Question

Please explain and discuss the building blocks of the insurance premium.

Answer 1

There are four blocks of insurance premiums they are

1.Estimated cost of the insured loss claims

2.Estimated cost to pay for administrative expenses of the insurer

3.Estimated investment income earned on premiums received from the policy holders.

4.Estimated loading expenses

In simple words we can summarize them as mortality, contingency, expenses, investment

a. 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.

b. 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.

c. 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.

d. 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.

Please rate the answer if you are satisfied. Thanks!