Computation of Premium of Life Insurance Plans

The consideration is very essential for any contract : A contract without consideration is considered to be void. In life Insurance before the offer of risk is accepted by the insurer, it is the consideration ie premium which the assessed has to remit to the Insurance co. before accepting the offer. We shale look at the way the premium rates are arrived at in a life insurance contract, the need for payment of premium in time and the effect of default of payment of premium on the contract. The pricing of Insurance product will depend on the nature of risk and security of risk dependant upon contingencies on human life during the term of the policy. The financial success and failure of the insurer will depend on the actual risk experience during the term of policy contract. The pricing of life insurance is based on both the average loss experienced as well as the level of fluctuation in losses. The price is calculated by assuring a certain average loss to be experienced in future with a certain fluctuation level. Hence, for life insurance prices to remain sound and to make the operation viable, the no. of lives to covered should be large enough to ensure that the claim experience of the company as a whole will be closer to the assumption made in pricing the cover.

Basic Elements in Computation of Premiums

The computations of premium has to take into account the following factors :Mortality The rate at which a given of persons of a given age are expected to die and survive is called the rate of mortality. If the proportion of persons actually dying in a in a given year are less than what is assumed in premium calculation there will be left a small surplus and if the actual no of deaths is more than what was assumed for premium calculation the extra claim will have to be met from the accumulated life fund. Since, the morality rate of the persons who are living cannot be calculated, the Insurance go about pricing their product on the basis of the study of past experience of deaths among a similar group of persons conducted either by themselves or some other insurers or in some cases some other outside the insurance business. The study of the mortality of such persons are summarized in the form of tables called,

Mortality Tables
For pricing a product that a life insurance co. would like to offer to its customers, first it decides on a mortality table, which is considered to be the closely matching that of the largest customers. By using the mortality table, it can go about the premium that has to be charged for persons of a given age. We shall see the various stages in computation of the rate of premium chargeable for the life insurance product.

Stages in Premium Computation of Premiums

The three main components of Life Insurance Premium are i) Mortality, ii) Interest and iii) Loading for expenses, options, bonus etc. The first step is to arrive at the Pure Premium which can meet all the claims payout that are expected within the first year.

This is illustrated by an examples as under :No. of persons insured for one year 10000 Age of the Assured 35 years Sum Assured per policy Rs. 10,000/Mortality Rate at age 35 within one years is 0.0028 This means out of 10000 person to whom the policy is sold , 28 persons are likely to die within one year term as per the Mortality Table. Hence the total claim out go would be 10000x28=Rs. 2,80,000/Share of each person taking Insurance Cover would be Sum Assured x No. of death in one year Total No. of Insured person ie 10000 X 28 = Rs. 28/- or Rs. 2.80 per thousand S.A. 10000

This sum of Rs. 2.80 is the Pure premium Required to cover the risk of death for a sum assured of Rs. 10000/- for a person aged 35 for one year. In this illustration, no expenses have been added and no benefit for the interest earned by the insurer have been provided The above premium arrived at is just sufficient for the insurer is issue a term insurance policy for one year term.

Premium Calculation an example :Now let us look at a single life insurance contract for a period of over one year, say for 5 years. From the mortality table, we can find the death rate each of the 5 years.. No. of estimated claim arise in each of the 5 year is illustrated in the following table. Age (x) No. of Person living at No. of claims by death Pure or Natural age x and sharing the (dx) prabability of Premium = SA(dx)/(lx) claims (lx) Death (qx) x (lx) 35 10,000 28 28.00 36 9,972 31 31.09 37 9,941 34 34.20 38 9,907 38 38.36 39 9,869 42 42.56

Pure Premium :We find from the above that the premiums keeps on increasing in each year of the contract. It has been observed that the pure premium goes on increasing with the attained age of life assured and so is the rate of mortality. So according to the above table the life assured would be required to pay the stepped up premium to cover the same risk each year.

Level Premium :The insurer can alternately apply method of level premium by charging single rate of premium uniformly through out the terrn of 5 years from the surviving policy holders then be would be able to meet all the claims. This can be done by way of modification to the calculation as show in the following table. Age (x) 35 36 37 38 39 Total No. of Person living at No. of claims by death Total claims out go. age x and sharing the (dx) prability of Death claims (lx) (qx) x (lx) 10,000 28 2,80.000 9,972 31 3,10.000 9,941 34 3,40.000 9,907 38 3,80.000 9,869 42 4,20.000 173 17,30.000

If the uniform amount of premium that the insurer wishes to collect from all the policy holders every year is P there the same can be found out by solving the following equation :(10000 x P) + (9972 x P) + (9941 x P) + (9907 x 9) + (9869 x P) = 17,30.000 P x 49689 = 1730000 P= 1730000 = P = 34.82 49689 By this method instead of collecting 5 different premiums in the 5 years of the policy term, the insurer can fix the premium at Rs 34.82 to be the premium payable every year for the entire 5 year term. The system is called, level premium method of premium collection.

