Fundamentals of Life Insurance
BASIC CONCEPTS AND DEFINITIONS
Insurance can be defined as an economic device that provides financial protection against a possible unexpected loss. This arrangement works by estimating the cost of all the potential losses that can be experienced in a group of insured people (insurance pool). This cost is then transferred back to the insured group. The cost of losses is redistributed by collecting a premium payment from every participant (insured) in the system. In exchange for the premium payment, the insurer promises to pay the insured’s claims and compensate the loss in the event of occurrence of the loss. Since only a small percentage of insureds actually suffer losses, the insurance companies effectively manage to compensate the losses, financially, using the premium collected. Thus, insurance involves the transfer of the cost of loss to an insurance pool and the redistribution of losses among members of the pool.1
Figure 1.1 illustrates this principle of pooled risk sharing which forms the basis of all types of insurance.
FIGURE 1.1 Principle of risk sharing—an illustration.
In the case of life insurance, the loss is in terms of loss of income for the family due to death or permanent disability of the insured person. Therefore, life insurance is defined as follows: Life insurance provides a sum of money called death benefit on the death of the insured person in return for small periodic payments called premiums. For example, if an insured member of the pool pays Rs. 20,000 annual premium to the insurance pool for Rs. 10 lakh of life insurance (also called sum assured, face amount or death benefit), the insurer (insurance company) will promise to pay Rs. 10 lakh in case of death of the insured. Without insurance, the unfortunate family would lose the income generated by the insured for all the years he would have earned. Death cannot be predicted, but the study of deaths in a population, over a period of time, helps in building data in the form of mortality tables which give the percentage of deaths in specific age groups in a population. The premium is calculated according to the mortality rates in a population and is expressed per Rs. 1,000 of sum assured. For example, if the premium rate for a 30-year old is Rs. 0.02 per Rs. 1,000 sum assured, and if a person aged 30 buys an insurance policy of sum assured 10 lakh, he/she will have to pay 10,00,000 × 0.2 = Rs. 20,000. 1.2
ORIGIN AND DEVELOPMENT OF LIFE INSURANCE Life insurance has its origin in ancient Rome, where people formed burial clubs to meet funeral expenses. As civilization progressed in Europe, social institutions and welfare practices got more refined. With the discovery of new lands, sea routes and consequent growth of trade, merchant guilds in medieval times took it upon themselves to protect their traders from loss due to fire, shipwreck and so on. Since most of the trade took place via sea routes, there was a constant threat of pirates. So, these guilds even offered ransom for members held captive by pirates. Burial expenses and support in times of sickness and poverty were other services offered. Essentially, all these revolved around the concept of insurance or risk coverage. In 1347, in Genoa, maritime European nations entered into the earliest known insurance contract and decided to accept marine insurance as a practice. Insurance in India can be traced back to the Vedas. For instance, Yogakshema, the name of Life Insurance Corporation of India’s corporate headquarters, is derived from the Rig Veda. The term suggests that a form of community insurance was prevalent around 1000 BC and practiced by the Aryans. Bombay Mutual Assurance Society, the first Indian life assurance society, was formed in 1870. Other companies like Oriental, Bharat and Empire of India were set up in 1870–1890. It was during the Swadeshi Movement in the early 20th century when insurance sector witnessed a boom in India with the set up of several more insurance companies. As these companies grew, the government began to exercise control on them. The Insurance Act was passed in 1912, followed by a detailed and amended Insurance Act of 1938 that looked into investments, expenditure and management of these companies’ funds. By the mid-1950s, there were around 170 insurance companies and 80 provident fund societies in India. In the absence of regulatory systems, however, scams and irregularities were almost a way of life in most of these companies.
As a result, the government decided to nationalize the life assurance business in India. The Life Insurance Corporation of India (LIC) was set up in 1956 to take over around 250 life assurance companies. Thereafter, insurance remained monopolized by the public sector. It was only after seven years of deliberation and debate in 2001—when the R.N. Malhotra Committee Report of 1994 became the first document calling for the re-opening of insurance to private companies—the insurance sector was finally opened to private players. The Insurance Regulatory and Development Authority, an autonomous insurance regulator set up in 2000, has extensive powers to oversee the insurance business and regulate it in a manner that will safeguard the interests of the insured.
