How the Cost of Life Insurance is Calculated
October 23, 2009 |
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A majority of people know that an individual’s health, age and lifestyle choices are used by life insurance companies for making decisions on whether to offer coverage or not to individuals. An applicant’s information is evaluated and then classified based on their insurance tables. The cost of the insurance premium that the applicant will have to pay is related directly to the classification. How are these tables formulated and how are premium prices derived? This article will discuss how life insurance premiums get calculated.
In insurance terms, risk refers to the probability of a loss. When an individual purchases insurance, risk transfers from the insured to the insurer. On order to accept the risk and still be a profitable business, the insurer needs to estimate how many losses are going to occur. Since the insurer cannot predict what the expected losses will be for any single individual, insurance companies use large numbers to make accurate predictions on how the number of losses that will occur in a group.
There is a basic principle to the law of large numbers. The larger a group is, the more predictable future losses will be in a given time period. Although insurance companies can’t predict which particular individuals will die, studying large groups and using statistics can help to accurate predict how many individuals will pass away.
An item of property or person being insured is referred to as an exposure unit. To make the law of large numbers effective, large numbers of homogeneous or similar exposure units are combined. For health and life insurance, the exposure unit is equal an economic value placed on the insured individual’s life. For other kinds of insurance what is being insured is the number of car, homes and other items.
As exposure units increase, errors for predicting losses decrease. The bigger the group is the closer predicted losses will be to actual losses. Insurance companies deal in averages. If they use average risk, the low and high extremes of loss cancel out.
Insurance companies hire actuaries, or mathematicians, who compile and analyze statistical data concerning risk and exposure units. The data is used for mortality (death) as well as morbidity (sickness) tables which are then used for predicting future losses which are due to death and sickness. The tables also consider other variables which lower or raise risk of loss. An insured individual is classified, and the premiums are based upon where the person’s profile is situated in the tables.
Insurance companies charge premiums to help cover their expenses, predicted losses, and profits. Expected losses are calculated based on past experiences with average risk. It is irrelevant that some people will live much longer than the average life expectancy (paying premiums for a lot longer), because others (who only pay a few premiums) die prematurely. These two extremes end up canceling the other out, which leaves average risk as the basis that the insurance company uses to calculate their expected losses.
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