Life Insurance Coverage

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How Coverage is Priced

To understand how insurers set their prices, imagine a hypothetical life insurance company starting from scratch. When customers buy insurance from the company; it isn't betting on a client living a long time or dying tomorrow: Its management knows that out of 1,000 34-year-old males, only two will die this year.

If 1,000 34-year-old males want to buy a $1,000 policy each the company knows it will pay $2,000 in death benefit claims during the next twelve months. Therefore, the company would have to charge $2.00 per $1,000 of insurance to cover mortality costs. This is a key part of the premium. Next year, out of one thousand 35-year-old males, 2.11 are expected to die, so the premium will go up a little bit. By the time the men are 75, 64-; out of the 1,000 will die-so the mortality charge is much higher.

It would be risky if the company didn't keep a reserve fund in case of unexpected changes in mortality or income. If an earthquake or some other catastrophe struck and the company didn't have enough to pay all the resulting claims, it the insurance company also has copay rent, salaries,overhead, etc. These operating arid administrative expenses are added into the premiums would go bankrupt. So, the company adds an additional amount to the premiums it charges to guarantee its reserve.

The company needs to sell its products-so it has sales expenses: commissions, advertising, promotion, etc. It adds these expenses to the premium. The company has to charge premiums for your insurance that will cover all of these costs.

The Underwriting Process

Underwriting is the process of selection, classification and rating of insurance risks. Simply put, underwriting is a risk selection process.

The selection element of the process consists of gathering and evaluating information and resources to determine how an individual will be classified-standard or substandard. Once this part of the underwriting procedure is complete, the policy will be rated in terms of the premium which the policy owner will pay. The policy will then be issued.

The underwriter must exercise judgment based on his or her years of experience to read beyond the facts and get a true picture of your lifestyle. Are there any factors (occupation, hobbies, lifestyle) which make this individual likely to die before his or her natural life expectancy?

An underwriter cannot, and is not, expected to foresee all circumstances. However, the underwriter's purpose is to protect the insurance company insofar as he or she can against adverse selection-very poor risks, and those parties with fraudulent intent.

An underwriter's job is to use all the information gathered from many sources to determine whether or not to accept a particular applicant.

Sources of Underwriting Information

The underwriter has various sources of information to provide the necessary information for the risk selection process. These sources include:

• the application
• medical exams and history
• inspection reports
• the Medical Information Bureau (MIB)
• the agent or salesperson

The form of the application may differ from one company to another. However, most applications provide the same basic information.

Part 1 of the application asks for general or personal data regarding the insured. This would include such information as: name and address, date of birth, business address and occupation, Social Security number, marital status, and other insurance owned. In addition, if the applicant and the insured are not the same person, then your name and address would be included here.

Part 2 of the application is generally designed to provide information regarding the insured's past medical history, current physical condition and .eersonal morals.

Part 2, also requires information regarding the current health of the'lnsured by asking for current medical treatment for any sickness or condition and types of medication taken. The name and address of the insured's physician is also required.

Usually Part 2 will also include questions regarding alcohol and any drug use by the insured. Avocations and high risk hobbies are also usually reported here.

If the amount of insurance applied for is relatively high, the proposed insured may be required to take a medical examination-and Part 2 is completed as part of the physical exam.

Increasingty, underwriters are re!ying on paramedical exams and blood tests for information in order to accurately evaluate a health risk. Blood testing is almost universally used to determine cholesterol levels, elevated liver enzymes, and the presence of AIDS or infection.

Another source of medical information available to the underwriter is an Attending Physician's Statement (APS). After a review of the medical information contained on the application or the medical exam, the underwriter may request an APS from the proposed insured's doctor. Usually, the APS is designed to obtain more specific information about a particular or potential medical problem.

The application will also record information regarding the policy owner's choices with regard to the mode of premium (monthly, annually, etc.), the use of dividends and the designation of a beneficiary.

Finally, the signatures of the insured (and the policy owner if different from the insured) are required in the appropriate places on the application.

Some simplified forms of life insurance require no medical exam and only ask very basic health related questions on the application. Usually this type of insurance is only available'in low face amounts, to minimize the impact'of adverse selection.

