CHAPTER ONE - BASICS OF LIFE INSURANCE

 

This text is furnished solely by C.E.I.S. as a reference to be used in Continuing Education.  It is to be used as educational material only and it is not intended to provide advice—legal or professional.  The readers of this text must consult their own legal advisor for legal advice on any information contained herein.

 

(NOTE:  The use of the male gender, i.e. “he,” “his,” “him” etc., is used in this text to designate a person of either sex for simplicity purposes, as having to refer to “he/she,” “him/her,” is rather clumsy and it certainly is not intended in any way to denigrate the important contributions those of the female gender make to the life insurance industry.)

 

DEFINITION

 

Another definition widely accepted:

 

POOLING OF THE RISK

There are many other definitions of Life Insurance, besides the two stated above, but the “spreading of risk” and the “transfer of risk” are the two most common and most accurate in discussing life insurance in today’s society.

The very basic element of these definitions is the pooling of risks, the sharing of losses by members of a group.  There are various ways to share the risk in Life Insurance, but principally it is an arrangement where the members of the group “insure” each other, or the risk is transferred to an organization that assumes the risk and pays the losses of the group.  In life insurance, the first arrangement is called a “mutual” arrangement, hence the Mutual insurance companies.  The second organization is known as a “stock” life insurance company.  While these are simplistic definitions and descriptions of stock and mutual companies, obviously there are other important elements involved.

For this purpose of this discussion, the very heart, the “essence,” of life insurance—indeed, all insurance plans—is the pooling of the risks and losses.

Textbooks often use the example of a fire insurance policy, as it is the easiest to understand when describing the pooling concept.  If—for example, obviously—there are 1,000 individual homes in the community, each is worth $100,000 (for simplicity purposes as few communities would have houses this cheap…) and they are all built the same with the same loss exposures, ergo, the same probability of being destroyed by fire.  The probability of a loss of a home would be remote, probably near 1 in 1,000 each year. However, to the owner of the house, a loss of $100,000 would be disastrous.  Using these assumptions, if each homeowner paid an annual contribution of $100, there would be large enough fund to reimburse the homeowner suffering the loss.  Actually, each homeowner is assuming a loss of $100 in order to eliminating the risk of losing $100,000.  Even though each homeowner contributes a “premium” of $100, and pays it year after year, it would still be a small sum when related to the possible loss.

Applying this basic principle to life insurance, if there were a group of persons in equal health, same age and each having the same prospect for longevity, the members of this group could agree that the group would pay $100,000 to the beneficiaries of each person who dies during each year.  Simply (very simply) put, it could be in the form of an assessment paid by each member in the group as the death occurs. 

What are the chances of an individual member of the group dying in any one year?  To determine the probability of death, if all members were 35 years old, 21 of them could be expected to die, taking the information from the Commissioners 1980 Standard Ordinary Mortality Table (referred to as the “1980 CSO Table”).  Therefore, ignoring expenses, 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.  Obviously, if the death benefit were to be twice as large, the assessment would be twice as much.

Please note that the actual premium within a group would be a much more complex calculation of premium, for many reasons, which will be discussed later in more detail.  One important factor is that the 1980 CSO Table is a sex-divided table, i.e., the mortality of males and females are different.  For example, using the same Table, a female at age 35 would pay an assessment of $165 (compared to the $210 for the male). 

It is important to be aware that the CSO Tables (yes, there are many, such as male-female, smoker-nonsmoker, etc.) are used as guidelines for the smaller companies.  The larger insurers will have developed their own mortality tables based upon their insured losses, which would reflect the type of business sold by this insurer, the geographical location of their insureds, etc. 

ASSESSMENT INSURANCE

Before one can understand the complexities of today’s life insurance plans, the starting point must be the simplest and most easily understood type of life insurance, such as the “Assessment Insurance” plans.  Actually, this is probably the oldest form of life insurance, as the Ancient Order of United Workmen “way back” in 1868, levied an assessment of $1 per member in order to pay a death benefit of $2,000 upon the death of the union member.  Originally, the assessment was levied after the payment of each death claim, thereby making sure that there would be enough funds to pay future death claims.  Later, the assessments made were on an annual basis.

In the very early years, the assessments were the same on all members, regardless of age as they felt that there would be a “flow” of new members at the younger ages, which would offset the aging of existing members.  Before long it became apparent that this theory did not hold water as with age the older members died “quicker,” i.e., deaths do not occur evenly at each age as death increases more rapidly the older the person.  For instance, if a group were made up of 20-year olds, and 50-year olds, the average age would be 35.  However, the mortality tables show that males who have a death rate of 3.02 per thousand at age 40, this would increase to 6.71 at age 50.  The fact that the average age will continue to increase as everyone gets older and the average age would increase as the number of new entrants could not compensate for the increase in mortality of existing members must be taken into consideration.  Combining these problems would lead to an increasing in assessments just to cover present mortality.

