How Would You Price A Life Insurance Policy?
I suppose you would not try, but think a little. The insurer wants to make some money and the insured wants to protect the economic value of their life from being lost should they die too soon. The question becomes what is the “equilibrium ” price. The one where both get what they need.
The insurer’s problem
The insurer is faced with a price they can live with. In cases with large carriers and individually owned policies, they guarantee the future price and may live with their guess for 60 or 70 years. Some years ago I bought an agency and there was a policy in it that was almost 90 years old when the insured passed away. Policies today are letter size and bound. That one was one page and about the size of a provincial roadmap. Insurers are careful when they set a price.
The insured’s problem
Dying young is statistically improbable. If you are 25, it is not certain you will live
to collect retirement benefits, but it is certainly the way to bet. Your principle concern is the price must fit your budget because you hope not to collect. Buying life insurance is like betting against the home team. Not easy, but in this case necessary.
The price is where the needs meet.
The insured decides on
- An amount that provides the survivors with the money they planned to have and needed.
- A policy type that matches the need. For example short term needs like paying off the house or creating education funds for children will tend not to be there at retirement. There are policies that are very cheap in the early years but become unusable later on.
- Many people own more than one policy to address different duration risks.
- Many people buy coverages that are convertible. They can change the way the policy works over time.
The insured’s purpose is to create predictability in two ways.
- The family has the money they need for sure.
- The insurer guarantees the price and the options.
The insurer decides the price.
That decision relies on factors they know from the past and can project for the future. The database has about 100,000,000 histories within it.
- What is the pattern of deaths for people similar to this applicant?
- Are they male or female? Females live longer usually. (Maleness is a birth defect??)
- Do they smoke? Smoking is very expensive for life insurance. One cigarette will make the difference. Cigars are a bit different but still a factor.
- Do they have any disease or condition we can assess? If yes, they will likely insure, but at a somewhat higher price.
- What is their family history? Genetics matter to a point.
- Do they have a condition that is unpredictable. Probably no insurance available. For example an inoperable brain or aortic aneurysm would mean you life expectancy at any point in time is either normal or about 60 seconds. It depends on whether it bursts. Insurers never insure that kind of risk. They want predictability.
- Do they do things that have higher risk than normal. Lifestyle choices. Do they skydive, scuba dive, parasail, or have a job handling potentially harmful chemicals. Do you drink alcohol to excess? Do you use drugs. Marijuana makes you a smoker but likely not much more. They will want to know how often you use the product. I had a client who claimed to have used drugs only once. When questioned about when, he said it was hard to remember exactly but he thought from early 1979 to about the middle of 1985. Harder drugs depend on when you used them. Within the last 10 years, they will decline the coverage or rate it highly.
- How much coverage do you want? Most insurers have bands. Per thousand issued, $1,000,000 is cheaper than $100,000. If the amount is very high they will have other insurers participate in the risk. They want their pool of coverages to be made from similar sized coverages. They don’t want one of those coverages to be half their risk.
You could expect that of a 100 randomly selected young people of a particular age and gender, about 1% will be declined, and about another 4%, more if older people, will be rated. From the insurer’s perspective, the 95 that remain behave as one for pricing purposes.
It is a “sinking fund.”
An orderly way to accumulate money to pay a future obligation.
- They decide the average age at death and that sets the time they have to get their money in place before they must pay anyone. Because there are thousands of policyholders and they don’t die at once, it works. Some die too soon, some live nearly forever.
- They decide how much they will pay for expenses to create and maintain the policy. The early years are expensive. Medicals, and underwriting assessment, commissions, and setting up the future payments and reporting. For some kinds of policies, one of the factors is within your control. Pay annually instead of monthly. In most cases, you can buy the annual premium for the price of eleven monthly payments.
- They estimate what they can earn by investing the premiums. They are conservative and most of the money, more than 75%, is invested in bonds and mortgages.
- They assess the duration of coverage. A 10-year renewable term policy will be very inexpensive for the first term because if you can make it through underwriting the chances of dying within 10 years are minimal. The renewal will become progressively more expensive. If healthy, you could buy a new 10-year policy cheaper than renew an old one. Why? Because not everyone who qualified 10 years ago could qualify today. The quality of the insured pool falls over time.
- They estimate their tax costs.
- They set a profit margin.
That gives them a clear idea of the pricing with one further wrinkle.
Not everyone will own the policy when they die. Some people will have cancelled it before then. Given their big data base, they can predict that too. When someone quits, the accumulated reserve belongs to the insurer, possibly subject to a cash value paid to the person surrendering the policy. That would depend on the type of policy. Now you know one of the reasons why policies with cash value have higher premiums than ones without. Most policies issued to young people have a higher lapse factor than those issued to older people. When you are young there are more variables in your future and you often don’t really know what you need. Older people know exactly what they need and why.
When all the parts are assessed, the price just happens.
An example for 10-year term renewable to age 80
Male age 25 non-smoker
- $1,000,000 coverage. Annual premium $460. monthly $41.40
- As a smoker, about double. $910
- First renewal $1,460. A healthy 35 year old could get coverage for $440.
Female age 25, non-smoker
- $1,000,000 coverage, $300 annually, or $27 monthly
- As a smoker, $500. They expect more females to quit, and sooner.
- First renewal, $1,080. or new coverage for a 35 year-old at $340
Insurance pricing is highly organized and based on the evidence they have to date.
All insurance costs the same to the insurer. People don’t die at a different rate depending on who is insuring them.
- If the premium is substantially lower, chances are the coverage is different. I had a client who had a $1,000,000 “Personal Catastrophe” policy whose premium was about a tenth of what real coverage would have cost. Upon examination, he decided if he was trampled by a rabid yak, in the shade, on a mountain in Tibet, in spring, he could collect. Otherwise, if he died, he could stop paying premiums.
- Be careful of a pre-existing condition clause. It doesn’t matter if you know about it. The insurer can deny payment if they do their underwriting when they get a claim and discover you had something wrong when you applied. Many group, creditor, and association coverages contain such a clause.
Think through the problem in this order
- How much coverage solves the problems for the survivors?
- How does the need behave over the future. If most of it is short duration, buying long duration coverage like term to 100 is wasteful. You will likely cancel anyway. For a 25-year-old male non-smoker, $1,000,000 of term to 100 has a price of about $5,000 annually. Females about $4,500
- Be sure you know the pattern of need and the options to deal with it. Agents earn based on premium. If you assess your need carelessly, you won’t be able to defend yourself from the unscrupulous ones.
- Decide on a policy after noticing guarantees, exceptions, ongoing service, and the price.
Then, just do it! And hope you don’t need it any time soon.
I help people have more income and larger, more liquid estates.
Call or email email@example.com in Canada 705-927-4770