What is life insurance?
Life insurance is an agreement between you and a life insurance company. Your part in the agreement is to pay certain premiums to the insurer. The insurer's part in the agreement is to provide financial compensation in case the insured life expires while your life insurance policy is in force.
Who receives the financial compensation? It can be one or many people. The policy owner decides who the policy's beneficiaries shall be. The policy owner also decides who the insured (or insureds) shall be.
In order for a life insurance policy to exist, then, there must be a financial relationship between the policy's insured (the individual(s) whose lives are insured) and beneficiary (the individual(s) who receive the indemnity). The beneficiary must incur a financial loss upon the death of the insured. This financial relationship is known as "insurable interest."
How & why insurance works
The reason behind insurance of any kind is that many people are willing to take a small loss (paying insurance premiums) in order to avoid the possibility of a much larger loss (such as the cost of a new car in the event of an accident). Insurance products allow such people to voluntarily share their risk with one another so that no single one of them is exposed to more loss than they can handle.
But what if some participants carry more risk than others? Would you want to pool your risk with someone who has cancer or alcoholism? It may seem that sharing risk with such a person is a bad idea, but the insurance industry offsets this inequity of risk by requiring higher premiums from people who carry greater risk. In any given period of time, the insurance company requires X amount of money to pay out in indemnity, and most of this money comes from the people who introduce the most risk into the collective pool.
In life insurance and health insurance, this means that people who take care of their health and live disciplined, responsible lives can (and must) pay less money for their insurance coverage. Meanwhile, people with pre-existing health problems, people with bad driving records, people with addictions, etc. pay more money for coverage.
