The Basic Principles of Life Insurance (Part VI)
Determining Life Insurance Premium
Mortality tables list different rates for men and women of different ages. The rate per $1,000 of benefit for women aged 35 is $1.65 in the 1980 Commissioners Standard Ordinary (CSO) table. The companies that issue policies to only the healthiest applicants will have rates significantly lower than those in the CSO tables. Even insurance companies issuing policies to applicants in average health usually offer rates lower than those listed in the CSO tables.
We will first examine how the premium for a yearly renewable term (YRT) insurance policy is calculated to demonstrate how the tables are used.
YRT is the simplest form of insurance offered by life insurance companies. It provides insurance for a period of one year and allows the policyowner to renew the policy for successive periods of one year each, paying just the mortality charges and administrative expenses for one year at a time, and no more. The interest component is minimal.
The mortality charge for YRT insurance is determined by the death rate for the attained age of the individual involved. Each premium purchases only one year of insurance protection. Each group of policy owners of a given age is considered to be a separate class for premium purposes; each group must pay its own death claims, the burden shared equally by the members of the group. Because the death rate increases with age, the premium for yearly renewable term insurance normally increases each year.
Because premiums are paid to the life insurance company in advance, the cost of the anticipated death claims would be distributed pro rata over the 100,000 policy owners, and a premium of $1.16 would be obtained from each policyowner. Note that:
• the premium is precisely the same as the death rate applicable to those insured
• those policyowners who, according to the mortality projection, will die during the year, contribute on the same basis as those who will survive
Each policyowner pays a share of his or her own death claim. This is a principle that underlies all life insurance contracts. The proportion, however, varies with the type of contract, age at issue, and duration of the protection.
If the 99,884 survivors of the original group of 100,000 policy owners were insured for another year, they would be exposed to the death rate for persons aged 26, or 1.19 per 1,000, which would theoretically produce 119 deaths and claims totaling $119,000. That sum, divided equally among the 99,884 participants would yield a share, or premium, of $1.19 per person. If the 99,765 women who survived the first and second year should desire insurance for another year, provision would be made for $122,000 in death claims, requiring a premium of $1.22 per person.
For the first several years, the premium would continue to increase slowly, being $1.35 at age 30, $1.65 at age 35, and $2.42 at age 40.
However, the premium would rise sharply thereafter, reaching $3.56 at age 45, $4.96 at 50, $7.09 at 55, $9.47 at 60, and $14.59 at 65. If the insurance should be continued beyond age 65, the cost would soon become prohibitive, soaring to $22.11 per $1,000 at age 70, $38.24 at 75, $65.99 at 80, and $116.10 at 85. The premium at 90 would be $190.75 per $1,000; at 95, $317.32. Finally, if a woman aged 99 should want $1,000 of insurance on the YRT basis, she would have to pay a premium of $1,000, since the 1980 CSO table assumes that the limit of life is 100 years and that a person aged 99 will die within the year (or at least the policy period will end).
The Basic Principles of Life Insurance (Part V)
Mortality, Interest, and Expense
All life insurance products are actuarially created by calculating the relationships of mortality, interest, and expense, and the financial values resulting from each based on time. The assumptions made concerning these three factors will determine the premium at which a policy is sold, the structure of the policy, and over time the performance of the policy and the profitability and solvency of the life insurance company. ALL life insurance policies, regardless of type, are based on these same elements.
Mortality rates project the cost of covering death claims as they occur. Interest earnings reflect the income the company expects from the investment of premiums over time that will be added to the reserves, held aside to pay future claims. Expenses include the cost of creating, offering, and maintaining the product to pay all promised benefits. These factors must also provide profit to the insurer.
Different products handle these factors differently. Term insurance has a pay-as-you-go structure. Premiums increase as mortality increases and the policy does not build cash value. Interest earnings have a smaller impact on the premium than in permanent policies and expenses are largely covered by the policy fee.
