Life insurance: a perfect info guide
BASIC PRINCIPLES OF LIFE INSURANCE
Insurance Defined
Insurance can be defined in many different ways, from many different points of view. For example, from an economic viewpoint, insurance is a system for reducing financial risk by transferring it from a policy owner to an insurer.
The social aspect of insurance involves the collective bearing of losses through contributions by all members of a group to pay for losses suffered by some group members. From a business viewpoint, insurance achieves the sharing of risk by transferring risks from individuals and businesses to financial institutions specializing in risk. The insurer is not, in fact, paying for the loss. The insurer writes the claim check but is actually transferring funds from individuals.
who as part of a pool, paid premiums that created the fund from which the claims are paid. Lastly, from a legal standpoint, an insurance contract (policy) transfers a risk, for a premium (consideration), from one party (the policy owner) to another party (the insurer).
It is a contractual arrangement in which the insurer agrees to pay a predetermined sum to a beneficiary in the event of the insured’s death. By virtue of a legally binding contract, the possibility of an unknown large financial loss is exchanged for a comparatively small certain payment. This contract is not a guarantee against a loss occurring, but a method of ensuring that payment is made for a loss that does occur.
Risk Management: in life insurance
Life entails risk, which is the possibility of loss. People generally seek security and avoid uncertainty. The risk of death is unavoidable, and is especially an economic threat if premature, when an individual may be exposed to heavy financial responsibilities, yet has not had the time to accumulate wealth to offset the financial needs of survivors. Life insurance provides a tool for risk management, a process for dealing with the risk of loss of life.
Insurance substitutes certainty for uncertainty, through the pooling of groups of people who share the risks to which they are exposed. Uncertain risks of individuals are combined, making the possible loss more certain, and providing a financial solution to the problems created by the loss. Small, certain periodic contributions (premiums) by the individuals in the group provide a fund from which those who suffer a loss are compensated.
The certainty of losing the premium replaces the uncertainty of a larger loss. Life insurance thus manages the uncertainty of one party through the transfer of a particular risk (death) to another party (the insurer) who offers a restoration, at least in part, of relatively large economic losses suffered by the insured individual.
The essence of insurance is the principle of indemnity, that the person who suffers a financial loss is placed in the same financial position after the loss as before the loss occurred. He neither profits nor is disadvantaged by the loss. In practice, this is much more difficult to achieve in life insurance than in property insurance.
No life insurance company would provide insurance in an amount clearly exceeding the estimated economic value of the covered life. Limiting the amount of life insurance sold to reflect economic value gives recognition to the rule of indemnity. Additionally, only persons exposed to the potential loss may legitimately own the insurance covering the insured’s life.
Risk Pooling: in life insurance
Life insurance is based on a mechanism called risk pooling, or a group sharing of losses. People exposed to a risk agree to share losses on an equitable basis. They transfer the economic risk of loss to an insurance company.
Insurance collects and pools the premiums of thousands of people, spreading the risk of losses across the entire pool. By carefully calculating the probability of losses that will be sustained by the members of the pool, insurance companies can equitably (fairly) spread the cost of the losses to all the members.
The risk of loss is transferred from one to many and shared by all insureds in the pool. Each person pays a premium that is measured to be fair to them and to all based on the risk they impose on the company and the pool (each class of policies should pay its own costs). If all insureds contribute a fair amount to the mortality fund held by the insurance company, there will be sufficient dollars in the fund to pay the death benefits of those insureds that die in the coming year.
Individually, we do not know when we will die, but statistically, the insurer can predict with great accuracy the number of individuals that will die in a large group of individuals. The insurance company has taken uncertainty on any individual’s part and turned it into certainty on their part.
Illustration of the Risk-Pooling Concept
The simplest illustration of risk pooling involves providing life insurance for one year, with all members of the group the same age and possessing similar prospects for longevity. The members of this group agree that a specified sum, such as $100,000, will be paid to the beneficiaries of those members who die during the year, the cost of the payments being shared equally by the members of the group. In its simplest form, this arrangement might involve an assessment upon each member in the appropriate amount as each death occurs.
In a group of 1,000 persons, each death would produce an assessment of $100 per member. Among a group of 10,000 males aged 35, 21 of them could be expected to die within a year, according to the 1980 Commissioners Standard Ordinary Mortality Table (more on this later).
