The Life Insurance Risk Pool- Part II
In Part I of this blog, we learned that life insurance, or insurance in general, is designed to eliminate or reduce the possibility of a loss. It is a technique used to alleviate the burden that a pure risk can create on the insured. We started to learn that by pooling together more insureds with similar low frequency risks, that a few of them will statistically be compensated when a severe loss occurs.
Congratulations! You are on your way to understanding the foundational law of life insurance that is behind risk pooling- the Law of Large Numbers. The concept of risk pooling wouldn’t exist without it.
The law of large numbers will state that if you flip a coin, the probability of getting a “tail” is 50%. If you flip it ten times, you will not be shocked if the results are 7 heads and 3 tails or 2 heads and 8 tails. However, if you flipped the coin 10,000 times you would ‘probably’ end up with very close to 50% heads and 50% tails. For life insurance purposes, the size of a sample (mass insured) must be large enough to allow the true underlining probability to emerge.
For example, let’s say that 10,000 40 year old males are contributing to a life insurance pool. Roughly, 17 are expected to die this year (based on the “composite” 2001 CSO mortality tables*). The mortality charge at that age/gender is $1.70 per $1,000 of life insurance benefit. If each of the 10,000 has contributed $170 that year to fund death benefits (excluding costs of operation), a death benefit of $100,000 could have been paid to each of the 17 expected deaths [10,000 insureds multiplied by $170 annual premium= $1,700,000 pool of benefit; $1,700,000 divided by 17 deaths= $100,000 life insurance death benefit payable]. If we only had a pool of 10 people, would the probabilities be the same? Definitely not, hence the effectiveness of the law of large numbers.
This should give you an idea of how life insurance can compensate those that have a severe loss, because they are part of a larger pool of insureds which decreases the frequency of risk. The law of large numbers and risk pooling create a greater level of certainty for a life insurance company through the probable outcome of how many people at a particular age and gender will have a loss that year. The value of life insurance is clear then…we are transferring our individual risk equitably among many to share the burden of possible loss. Are you ready to share your burden and lighten the load you are carrying?
*Please read Part III for a more in-depth explanation of the development and use of mortality tables.
About the author: Kyle McDonald holds FIC, FICF, FSCP® & CLTC designations. His viewpoint on life insurance is simple, “Anyone with a family must have life insurance. In the end, life insurance is for others you care about, not you.” He is ready to help you and your family get the best option available. Contact Kyle today at 1-800-651-1953 or KMcDonald@Pivot.com.