In permanent whole life insurance (WL), the policyowner pays premiums in advance, paying a higher, or excess, premium that can be “reserved,” so that increases in premium are not required. This higher premium level builds cash value the policyowner can access through loans or cash surrender of the policy. In WL, these factors are “bundled,” meaning they are not itemized or disclosed separately.
In universal life (UL), the costs are unbundled, meaning the components of mortality, interest, and expense in the policy are identified and the values and charges for each are itemized in regular reports to policyowners.
Mortality charges are identified as cost of insurance (COI), which are monthly charges based on the insured’s issue age, attained age, net amount at risk, gender, and underwriting class. Interest is paid each month on the cash value at the current crediting rate. Administrative expenses are charged monthly. All of these elements have a current rate, and are subject to maximum and minimum guaranteed charges or interest crediting as stated in the policy.
Because of the unbundled nature of policy costs, UL looks like an investment account with term coverage. The mortality charges are similar to those of term, and the interest rates reflect the current market and adjust to changing market conditions. The policyowner accepts more of the investment and mortality risk, with a minimum guaranteed interest crediting rate, and maximum mortality and expense charge guarantees.
Variable universal life (VUL) contains death benefits and cash values that vary with the performance of the subaccounts selected. The death benefit and cash value are not guaranteed, and can fluctuate according to market performance. The life insurance aspect of VUL is essentially the same product as UL with the same features and specifications for the most part.
The main difference between UL and VUL is the variable investment aspects of the VUL product.
Mortality
To price insurance products, and ensure the adequacy of reserves to pay claims, actuaries use mortality tables to project the number and timing of future insured deaths. They study the incidence of deaths in the recent past, and develop expectations about how these events will change over time and develop an expectation for what the timing and amount of such events will be into the future. A safety margin is built in that increases the mortality rates above what is expected. In participating policies, savings created by these conservative assumptions can be returned as dividends. In nonparticipating policies, the safety margins must be smaller in order for the premium rates to be competitive.
A mortality table shows mortality experience used to estimate longevity and the probability of living or dying at each age, and is used to determine the premium rate. Mortality tables may include the probability of surviving any particular year of age, remaining life expectancy for people at different ages, the proportion of the original birth cohort still alive, and estimates of a group’s longevity characteristics. Life mortality tables today are constructed separately for men and women, and are created to distinguish individual characteristics such as smoking status, occupation, health histories, and others.
With significant improvements in mortality over the last 20 years, mortality rates are decreasing. One resulting change is the extension of the life span in the 2001 CSO Mortality Table to attained age 120 (compared with age 100 in the 1980 CSO table). The CSO mortality tables represent the most widely used estimates of expected rates of death in the United States based on 2001 CSO Mortality Table age. The data used for the CSO tables is taken from data developed by the American Academy of Actuaries, and adopted by the National Association of Insurance Commissioners (NAIC). The CSO mortality tables are used to calculate reserves and minimum cash values for state regulatory purposes, as well as life insurance premiums. The recent changes will lower the statutory reserves required by state insurance departments on all life products. Larger insurance companies use their own mortality statistics to calculate their pricing of products, based on their own selection and underwriting practices. Since 1980 CSO mortality represents the vast majority of in-force policies, it is, and will be, relevant for years to come, even though newly issued policies will increasingly be using 2001 CSO rates.
The 2001 CSO Mortality Table is currently being introduced and approved for use in the various states. Companies can base product designs on either the 1980 or the 2001 CSO mortality tables. As of January 2009, all new products must use the 2001 CSO table. For term products, this means mortality costs, and consequently premiums, are going down. For cash value products, the 2001 table lowers the amount of premium that can be put into accumulation products and still be considered life insurance, based on IRS rules for defining life insurance. These rules, will allow individuals to pay less premium for the same amount of life insurance. Since the life insurance will be less costly, the allowable cash value must also fall, due to the maximum ratio of cash value to death benefit.
