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Introduction to Life Insurance
Types of Life Insurance

1 INTRODUCTION TO LIFE INSURANCE 
 
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1.1 DEFINITION OF LIFE INSURANCE 
 
 
 
 
In the first of an excellent series of textbooks produced by the U.S. Life Office Management Association Inc. (LOMA), life insurance (or ‘life assurance’ in British terminology) is defined as follows: 
 
 "Life insurance provides a sum of money if the person who is insured dies whilst the policy is in effect." 
 
Anybody who has some knowledge about life insurance will be tempted to say "Yes, BUT.....". In other words, surely this is too brief an explanation for a financial service that provides a very sophisticated range of savings and investment products, as well as mere compensation for death. Nevertheless, this is apt for the first chapter on life insurance for beginners. 
 
The definition captures the original, basic intention of life insurance: i.e. to provide for one's family and perhaps others in the event of death, especially premature death (i.e. death occurring at such a time that financial hardship will likely be caused to the dependants). Originally, policies were for short periods of time, covering temporary risk situations, such as sea voyages. As life insurance became more established, it was realised what a useful tool it was for a number of situations, which would include: 
 
(a) Temporary needs/threats: the original purpose of life insurance remains an important element in life insurance and estate planning, as things like children's education, etc. occupy responsible people's thoughts. 
 
(b) Savings: providing for one's family and oneself, as a long-term exercise, becomes more and more relevant as society evolves from a tribal, clan, family orientated community to relatively affluent individual independence. 
 
(c) Investment: investment is a process of exchanging current resources for expected benefits. The accumulation of wealth and safeguarding it from the ravages of inflation become realistic goals as living standards rise. 
 
(d) Retirement: provision for one's own later years becomes increasingly necessary, especially in a changing cultural and social environment. 
 
 So our purpose, as we begin this study, is not so much to remember certain facts, but rather to understand something of the fundamentals of long term insurance, and to appreciate its role in modern society.
 
1.1.1 Needs for Life Insurance 
 
Whilst 1.1 above outlines the developing appreciation of the many uses of life insurance, the modern scene tends to look upon available life insurance products from the perspective of meeting various needs. These we may think of as: 
 
 (a) Personal needs: 
 
 (i) dependants’ living expenses; 
 
 (ii) final (end of life) expenses; 
 
 (iii) educational funds; 
 
 (iv) retirement income; 
 
 (v) mortgage repayment fund; 
 
 (vi) emergencies fund (usually needed to meet unexpected expenses); 
 
 (vii) disability income. 
 
(b) Business needs: 
 
 (i) key persons; 
 
 (ii) business owners; 
 
 (iii) partnerships; 
 
 (iv) employee benefits. 
 
 
1.2 PRINCIPLES OF LIFE INSURANCE 
 
In the Core Subject for this Insurance Intermediaries Quality Assurance Scheme, "Principles and Practice of Insurance", the principles of insurance were studied in detail. By way of reminder, but not detailed comment at this stage, these principles are: 
 
(a) Insurable Interest: the legal right to insure; 
 
(b) Utmost Good Faith: the requirement to reveal material information; 
 
(c) Proximate Cause: determining the effective reason for a loss;
 
(d) Indemnity: providing an exact financial compensation; 
 
(e) Contribution: insurers sharing an indemnity payment; 
 
(f) Subrogation: the insurer taking over rights against third parties. 
 
1.2.1 Insurable Interest 
 
In simple terms, insurable interest is that relationship with the subject matter of insurance (a person’s life, in the case of life insurance) which is recognised at law as giving rise to a legal right to insure that person’s life. This is a legal concept that has applied for more than two centuries and is obviously based on common sense. If you have no relationship with a given person, why should you have the right to insure his life and thus profit from his death? 
 
Some particular points to be noted with this principle are: 
 
(a) Statutory requirement: in life insurance, the legal requirement for insurable interest is derived from section 64B of the Insurance Companies Ordinance (ICO). 
 