1.3 HUMAN LIFE VALUE CONCEPT Insurance works on the mechanism of pooled risk sharing. Insurance companies recognise the loss, be it loss of life, health, home, car, business, income or profit and utilise pooled resources to indemnify the loss. By its very nature, life insurance encourages the individual to be socially responsible. It emphasizes both the immediate and the long-term benefits of acting responsibly towards dependent individuals and society. Dr. Solomon S. Huebner, father of modern life insurance, established the concept of human life value as the economic and philosophical framework of life insurance. Huebner’s concept of the human life value is more than just a proposition that human life has an economic value. Conceptually, human life value involves several important concrete elements, among the following socioeconomic relations and characteristics: Human life value is the capitalized value of an individual’s earning that supports family members, dependent loved ones and business partners. The value of one life in relation to another is the foundation of life and health insurance. The monetary value of a human life is derived from an individual’s talents and the will to put them to productive use. Huebner contended that human life values greatly exceed all property values in importance. Without human life values, there would be no property values. Life insurance allows individuals to pool risk and share costs to protect the dependents from impoverishment, without passing on this responsibility to their community and society. This pooling and sharing illustrates that the basic principle of life insurance is cooperation. Life insurance is essentially a social instrument that cares for individuals. It recognizes the value of the human life. No other financial product recognizes this concept in its individual and social dimensions. Next to the government, life insurance is the chief provider of social and economic security.
2 1.4 PRINCIPLE OF INSURABLE INTEREST In order to help insurance to operate effectively, the insured should have an incentive to prevent or at least regret the loss. If the insured is indifferent to loss then the insurance pool will experience more loss than predicted. The increased losses, in turn, will require higher insurance premiums. Because of which many insured will not be able to afford insurance and the system will collapse. Insurance law, therefore, requires insureds to demonstrate that the insured event represents a loss to them. For non-life or general insurance, 3 when insuring a property, it is vital for the insurance company to establish that the individual who has taken the insurance policy for a property has an insurable interest in the property. The policy is, therefore, issued only if the applicant is the owner of the property and stands to suffer a direct personal financial loss in case there is any damage to the property. In life insurance, an applicant4 (also called proposer) is the owner of the policy when he5 applies for insurance on his own life or when he applies for or proposes insurance on another person. If he buys a policy on his own life, as per insurance law, a nominee6 has to be named, who is entitled to receive the death benefit on his (insured) death. People are assumed to have unlimited insurable interest in their own lives and, in such cases, the insurer checks the relationship with the nominee to determine insurable interest. If an applicant proposes life insurance on another person, he (the applicant/proposer) is entitled to receive death benefits on death of the insured person. In such cases, insurable interest between the insured and the policy owner must necessarily exist to have a valid contract. The law recognizes the following relationships to have insurable interest:
(i) Husband and wife in each other’s life
(ii) Parents on life of their children
(iii) A creditor has insurable interest in the life of a debtor to the extent of the amount involved plus a reasonable amount of interest.
(iv) Partners in a business have insurable interest in the lives of their copartners.
(v) A company has insurable interest in the lives of the key employees of the company.
Though it is said that a person has unlimited interest in his own life or the life of his spouse, it may be noted that insurable interest must be a pecuniary (economic) interest, and it is measured by the extent of financial loss which the family of the insured will suffer in the event of his death. Thus, insurable interest, in cases where the insurance is on self or spouse, is limited to the extent of monetary loss of income to the family on death of the insured. In cases where a company proposes insurance on the life of a key employee or partner, the insurer has to make sure that the death benefit amount does not exceed the estimated loss to the company in the event of the insured’s death. Insurance companies follow a structured approach to evaluate the suitable amount of insurance that can be offered to individuals or business applicants. This topic is discussed in
Chapter 5.
1.5 LIFE INSURANCE PREMIUM Like all products, the price of a life insurance product is based on the costs of providing the product, plus a margin for profit. The matter of premium pricing is complicated in insurance since the insurer does not know in advance the exact amount or definite timing of the largest cost element, i.e., the amounts to be paid as claims to those who suffer the loss. Claims can only be estimated. Actuaries, who are specialists in the mathematics of insurance, carry out prediction of future costs of loss and their timing, as well as adding necessary margins for expenses and profit to those predictions.
