Life Insurance Pricing and Ratemaking

Types Of Life Insurance Contract

An important aspect to consider when performing pricing or ratemaking functions for an insurance contract is the type of contract involved. Broadly speaking, there are 3 types of life insurance contract:

• Term life insurance policies have a specific term length such as 10 or 25 years and life insurance coverage expires at the end of this period. Because this coverage is “temporary” in nature, the risk of unforeseen consequences that may affect the insurer’s financial position is less than the insurer bears under permanent insurance contracts described below. Under these contracts, the death benefit is usually the most significant benefit and payments on surrender of the contract are usually insignificant;
• Permanent life insurance contracts are similar in many respects to term insurance policies but have one important difference – there is no specific expiry date. As a result, barring voluntary discontinuation by the policyholder, the risk under these policies is borne by the insurance company until the policyholder dies;
• Universal life insurance contracts have become more significant in in the past 50 years or so. Under these contracts, the gross premium is usually (after deduction of a specified percentage) paid into an investment fund or funds that are under the control of the policyholder. The insurer will then (usually at monthly intervals) deduct specified charges from the funds to cover the cost of administering the contracts as well as the loss experience due to death or other benefit claims. These deductions may be varied from time to time by the insurer to offset significant changes in its losses or expenses incurred in connection with these policies On death, surrender or maturity of the contract, the residual fund balance is paid to the designated beneficiaries.

In addition to benefits paid on death, many life insurance contracts also pay benefits in response to disability of the insureds as well as in the event that a “critical illness” (such as a stroke) is experienced. This means that the cost of the life insurance must adequately reflect the future cost of these additional events.

Generally speaking, the fact that the insurer cannot vary its charges under permanent or term policies means that these contracts are high risk in nature compared to universal life policies.

For term or permanent life insurance contracts, the total cost to the policyholder is reflected in the life insurance premiums paid under the contract. For universal life policies, the cost to the policyholder is a function of the charges deducted (from the premiums or the investment fund) during the currency of the contract.

For term contracts in particular, competition between insurers tends to be based on the premium that must be paid for a specific coverage level. For competitive reasons therefore, insurers sometimes subdivide the total group of insureds into subgroups and apply different class ratings to each subgroup based on factors such as the medical exam results or lifestyle choices (e.g. smoking habits) of that subgroup.

Why Is Life Insurance Pricing/Ratemaking Important?

As with any other type of business, correct life insurance ratemaking is critical to the financial success of the organization. However, there are several factors that make correct pricing of a life insurance contract a more complicated exercise than it might be for an organization that sells tangible products:

• Probably the most critical factor is the long term nature of a life assurance contract. The contract can have a duration of several years or even decades. As a result, the magnitude of the cash flows that may occur under the contract (in either direction) can vary considerably depending on the unfolding of economic scenarios. Economic variables such as interest rates or asset prices can have a particularly large effect on these cash flows;
• In addition to the uncertainty of future changes in economic variables such as interest rates or stock prices, many life insurance contracts include financial options that allow the policyholder to reap disproportionately large benefits from specific events such as interest rates falling below specific levels. Much of this type of risk can be mitigated by the use of asset-liability risk management techniques. However, the ability to recognize these scenarios and the optionality they can present, and to correctly include their cost in the pricing of the contract, can have a significant effect on the financial success of a life insurance company. Even if the company is able to hedge these options using financial instruments as part of its asset-liability management strategy, the cost of doing so must be correctly included in the pricing of the contract;
• Unforeseen events that affect general levels of mortality or morbidity (the Covid-19 pandemic, for example) can also adversely affect the performance of a life insurance contract; Much of this risk can be mitigated by means of reinsurance and requiring medical exams before coverage is confirmed. However, the cost of these mitigation measures must be correctly reflected in the pricing calculations. Any residual mortality and /or morbidity risk that must be borne by the insurer must be reflected by incorporating margins in the respective pricing assumptions. To do this, the actuary responsible for the pricing model needs to adopt assumptions for mortality, morbidity and other demographic factors that are somewhat more adverse (or pessimistic) than the currently known levels would suggest. Another way to think of this is the use of assumptions that reflect the expected loss under the insurance contract plus a margin to allow for volatility in that cost around the expected or average levels.;
• To ensure adequate protection for its policyholders, life insurance companies are usually required to hold significant resources on their balance sheets. These resources can be policy reserves that are needed to provide for the average cost of life insurance over in the future. However, in addition to reserves, life insurers must set capital resources aside to cover events that may not be expected to occur in the normal course of events but may still possibly happen. Proper pricing of a life insurance contract requires companies to include provision for the cost of financing the reserve & capital resources that may be needed to support the contractual promises made to their policyholders.
• Because the performance of a life insurance contract can vary so markedly depending on the financial or other scenarios that unfold during its life time, scenario testing is a critical tool that helps the company to recognize and plan for the scenarios that can have the greatest possible effect. Identifying and modelling these effects is one of the areas in which Actuarial Services, Inc. can provide critical support to its clients. In addition to scenario testing, stochastic testing (using probability weighted and automatically generated scenarios) is a critical tool for properly evaluating the long term profitability of a life insurance contract and the cost of the financial options it includes.

How Actuarial Services Can Help

The life insurance pricing/ratemaking services we can offer include the following:

• Developing rates for a new life insurance product to meet stated product performance and/or competitiveness criteria;
• Filing these rates with regulators and responding to technical questions from those regulators on the filing;
• Working with your sales agents, marketing, information technology, customer service and administration personnel to implement your new product;
• Helping to develop marketing materials (including life insurance quotes or projections of product performance used with these materials);
• Repricing an existing life insurance product to ensure it continues to meet its original performance and profitability goals;
• Setting up procedures for monitoring mortality, morbidity and other factors for consistency with the assumptions used in pricing the contract;
• Advising on the reinsurance, hedging and other risk management strategies that may be needed to manage the financial and operational risks introduced by the contract. This includes the development of internal administrative procedures to monitor and manage operational risks.