Insurance Is A Practice Of Exchanging

Published Date: 02 Nov 2017

Insurance Company is a business; it is obvious that the rate charged should be adequate and must cover losses and expenses and allow for a profit otherwise the insurance company would not be successful. The principle of assigning premiums according to the underlying risk is an essential element of actuarial science. Based on the proportional hazards (PH) different risk-adjusted premiums are proposed for pricing risks. For the same underlying risk, the risk-adjusted premium is larger for a party which is more risk-averse. For an insurer, the risk-adjusted premium automatically and consistently adjusts the risk loading relative to the expected loss for different risks. The essential requirement is that the rate must be sufficient to meet insurer’s losses and expenses of administration and the first obligation is to keep the insurer solvent. The premium or the rate is the price charged for insurance. The rate has essentially only two functions :

It should produce total funds sufficient to cover the insurer’s obligation.

It should distribute the cost of insurance fairly among insured persons.

Pricing of insurance product is a complex task, as premium rates to be charged depend upon variety of factors namely, expected losses, operating expenses, income from investments and profit margin of the insurance company. Actuaries employed by the insurer calculate and determine the premium rates to be charged for different policies and from people of different age. If the premium charged is very low, the company would not be able to collect sufficient amount to pay claims, bear expenses and earn some profit. On the other hand, excessively high premium charged will result in loss of prospective clients of the insurance company because company may lose the prospective insurer to its competitors in the market. Pricing also depends on the market forces of demand and supply of insurance products. Pricing refers to the methods used to calculate rate of premium to be charged on insurance products. Premium is a price for which the insurer is willing to accept the risk. The payment of premium by the proposer is acceptance of the price charged by the insurer for providing the life insurance cover.

Life Insurance Pricing Elements

Rate of death of large number of insured persons

Administration cost and other expenses of the insurer

Income from investment of premium

Rate of Death of Large Number of Insured Persons - The mortality rates depend on the age, occupation, life style and medical history of the insured. The premium rates charged are calculated on the basis of rate of deaths of very large number of persons insured, i.e., the past experience of large number of cases is taken into consideration before deciding on mortality rate. (Refer chapter 3 for further details)

Administration Cost and other expenses of the Insurer - Every insurer incurs certain expenses or administrative costs related to the service provided. The administration cost incurred may depend on frequency of payment of premium and the volume of records kept. If the premium is paid annually, cost is lesser as compared to quarterly and half yearly or monthly payments.

Income from Investment of Premium - Premium collected by the insurance company from various policyholders is again invested and the income earned on the same helps the insurance company to bear various expenses incurred and benefits given to policyholders.

OBJECTIVE OF RATE MAKING

Rate Making refers to the pricing of Insurance.

Pricing of insurance products is a crucial subject in relation to the business of insurance. Insurance prices called ‘premiums’ or ‘rates’ are based on per unit of exposure. The insurance companies generally adopt comprehensive pricing strategy. However, in a competitive world, it is difficult to sell the product at statistically calculated prices. Moreover, the insurance companies are required to give incentives which leads to reduction in the realized prices.

The non-life insurance business in India is considerably regulated by the Insurance Act, 1938 which empowers the tariff advisory committee (TAC) constituted under it, to control and regulate the rates as well as prescribe the terms and conditions offered by insurers in respect of general insurance business.. These rates are based on statutory standards while all other products are non-tariff. Non-life Insurance pricing is based on claims cost, business acquisition costs, management expenses, margin for fluctuations in claims experience and expected profits. These prices are obliviously subject to wide fluctuations as the insurers make estimates based on past experiences, which are reviewed periodically.

In contrast, life insurance pricing is less complicated and the prices do not change frequently. This is because, the determining factors for life insurance pricing, namely, mortality rate, expenses and interest rate are relatively stable.

