How Do Life Insurance Companies Calculate Their Premiums?

Finance is largely about risk. An investment is the process of taking risk, and expecting a potential return for that risk. Most people focus on the reward part, but they forget about the risk until it is too late. In a world of endless government and corporate bailouts, it’s easy to forget that risk really does have consequences.

We all know the risk of death is always there and each family has a different way of handling that risk. When the risk of death of a family member become a financial concern, it is smart to transfer that risk to a third party, and this is what life insurance is all about. Financial loss due to death is a catastrophic event for most families, and insurance companies, for a fee, take on that risk of loss.

You don’t get your premiums back

The biggest complaint against life insurance is that you don’t get a return on your money. If you don’t make any claims against your policy, if you don’t die, shouldn’t you get your premiums back? After all, the insurance company didn’t pay anything out.

The fact is, if you made no claim against the policy, those premium dollars were still paid out, they just weren’t paid to you. One way to look at the process of transferring risk is to think about it as sharing risk with others. Let’s say you are 45, female and a non-smoker and you decide you need to ensure your own life for $500,000 for one year.

To determine the amount of premium required to cover the risk, the insurance company will place you in a risk class. We’ll keep this example simple, let’s say they also have 999 other 45 year old females, also non-smokers, all purchasing $500,000 of death benefit around the same time as you. How much will they pay out in the next year?

Insurance companies have very accurate data going back hundreds of years that help them determine the risk of loss. Take a look at the chart below.

Find age 45, trace over to non-smoker and female. The mortality risk for this class is 1.05. In other words, out of 1,000 45 years old non-smoker females, 1.05 of you will not make it to the next year. The insurance company now knows that it will most likely have to pay out a statistical average of $525,000 for those 1,000 policies in your risk class. With 1,000 people paying premiums, they need to charge $525 ($525,000 ÷ 1,000) just to cover their risk. They need to make a profit too, so their actual premium is probably larger than this.

Risk gets higher as you get older

Now that you understand the basics for a 45-year-old, look at some of the other ages. A 60 years old non-smoker female has a mortality rate of 3.55. So out of 1,000 45-year-old females, 1.05 will die, but out of 1,000 60-year-old females, 3.55 will die in the next year. The risk is higher so the premium needs to be higher.

Men are riskier

Take a look now at a 45-year-old male non-smoker. Mortality rate is 1.83 versus 1.05 for a female. Risk of death for a 45-year-old male is 74% higher. But look at a 20-year-old; 0.89 for males and 0.33 for females. At age 20, males have a mortality 170% greater than females. Why? The answer comes down to the fact that, in their 20s and 30s, men are more likely to die of the number one cause of death for people under 45, car accidents. In fact, for men, mortality risk is almost twice as high for a 20-year-old than for a 30-year-old, which is not the case for women.

Another thing to note on the chart, mortality and thereby cost of insurance is much higher for smokers.