30 Life Insurance

Premium

Learning Objectives
Thischapter explains the general considerations behind life insurance
premium calculation and basic elements in computation of
premium.
Thus this chapter helps in
achieving following objectives:
1. General consideration for
whole life, term and endowment
2. Basic elements of policies
premium calculation
3. Bonus loading

GENERAL CONSIDERATIONS
Life insurance is a contract between insurer and the
insured whereby the
insurer in consideration of a
premium undertakes to a certain sum of
pay
money either on the death of the insured or on the expiry of a fixed period. Thus
all insurance contracts carry with them
rights and liabilities of various types.
The rights are in the form of receiving the assured sum
(when, how and how
much) and the liabilities are in the form of payment of the premium. The
insured has to pay this premium in advance. The insurance
company collects
the amount of premium as fund and increases this fund
by properly investing
this premium in different schemes. This fund is known as life fund. This fund
is constituted mainly for fulfilling the future liabilities of the insurance
Thus proper and exact computation of premium rate is a key for the success of
company.
life insurance business.
In life insurance contract premium computation is done in the following two
ways Calculation of Net Premium, and Calculation of Gross Premium.

Calculation of Net Premium

Net premium is that premium which is received by the insurer in a lump sum
and is exactly adequate along with the return earned thereon, to pay the
 Lile Insurance Premiun

an1ount of claim
where-ever it arises 673
SurTender. It does not
provide for whether at death or at
The calculation of net expenses of management maturity or even a

and the rate of interest.

premium is based on
and for
contingencies.
two
of net premium and Higher is the
rate of things-the rate of mortaluy
vice-versa. interest, lower will be the
be the amount of net Similarly,
premium higher the rate of mortality, amount
and vice-versa. higher will
Table 27.1
Years 3%
4% 5%
.971 .962
2 .952
.943 .924
3 907
915 .889
4 864
.888 .855
5 .823
.863 822
6 .784
.837 790
7 .746
.813 .760 .710

Example 1. Calculate
single net premium for an endowment assurance of Rs.
1,000 on a life aged 30, payable at the end of 4 years or at
rate of interest is 4%. previous death. The
Solution. First refer to mortality table at age 30, there are 980776 lives who are
assured out of them 1,314 die in the lst year and then in 2nd, 3rd and 4th
years 1,361, 1,428 & 1,514 people die respectively. Thus following claims will be
payable
Table 27.2

Amount Payable (in Rs.) Present Values of Re. 1 Product

lst year 13.14.000 .962 12,64,0658

13,61,000 .924 12,57,564
2nd year
14.28,000 .889 12,69,4992
3rd year
15,14,000 .855 12,94,470
4th year
At the end of
9.76673,000 .855 83,50,55,410
4th year
50,85,594
Total Present Value Rs. 84,01,41,004
value by the number of assurances 9.80.776
By dividing the total present
find that the single premium
required for each assured is
we 858.61.
9,80,776 R s .
Rs. 84,01,41,004
 Principles of Ins1urance
674

Calculation of Gross Premium

rate, the assumed
upon the mortality
The amount of gross premium depends
and the bonus loading.
interest rate, the expenses + Expenses +
the Bonus Loading.
Premium = Net premium
The Gross in the net premium,
amount of expenses and the bonus loading
Ifwe add the and this
Gross Premium. This is office premium
amount will be known a s

is chargedfromn the policy holders.

premium
COMPUTATION OF PREMIUM
BASIC ELEMENTS IN
insurance services. When price
of any commodity is to
Premium is the price of
determined on the basis of cost
incurred on that
be determined then it is
insurance company quote this price (premium)
on
commodity. In the s a m e way, three basic
basis of cost. Now, the cost of life insurance depends upon
the
Interest Rate, and 3. Expenses.
elements 1. Mortality Rate, 2.