Interest
Insurers invest the premiums they receive and accumulate them for future claims and other obligations, such as policy loans and surrenders. Life insurance company portfolios are traditionally long-term and emphasize safety of principal and predictable rates of return, to accommodate their long-term obligations. Typically, two-thirds or more of this capital is invested in bonds and mortgages, which meet the above criteria. A smaller percentage is invested in common stocks, due to their volatility, and these represent less than 10 percent of an insurer’s general portfolio.
Since recently issued policies have low claims experience as a whole until years later, there is an adjustment in the calculation of the premium for the time value of money (compound interest). If the investment results exceed the guaranteed minimum, policyowners benefit from either participating dividends or excess interest crediting to the policy’s cash value.
Expense
Life insurance companies incur acquisition and administrative expenses in the course of doing business. Acquisition expenses include the costs incurred in obtaining business and placing it in force, such as advertising and promotion fees; commissions; underwriting expenses; costs associated with medical exams and attending physicians’ statements, inspection report and credit history fees; home office processing costs; and an addition to the insurer’s reserve, surplus, and profits. Administrative expenses include the costs associated with collecting premiums and distributing dividends, continuing producer compensation, investment expenses, and home office overhead. Any costs the insurer incurs must be recovered through mortality savings, expense charges, or reduced interest crediting.
The Basic Principles of Life Insurance (Part IV)
The Law Of Large Numbers
For a plan of insurance to function, the pricing method needs to measure the risk of loss and determine the amount to be contributed to the pool by each participant. The theory of probability provides such a scientific measurement.
Probabilities for life insurance are represented in a mortality table. The mortality table is very versatile, developing probabilities of dying over the entire life span. Life expectancy at any age is the average number of years of life remaining once a person has attained a specific age. It is the average future lifetime for a representative group of people at any given age. The probable future lifetime of any individual, of course, will depend on his or her state of health, among other things, and may be much longer or shorter than the average.
The statistical group that is observed for purposes of measuring probability must have mass—that is, the sample must be large enough to allow the true underlying probability to emerge. The law of large numbers states that as the size of the sample (insured population) increases, the actual loss experience will more and more closely approximate the true underlying probability. This means that the insurer’s statistical group must be large enough to produce reliable results, and that the group actually insured must be large enough to produce results that are consistent with what probability predicts.
Insurance relies on the law of large numbers to minimize the speculative element and reduce volatile fluctuations in year-to-year losses. The greater the number of exposures (lives insured) to a peril (cause of loss/death), the less the observed loss experience (actual results) will deviate from expected loss experience (probabilities). Uncertainty diminishes and predictability increases as the number of exposure units increases. It would be a gamble to insure one life, but insuring 500,000 similar persons will result in death rates that will vary little from the expected.
A peril is a cause of a loss. In life insurance, the event against which protection is granted, death, is uncertain for any one year, but the probability of death increases with age until it becomes a certainty. If a life insurance policy is to protect an insured during his or her entire life, an adequate fund must be accumulated to meet a claim that is certain to occur.
Some people claim that insurance is a gamble. Insurance is actually the opposite of gambling. Gambling creates risk where none existed. Insurance transfers an already existing risk exposure and, through the pooling of similar loss exposures, reduces financial risk.
The Basic Principles of Life Insurance (Part III)
Risk Pooling
Life insurance is based on a mechanism called risk pooling, or a group sharing of losses. People exposed to a risk agree to share losses on an equitable basis. They transfer the economic risk of loss to an insurance company. Insurance collects and pools the premiums of thousands of people, spreading the risk of losses across the entire pool. By carefully calculating the probability of losses that will be sustained by the members of the pool, insurance companies can equitably (fairly) spread the cost of the losses to all the members. The risk of loss is transferred from one to many and shared by all insureds in the pool. Each person pays a premium that is measured to be fair to them and to all based on the risk they impose on the company and the pool (each class of policies should pay its own costs). If all insureds contribute a fair amount to the mortality fund held by the insurance company, there will be sufficient dollars in the fund to pay the death benefits of those insureds that die in the coming year. Individually, we do not know when we will die, but statistically, the insurer can predict with great accuracy the number of individuals that will die in a large group of individuals. The insurance company has taken an uncertainty on any individual’s part, and turned it into a certainty on their part.
