How Life Insurance Works

Understanding how life insurance works—from how premiums are calculated to how benefits are paid—is essential for anyone studying for the licensing exam or advising clients.

The Basic Concept

Life insurance operates on a simple principle: pooling of risks. Many people pay premiums into a common fund. When an insured person dies, benefits are paid from this pool. Because not everyone dies at the same time, the pool can provide substantial benefits to beneficiaries of those who die while remaining solvent.

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Mortality Tables

Mortality tables (also called actuarial tables or life tables) are statistical tools that show the probability of death at each age.

How Mortality Tables Work

Key Points About Mortality Tables

• Based on large population studies
• Updated periodically as life expectancy changes
• Separate tables for males and females (different mortality rates)
• Used by actuaries to calculate premiums and reserves

The 2017 CSO Mortality Table

The Commissioners Standard Ordinary (CSO) Mortality Table is the standard table used by insurers in the United States. The 2017 CSO table is the most current version and reflects improved life expectancy.

Exam Tip: The CSO mortality table sets the minimum reserve requirements for life insurers. Higher reserves are required for policies with higher mortality risk.

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Premium Calculation Basics

Life insurance premiums are based on three key factors:

1. Mortality Cost

The mortality cost is the pure cost of providing the death benefit, based on:

• Age of the insured
• Gender (where legally permitted)
• Health status
• Lifestyle factors (smoking, occupation, hobbies)

2. Investment Income (Interest)

Insurers invest premium dollars and earn returns. This investment income reduces the amount policyholders must pay.

3. Operating Expenses

Insurers must cover their costs:

• Commissions to agents
• Underwriting expenses
• Administrative costs
• Taxes and fees

The Premium Formula

Basic formula: Premium = Mortality cost + Expenses − Investment earnings

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Face Amount and Death Benefit

Face Amount

The face amount (also called the face value or sum insured) is the stated amount of coverage on the policy—typically the amount that will be paid upon death.

Death Benefit

The death benefit is the actual amount paid to beneficiaries when the insured dies. It may equal the face amount or differ based on:

• Policy type (some policies have increasing or decreasing death benefits)
• Outstanding policy loans
• Dividends left to accumulate
• Riders that modify the benefit

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Cash Value

Some life insurance policies—called permanent or cash value life insurance—build up savings over time.

How Cash Value Accumulates

When you pay premiums on a whole life or universal life policy:

1. Part of the premium covers the cost of insurance (mortality charge)
2. Part covers expenses
3. The remainder goes into the cash value account

Characteristics of Cash Value

Cash Value vs. Death Benefit

The relationship between cash value and death benefit depends on the policy type:

• Whole life: Death benefit remains level; cash value grows until it equals the face amount at maturity (typically age 100-121)
• Universal life Option A: Death benefit remains level; cash value included within the death benefit
• Universal life Option B: Death benefit equals face amount plus cash value

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Policy Loans

Policy owners can borrow against the cash value of their permanent life insurance policies.

How Policy Loans Work

Important Points About Policy Loans

• Not considered taxable income when taken
• If policy lapses with an outstanding loan exceeding basis, gain may be taxable
• Interest charges accrue if not paid
• Loan balance deducted from death benefit if insured dies

Example

An insured has a policy with a $100,000 death benefit and $30,000 cash value. They borrow $20,000 against the policy. If they die without repaying the loan:

• Death benefit payable = $100,000 − $20,000 = $80,000 (minus any accrued interest)

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Premiums: How Payment Works

Premium Payment Modes

Policyholders can typically pay premiums:

More frequent payments cost more because:

• Administrative costs are higher
• Insurer has less money to invest for longer periods

Grace Period

All life insurance policies provide a grace period—typically 30 or 31 days—during which a late premium can be paid without policy lapse.

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Key Takeaways

• Life insurance works through the pooling of risks among many policyholders
• Mortality tables show death rates by age and are used to calculate premiums
• Premiums are based on mortality cost, expenses, and investment income
• The face amount is the stated coverage; the death benefit is the amount actually paid
• Cash value in permanent policies grows tax-deferred and can be borrowed against
• Policy loans reduce the death benefit if not repaid
• More frequent premium payments result in higher total annual cost