Determining Life Insurance Premiums for Term and Level-Premium Policies

There are 2 basic methods of determining premiums for life insurance: the yearly renewable term method and the level premium method. While there are many different types of life insurance policies, their financial basis rests on these 2 methods or their variations.

Yearly Renewable Term

The yearly renewable term insurance policy covers the policyholder for 1 year. It provides no cash value, so most of the premium covers the mortality charge, the amount that must be paid for those who die. The cost of the premium is largely determined by the death rate of each age group. Each policyholder must pay the pro rata share of death claims within his age group.

For instance, consider a group of 1,000 50 year old nonsmoking males that want $1,000 of life insurance. This is the mortality rate, based on the 2001 Commissioners Standard Ordinary (CSO) Table of Mortality:

2001 Commissioners Standard Ordinary (CSO)
Mortality Table by Decade
Source: 2001 Valuation Basic Table and 2001 CSO Table.

Out of 1,000 50 year old nonsmoking males, 3.32, or 0.332%, will die before reaching age 51. An insurer of this group would have to pay out $3,320 for the death claims. That means that it would have to collect at least $3.32 per year from each policyholder to cover the death claims (and, of course, a little extra for operating expenses and profit).

As you can see, the premiums rise steeply in the later ages. This is why the premium increases each year that the policy is renewed. If you are a smoker, take note that smokers have almost twice the death rate for both men and women at most age levels. The difference between men and women and between smokers and nonsmokers diminishes as they approach the age of 120. However, don't count on living that long! Very few people live to be 120, although that number should increase significantly with advances in medical technology and the increase in healthy lifestyles.

Why bother classifying people as men or women, or as smokers and nonsmokers for calculating premiums. Because there is a significant difference in life expectancies for the groups. For instance, if one insurance company charged the composite rate for all people in an age group, then other insurance companies would offer the women and nonsmokers a lower rate and take away business from the insurance company charging a composite rate. That company would suffer from adverse selection, because the composite rate is lower for the high risks and higher for the low risks. Thus, the low risk group would buy insurance from other companies because of the lower rate, and then the company charging the composite rate would have to charge higher prices to cover the high risk group.

Then why not extend this segmentation by classifying people according to family history of disease or genetics, for instance? Because, currently, it is not easy to segment the population in this way, and there may not be a large enough difference in mortality rates to justify the expense of segmentation. There will also certainly be political and social resistance to this degree of segmentation, since it will be viewed as an invasion of privacy and discrimination. Of course, basing life insurance premiums on sex and smoking status can also be viewed as discriminatory, but it has a sound actuarial basis. However, sex and smoking status, unlike family history or genetics, are easily observable traits, and, thus, cannot be considered an invasion of privacy.

Nonetheless, as technology advances, there will probably be more attempts at segmentation based on genetics. While many view it as discriminatory, others will argue, and rightly so, that to not allow it would force others to subsidize the premiums of others. Since insurance rates are determined by the death rate of the insured, including people with a higher death rate at the same premium would make the premium higher for all. As with the different rates for sex and smoking status, companies will offer those who are willing to show their good genetic profiles better rates, which, in turn, will cause adverse selection for the other companies not using genetics, which, in turn, will force companies either to raise their premiums for all or to start using genetic profiles as well.

Level-Premium, Legal Reserve, Net Amount at Risk

The level-premium method is used to determine premium prices for lifetime protection by charging a single premium rate while the policy is in force. The life insurance policy provides protection to age 100. If the insured survives to 100, then the face value of the policy will be paid to the owner of the policy.

To be able to charge a level premium for the life of the policy, the premium must be higher in the early years of the policy than is needed to cover the mortality charge. The excess money is segregated into a fund and invested to cover the mortality charge in later years when the premium will be less than that needed to cover death claims.

The method of investing and accumulating the fund is regulated by state law; therefore, it is called a legal reserve. The states require a minimum amount of legal reserves to maintain the insurance company's solvency, so that it can pay claims and benefits, and is generally commensurate with its contractual liabilities of the policies that it has written. The legal reserve covers all policies that an insurance company writes, and is equal to the present value of future death claims minus the present value of future premiums.

Legal Reserve = Present Value of Future Death Claims - Present Value of Future Premiums

Why use present value? Because insurance companies invest the premiums to earn interest, so the present value accounts for this interest. The interest earned lowers the legal reserve requirements. As the insured gets older, the present value of the death claim becomes greater because there is less time until death; at the same time, the number of future payments that will be made is declining, and, thus, the present value of the future premium payments is also declining.

The legal reserve can also be viewed at the individual policy level. With individual policies, the legal reserve increases steadily, reaching the face value of the policy at age 100. Obviously, the later the policy is purchased and the higher the amount of insurance, the more expensive the premiums.

The difference between the face amount of the policy and the legal reserve is the net amount at risk for the insurer, which is pure insurance. If you should die before age 100, then the insurance company loses the net amount at risk for your individual policy. This loss is compensated by the premiums of those who haven't died yet, and from income from the invested premiums. Since the sum of the net amount at risk and the legal reserve equals the face value of the policy, the net amount at risk and the legal reserve are inversely proportional. As the legal reserve increases, the net amount at risk decreases.

Face Value of Policy = Legal Reserve + Net Amount at Risk

Graph showing the relationship of the legal reserve, net amount at risk, and the face value of a life insurance policy.

The legal reserve requirements of most policies are either currently based or soon will be based on the 2001 Commissioners Standard Ordinary (CSO) Mortality Table.

The main purpose of the legal reserve is to provide lifetime protection, but because more money is collected in premiums in the early years than is needed to cover the mortality charge, level-premium policies develop a cash value, which the policyholder can borrow against, or can surrender the policy for its cash value if the policyholder no longer wishes to continue the life insurance policy. However, the cash value is initially less than the legal reserve because of deductions of sales expenses and other acquisition costs.

If you want to buy insurance, but are unsure for how long, it is better to buy term insurance initially, especially convertible term insurance, because it is much cheaper than a level-premium policy, which is designed for lifetime protection. A level-premium policy that is terminated within the 1st few years will have little or no cash value and will have cost considerably more than comparable term insurance. A convertible term policy can be converted to a cash-value policy without providing evidence of insurability.