Because insurance rates – primarily property and liability rates – are regulated by the states, certain statutory and regulatory requirements must be satisfied. Also, due to the overall goal of profitability, certain business objectives must be stressed in rate making. The following are the objectives kept in mind while deciding upon the pricing of various insurance products :

The rating system must generate sufficient premium income for the insurance company to be able to pay its claims and expenses; to cover expected losses, to give a reasonable rate of return to the investors of funds and to finance continuing growth and expansion. In other words, the premium rates fixed by the insurance company should be adequate in order to pay the benefits promised to the policyholders and meet all the operating expenses. A corollary of this is that the insurer must maintain solvency in order to pay claims.

The rate must not be unduly high as to allow abnormal gains to be earned by the insurer and it will further lead to loss of insurance business to the competitors in the industry. The rate should be justifiable. The rates of the premium charged to the policyholders should not be too high. Also, charging excessive premium is therefore unfair to the customers.

To produce rates that includes an adequate provision for profit/ contingencies.

To encourage loss control. This refers to designing the classification plan to provide discounts for loss prevention behaviour.

The rates must not be unfair and inequitable, in sense that it should not be the same for heterogeneous buyers and must not be different for homogenous buyers (say of different age groups). In other words, the rates charged to the policyholders with the same expected losses and other costs should be equal. This is known as rate equity. It means that the insurance company should charge premiums in accordance with the expected payment of benefits and expenses. For example; if the two individuals of different ages, say one 25 years and other 50 years intend to purchase same policy for the same time period with same terms, the insurer will be charging the higher rate of premium from the person who is 50 years old as there is comparatively higher death probability of the older client. In the case of the young person of 25 years the company cannot associate very high death probability. If there are two persons of the same age who want to take same policy with same terms and conditions but one person is chronically ill, the insurer must charge them different rates as the ill person has higher probability of dying at a certain age (so should be giving higher premium).

The rating system must be simple and easy to understand by the customer and should not change very frequently.

To produce reasonably stable rates and responsive to changes and should be able to satisfy rate regulators.

The pricing system should not be very costly to use and the rates should not be subjected to wide variation in costs year after year.

The mechanism should promote the reduction of losses by providing incentives to the insured to prevent losses.

Although competition would compel businesses to meet these objectives any way, the states want to regulate the industry enough so that fewer insurers would go bankrupt than would otherwise be the case if competition was the main factor in determining the viability of a company so as to protect the many customers dependent on insurance companies. The main problem that many insurers face in setting fair and adequate premiums is that actual losses and expenses are not known when the premium is collected, since the premium pays for insurance coverage in the immediate future. Only after the premium period has elapsed, will the insurer know what its true costs are. Larger insurance companies maintain their own databases to estimate frequency and the dollar amount of losses for each underwriting class, but smaller companies rely on rating bureaus for loss information.

DEFINITIONS IN RATE MAKING

Ratemaking – It is the process of calculations and further building up of rates used in insurance and other risk transfer mechanisms. Number of considerations during this process have to be made and thought of, to the extent they affect the estimation of future costs associated with the transfer of risk, like; competition, marketing goals and legal restrictions. The costs are broadly estimated by a careful thought before making any decisions and using all the available information such as industry statistics and past losses which the industry must have experienced. Minor calculations of costs for a particular company include operational and administrative expenses, number of claims, claim settlement expenses and the cost of capital. Here is the summary of descriptions of these costs :

General Administrative Expenses - are all other operational and administrative costs.

Acquisition Expenses - are all costs, except commission and brokerage, associated with the acquisition of business.

Commission and Brokerage Expenses - are compensation to agents and brokers.

Policyholder Dividends - are a non-guaranteed return of premium charged to operations as an expense.

Incurred Losses - are the costs of claims insured.

Allocated Loss Adjustment Expenses - are claims settlement costs directly assignable to specific claims.

Unallocated Loss Adjustment Expenses - are all costs associated with the claim settlement function not directly assignable to specific claims.

The Underwriting Profit and Contingency Provisions - are the amounts that, when considered with net investment and other income, provide an appropriate total after-tax return.

Taxes, Licenses and Fees - are all taxes and miscellaneous fees except federal income taxes.