(b) Effect of lack of insurable interest: Section 64B renders a contract of life insurance void where the person for whose use or benefit or on whose account it is made has no interest. 
 
(c) Insurable interest in oneself and in spouse: we all have an insurable interest in our own lives for an unlimited amount. In addition, a person is presumed to have an insurable interest for an unlimited amount in the life of his spouse, so that no proof of such an interest is required. 
 
(d) Insurable interest in others: to have an insurable interest in other people (i.e. people other than oneself and one’s spouse), the law requires some financial involvement which could be at risk by the other persons dying. Some examples which may be reasonably common are: 
 
 (i) debtors: if a person owes you money, you may insure his life for the amount of the loan, plus accrued interest; 
 
(ii) business partners: especially where personal services are involved, such as performers and musicians; 
 
(iii) contractual relationships: if another person's services have been engaged under contract (booking a singer for a concert, a professional sportsperson, etc.), that person's death may cause the other contracting party to suffer financially. That potential loss is insurable. 
 
Note: This heading would include a type of life insurance known as Key Person Life Insurance (or Key Employee Life Insurance), where an employer insures the life of an important employee, in case of loss to the business from the employee's death.
 
(e) Blood relationships and family members: in some countries (e.g. in most jurisdictions of the U.S.), a family relationship (brother, sister, parent, child, grandparent, grandchild, etc) is sufficient to constitute insurable interest. This is not true in Hong Kong, where blood relationship in itself is not regarded in law as constituting an insurable interest. 
 
(f) Statutory extension of insurable interest: by virtue of Section 64A of the ICO, a parent or guardian of a minor (i.e. a person aged under 18) is given an insurable interest in that young person. This is an important exception to the general rule in (e) above. It also means that, apart from one’s spouse, only the relationships mentioned (parent/guardian of a minor) constitute insurable interest arising from blood or family connection. An insurance effected on the basis of any other blood or family relationship is technically void (see (b) above). 
 
 (g) Sections 64C and 64D of the ICO: these Sections have two other important provisions: 
 
 (i) the person interested in the life insured, or for whose use or benefit or on whose account the contract is entered into, must be named in the contract; 
 
 (In practice, this provision has not been construed so widely as to include all those who the policyowner intends to benefit by receiving the policy proceeds. Therefore, where a life insurance policy is payable to the executors of the policyowner, no one cares whether the names of the executors and of the persons who are intended to benefit under the will appear in the policy.) 
 
 (ii) no more than the amount of the interest the insured (i.e. policyowner) has in the life insured is recoverable under the contract [this provision is significant only where the life insurance concerned is effected on an indemnity basis, credit life insurancebeing an example (see 2.1.1a(b)(i))]. 
 
 (h) When is the interest needed?: this is a key question, and very important consequences flow from its answer. The answer is that insurable interest is only needed when the contract begins, and becomes irrelevant thereafter. What could be the (quite legal) consequences of this? Some examples are: 
 
 (i) Divorce: a spouse, who insures his/her spouse and then becomes divorced, can keep the policy in force and be perfectly entitled to collect the benefit in due time.
 
(ii) Debts: it is legally possible to insure your debtor, have the debt repaid, keep the policy in force, and be "paid again" in due time by the insurer. 
 
 (iii) Assignment: a policyowner is capable of assigning a properly arranged life insurance contract to a third party even though the latter has no insurable interest in the life insured, provided that this is not a premeditated act of getting round the requirement for insurable interest. The latter act will be ineffective on the grounds that it is done for the purpose of defeating the object of a statute, and the contract is indeed void as from inception because the de facto insured (i.e. the intended assignee) has not the required insurable interest. Therefore, what matters is the intention of the policyowner when he is effecting a life policy. Taking out a life policy with the general intention of assigning it is legitimate, but doing so with the intention of assigning it to a specified person who has no insurable interest in the life insured is another matter. 
 