Mortality Rate
against which
contract of assurance in which the event
Lite insurance is a

certain to The claim for life insurance may arise

happen.
insurance is given is
or at the maturity of the policy.
Thus in life
at the death of the life insured
the death. If a person has
insurance. premium in most of cases depends upon
5,00.000. But the person dies in
taken an insurance policy for 20 years of Rs.
Then the insurance company has
1 year after paying premium for only 1 year.
insurance company has got premium for 1 year
to pay the full claim whereas the
Thus the main problem before
only. Thus it is too costly for insurance company.
take place and out of
the insurance company is to decide when the death will
the persons insured, what is the probability of death of the people. Generally
as

of death increases.
the age increases, the risk increases and thus the probability
If the period and amount of claim have been decided. the premium can be easily

calculated. For calculating the cost of life insurance it is necessary to kuow the
can
probable death rate of life of insured. With the help of deat1 rate, we

estimate the amount of future claim.

Mortality table helps us in the death rate. Mortability table is a
knowing
A
table with the help of wBhich we know the possibilities of life and death.
deaths per thousand
mortality rate is usually expressed in terms of the number of
at given age. Mortality table tell the death rate of different age groups. Th
premium rates are fixed on the basis of mortality rate in such a way that these
amounts will be sufficient to meet the claims as and when they arise.
Lite InsSurance Premium

Rate of Interest
675

Insurance premlums are

generally
company gets tne premium in collected for a long
company does ot
keep the
advance and claim is period of time. Insurance
to earn interest. The money idle. This money ispaid afterwards. Insuran
huge amount of invested by the
investment and this
income from interest is in fact earned every yearcompay
on
insurance. The company is interest is utilised in u
earned taking into required to assume reducing the
cos
account various a rate of
is generally conservative in factors that affect such return that may D

earnings. The
in advance and the presentassuming rate of interest.
Since the premiumcompany
is Xed
value should be
assumed compound rate of calculated so that this value at
a
claim. interest must be sufficient to pay the amount ol

If interest rate is
higher in the market, then more cost of insurance will be
recovered from the earnings, thus it will result in lowering the
In the same way, if
interest rate is lower, premium ratesS
earnings will be lower and thus
premium rate will be higher.
LIC is the biggest life
insurance company. It has the collection of maximun
premium. Earlier in India, interest rates were higher, thus the cost of insurance
was low and thus premium rates were lower. Interest rates also
affect the bonus
given by the insurance company. When interest rates were higher in the market,
LIC was giving very good bonuses. Almost in all policies bonus was Rs. 70 per
thousand sum assured every year. But now interest rates in the market are
lower. Thus bonuses have reduced. Now bonus is decided every year and generally
it is maximum to the extent of Rs. 50 per thousand sum assured.
Thus interest rates affect the premium in a very significant way. For
calculation of premium, a lower rate of interest that which can confidently be
assumed in the calculation of premiums. This
expected to be earned is usually
is made for a margin in the insurance premium by
way automatically provision
than those arrived at on experience basis. The
bringing out higher premiums calculated on a cautious estimated rate of
difference between the two premiums Loadins' in tha
realised rate can be called Interest
interest and the actually
premiuns.

Expenses m u s t be sufficient to meet the claiims

insurance company
fixed by D u s i n e s s . In addition to the claims. the
The premium of i n s u r a n c e
the expenses also such a s : salariee e of the
and also cover certain
o t h e r expenses

has to
incur
oI the building,
commission e
company cnarges
rent or
maintenance

etc. The amount of these avna.

employees, expenses,
administrative
and other
 Principles of Iis1urance
676

is estimated o n the basis of experience

cannot be definitely but it
determined
added to the cost of insurance and is known: 1S
This amount of expenses is
undertakes to provide funds to meet contingencies
S
loadinq. The loading also foor
calculation. Therefore, loading is required to provide
unforeseen in the
and for contingencies.
expenses of operation

INCURRED IN WRITING A LIFE INSURANCE CONTRACT

TYPES OF EXPENSES
insurance company wants to sell a new policy.
In order to
Suppose that a life
r u n the business at a profit,
it will need to
.determine what the expenses attributable to that policy will be, on
average. and
calculate a premium for the policy which allows for those expenses.
One complication is that. given the long time for which life insurance
contracts stay on the books, the expenses that the company will incur in respect
of this policy will increase due to inlation. If the policy is a conventional
contract, where normally the premiums cannot be varied (as opposed to a unit-
linked contract, where normally the charges can be varied throughout the
lifetime of the contract). it is vital that the company allows correctly for such
inflation.

