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2. How Does Life Insurance Work?

Life insurance is an example of risk pooling. Risk pooling means that individuals transfer or share their financial risks with others to reduce potential catastrophic losses from death, accidents, or health problems. While everyone pays into this insurance pool, because there are a lot of participants and hopefully few recipients, the cost per participant is small and available to a larger number of participants.

There are two main risks that life insurance can share or transfer: mortality and investment risk.  Mortality risk is the risk that the insured dies within the contract period and is therefore covered by insurance. Some insurance contracts must be renewed each year, and are therefore very risky, as health or other concerns may make the individual unable to obtain coverage.  Other products cannot be cancelled by the insurance company (except for lack of payment), and therefore ensure mortality coverage.

Investment risk is who takes responsibility for the investment outcome. With some policies, the individual takes responsibility for the investment outcome; with others, the insurance company takes responsibility. 


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