Rating the Risks

One of the most important steps in the insurance underwriting process is the rating of the risk; or in layman's terms, the determination of the policy premium. Basically, three factors are used in making this determination: mortality (for life insurance) or morbidity (for health insurance) rates, interest, and expenses. In this article we'll closely examine each of these variables.

Mortality and Morbidity. To begin with, if a life insurance underwriter were to be able to predict exactly how long each insured client would live, he or she could charge a premium for each person that would be the precise amount necessary to cover the policy's face amount and the company's expenses, while taking into account the interest to be earned on the premium paid. Of course, underwriters can't do this for individual policies, but they're quite capable of predicting the probability of numbers of deaths for a large group of people. The larger the group of people and deaths that have previously been recorded, the more reliable actuaries can be in predicting the number of people that will die at a specific age out of the entire population of insureds who are that age. If records are maintained for many millions of people over a long period of time, the predictability in fact becomes very accurate. This is a working example of the Law of Large Numbers.

Life insurance companies have kept such records for many years in order to produce precise predictions, and have compiled the information into mortality tables. These tables are based on statistics of mortality (or death) by age, sex, and other characteristics. The mortality rate (the number of deaths per 1,000 individuals) is taken from the mortality table and converted into a monetary rate. For example, if the mortality rate for a particular age group of people is 4.00, it would mean that – on the average – four out of every 1,000 people can be expected to die at that age. Knowing that figure, the insurance company would need to collect $4 from each of those 1,000 policy owners in order to have sufficient premiums to pay out $1,000 in benefits for those who will die in that age group.

Health insurance companies use related but considerably more complex statistical data to compile their morbidity tables. Morbidity is the rate of likelihood that a person will get sick, suffer an accident, or otherwise require medical care. For decades insurance companies have kept records that document the outcome of insuring various types of risk. For instance, they know that older people are more likely to become ill than younger people; this is the reason that health insurance premiums tend to be higher for older individuals. Similarly, insurers are aware that people who work in certain career fields are generally more likely to be injured than those employed in other occupations. These determinations are based on historical track records – both the company's and the industry's past experience.

In order to set rates for health insurance, however, insurers must not only consider how often people will become ill or injured, but also how much it will cost when they do. They must examine the frequency with which claims occur among a particular population (known as the claim frequency rate) as well as the average dollar amount per claim. These two figures are used to determine the aggregate claim amount, which is a primary element in calculating health insurance rates.

Interest. Because premiums are generally paid well in advance of claims, insurance companies have money to invest that will earn interest. This interest helps to lower the customers' premium rates. As previously stated, the basic cost component of life or health insurance is the cost of mortality or morbidity; however, in arriving at an actual rate, interest must be calculated in. It's assumed that all premiums are paid at the beginning of the year and all claims are paid out at year's end. The company, therefore, must determine how much should be charged at the beginning of the year (assuming a given rate of interest) in order to have enough money at the end of the year to pay all claims that will arise.

Expenses. By using the cost of mortality/morbidity and discounting for interest earned, the insurance company has enough money to pay its insureds' claims, but none left over to pay their operating expenses (this is known as a "net" premium). An expense "loading" is therefore added to the net premium in order to cover all company expenses and contingencies, to have funds for additional expenses when needed, and to spread cost equitably among the insureds.

Four main items are added as loads:

• Acquisition costs – These are all costs associated with putting the policy on the company's books.
• General overhead - Clerical salaries, furniture, fixtures, rent, management salaries, etc., are all included in this category.
• Loading for contingency funds - Once a level premium policy has been issued, the premium can never be increased. However, unforeseen events could cause the rate to become inadequate.
• Immediate payment of claims – Although when setting rates it's assumed that all claims are paid at the end of the year, this, of course, is not literally true. It's certainly safe to assume that claims will be spread throughout the year.

So again, the net premium is the mortality risk discounted for interest, without any expense loading. The gross annual premium, which is the amount that the customer actually pays for the policy, is equal to the mortality risk minus interest, plus expenses.

Because the risk factor increases – and thereby the policy premium as well – with age, the level premium concept was devised. Simply put, in the early years of the policy, the level premiums paid are actually more than the amount necessary to cover the cost of the risk. Conversely, in the policy's later years, the premiums paid are less that the amount necessary to cover the increased cost of mortality. However, this shortage in the latter years has already been accounted for by the overcharges (plus interest earned) during the early policy years.

Finally, once the full premium amount has been determined, the insurance company will divide this amount into smaller payment portions (annual, semi-annual, quarterly, or monthly payments) that are more convenient for the customer to pay. This frequency of payment is called the premium mode. This is important because the insurance company invests the premium amounts it receives and uses the income as part of their eventual claims settlements. The more payments that the insured wishes to break the premium into, the higher the total premium that must be paid, because the company will generally add a "service charge" to each payment to compensate for the interest lost by not receiving the money in advance for coverage and for increased administrative expenses.