Life insurance premium factors: mortality, investment return, expense, and premium mode

Where a life insurance premium comes from

Every life insurance premium is built from three ingredients: mortality, interest and expense. The first two are the underlying concepts, and expense is the third variable added on top. A fourth idea, the premium mode, does not change what the coverage costs the insurer to provide. It only changes how often the policyowner pays, and that frequency has a price of its own.

Factor 1: Mortality

Life insurance works by spreading the risk of death across a large group of people. To price that risk, the insurer must predict how many members of each age group will die each year. It does this with a mortality table, which shows the expected rate of death at each age and lets the insurer estimate how much money it will need for death claims.

Mortality is the factor that raises the premium. The higher the probability of death, the higher the premium. That is why the insurer classifies applicants by the characteristics that affect mortality:

• Age: the single biggest driver. Older applicants pay more.
• Sex: women, on average, live longer than men, so they generally pay less for the same coverage.
• Health and medical history, tobacco use, occupation and hazardous avocations such as aviation or scuba diving.

Applicants are then placed in a risk class such as preferred, standard or substandard (rated).

Factor 2: Interest

The insurer does not keep premiums in a vault. It invests them in bonds, mortgages, stocks and real estate, and it assumes it will earn a certain rate of return on those funds between the day a premium arrives and the day a claim is paid.

Interest is the factor that lowers the premium. The more the insurer expects to earn, the less it needs to collect up front. Exams like to test this inverse relationship: a higher assumed interest rate means a lower premium, and a lower assumed rate means a higher premium.

Factor 3: Expense

The insurer also has to run a business. Salaries, agents' commissions, rent, legal fees, medical exams and inspection reports, underwriting, printing, advertising and premium taxes all have to be paid. Each policy's share of those operating costs is called the expense loading. It is the factor that varies most from company to company, because it reflects each insurer's own efficiency.

Some expenses are the same no matter how large the policy is. That is why smaller policies tend to cost more per $1,000 of coverage than larger ones.

Lapse rate feeds into the expense picture too. When a policy lapses before enough premiums have been paid to cover the company's early costs of issuing it, the insurer has to recover that loss from the policyholders who remain. A block of business with high lapses therefore costs more.

Putting the factors together

• Net premium = mortality cost minus assumed interest earnings. This is the pure cost of the death protection.
• Gross premium = net premium plus expense loading. This is what the policyowner is actually billed.

The same three factors also explain dividends on a participating policy. A dividend reflects the company's favorable experience: investment earnings above what was assumed, fewer deaths than expected, or expense savings. Dividends are not guaranteed. On current-assumption and indeterminate-premium products, the insurer can adjust the premium later as its estimates of mortality, interest and expense change, but never above the maximum guaranteed premium stated in the policy.

Premium mode: how often you pay

The premium mode is the payment frequency the policyowner chooses: annual, semiannual, quarterly or monthly (monthly is often by automatic bank draft). A single premium policy is paid in one lump sum and needs no further payments.

Paying more often than once a year usually costs more in total. Most insurers apply a modal factor to the annual premium, so twelve monthly payments typically add up to more than one annual payment. There are three reasons for this:

1. Lost interest. With an annual premium the insurer invests the whole year's money on day one. With monthly payments it receives the money gradually and earns less.
2. Extra administrative cost. Twelve bills or drafts cost more to process than one.
3. Higher lapse risk. Each payment is another chance for the policyowner to stop paying.

When a policy adds a modal charge to the other modes, as is usual, the annual mode is the cheapest total cost for the year. The mode changes the cost and the billing schedule, never the face amount or the coverage itself.

The policyowner can usually change the mode, typically on a premium due date or the policy anniversary.