What is Life Insurance (1)
Life insurance is a type of insurance that pays money when someone passes away. That’s simple. However, to understand what life insurance is today you should look at how life insurance originated. Life insurance is one of the very oldest types of insurance/financial products in existence. It stems from the old principle that if a villager’s house burned down, and then the other villagers would help to rebuild the house.
The first life insurance came from this concept. Then a concept known as the tontine annuity system was founded in Paris by the 17th-century Italian-born banker Lorenzo Tonti. Although essentially a form of gambling, this system has been regarded as an early attempt to use the law of averages and the principle of life expectancies in establishing annuities. Under the tontine system, associations of individuals were formed without any reference to age, and a fund was created by equal contributions from each member. The sum was invested, and, at the end of each year, the interest was divided among the survivors. The last remaining survivor received both the year’s interest and the entire amount of the principal.
However, as the amount of money that people wished to be insured for increased, the greater the risk as well as the potential for violent fluctuations for those involved. To minimize this effect, it was necessary that the law of large numbers be applied to this situation. This is where we see the first roots of the actuarial practice. An actuary is defined as a mathematician employed by an insurance company to calculate premiums, reserves, dividends and insurance, pension and annuity rates, using risk factors obtained from experience tables. These tables are based on the company’s history of insurance claims as well as other industry and general statistical data.
This is an example of the principle known as the law of large numbers. This principle states that the greater number of similar exposures (in this case-lives insured) to a peril (e.g. death), the less the observed loss experience will deviate from the expected loss experience. Basically, the more people that the risk is spread out over, the more money (premiums) will be coming in; that when a person does die, it will not be as big of a burden to the rest of the insured’s. Of course, in certain circumstances, there will not be much that can be done.
The function of insurance is to safeguard against misfortunes by having the losses of the unfortunate few paid by the contributions of the many that are exposed to the same peril. This is the essence of insurance-the sharing of losses and, in the process, the substitution of a certain small “loss” (the premium payment) for an uncertain large loss.