Another problem reared its ugly head—that will be addressed in various forms and situations later—created by the fact that as the assessments increased in amount (and sometimes, frequency), young and healthy persons had a tendency to withdraw from the society.  This happens even today, where the young and healthy seem to feel that they are indestructible and immortal.  Therefore, the average age increased with the comparable increase in assessments to the point to where it was impossible to attract new members.  This is known as “anti-selection” or “adverse selection,” which is in reality the process in life insurance when an applicant who is uninsurable—or, at least, a greater than average risk—attempts to purchase a policy at a standard premium.  This is the principal reason that insurers soon discovered that they needed qualified persons to screen applications, a practice now known as “underwriting.”

The first change many societies imposed on their members was the grading of the assessment depending upon the age of the member at time of entry.  The problem with this is that the assessment remained level as the member grew older and the mortality risk increased, working a hardship upon the younger members.

Next, the assessments were increased, as the member got older.  While this may seem to be the perfect solution—the older paying more because the risk of loss is greater at the older ages—over the horizon, the problem comes, riding on a galloping black horse, called “adverse selection.”  Healthy member withdrew from the plan, which created an abnormally high assessment for the older members.  The assessments would become so high that the older members could not afford to pay them, but at their age, they were the ones who needed the plan, as they were the ones that would be using the benefits the most.

The final attempt by some societies was to reduce benefits with advancing age but the assessments would remain level.  While this then created a block of “insureds” who were progressively getting older, their benefits were decreasing at the age, again, where the benefits were the most needed as they were the most likely to die.  This is not totally a bad idea, as it is found today in some forms of group insurance. 

These plans are not important today, in the field of life insurance, and those old assessment plans have become insolvent or they have reorganized using more modern principals of life insurance. 

YEARLY RENEWABLE TERM

Yearly renewable term insurance is much like assessment insurance, and is used mostly with group insurance and reinsurance, but for the insurance needs of today’s societies, the appeal is quite limited.  However, it needs to be understood, as it is the basis for understanding the more complex and modern forms of life insurance.

Yearly renewable term insurance is the simplest form of insurance, providing life insurance on an annual basis but allows the insured to renew the policy each year without having to provide evidence of insurability.  The time that the policy may be renewed without providing evidence of insurability is limited to a specified time or to a specified age.  If the insured does not die during the specified period, the policy is completed and the insured no longer receives benefits in case of death.  The premiums paid to the insurance company that were not received in claims, are used to pay the claims of those insureds that die during the period of insurance.

CALCULATION OF PREMIUM

It is outside of the scope of this text to go into detail as to how life insurance premiums are calculated for many of the life insurance plans.  However, it is important to understand the premium calculation procedure so that premium and reserve problems in respect to various products can be better understood. 

Basically, the yearly renewable term insurance premium is determined by the mortality rate of the age (attained) of the individual, such rate is determined, as described above, from a mortality table such as the 1980 CSO Mortality Table, or from the mortality experience of the insurance company. 

For purposes of illustration, the 1980 CSO Table shows representative mortality as follows:

 

Again, very simply put, this illustrates that a male age 30 shows a mortality rate of 1.73—of 100,000 persons, 173 of them will die within the year.  Therefore, for each $1,000 death benefit per deceased there will be $173,000 in claims.  Each female would contribute $1.38 for the cost of the same benefit amount (ignoring expenses).

For the second year—remember, the premium for yearly renewable term increased by age (and mortality)—there would be 99,827 out of the original 100,000 and if they were to be insured for another year, they would be exposed to the death rate at age 31 (which is 1.78), so (theoretically) that would produce 178 death claims totaling $178,000.  Divide that sum equally among the 99,827 participants and each would then require a premium of $1.78.

Limitations

The limits of Yearly Renewable Term (YRT) life insurance is readily apparent—anti-selection as discussed earlier.  The fact that the premiums increase with age creates the atmosphere of charging “too much” at older ages, therefore the older insureds have a tendency to discontinue their coverage.  Not understanding the nuances of life insurance premiums can easily lead an older person to look back at all of the premiums that they have paid and see that since they are still alive (obviously) they feel that they didn’t get much for their money.  The fallacies in this thinking are obvious, but they do exist.

Actually, the premiums at the older ages are adjusted to make up for the increasing chances of anti-selection, so not only do those older policyholders pay the mortality premium, they pay an additional amount—a “loading”—because of the added mortality risk of those who keep the policy in face of higher and higher premiums.

Additionally, there are no “living” benefits such as cash values, policy loans, etc., so essential to the modern version of life insurance.  However, it is interesting to note that when the interest rates were quite high, insurance companies created YRT policies that were sold in conjunction with Mutual Funds or other investment vehicles, in effect creating a whole life policy with increasing premium that, along with the cash value, fluctuated with the cost of living. 

This is not to belittle the value and the use of YRT life insurance as it can provide life insurance protection, usually for a short period of time, such as the length of an obligation, for instance.  One can get the maximum amount of protection for a short period of time at the lowest cost, but using YRT.  Incidentally, reinsurance (the assumption of mortality risk by another insurance company, usually of large and/or substandard policies) uses YRT premiums in reinsuring the net amount at risk for mortality risks.  The higher and increasing cost does not usually come into play in reinsurance as the reinsured policies are generally “recaptured” later by the original ceding company.

LEVEL PREMIUM INSURANCE

This type of life insurance policies provides the basic protection for a basic premium, but the objections to YRT insurance had to be overcome; ergo, a life insurance policy that will have premiums that will remain level for the term of the policy was developed.  It is apparent that if level premiums were to be paid for a life insurance policy, the premiums would have to be more than the anticipated mortality rate in the early years and less than the anticipated mortality rate in the later years.  Saying this another way, the early premiums are more than adequate to pay incurred claims, but later premiums are inadequate to pay incurred claims—combined, so theoretically the level premium should be sufficient to pay claims at any time the policy is in force. 

During the early years of the level premium plan, the premiums in excess of what is necessary to pay claims (“redundant premiums”) are held by the insurance company for the benefit of the policyholders.  These premiums are called the “reserve,” which is defined as the amount that must be accumulated by the insurer and maintained by them so that future obligations can be met.  Legally, these reserves are called legal reserves, which are, technically, the total liability account of the insurance company.  These reserves are lumped together for accounting purposes, but for purposes of individual policy discussions, they will be treated as an individual account part of an accumulated fund established as a credit of the various policyholders.

The excess part of the premiums paid in the early years of the policy are accumulated by the insurer at compound interest and the total amounts are then used to supplement the later-year premiums that, obviously, are otherwise inadequate.

PREMIUMS & RESERVES OF TERM POLICIES

As discussed, there are two types of term policies—level term and yearly term.  The differences in the premiums throughout the life of the policy can best be illustrated by a graph.

 

 

The area from age 25 to age 45 shows a difference between the level premium and the YRT premiums of $1,000 of life insurance, such difference indicates the deficiency of the premium.  After age 45, it is apparent that the deficiency is much larger—which is caused not so much by increase in mortality, but is a function of compound interest of the reserving of the premium.  At age 65 this “reserve” is exhausted simultaneously with the exhaustion of the coverage.  What has happened is that the reserve, which includes the investment earnings that is earned on the reserve for supplementing the deficient level term premium, is used up after age 45. 

ORDINARY LIFE INSURANCE

One might think that ordinary life (a.k.a. “Whole Life”) would produce premiums and reserves identical to level premium term insurance.  Both products have level premiums, but there the similarity differentiates.  Term insurance has a “contingency,” i.e., the insured may survive the policy—while the policy may terminate, the insured may not.  Ordinary life, however, has more than a “contingency,” it has a “certainty.”  The certainty is that (according to the mortality tables) everyone will die by age 99 (or 100). 

Will everyone die before or on their 100^th birthday?  Of course not but few are left.  True story—the Chairman and founder of a substantial Midwestern life insurance company came to his office every working day until he passed at the age of 97.  His goal, as he would tell anyone that asked, was to outlive his life insurance policy. Not quite.

Basically, by the time that an insured has reached age 99, the reserve under his/her policy must have accumulated an amount which, when combined with the last annual premium and interest on the premium, will equal the face amount of the policy.  What happens is that the long-living policyowners pay off their own death claims, and, indeed, the aggregate premiums paid by those who live a long time, might be more than the face amount of the policy.

Cost of Insurance

For a level premium policy, the reserve that is accumulated by the payment of premiums and the interest earned thereon is part of the face amount of the policy that is paid when the insured passes.  From the view of the insurer, the actual “out-of-pocket” insurance is the difference between the face amount of the policy and the reserve.  This is known as the net amount at risk.”  As the reserve increases, the amount at risk decreases, so as the death rate increases the net amount of risk decreases, producing what is known as the “cost of insurance.” 

Just as a note of interest, when a life insurance policy is reinsured under an YRT basis—the insurer pays the reinsurer an YRT premium for each year the policy is reinsured—the amount that is reinsured is the net amount at risk.  Therefore, a reinsured policy would decrease in amount each year as the reserve increases, until finally the original writing company has no need for reinsurance on that policy.

To illustrate the difference between whole life and yearly term premiums, the following chart shows the difference using a male age 30.

 

This graph looks odd because of the sudden increase in YRT rates at the older age—due to the increase in mortality between ages 70 and 99.  The annual premiums, using the 4.5% interest factor and 1980 CSO Male Table, would show a level premium of approximate $7.00 per thousand of face amount (rounded). 

Under the level premium plan, it is safe to say that a $1,000 policy does not provide $1,000 of insurance.  Actually, the insurance company is never at risk for the full face amount of the policy, even in the first year as the amount of actual insurance is always the face amount of the policy less excess premiums that have been paid by the policyholder.  While the insurance company holds these excess premiums, they are also available to the policyholder in an ordinary life policy, in the form of a cash value.  The policyholder can withdraw these funds at any time through surrender or loan (discussed later); therefore, the cash value is considered as a “savings” or accumulation account.

 

A level premium policy does not provide pure insurance, but provides a combination of decreasing insurance and increasing cash values; in any year, their sum is equal to the face amount of the policy.

The following graph shows that the “reserve” or savings element, plus the net amount at risk, equal the protection element at any given age.  However, by age 95 or so, the protection element of the policy has diminished to where it is inconsequential, and by age 100, it has disappeared.  At age 100, the policyholder would receive a check from the insurance company for the total face amount of the policy.  Note that the actual differences would not be as evenly divided as shown on the graph, because of the increase in mortality rates at older ages.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

THE IMPORTANCE OF THE LEVEL PREMIUM PLANS

The importance of the level premium concept cannot be over-emphasized.  The level premium impact on insurers accounts for most of the assets of the life insurance companies in the United States— exceeding $3.1 trillion and growing at a rate of $100 billion per year.  The other major contributor to this incredible growth is the reserves for annuities and pension plans.

The level premium plans gave birth to the system of cash values and other surrender options that has made the life insurance policy so flexible and so important to the economy of the nation.  The cash value concept has made the life insurance policy highly flexible and valuable.  It permeates our economy in many ways—including using life insurance as collateral for credit, even in million-dollar credit lines.

Still, the greatest significance of the level premium plans is that it is the only financial arrangement where insurance protection can be provided to the entire life-span without the cost of such protection becoming prohibitive.

STUDY QUESTIONS

1.  Insurance reduces risk by

     A.  pooling similar loss exposures.

     B.  pooling premiums so that the last exposure pays for all claims.

     C.  not accepting questionable risks.

     D.  eliminating fraud and misrepresentations.

 

2.  Insurance

     A.  is a form of gambling.

     B.  is not regulated by governments.

     C.  transfers an existing exposure.

     D.  companies are eleemosynary institutions.

 

3.  Perhaps the oldest form of life insurance is

  A.  yearly renewable term insurance.

  B.  whole life insurance.

  C.  reentry term insurance.

  D.  assessment insurance.

 

4.  The simplest form of life insurance is

     A.  whole life insurance.

     B.  Variable  life insurance.

     C.  yearly renewable term insurance.

     D.  endowment insurance.

 

5.  If a mortality table shows a mortality rate of 3.02 for a male age 40, that means that at age 40

     A.  for every 100,000 persons, 302 of them will die within that year.

     B.  for every 100,000 persons, 302 of them will survive that year.

     C.  for every 100,000 persons, 30 will die within that year.

     D.  for every 10,000 persons, 302 of them will die during that year.

 

6.  The principal limit of Yearly Renewable Term is that premiums increase with age, therefore this creates

     A.  a level premium plan.

     B.  anti-selection.

     C.  an atmospheres of non-trust between the insured and the insurer.

     D.  an endowment plan.

 

7.  Term insurance has a “contingency” of the insured surviving the policy, but ordinary life insurance has a

     A.  “certainty” that everyone will die by age 99-100.

     B.  “possibility” that some will live past age 99.

     C.  “probability’ that the insured will die within one year.

     D.  “conception” that the insured will live past age 62.

 

8.  The feature that has been the driving force behind the variations and modifications of the modern versions of life insurance is

     A.  the commissions structure.

     B.  cost.

     C.  the “savings account.”

     D.  the improvement in mortality.

 

9.  The reserve plus the net amount at risk in a life insurance policy, equals

     A.  the claims reserve.

     B.  element of protection.

     C.  the asset allocation.

     D.  the gross premium.

 

10.  The only financial arrangement where insurance protection can be provided to the entire life span of an individual without the cost being prohibitive, is

     A.  level premium plans.

     B.  renewable and convertible term insurance.

     C.  re-entry term insurance.

     D.  Universal Life insurance.

ANSWERS TO STUDY QUESTIONS

1A     2C     3D     4C     5A     6B     7A     8C     9B     10A