Illustration of the risk-pooling Concept
The simplest illustration of risk pooling involves providing life insurance for one year, with all members of the group the same age and possessing similar prospects for longevity. The members of this group agree that a specified sum, such as $100,000, will be paid to the beneficiaries of those members who die during the year, the cost of the payments being shared equally by the members of the group. In its simplest form, this arrangement might involve an assessment upon each member in the appropriate amount as each death occurs. In a group of 1,000 persons, each death would produce an assessment of $100 per member. Among a group of 10,000 males aged 35, 21 of them could be expected to die within a year, according to the 1980 Commissioners Standard Ordinary Mortality Table (more on this later). If expenses of operation are ignored, cumulative assessments of $210 per person would provide the funds for payment of $100,000 to the beneficiary of each of the 21 deceased persons. Larger death payments would produce proportionately larger assessments based on the rate of $2.10 per $1,000 of benefit.
The Basic Principles of Life Insurance (Part II)
Life entails risk, which is the possibility of loss. People generally seek security and avoid uncertainty. The risk of death is unavoidable, and is especially an economic threat if premature, when an individual may be exposed to heavy financial responsibilities, yet has not had the time to accumulate wealth to offset the financial needs of survivors. Life insurance provides a tool for risk management, a process for dealing with the risk of loss of life.
Risk Management & Indemnity
Risk Management. Insurance substitutes certainty for uncertainty through the pooling of groups of people who share the risks to which they are exposed. Uncertain risks of individuals are combined, making the possible loss more certain, and providing a financial solution to the problems created by the loss. Small, certain periodic contributions (premiums) by the individuals in the group provide a fund from which those who suffer a loss are compensated. The certainty of losing the premium replaces the uncertainty of a larger loss. Life insurance thus manages the uncertainty of one party through the transfer of a particular risk (death) to another party (the insurer) who offers a restoration, at least in part, of relatively large economic losses suffered by the insured individual.
Indemnity. The essence of insurance is the principle of indemnity, that the person who suffers a financial loss is placed in the same financial position after the loss as before the loss occurred. He neither profits nor is disadvantaged by the loss. In practice, this is much more difficult to achieve in life insurance than in property insurance. No life insurance company would provide insurance in an amount clearly exceeding the estimated economic value of the covered life. Limiting the amount of life insurance sold to reflect economic value gives recognition to the rule of indemnity. Additionally, only persons exposed to the potential loss i.e. with insurable interest, may legitimately own the insurance covering the insured’s life.
The Basic Principles of Life Insurance (Part I)
Life Insurance Defined: 4 Different Viewpoints
Economic Viewpoint
- A system for reducing financial risk by transferring it from a policyowner to an insurer.
Social Viewpoint
- The collective bearing of losses through contributions by all members of a group to pay for losses suffered by some group members.
Business Viewpoint
- Achieves the sharing of risk by transferring risks from individuals and businesses to financial institutions specializing in risk. The insurer is not in fact paying for the loss. The insurer writes the claim cheque, but is actually transferring funds from individuals who as part of a pool, paid premiums that created the fund from which the claims are paid.
Legal Viewpoint
- An insurance contract (policy) transfers a risk, for a premium (consideration), from one party (the policyowner) to another party (the insurer). It is a contractual arrangement in which the insurer agrees to pay a predetermined sum to a beneficiary in the event of the insured’s death. By virtue of a legally binding contract, the possibility of an unknown large financial loss is exchanged for a comparatively small certain payment. This contract is not a guarantee against a loss occurring, but a method of ensuring that payment is made for a loss that does occur.
