As with all types of insurance, life assurance policyholders pay premiums into a common fund from which all claims are paid out. In order for the insurer to be certain there will be sufficient funds to pay out all the claims, there has to be a relationship between the premium charged and the benefit given under a policy.

This is easier to predict with life assurance than with other types of insurance, because mortality tables can be used to predict the number of deaths and therefore the number of likely claims.

By using mortality tables, an actuary can find out the mortality rate for any given age and, by multiplying this by the sum assured, can work out the premium for that year.

If a large enough group of healthy people is insured, the chances are that some of them will die in the course of a year. It is obviously impossible to predict who will die during the period, but if everyone pays the premium that is appropriate for their age, there should in principle be enough money to pay all those who die and leave nothing over.

It can be seen from the mortality tables that the risk of death generally increases with age. If a level premium is charged throughout the duration of a policy, the premium in the early years is higher than is needed to meet the current claim costs. Thus there will be money in hand to meet the cost of the greater risk in later years, when the premium will be less than is required to cover such risk.

The excess in the early years forms a reserve that can be drawn on to meet the heavier claims in the later years. In any group of insured lives, there will be just a few deaths in the first year, causing a moderate proportion of the total premiums to be paid out in claims. The balance will go into the reserve to be held against future claims. In the second year, a slightly higher proportion of the premiums will be needed to pay claims and a slightly lower proportion will go into the reserve. Each year the claim cost will be slightly higher and the amount going into the reserve slightly lower, until eventually the reserve starts to decrease as claims exceed premiums.