 
1.2.2 Duty of Disclosure 
 
 This concerns another important insurance principle, that of utmost good faith. Put simply, utmost good faith requires the disclosure of all material facts, whether the insurer requests them or not. A material fact is legally defined as ‘every circumstance which would influence the judgment of a prudent insurer in fixing the premium, or determining whether he will accept the risk’. 
 
Some points to note: 
 
(a) What to disclose: clearly, the insurer wishes to know all important facts, but you cannot be expected to disclose what you reasonably cannot be expected to know. Some conditions, for example, may be easily recognisable to qualified doctors, but the average layman cannot be expected to self-diagnose and reveal such things.
 
(b) Non-medical application: if the insurance is arranged without a physical examination of the applicant, the insurer will normally have 1/8 great difficulty in alleging non-disclosure of a material fact not covered by questions on the application or the personal physician's form. 
 
(c) Medical application: if the insurance is arranged with a physical examination of the applicant, the insurer cannot hold against theapplicant negligent omissions or mis-diagnosing by the medically qualified person concerned.
 
(d) Medical tests: the insurer is entitled to supplement information supplied verbally with reasonable medical examinations or tests, but great caremust be taken not to breach the Personal Data (Privacy) Ordinance, which requires insurers to explain the need for gathering information before any testing takes place. The subject of the tests also has the right under that Ordinance to be told their results. 
 
 (e) Breach of the duty on the part of the policyowner: at law, a breach of utmost good faith renders the contract voidable by the insurer. But with most life policies in Hong Kong, regard has to be taken of the Incontestability Provision (see 4.2), which means that the policy cannot be contested after it has been in force for a specified period (contestable period), unless there is proof of fraud. 
 
1.2.3 Other Insurance Principles 
 
(a) Proximate cause: this principle is concerned with the identification of the dominant, effective cause that produced the loss being claimed for under the insurance. The principle does apply to every class of business, but it is very likely to have rather less significance with life insurance partly because of the minimal use of exclusions. The application of proximate cause is very much concerned with different kinds of perils(i.e. causes of loss): 
 
Note: 1 Suicide is an exception to the general statement that life policies seldom have exclusions, so proximate cause will be important indetermining whether death arose from suicide or not. However, even here the principle does not have full impact, because suicide is only excluded for a limited time period (suicide exclusion period) (see 4.12). 
 
 2 We may conclude that the principles of insurance, especially those concerned with claims, have less application in life insurance than in non-life insurance. 
 
(b) Indemnity: this means an exact financial compensation for the loss sustained and is very important in most General Insurance policies. As far as life insurance is concerned, however,  (i) it is immediately obvious that the policy proceeds (or ‘insurance proceeds’) in no way pretend to (or can) represent an exact financial compensation. That is why life policies are called benefit policies, not indemnities; 
 
(ii) it is impossible to over indemnify. The insurable interest (closely linked with indemnity) in many cases is unlimited (see 1.2.1(c)).
 
(c) Indemnity corollaries: a corollary is a sub-principle and indemnity has two corollaries, Contribution and Subrogation. 
 
 (i) Contribution: in most General Insurance classes, if by some chance a person has more than one policy covering the loss, he does not get paid twice. Each policy contributes to (shares) the loss rateably. On the other hand, if he has more than one policy not by chance, a vigilant claims handler might well take that as an indication of fraud! 
 
 Life insurance policies are normally not subject to the principle of indemnity, so it is quite normal for a person to have more than one life policy and each must pay in full upon the insured event happening. 
 
(ii) Subrogation: this relates to the legal right of the insurer who has provided an indemnity to take over any remedies the “policyholder” (the UK equivalent of the American term “policyowner”) possesses against third parties, to seek to recover his payment to the policyholder. This does not apply to life insurance. 
 
 If, for example, a third party negligently damages a person's car (which has comprehensive cover), the person's motor insurer must pay but can attempt to recover its payment from the third party.In that same accident if an innocent victim in the car is killed, his life insurer must pay, but the life insurer has no right of recoveryfrom the third party.
 