1.5.1 Components of the Insurance Premium The following are the four building blocks that constitute insurance premiums: (i) Actual cost of losses (claims to be paid out based on mortality rate in the population) (ii) Expenses of operating and maintaining insurance pool (iii) Allowance for unexpected loss (iv) Earnings on investment of collected premiums The insurance premium is the price charged for coverage the policy provides. It includes all the four components discussed above. The price charged for each unit of coverage (exposure unit), which the policy provides, is also called the insurance rate. In life insurance, the unit of coverage is Rs.1,000 of the face amount. The premium is the rate multiplied by the number of units of coverage. For example, in life insurance, the rate for a particular category of insureds might be Rs. 30 per Rs. 1,000 of face amount per year. Therefore, the annual premium for a Rs.5,00,000 policy is: Rs. 30 × 500 units = Rs. 15,000. First, the rate is derived from a pure (net) rate which is based on statistical analysis of past loss (mortality) data for each age group of insureds, and a projection of that loss experience into the future time. Then, a factor called loading is added to cover the insurer’s anticipated expenses, and to provide a margin for profit and contingencies. The sum of pure (net) rate and loading is called the gross rate.
7 The insurance company has a table of gross premium rates for the average insured population for each product line.8 The pure premium, as mentioned earlier, is a function of the average lifespan of individuals in a population and their death rates. Insurance companies use mortality tables9 to estimate how long an average person of a given age is expected to live. These tables are based on trends followed among large number of people, and cannot, obviously, predict how long any one particular individual will live. The mortality table lists the probability of death for persons of all ages till they reach their next birthday. This probability, given as (qx) in the table, is calculated by a mathematical formula which uses the number of people alive at the beginning of the age interval and the number dying during the age interval. The mortality table represents the death rate for a person of a specific age with average health. It is not possible to have different mortality tables for people from diverse backgrounds with varied habits and different conditions of health. Therefore a standard mortality table representing life expectancy of an average individual in the country is used by insurance companies. For those who do not conform to this standard due to bad health or other reasons, the premium is adjusted based on the mortality they are likely to experience. Such people are assigned a different risk class at the stage when they apply for life insurance. This is done through a risk selection process, which is explained in detail in subsequent
Chapters. Insurance companies rely on actuarial mathematics to compile data based on the mortality tables, and develop gross insurance premium rates for different products. Actuaries review past statistics, and project future results, and using the data from mortality tables, predict how many people who are insured by the company, will die in a given year. They also predict the expenses of the company and interest earnings on premiums received by the policy owners to develop a final premium table for each product. Good risk selection and classification lie in ensuring that only those applicants, who have an average risk of death, are given insurance at the normal premium rates, according to the premium table, and those with higher risks are charged higher.
1.6 LAW OF LARGE NUMBERS Another important factor to obtain a predictive accuracy of loss in an insurance pool is the need of a substantial number of individual units. This is called the law of large numbers. It states that an insurer’s or an insurance company’s loss prediction becomes more accurate as the number of insureds in the risk pool increases. Each group or class of risk must also have a sufficient number of people in the class to have an accurate loss outcome similar to the probability of loss. In other words, if an insurance company expects 1% of its members to experience a loss, based on historical records of losses (such as mortality data), the law of large numbers states that the greater number of people in the insurance pool, the more likely is the loss to be around 1%.
1.7 TYPES OF RISKS The word risk has many connotations.
In the life insurance perspective, it denotes the degree or probability of loss. Therefore, a person who is suffering from cancer, is supposed to be at a greater risk as his death probability is more as compared to a healthy person. Fundamentally, risks are categorized on the basis of possible outcomes of an event. Risks can be divided into two—pure risks and speculative risks. Pure risks are those, which would not result in any gain. Speculative risks are those where there might be gain or loss due to the event. Risks of death, injury or damage to property are pure risks as these events invariably cause losses to the sufferer, and do not attribute any gain. Risks taken in investing in the stock market or in gambling are speculative risks as they may result in either gain or loss in the transaction.
Insurance can be taken only on pure risks. Speculative risks are not insurable (uninsurable). An insurance policy taken with an intention of gaining from it is called a wagering (gambling) contract and is invalid as it goes against the concept of insurable interest. As explained earlier, to ensure the insurable interest, life insurance companies ascertain that beneficiaries of the policy have a monetary interest in the life of the insured, and the amount of insurance does not exceed the extent of loss. Lack of insurable interest in an insurance contract makes the policy invalid even if a life insurance company inadvertently issues such a policy.