The economic value of a human life is the basis for the need for life insurance, and can help determine the amount of life insurance needed by an individual or a family. A human life has an economic value only if some person(s) or organization depends upon it or expects to receive some monetary benefit through that life. The following discussion explains how human life value is determined, and enumerates the specific needs for life insurance.
The Concept of Human Life Value
A human life possesses many values, most of them irreplaceable and not easily measured. These values are founded on religious, moral, and social relationships. From a religious standpoint, for example, human life is regarded as immortal and endowed with a value beyond the comprehension of mortal man. In a person’s relationship with other human beings, a set of emotional and sentimental attachments is created that cannot be measured in monetary terms or replaced by material things.
Such values, however, are not the foundation of life insurance. Although not oblivious to these values—in fact, the life insurance transaction has strong moral and social overtones—life insurance is concerned with the human life value, or the economic value of a human life, which is derived from its earning capacity and the financial dependence of other lives on that earning capacity.
The Economic Value of a Human Life
In terms of its physical composition, the human body has a limited dollar value. In terms of earning capacity, however, it may be worth millions of dollars. Yet, earning power alone does not create an economic value that can logically serve as the basis of life insurance. A human life has an economic value only if some other person or organization can expect to derive an economic advantage through its existence.
If an individual is without dependents and no other person or organization stands to profit through his or her living, either now or in the future, then that life, for all practical purposes, has no monetary value that needs to be perpetuated. Such an individual is rare. Most income producers either have dependents or can expect to acquire them in the normal course of events. Even those income earners with no family dependents often provide financial support to charitable organizations. In either case, a basis exists for life insurance.
Preservation of a Family’s Economic Security
In many cases, an income producer’s family is completely dependent on his or her personal earnings for subsistence and the amenities of life. In many cases, the “potential” estate, or the earnings and savings that may be received and accumulated in the future, is far more substantial than the existing estate—the savings that the family has been to date able to accumulate. The family’s economic security lies in the earning capacity of each income earner, which is represented by his or her “character and health, training and experience, personality and power of industry, judgment and power of initiative, and driving force to put across in tangible form the economic images of his mind,” said Solomon S. Huebner in 1950.
Over time, this economic potential are gradually converted into income, a portion devoted to self-maintenance, a portion to support of dependents, and if the income is large enough, a portion to savings to meet future needs and contingencies. If the individual lives and stays in good health, the total income potential will eventually be realized, for the benefit of the family and others who receive benefits from his or her efforts. If an income earner dies or becomes permanently and totally disabled, the unrealized portion of his or her total earnings potential will be lost, and in the absence of other measures, the family will soon find itself destitute or reduced to a lower income than it previously enjoyed.
This need not happen, however, since there are life insurance contracts that can create a fund at death to at least partially, and possibly fully, offset the lost income of the insured. By means of life insurance, an individual can ensure that the family will receive the monetary value of those income-producing qualities that lie within his or her physical being, regardless of when death occurs. By capitalizing this life value (creating a fund large enough to generate investment income approximating the salary or wages of the individual), an income earner can leave the family in more or less the same economic position they would have enjoyed had he or she lived.
The Moral Obligation to Provide Protection
Most people assume major responsibility for the support and maintenance of their dependent children during their lifetime. In fact, they consider it one of the rewarding experiences of life. In any case, the law attaches a legal obligation to the support of a spouse and children. Thus if there is a divorce or a legal separation, the court will normally decree support payments for dependent children and possibly alimony for the dependent spouse. In some cases such payments, including alimony, are to continue beyond the provider’s death if the children are still dependent or if the alimony recipient has not remarried. In such cases, the parent and ex-spouse are required to provide life insurance or to set funds aside in trust.
It takes a high order of responsibility for a parent to voluntarily provide for continuation of income to dependents after his or her own death. It virtually always involves a reduction in the individual’s own standard of living. Yet, few would deny that a person with a dependent spouse, children, or parents has a moral obligation to provide them with the protection afforded by life insurance, as far as his or her financial means permit.
