What to Know About Ordinary Level Whole Life Premiums

Life insurance companies are free to set premiums according to their own marketing strategies. Almost all states have statutes prohibiting any form of rebating (sharing the commission with the purchaser) by the agent. The premium includes a “loading” to cover such things as commissions to agents, premium taxes payable to the state government, operating expenses of the insurance company such as rent, mortgage payments and salaries, and other company expenses.

A few companies offer “no-load” or “low-load” life insurance policies. These policies are not really no-load, because certain expenses are unavoidable (e.g., the premium tax), but rather pay either no sales commission or a very low sales commission. Consequently, the cash value buildup tends to be larger in the early years. Although commissions are lower, these companies typically must spend somewhat more money on alternative methods of marketing and may therefore incur generally higher expenses in this area than companies that pay commissions to agents.

The bulk of an insurance company’s expenses for a policy are incurred when the policy is issued. It may take the company five years or longer to recover all its front-end costs. The state premium tax is an ongoing expense that averages about 2 percent of each premium payment. With most cash value policies the aggregate commission paid to the selling agent is approximately equal to the first year premium on the policy. About half (often 55 percent) is payable in the year of sale and the other half is paid on a renewal basis over a period of three to nine years.

Most ordinary-level premium life insurance policies have no explicit surrender charges. However, most participating policies will pay a terminal dividend. The terminal dividend is typically higher the longer the policy has remained in force. In essence, this is a form of surrender charge because the company is essentially holding back dividends it could otherwise pay currently and rewarding those policyholders who maintain their policy longer with a greater terminal dividend.

Frequency of Premiums

Insurance companies usually quote insurance premiums on an annual basis, but the insurer can convert the annual payment to monthly or quarterly payments, if the policyowner desires. When insurers convert annual premiums to monthly or quarterly payments, they typically charge an implicit interest rate on the payments that are deferred until later in the year. In other words, the insurance company essentially is loaning the policyowner a portion of the annual premium that the policyowner then repays over the term of the year with a “borrowing” rate equal to the implicit rate. If the implicit rate is greater than the policyowner’s after-tax opportunity cost of funds (the policyowner’s potential after-tax investment rate), he or she should pay the premium annually, if possible. Conversely, if the implicit rate is less than the policyowner’s potential after-tax investment rate, the policyowner will be better off deferring payments by electing to pay monthly or quarterly.

If, for cash flow reasons, the policyowner cannot pay the premiums annually, the issue is whether the insurance company’s implicit rate is greater than or less than the after tax-rate at which the policyowner could otherwise borrow money to pay the annual premium. If the implicit rate is higher than the policyowner’s after-tax borrowing rate, he or she should borrow the money elsewhere and pay the premium annually. Conversely, if the implicit rate is lower than the after-tax borrowing rate, the policyowner should elect to pay premiums quarterly or monthly.

The decision as to which payment plan to elect depends on the insurance company’s implicit rate. One may determine the implicit rate in the following manner. The ratio of the monthly (or quarterly) premium to the annual premium is called the monthly (or quarterly) conversion factor. Once one knows (or computes) the conversion factor, one can determine the interest rate that the insurance company is implicitly charging for the monthly or quarterly payment plan. For example, if the monthly payment is equal to 1/12 (.083333) of the annual premium, the insurance company is charging 0 percent interest on the premium payment plan.

In virtually all cases, however, the monthly payment is greater than 1/12 (.083333) of the annual premium because of an implicit interest charge. Figure 14.1 shows the interest rate the insurance company is implicitly charging for various monthly and quarterly conversion factors. For example, assume the premium for a policy is $1,000 if paid annually or $88.75 if paid monthly. The monthly conversion factor is the ratio of the monthly premium to the annual premium, $88.75/$1,000, or 0.08875. According to the table, the implicit interest rate for this monthly conversion factor is about 14 percent.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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