It is good to understand how a Term Plan works: how the insurance company collects the premiums and how it spends them; for it will help us to assess the goodness of a Term Plan. Also we will be able to better understand what an insurance company communicates to us, and can take enlightened decisions.
At the simplest level, we know that a term insurance plan becomes feasible when the total premiums collected during a year are sufficient to pay the claims that are expected to arise during the year. But for a term insurance plan to be commercially viable, the total premiums collected during the year have to cover the marketing and administrative costs of the plan besides the claim amount. And a surplus should be left for the insurance company to do that business; insurance companies are not charity trusts.
Of course, the premium collected and not spent at any given time, is invested. This earns additional income for the insurance company. So the arithmetic is as follows : [Premium income + Investment income] = [Claims + Administrative / Marketing expenses + Profit for the insurance company]. Therefore the premium for a term insurance plan is fixed in such a manner that, after accounting for the investment income, it covers the expected claim amount and the expenses, and leaves behind some surplus for the insurance company. The insurance company can maximise the surplus that it earns by minimising its expenses and claims paid out.
An important factor that determines the claims paid out is the quality of underwriting.Underwriting refers to the process of evaluating the risk that the insurance company is contemplating to take over and determining the price that it should charge by way of premium for taking over that risk. At the heart of underwriting is the answer to the question : what is the probability of this person dying this year ?
The insurance company calculates this probability from probability tables called the Mortality Tables. Mortality tables are based on past claim experience, and are revised continuously as the experience changes over time. The tables are different for males and females, and also for different geographical regions and ethnic communities.The basic mortality table relates the probability of death to the age of the person. This probability is further modified to take into account various health and other parameters. For instance, how much higher is the probability of death of a male of age 40, whose blood pressure is 145/95 instead of the normal 112/79 – 137/87 range ?Or how much higher is the probability of death of a male of age 50, whose father died of a heart attack at the age 55 ?Or how much higher is the probability of death of a female of age 35, whose smear tests show some abnormality ?Or how much higher is the probability of death of a male of age 30, who regularly engages in scuba diving ?Or how much higher is the probability of death of a female of age 45, who is a regular party goer ? You will realise this is a tough call. A whole discipline has been built around this arithmetic of death called the actuarial science; those who practice it as a profession are called actuaries. Somehow not many take to this speculative number crunching; therefore there is an acute shortage of actuaries, not only in India but across the world; consequently they are very well paid.
A higher probability of death means a higher premium. Charging a premium higher than the normal for a given age is called as loading. Starting with the normal premium, which is the premium chargeable to a person with normal parameters, called in insurance language as the tabular premium, additional premium is loaded onto it depending upon the deviation from the normal parameters. This process of increasing the premium is also called as rating up.
An insurance company may even decide not to take over the risk, if it finds it too high. The company then is said to have declined the proposal.
SA is the quantum of risk that an insurance company assumes when it accepts the insurance proposal. SA may or may not be equal to the financial distress that the proposer experiences when the adverse event occurs. But the insurance company is not concerned about that. For the Principle of Indemnity which requires that the SA should be equal to or less than the loss (financial distress) suffered, is not applicable in life insurance; it is strictly followed in non-life insurance.
However, the insurance company does decide how much risk it should take over. So the underwriting has to tackle this question as well. How much risk the company is ready to assume will again depend on the probability of death. If the SA asked for is too large and the probability of death is also too high, then the company may offer a lower SA. Themeasure of risk that an insurance company takes over when it offers cover to a person is called the value at risk, and is given simply by (SA) X (Probability of death). So what an insurance company looks at while deciding whether to offer cover to a person or not, and how much cover to offer is this value at risk.
The reason is, an insurance company finds it imprudent to take a disproportionately high bet on a single life; it is better to distribute the risk assumed over a large number of lives. By limiting coverage and thereby reducing exposure to large claims, the company can also minimise consequences of adverse selection.Good underwriting is the key to the success of a term insurance plan – because it makes the plan equitable to all the policy holders and viable to the insurance company.
I have gone into the finer details of how the underwriting level decision making in an insurance company takes place so that the readers are able to better understand what an insurance company communicates to them when they ask for a Term Plan, and can take enlightened decisions themselves.
