Note: This is a 12 Part Series.

That’s a bold statement I know, but I’m going to tell you an analagous (but fictitious) story of how life insurance came about and how it was designed. Once we get through the series, you’ll know more than 75% of life insurance agents out there – but best of all, it won’t be boring! To start we have to get a basic understanding of the machine that is life insurance – allow me to tell a story…

Let’s go back a few hundred years… In a pub there was a frequent visitor named Lloyd who was a wealthy man, and always looking to make more and more money. Everyone in the town knew of Lloyd’s wealth and they would come to him to ask for his money for business transactions, for loans, or just to plain beg!

One day, a farmer came to Lloyd and said, “Listen I have a problem. It is July and my crops are due to be harvested in August.  We’ve had a fantastic year this year and we will earn more selling this year’s crops than for the last 5 years combined.”

Lloyd retorted by saying, “That hardly sounds like a problem friend!”

“Well,” continued the farmer, “hear me out: I am the only one in the household who can harvest those crops – without me, the crops will sit and die and become worthless. I know that once I harvest those crops I can stop working for life! But I am close to 40 years old (old back then!) and I would like to make sure that no matter what happens to me, my family will be taken care of…  Even if it costs me money for that peace of mind!”

Lloyd thought for a moment.  He had a solution.  He would offer the farmer the choice of giving him 100 gold coins if he died before the harvest was done in one month’s time in exchange for the farmer giving Lloyd 20 gold coins NOW.  And if the farmer didn’t die, Lloyd would keep the 20 gold coins nonetheless.

To Lloyd, he looked at this farmer and believed that he was in exceptionally good health for a 40 year old.  Lloyd knew that for every one hundred 40-year-old men in the town, that on average 5 of those one hundred would die in the next month. And Lloyd was willing to bet that this farmer wouldn’t be one of them!

The farmer agreed to this scheme of insuring his life – he lived, he harvested and he sold his crops and retired wealthy to make for a nice story. Lloyd was happy too, he had 20 gold coins that he did not have before for making this “bet” on the farmer’s life.

Okay – so now let’s take a look at the math behind this. The statistical odds of that farmer dying were 5 in 100 (or 1 in 20) which is a 5% chance. So there was a 5% chance that Lloyd would’ve “lost” on his bet about the farmer’s life, and had to have paid out 100 gold coins.  Considering that he had collected 20 gold coins, he would really only be out 80 gold coins.  To Lloyd, he saw this as a 95% chance that he would make 20 gold coins versus a 5% chance that he would lose 80 gold coins. Since he was wealthy, he decided to take the risk.

Now, this is a risky thing for Lloyd to do because it is possible that the farmer would’ve died.  Since Lloyd was taking on this risk of having to pay 100 gold coins, instead of just charging 5 gold coins (which would be the statistical break-even point) he charged more (20 gold coins).  He did this to compensate for the risk he was taking.

Let’s fast forward 10 years – this “scheme” had caught on like wildfire and other people were coming up to Lloyd for the very same proposition – they wanted to be insured for 100 gold coins in exchange for a price.  Lloyd was a shrewd business man and knew that if he lowered the “premium” he would attract more customers. As he attracted more customers, he could lower the premiums since one bad “bet” would not wipe him out as there would be 20 good “bets” for each bad bet – going by the statistics.

So let’s look at this new business Lloyd has set up for himself.  This year, he has 1000 men (all aged 40) who have bought a life insurance policy for him for the next month.  He knows that statistically 50 of those men will die and he will have to pay (50 men x 100 gold coins) 5000 gold coins out in death benefits.  He also knows that 950 men will survive – if he wanted to break even, he would have to generate 5000 in premiums from all 1000 men – so he could charge them each 5 gold coins instead of 20.

BUT – being the business man that he is, he knows that some months 60 of 1000 men will die, and some months 40 of the 1000 men will die.  He doesn’t want to get caught out – and in exchange for this risk that he is taking and to make sure that all his time isn’t for naught (this new endeavour was taking up all of his time!), he charges an extra 2 gold coins on top of the 5 needed to break even – to make sure that he makes a profit. So during the next month, he collects 7 gold coins each from 1000 men (7000 gold coins) and pays out 5000 gold coins – he is earning 2000 gold coins per month!

So let’s now look at this from a “policy-holders” point of view.  They also know that 50 out of 1000 men like them will die in the next month.  By taking out the policy and paying the 7 gold coins they “win” if they die – their family will receive 100 gold coins in exchange for 7. It is a very morbid way to think about it, I know.  The insurance company wins if you don’t die – because they keep your premium and didn’t pay out a death benefit.

I’ll stop here for Part 1 in this series.  In Part 2 we are going to fast foward to the present time, and look at how some of the life insurance lingo developed by building on what we have learned in Part 1!

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Learn more about Life Insurance than your Insurance Agent knows part 10

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Learn more about Life Insurance than your Insurance Agent knows Part 4

Learn more about Life Insurance than your Insurance Agent knows Part 3

Learn more about Life Insurance than your Insurance Agent knows Part 2