Insurance premium rates
The amount of money that a customer pays on a life insurance policy is based on premium rates. When life insurance companies establish premium rates, they list the rate as the cost per coverage unit--for example $2 per $1,000 of coverage. Many factors go into calculating what the correct premium rate should be, including cost of benefits, investment earnings, expenses and the insurance company's profit.
Cost of Benefits
Calculating the cost of benefits
The cost of benefits is simply the amount that the insurance company has to pay to the policy owner multiplied by the probability that the benefit will be payable. The insurance company has to pay the benefit that the policy specifies. For example, if your insurance policy states that the benefit that will be paid to you is $1,000, the insurance company will have to pay $1,000.
The insurance company uses mortality rates to calculate the probability that a benefit amount is payable. A mortality rate is the rate of death for a particular segment of the population each year. To calculate the cost of benefits, an insurance company uses the following formula:
Cost of benefits = benefit amount x mortality rate.
Investment Earnings
Setting money aside to earn a return
When an insurance company receives a premium, it invests the money. The insurance company estimates the rate of return it will earn on the premiums paid by the policy owner. This amount is multiplied by the number of years the policies will be in force to get the investment earnings. The insurance company then takes the total amount of benefits payable and subtracts the expected investment earnings to get the amount it must charge the customer in premiums.
Expenses
Insurers must account for expenses.
When a policy lapses or is canceled, the insurance company doesn't collect enough money to offset the costs of issuing the policy. To take this expense into account, the insurance company uses the lapse rate--the rate of policy cancellations. Based on the amount of policies the insurance company thinks will lapse, the insurance company adds an amount to an insured's premium to cover the costs incurred to issue policies that are then later canceled.
Gross Versus Net Premium
The net premium is the cost the insurance company incurs to provide policy benefits. Net premiums could be expressed in a formula, as follows:
Net premium = cost of benefits + investment earnings + expenses (for lapses)
However, the insurance company must add more to the premium to cover all the costs of doing business. This is called "loading," and it includes things such as paying salaries and commissions, maintaining an office, making a profit and paying taxes. The gross premium is the net premium with loading added on. The gross premium is what you as a customer pay to the insurance company.
Premium Amount
The premium paid is based on the premium rate and amount of coverage
If your insurance company calculated premium rates as $2 per $1,000 of benefits and you wanted $20,000 of coverage, you would calculate your premium as follows:
Number of insurance units = amount of coverage/coverage base unit
Number of insurance units = $20,000/$1,000, or 20 units
Premium amount = $2 premium rate (per $1,000 coverage) x 20 units
Premium amount = $40
