How Is The Cost Of An Insurance Premium Calculated?
Let’s look at insurance premium calculation. No math- we promise.
We know that anyone who actually enjoys doing math has already long since calculated their optimal insurance premium and coverage level and signed up for various types of insurance long ago.
For those of us who are a bit curious as to how insurance premiums are calculated, we thought we’d look at how it all works and how the computers calculate the numbers.
Term life insurance rests heavily on what is referred to as “the law of large numbers”. What this means for the mathematicians is as follows: it is impossible to guess when one person is going to die, but it is actually very easy to predict how many people out of 100,000 will die each year.
What all these big calculations boil down to are what as referred to in the business as “actuarial tables”. What these tables do is lay out the probability of someone dying, given key information about their age, country of residence, and general health data.
When looking at large populations of people, the actuaries (the men and women in the way-back-offices with no windows…) can actually predict with stunning accuracy the average population death rates. Another word for this is “mortality risk”.
Mortality risk, or likelihood of death in a given year, is the main factor in determining insurance premium level. The other key ingredients are the investment returns and cancellation rates. The big reinsurance companies (the ones that actually cover your risk) take in billions of dollars in annual premiums, and hold an enormous amount of cash in reserves. While this cash is sitting on the sidelines waiting to be paid out as death benefits, the insurance companies can invest them in low risk investments and get 2% or 3% returns each year. This makes it cheaper for them to provide coverage, bringing down the cost of your insurance cover.
Cancellation rates are another interesting unknown element that reduces your premium cost (if you commit to a longer term plan). The insurance companies know that each year a percentage of customers will cancel their plan, releasing the company from the risk of having to pay out if they die. This further drives their costs down, which also brings average premium cost down. This is one of the main reasons why if you set up a 20 year guaranteed level premium term insurance plan, you end up paying much much less than starting at a lower cost 1-year plan and then renewing each year at a higher price (as your mortality risk goes up). It pays to commit and lock in a low rate sooner. Annual premiums also typically enjoy a slight discount to monthly premiums, as it involves less admin work for the insurance company.