1.8 MORAL HAZARD The insurance company uses a host of information to select and classify the applicants for life insurance policies. Most of this information comes from the applicant himself. Thus, risk assessment cannot be accurate if the applicant lies, conceals or withholds information. Hiding or distorting information (nondisclosure or misrepresentation) affecting risk appraisal may lead to an increase in the probability of loss experienced in the insurance pool. Any act of an applicant aimed at hiding financial information, overstating income, understating age or being dishonest about health and other variables that affect risk assessment is called moral hazard.
1.9 RISK SELECTION IN LIFE INSURANCE: THE UNDERWRITING PROCESS In a broad sense, underwriting refers to the process that a large financial service provider, either a bank or an insurance company, uses to provide access to products such as credit (loan) or insurance to a customer. Historically, the term originated from marine insurance, and was used in its literal meaning where the person who assumed liability for damage to the ship or its cargo during transit would sign his name at the end of the agreement.
This trend of writing under the agreement, to share or assume the risk liability or loss led to the term underwriter. With the passage of time, the individuals were replaced by companies who were ready to take on a part of the risk (probability of loss). However, the term underwriter continued to mean the same—someone who selected or rejected risks. In the banking sector, underwriting is concerned with detailed credit analysis preceding the granting of a loan, based on information furnished by the borrower such as employment history, salary and financial statements. In life insurance companies, the underwriting process is one of the most important processes. Unlike the banking industry, where the bank is compensated in case of non-payment of the loan through guarantors or collaterals, such protection does not exist for the life insurance business.
Underwriting is a method of evaluating and assessing each life insurance application to determine whether the applicant can be insured and, if so, at what premium rates. The underwriters are the assessors of risk and take decisions on every case (application) that comes to their desk. The sale of a life insurance policy is not complete till the application is underwritten. No proposal for insurance can be accepted without an analysis by the underwriters who decide whether to accept the risk or not. Underwriting consists of two processes, the selection process and the classification process. The selection process evaluate the applications to gauge whether the applicant can be insured or not. Individual applicants who are deemed as acceptable risks represent varied profiles, backgrounds and health conditions. Therefore, a classification process is used to determine the degree of risk of every applicant, and each applicant is assigned a particular risk category known as risk class.
By classification, underwriters ensure that insured individuals with homogenous loss potential (i.e., similar probability of death) are placed in a distinct class, paying a premium corresponding to the degree of risk they represent. The basic principle behind the underwriting process is higher the risk, greater the premium. Each class of insured individuals bears a fair share of losses and expenses in proportion to the overall group of insured people (insurance pool) in the company. The classification process of underwriting has mathematical implications. If an underwriter places an insured, representing a certain risk level, in a higher risk class than appropriate, then the insured ends up paying more than his share of the fair price. This means that the insured is actually subsidizing the cost of insurance for others in the risk pool, which makes insurance unfair and inequitable for people in the insurance pool. Albeit, it must be noted that some degree of subsidization will occur since the risk classes represent a large number of insureds who are unique individuals, and would differ even though the risk class is defined based on many of their similar characteristics. The underwriting process primarily involves the evaluation of financial and medical information to determine insurability. Underwriters seek out those characteristics that can increase the client’s risk of disease or accident. They also watch out for any indication of trouble in client’s financial situation that can lead to lapse of the policy or even fraud. (see Fig. 1.2).
FIGURE 1.2 Key risks for life insurance purposes.
1.9.1 Risk of Disease As shown in the mortality table in
Appendix II, mortality increases with the increase in age. The age is the fundamental factor affecting risk of disease (represented graphically in Fig. 1.3). This is due to vulnerability to various diseases associated with increase in age. This risk is managed by the increasingly higher premium rates, for each year of advancing age, as seen in the premium table chart in Appendix I.