1.3 CALCULATION OF LIFE INSURANCE PREMIUM 
 
 The individual premium to insure a given life may have to take into account individual features which make the risk better or worse than the average for a person of that age and sex. That, however, is essentially a matter of underwriting, which we shall consider in more detail in 5.3. Life insurance (premium) rates, which may be thought of as the normal or standard premiums applicable according to age and sex, are subject to certain common features considered below. 
 
1.3.1 Premium 
 
 The classic criteria usually applied to life insurance premiums are that they should be: 
 
 (a) adequate: so that the insurer will have money to pay the benefit and meet other obligations under the contract; and 
 
 (b) equitable (fair): so that each policyowner is paying an amount in linewith the risk and contracted benefit involved.
 
To achieve these criteria, a number of factors must be taken into account 
in the course of rating. 
 
 1.3.1a Mortality, Interest and Expenses 
 
(a) Mortality: perhaps more accurately phrased as the Rate of Mortality, this indicates the rate at which insured lives are expected to die. Whilst this sounds very morbid, it will be immediately obvious that this is absolutely at the heart of life insurance premium calculation. To know, on average, when the life to be insured may be expected to die is a crucial factor in determining the correct premium to charge. 
 
 Of course, individual lives may live much longer or shorter than the average, but following the "law of averages" (which is sometimes called the "law of large numbers") reasonable predictions and calculations can be made. These are greatly facilitated by the use of mortality tables, which are published tables showing the expected rate of mortality at any given age. 
 
 As mentioned above, individual risks may call for special terms and consideration, but that is an underwriting matter. Premium rating using mortality tables merely deals with normal risks and normal expectations. 
 
(b) Interest: in very simple terms, life insurance involves collecting money now and at specified intervals, to provide for a benefit at some time or upon some event in the future. This, by definition, means we have some time, and as the old saying goes "time is money"! 
 
How much time we have, on average, largely concerns (a) above. The fact that we have some time means that we have an opportunity for investment. The interest earned on invested premiums and previous interest earnings is another crucial factor in determining premium rates. If the anticipated returns of investment are good, an insurer can charge lower premium rates than its competitors, and/or make more profit for its shareholders. 
 
 Note: The above two factors combined will produce what is called the net premium (sometimes called the pure premium), i.e. the money required to be collected from the policyowners just to meet death claims arising in the future under normal statistical expectations. But there is more to consider. 
 
(c) Expenses: the net premium has to be subject to a loading (surcharge or additional sum) to take care of all expected and possible expenses. These will include all internal operating costs, commissions, tax and overheads to which any business is subject. With life insurance, there is also the possibility (however remote) of unusual mortality rates from some new disease or other disaster - and existing premiums cannot be increased later to deal with changed circumstances. Loading the net premium will include an amount to cover that kind of contingency. 
 
 Note: The loading added to the net premium produces the gross premium, which takes into account all three basic factors mentioned above. 
 
1.3.1b Other Factors 
 
 As mentioned, premiums for existing policies cannot be changed. Life insurance belongs to long term business, and this implies that the contract not only is very likely to last several years, but also it cannot be cancelled or amended by the insurer without the consent of the 
policyowner. Therefore, other factors which may arise from time to time can only affect new policy premiums. Some of the influences which might have an effect on life premium rating are mentioned below: 
 
1.3.2 Natural and Level Premium (Pricing) Systems 
 
 These systems for life insurance premium calculations might well be described as "ancient" and "modern", for reasons that will be clear shortly. 
 
 1.3.2a The Natural Premium (Pricing) System 
 
 The natural premium system (or the natural premium pricing system) was used by some life insurers in the early days of the business. It was very logical, but it was doomed to failure because of built-in features which virtually guaranteed that it could not work long-term in practice. Its features were: 
 
(a) Premiums: these were not to be constant throughout the policy term, but individually calculated each year so that they reflected the natural risk position (age, etc.) of the life insured at each policy anniversary. 
 
(b) Short-term consequences: with increasing age, there is increased mortality risk. Premiums for existing policies therefore increased every year.
 
