45ADE867 21EA 28BEF3 A Laymans Guide To Individual Life Insurance

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A LAYMAN’S GUIDE TO INDIVIDUAL LIFE INSURANCE

A LAYMAN’S GUIDE TO

INDIVIDUAL LIFE INSURANCE
Version 2.0
Prepared By

Ashwin Nair

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A LAYMAN’S GUIDE TO INDIVIDUAL LIFE INSURANCE

Document Name

: A Layman’s Guide to Individual Life-Insurance

Description

: This document explains the concepts of Individual Life Insurance from a Layman’s
perspective.

Date of Creation

: 05-Dec-2006

Author

: Ashwin Nair

E-mail

: ashwin.nair@patni.com

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A LAYMAN’S GUIDE TO INDIVIDUAL LIFE INSURANCE

Preface
This document explores the concepts of Individual Life Insurance from a layman’s
perspective.
On reading this document, one would be exposed to the general concepts of Life
Insurance and be prepared to delve further into broader aspects of Life Insurance.

Life Insurance
It is a known yet unspoken fact that life has to end one day. The question is when
and where? One goes through different phases in life, where he embraces
responsibilities and looks forward to abide by them. But, any moment can be his
last. Every individual faces some or the other risk in his life. It’s not just death
alone; there are other insecurities like accidents, terminal illness too.
These insecurities are closely linked with one’s fears. Why? Any of these risks like
death, illness, etc may cause problems for his family, especially if he is the lone
bread earner.
So, how does one reduce this insecurity? If someone gives him an assurance that on
occurrence of such a dreadful incident (risk of death occurs), his family will be
taken care of, he can be rest assured that his risks have been covered.
This assurance is given by Insurance providers, who undertake an agreement
(policy) with the insured to cover the risk for a fixed amount to be paid at regular
intervals (premium).
Types of Life Insurance
There are briefly two types of life insurance:
- Whole Life
- Term Life
Whole Life
Under Whole life insurance, the Insurance provider insures the insured from the
time he applies for the policy till the age of 99 (i.e. his entire life). Here, the
prime intent of acquiring a policy is guarantee against the risks of the insured.
Term Life
Under Term life, the Insurance provider insures the insured for a fixed period.
The term (lifespan) of a term-life policy is defined by the Insurance provider
(e.g. 10 years, 20 years, 30 years). Term life policies are more often looked
upon as investment options. The returns offered (on the cash value/reserve) at
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A LAYMAN’S GUIDE TO INDIVIDUAL LIFE INSURANCE

the end of a term life policy is usually higher that that of a whole life policy.
Hence, here the prime intent of acquiring a policy is not only assuring guarantee
of the risks of the insured, but also a source of investment for the policyholder.
Note: Policies that give you benefits in the event of the Insured’s death and on
maturity of the policy coverage are known as endowment policies.
Risks and their types
Any disruption in the normal routines of the insured that may change/alter his life
or that of his family can be classified as a risk. Lets list down some of the common
risks that come to our mind:
- Risk of Death
- Risk of Disability
- Risk of Terminal Illness
Risk of Death:
This is where the insured faces a risk of loosing his life and thus insures himself
against this risk.
Risk of Disability:
This is where the insured faces a risk of disability upon which he may not be
able to continue with his occupation of professional life (E.g. A Dentist cannot
continue his profession without his hands and A soccer player cannot play without
his limbs). Under such circumstances, the insurance provider would either continue
paying the premiums of the insured or pay the insured a lump sum amount.
Risk of Terminal Illness:
This is where the insured faces a risk of acquiring an illness, which would cost
his life in a year. Such illnesses require huge sums of money for treatment. On
occurrence of such a risk, the Insurance provider assures the insured a fixed sum of
money or a percentage of the sum assured of the policy.
Lets put in some thought process here: Assume the insured is assessed with a
terminal illness. So, the insured is expected to lose his life within a year and the
Insurance provider is still insuring him against the risk of death. In this case, should
the company charge the same Cost of Insurance? No. Why? The life expectancy of
the person is very less. He is as prone to death as that of an old aged person (e.g.
99). Hence, the company could increase the age of the insured by a certain value
and then charge a higher Cost of Insurance accordingly.

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A LAYMAN’S GUIDE TO INDIVIDUAL LIFE INSURANCE

What is a Universal Life-Insurance policy?
Let’s take a very general scenario: How long would you serve your employer? As
long as the employer pays you, right? What if the employer stops paying you? You
stop working.
It’s very simple: nothing comes free in life.
Assume that one has taken a policy, where on payment of a monthly premium, the
insurance provider continues to keep him insured.
So, what happens if the insured defaults to pay his premium for a few months due
to some personal problems? The insurer will cancel his policy. In this case, if the
risk (death) occurs, the person’s family (beneficiaries) will not get any of the
benefits assured to him.
In Universal Life Insurance, the insurance coverage does not depend upon the
premium payments made by the insured (policy holder), but depends on the
accumulated balance (reserve/cash value) of the premium payments made towards
the policy.
Every Insurance provider would,
1. Charge an amount towards the services being provided called administration
charges and
2. Pay commissions to its agents responsible for bringing businesses to the
company.
These amounts are deducted from the premium paid by the policyholder.
The balance remaining after deducting the commissions, administration charges,
etc., is called remainder, which is credited to the accumulated cash value/reserve.
What is Face Amount or Sum Assured?
Face Amount or Sum Assured (both are synonymous) is the amount (contracted) that
is paid to the insured/policy holder/beneficiary on occurrence of the risk.
Eg. The amount that is paid to the beneficiary (could be spouse/mother/child) on
the death of the insured is the face amount.
Remember, the beneficiary can also be the policy holder/insured himself.
Eg. Once the risk of terminal illness or disability occurs, the beneficiary will be the
insured himself.

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A LAYMAN’S GUIDE TO INDIVIDUAL LIFE INSURANCE

What is Cost of Insurance?
Cost of Insurance (COI) is the amount charged to cover the risk of the insured for
the given month. This Cost of Insurance is deducted every month from the cash
value/reserve and not the premium.
Some
are:
-

of the main factors on which the calculation of the Cost of Insurance depends
The sum assured (Net amount at Risk)
Plan of the policy
Coverage (Type of Risk) for which the COI is being calculated
Age

The calculation of the Cost of Insurance would vary from Company to Company
(Insurance provider). The mortality factors have a major role to play in the
calculation of the Cost of Insurance.
What constitutes the Premium?
Premium is the amount one agrees to pay the Insurer to insure his risks.
How is the premium of an insured derived?
The Insurance provider usually derives this amount through a process called the
underwriting process. Some of the factors that are considered in this process are:
- Age
- Mortality factors
- Occupational hazards
- Medical history
- Personal habits
Other factors that affect the calculation of the premium could also be the type of
plan that is being provided, the administration costs that are incurred by the
Insurance provider, etc.
The Insurance provider may give several choices to the policyholder for paying his
premiums. One may pay his premiums directly to the Insurance provider or may
have his premiums deducted from his salary or from his bank account.
He may be given the option to pay his premiums monthly, quarterly, half-yearly or
even once a year (frequency of payments).

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A LAYMAN’S GUIDE TO INDIVIDUAL LIFE INSURANCE

Actuarial and Underwriting
Actuarial is the department that is responsible for collating market information like
mortality rates, insurance trends, etc and translating this information into data that
will be used by the underwriters while assessing an insurance application. This
involves a lot of numerical and statistical data.
Actuarial is basically a science that includes a lot of mathematical (probability and
statistics) methods used for risk assessment.
Actuaries are professionals who are highly qualified in this field.
Mortality rates are derived from mortality tables that are statistically based tables
showing average life expectancies.
The following table is a typical mortality table:

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A LAYMAN’S GUIDE TO INDIVIDUAL LIFE INSURANCE

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A LAYMAN’S GUIDE TO INDIVIDUAL LIFE INSURANCE

Note: The above table is only for representational purposes. Do not get into the
intricacies of the table.
Underwriting is a process where one interprets the data of the insured (viz.
medical history, occupational information, personal information, etc) and uses the
actuarial data to give a verdict on the issuance of a policy. This process plays a
major role in deciding the premium of a policy.
Examples: Lets look at a few examples that would make things more clear:
1. Example 1: If we have one person who is an alcoholic and a smoker, while the
other (of the same age and profession) is a non-smoker and a non-alcoholic.
Who’s life expectancy do you think is less? Well, definitely the smoker and
alcoholic person. So, why not charge an extra amount from him for his
insurance.
2. Example 2: There are two professionals who need to be insured. One works with
the fire brigade, while the other is a chartered accountant. Who do you think
has a more risky profession? There’s no doubt that the person working in the fire
brigade faces more dangers in his profession and thus would be charged an extra
amount based on his profession.
3. Example 3: Take a person who does not have a good medical history, who may
be diabetic person or might have had a heart attack in the past. Insuring him is
definitely not a profitable proposition for the Insurance provider. But, this is still
business for the company. So, instead of denying insurance to the applicant, the
Insurance provider would rather accept his insurance by charging an extra
premium amount.
These are just some of the areas that underwriters look into while giving their
verdict for an insurance application.
What is a Coverage/Rider?
The assurance given against each of the risks as classified above is known as a
coverage/rider.
Eg. The assurance given against the risk of disability is known as disability
coverage/rider.
Initially, Insurance providers provided insurance that covered only the risk of death
of the insured. But, as time progressed and competition in the Insurance market
increased, Insurance providers started providing more benefits to their customers
allowing them to insure additional risks.

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A LAYMAN’S GUIDE TO INDIVIDUAL LIFE INSURANCE

Today, one may have the following coverages under the same policy:
- Insurance against Terminal Illness
- Insurance against disability
- Insurance against the death of spouse
What is a Claim?
Claim is the process of applying (claiming) for the benefits (sum assured) on
occurrence of a risk.
Eg. On occurrence of the death of the insured, the sum assured is paid to the
beneficiaries through a process called the claim process.
How are claims paid?
The insurance company receives premiums from the policy owner and invests them
to create a pool of money. A percentage of this money is carefully invested into
various external funds, stock markets, etc. This helps in paying claims and financing
the insurance company's operations.
Eg. An Insurance provider has one million policyholders. Assuming, as per the
actuaries, the death rate is 10 in 10000, considering all the statistics and
calculations. Hence, considering the death rate and the number of people paying
premiums, the Insurance providers would always have healthy returns with proper
planning, investments and strategies.
What are commissions?
In Life Insurance, business is primarily brought in by people called agents. They are
trained professionals indirectly working for the insurance provider, who market and
sell insurance to prospective customers.
What is in it for the agents who bring in new businesses for the Insurance provider?
An agent would convince a person to get himself insured by the respective
Insurance provider. In return the Insurance provider pays the agent an amount
called commission.
The commission is usually a percentage of the premium paid by the
Insured/policyholder to the Insurance provider.
Commissions are usually paid for a fixed term.

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A LAYMAN’S GUIDE TO INDIVIDUAL LIFE INSURANCE

Eg. Suppose a policyholder pays Rs. 10000 as the monthly premium to the Insurance
provider. The insurance provider sets the commissions percentage at 30% for three
years.
Then, in this case the agent who brought this business to the Insurance provider
would get 30% of the premium (Rs. 3000) every month for the next three years.
How is a Policy Issued?
How is a policy issued?
The insurance provider through its agents would approach prospective customers
and convince them to take a policy that would insure them of their risks.
Once convinced, the customer (applicant) submits an application to the Insurance
provider.
Upon initial verification of all the required data, the application is then
forwarded to the underwriting department. The underwriters would collate all the
information of the applicant like occupation, medical history, etc. The underwriters
then assess the information (medical history, occupational data, habits, etc) of the
applicant and give their verdict. Using all the information at hand and the type of
insurance requested for, the premium of the policy is calculated.
The insured would nominate beneficiaries for the policy (viz. spouse, children,
etc).
The policy is then issued and the original policy (agreement) is handed over to
the policyholder/insured.

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