In his book, Life Insurance, Dr. Solomon S. Huebner said the following concerning the obligation to insure:
From the family standpoint, life insurance is a necessary business proposition that may be expected of every person with dependents as a matter of course, just like any other necessary business transaction which ordinary decency requires him to meet. The care of his family is man’s first and most important business. The family should be established and run on a sound business basis. It should be protected against needless bankruptcy. The death or disability of the head of this business should not involve its impairment or dissolution any more than the death of the head of a bank, railroad, or store. Every corporation and firm represents capitalized earning capacity and goodwill. Why then, when men and women are about to organize the business called a family should there not be a capitalization in the form of a life insurance policy of the only real value and goodwill behind that business? Why is it not fully as reasonable to have a life insurance policy accompany a marriage certificate, as it is to have a marine insurance certificate invariably attached to a foreign bill of exchange? The voyage in the first instance is, on the average, much longer, subject to much greater risk, and in case of wreck, the loss is of infinitely greater consequence.
The growth of life insurance implies an increasing development of the sense of responsibility. The idea of providing only for the present must give way to recognition of the fact that a person’s responsibility to his family is not limited to the years of survival. Emphasis should be laid on the “crime of not insuring,” and the finger of scorn should be pointed at any man who, although he has provided well while he was alive, has not seen fit to discount the uncertain future for the benefit of a dependent household. . . . Life insurance is a sure means of changing uncertainty into certainty and is the opposite of gambling. He who does not insure gambles with the greatest of all chances and, if he loses, makes those dearest to him pay the forfeit.
Diminishing Nature of the Human Life Value
The economic value of an income earner tends to diminish with the passage of time. His or her earning level may continue to increase for a certain period or indefinitely, but with each passing year, the remaining period of productivity becomes shorter. Each year of income that is realized means that there is one year less that remains to be earned. Because an individual’s economic value is the unrealized earning capacity represented by his or her abilities and skills, his or her value must diminish as potential income is converted into actual income.
Life Cycle of Life Insurance Needs
There are three broad categories of the insurance life cycle. The first is childhood. During this period, an individual’s needs are met by their parents or other persons responsible for their welfare. If the child dies before becoming an income producer, the investment in nurturing, maintenance, and education is sacrificed. This can be a sizable sum, especially if the child has been educated at private schools. Various studies have shown that the cost of rearing a child to age 18 ranges from 1.5 times to 3.25 times the parents’ average annual income. At today’s prices, the costs are even higher. While most parents regard these expenditures as one of the duties and privileges of parenthood, and shrink from labeling them as an investment to be recovered in the event of the child’s death, such costs do create a substantial insurable value. This value can logically serve as one of the bases for juvenile insurance, or insurance on children.
The second category of insurance is the adult productive years. The surplus earnings are the source of support for an individual’s dependents and a broad measure of the economic loss to the family if the producer(s) should die. A portion of these earnings will go toward insurance premiums, and another portion should be set aside for both spouses’ retirement needs, but the share that is needed for the care and maintenance of the family should be capitalized and preserved for the family through life insurance.
Finally, the individual’s retirement needs. Although the income loss may be partially filled by federal benefits, pension plans and other tax-qualified plans (such as profit sharing, income deferral, and thrift or savings), and individual investments, the most realistic source of funds to cover any income shortage is investment income, life insurance and annuities. This remaining need can be satisfied with group life insurance through employment and/or a personal insurance program. For long-term planning purposes, however, individuals should not rely on group life insurance for any more than the funds that can—and will—be kept in force after an unforeseen job loss. Individuals should check their employer’s plan to find out how much of the group life insurance they can convert to individual insurance after termination of employment.
When is a person not a prospect for life insurance? When he asks himself two questions; will anyone experience an economic loss if he dies and if yes, does he care? The answer is obvious.
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