That is a very complex arithmetic question. The summary here is necessarily simplified. The premium required is the amount that makes a sinking fund balance given the expected dates of payout, the ultimate duration of risk, costs including taxes, investment yield, and rate of lapse.
Some of these have many sub-parts.
The expected date of the payouts comes from statistics about deaths.
Mortality rate. Insurers know a great deal about how long people will live. So many for one year, some for two, some for 90 years. Most somewhere between. There will be a Bell curve like distribution. If you have enough people in your insured pool, the outcomes are near certain.
You will know the differences between the genders, the effect of smoking, alcohol, drugs, avocations and dangerous hobbies.. Travel to places with physical risk or with inadequate medical facilities should an unforeseen crisis arise will cause problems.
You will improve the likelihood of insuring only people who live long by underwriting. Already have pancreatic cancer? Decline. Have ulcerative colitis. Maybe not a big deal, but there seems to be a connection to some forms of cancer. Charge a little extra. Use hard drugs. Call back in 10 years.
Duration of risk accepted.
Mortality is a big factor. If the insurer is willing to pay for the entire mortality curve, they will charge more than if they only cover five years. Many policies expire before 85. People who are insurable almost never die in the next five years. The risk of death while covered factors into the premium.
Costs to operate the business.
Underwriting, medicals, commissions, administration, income taxes, cost of capital, and profit add up and must be recovered from the customers.
Until there is a claim money is invested. Often for a very long time. Insurers take that income into account when calculating the premium and have sophisticated models to estimate what it may be based on their investment protocol. Basically they buy near riskless investments. They have a long time and no special reason to take chances.
This is a meaningful number in some forms of policy. It is the money the insurer received and keeps after the customer cancels the insurance or it expires. No more risk, money in hand. Good deal. Large lapse factors reduce premiums or increase cash values for the ones who stay in the pool. Some policies are designed to create lapses, others might not. The age at issue matters. A 30-year-old is more likely to cancel a policy than is a 70-year-old. Clients should see the differences between lapse loaded premiums and those that are not before deciding. There are meaningful differences.
Loading all the factors into a computer, actuaries are able to say the premium for a 35-year-old female non-smoker with no adverse indicators buying a non participating, universal life policy with term to 100 cost guarantees, no cash value and a face amount of $1,000,000 should be $477.05 per month.
If input values change, so does the premium. $557.83 because of maleness. $634.36 for a female smoker.
Insurers know their numbers exactly, notice the pennies, and the numbers are the same for each insurer. If you buy a product with a materially lower premium, something in the assumptions is different. It might be wise for you to find out what it is before you buy.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772