Measuring and Allocating Costs

In addition to the costs of providing benefits, an insurance company will incur
other costs in running its businesses. These costs must be recovered by a
loading for expenses in the premiums charged to policyholders. A mechanism to
measure costs and to allocate them as expenses to individual contracts is
required.
But this does not mean that the company would work out the precise costs
to each individual policy on a policy-by-policy basis and then
attributable
charge each of the individual policies accordingly. Rather, they determine the
costs which they expect policies to incur. given the recent experience of
average
the company, and then price new contracts
appropriately. For this they split
policies into broad groupings.
The term for this process is
'expense investigation'.
The measurement of costs is part of the accounting function within the
company. Costs are usually allocated to business functions within the company,
e.g.. policy servicing, computing, new business, buildings and their maintenance,
cost of selling/salesforce.
These categories
of costs can be divided into overhead expenses and direct
expenses given as follows:
Life Insurance Premium
677
Overhead
expenses are those that in the short term do not vary wiu he
amount of business written.
Duect
expenses are those that do vary with amount of business wnuei
In the long term, large changes in the amount of business written wiu i
in all expenses being direct.
Forinstance, the cost of head office
premises is an overhead in that t W
not change if we double next
month's new business figures. However, u i w
business levelS over the next three years are doubled, then the company will
need t0 physically expand in order to
cope with the extra sair requu
process and administer the business.
Once total overheadand direct expenses are determined, the average
Cpe
per policy are calculated.

Charging for Expenses

Once a life insurance company has established the average expenses that t
thinks its new policies will incur, it needs to ensure that premium rates reilect
these expenses. In practice, companies may adopt different ways of pricin8
policies to recoup expenses. Here is one, theoretically valid, approach.
Direct expenses are divided into:
Initial expenses-those arising when policies are issued,
R e n e w a l expenses-those arising regularly during
the policy term,
when the policy terminates a s a
Termination expenses-those arising
result of an insured contingency (e.g., a death claim for a temporary life
insurance policy).
to their appropriate driver in the
These are allocated to policies according
form of cashflows that
have to be met at the specified time in the policy's life.
a r e usualy allocated on a per policy basis.
Overhead expenses
SnnaSe that the accounting department has determined that the company

deemed 'overhead t h a t a m o u n t to Rs. 14.2 lakh over the vear

has expenses
A share would be the total Rs
w h a t is a fair share
of this 1or any ponyr lair
AOLalh divided by the number ot policles in torce over that year. So no olicy
Do no
policy
share of, say, building costs, than
is deemed
to require a greater any other
policy.
Direct expenses are allocated according to their 'drivers'. Drivers are the
are the
Direct expe size of premiunm and size of S
factors (e.g., number
of policies, Size of ben
benefit) changes in
to lead to changes in direct
observed expenses For example,
expenses.
which are
c o s t s a r e directly
related to the
directly related the ssize
iz. of the siim assured. Tn2e
underwriting
 Principles of lisiurane
678

are driven by the number of policies in force

majority of direct expenses
c o m m i s s i o n s paid a s part of obtaining ththhe
Further costs may result irom
commission) and its renewal (renewal commission
sale of a policy (initial
direct in nature rather than overheai
Commission costs are, by definition,
the amount of annual o r single premimm
and their 'drivers' are normally
fee-based advice would. however, result in
concerned. The recent mnove towards
'driver.
the number of policies being the
Commissions are normally refeTed to separately from expenses because
from the point of view of the life insurance company

the level of commissions may be defined by the company itself, and

the level may be changed at the will of the company.
The level of expenses. by comparison, cannot be changed at will, or as
quickly as commissions could be changed. because complex factors are at play
in the structure and hunman resource requirements of the whole company.
The valuation of expenses uses the same methodology as that used for the
valuation of benefits. This means that if we determine the value of benefits
deterministically. for instance, then we should apply the same method to valuing
the expenses.

