How are Life Insurance premiums calculated?
Author: Daniel Sharpe-Szunko
It’s important to understand how your life insurance premiums are calculated so you know what you’re paying for. Life cover is mainly designed to protect your family, home and business if anything happens to you.
Ultimately if you were no longer around to support your family or your income was impacted because of an illness or accident, these policies would relieve the financial burden. Life insurance, critical illness cover and income protection all come under the same umbrella of personal protection products.
Life insurance is the main type of cover because it’s the most common and the most affordable. This is simply because you’re much less likely to have to claim on a life insurance policy than critical illness cover or income protection.
A life policy is a contract between you (a policy holder) and an insurer. The policy becomes valid when premiums are collected (monthly or annually) after ‘acceptance terms’ are issued.
The policy is set to cover an amount (sum assured) over a period of time (term) to pay out to on death, serious illness or accident (depending on cover type).
What is life insurance?
A life insurance policy is simply a policy that pays out to a beneficiary (e.g. wife, children, partner or family) in the event of death. This pay-out is usually a tax free lump sum which can form part of your estate or this can be avoided using a Trust.
Life insurance also comes in 4 main forms which are all designed for different purposes depending on what you want to cover:
- Level term (family protection) which is simply to protect your loved ones in the event of death
- Decreasing term (mortgage protection) which is specifically designed to cover a mortgage (repayment mortgages only)
- Whole of life is a more recent addition to the life insurance market which is a non-investment based guaranteed life cover
- Family income benefit is also a newer type of cover which is specifically for your family and provides an annual income rather than a lump sum
All of these different types of life cover also cost different amounts per thousand pounds because of how they pay out. Whole of life is always the highest because it is guaranteed to pay out (as long as you continue to pay your premiums). Family income benefit is the cheapest because the amount of cover reduces faster than the other types of cover.
How are basic life insurance premiums calculated?
A life insurance premium is made up of several main factors before health and lifestyle are taken in to account. These are the things that would be taken in to account to give a base premium, which includes:
- Age (Note: every time you pass a birthday your premiums will increase)
- Smoker status (Note: No nicotine or nicotine replacement products for at least 12 months to be classed as a non-smoker)
- Sum assured (amount of cover)
- Term (length of policy in years or to age)
- Type of cover (e.g. level term, decreasing term, family income benefit or whole of life)
Note: Gender– In February 2012 the EU Gender Directive made it illegal to use gender to differentiate between individuals for insurance
What else is used to calculate a life insurance premium?
There are also several other elements that are used to calculate the premium that a person (policyholder) will pay for cover. The following elements are behind the scenes calculations which will also be different for each insurance provider.
When an application is submitted to an insurer, it will enter one of several potential routes depending on the disclosures. Generally the more complex the disclosures (e.g. medical conditions, hazardous occupations and dangerous activities) the more work that will be required at the back end.
The various types of underwriting processes are:
Underwriting Rules Engine (URE’s) which is where modern technology is used to apply a premium based on disclosures on an online application. Usually an insurer will allow a system (URE) to make a decision up to a set threshold (level of risk)
Manual underwriting is simply where an application will be referred to an underwriter (a person who assesses risk) to calculate a premium. An underwriter will also have certain limits that they will be allowed to go to before the next stage
Nurse screening or telephone medical will be used to gather additional medical evidence via a professional (e.g. nurse). These tests will usually include BMI (height & weight), blood sugar levels, cotinine test (smoker test), and blood pressure
Full GP report (medical report) which will be obtained directly from your GP or Doctor to provide a full breakdown of your medical history. Medical reports are usually for more complicated medical conditions or where symptoms are more severe
Once the underwriting process has been completed by whichever process, a premium will be offered based on information provided. Each insurer has a different set of parameters for each persons circumstances based on their ‘underwriting philosophy’.
Mortality and Morbidity data
All life insurance offices will have a team of actuaries who are mathematical people that calculate risk. These people will constantly be looking at trends in data which help them to make decisions for certain groups or risk categories.
Some of the most common types of morbidity are heart disease, cancer, chronic lower respiratory diseases, stroke, diabetes, pneumonia and influenza, Alzheimer’s disease, kidney disease and suicide.
Also co-morbidity is where two conditions occur simultaneously in the same person. The conditions don’t need to be directly linked to a cause, however they may often occur together. Some examples of co-morbidity are depression, diabetes and obesity which often occur together but are not likely to have the same cause.
There is no exact science to how an insurer will calculate a premium for an individual, however the insurer will use this information to calculate risk of death. It is a fair assumption for example that ‘a person in their 50’s is more likely to fall ill or have an existing medical condition to a younger person.’
Costs and margins
Any business will need to make sure that it is profitable and insurance is no different. There is a cost associated to running an insurance company and for processing an application. Each insurer will have their own costs and these will be different depending on the size of provider and how they operate.
There are several main costs that will be taken in to account when processing an application for life insurance. Some of the main costs will include:
Underwriting – a team of underwriters is a cost to a business so that must be taken in to account
Medical evidence – medical reports from a GP or doctor will costs anywhere between £60 and several hundred pounds
NTU rates (not taken up) – every time an application is processed that is either declined or not accepted, there will be a cost associated to that
Lapse rates (cancelled cases) – if a policy is cancelled within a certain period of time then it may then incur cost to the insurer
Generally bigger insurance providers are more efficient than smaller or newer insurance providers so can therefore drive lower premiums. Profit margins for life offices are difficult to project as they are forecasts based on future premium collections and potential claims.
For more information about this subject you can contact one of our team of experts at iam|INSURED on 01244 732896.