Interest and its effect :Life Insurance Contract are normally for longer periods than a year. The claim payout also take place after an expiry of some time from the date of effecting the contacts. As the premiums are received in advance and the insurers have opportunity to invest this fund for some time and earn interest on it. If we give credit of this interest earning to the policy holder the premium receivable from them shall be lesser than calculated under the Pure premium Method. This can be illustrated in the following table showing a simplified premium calculation where it is assumed that the movies earn an interest at the rate of 6% per annum.

Table showing the estimated claims pay out and their present value :Year 1 2. 3. 4. 5. No. of Persons Living 10,000 9,972 9,941 9,907 9,869 No. of Persons dying 28 31 34 38 42 Claims Payout 280000 310000 340000 380000 420000 Total P.V. of Claims 264,150.94 275,898.90 285,470.56 300,995.59 313,848.43 1,440,364.42

The present value of the claim payments during the 5 years term assuming the claims are payable at the end of the year will earn interest@6% p.a. is Rs. 1,440,364.42/The sum arrived at should be equal to the P.V. of the premium payable every year at the same rate of interest. This can help to find out the premium required to be paid by each policy holder using the following table. Table showing the present value of Unit Premium receivable from surviving persons and the calculation of level premium. Year 1 2 3 4 5 No. of Persons 10,000 9,972 9,941 9,907 9,869 P.V. Factor @ 6% 1.000000 0.943396 0.889996 0.839619 0.792094 Total P.V. of premium of Re. 1/= from each 10000.00 9407.55 8847.45 8318.11 7817.17 44390.28

Level premium Required 1440364.42 :- 44390.28=32.45 Thus, we see that the level premium required comes down from 34.82 to Rs. 32.45 when interest is takers into account We can easily notice that the level premium collected during the first two years of the contract is more than the actual premium required to meet the claims as calculated under stepped method and it is less than this in the subsequent year. The excess premium collected in the initial period shall be sufficient to meet the shortfall in the later year with the additions of interest earned. It constitute a reserve and is used to meet the deficit in the later years. it can be illustrated as shown below graphically :-

Comparison of Level and Stepped Premiums.

Premium

50 40 30 20 10 0 Year 1 2 3 4 5

- - - - - - Stepped up Premium Level Premium

Office Premium :For manufacturing of any product, we need proper establishment and the expenses that are required to run the establishment. All these expenses are taken into consideration while fixing a price of such products. In life Insurance products also lot of expenses are incurred in product development; its marketing in the shape of commission etc and day to day establishment expenses required for running an organization. There for, the premium received from the policy holders should include a loading of these expenses and also for the so arrived at after loading for expenses and other benefits like participation in the Profits of the insurer etc. is called the office premium. The insurer will also like to keep some margins for adverse fluctuations in the experience of all the three components viz, mortality, interest and expenses and also for his profits. Selection and Classification of Risks The process of selection and classification of risks is very important aspect of Insurance underwriting. Before accepting a risk on any particular life, the underwriter has to make a classification of risk whether it is standard sub. Standard or if such a nature that may not be accepted depending upon the Mortality rating of that class of life. The objective of selection is that the insurer should be in a position to ascertain the correct mortality of a person who is applying for insurance. This process consists of the following steps :1. Selecting a Life :- On the basis of proposal form, personal statement, medical report, agents report etc. 2. Classifying the Life according to the risk This is also done on the basis of the information gathered through the various forms completed by the life to be assured.

3. Measuring the risk By this we mean measuring the impact of various favorable and unfavorable factors that would affect the mortality of the person to be insured. 4. Changing appropriate premium It will depend on the type of risk that one carrier on his life the premium may be not that same or some extra premium or terms or plan may be modify so as to make the life conform to the relevant mortality table. 5. Factors affecting mortality The rate of Mortality is the rate of lying with in a year. The proportion of people in a certain group dying with in a particular year is the rate of Mortality of group for that particular year. Any factor which would influence the rate of Mortality is a hazard? These Hazards are of three types : Hazards peculiar to the person himself, these are called Physical Hazard. Hazards peculiar to the occupation of the person to be insured these are called Occupational Hazards. Hazards which arises because of habit, mode of living, his financial standing etc are attributed to Moral Hazards.

Physical Hazards :- These pertain to the physic of a person taking the insurance. The probability of death or expectation of life are largely dependent on there physical factors. The following are the factors that influence the physical Hazards. Age :- Mortality increase with are. The probability of death increases as the age advances. This can happen because of so many reasons. In normal course higher age brings in its wake many ailments, diseases or disability certain diseases are peculiar to old age i.e. high B.P. Diabetes, Kidney disease etc. The natural faculties like seeing, hearing, walking are affected to a varied extent during old age. Sex :- The male and female distinction is material from the view point of selection and classification of risk. Occupational and Hazard : It depends on the type of profession being personal by the individual life. Present State of Health Includes 1. Build It is related to height, Weight and the chest and abdomen measurements, to find out whether the life is normal weight, Under weight or overweight which can affect mortality.

