Life Insurance

Most applicants are generally aware of how their life insurance premiums are calculated, in that the premiums reflect variables like age, health status, lifestyle, etc. However, very few people understand the actual risk assessment process that life insurers go through when evaluating applicants for coverage. An applicant’s information is assessed and classified based on algorithmically-based insurance tables. The applicant’s premiums directly depend on his/her classification according to these tables. To understand the risk assessment process, though, you must first understand how insurers formulate the tables and determine the exact premium the insured must pay. In this post, we will offer a window into the life insurance risk assessment process and how it affects premiums.

Quantifying Risk

Insurers define risk as the likelihood of loss. When you purchase an insurance policy, the risk of loss is transferred from you to your insurance company. To make the transfer of risk a profitable endeavor, insurers have to figure out the number of losses that will occur. However, this is impossible to do on an individual basis, so insurers instead rely on the statistical principle of the law of large numbers. In doing so, they are able to predict fairly accurately how many losses will actually occur within a group of individuals.

The Law of Large Numbers

A life insurer has no way of determining which individual policyholders will die, but as the sample or group becomes larger, the predictions become more and more accurate. With statistics, the insurer can accurately predict the number of policyholders that will pass away within a large group. This is where the law of large numbers comes into play: the bigger the group, the more accurate the prediction of future losses over a certain period of time will be. A good example of the law of large numbers if the flipping of a fair coin. If you flip the coin only two or three times, you will likely get skewed results that inaccurately favor either heads or tails. However, as the number of trials increases, the frequency of heads or tails will get closer and closer to 50%. The law of large numbers is critical in the insurance industry because it guarantees consistent results over the long term for otherwise random events.

Exposure Units

With insurance, an exposure unit is the piece of property or individual that is insured. For the law of large numbers to work, insurers must combine a large amount of homogeneous exposure units. Applied to life insurance, the exposure unit is the monetary value of the policyholder’s life. As the number of exposure units in a group increases, the amount of error in predicting losses drops. Insurance companies focus only on average risk because, in doing so, the extremes of the loss spectrum cancel each other out.

Actuaries

Actuaries are mathematicians who collect and evaluate statistical data related to risk and exposure units. It is this data that is the basis for the formulation of life insurers’ morbidity (sickness) and mortality (death) tables. Using these tables, actuaries predict the likelihood of future losses resulting from death and illness. The tables factor in many variables that can raise or lower the loss risk, such as age, medical history, tobacco use, etc. Each applicant is classified and his/her premiums are determined according to where his/her profile falls based on the tables.

Where Premiums Come From

So how does the risk assessment process finally translate into the premiums that an applicant will pay? Basically, premiums are what a life insurance company charges in order to provide for expenses, profits, and the cost of anticipated losses. The amount of loss expected is based on the insurer’s past experience with average risk. Of course, some applicants will far outlive their life expectancy, and thus will pay premiums for a much longer time than expected. However, for every applicant like that, there is also one who will die prematurely after paying premiums for only a very short period of time. Consequently, both the high and low extremes negate each other, which leaves the average risk as the basis for determining expected losses.

Cash Value Insurance – Insurance that, in addition to paying out a death benefit, also accumulates cash value over time which may be withdrawn after a certain period.

More detail on Cash Value Insurance

Cash value life insurance policies come with a higher premium than other life insurance policies and this is due to the fact that part of your premium is put into an interest-bearing account for you—tax free—which becomes available to you after a certain period of time. These insurance policies are generally lifetime policies rather than term life insurance which is coverage planned only for a certain period of time (5, 10, 15, 20 years).

The Cash Value Account

All life insurance policies are somewhat different so you will want to check the specifics of a cash value life insurance plan before you sign any paperwork. A cash value policy pays part of your premium into an account for you where your money makes interest and grows for you until a certain amount is reached (again, check your policy). Once that amount is reached, you have the option of stopping premium payments altogether and keeping your insurance policy, or you can continue to pay into it to grow the cash value of the account. Technically this money is used in the same way a bank uses the money you put there in savings. The insurance company invests with it to their own ends while keeping your principal safe for you. This cash value account also has the advantage of helping to pay the higher costs of insuring you as you grow older, so your premiums do not increase.

