Basic Elements in Computation of Premium Insurance

12/05/2020 1 By indiafreenotes

Basically, your life insurance premium consists of four key elements:

  • Mortality amount (“natural premium”)
  • Expenses element
  • Investment element
  • Contingency provision
  1. Mortality

Life insurance operates on actuarial basis that considers the probability of death occurring at certain ages or age groups. Put in a layman’s language, we all expect older people to die before younger ones. The   same concept applies to life insurance. The older someone is, the higher is the probability of his death.  Apart from age, the  state  of  health, occupation,  habits, and  pastimes of an individual  can  have significant  effects on  his/her  likelihood of dying  early.   All these put together form the mortality aspect of an insurance company’s life insurance premium.

In order to make things easier, insurance companies make use of mortality tables constructed by actuaries. These mortality tables show, for each age, what the probability is that a person of that age would die before his or her next birthday. So, using this table, an insurance company can determine the probability of someone surviving any particular year of age, and the remaining life expectancy for people at different ages.  The  premium derived  from  using  the mortality table  is known  as the “natural  premium”  and  it  is the first and major part  of  the entire premium that  a  policyholder pays.

At its early stages, life insurance was actually operated in form of mutual societies that run on guilds basis. A bookseller called John Hartley started one of those societies in London in 1705 in which he restricted membership to only those within the ages of 12 and 45. Under Hartley’s scheme, members paid the same premium irrespective of age and, at the end of the year, fund was shared by dependants of members who died during the year. Two years after the commencement of the scheme, the society introduced a fixed benefit of £125 for each member.

In one of my presentations, a gentleman had signified his intention to speak and I asked him to go ahead. While making his contribution, he erroneously addressed me as an “Undertaker.” Of course, I had to correct him that we are “Underwriters,” not “Undertakers.” But the man might not be totally wrong when one traces the history of mortality tables further.

A guy called James Dodson, a Mathematics teacher, was refused entry into John Hartley’s scheme because he was 46 – a year older than the maximum entry age. For that reason, James Dodson, being a mathematician, headed for the graveyards to compile a mortality table. His table showed number of deaths at each age between 1756 and 1759 and this actually became the first scientifically constructed mortality table ever. Dodson’s table made it possible for each member to pay a fixed amount of premium till date of death when the sum assured became payable to dependants. It also marked the commencement of what is today known as “level premium” for life insurance policies.

  1. Expenses

The premium rate also includes a figure for the expenses that an insurance company incurs in writing your policy. These expenses will include the commission paid to the agent who sells the policy to you, the cost of printing your policy document, and other overhead expenses of the insurance company. But don’t worry. Because there are thousands or millions of other people buying the same insurance product from the company, the cost is thinly spread so the impact is not that much on the total premium you pay as an individual. That’s why you don’t usually notice this aspect in your premium computation. But it is actually there. This further confirms the basic concept of “Law of Large Numbers” in life insurance.

  1. Investment

Call it “Savings element,” “Investment element,” or “Profit element;” you will be right. The premium charged by your life office includes a percentage for investment. This portion of the premium is invested by the company and it is  from  it  that  bonuses, cash  values,  policy loans  etc  are paid  to  policyholders  who buy  permanent life  policies.  Of course, this statement presupposes that investment element is ONLY included in the premiums for policies that are of permanent nature (e.g. endowment and whole life).  That is quite true but not totally accurate. Irrespective of the type of policy issued, an insurance company will expect to make some profit as a business enterprise. For this reason, the investment aspect of a life assurance premium includes an allowance for the moderate profit of a life office. It is just the same way any manufacturer would include a profit margin in the cost of his product.

  1. Contingency

What if some of the assumptions of a life office fail? What if, instead of the assumption that 20 policyholders would die in a year, the company ends up with 200 deaths? What if something drastic happens in the economy that has a negative effect on the company’s investment? What if it initially made wrong projections on the expected number of would-be buyers of its product? What if the company’s cost of doing business doubles unexpectedly? What if….? We can continue to list possible occurrences that could make nonsense of a life office’s computations.

In the light of all these possible unforeseen circumstances, the life office usually includes a percentage in its premium that is solely reserved for contingencies. Like the expense element, the contingency allowance is not weighty on each individual policyholder because of the large pool of people that are covered by the life office. That, again, is why we say in life insurance that “the larger the pool, the cheaper the premium.”