Life Insurance Companies

The unfortunate experience of assessment societies demonstrates the need to reflect relative risk in the charges made by a voluntary organization intended to pool life insurance risks. The basic premise of assessment societies that each member should share equally in assessments did not offer an easy method of recognizing such differences in risk, even those caused by differences in age. The explicit recognition of age as a predictor of longevity characterizes the life insurance companies that thrived while the assessment societies were failing. These companies use a structure of level periodic payments and mathematically determined reserves to reflect the impact of age on risk.

Life insurance companies that use this structure might be organized as mutual companies or as stock companies, but in any case were in competition with one another for the voluntary business of individuals or groups. For both mutuals and stocks, the relationship with the individual customer is defined by a contract or policy. The policy contains conditions of coverage, as well as rates, or premiums, that must be paid initially and at subsequent intervals. Because each customer or policy owner enters into a separate contract, premiums can reflect differences in age or indeed in any other factor expected to affect the risk of death of the insured. Premiums can thus be designed to reflect the specific risks posed by each definable risk class.
Initially, life insurance companies primarily offered individual insurance, which pays a benefit only on the death of a specific individual (the insured). The policy owner might be the insured, another individual, or even a trust or other legal structure, but because this legal distinction does not normally affect the decision-making process, no generality is lost by restricting the consideration of individual insurance to the case where the policy owner is an individual.

In attempting to form a contract of insurance, a central concern is obviously the risk to be insured. Not all risks are suitable for insurance. In fact, insurance is usually limited to coverage that pays out on the occurrence of an insurable event. Generally speaking, five conditions must be met for an event to be considered insurable. First, it must result from an actuarial risk; in other words, it must involve uncertainty with respect to occurrence, timing, or severity. Second, this risk must display enough statistical regularity to allow its frequency of occurrence to be predicted with some degree of confidence. Third, the fact that the event has occurred must be definitely determinable. Fourth, the event must involve loss to one or more persons. Fifth, the person or persons suffering loss must not be in a position to influence the occurrence, timing, or severity of the event.

If a person has an insurable interest in an insured risk, this person is expected to suffer loss if the insured event occurs. Moreover, the insurer is expected be in a position to limit the insurance amount so that the person loses more than he or she would gain from the insurance benefit, thus reducing the chance of moral hazard. For life insurance, given the unacceptable course that moral hazard might take, the requirement of insurable interest has been inserted into state laws and regulations, and this is one of the primary reasons why a secondary market in life insurance policies has so far failed to develop in the United States.

The unfortunate experience of assessment societies demonstrates the need to reflect relative risk in the charges made by a voluntary organization intended to pool life insurance risks.

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