What do life insurance insurance premiums pay for?

When you purchase a life insurance policy, it may not be entirely clear what is being paid for. It is designed to protect you from the impact of a contingent event. But the hope is that the event won't occur in the near future - if at all (although the one thing that is certain in life, is death). So what do life insurance premiums pay for?

Claims:

Life insurance protects beneficiaries from the financial impact of the life insured's death or incapacitation (through illness or injury). The premium, therefore, must cover the cost of potential claim (and related expenses).

The expected cost of claim is the greatest component of the premium. How does the insurer estimate the cost of a hypothetical event? They don't have a crystal ball but they do have statistics to assist them.

Statistic sources:

Insurers get their statistics from a number of sources.

Industry bodies - organisations such as the Institute of Actuaries of Australia collate and publish mortality, total and permanent (TPD), trauma and income protection statistics. These are based on studies of the life insurance industry's experience.

The insurer - insurers usually have their own track record of claims and related expenses in conjunction with industry statistics.

Government bodies - if a new benefit is introduced for which there is no industry or company experience, statistic are obtained from sources like the Australian Bureau of Statistics and the Australian Institute of Health and Welfare.

Reinsurers - all reinsurance companies in Australia also operate overseas. As a result, they often have international statistics which may not be available to the Australian market.

All statistics are analysed in line with the terms and conditions of the particular product [policy cover].

Production expenses:

Like any other product, there are certain costs involved in 'manufacturing' a life insurance policy. These include the services of the sales teams, underwriters, new business administrators, product managers and actuarial analysts. Ongoing expenses include policy administration, claim assessment and servicing the client call centres. These costs include staff salaries and equipment expenditure.

There are also indirect costs such as human resource services, finance and legal assistance. The premium must also cover a portion of the tax and stamp duty that is payable by the insurer.

Commissions:

Another component of the premium is the cost of adviser commissions. The insurers need to forecast the expected term of the policy and calculate the total estimated commission value. An assumption for lapse/cancellation rates must also be factored in, which is typically based on that insurance company's experience. Therefore recouping commission costs on policies that cancel before their expected term is also a consideration.

Return to shareholders:

In the first year of a policy, the following costs must be outlaid;

• expected cost of a claim
• initial commission [if any]
• production expenses
• statutory capital [this is an APRA requirement that insurers hold a certain level of capital for each policy]

The first year's cost to the insurer easily exceed the first year's premium. To cover the shortfall an investment is required from the insurer's shareholders, and like any other investment, a return on investment is expected. Therefore, in addition to the other costs already mentioned, the premium must provide a rate of return to the shareholder.

On average it takes 8 years to fully recover the shortfall from a policy's first year. This is before any profit is made on that policy by the insurance company.

Calculating different premium types - most policy holders choose to have stepped premiums as these are generally less expensive than level premiums at the inception of the policy. The stepped premium must cover the costs associated with a given age over one year. These include expected claims costs, renewal commission [if any], and ongoing expenses. Stepped premiums increase each year according to the costs noted above, age and policy indexation. Level premiums ,while generally more expensive in the initial years of the policy, will remain reasonably level throughout the life of the policy, and therefore may be a more cost effective way to pay for your policies in the longer term.

Hopefully the information in this article has given you an insight into how an insurance company calculates a premium for a particular policy type. There are many factors involved in the calculation of a life insurance premium [covering term life, TPD, trauma, income protection and business expenses]. A term life policy will generally be the least expensive of all the cover types as there is one main factor influencing that policy, and that is the insured person has to die for the policy to respond. Policies such as trauma and income protection generally have a higher premium rate imposed on them as they provide cover for more events, and recent historical data [the last 10 - 20 years] has shown that these policy types have the highest claim rates.

If you have any questions regarding your insurance policies, please do not hesitate to contact us.

Disclaimer: this article is an extract from the ING Life Lines magazine, Issue 2, 2009, article by Stephen Hungerford, Risk Products Actuary.