I previously addressed the question “How Much Does Life Insurance Cost?”, but now I will address how the insurance company determines the premiums for the policies it will market. Please be aware that actuaries calculate the premiums to be charged, and that in doing so, they use sophisticated formulae that are far beyond the scope of this short essay, so think of this as the layman’s version.
The three primary components of the premium are mortality, investment experience, and expenses. The actuary will develop and use estimates of all of these components when determining the premium.
Let’s start with expenses. Insurance companies have many of the same expenses as other companies: employees, real estate, computers, supplies etc. With historical data provided by the accounting department and future estimates provided by management, expenses are the easiest of the three components to estimate.
The mortality component is a little more difficult. In addition to accurately estimating the expenses listed above, actuaries must also accurately predict the amount and timing of claims. So therefore the biggest determining factor of the premium is the likelihood of the policy maturing in a death claim. That is why term insurance is priced so much less than whole life insurance; because it is so much less likely to result in a claim. It is also why 15 year term costs more than 10 year term, and why 20 year term costs more than both.
The third component in determining the premium is the company’s investment experience, or return on investment. After paying expenses, the company will invest the balance of the premium, mostly in bonds and mortgages, to pay future claims. To the extent that it can invest the monies efficiently and profitably, it can use investment gains to help lower the premium.
So there you have it, the primary factors that go into developing the premium for a life insurance policy. First and foremost is the likelihood that the policy will mature in a death claim (term or whole life). Mortality (the older you are, the more life insurance costs), investment return (the better the return, the lower the premium), and company expenses are the other main factors.
N.B. This is an extremely simplified explanation to a complex topic. Should you want/need additional information or clarification of anything mentioned herein, please call or email and I will provide the requested information.