When you buy a car, you have to buy third party insurance. That is life insurance; you are buying an insurance policy on the life of the yet unknown victim whom your car may kill or maim. It is similarly possible to buy a pure life policy on your own life. Some foreign countries insist on your having one before they give you a visa, and Life Insurance Corporation sells you one at an exorbitant price.
But most life insurance policies bought are endowment policies; they promise you a certain sum of money if you die before a certain age, and that sum at that age if you are alive. In other words, it is a life insurance policy combined with a long-term investment. You pay the insurance company annual premia, it invests the premia, and pays you a certain rate of return on your investment should you reach the terminal age. That return is less than what you would get on investments that are not combined with insurance; the difference between the two returns is the insurance premium.
What an insurance policy does is to lock you in for its term; you cannot cash your investment and put it somewhere else, and you cannot shop for the cheapest life premium. You could equally well buy pure life insurance every year or every five years, and reshuffle your investments whenever you like.
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Equally, an insurance policy locks the insurance company in. It has to pay you whatever it promises when the policy matures. If it makes mistakes in its investments and fails to earn enough to pay policyholders on maturity, it will go bankrupt.
It would be even more profitable for an insurer to collect premia from a lot of people and run away. Hence most governments regulate insurance companies. Basically, they restrict insurance companies' investment options to fixed-interest investments, and they impose accounting standards which ensure that pure insurance premia at least cover the risks of the insured people dying, and that the maturity pattern of the insurance companies' investments matches that of their liabilities. Some governments also license insurance companies. Ours permits only one life insurance company -- its own -- to do business. It has been promising for the past seven years to allow us to choose insurance companies; but all it has done to fulfil its promise is to appoint an insurance regulator. The regulator, Mr Rangachari, has made it clear that his prime concern would be to ensure that the premia are not "too low".
In Britain, on the other hand, insurance companies have been self-regulated. The first insurance companies were pure insurance companies: they insured people against death or disability. But they were cautious; they charged higher premia than they needed. Over time they found they were accumulating surpluses. They were mutual societies, and not companies; they were in theory owned by the policyholders, and not by shareholders. So their surpluses belonged to the policyholders. But if they had reduced premia, they would have offended their old customers who had been paying high premia. So instead, they started giving back to old customers some of the premia paid by them: they started declaring a bonus. The bonus was not necessarily paid back every year; it was credited to the customer's account, and given to him with interest when his policy matured. Such policies, called with-profits policies, were invented in 1781 by Richard Price, who was consultant to Equitable Life Assurance Society, the world's oldest life insurance society. Soon two distinct types of policies came to be offered -- with-profits policies, and non-profit policies which cost less but were not entitled to bonuses. And once the concept of profit-sharing came in, an insurance policy also became an investment, and people began to use policies as a long-term saving instrument. So a third type of policy -- the endowment policy -- also came into existence.
This was more or less all there was to life insurance business till the 1970s. But then, as described by Simon London in the Financial Times, insurance companies began to distinguish between the insurance and the investment elements in policies, and to allow customers a choice of investments. If the customers chose equity investments, their value could go down as well as up; insurance companies might pay a bonus when share prices went up, but could not ask for higher premia to make up for losses if prices went down. So they began to announce lower annual bonuses on equity-linked policies, and to give big terminal bonuses.
A policy with a large terminal bonus pays you too little if you cash your policy before maturity, and tries to make up if you cash on maturity. There is another type of insurance where you are not penalised for early withdrawal: a unit-linked insurance policy. Here, you pay a one-time premium; the insurance company invests it in a mutual fund. You can cash this investment at any time. The insur