You might think that the insurance company just make up their premiums or charge as much as they think they can. Although there may be some truth in them charging as much as they can, the minimum amount that they will charge (and therefore the level that premiums will often be at if there is competition) is actually worked out in a very mathematical way.
Actuaries and Actuarial Tables
Actuaries are key to the way that the pure life cover part of your premium (the only part if you have term insurance) is calculated. They are people that specialize in analyzing death rates for people starting at various different ages. They can apply various other factors (gender, health, family history etc.) to come up with an percentage risk that any person will die within a specified period. These figures can then be put into a table that can be used for calculating premiums. These days, the rules that they decide are far more likely to be used to create a computer program to work out any person’s risk of death. For example:
If John age 25 wants to arrange term insurance of $100,000 for the next 25 years the insurance company will calculate his risk of death within this period, having asked whether he smokes, drinks, is healthy etc. If the risk is calculated as 2% (and this figure is only chosen to make the math easy!) then out of every 100 people like John that the insurance company insures they would expect 2 to die. They would therefore have to pay out $200,000. Ignoring investment returns on premiums and profit margin, the premium that the insurance company would need to charge would be $200,000 divided by the number of people insured = $2000. Dividing this figure by the number of years/months in the insured period gives a monthly premium of approximately $7.
Investments and Whole Life Policies
Whereas term insurance is like a gamble for the insurance company on whether you will die, with whole life insurance the company know that (as long as you keep up your premiums) they are going to pay out the set amount. In this case a complicated calculation is required to work out how much of your premium needs to be put into investments to pay out the insured amount at whatever age you die . This needs to be combined with the above calculation to see how likely it is that you will die in the early years of the policy. The fact that you are receiving both pure life insurance and an investment explains why whole life premiums are a lot more expensive than term insurance.
Tags: Life Insurance
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