FIGURE 1.3 Age-An important risk factor for insurance The risk classification process requires the underwriters to determine any deviation from normal health of the applicants and placing them in different risk categories. The underwriter searches for information in the application form that impacts the lifespan of a person and increases the likelihood of death. Diseases such as heart disease, cancers etc. are known to decrease lifespans, therefore, any indication of such diseases in the application form is thoroughly investigated by the underwriter. The underwriter also looks for potential factors (information) that might cause the client to suffer from a disease at a later stage. For example, if a woman applies for insurance and mentions in the application form that her sister and mother both have had breast cancer, the underwriter may charge an extra premium as medical research proves that the risk of breast cancer increases if a person’s family members have suffered from it. Table 1.1 lists some indicators present in application forms that can be a sign of increased risk of disease.
TABLE 1.1 Indicators of Disease Risk The underwriter ignores the history of diseases that do not affect lifespan such as common cold, minor skin diseases, etc. If the client is suffering from a very serious disease or critical ailments, and death is almost certain, the underwriter rejects the application and the company does not issue any life insurance policy. Individuals who have advanced stage cancer or are HIV (Human Immunodeficiency Virus) positive are usually declined life insurance. In some instances, complicated cases of heart disease or diabetes also result in rejection of an application.
1.9.2 Risk from Accident The other risk that the underwriter looks for is the presence of an increased probability of risk of accidents. Though any individual can meet with an accident irrespective of social status, health or age, but certain services, occupations or hobbies increase the risk. Bomb disposal experts, circus trick performers and mine workers are some examples of people with increased risk of accidents which enhance the probability of death due to their jobs. People with adventure sport hobbies such as sky diving, gliding, scuba-diving etc., are also carefully evaluated by underwriters to assess their potential risk of accidental deaths. The region or country of residence can also increase the risk of death or disease due to riots, terrorism and land mines. Table 1.2 lists risk factors that increase possibility of disease or accident in life insurance applicants.
TABLE 1.2 Comparison of Risk Factors of Accident and Disease 1.9.3 Risk due to Financial Reasons Another factor that can give rise to potential losses to the company is the client’s financial inability to pay the premium, which may lead to discontinuation or lapse of the policy. High number of policy lapses affects the insurance company financially, as there is a high acquisition cost associated with the sale of an insurance policy. Aspects of insurable interest and moral hazard have to be kept in mind while underwriting to ensure that the insurance amount is commensurate with the applicant’s actual financial worth. Forgery is not uncommon in financial documentation. Applicants may attempt to get higher amounts of life insurance issued with intention to defraud. Some cases of suicide by life insurance policyholders have also been documented. In situations of acute financial distress, the policyholder may commit suicide so that the life insurance benefit can be used by their families (nominees) to get out of the financial crisis. There have also been cases where clients have fabricated stories of their own death to claim life insurance death benefits. The financial well-being of the client is assessed to ensure that he has enough funds and resources to pay the premiums and to guard against fraudulent claims due to deaths as a result of financial problems.
Table 1.3 enumerates the possible causes that increase risks of lapse or fraud.
TABLE 1.3 Causes of Financial Risks
UNDERWRITING RISK CATEGORIES The previous section has enumerated the types of risks that the underwriter evaluates to arrive at an underwriting decision. Based on evaluation of these risks, the underwriter’s aim is to protect the company against loss and early claims by placing insureds in appropriate risk class/category and charging extra premiums for higher risk classes/categories. If a particular applicant’s risk of death is so high that the probability of death in effect becomes a certainty, the person is no longer insurable (uninsurable). Lack of insurable interest can also result in rejection of an application by the underwriter. Underwriters divide life insurance applications into three broad categories of risk, i.e. standard risks, substandard risks and rejected risks (see Fig. 1.4).
1.10.1 Standard Risks When the underwriter, after careful examination of potential risks, finds that the client does not have any additional risk (i.e. the risk or chance of death is the same as expected for an average individual of that age as per the mortality table) then the policy is issued at regular premium rates (standard rates). This premium is the same as given in premium tables of the insurance company.