(c) Longer-term consequences: these, in hindsight, were very predictable and included: 
 
 (i) increasing premiums with increasing age and, in later years, decreasing disposable resources or earning power of the policyowner, often presented real problems with 
continuation of insurance; 
 
 (ii) the system was vulnerable to anti-selection (also known as selection against the insurer), whereby the better risks - those in good health and with real prospects of a long life - dropped out of the scheme as it became more expensive, and the bad risks would normally decide to continue, for obvious reasons. This creates an imbalance of risks, with 
predictable results. 
 
(d) Present day: the Natural Premium System is no longer practised, at least not for policies which are truly "long-term". 
 
 Note: We may be tempted to be scornful of a scheme which we can now see to have such obvious defects. But it is easy to live life in retrospect. Problems and shortcomings usually only appear through experience. 
 
1.3.2b The Level Premium (Pricing) System 
 
 The level premium system (or the level premium pricing system) is now the norm and its features are described below: 
 
(a) Basic concept: by the judicious use of mortality tables and actuarial calculations, it was realised that it was possible to quote an annual premium that would remain level (unchanged) for the duration of the contract, based upon the age, sex and individual underwriting features of the life to be insured. This, of course, assumes that the death benefit also remains unchanged.  Compared with the cumbersome and unsatisfactory features of the natural premium system, the advantages and attractiveness of such a system are obvious. It quickly superseded the old system. 
 
(b) Short-term consequences: clearly, the level premium system envisages a long-term contract, where an unchanging annual premium will effectively "average out" over the years. In other words, the annual premium is "too much" for the risk involved in the early years, and may be "too little" for the risk involved in later years. 
 
 Of course this is a simplification, but it is not inaccurate. From this concept, it may be seen that once the initial expenses and costs of setting up the policy have been absorbed, the early "excess" premiums and interest earnings thereon start to create a fund or reserve against the future liability. 
 
 With other types of insurance, the premium is calculated each year and at the end of the year the premium is considered fully earned by the insurer. The life policy, under the level premium system, soon begins to build up a cash value for the policyowner. 
 
(c) Longer-term consequences: some of the implications and products of (b) above will be examined in more detail in Chapter 4, but we may briefly mention the features that developed from the early years’ "surplus" premiums found with the level premium system:
 
(i) Cash value and surrender value: the insurer cannot cancel a life policy, but the policyowner can. When a policy has been in force long enough to "clear" the set-up costs, part of the premiums paid – after the risk premium for the past period has been deducted – can be considered to be "not yet earned" by the insurer; it is referred to as “cash value”. Therefore, when a policyowner cancels apolicy with cash value, there should be a sum of money payable to him, representing a refund of premiums "unearned" by the insurer. This sum is known as “surrender value”. Surrender value equals cash value minus surrender charge, a charge that is applicable when a policy is surrendered for its cash value or when a policy, under some plans, is adjusted to provide a lower amount of death benefit. 
 
Note: This is not true for Term Insurance (see 2.1.1), where the premium is geared only to the risk of death during a specified period of cover. Such policies have no cash value. 
 
 (ii) Policy loan: the cash value is excellent collateral security for a loan. Borrowing money from the insurer using the cash value as security is now a right under modern policy terms. 
 
 (iii) Nonforfeiture: without specific policy provisions to the contrary, the policy will lapse if renewal premiums are not paid. However, the cash value may be used voluntarily by the policyowner or sometimes automatically under policy terms, to keep the insurance in force (see 4.5). 
 
 (iv) Paid-up insurance: should the policyowner decide that he cannot or does not wish to pay any further premiums, as an alternative to policy surrender he may have what is termed a fully paid policy. This means that he pays no more premiums and the policy stays in force exactly as before (so that it continues to be entitled to dividends if it is a participating policy), except that the sum insured (the face amount) is lower, in line with the net cash value and the premiums saved. This is largely possible because the premiums are not "fully earned" by the insurer in the earlier years of the policy.