How life insurance premium rates are set

To an outsider, it all looks so simple. You answer a few questions about yourself and, by return, life insurance quotes come back. This hides the fact that generations of statisticians called actuaries have been collecting information about our lives to be able to estimate life expectancy. So what exactly do actuaries know that helps them set the annual premium rates?

To help you understand the process, here's a simple example. Suppose you're twenty-five years old and the average life expectancy is seventy-five. This gives you fifty years to pay into a fund. Now let's say you think your family will need at least $100,000 to cover your funeral expenses and pay off whatever debts you have. If you divide the target amount by the estimated number of months:

100,000 / 600 = $166.67

Theoretically, if this was straight savings plan, you would pay $166.67 per month and this would produce the actual cash amount. Except life insurance is supposed to be more than a savings plan. The insurer is expected to invest the cash it receives and this generates an annual income which is added to your payments. This compounds over fifty years and produces an amount rather greater than $100,000.

If you start at $0 and pay $2,000 per year for fifty years and the insurer adds 2% interest a year, this produces a total of $172.541. If the insurer managed to add an average of 4% per year, you would have a total of $317,547.

The difference between the two amounts explains why life insurance companies give you a guaranteed amount and an estimated amount as death benefits. However, the insurer is a for-profit company and therefore takes a percentage of your premium payments as a management fee. The investment income may also vary from year to year. You will remember the stock market crashed in 2008 and is only now recovering. Interest rates are also poor because of quantitative easing, i.e. the Fed giving away almost free money to the banks. So some years, the value of your invested fund may fall, and in other years it may rise. This makes predicting the actual value in fifty years time difficult. That's why premium rates tend to be set slightly higher than you might expect and guaranteed minimum payouts seem quite low. Insurers like to give themselves a margin for error.

So the actual amount you will be asked to pay will be based on the mortality and sickness tables produced by the actuaries but changed to reflect your own family's medical history. Life insurance companies make the best estimate they can about when the claim is likely to be made. So even though the average life expectancy may be high, your family may have a history of cancer. That means your life insurance quotes will come in higher to reflect the risk of an earlier death.