the insurer. This can end in disaster to his family, because he will not be there to realise that they have lost everything by his failure to state all the relevant facts.

Lapsation and its consequences

If you do not pay your premium on time, your policy can lapse, and you can either lose all that you have paid, or you will only get a proportion of what you had otherwise hoped to get.

What are known as “days of grace” from 15 days to 45 days are granted to keep the policy in force and you can pay the premium within this period. If you do not pay your premium the policy will lapse. Usually if it is a term insurance policy it will lapse at the end of the days of grace. If it is an endowment or other type of policy, and if the period you have paid is less than three years, it will normally lapse.

If, however, it is more than three years, the policy will acquire what is known as a “paid up” value which means that it will cease to be in force, but it will keep you covered for a reduced sum insured.

Alternatively, you can surrender the policy and get back a portion of what you have paid. If it is in the early years it will be not more than 50 or 60% of the premium paid. In the later years it can be as much as 75 or 80% but, the fact is that if you surrender your policy, it is a loss not only to you but also to the insurer who has calculated his premiums on the basis that the policy will run the full period, and he will be able to recover his expenses over that period.

Nominations

Policyholders can always nominate one or more beneficiaries who will receive the policy money upon the death of the policyholder without any delay whatsoever, provided the relevant documents, such as a death certificate, are submitted. The appointment of a beneficiary or nominee is very important, and this must preferably be a major, because if it is a minor, the company cannot pay the money to the minor until the minor reaches the age of 18.

Other uses of insurance policies

Many years ago in Sri Lanka and still in UK and other countries, policies were useful as a cheap means of providing for death duties. The policy holder took what was called a whole Life policy on which a low premium, marginally higher than the term insurance premium, was paid by the policyholder for life, or for a limited period. The company undertook to pay a guaranteed sum of money on the death of the policyholder.

Wealthy individuals took out policies such as this to meet the death duty payments arising on their estates at their death, and thereby spared the heirs from having to sell a part of their inheritance to meet the death duties.

In the case of wealthy persons, particularly those who have more land and houses than cash, the burden of meeting death duties can be extremely heavy, and property may have to be sold to meet this need. In Sri Lanka this is no longer a problem, but in the Western world it is.

Insurance policies are very useful for assignments to banks. One goes to a bank for a temporary facility. The bank usually takes an assignment on the policy to grant the facility to the extent of the surrender value of the policy. The bank is assured that, if the policyholder does not pay, the loan they will claim the surrender value and recover the debt. If the policyholder dies, the full sum assured becomes payable and the bank will credit itself with the outstanding loan, and pay the balance to the heirs of the deceased.

Life insurance for whom?

Who should take Life insurance? The simple answer is that each and every person who either has dependents, or expects that he or she will have dependents in the years to come, must have adequate insurance to provide for those dependents.

The primary purpose of Life insurance is to provide protection for dependents. Everything else comes after that. To put the position a little more simply, a wealthy bachelor who has plenty of money and no dependents at all need not take Life insurance unless he is in a country where death duties are payable. Most of us, probably 99% in this world, are either dependants of somebody or have people depending on us, and so the person who is the a bread winner in one way or another must take out Life insurance to protect those he loves, and those who depend on him, against a situation which could arise in the event of his untimely death.

Why not put your money in a savings bank?

What’s the difference between Life insurance and putting your money in a savings bank? If you put in your money in a savings bank you only get back what you put in plus the interest. If you put your money in a term insurance policy, you pay say Rs. 2,000 per annum if you are young, and in the event of your death the company will pay Rs. 1 million. The savings bank does not do that. That is the primary difference between putting your money into the savings bank and into Life insurance.

The downside is that, in the case of the savings bank, you get what you put in plus interest. In the case of the Life insurance company, however, you do not get your money back unless you die, but then if you look at it sensibly, it is a small price which you pay for the comfort of knowing that your loved ones are protected.

Of course you can go one step further by taking out an endowment policy under which you will get not only Life insurance cover but also a reasonable return. So you have to balance the two, as to whether you take an endowment policy as against putting your money in a savings bank. The truth of the matter is that if you do not have a lot of spare money, and very little to save, it is far better to spend it in taking Life insurance, and not leaving your loved ones destitute.

How is Life insurance sold?

Life insurance is generally sold through agents and brokers. Agents go to people and convince them of the need for taking Life insurance. They talk about the benefits of the various policies which their company markets, and try to convince them that their company is the best. It is the policyholder’s duty to check this information, and then take out the policy.

Employers take insurance to protect their employees. Caring employers are fully aware of the fact that their employees cannot afford to take out Life cover and therefore do it themselves for the benefit of their employees, and for the protection of their families.

Life insurance, as you will see, plays a very important part in the life of the country. The tragedy is that very few appreciate it.

(Often referred to as the ‘Father of Insurance’ in Sri Lanka, Chandra Schaffter has been a vivid and vital figure in the industry for over 60 years. In 1994 he founded Janashakthi Insurance PLC – one of the country’s largest and most successful insurers. Having formerly represented the nation at cricket and hockey and serving as Manager of the National Cricket Team, he is now Deputy Chairman on Janashakthi’s Board of Directors.)