2. Physical Condition :- The expected mortality of a person will be influenced by the present condition of various systems of the body viz, nervous, digestive, Cordova cube, respiratory etc. There may need further examination. 3. Personal History :- This provides information about proposers health, habits and previous insurance history past illness or operation can leave a permanence mask on the health or some illness may resurfaced in such cases it is usual to obtain medical repast of the past illness suffered by him. 4. Family History :- The family history helps to ascertain the longevity in the family or there is any here dietary ailments in the family like debited heart disease etc which are inherited in nature. 5. Habits :- A person who is addicted to smoking, drink, narcotics, Opicim ganja etc is a bad risk for underwriting. 6. Hobbies and Auction :- Some of the hobbies and avocation are more risky in risk perception such as mountaineering, traking, racing of any king sky diving since the risk of accident is very high, double accident benefit is not available if death occurs due to these reasons. Occupational Hazard The occupation of the proposes may affect the risk attached to the proposal. The risk can arise from variety of causes. Firstly the incidence of accident is very high in certain occupations. The probability of death due to accident is very high in comparison to other occupations. These are known as hazardous occupations Take for instance a Truck driver or an Air Force Pilot. The military (Army, Navy, Air force) employment raises different set of obligation on the person concerned. Probability of death is quite high in such occupation. It is, there fore, customary to charge extra premium or impose restrictive clauses, reducing death benefit due to the occupation Hazards. All such hazards on the lives of Military Personnel, (Army/Navy), Aviation Hazards such as Para trooping or gliding, liable to do any work in a submarine, mine sweeping or mine laying, the acceptance of risk will be decided after getting special questionnaire completed by the people engaged in such occupations. Other Occupations Trusting occupations have under gone a sort of revolution in their operations. Manual jobs have been replaced by mechanical operations this has reduced the incidence of accidental deaths. Certain occupations are so hazardous that these are not consider fit for acceptance under any of the life insurance plans. For example Jockeys, Riding Boys in Horse races, Explorers. The extra Hazard of occupation may be one or both of the following types. Hazard of accident As applicable to pilot circus employees etc.

Hazard of disease As applicable to textile workers who in hales minute year particles while on work, Quarry Workers in hale stone alms. This gives rise to various kinds of chest and long diseases. Hazards of accident & disease (both) Mines workers are exposed to accidents as well as diseases due to into line of poisonous gases etc.

Morale Hazards Moral Hazard is difficult to define. A person who proposes for insurance has to give pat of information in the proposal form and personal statement. He is expected to give a truth for account of the material facts affecting the risk. If any concealment is done on this score, the insure will grant him the insurance cover on the basis of such incorrect statement, a risk which they may not accept other wise or might have accepted with some modified terms. The assessment of risk thus wholly depends on the information furnish by the proposes for life assurance. The likely hood of hiding or distorting some information affection risk appraisal is called Moral Hazard. Generally while accepting any proposal for life assurance such risks are avoided by the insurer where moral hazard is involved. This may help in many ways : If the death of the life assured in imminent, this there would be temptation to insure his life by concealing material facts to influence the assessment risk. He may fear that if correct facts are disclosed be may not get insurance. In order to avoid payment of extra premium in certain ailments, he may conceal material facts. Some times to avoid submission of special reports be X-ray, ECG etc; The proposer is templed to conceal to. Some times proposer is unwilling to disclose purel family secrets concerning health & habits of family. Some time proposer thinks that previous treat must a special reports are not that impotent. The difficulty in respect of moral hazard is this it is difficult to locate and equally difficult to assess its impact on mortality experience.

If the presence of moral hazard is doubtful blot of is not completely ruled out, the practice is to limit by limiting the sum assured that can be granted in such cases.

We have to find out, how we should locate the presence of Moral Hazard. There are certain situation which, if present, would give us an indication that moral hazard may be present in the particular case. There are some such situations which can give some indication about the presence of Moral Hazard. There are as follows :1. Outstation Parity :- The place of medical examination or the place of completion of proposal form may be other then the usual place of residence. 2. Norminer not the nearest dependent :- If the nominee is not the parent, wife any of the child or near relative, if he is stranger, he will not have an insurable interest in the life of the propser. 3. Address c/o the Agent :- This is serious situation. We have to find out what the motives behind it are should be enquired thoroughly. 4. Over Insurance :- If the total insurance goes out of proportion to persons having capacity and if it is beyond his total need for insurance, it is necessary probe further in the matter. 5. If there is a proposal for insurance at a frequency inter vats :- It may suggest some adverse factors this is inspected when insurance is asked for at a advance age. So, it is very important to assess the risk from the paint of view of all the above factors, which may help the insurer in accepting such risks out the Reserves and surplus of an insurer company. The Actuarial principles are applied for arriving at the rate of bonus of with profit polices. It helps the insurers to formulate a strong investment policy. It paid down rules for underwriting of risks for identification and classification of risks. It provides guidelines for the Reinsurance of big risks etc. It provides through investigation and Research studies about the causes of early death claims etc.