Your Benefits From the Cash Value Account

Once you have paid into the cash value account for the specified period you have several options of what you can do with it. You can either:

• Stop making premium payments and let the amount in the account “pay” them for you. This does not decrease the principal amount in your account and keeps your life insurance policy active for you for the rest of your life for ‘free’.
• Continue making premium payments which will grow your cash account significantly for the future. Many people like to think of it as a second retirement account which, after a long enough period of making payments, could equal several hundred thousand dollars.
• Take Out Loans From the Account. This has the effect of making you your own lender. You can borrow money from the account, which may be taxed, and you do not necessearily have to pay it back. If you choose not to pay the loan back, the amount borrowed plus interest will be deducted from your death benefit if you die.

Other Things to Consider

Cash value life insurance policies have the added benefit of the extra account for your use once you have reached a certain amount deposited, but the higher premiums are criticized for some as not being worth it. Many agents recommend simply using a term life insurance policy and taking the savings in premium amount and investing it in other retirement portfolios to achieve the same effect as the cash value account. The downside to this, however, is that if your term policy reaches its natural end, renewing it or getting another policy could be significantly more expensive based upon your age. One of the benefits of a whole life, or cash value policy is that your premiums will not change as you get older, so if you begin a policy when you are relatively young, you will be paying next to nothing (or literally nothing) for life insurance through the rest of your life. The increased premium that you pay now could balance out later in life when others are paying higher premiums to renew their term life policies - and do not have the cash value account.

Another consideration for cash value insurance is that there may be a substantial penalty for canceling your policy early. Early is defined as the period before your cash value account is fully paid for. Once your cash value account has matured through your making enough premium payments, you may cancel your account at any time, though doing so may not be the wisest move since you have already invested a good deal of money into the policy and essentially may now keep it for the rest of your life without paying another dime.

Choosing a Side

For most people, making the decision between term or permanent life insurance is the most difficult aspect of purchasing a policy. However, if you end up going with permanent insurance, you’re not quite out of the clear yet. You’ll soon find that it’s time to make another important decision in which type of permanent life insurance fits you best. There are four basic types available to you – whole, universal, variable, and variable universal. While all types of permanent life insurance share similar characteristics, they each have their own advantages and weaknesses. If you’re having trouble deciding which form of life insurance is right for you, use this helpful guide to permanent life insurance types. Keep in mind that depending on the insurance provider, you may run into variants of these forms of permanent insurance.

Types of Permanent Life Insurance

Whole Life

Probably the most common type of permanent life insurance, whole life has become popular as a type of retirement investment because it builds cash value over time. Whole life can be more expensive than other types of life insurance, but it can also provide greater benefits. Some insurance companies may even offer a dividend option, where any excess premiums you’ve paid get returned.

Universal Life

Sometimes referred to as adjustable insurance, universal life insurance is comparable to whole life, but with its own advantages. Universal policies have a savings vehicle like whole life, but they allow you to withdraw or borrow against its cash value. This flexibility allows you to take out a loan on your policy or even pay smaller premiums if your cash value can cover the costs. Remember, if you take out a loan and fail to pay it back, you risk losing your insurance policy completely.

Variable Life

In addition to the death benefit, variable life policies offer different investment options, which are usually professionally managed. You can use whatever cash value you’ve accumulated to invest in stocks, bonds, and mutual funds to earn a greater return. Of course, there’s always the risk of losing money through these investments too. Also, you can borrow against or withdraw from variable life policies, just like universal.

Variable Universal Life

As the name suggests, variable universal life insurance policies combine several of the aspects involved with variable and universal policies. Like variable policies, you have different investment options for your money and the risk that comes with them. Similar to universal life insurance plans, you can also adjust your premiums if your cash value can cover the difference.