Rate - Price per unit of Insurance.

Exposure Units - Unit of measurement used in Insurance pricing like model year of car.

Pure Premium - portion of the rate needed to pay losses and loss adjustment prices i.e. loss related expenses. It is determined by actuarial studies.

Loading - amount that must be added to pure premium for other expenses, profit and a margin of contingencies.

Policy holders’ surplus - difference between an insurance company's assets and liabilities.

Life Insurer’s Net Gain from Operations - Total Revenues - total expenses, policy owner’s dividends, and federal income taxes

Gross Rate - consists of the pure premium and a loading element

Manual (Class) Rate - exposures with similar characteristic are charged the same rate and are placed within the same underwriting class.

Gross Premium - Premium charged to the insured which consists of the number of exposure units multiplied by the gross rate.

Net Single Premium - the present value of the future death benefit.

Loss Reserve - Estimated amount for :

Claims reported and filed, but not yet adjusted.

Claims reported and adjusted, but not yet paid

Claims incurred but not yet reported to the company.

Unearned Premium Reserve - is a liability item on all outstanding policies at a time, which represents the unearned portion of gross premiums.

Underwriting - process of selecting, classifying and pricing applicants for insurance

BASIS OF RATING IN INDIAN CONTEXT

In a contract of Insurance, the insurer promises to pay a specified sum of money to the insured in the event of any unfortunate happening which should be unintentional in nature. In order to secure these benefits, the policyholder in return, agrees to pay a fixed sum of money either in installments (monthly/ quarterly/ half yearly/ annually) or lump sum to the insurer which is known as ‘premium’. This premium can also be called as ‘cost/ price of insurance policy’. Any default in paying the premiums can endanger the continuance of policy or it is said ‘the policy has lapsed’ and the further expected benefits may not be available. The consequences of default are specified in the policy conditions, explained in detail in chapter 9.

The calculation of premium involves actuarial and statistical principles. It is a technical and complex process which can be done only by trained professionals known as ‘actuaries’. In order to quote the premiums for a particular policy being offered to a prospect, the insurance company makes the ‘tables of premium rates’ available for the use of agents. Let us understand the rationale behind the premium calculations.

Components of Premium

Risk Premium (Mortality/ Natural Premium)

Net Premium (Margin of Interest)

Office Premium (Margin of Office Expenses and Exigencies)

Risk Premium – It is calculated on the basis of an expectation as to how many persons are likely to die within a year in an age group. This expectation, regarding the number of persons likely to die within a year, at each age, is calculated by actuaries on the basis of past experiences and made available as ‘mortality tables’.

Net Premium – The premium worked out after taking into account the interest likely to be earned, is called the net premium or pure premium.

Loadings on the Premium amount :

The net or pure premium has to be increased for various reasons. Such increases are called ‘loadings’. One of the loadings is because of expenses. The expenses of the insurer, to procure and to administer the business, have to be met out of the premiums paid by the policyholders. To the premium to be collected will be higher.

Bonus has to be given to participating policyholders. Bonus is declared out of the surpluses determined after actuarial valuations. Surpluses, in a way, reflect the profitability of the business or the quality of management of the business. Nevertheless, insurers load the premiums on account of the bonus. In practice, the actual bonus declared would be higher than the loading. Otherwise, it would mean that the quality of the management of the business leaves much to be desired.

Another loading would be for unexpected contingencies and fluctuations. A major catastrophe like an earthquake or accident or riots or epidemic, can raise the number of deaths to much higher levels than indicated by the mortality tables. The risk premium based on mortality tables would be found to be inadequate to meet such catastrophic claims. Insurers therefore, as a matter of safety, provide for such contingencies and fluctuations, by loading the premium suitably.

The premium is calculated on the basis of assumptions relating to the future experience on mortality, interest rates and expenses. These assumptions are based on the insurer’s own experience in the past and therefore, not arbitrary. Yet, they are assumptions as far as the likely future experienced is concerned. The margin for contingencies is provided because of the uncertainty that these assumptions will turn out to be valid, as the future unfolds.

