LOMA 280

Principles
of
Insurance

CHAPTER 4

Financial Design of Life Insurance

Products

CHAPTER FOUR 1
Chapter 4

The Legal Reserve System

Legal
LegalReserve
ReserveSystem
System
AAmodern
modernfunding
fundingmethod
methodbased
basedononlaws
lawsrequiring
requiringinsurance
insurance
companies
companiestotoestablish
establishpolicy
policyreserves
reserves
The legal reserve system is based on the following premises:
 The amount of benefit payable under a life insurance policy
should be specified or calculable before the insured’s death.
 The money needed to pay policy benefits should be collected in
advance so the insurer will be able to pay claims as they occur.
 The premium an individual pays for an insurance policy should be
directly related to the amount of risk the insurer assumes for that
policy.

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Chapter 4

Elements of a Product’s Financial

Design
Insurers include the following factors in the calculation of
life insurance premium rates:
 Cost of benefits
 Investment earnings
 Operating Expenses

In performing premium rate calculations, actuaries make

actuarial assumptions, which are estimated values
used in life insurance and annuity pricing, concerning
each of these factors.

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CHAPTER FOUR 3
Chapter 4

Cost of Benefits
The cost of benefits for an insurance product equals all
of the insurer’s potential payments of benefit obligations
to customers multiplied by the expected probability that
each benefit will be payable.
The probability that policy proceeds will be payable in a
given year is measured by mortality statistics.
Mortality
Mortalityisisthe
the Mortality rate is the
incidence
incidenceofofdeath
death rate at which death
among
amongaaspecified
specified occurs among a
group
groupofofpeople.
people. specified group of
people during a
specified period,
typically one year.
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Chapter 4

Investment Earnings
investment
investmentearnings:
earnings: Premium dollars are the
money
moneyinsurers
insurersearn
earnby
by main source of funds
investing
investingpremium
premium used to pay life insurance
dollars
dollars claims
 The effect of investment earnings on insurers and
policyowners is important in premium rate
calculations.
 Investment earnings enable an insurer to charge
lower premium rates than would be possible if the
insurer considered only the mortality risk factor.
 The longer a life insurance policy is in force, the
greater the effect investment earnings will have on
premium calculations.
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Chapter 4

Simple Interest
Interest
Interestisismoney
moneythat
thatisispaid
paidfor
forthe
theuse
useofofmoney.
money.Investments
Investments
create earnings through interest.
create earnings through interest.

Simple interest is interest paid on the original principal only.

Example: Susan Chen loaned Juan Bonitez $1,000 for one

year at an annual interest rate of 10 percent. If Ms. Chen
earned simple interest on the loan, at the end of the first year,
Mr. Bonitez would owe Ms. Chen $1,100.
Calculation: $1,000 × .10 = $100
$1,000 + $100 = $1,100

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Chapter 4

Compound Interest
Compound interest is interest paid on the original principal sum
and on accrued interest.

Example: Assume that Ms. Chen earned compound interest on

her loan to Mr. Bonitez, and she allowed Mr. Bonitez to keep the
$1,000 loan for an additional year without paying the $100 of
interest for the previous year. At the end of the second year, Mr.
Bonitez would owe Ms. Chen $1,210.
Calculation: $1,000 × .10 = $100 - Interest at end of Year 1
$1,000 + $100 = $1,100
$1,100 × .10 = $110 - Interest at end of Year 2
$1,100 + $110 = $1210

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Chapter 4

Operating Expenses

Operating
OperatingExpenses
Expenses

These
Theseare
arethe
theexpenses
expensesthat
thatarise
ariseininthe
thenormal
normalcourse
courseofofthe
the
insurer’s operations.
insurer’s operations.

Example
Example: :payroll,
payroll,office
officeexpenses,
expenses,advertising,
advertising,ITITcost
costand
andtaxes
taxes

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Chapter 4

Conservative Values in Financial Design

Conservative
Conservativevalues
valuesfor
forspecific
specificlife
lifeinsurance
insuranceproduct
productelements
elements
generally
generallytake
takethe
theform
formofof

Mortality

Mortalityrates
ratesthat
thatare
arehigher
higherthan
thanexpected
expected

Investment

Investmentearnings
earningsthat
thatare
arelower
lowerthan
thanexpected
expected

Operating

Operatingexpenses
expensesthat
thatare
arehigher
higherthan
thanexpected
expected

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Chapter 4

Premium Rates
AApremium
premiumraterateisisaacharge
chargeper
perunit
unitofofinsurance
insurancecoverage.
coverage.
AAcoverage

coverageunit
unitusually
usuallyequals
equals$1,000
$1,000ofoflife
lifeinsurance
insurance
coverage,
coverage,andandthethepremium
premiumrate
rateisistypically
typicallyexpressed
expressedasasthe
the
rate
rateper
perthousand.
thousand.The Theannual
annualrate
rateisiscalculated
calculatedby bymultiplying
multiplying
the
thepremium
premiumrateratebybythe
thenumber
numberofofcoverage
coverageunits.
units.
Example: The annual premium rate for a $50,000 life insurance
policy is expressed as $3.50 per thousand.
Analysis: The annual premium amount for that policy would be
$175, which is calculated as follows:
$3.50 - Premium rate = Price per unit ($1,000 of coverage)
× 50 - Number of units ($50,000 ÷ $1,000)
$175 Annual premium amount

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Chapter 4

Premium Rates

Actuaries seek to make sure that premium rates and

other policy charges are
Adequate
Equitable
Not Excessive

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CHAPTER FOUR 11
Chapter 4

Level Premium System

The level premium system is a life insurance premium system
that allows the purchaser to pay the same premium amount
each year the policy is in force.

The

Theleveling
levelingofofpremiums
premiumsisispossible
possiblebecause
becausepremium
premiumrates
rates
charged
chargedforforlevel
levelpremium
premiumpolicies
policiesare
arehigher
higherthan
thanneeded
neededtoto
pay
payclaims
claimsand
andexpenses
expensesthatthatoccur
occurduring
duringthe
theearly
earlyyears
yearsofof
those
thosepolicies.
policies.Excess
Excesspremium
premiumdollars
dollarsfrom
fromthese
thesepolicies
policies
are
areinvested
investedby bythe
theinsurer.
insurer.
 At the time of purchase, a 1-year term insurance policy is
less expensive than a similar level premium, long-term
policy. As the insured's age increases, however, so does the
premium rate for a 1-year policy. The premium rate for a
level policy, on the other hand, does not increase after the
policy has been issued.

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Chapter 4

End of Chapter 4

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