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How does life insurance work?

At first sight, the operation looks easy. The life insurance company collects in the premiums, invests them and, when those insured die, it pays out to the beneficiaries named in each policy. But appearances are deceiving and, in reality, life insurance is complicated. If the company knows it has to pay out, say, $50,000 to an insured when she dies, it divides this amount into equal instalments, adds on the investment income and subtracts a percentage of the company's running costs. Except, how does the company know how long the insured will live? And how does it make a profit?

Every insurance company depends on a team of people called actuaries who work out the risk. They collect every single piece of available information.

So, if someone aged 25 who works in an office in Oklahoma, applies for a policy, the actuaries have a mass of data from which to calculate her probable life expectancy. The company can now calculate the premium and, hopefully, make a profit.

The key factors in addition to age are:

  • whether the policy has a set term of years or is "whole life" - the longer the term, the more likely it is the insurance company will have to pay out;
  • whether the policy has a guaranteed minimum amount payable on death - the higher that minimum, the more the company must collect as premiums;
  • gender - women live longer than men so premiums tend to be higher for men;
  • body weight - everyone with a Body Mass Index of 25 and above has a higher risk of health-threatening conditions such as high blood pressure and heart disease;
  • smoking - using tobacco in any form increases the risk of cancer and shortens life expectancy;
  • where you live - life expectancy varies by state depending on the lifestyle of local people, the performance of their healthcare services, the presence of environmental hazards, etc;
  • and so on.

Using this information, all the insurance company has to do is set the premiums to cover its running costs which may rise over the years and make a profit.


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