Most Pakistanis in their mid-20s or older would remember the old advertisement from State Life from the early 1990s: a young girl singing about her father while playing with him. The father then suddenly vanishes and the family is then somehow grateful that he bought a life insurance policy. The ad was memorable, but it did not really address the main question: what is life insurance? And more importantly, should you get it?

The answer to that second question, of course, depends on your personal financial situation. But in making that decision, it would be helpful to know how life insurance works and what the different varieties are. And in this particular case, it is also probably helpful to know the incentives of the people who might come knocking on your door trying to sell life insurance to you.

The fundamental concept of life insurance is this: most of us have financial obligations to our families that we plan to meet over the course of our lifetime, particularly those of us who have children, elderly parents or other dependents. But what would happen to them if you died before you were able to meet those obligations? Life insurance offers protection against premature death, offering a payout to your loved ones so that, while they will mourn your death, they will at least not be in financial ruin because of it.

Here is how it works. Let’s suppose I, a 29-year-old healthy non-smoking male, walk into an insurance company and ask for a life insurance policy. One of the first things they will ask me — after my age, health and particulars — is how much I want life insurance for. In other words, if I were to drop dead tomorrow, how much do I want the insurance company to pay to my heirs? Now, I am a young, unmarried man so I have no dependents, but I do have some debts. So I would choose the amount equal to my total debts.

How policies work and how to think about selecting the right one for you

For other people, it would work differently. Of course, if you have any debts, you should include that in your amount. You should also include any lump sum amounts you are planning on saving up for, such as children’s education or retirement savings. Add those amounts and then seek insurance for that much.

The insurance company will guarantee that your loved ones will be taken care of, but of course, you will have to pay for that guarantee in the form of a monthly premium. That amount of the premium depends on a variety of factors, including your age (younger people get charged less than old people), health (smokers get charged more) and what type of policy you choose (more on that below).

The insurance company makes money by betting that, of all the people who buy life insurance, only a few will actually die young. It takes the premiums that everyone pays in and invests them in a variety of different instruments such as stocks and bonds. The families of the few people who do die young are paid out from the premiums paid by the people who live to old age. You can also probably guess why some people get charged less than others. If you are young, you are less likely to die before your policy expires than if you are older. And if you are a smoker, you are more likely to kill yourself than non-smokers.

Now, you might be wondering: what happens to the premiums I paid if I don’t die young? Here is where we come to the two different types of insurance: conventional life insurance and term life insurance.

In ‘conventional life insurance’, the premiums you pay are in fact paying for two things: firstly, to insure your family against your premature death and secondly, an investment account that accumulates savings over time. In this account, if you are still alive on your 60th birthday, you will get the amount of money in your investment account, which can be a considerable sum.

In ‘term life insurance’, you pay a smaller premium, but if you do not die, you will get absolutely nothing from the insurance company when you turn 60.

So why would anyone choose the former? Well, for starters, the premiums are way lower in term life insurance than in conventional life insurance. For the same amount of insurance, you may be charged a premium of Rs500 per month for term life insurance and Rs5,000 per month (or more) for conventional life insurance.

A second major difference is the commission structure. Of the first year of premiums that you pay in a conventional life insurance scheme, between 75pc and 90pc is paid as commission to the agent who sold you the insurance policy. Only in your second year do you begin accumulating investments. This first years’ commission may not sound like much if you are considering a life insurance policy of 20 years or longer, but it can knock your returns down more than you might think.

This difference in commission structure is also why insurance agents are far less willing to sell you term life insurance than conventional life insurance.

This is not to suggest, of course, that one is better than the other. It is just that both have different characteristics. If you want the certainty of a payout, are willing to use your insurance policy as your savings plan and are willing to pay the commission, then you should choose conventional life insurance. If you want just the protection against premature death and are willing to invest through mutual funds or other means, then term life insurance is probably your best bet.

So what about the initial question: should you have life insurance at all? Well, as I write this, a wave of terrorism is gripping the country and many people are being killed. So the question you have to ask yourself is: “Do you feel lucky, punk? Well, do ya’?”

 This article is meant only to provide information about financial services products. It is not meant as a solicitation or recommendation to buy or sell securities or other financial instruments of any kind. Readers should do their own research carefully before making personal investment or financial decisions.

Published in Dawn, Sunday Magazine, June 15th, 2014