Level Premium Concept

If it is expected that out of 10,000 persons at a specified age, the probability is that one may die within one year, the mortality rate at that age is said to be 0.01 %. The risk premium chargeable for persons at that age would be Rs. 0.10 per Rs. 1,000 SA. If a policy has a term of 20 years, the risk premium and therefore, the premium charged, would vary for each of the 20 years. It would be increasingly steadily from year to year. It would be difficult to administer annual charges in a continuing contract. Apart from that, the premium at later ages, towards the end of the policy term, would be very high and people may find it beyond their ability to pay. They will then be without the protection of insurance at times when they need it most. To offset this problem, insurers spread the risk premium on a uniform basis, throughout the term of the policy. The premium remains constant for 20 years. Such uniform premium is called ‘Level Premium’. This implies that the premium collected would be more than necessary for the risk in the early ages and less than necessary towards the later part of the policy.

There is another reason for level premiums being charged. As mentioned already, it is possible that many policyholders would find the higher premium payable otherwise, towards the later part of the policy, too burdensome, and drop out. The persons who drop out are likely to be healthier than those who continue. The relatively unhealthy ones may try to pay somehow and continue the insurance cover. This would work against the insurer, as the assumptions made in calculating the premium would be disturbed. The continuing policyholders would not be of the same kind of population, as the mortality tables would have assumed. The mortality tables show the probabilities (of death) for a group of healthy persons, while in this case, the population of policyholders would have large than normal proportion of the unhealthy. This is referred to as ‘Adverse Selection’, because the result of the decisions of the healthier policyholders walking out of the group is adverse to the interests of the remaining community of policyholders. The calculations of the insurer and his experience would go awry. The practice of charging level premiums, avoids such adverse selection.

CASE APPLICATION

Client Name: Ekta; Status: 27, single, no children

Ekta earned an income of Rs.50,000 and had Rs.3000 of credit card debt and a Rs.15,000 car loan. Her superannuation policy also provided a life insurance cover of Rs.100,000, which had an accumulated value of Rs.20,000. She was scared seeing one of her good friends who was captain of the ship, becoming financially susceptible in an accident at ship. Ekta finally decided to buy an insurance policy to protect herself from any similar kind of misfortune happening to her.

In addition to the life insurance provided through her superannuation, with the help of her financial adviser, she took a life, total & permanent disability and trauma cover of Rs.200,000. Ekta now felt financially protected as the combination of superannuation and stand-alone insurance would provide her with a lump sum amount, which would enable her to pay for any necessary treatment, if in case she suffers a specified traumatic condition or becomes totally and permanently disabled.

Now, even if having financially organized herself with an adequate coverage, she was still concerned about, if as a result of any suffering or an illness or any injury which in case will prevent her from working, so how would she pay her bills and afford to live in those circumstances ? When she calculated her present benefits from the current job, she realized that, her employer provides up to four weeks of paid sick leave but without a regular salary. Other than this, she has no other income to rely upon.

Now, she wants further protection and chooses an ‘income protection cover’ with a monthly benefit of Rs.3,125 (being the maximum cover available – 75% of her income), a four-week waiting period and benefits paid up to the age of 65. Ekta wanted to ensure that, when she was on claim, her monthly benefit would keep up with the inflation.

She further chooses to pay level premiums*, as she wanted to avoid sudden increases in premium payments as she aged. Ekta was aware of the fact that, with this option of level premiums, she would be paying a little more than stepped premiums in the first few years of the policy, but she would save in the long run.

Level Premiums* - The amount of premium on a level premium option are likely to remain the same, unlike stepped premiums which usually increase as the insured gets older.

Key Questions :

Comment on her all decisions.

Level premiums are slightly more expensive than stepped premiums in the first few years of the policy, but over the term of the policy, its longer-term savings typically far outweigh short-term savings of stepped premiums. Explain.