1.10.2 Substandard Risks The life insurance application process was not very sophisticated in the beginning. To get a life insurance policy it was sufficient for a person to appear before the board of directors who assessed his health by appearance, and issued the policy if they found that he looked healthy. With the advancement of medical science and emergence of new diagnostic techniques, it was possible to test the applicant for insidious health problems. If untested such an applicant would be issued the policy at standard rates. This kind of miscalculation would lead to an increase in the number of claimed and affect the profitability of the company. Therefore, a system of medical examination was evolved and the process of medical tests for life insurance policies came into being. From the result of medical tests and examinations for each applicant, it was found that the health status of applicants ranged from slight unhealthy to serious unhealthy conditions. Different classes of substandard risk classification and a system to determine extra premium for each substandard group was consequently devised. Hence, when the underwriter finds an additional risk and a higher probability of death in an average individual as compared to other individual of the same age, the percentage of extra risk or extra mortality is calculated for the particular risk.10 The underwriting manuals form the backbone of the system to calculate the extra premium. It lists almost all possible causes of death by diseases or accidents, and also gives the Extra Mortality Rate (EMR) for each condition. The mortality data available from life insurance, epidemiological studies and clinical literature over the years have been used to determine the effect of various factors on human lifespan. Underwriting manuals have been compiled based on these data. The manuals are continuously upgraded to reflect the changes in disease patterns and mortality predictions.
1.10.3 Rejected Risks-Declined and Postponed Risks If the health of the client is very poor and the probability of death is very high life insurance companies do not offer insurance to the applicant and the case is declined (rejected). Diseases such as cancer, Human Immunodeficiency Virus (HIV) infection, kidney failure etc., fall in this category. The list of such diseases, which are commonly not accepted for insuring applicants by life insurance companies are given in Chapter 5. Sometimes the underwriter decides to postpone a case. This means that the client cannot be insured at that point of time. However, he can be insured at a later date based on fresh medical tests. Figure 1.4 Underwriting risk categories.
1.11 PREFERRED RISKS Some companies have a preferred rate where an exceptionally healthy person can get a lower than normal premium. In general, preferred rates are offered to applicants in excellent health, with few risk factors.
1.12 RISK CALCULATION PRINCIPLES The basic principle for risk calculation is to assign a numerical value to each factor that determines longevity. Average mortality as per mortality table for each age group is taken as 100. Debit points are given for unfavourable factors like tobacco use, pre-existing health conditions and weight problems etc. Credit points are given for favourable features like proportionate body weight, normal blood pressure and healthy family history. Based on this, the net rating is calculated. The excess of this rating over 100 is the Extra Mortality Rating (EMR) for that applicant. Figure 1.5 illustrates the EMR calculation with an example.
Figure 1.5 Life insurance risk calculation. Based on the above system of rating, insurance companies classify individual applicants into different risk classes with EMRs in sets of 25. Therefore, the different substandard risk classes into which the underwriter classifies risks are +25, +50, +75, +100 and so on. The insurance companies charge additional premium for each particular EMR, which is called rating is based on a specific formula. This formula is a combination of applicant’s age and the product he has applied for. The higher premium rate (substandard premium rate) is charged in order to provide the possibility of shorter than average lifespan of the substandard client. Most of the applications for life insurance are issued at standard premium rates, only a small number of applications are given substandard rates and even fewer are declined or postponed. More than 90% of insurance policies are issued at standard rates. The rest are either substandard or rejected (refer to Table 1.4). Companies track the ratio of standard, substandard and rejected cases because excessive number of rejections or substandard policies affect the morale of the sales force. It also increases cost of doing business and causes loss of goodwill among the insurable public.
TABLE 1.4 Distribution of Underwriting Risk Categories.
REVIEW QUESTIONS 1.1 Fill in the blanks with appropriate terms. (a) Life insurance provides a sum of money called ___ upon the death of the insured person in return for small periodic payments called ___. (b) The ___ is calculated according to the mortality rates in a population. (c) ___, the name of Life Insurance Corporation of India’s corporate headquarters, is derived from the Rig Veda. (d) ___, an autonomous insurance regulator was set up in 2000. (e) ___ is the capitalized value of an individual’s earning that supports family members, dependent loved ones, and business partners. (f) The risk selection and classification process of applicants in life insurance is called ____. 1.2 Give the answers in brief. (a) What is insurable interest? (b) Which relationships are recognized as having insurable interest? (c) What are the four building blocks of life insurance premiums? (d) What is the law of large numbers? (e) What is moral hazard? (f) What is underwriting? Answers 1.1 (a) death benefit, premiums (b) premium (c) Yogakshema (d) The Insurance Regulatory and Development Authority (e) Human life value (f) underwriting CHAPTER 2 Legal Aspects of Life Insurance and
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