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What Is Life Insurance, Where Did It Come From, and Why Should I Care?

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, 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, and the risk potential for violent fluctuations for those involved increased as well. 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 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 the 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. So, when a person does die, it will not be as big of a burden to the rest of the insureds. 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 for 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. (Reference—Black, H. and Skipper, K.; Life Insurance, Twelfth Edition, Prentice Hall (Englewood Cliffs, NJ), p. 18)

Life insurance, like any other financial product, is a tool to assist you in accomplishing a specific goal (or goals). As such, it will assist the beneficiary when there is an economic loss, due to the death of the insured that extends well beyond just funeral or final medical expenses. The loss of future income, due to the death of a breadwinner, can have a severe impact on the lifestyle of the surviving family members. Debt owed by the deceased may become due and payable as well as possible estate or inheritance taxes. Life insurance can create an immediate source of funds to enable the payment of these expenses and to provide a source of future income.

Benjamin Franklin helped found the insurance industry in the United States, in 1752, with the Philadelphia Contributionship for the Insurance of Houses from Loss by Fire. The current state insurance regulatory framework has its roots in the 19th century, with New Hampshire appointing the first insurance commissioner in 1851. Insurance regulators’ responsibilities grew in scope and complexity as the industry evolved. Congress adopted the McCarran-Ferguson Act in 1945 to declare that states should regulate the business of insurance, and to affirm that the continued regulation of the insurance industry by the states was in the public’s best interest.

The purchasing of life insurance is an uncomfortable task for many people, and the image of most life insurance advisors leave something to be desired with examples such as Bill Murray in Groundhog Day and Mel Brooks in High Anxiety. Typically, there is recognition of an obligation to protect one’s dependents from the financial hardship of an untimely death, but no one likes to think about the fact that they will die someday. This is another reason—aside from the potential discomfort of dealing with a life insurance advisor—that can make it easy to delay and put off the decision to purchase life insurance.

Keep in mind as you go through this process that life insurance is not for you, it is for your survivors. Therefore, you typically will only have a need for life insurance when you are leaving behind someone or some entity that is dependent on your income.

“Any road will get you there as long as you don’t know where you’re going.” —Socrates

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