Office Premium – The premium figures arrived at after loading the net premium or pure premium is called the office premium. The premium figures printed in the promotional literature and brochures are office premiums. They are also referred to as ‘tabular premiums’.

Extra Premiums

Extra premiums may be charged on any particular policy. This may happen because of :

the grant of some benefit in addition to the basic benefits under the plan called riders (discussed in detail in chapter 9).

Extra premiums may become chargeable because of decisions relating to the extent of risk in any particular case.

If the risk of the person to be insured is assessed as more than normal, because of health (called health extra) or because of occupation (known as occupation extra) or habits, insurers may charge extra premiums. These are usually stated as Rs. 2 per thousand, and will be added to the premium otherwise chargeable.

Points to Ponder

Lump Sum Injection

In addition to regular premiums, the client can make lump-sum injections during the premium-paying period when he/ she want.

Lump Sum Injection facility for unitized plans :

There could be a number of injections, but the amount injected in a policy year should not exceed 25 % of the basic sum assured.

A supplementary Accumulation Account will be created for this, which will earn returns at the same rate and in the same manner as returns declared in the Accumulation Account.

The client have the option of using the Supplementary Accumulation Account created for "Lump sum injections" to pay premiums, if need arises. (This would be done only at the request from the clients and not automatically)

The lump sum injections may be considered as Supplementary Premium Payments, which give rise to supplementary Sum Assured and supplementary Accumulation Account. There are separate premiums rates for supplementary Sum Assured that depend only on term to maturity in years.

Lump Sum Injection facility for unit-linked plans :

This facility with all unit-linked plans upto 25 % of the cumulative premiums paid till that date.

Service Tax

The Finance Act has brought life insurance business within the ambit of service tax. Service tax, as you know, is an indirect tax and has to be collected by the insurance Company and paid to the Government. This tax has to be calculated on the risk premium and would be levied at the prevailing service tax rate, as applicable from time to time.

On which policies will service tax be leived ?

Service Tax to be levied on :

First year and renewal premium for all policies that will be purchased.

Renewal premium for all policies already in force.

How will it work ?

To pay the service tax to the Government of India, the Insurance Company will recover and amount equal to the service tax liability.

RATE MAKING IN PROPERTY AND LIABILITY INSURANCE

The individual will be held responsible in a court of law for injury to another person, property or other interests; taking this possibility into account, the liability insurance is designed. Any accident happening on the property, and if owner’s negligence can be established or legal liability exists by statute, the property owner will be held responsible for the same. Similarly, the manufacturer is held responsible for accidents arising from the use of his product, the contractor for accidents that result from his operations, while the professional may even be held liable for the advice he gives. The insurance for these varied forms of liability is provided by numerous lines of insurance which are generally grouped together under the title ‘General Liability Insurance’. However, the manuals of rules and rates are published by several independent insurance companies.

The techniques of rating used by the general liability underwriter are in some ways similar to those used by fire underwriters regardless of their superficial antitheses. Determining the premiums is a complex process both in liability and fire insurance where the rates are mostly influenced by the business of the insured occupying the premises and by risk characteristics that modify the hazard like existence of elevators, fire sprinklers. However, the actuarial procedures used to establish the rates charged by the general liability underwriter are closely related to the other casualty lines rather than property insurance. Determination of the overall rate level change closely resembles the procedure used for automobile liability insurance, while the determination of class rates mixes techniques borrowed from both automobile and workmen’s compensation ratemaking with some unique procedures. There is no single general liability insurance rate filing in a given state, which is unlike many other lines of insurance. Individual rate filings are made for each coverage and each sub line of general liability insurance. Since the form of liability insured under individual sub lines is quite different, the filings for them differ significantly from each other; therefore, knowledge of the coverage provided by the various sub lines is essential in understanding the ratemaking procedures.

‘Rate Making’, also known as ‘insurance pricing methods’, provide standard or baseline rates that form the basis for pricing individual case scenarios. When other factors like risk and claims history are involved, different pricing methods may rely more heavily on baseline rates. There are generally three methods for determining rates in property and liability insurance ; class rating, judgment rating and merit rating. Merit rating can be further classified as schedule rating, experience rating and retrospective rating.