If expenses of operation are ignored, cumulative assessments of $210 per person would provide the funds for payment of $100,000 to the beneficiary of each of the 21 deceased persons. Larger death payments would produce proportionately larger assessments based on the rate of $2.10 per $1,000 of benefit.
The 3 main Building Blocks of Life Insurance—
- Mortality,
- Interest,
- and Expense
All life insurance products are actuarially created by calculating the relationships of mortality, interest, and expense, and the financial values resulting from each based on time.
The assumptions made concerning these three factors will determine the premium at which a policy is sold, the structure of the policy, and over time the performance of the policy and the profitability and solvency of the life insurance company. All life insurance policies, regardless of type, are based on these same elements.
Mortality rates project the cost of covering death claims as they occur. Interest earnings reflect the income the company expects from the investment of premiums over time that will be added to the reserves, held aside to pay future claims. Expenses include the cost of creating, offering, and maintaining the product to pay all promised benefits. These factors must also provide profit to the insurer.
Different products handle these factors differently. Term insurance has a pay-as-you-go structure. Premiums increase as mortality increases and the policy does not build cash value. Interest earnings have a smaller impact on the premium than in permanent policies and expenses are largely covered by the policy fee.
In permanent whole life insurance (WL), the policy owner pays premiums in advance, paying a higher, or excess, premium that can be “reserved,” so that increases in premium are not required. This higher premium level builds cash value the policy owner can access through loans or cash surrender of the policy. In WL, these factors are “bundled,” meaning they are not itemized or disclosed separately.
In universal life (UL), the costs are unbundled, meaning the components of mortality, interest, and expense in the policy are identified and the values and charges for each are itemized in regular reports to policy owners. Mortality charges are identified as the cost of insurance (COI), which are monthly charges based on the insured’s issue age, attained age, the net amount at risk, gender, and underwriting class. Interest is paid each month on the cash value at the current crediting rate. Administrative expenses are charged monthly.
All of these elements have a current rate and are subject to maximum and minimum guaranteed charges or interest crediting as stated in the policy. Because of the unbundled nature of policy costs, UL looks like an investment account with term coverage.
The mortality charges are similar to those of term, and the interest rates reflect the current market and adjust to changing market conditions. The policy owner accepts more of the investment and mortality risk, with a minimum guaranteed interest crediting rate, and maximum mortality and expense charge guarantees.
Variable universal life (VUL) contains death benefits and cash values that vary with the performance of the subaccounts selected. The death benefit and cash value are not guaranteed and can fluctuate according to market performance. The life insurance aspect of VUL is essentially the same product as UL with the same features and specifications for the most part. The main difference between UL and VUL is the variable investment aspects of the VUL product.
Mortality introduction.
To price insurance products, and ensure the adequacy of reserves to pay claims, actuaries use mortality tables to project the number and timing of future insured deaths. They study the incidence of deaths in the recent past and develop expectations about how these events will change over time and develop an expectation for what the timing and amount of such events will be into the future. A safety margin is built in that increases the mortality rates above what is expected.
In participating policies, savings created by these conservative assumptions can be returned as dividends. In nonparticipating policies, the safety margins must be smaller in order for the premium rates to be competitive. A mortality table shows mortality experience used to estimate longevity and the probability of living or dying at each age and is used to determine the premium rate.
Mortality tables may include the probability of surviving any particular year of age, remaining life expectancy for people at different ages, the proportion of the original birth cohort still alive, and estimates of a group’s longevity characteristics. Life mortality tables today are constructed separately for men and women and are created to distinguish individual characteristics such as smoking status, occupation, health histories, and others.
The data used for the CSO tables is taken from data developed by the American Academy of Actuaries and adopted by the National Association of Insurance Commissioners (NAIC). The CSO mortality tables are used to calculate reserves and minimum cash values for state regulatory purposes, as well as life insurance premiums.
The recent changes will lower the statutory reserves required by state insurance departments on all life products. Larger insurance companies use their own morality statistics to calculate their pricing of products, based on their own selection and underwriting practices. Since 1980 CSO mortality represents the vast majority of in-force policies, it is and will be, relevant for years to come, even though newly issued policies will increasingly be using 2001 CSO rates.