The Influence of Inflation on Expenses

Inflation aflects underlying costs which. in turn, influence the level of expenses
allocated to policies.
The main categories of COsts are

salaries and salary-related expenses,

buildings and other property costs,
computing and associated costs, and
costs associated with the investment of funds.

Note that this is a different split to the overhead/direct split we discussed

earlier.
Many of these items are directly or indirectly linked to wage and salary
levels. Other items are influenced by the
general level of prices or by the prices
of particular commodities. Publicly available data e.g. retail price Index, national
average earnings index, and similar data internal to the insurance company can
be used to forecast the
expected general price, future wage or specific price
inflation.
These forecasts enable the
expenses being valued to be adjusted for expected
inflation.
 Life Insurance Premiumn 679

Loading in Premium Rates

Bonus
In many types of Endowment assurance plans which are with profit policies,
declared a s
profits earned are distributed as bonus. Bonuses are generally
form an
additions to s u m assured for each year's premium paid. Thus they at
rate is much less
increasing a s s u r a n c e . The cost of bonus at a particular maintain
and for policies with short unexpired terms. To
young ages and for ages duration of
uniformity of premiums, the total cost of bonuses for the whole
the t with
has to be distributed uniformly over all the premiums by dividing
a policy for a n
relative annuity due, which gives the addition to each premium
the for a
annual rate of bonus per unit s u m
assured. This addition
anticipated
in the premium.
definite bonus is called bonus loading

Managerial Valuation
other costs are also to be
consideration of above costs, some
In addition to the
included. Thus finally premium
charged consists of following:
amount
calculations and includes the
based o n actuarial
Pure Premium. It is expenses.
losses and loss adjustment
needed to cover expected and other
commission
includes the sales
This component size
Operating Expenses. claims. This component
cost of handling
taxes and the the extent and variety
marketing costs, dependent upon
line to another, largely
varies from one

s e r v i c e s that
the i n s u r e r provides.
of policyholder allowance for (a) Contingencies, and
This includes a n
Other Incomes. to meet unexpected
funds a r e needed
Margin and contingency
Underwriting gain
or profit underwriting gains
are
(b) of benefit payments and
number o r size
increase in the growth and
expansion.
funds for financing losses + Cost of operating
needed to provide = Cost ot paying for
Premium Reserves
Finally,
Insurance
and maintaining
insurance pool +

losses + Investment earnings

for unexpected
o n past experience,
which
claim, cost based
are subject
to review from time to time.

insurance. the
Non-life
nsurance Pricing. In non-life
Factors
considered in a m o u n t or
1Osses incurred during the vear If the
of the
estimates otherwise if
make the minimum premium,
insurers i n s u r e a will pay
very
small, the the maximum oremium.
losses are insured
wil De charged
the business
are very large, s undertaken to attract the new
thev underung is
cash flow premium
Sometimes the l0ss.n such a case, the insurarnce
and
the insurance 'at a Cost of operating
hy pricing Premium
= C O s t OI paying for losses +
Insurance
fixed as
680 Principles of Insurance

maintaining insurance pool + Reserve for unexpected losses + Investment earnings

claims cost based past
on experience, which are subject to reviewfrom timeto
time The factors considered when pricing general insurance productsare:
(a) Claims cost
cost
(b) Business acquisition
(c) Management expenses
(d Margin for fluctuations in claims experience
(e) A reasonable profit

SInaAPY