Class Rating

Judgment Rating

Merit Rating

Schedule Rating Method

Experience Rating Method

Retrospective Rating Method

Class Rating

In class rating, exposures with similar characteristics are placed in the same underwriting class and each is charged the same rate. The rate charged reflects the average loss experience for the class as a whole. This type of rating is used when the factors causing losses can either be easily quantified or there are reliable statistics that can predict future losses. It is based on the assumption that future losses to insureds will be determined largely by the same set of factors. These rates are published in a rating manual and so the class rating method is sometimes called a Manual Rating also. Class rating is widely used in homeowners insurance, private passenger auto insurance, workers compensation, life and health insurance. Merit of using this method of rating is that, it is simple to apply and also allows agents to give an insurance quote quickly.

There are two basic methods for determining class rates :

Pure Premium Method

Loss Ratio Method

Pure Premium Method – It is that portion of the gross rate needed to pay losses and loss-adjusted expenses. It is first calculated by summing the losses and loss-adjusted expenses over a given period and dividing further by the number of exposure units. Then the loading charge is added to the pure premium to determine the gross premium* (Gross Premium = Pure Premium + Load) that is charged to the customer.

Actual Losses + Loss Adjusted Expenses

Pure Premium =

Number of Exposure Units

*Gross Premium - It is determined by adding a loading allowance to the ‘net annual level premium’. The loading must cover all operating expenses; provide a margin for contingencies, margin for dividends (in case of participating policy). major types of expenses are reflected in the loading allowance :

Production Expenses

Distribution Expenses

Maintenance Expenses

Loss Ratio Method – It is used more to adjust the premium based on the actual loss experience rather than setting the premium i.e. actual loss ratio is compared with expected loss ratio. The loss ratio is the sum of losses and loss-adjusted expenses over the premiums charged. If the actual loss ratio differs from the expected loss ratio, then the premium is adjusted according to the following formula :

Actual Loss Ratio – Expected Loss Ratio

Rate Change =

Expected Loss Ratio

Judgment Rating

These types of ratings are used when the factors that determine potential losses are varied and cannot easily be quantified i.e. when the loss exposures are so diverse that a class rate cannot be calculated or when credible loss statistics are not available to assess the probability and quantity of future losses. Hence, an underwriter must evaluate each exposure individually and use intuition based on past experiences. Each exposure is individually evaluated and the rate is determined largely by the underwriter’s judgment. These ratings are predominant in determining rates for ocean marine insurances and in some lines of inland marine insurances. Generally the ocean marine rates are determined largely by judgment because ocean-going vessels, ports of destination, cargos carried and dangerous waters are all diverse.

Merit Rating

Merit Rating is based on a class rating, but the premium is adjusted accordingly upward or downward based on individual actual loss experience of that customer. It is based on the assumption that the loss experience of a particular insured will differ substantially from the loss experience of the other insured. Merit rating often determines the premiums for commercial insurance and in most of these cases; the customer has some control over losses. Merit rating is generally used when a class rating can give a good approximation, but the factors are diverse enough to yield a greater spread of losses than if the composition of the class were more uniform. Thus, merit rating is used to vary the premium from what the class rating would yield based on individual factors or actual losses experienced by the customer. Further various plans are used to determine merit rating.

Schedule Rating Method – In this method, each exposure is individually rated depending on the degree of risk they carry which is then modified by debits or credits for undesirable or desirable physical features, using baseline rates as a starting point. Commercial property insurance generally uses this method, where factors like; size of the business, its location and business purpose provide baseline indicators for determining pricing rates. It is used for large complex buildings like industrial plant where each building is rated on :

Construction

Occupancy

Protection

Exposure and

Maintenance.