To supplement the information on the application, the underwriter may order an inspection report on the applicant from an independent investigating firm or credit agency, which covers financial and moral information. This information is used to determine the insurability of the applicant. If the amount of insurance applied for is average, the inspector will write a general report in regard to your finances, health, character, work, hobbies, and other habits. The inspector will make a more detailed report when larger amounts of insurance are requested.

Another source of information which may aid the underwriter in determining whether or not to underwrite a risk is the Medical Information Bureau (MIB), based in Westwood, Massachusetts. This is a nonprofit trade association which maintains medical information on applicants for life and health insurance. The MIB has 650 member companies that write 80 percent of the health insurance and 99 percent of the life insurance policies in the US.

MIB information is reported in code form to member companies in order to preserve the confidentiality of the contents. The report does not indicate any action taken by other insurers, nor the amount of life insurance requested. .

An insurance "company may refuse to accept a risk based solely upon the information contained,in an MIB report; There must be over substantiating factors Which leads an insurer to decide to deny coverage.

Beginning in 1995, the MIB must provide explanations to applicants who are denied coverage, allowing consumers to challenge possibly inaccurate information about their medical history.

Adverse Underwriting Decisions

A risk will be rejected when the insurance company believes the applicant cannot be profitable at a reasonable premium or with reasonable coverage modifications.

As a response to gender discrimination, the Norris Act was passed into law in the late 1970s, prohibiting the use of gender as a rating factor. In the past, using sex as'a factor in determining rates generally resulted in women paying lower life insurance premiums than men.

Acquired Immune Deficiency Syndrome (AIDS) is beginning to have a large impact on the insurance industry. The costs associated with AIDS are those of premature death and medical costs including long hospital stays and very expensive drug treatments. These costs affect medical, disability, and life insurance coverages.

In recent years, there have been various state and federal court decisions holding that sex cannot be used as a factor to determine a life insurance or annuity policy premium.

AIDS testing prior to policy issuance has become a common underwriting requirement. Typically, this takes the form of a blood test which is consented to and acknowledged by the proposed insured.

The requirement for AIDS testing will especially hold true for those situations where a large amount of insurance is desired. All companies will set the ages and amounts of insurance as underwriting requirements for physical exams and also blood tests for the AIDS virus.

Inillatly jurisdicti0ns,HIV testing requires informed consent of the applicant, confidentiality of results, and proper n0tification procedures.

Loss Ratios and Related Concepts

Loss and expense ratios are basic guidelines as to the quality of company underwriting. A loss ratio is determined by dividing losses by t0tal premiums received. Loss ratios are often calculated by account, by line of insurance, by book of business (all accounts placed by each agent or agency) and for all business written by an insurer. Loss ratio information may be used to make decisions about whether to renew accounts, whether to continue agency mntracts, and whether to tighten underwriting standards 0n a given line of insurance.

An expense ratio is determined by dividing an insurer's operating expenses (including commissions paid) by total premiums. When the combined loss and expense ratio is 100 percent, the insurer breaks even. If the combined ratio exceeds 100 percent, an underwriting loss has occurred. If the combined ratio is less than 100 percent, an underwriting profit, or gain, has been realized.

Example: The ABC Insurance Company realizes $3 million in underwriting losses for all term insurance policies. This same block of business also generates $10 million in premium. The loss ratio would be calculated as follows: Loss Ratio = Losses/Premiums Loss Ratio'= $3 million/$lO million = 30 percent Further, assume that the ABC Insurance Company has operating expenses totaling $2 million for this same block of term insurance. The expense ratio would be: Expense Ratio = Operating Expenses/Premiums Expense Ratio = $2 million/$lO million = 20 percent

The combined loss and expense ratio equals 50 percent Thus, the ABC Insurance Company has an underwriting gain or profit on this block of tenn insurance. Adverse selection exists when the group of risks insured is more likely than the average group to experience loss.

Example: In a randomly-selected group of 1,000 25-yearold individuals, only two might be expected to die in a given year. However, human nature is such that many healthy 25year-olds do not see the need to buy life insurance and prefer to spend their money elsewhere. It is only those 25-year-olds who are ill or perhaps employed in dangerous occupations who are likely to buy insurance. An underwriter must take care not to accept too many of these poorer-than-average risks or the insurance company will lose money.

A moral hazard is the likelihood of an applicant to misrepresent himself or herself to the insurance company with reference to health status, occupation or other pertinent information. In other words, a moral hazard deals with an individual's tendency to lie or be dishonest. A morale hazard is a person's indifferent attitude toward risk.

Example: An insurance applicant with a history of speeding tickets and drunk driving would display an indifferent or apathetic attitude toward his or her own health and well-being and thus present a morale hazard to the underwriter.

Classification of Risks

Besides the problem of adverse selection, the underwriter must guard against moral hazards and morale hazards.

Risk classification refers to the determination of whether a risk is standard or substandard based on the underwriting or risk evaluation process. Standard risks are those who bear the same health, habit, and occupational characteristics as the persons on whose lives the mortality table used was compiled. Basically, a standard risk is simply an average risk.

A percent of individualss covered are standard risks. Less than 22percent of individuals applying are turned down for coverage completely. That leaves about 8 percent that fall somewhere inbetween.

Most insurers offer special but higher rates to persons who are not acceptable at standard rates because of health, habits or occupation. This is sometimes called substandard or extra risk insurance.

More and more high risk cases are becoming acceptable (and, also, many conditions once considered high risk are now; on the basis of more experience, being accepted as standard). Today it is a rare case when coverage cannot be found anywhere for almost any risk.

Some companies have coined euphemistic names for it in order to avoid the rather inswting implication that persons offered this type of coverage are substandard.

There are several methods of determining the extra rate for the substandard class of risk:

• Rated-Up Age. This assumes that the insured is older than his or her actual age, which is a way of saying that he or she will not live as long as a standard risk. Thus, an impaired risk of age 35 may be issued a policy as applied for but with the rate of age 40. While having the merit of simplicity of handling, this method is no longer widely used.
• Flat Additional Premium. A constant (that is, not varying with age) additional premium is added to the standard rate.
• Tabular Rating. Applicants are classified on the basis of the extent to which mortality of risks with their impairment or degree of impairment exceeds that of the standard risk. Percentage tables are developed and used to calculate the amount of extra premium to be charged for any class of impaired risks.

Extra percentage tables are usually designated as Table A, Table B, etc. Each usually reflects about a 25 percent increase above 100 percent-or standard. Insurers vary in the number of tables on which they will accept risks. One may not accept anything lower (or higher, depending on your perspective) than, say, Table C (175 percent). Another may write through Table F (250 percent). Companies can be found that will write up to 1,000 percent-and even higher.

• Graded Death Benefits. The policy owner pays the standard premium for, say, $20,000 of insurance but receives a policy with a face amount of perhaps $15,000. Mter some time has elapsed the company may increase the amount of insurance periodically and, when the company considers the substandard condition to no longer exist, the full $20,000 of coverage would be granted.

If a substandard risk presents an above average risk of loss, a preferred ..risk presents a belowaver,:ge risk of loss. In an effort to encourage the public to practice better health, the insurance industry has developed preferred risk policies with lower (or preferred) premium rates.

Those applicants who may be eligible for preferred risk classification are those who:

• work in low risk occupations and do not participate in high risk hobbies (scuba diving, sky diving, etc.)
• have a very favorable medical history
• presently are in good physical condition without any serious medical problems
• do not smoke
• meet certain weight limitations

Determining Premiums

The final step in the underwriting process is the rating of . the risk or the determination of the premium. There are three factors used in determining life insurance rates:

• mortality
• interest
• expenses If an underwriter could predict exactly how long each insured person would live, he or she could charge a premium for each risk that was precisely correct for covering the policy face amount and expenses, while taking into account the interest to be earned on the premium paid.

Of course, an underwriter cannot do this on an individual policy, but he or she can predict the probability of numbers of deaths for a large group of people by using a standard mortality table, such as the 1980 Commissioners' Standard Ordinary Mortality Thble. The table is based on statistics kept by insurance companies over the years on mortality by age, sex and other characteristics.

The deaths per 1,000 (or mortality) rate is taken from the mortality table and converted into a dollar and cents rate. For instance, if the mortality rate for a particular age group is 3.00, it means, on the. average, three out of every 1,000 can be expected to die at that age in the next year.

The basic cost of life insurance is the cost of mortality. However, inconsttucting a rate, interest enters the equation. It is assumed that all premiums are paid at the beginning of the year and all claims paid at the end: Therefore, it becomes necessary to determine how much should be charged at the beginning of the year, assuming a given rate of interest, to assure enough money at the end of the year to pay all claims.

Using the cost of mortality and discounting for interest, there is enough money to pay claims, but there's no money to pay operation expenses. The premium without expense loading is a net premium. (Do not confuse net as it is used here with the same term sometimes used to indicate a participating premium minus dividends paid.)

Expense Loading

An expense loading is added to the net premium in order to:

• cover all expenses and contingencies . have funds for expenses when needed
• spread cost equitably among insureds

Loading consists of four main items:

• Acquisition Costs. All costs in connection with puttfug the policy on the books are charged as incurred in the insurance accounting. In most cases, these costs will be so proportionately high in comparison to ensuing years that they must be amortized over a period of years. One of the highest acquisition costs is the agent's first year commission.

A policy that lapses in the first two or three years creates a loss for the insurer. It has not yet recovered acquisition costs.

• General Overhead Loading
• Clerical salaries, furniture, fixtures, rent, management salaries, etc.,
• must be considered when determining expenses

The allocation of these costs is unaffected by the size of the premium, probably little affected by the face amount, but is most likely affected by the number of policies.

Loading for Contingency Funds. Once a level premium policy has been issued, the premium can never be increased. However, unforeseen contingencies could make the rate inadequate.

Assessment companies reserve the right to charge additional premiums in such a case. Legal reserve companies establish contingency reserves to draw on in such cases.

Immediate Payment of Death Claims. In ratemaking, it is assumed that all claims are paid at the end of the year. This is not literally true, of course. Relying on the law of large numbers, it is safe to assume that death claims will be spread throughout the year. Therefore, theoretically, all claims will be paid six months before the end of the year. Allowance must be made for this loss in the expense loading.

The Gross Annual Premium The gross annual premium, the amount the policy owner actually pays for the policy, equals the mortality risk discounted for interest, plus expenses.

By formula: Gross Premium = Mortality - Interest + Expenses Net Premium = Mortality - Interest

The mortality risk factor increases with age. This is the reason that some life insurance policy premiums increase periodically.

The level premium concept was devised to solve this problem of increasing premiums. Mathematically, the level premiums paid by the policy owner are equal to the increasing sum of the premiums caused by the increased risk of mortality.

Reserves

Reserves are accounting measurements of an insurance company's liabilities to its policyholders. Theoretically, the reserve is the amount together with interest to be earned and premiums to be paid that will exactly equal all of the company's contractual obligations.

A life insurance reserve is a fixed liability of the insurer. This liability represents the insurer's promise to pay the face amount of the policy at some future time. By law; a portion of every premium must be set aside as a reserve against the future claim from the policy as well as other contractual obligations such as cash surrender and nonforfeiture values.

Insurance companies demonstrate their solvency to state insurance regulators by showing their assets as well as adequate funds to cover their reserve obligations. In addition to its assets, the insurer must show that it will continue to receive future premiums plus interest in order to cover its reserve obligation.

Commissions Differ Another important point in how companies set their prices is how they pay their salespeople. As a general rule, mutual life insurance companies pay 6 percent of revenues in commission while stock companies pay between 10 and 17 percent.

If you are being presented with stock company products, the agent may receive up to 50 percent more commission than a similar mutual company's product. Lower commission means lower company expenses.

No-load insurance products typically pay the same sales expenses as the stock companies, but they don't call the expense commission. So, the term no-load is mostly a sales gimmick borrowed from the mutual fund industry company financials reveal similar or higher marketing costs in most cases.

Whether an insurance company calls an expense a commission or advertising should make no difference to you, as a consumer.

Company operating expenses differ significantly. Whether the company is an auto manufacturer or a law firm, overhead and salaries companies are simply more differ in all companies. Some efficient than others.

Insurance companies are required to publish their operating expenses. When you compare companies, aSK to see the operating expenses for each.

Conclusion

All insurance companies price their policies to cover mortality and operating costs. What happens after that makes each company unique. Some will keep prices low in order to sell a high volume of policies-others will build in more cost drivers to weed out certain kinds of risks or bolster profits. Some pay higher sales commissions, some lower.

As a smart consumer, your job is to ask the right questions which will help you identify the, Strategies a company is using to price the life insurance it sells. This can help you choose between similar policies. It can also suggest what a specific company expects from its products and the marketplace. This can give you some idea of what to expect from the company over the course of several years.