The 2001 CSO Mortality Table is currently being introduced and approved for use in the various states. Companies can base product designs on either the 1980 or the 2001 CSO mortality tables. As of January 2009, all new products must use the 2001 CSO table. For term products, this means mortality costs, and consequently, premiums, are going down. For cash value products, the 2001 table lowers the amount of premium that can be put into accumulation products and still be considered life insurance, based on IRS rules for defining life insurance.
These rules, covered in Chapter 5, will allow individuals to pay less premium for the same amount of life insurance. Since the life insurance will be less costly, the allowable cash value must also fall, due to the maximum ratio of cash value to the death benefit.
Interest introduction
Insurers invest the premiums they receive and accumulate them for future claims and other obligations, such as policy loans and surrenders. Life insurance company portfolios are traditionally long-term and emphasize the safety of principal and predictable rates of return, to accommodate their long-term obligations. Typically, two-thirds or more of this capital is invested in bonds and mortgages, which meet the above criteria.
A smaller percentage is invested in common stocks, due to their volatility, and these represent less than 10 per cent of an insurer’s general portfolio. Since recently issued policies have low claims experience as a whole until years later, there is an adjustment in the calculation of the premium for the time value of money (compound interest). If the investment results exceed the guaranteed minimum, policy owners benefit from either participating dividends or excess interest crediting to the policy’s cash value.
Expense introduction
Life insurance companies incur acquisition and administrative expenses in the course of doing business. Acquisition expenses include the costs
incurred in obtaining business and placing it in force, such as advertising and promotion fees; commissions; underwriting expenses; costs associated with medical exams and attending physicians’ statements, inspection report and credit history fees; home office processing costs; and an addition to the insurer’s reserve, surplus, and profits.
Administrative expenses include the costs associated with collecting premiums and distributing dividends, continuing producer compensation, investment expenses, and home office overhead. Any costs the insurer incurs must be recovered through mortality savings, expense charges, or reduced interest crediting.
LIFE INSURANCE IN INDIA
In India, insurance started with life insurance. It was in the early 19th century when the Britishers on their postings in India felt the need of life insurance cover. It started with English Companies like. ‘The European and the Albert’. The first Indian insurance company was the Bombay Mutual Insurance Society Ltd., formed in 1870.
In the wake of the Swadeshi Movement in India in the early 1900s; quite a good number of Indian companies were formed in various parts of the country to transact insurance business. To name a few: ‘Hindustan Co-operative’ and ‘National Insurance’ in Kolkata; ‘United India’ in Chennai; ‘Bombay Life’, ‘New India’ and ‘Jupiter’ in Mumbai and ‘Lakshmi Insurance’ in New Delhi.
WHY LIFE INSURANCE?
The risk of death is covered under insurance scheme but not under ordinary savings plans. In case of death, insurance pays the full sum assured, which would be several times larger than the total of the premiums paid. Under ordinary savings plans, only the accumulated amount is payable.
It Encourages Compulsory Saving
After taking insurance, if the premium is not paid, the policy lapses. Therefore, the insured is forced to go on paying a premium. In other words, it is compulsory. A savings deposit can be withdrawn very easily.
Easy Settlement and Protection against Creditors
Once nomination or assignment is made, a claim under life insurance can be settled in a simple way. Under M.W.P. Act, the policy money becomes a kind of trust, which cannot be taken away, even by the creditors.
It helps to Achieve the Purpose of the Life Assured
If a lump sum amount is received in the hands of anybody, it is quite likely that the amount might be spent unwisely or in a speculative way. To overcome this risk, the life assured can provide that the claim amount is given in instalments.
Peace of Mind
The knowledge that insurance exists to meet the financial consequences of certain risks provides a form of peace of mind. This is important for private individuals when they ensure their car, house, possessions and so on, but it is also vital importance in industry and commerce.
Loss Control
Insurance is primarily concerned with the financial consequences of losses, but it would be fair to say that insurers have more than a passing interest in loss control. It could be argued that insurers have no real interest in the complete control of loss because this would inevitably lead to an end to their business.
Social Benefits
The fact that the owner of a business has the funds available to the receiver from a loss provides the
stimulus to the business activity we noted earlier. It also means that jobs may not be lost and goods or services can still be sold. The social benefit of this is that people keep their jobs, their sources of income are maintained and they can continue to contribute to the national economy.
