Annually renewable premium
There are 2 basic methods of determining variable life insurance premiums: the annually renewable premium method and the single premium method. While there are many different types of life insurance policies, their pricing is based on these 2 methods and their variations.
In life insurance, the value of the premium is largely determined by the death rate of the age group to which the insured person belongs. He must pay the proportional part of the death indemnities within his age group and in the period he has chosen.
For example, consider a group of 1,000 50-year-old males who want to take out life insurance for R$100,000 each for 1 year. The IBGE mortality table indicates that, in this group, 0.737% will die before completing 51 years of age. Therefore, an insurer that accepts group life insurance will have to pay an estimated BRL 737,000 per year in death indemnities. This means that it will have to collect RS 737 from each policyholder just to cover death claims, plus operating expenses and profits. By renewing the policy annually, the group will be able to obtain insurance for several years, paying the probabilistically exact premium each year.
Single award for several years
The same group could claim insurance for, say, 5 years at a constant premium. The table shows that the chance of people in the group dying in 5 years (the sum of annual probabilities from 50 to 54) is 4.278%. This would mean that, apart from the interest income that could be obtained by the insurer with the collected premiums (which could deduct part of the fee charged to policyholders), the expectation of payment of indemnities would amount to R$ 4,278,000 (0.04278 times R$ 100,000 times 1,000), which would give a single annual premium per insured person of R$ 857.40 over 5 years. It is easy to verify that this premium is higher than what would be charged if the contract was only for the first year (from 50 to 51 years, R$ 737) and lower than the premium that would be charged if the contract were only for the last year (from 54 to 55 years, that is, R$ 1,053).
Differences in mortality between men and women, young and old, smokers and non-smokers.
The table above shows that the odds of death are higher for men than for women and increase with age. That's why the life insurance premium is lower for women and increases each year the policy is renewed, which can be very expensive for seniors, both men and women.
Some mortality tables go further and separate smokers and non-smokers within each group. This is the case of the “Commissioners Standard Ordinary (CSO)”, in the United States.
It shows that the mortality rate for the subgroup of 50-year-old non-smoking men is 49% lower than that of smokers and 12% lower than that of men in general. If the same were true for Brazil and the group in the example above were non-smokers, the premium would drop from R$737 to R$651. The difference between men and women and between smokers and non-smokers decreases as both approach the maximum age of the mortality tables (in general, 120 years).
Why classify people as men or women or as smokers and non-smokers when calculating insurance premiums?
In addition to the issue of fairness, insurers seek to rank risks more accurately due to a phenomenon called “adverse selection”. If an insurer charges the same rate for
all people in an age group (men and women, smokers and non-smokers) it is likely that people at lower risk will perceive that they are paying more, subsidizing those at higher risk, and will refuse insurance.
This concentrates in the group the people with the highest risk who will generate a higher loss ratio for the insurer and, hence, less profit or, what is worse, loss. The insurer is then said to have undergone an adverse selection process due to the fact that it has set the same rate for both high and low risks.
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