Although interest and mortality are the two principle factors in premium calculations, in reality insurance companies must include other factors. When insurers set premiums, they include various expenses as well as risk loadings. One major expense is agent sales commissions, which for a level-premium whole life insurance policy typically run about 55 percent or more of the annual premium in the first year and about equal to one to two annual premium in total over the life of the contract. Although this may seem high, it is not out of line with commissions and sales fees on other types of investments such as stocks, bonds, and mutual funds over the same period as a whole life insurance policy would typically be in force. For instance, in the case where the total commission is equal to one annual premium, the total commission expense would be equal to 4 percent of the total premiums a forty-year-old would pay to age sixty-five. The sales fees or commissions on stocks and bonds and other types of investments are lower as a percent of the amount invested, but they are typically incurred both when buying and selling. If instead of paying premiums, this same person bought and held stocks and paid only a 2 percent commission on each purchase, he or she would have paid total commissions equal to only 2 percent of total investments by age sixty-five. But this person would still have to pay 2 percent of the accumulated balance when selling the stocks. Because the accumulated balance would presumably be much greater than the total amount invested as a result of the growth in the value of the stock, the selling commissions would be considerably greater than another 2 percent of the total amount invested over the years.
The total “round trip” commissions on the stocks would almost certainly be greater than the total commissions paid for the insurance. Furthermore, it would be a rare individual indeed who never had any turnover (sales and repurchases) of his or her investments in the intervening years. Sell/buy transactions in the intervening years would further increase the commissions paid on the stock investment relative to the life insurance purchase. Compared with other types of investments, the sales commissions paid on life insurance look more and more favorable the longer the policy is expected to remain in force.
In addition to the expenses described above, the insurance company also must recover other typical business expenses for home office salaries and administrative costs, advertising and promotion, research and product development costs, underwriting, investment management fees, rent, and other operating and overhead expenses. These expenses together with agent sales commissions are typically recovered through some combination of front and/or back-end charges and annual policy fees that the insurer must recover from premiums or from the “savings” component of the policy.
Finally, the insurance company must charge loadings for various risks in addition to mortality risk. Because the bulk of the expenses associated with a policy is incurred when the policy is first issued, (but the majority of these expenses are not recovered through expense charges for several years) policies that are lapsed or terminated within the first few years are a drain on the company’s surplus. Therefore, the company must estimate lapse rates when setting premiums. It also adds a risk charge or load to cover the risk that the actual lapse rate will exceed projected rates. Also, because the insurance company bears a risk that it will not actually earn the guaranteed minimum rate on its investments, it must include a risk loading to the premium to cover this contingency. Similarly, although the insurer can predict with remarkable accuracy the number of people who will die each year out of a large group of people with similar characteristics and of the same age, the insurer still faces a residual risk that the company’s actual mortality experience will be worse than was anticipated. Because a life insurance company guarantees that mortality charges will not exceed certain maximums, it adds a risk loading when setting premiums to help cover the risk that its actual mortality experience is worse than projected.
Similar to the lottery illustrated in the chart above, insurance companies combine their interest, mortality, lapse and expense assumptions, and loading factors to determine the premium that is necessary for any given premium payment plan to equate the present value of the expected future benefit payouts and expenses with the present value of the expected premium pay-ins from the group of similar policies. If the premium payment plan is other than a pay-as-you-go annually-renewable term plan, per-policy reserves (the savings component) will build up and serve as the basis for cash values that are available for policy loans or as surrender values if a policy is terminated. Based on statutorily mandated conservative assumptions, the insurance company can guarantee a minimum schedule of cash values. In the initial years, the cash value available to the policy owner is usually less than the reserve, because either front- or back-end charges are imposed to recover the high initial policy issue costs. However, as the years pass and issue costs are fully recovered, the cash value that is available to policy owners grows ever closer to the entire reserve.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM