CHAPTER ONE - HISTORY & ELEMENTS OF LIFE INSURANCE

As with many of the institutions of the civilized world, life insurance can be traced back to a Greek heritage, even though some scholars attribute the origin of life insurance to the Code of Hammurabi, about 1750 B.C., which provided for the state to pay indemnity for the murder of a member of the household, by a robber. The Greek societies, basically religious groups which flourished around 500 B.C. to 200 B.C., provided a fund for burial as it was believed that the departed could gain entrance into what they conceived as their “heaven” through a system of rituals, feasts and sacrifices to their gods. Obviously, this was expensive, so the fund was created to offset these final expenses.

The Roman “collegia”, which was similar to the Greek societies, gradually became mutual benefit associations and had specific benefits and operated from membership contributions. These associations ceased to exist after the decline of the Roman empire. However, the need for such societies/organizations continued and were followed by “Guilds” which while being organized for religious, social and economic reasons, did provide relief for several perils, such as shipwreck, loss of home by fire, loss of tools used to make a living, etc. While these guilds originated primarily in England, they also were present in Japan as Craftsmen’s guilds from the end of the 1600’s until nearly 1900.

The English created the English Friendly Societies, which were actually mutual benefit groups and while they were not concerned with trade, religious or similar groups, they provided some death or burial fund benefit. They were funded by assessments, but since they were not constructed on any scientific or actuarial basis, the financial burdens evolved to the younger members, who, being mostly in good health, dropped out of the plan. Therefore, some private insurance companies were formed, failed, and formed again, but they were all the ancestors of the true life insurance concept.

The earliest insurers were wealthy individuals who either alone, or with a consortium of other wealthy persons, assumed insurance risks. They were for short duration, and were used for such situations as the voyage of ships. Of course, life insurance could not be written in this fashion as the insured could possibly outlive the insurers. Incidentally, the insurers would sign their name(s) under the amount of the risk that they were agreeing to bear, hence they were called “underwriters.”

The earliest life insurance contract on record was written in 1583 for a period of 12 months, on the life of a William Gybbons, for a premium of 75 pounds, with a “face amount” of over 383 pounds. Interestingly, the insured died just before the end of the year, but the underwriters refused to pay because they insisted that their payments were based on “lunar months” (which are longer than calendar months). The English courts would have nothing to do with that, so the underwriter(s) paid.

The first true mutual insurance company for life insurance was The Life Assurance And Annuity Association, established in 1699, which went out of business 46 years later. Then the Amicable Society for a Perpetual Assurance Office was formed, which did not offer a stated death benefit, but operated more as a “tontine” (described below).

Around 1720, two English insurers which were stock companies, created a monopoly on British insurance, but when The Equitable applied for a charter in 1761 and it was denied, they formed a mutual company (which did not require a charter). The Equitable is considered as the first life insurance company that operated on a modern insurance basis.

The modern life insurance company had its origins in Europe, and the Equitable was followed by The Globe in 1803, and other companies in France in the late 1700’s and early 1800’s. The first stock life insurer in Germany was formed in 1828, and The Prudential (U.K. company), formed in 1848 was the first company to introduce industrial insurance about 1850.

As is typical with many industries in Europe, the government and the insurers were intertwined in many ways, and some governments used the insurers as a means to raise funds for government expenditures. One of these systems was the French system of “tontines” and in the past, some new insurance operations were compared to tontines.

In the late 1600’s, King Louis XIV of France used an annuity scheme to raise funds for the government, which the government needed very badly at that time. This scheme was created by a nobleman, one Lorenzo Tonti (from which comes, tontine). It worked as follows:

All participants would contribute a specified sum each year, and from these “payments”, a sum was set aside each year to purchase an annuity for life to those who participated in the tontine. As the participants died off and their payments were no longer being received by the other participants, the amount of the annuities grew every year, and was available to the survivors. Therefore, the longer one lived, the larger the amount of the annuity that was paid out to the survivors.

Later, other governments and some private firms used the tontine scheme, until it was outlawed in the early 20^th century.

In the early colonial years in the United States, the English insurers had a monopoly, and there were few, if any, colonials that were wealthy enough to compete as individual underwriters. However, before the Civil War, some English “orders”, such as the Odd Fellows and the Foresters, were introduced into the U.S. and they exerted a strong fraternal influence at that time.

The first mutual life insurer in the U.S. was the Corporation for the Relief of the Poor and Distressed Presbyterian Ministers and for the Poor and Distressed Widows and Children of Presbyterian Ministers, founded in Philadelphia in 1759. (Imagine representing this company at a convention – the sheer size name tag would be impressive!) This company incidentally, is now part of the Provident Mutual Life Insurance Co. Mutual of New York (MONY) was formed in 1842 and other mutual insurers were formed until the state of New York in 1849 required all insurers to place a security deposit of $100,000 with the State insurance department. This move was instigated by the established mutuals and effectively stopped the creation of new mutuals.

The first stock insurer was Insurance Company of North America, chartered in 1794, basically to sell annuities, and 10 years later it had only sold 6 life insurance policies, so it closed the doors on its life insurance business. The first company in the U.S. that sold a decent amount of life insurance was The Pennsylvania Company for the Insurance on Lives and Granting Annuities, chartered in 1812, discontinuing its business 60 years later.

The Prudential Insurance Company of America introduced industrial life insurance in 1875, followed by John Hancock and Metropolitan Life. The marketing of industrial life insurance had probably the greatest influence on the public awareness of life insurance in the United States.

WHY LIFE INSURANCE

While it may seem rather cold, economists have recognized for many years that there is an economic value to a human life and that these values are an important and necessary part of the nation’s economic wealth. The marketplace universally acknowledges investment in the human personal development, so any improvement in this investment is recognized as increases in income and/or wages. Therefore, any increase in earnings is simply an increase in the yield in an investment. For instance, those with college degrees traditionally make more money than those without such degrees, therefore this difference in income can be considered as a return of the investment in education.

For centuries, from the Code of Hammuabi, and throughout the religious texts such as the Bible and the Koran, and especially in early Anglo-Saxon law, there have been established methods of determining compensation given to a relative of an individual who was killed by a third party. Today, the value of a human life taken by a third party, and the recovery for wrongful death is in the news continually, with libraries full of books on wrongful death situations, cases and laws - it is a very large and important part of Liability insurance.

For the purpose of Life Insurance, the computation of the value of a human life takes a more scientific approach, as contrasted with the legalistic approaches used to determine how much money a surviving relative is awarded. The impact of and the importance of punitive damages is more properly discussed in books on liability and property and casualty insurance.

It is difficult to determine the value of a human life for insurance purposes, as every human life is unique and some, if not many, believe that it is not appropriate to attempt to place a monetary value on human life in any event because society does not condone the sale of a human life. Therefore, it is important to stress that the “Human Life Value” concept is a method of placing a value on the services of a person’s life. This is not unaccepted or immoral; indeed the ownership of a person’s life itself is what is unaccepted and immoral.

The “Human Life Value” concept was first introduced in the 1920’s, but as any Chartered Life Underwriter (CLU) can attest, in 1942, S.S. Huebner proposed this concept as a philosophical framework for analyzing certain economic risks that individuals face. Without going into the qualitative and quantitative considerations of the Human Life Value concept, this concept recognizes that a human life is subject to 4 types of losses: premature death, incapacity (disability); retirement and unemployment. Since any of these losses can affect an individual’s earning capacity, there is a resultant negative impact on their human life value.

Even though the probability of loss from death or disability is considerably greater than from any other commonly insured peril, people still generally purchase property insurance and avoid purchasing life (or disability) insurance. When life insurance is purchased, it is usually for an inadequate (sometime insignificant) amount.

The human life value concept is highly recommended for a serious student of Life Insurance. A general feeling for this concept can be obtained by recognizing Dr. Huebner’s “Human Life Value Admonitions.”

The human life value should be carefully “appraised and capitalized.” For those who earn more than is necessary to individually maintain their own lifestyle, the excess amount is of value to those who are dependent upon it (generally this is the family). The present value of this excess earnings creates an economic basis for life (& health) insurance.

“The human life value is the creator of property values, i.e., the human life value is the cause and property values are the effect.”

“The family is an economic unit which is organized around the human life values of its members.” The “family” per se, needs to be treated just like any other business and its organization and management, and eventual discontinuance, in the same manner that a business would go through these phases.

“The human live value and the protection it affords, must be considered as the principal (economic) link between the present and succeeding generations.” The earnings of the breadwinner(s) creates the funds and the foundation for the proper education and development of the children in case the breadwinner(s) are unable to fulfill that role because of death or disability.

Because of the significance of the human life value, the areas affecting the successful operation of a business must be used to life values as well, such as appraisal, indemnity and even depreciation.

LAW OF LARGE NUMBERS

The entire function of insurance of any type, is to guard against financial conclusions of perils by having the losses of those who suffer from the effect of these perils, paid by the contributions of many that are concerned that they will also suffer from the effects of these perils. To be concise, this is “insurance in a nutshell” – sharing of losses.

Insurance relies upon the effects of the laws of large numbers to reduce the speculative element of insurance, and to compensate for fluctuations in losses. Simply put, the law of large numbers that applies to life insurance states that the larger the number of those insured against premature death, the less the loss experience will “deviate” from the expected loss experience.

This law of large numbers does not mean that losses to particular insureds will be more easily predicted, it simply means that the more persons insured, the more the loss experience can be predicted, all things being equal.

If a single person is insured for $1,000, this would be a gamble; and if the number is increased to 100, then there still is a gamble. However if half a million persons are insured for $1,000, anticipated death rates will vary from actual death rates by no more than one percent. Theoretically, if the number of lives insured on the same basis were of sufficient number so that the law of large numbers would be exactly predictable, then there would be no uncertainty in the estimating losses during a given period of time, barring catastrophes such a war, terrorist attacks, mad-cow diseases, or other epidemics.

The major difference between life insurance and non-life insurance, is that the peril insured against, premature death, is an uncertainty for a year, and each year thereafter. However, the probability of death will increase until it is a virtual certainty – everyone dies at some time or other. (It is a “virtual” certainty as it is possible for a person to outlive the insurance policy – for instance a person who lives past age 100 will have outlived the mortality tables). Therefore, if a life insurance policy is to protect an individual throughout the lifetime of the individual, a fund must be generated to meet a claim that is certain to occur. (Even a person age 101 will receive the fund, one way or the other).

Many persons consider insurance as “gambling”, particularly with life insurance, where they believe that the insurance company is simply gambling that they will die prematurely. A very important principle of insurance is as follows:

F Insurance transfers an existing exposure and, through the pooling of similar loss exposures, reduces risk.

Another definition widely accepted:

F Life insurance is a device to spread the cost of financial loss resulting from death from an individual to a group through an insurance company by transferring the cost so the financial loss to any one individual is small.

Make no mistake; however, insurers much prefer that their insured do not suffer the loss for which they are insured. In life insurance such losses are inevitable, and the insurer plans for such losses within the premium structure.

DETERMINING PREMIUM FOR LIFE INSURANCE

Premiums for insurance should always meet three criteria; they must be adequate, reasonable (or equitable), and should not be excessive.

First, premiums must be adequate in order for the insurance company to provide the benefits contracted with an individual under the contract with the insurer (the policy). Obviously, if the premiums are not adequate then the insurance company will eventually not be able to pay the claims to the insured, so everyone suffers.

Secondly, the premium must be reasonable (or equitable) and the insurance company should not be able to earn an excessive profit. The pursuit of equity is one of the goals of underwriting (discussed in more detail later in this text) and equitable treatment of insureds is accomplished by rating factors such as age, sex, plan, health and benefits provided.

And lastly, the premiums must not be unfairly discriminatory or inequitable. There are different interpretations of “inequitable,” for example, some feel that it is not acceptable to charge different life (and health) insurance rates to men and women who are otherwise identically situated. One of the strongest forces that keeps premiums from becoming excessive is simply that of competition.

Theoretically, one could say that each insurance applicant should pay an exclusive (unique) premium to reflect a different expectation of loss, but this would be impractical (imagine agents having to carry a huge rate manual everywhere). So, classifications are established for applicants to be grouped together according to similar expectation of loss. Statistical studies of a large number of nearly homogeneous (similar or identical in nature or form) exposures in each underwriting classification enable the projection of losses after adjustments for future inflation and statistical irregularities. These adjusted statistics are used to calculate the pure cost of protection, or pure premium, to which the insurance company adds on “loadings” for agent commissions, premium taxes, administrative expenses, contingency reserves, other acquisition costs and profit margin. The result is the gross premium that is charged to the insured.

PRICING

The pricing of life insurance is a complex, technical and methodical procedure, performed by actuaries who are arguably the most technically educated professionals in the insurance industry. Therefore it is completely outside the purview of this text to discuss in detail the actual pricing procedure. However, in order to understand life insurance, it is necessary to understand certain elements of pricing life insurance and how they apply to the determination of life insurance premiums.

It is generally acknowledged that in order to determine the insurance premium (and reserves) there must be information and assumptions available regarding four elements: (1) the probability of the insured event happening; (2) the time value of money; (3) the benefits of the contract; and (4) loadings.

Before the insurer can determine the amount of the premium to be charged to each insured, the probability of losses for the group as a whole must be determined. In life insurance, these probabilities are shown on a yearly basis as mortality tables. (For health insurance, morbidity tables show yearly probabilities of loss.) These tables are the very foundation of life (or health) pricing.

Other important factors in pricing includes the fact that those people who purchase life insurance are not all of the same age, and obviously, younger people have a less likely chance to die in the early years than older persons. Therefore premiums rates should be higher for older persons than for the younger persons.

Another factor is that life (and health) insurance companies require that premiums be paid in advance, and for policies of longer maturity, the portion of the premium that is not needed to cover immediate benefits is invested to fund future expected benefits and expenses.

Other important items must be taken into consideration, for instance the amount of coverage, the level of coverage, etc., and very importantly, the recognition that some policies will remain in force longer than others – this is called persistency.

There are a wide variety of policies sold, as later discussions will reveal, as some insure against death or disability for a certain number of years, or for the whole of life and premiums may be paid for a short period of time, or for the length of coverage. With some policies premiums are fixed, with some they vary according to the wishes and needs of the policyowner, or vary with the tem of the policy. Some policies pay a single sum at death or maturity; others pay a benefit over a period of years. There are obviously many differences, and each type of policy will have its own statistics.

There is one important factor when discussing life insurance premiums: unlike other kinds of insurance, the life insurance policy cannot be cancelled and can extend for a long period of time.

Net rates are calculated to recognize the probability of the insured event, the time value of the money, and the benefits of the contract. When expenses and other loadings are added to the net rates, then they become Gross rates.

Practically speaking, companies frequently do not develop new net rates for new products introduced, especially if there are similar products already in the marketplace. The rates on those plans will be analyzed by the actuaries to determine if those premiums meet the company’s objectives and profit requirements. If not, the premiums will be so adjusted. If it is discovered that the rates are higher than those needed by the profit requirements of the company, the rates could be adjusted downward. If they are inadequate, then the actuaries will have to determine if they (1) want to develop such a product for their own sales force; (2) if they want to maintain a comparative premium so that their sales force can be competitive, even if the premiums do not quite match the company’s objectives; or (3) if benefits can be changed in such a fashion so that the price will be competitive, but certain benefits may be different or less.

Of course, the actuaries may determine the gross premiums by using what is considered as a realistic interest, mortality, expense, taxes and persistency assumptions, and with the company objectives and profit margin intact.

YEARLY RENEWABLE TERM RATE CALCULATION

As stated earlier, it is entirely beyond the purview of this text to go into detail as to rate calculation, however the calculation of the premium for a Yearly Renewable Term (YRT) policy, the simplest term insurance policy, can be understood and is quite illustrative.

A YRT policy provides coverage for a period of one year only, but allows the policyowner to renew the policy at the end of each year, even if the policyowner suffers poor health. Therefore, each year’s premium pays the policy’s share of the mortality cost for that particular year, only. The premium then increases each year which reflects the increase in mortality (more persons dying) each year as the individual gets older.

Mortality tables are derived from company’s experiences for certain periods of time. One table in common use is the 1980 Commissioners Standard Ordinary (CSO) Mortality Table. It is used by regulatory bodies for determining the reserves that must be posted by the insurance companies and regulators require very conservative assumptions, particularly when it comes to establishing reserves – as their primary function is to make sure that insurance companies have sufficient funds on hand to pay claims. While mortality has improved considerably since 1980, this mortality table is still used in some situations. The following chart shows the rates of mortality per 1,000 lives:

AGE MALE FEMALE

10 0.73 0.68

20 1.90 1.05

30 1.73 1.38

40 3.02 2.42

50 6.71 4.96

60 16.08 9.47

70 36.51 22.11

80 98.84 65.99

90 221.77 190.75

99 1,000.00 1,000.00

This table shows that the chances of dying increase with age, and it also shows that female mortality is better than male mortality – which incidentally shows up in all mortality tables, including foreign tables. Therefore, males pay higher premiums for life insurance (females pay higher premiums for annuities for the same reason).

As an example, the mortality rates for females age 30 is 1.38 per 1,000 lives. Therefore, if 100,000 females age 30 are insured for $1,000 each, the insurance company would pay 138 death claims for a total of $138,000. If 100,000 persons were insured, the company would have to collect $1.38 from each insured to meet the 138 death claims. This is the death rate and it ignores investment income and loadings.

If the insurer assumes a 5% investment return on all funds invested, and since premiums are paid at the beginning of the policy year (which is typical), and then use the (unrealistic) assumption that all death claims are paid at the end of the year (for simplicity and illustrative purposes), the insurer would then have the funds for an entire year for investment.

The insurer does not have to collect the entire $138,000, but only has to collect $131,430 ($131,430 x 1.05 = $138,000 [$1.50 left over]), or collect $1.31 from each insured.

To this would be added expenses (loading) and simply put, the loading expenses would be distributed among the 100,000 lives and added to the total premium, then split among the policyowners.

This is simple, but it should be taken one step further to explain the process of determining premiums for a level premium policy. In the situation above, the premium will have to increase each year, and where the mortality rate goes up, premiums increase. Then what inevitably happens? Obviously there will be some insureds drop out as the premiums become too expensive, particularly the healthy ones. This means that the ones who are not as healthy (or as old) will remain, as they are more likely to incur a claim. This is known as adverse selection (discussed later in more detail) and it means that those who are more likely to receive benefits will stay, and the better risks will leave. Because of this, insurers are likely to limit the period in which a YRT policy can be renewed, or will adopt much higher premium levels at the older ages to compensate for the adverse selection.

For single-premium life insurance plans, a modified CSO mortality table (Commissioners Standard Ordinary) approved by the NAIC and used in calculating minimum nonforfeiture values and policy reserves for ordinary life insurance policies. It depicts the number of people dying each year out of the original population, not as individuals, but in age groups. The formula to obtain those premiums uses the number living at the first of the year (such as 100,000 in the previous illustration) decreased by increments as the population of the tables age.

Actually, a life insurance policy can be seen as a series of YRT insurance policies continuing to the end of the mortality table. With single premium plans, the premiums are all paid in advance for the life of the policy, so the excess funds will have to be invested and then credited properly throughout the life of the contract.

Few persons purchase life insurance on a single premium basis because of the up-front premium. Also, because of the ever-increasing premiums for a YRT policy, few people are interested in purchasing YRT insurance, except for special situations where short term insurance is needed. These problems are solved through the use of a level-premium plan.

Level premium plans were devised so that the company can accept the same premium each year if the premiums collected are the mathematical equivalent of the corresponding single premium. As is obvious, the premiums collected in the early years will be more than necessary to pay for death claims, and the premiums in the later years will not be sufficient to pay death claims. It has sometimes been said that life insurance was the first product that was sold on an installment plan.

The premium is level because of this overpayment of premium in the early years. At any time, the fund, future interest and future premiums, all together, should be mathematically able to pay all death claims as they occur during the time that the coverage continues.

A “whole life” policy can have premiums paid over the entire policy duration – this policy is also known as ordinary life insurance. Whole life policies can have level premiums that can be paid over a shorter period, such as 10 or 20 years, or for a specified period, such as age 65.

RESERVE CALCULATION

There is one other important calculation that must be discussed, that of policy reserves. Reserves will be considered in more detail later in this text, but at this point the “Prospective” Reserve definition is applicable.

FA Prospective Reserve is the amount designated as a future liability for life (or health) insurance to meet the difference between future benefits and future premiums.

In determining this reserve, the Net Level Premium is determined so that this basic relationship holds: The present value of a future premium equals the present value of a future benefit (which is a simpler way of expressing the Prospective Reserve). This relationship, incidentally, exists in fact only at the point of issuance of a life insurance policy. After that, the value of future premiums is less than the value of future benefits because fewer premiums are left to be paid. Thus, a reserve must be maintained at all times to make up this difference.

The actual amount of life insurance protection (before loading) at any point in the policy term, is the difference between the policy reserve at that point, and the face amount. This is called the net amount at risk.

When looked at in this aspect, it is simply dividing a life insurance into two sections – an increasing reserve and a decreasing net amount at risk.

FLEXIBLE PREMIUM PLANS

Many insurers sell policies that have flexible premiums; i.e. the policyowner determines the amount of premium that they would like to pay. This is the case with Universal Life (UL), Variable Universal Life, etc. Unlike other policies, the cash values of an Universal Life policy are a function of the premium payments that have been made in the past, and in the present. The UL type of products have cash values that are determined differently than the calculation of the Net Amount at Risk, as shown above where the Net Amount at Risk and the Reserve always equal the face amount of the policy. Rather, the cash values of the UL products are determined by the way the policy is structured.

The policyowner may pay whatever premium they wish (subject to company rules). An amount, which is equal to the insurer’s loading and expenses, and mortality charge, is subtracted from the cash value. Thereafter, the amount remaining in the cash value, plus any premium payment made and the previous period’s fund balance equals the cash value for the next period. The mortality charges are based on the policy’s net amount at risk, but using a cash value instead of the reserve. Any interest earnings on the cash value are credited to the cash value, usually on a monthly basis. In addition, there usually is a surrender charge if the policy is terminated early.

This is a highly flexible plan (as discussed later) so there can be no illustration to show how the premium develops, as the insured develops the premium payment schedule as they wish.

THE SAVINGS ELEMENT IN LIFE INSURANCE

Many life insurance policies have cash values and all cash values stem from the same cause; the excess premium charged in the early years in order to maintain a level premium. However, cash value is viewed by the general public as simply a by-product of the level premium payment-of-premium method. This was the view held for many years, until the advent of interest-sensitive insurance products, in particular Universal Life. In these cases, the cash value is looked upon as a separate and independent part of the policy, from which funds are withdrawn to pay for mortality and loading charges.

Some have considered a permanent type of level premium policy as simply a liability held by the insurance company to pay any future claims – the reserves – plus term insurance. To some this is witnessed by the ability to withdraw all of the cash value, and the policyowner can borrow part of the cash values as a loan. Regardless of the appearance of two contracts – death benefit and cash value – it is important to understand that it is still only one policy. This is evidenced by the fact that a policyowner cannot withdraw all of the cash value without also giving up all of the death protection. Legally, and actuarially, a life insurance policy is an indivisible contract. Unfortunately, some companies and individuals continue to present permanent life insurance as a combination of decreasing term and increasing savings. Not too many years ago, there have been financial fortunes built on the concept of “buy term, and invest the difference.”

Universal Life will be discussed in more detail later, however at this point it is important to recognize that Universal Life (UL) and other “interest-sensitive” products are different from other insurance products inasmuch as they are extremely flexible and they are “transparent.”

UL type policies are flexible as the policyowner may increase or decrease the premium (even eliminate the premium, in some cases), and they may also increase or decrease the policy face amount within certain guidelines.

UL type policies are “transparent” inasmuch as the main ingredients of a life insurance policy premiums – mortality, interest and expense/loading – are identified to the purchaser, individually and collectively. As stated earlier, the savings part of the policy is directly related to the amount of premium paid by the policyowner. Generally, the higher the cash value, the higher the premium. Therefore the mortality protection portion of the policy and the savings element are divisible, and they are “transparent”, as the methods used to determine these aspects are apparent to the policyowner.

Like a couple looking at a Corvette and a Minivan – they are both transportation but they serve different purposes. So whether a policy can be divided or is indivisible is simply different ways of looking at the same thing.

POLICIES THAT PARTICIPATE IN COMPANY EXPERIENCE – OR NOT

Life insurance policies can be segregated into those that allow for variation depending upon the experience of the company or a particular block of business; and those that are engraved in stone. There is also the class of policies that will provide variation depending upon anticipated company or business results.

NON-PARTICIPATING POLICIES

Some policies provide that the premiums, benefits and cash values are “etched in stone.” These are traditionally called “non-participating” policies as they do not participate in any improvement in mortality or cash values, and the premiums are fixed as long as the policy is in force. Also traditionally, these policies were sold by stock companies as the mutual companies, which are owned by the policyowners, would allow their policyowners/company owners to participate in better than anticipated experience by issuing dividends. Today, stock companies may issue participating policies and mutuals may issue non-participating policies.

Since traditional non-participating policies do not share in positive experience from lower-than-expected mortality, higher interest earnings than anticipated, or lower expenses &/or taxes, the policyowner has no way to participate in these favorable results. If the policy does not reflect an increasing economy, lower taxes, etc., policyowners are tempted to exchange their policies for those that do participate. Of course the healthy policyowners are the ones that would be changing, with those who could not change policies because of health reasons, would stay with the non-participating policy. Therefore, the premiums would be insufficient on the existing block of business. Another example of adverse selection.

PARTICIPATING POLICIES

Participating policies allow their policyowners the ability to share in the increased profits of an insurer because the actual results and experience is better than that assumed in constructing the policy and the premium – hence the name “participating.” Actually, these profits go toward increasing the surplus of the company. The company will then declare a “distributable surplus” which will be returned to the policyowners in the form of dividends. For example, if the company is receiving 7% on its investments, and it had used a 5% assumption when determining premiums, the 2% difference may be returned to the policyowner, completely or a portion thereof.

It should be noted that a “dividend” in a life insurance policy is very different from a dividend that is declared in other industries when their profit experience is better than anticipated. Premiums are usually, not always - but usually, are higher for participating policies as they use very conservative assumptions for mortality, interest and loadings. As a matter-of-fact, the Supreme Court has determined that a “dividend” in these cases is simply a return of premium for tax purposes.

Agents representing mutual companies (primarily) have used policy projections when marketing participating policies which show that the dividends more than compensate for the higher premium, and the dividends can allow certain flexibility that non-participating policies cannot. This is one reason that stock companies started issuing participating policies) discussed later in this text).

DIVIDEND PAYMENT OPTIONS

The owner of a participating policy may choose how the dividends are paid-which dividend payment option to choose from among those the insurer offers. Six basic options are discussed in the following paragraphs, but many companies do not offer all six.

Cash Dividend

Policyowners may choose to take cash dividends. Whenever the insurer pays a dividend, the policyowner receives a check from the insurance company.

Premium Reduction

The dividends may be used to help pay the next premium. Under the premium reduction option, the amount of the dividend is deducted from the premium so the policyowner pays less the next time a premium is due. Since the amount of the reduction depends upon the amount of the dividend, the normal premium is required when no dividend is paid.

Paid-Up Policy: By using both dividends and the accrued interest on cash values, the policyowner might be able to have a paid-up policy, i.e., both dividends and interest are used to pay future premiums. This option requires a large policy paying large dividends and earning significant interest. Some policies are purposely written to do just this and the transaction is sometimes termed "vanishing premium” (discussed in detail later in the text). A caution is in order, though, dividends are not guaranteed and if the insurer's experience is much worse than anticipated, the policyowner might have to keep paying premiums. In addition, the premiums required in the first years of the policy are typically higher than policies that do not include this feature.

Paid-Up Additions: Alternately, dividends could be used to purchase paid-up additions to the policy which are small additional amounts of whole life insurance added to the existing policy without evidence of insurability and with no additional premium required in the future for the additions. This use of dividends is essentially the purchase of small amounts of single-premium cash value life insurance.

Accumulation at Interest: Leaving dividends with the insurance company allows them to accumulate at interest. The accumulated dividends and interest are then added to the death benefit. Therefore, a $100,000 policy, in which dividends which have accumulated at interest, and now totals $2,000, would result in death proceeds of $102,000. While the dividends themselves are not taxable because they're considered a return of excess premium paid by the policyowner, the interest is taxed under this option.

One-Year Term Insurance: Dividends may also be used to purchase one-year term insurance. The amount of term insurance that may be purchased is whatever the dividend will buy at the insured's current age, up to the cash value of the policy. If part of the dividend remains after the term purchase, it is usually left with the insurer to accumulate at interest. No proof of insurability is typically required under this option.

Remember, not all of these options are available from every insurance company. In addition, while policyowners normally select a dividend option when the policy is issued, they usually may later switch to another option if they wish.

CURRENT ASSUMPTION POLICIES

The principal difference between “Current Assumption” policies and participating policies is that the participating policies are adjusted according to past experience of the insurance company, while the current assumption policies are adjusted according to anticipated experience of the insurance company. In affect, they discount in advance for expected favorable results.

STUDY QUESTIONS

Chapter 1

1. The earliest life insurance contract was written

A. in England.

B. by wealthy individuals.

C. by the Insurance Company of North America created in 1794.

2. The “human life value” concept

A. recognizes the value of slavery.

B. states that the probability of loss from automobile accidents is greater than the probability loss from death.

C. is a method placing a value on the services of a person’s life.

3. A description of insurance can be reduced to three words:

A. fire and casualty.

B. life an health.

C. sharing of losses.

4. Insurance _______________ risk.

A. eliminates.

B. transfers.

C. increases.

5. Premiums for life insurance

A. should reflect a different expectation of loss.

B. must be adequate.

C. should be lower that competitors.

6. The probability of losses for life insurance comes from

A. mortality tables.

B. morbidity tables.

C. probability tables.

7. Life insurance companies

A. charge more for younger people.

B. require premiums be paid in advance.

C. charge a premium calculated to cover the pure cost of probabilities only.

8. With a Yearly Renewable Term policy

A. the premium remains the same each year.

B. provides coverage for a period of one year.

C. the policy cannot be renewed if the insured suffers bad health during a premium period.

9. Level premiums

A. means the policyowner pays less for the coverage.

B. were devised so the insurance company can accept the same premium each year.

C. provide for overpayment of premium in the later years.

10. The cash value of a life insurance policy

A. comes from the excess premiums charged in early years.

B. cannot be withdrawn.

C. means there are two policies; 1) death benefit and, 2) cash value.

11. The probability of loss form __________________is higher than any other commonly insured peril.

A. fire.

B. death.

C. earthquake.

12. Life insurance companies rely upon the effects of “the law of large numbers” to

A. reduce the speculative element of insurance.

B. identify specific individuals that will die in a one-year period.

C. estimated losses during a terrorist attack.

13. Mortality tables, are not only used by life insurance companies, but also by

A. health insurance companies.

B. the state department of insurance.

C. automobile insurance companies.

14. All life insurance policies require premiums be

A. fixed.

B. excessive.

C. paid in advance.

15. A “participating” life insurance policy

A. is adjusted according to anticipate experience of the insurance company.

B. pays dividends that are taxed as ordinary income.

C. allows the policyowner to share in the increased profits of the insured.

Answers to Chapter One Study Questions

1A 2C 3C 4B 5B 6A 7B 8B 9B 10A 11B 12A 13B 14C 15C