Investment of Funds
Insurance companies have at their disposal large amounts of money. This arises from the fact that there is a gap between the receipt of a premium and the payment of a claim. A premium could be paid in January and a claim may not occur until December if it occurs at all. The insurer has this money and can invest it.Invisible Earnings
We have already said that insurance allows people and organizations to spread risk among them. In the same way, we can also say that countries spread risk. A great deal of insurance is transacted in the UK in respect of property and liabilities incurred overseas. London is still very much the centre of world insurance and large volumes of premium flow into London every year; these are described as invisible earnings.Insurance Facilitates Liquidity
If a policyholder is not in a position to pay the premium, he can surrender the policy for a cash sum.Loan Facility and Tax Relief
The person can also take a loan for a temporary period to tide over the difficulty. Sometimes, a life insurance policy is acceptable as security for a commercial loan. By paying the insurance premium, the insured obtains significant reliefs in Income Tax and Wealth Tax.NATIONALIZATION OF LIFE INSURANCE IN INDIA
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| LIFE INSURANCE |
In 1956, the life insurance business was nationalized and LIC of India came into being on 01-09-1956. The government took over the business of 245 companies (including 75 provident fund societies) who were transacting life insurance business at that time.
Thereafter, LIC got the exclusive privilege to transact life insurance business in India. Relevant laws were amended in 1999 and LIC’s monopoly right to transact life insurance business in India came to an end. At the close of the financial year ending 31-03-2004, twelve new companies were registered with the Insurance Regulatory and Development Authority (IRDA) to transact life insurance business in India.
LIFE INSURANCE CORPORATION (LIC)
As the name suggests, Life Insurance is an insurance of the life of an individual. Thus, life insurance is a contract between the insured and the insurer i.e., the Life Insurance Corporation (LIC). The written record of this contract is called an Insurance policy.The person who is specified by the insured to receive the insurance policy in case premature death is called a Nominee.
1. Whole Life Policy
In some policies, the premium is to be paid throughout the lifetime of the insured. The payment of premium stops on the death of the insured and the money i.e., the amount of the policy is paid to the nominee. This type of policy is called the whole life policy.2. Endowment Policy
In some policies, the premium is paid for a fixed time period and the amount of the policy is paid to the insured after this time period. The date on which the amount of a policy becomes due is called the date of maturity and the time period for which the insurance is taken is called Endowment Term. In case, the insured dies before the date of maturity, the payment of premium is stopped immediately and the nominee gets the amount of the policy.Such a policy is called the Endowment Insurance Policy. There are many policies under both these categories. Some of the most popular ones are Jeevan Dhara, Jeevan Mitra, Jeevan Sarita, Money Back Policy, Jeevan Kishore etc.
Some of the policies are said to be ‘with profits’ and some ‘without profits’. The policy-holders (i.e. insured) who have a policy ‘with profits’ share the profits of the LIC. The LIC pays a part of its profits called bonus (as a percentage of the amount of the policy) to such policyholders.
The policyholders who have policies without profits are not paid this bonus. The premium in case of policies with profits is generally higher than the premium of policies ‘without profits’.
3. Group Savings – Linked Insurance Scheme (GIS)
This insurance scheme is offered to a group of salaried employees of State/Central Government Undertakings. The scheme is also available to reputed limited companies subject to certain conditions being satisfied. The rate of premium is much lower in group insurance as compared to LIC. The employees are grouped into categories based on their designations. Maximum risk cover available under the scheme is given in the following:
Group Size
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Category
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Maximum Cover
|
50-99
100 and above
|
A
B
C
D
A
B
C
D
|
80000
60000
40000
20000
1,20000
90000
60000
30000
|
The monthly premium paid towards GIS is Rs. 10 for an insurance cover of Rs. 10,000 wherein Rs. 10 covers insurance premium and savings both. The savings is 65% and the insurance premium is 35% of the amount paid towards the GIS i.e. out of Rs. 10, Rs. 6.50 is the savings and Rs. 3.50 is the insurance premium of the individual.
Compound interest at a fixed rate of 8% is paid on the savings in GIS. In case of death of the individual during service, the nominee gets both the full Insurance money and the savings with interest.
In this lesson, we will now learn how to calculate the premium using the Tables (See Annexure-A) in the life insurance policies. The tables give the premium for insurance of Rs. 1000 at a particular age.
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