Experience Rating Method – This method while determining the premium rates to be charged, rely more heavily on a policyholder's past loss/ claim experience, typically, prior 3 year period, as an indication of the level of risk involved and the likelihood that future claims will be filed, which is known as ‘credibility factor’*. Once a risk level is determined, the credibility factor is measured against a baseline pricing rate that represents to average rate charged to a class of policyholders that have similar characteristics. In determining the magnitude of rate change, the actual loss experience is modified by this creditability factor based on the volume. Adjustments are then made to the baseline pricing rate based on each policyholder's credibility rating. The adjustment to the premium is determined by the loss ratio method and is multiplied by a credibility factor to determine the actual adjustment. The greater the credibility factor, larger the adjustment of the premium up or down. As the credibility factor for small businesses is small, they are not generally eligible for experience rated adjustments to their premiums. Experience rating is typically used for general liability insurance, workers compensation and group insurance. It is also extensively used for auto insurance, including personal auto insurance, because losses obviously depend on how well and how safely the individual drives.

*Credibility Factor - is the reliability that the actual loss experience is predictive of future losses. In statistics, the larger the sample, the more reliable the statistics based on that sample. hence, the credibility factor is largely determined by the size of the business—the larger the business, the greater the credibility factor, and the larger the adjustment of the premium up or down. Because the credibility factor for small businesses is small, they are not generally eligible for experience rated adjustments to their premiums.

Retrospective Rating Method - This method uses the actual loss experience for the period to determine the premium for that period, limited by a minimum and a maximum amount that can be charged. Part of the premium is paid at the beginning and the other part is paid at the end of the period, the amount of which is determined by the actual losses for that period. Retrospective rating is often used when schedule rating cannot accurately determine the premium and where past losses are not necessarily indicative of future losses, like, burglary insurance where the odds of predicting how often a business would be burglarized are more difficult. Now, here in the case of burglary insurance, the amount of the remaining premium payment is based on whether a burglary occurred since the start of the policy period.

RATE MAKING IN LIFE INSURANCE

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As a matter of actuarial theory, life insurance policies should be priced so that the present value of expected premiums is equal to the present value of expected death benefits.

If you have ever shopped for life insurance, you know that all policies are not created equal. Availability of riders, dividends and policy provisions are just some of the variables that differentiate one policy from another.

Most consumer advocates counsel potential policyholders to look at three factors before buying a life insurance policy : company strength, claims service and price.

Financial strength is important because it has bearing on a company's ability to meet obligations to policyholders and to weather adverse market conditions. Consumers can easily check out a company's financial strength by reviewing information from ratings agencies such as Moody's, Standard and Poor's and Fitch.

When it comes to price, however, things get a little more complicated. As with anything you buy, the cheapest isn't always the best, but neither is the most expensive. If you've looked at whole life policies in earlier chapters and reviewed them recently, you would know prices vary widely and it's difficult to make an apples-to-apples comparison between policies. How can you know if you're getting the policy that is best for you? The more important question to ask today, perhaps, is not how much does a policy cost, but what value are you receiving for your premium rupee ?

When pricing a policy, companies consider several factors like mortality, persistency, investment earnings and expenses. These factors along with a company's unique value proposition — the idea or concept that separates a company from its competition — affect how companies price their products. For example, one company's value proposition might be to provide the lowest cost insurance in the marketplace. This company will compete on price alone. To have lowest price, this company may be willing to sacrifice the solid financial practices that would earn high marks from the ratings agencies, have a less than first-class service operation in order to keep overhead down, or fewer policy features that offer stability. This company has the lowest price. Does it offer the best policy? If your decision is guided strictly by economics it may. It all depends on your needs.

In contrast, another company might want its policies to provide policyholders with maximum flexibility and first-class service. These policies may be the most expensive in the market. Are they the best? For those consumers who want the flexibility and service it probably is.

For those who see no need to pay for "bells and whistles" that they feel they will not use, there are better alternatives (however, their needs may change in the future).

Different Life Insurance Companies have different value propositions; where the optimum can be : to deliver the highest quality products at the lowest possible price with the promise of ongoing service and support from the most professional sales force in the industry.

Majorly, the key factors for a Life Insurance Company include a commitment to financial strength, agent training and support and policyholder service.

Agent Training – Today, the agent is face of the company and to support its agents, life insurance companies invests millions of dollars annually to provide the best training and professional education to them. The cost for this training is also factored into their pricing. As mentioned in earlier chapters the role of the life insurance agent is not simply to sell a policy, but to guide policyholders, to help them select the right policy for their specific needs and budget. Now a days, agents are doing an excellent job of explaining the policy, educating their clients and providing follow-up service, due to which maximum policies stay in force for so many years.

Financial Strength - A part of the pricing model is to achieve profits while setting aside some amounts each year that accumulated with interest, are adequate to pay future claims and support policy guarantees. The company must also set aside some profit to build a prudent level of surplus in case of future loses.

Policyholder Service – With the increasing competition, companies are providing outstanding services to policyholders and are committed to making continuous improvements. These in progress service improvements include generating and sending out consolidated policy statements, maintaining online service features that offer up-to-date account information and self-service functions.

Each of these pricing factors is consistent with the Life Insurance Company to run profitably for the sole benefit of its policyholders.

The goal of the pricing process is to produce a policy that keeps the company financially strong and offers clients competitive options at competitive prices.

Other factors that enter the pricing equation include:

Competitive information

To meet regulatory requirements from states and federal regulators. For example, the company must comply with state regulations, which requires a product to satisfy certain tests before it can be illustrated for sale.

The policy owners can add additional features — called ‘riders’ — to their policies if they choose. Most riders have an additional cost associated with them and provide an additional benefit. Some common riders are Accidental Death Benefit, Waiver of Premium, Term Riders and Policy purchase option rider (explained in detail in Chapter 9). The insurer pays an extra death benefit if the policy has an Accidental Death Benefit Rider and the insured dies by accidental means. If the policy has a Waiver of Premium rider, the insurer will pay the insured's premiums if the insured becomes disabled. Term Riders provide term coverage just like a term policy and the Policy Purchase Option allows policy owners to purchase additional coverage without evidence of insurability. Plenty of other riders are available with Insurance Companies which an applicant should enquire about from the agent before purchasing the policy. This affords the policy owners the ability to buy a combination of base plan and riders that suits their needs.

Conversion privileges are policy provisions (see chapter 9 for details) that allow the policy owners to convert from term to permanent insurance without providing evidence of insurability. These provisions add a great deal of value to Life term plans.

At the end of the day, the most valuable feature a policy from Life Insurance Company offers a policyholder is the promise to pay in the future.

Points to Ponder

There are well known factors that have a significant effect on life expectancy, such as age, gender, health of the individual and other habits like smoking. Accordingly, healthy persons who are the same age and gender and who do not smoke are placed in the same underwriting class and charged the same ordinal rate for life insurance. Smokers are placed in different class and charged higher rates with loading. Thus, an actuary can reasonably estimate the average age of death for example; for a group of 25-year old males, who don’t smoke.

Baseline indicators rely on identified risk factors found within a group or class of policyholders that have similar characteristics such as age, sex and line of work. These indicators provide the starting points or baseline rates, which are used to calculate a premium rate for individual policyholders.

Mortality tables used that tabulate number of deaths for each age, which includes a population of many people.

Life Insurance policies can be purchased with a single premium or with annual, semi-annual, quarterly or monthly premiums.

The Net Single Premium is simply the present value of the death benefit. The net single premium is less than the death benefit because interest can be earned on the premium until the death benefit is paid.

Although most policies are not purchased with a single premium, the net single premium forms the foundation for the calculation of all life insurance premiums. The simplest case is, determining the net single premium, which is the premium that would need to be charged to cover the death claim, but does not cover expenses or profit. Although most people don’t pay single premium because of the cost, all life insurance premiums are based on it.

Annual level premiums can easily be calculated from the net single premium.

The Gross Premium includes the premium to cover the death claim plus all expenses, a reserve for contingencies and profit.