There is a lot of speculation in the news of term insurance premiums for new policies going up by 15-20%. In this article, we investigate this and break down the problem into how term insurance policies price policies, why the premium might be going up and what can insurers do about it.
The event that stirred the pot (or hornet’s nest as you make like it) was an LIC Media conference. This is where the representatives of India’s largest life insurance companies gave indications that term insurance premiums are likely to go up very soon. The statement was not specific to LIC but for the entire life insurance industry.
I have a video of the same. Watch from 00:50 seconds onwards.
Very soon this news was picked up by media houses and news agencies singing the same tune. There were news items in Livemint, Moneycontrol, Deccan Chronicle, Business Standard, Times of India, CNBCTV18 etc.
This got me curious
So I made a few calls and met a few insurance company representatives. I gathered a whole bunch of information to see if we can make sense of what is exactly going on.
How Life Insurers arrive at the Term Insurance Premiums?
A good place to start our analysis is to have an understanding of the pricing rules of term insurance premiums
A term insurance policy is a very long term contract running into 30, 40 or even 50 years. This means that the insurance or reinsurance company takes a fairly high amount of risk with the assumptions. These assumptions are the root of the four pricing elements used in arriving at term insurance premiums.
There are four variables that are considered by the life insurance companies in pricing their term insurance plans. These pricing factors in life insurance contracts are –
- Cost of Mortality
- Operating Expenses
- Lapse and Persistency Rate
- Investment Income
Let’s look at each of these in greater details
1. The Cost of Mortality
The mortality cost is that part of the premium that is the charge on basis the probability that the policyholder will die at a particular age.
This cost is the most important component in determining term insurance premiums with a 50% to 70% weightage.
We’ll discuss more on this later in this post.
2. Operating Expenses of the Insurance Company
Operating expenses includes the day-to-day costs of running an insurance company. The major operating expenses include:
- Marketing costs
- Underwriting costs
- Policy creation costs
- Distribution expenses
- Post-sale servicing expenses and
- Claim disbursement expenses
The nature of the operating expenses can be different from different life insurance companies. Insurance companies who primarily distribute via banks will have a different cost structure. While those who agent-driven distribution nodes (LIC) have a distinctly different cost structure. Some insurers with heavy bancassurance programs are ICICI Prudential Life , HDFC Life, Canara HSBC Oriental Bank of Commerce Life and Max Life Insurance.
3. Lapse Rate or Persistency Rate
Lapse rate is the inverse of Persistency Rate. I mention both in this post because some insurers use lapse rate while other use persistency as their internal metric.
The lapse rate is an assumption.
This is where the insurer is guesstimating how likely is it that a policyholder will stop paying premiums in the future.
The lapse rate is not always a bad thing for the insurer.
Look at it this way. You bought a term life insurance plan at the age of 30 years. The chance of you meeting your death at the age of 30 was very low, say 0.2%. Now, you continued to pay premiums for the next 35 years. At the age of 65 years, your chances of dieing within the year is much higher, say 8%.
If you were to stop paying your premium at this age of 65 years, the life insurance company does not need to pay any benefits to your family upon your death. In other words, the entire premium you paid from age 30 to 65 years is a profit to the insurer.
Got the picture?
Crudely put, young term insurance buyers lapsing their policy is bad for business. But older term insurance policyholders lapsing is actually good for the insurer’s business.
Most insurance companies operate at a 5 year persistency level of between 60-65%. In other words, 35-40% of the consumers who bought a policy in year 0 will not be paying the premiums in year 5.
4. Lapse Rate or Persistency Rate
Investment income are the returns earned by the insurer on the premiums advanced by policyholders.
Remember – all consumers have to pay the premium in advance towards insurance contracts. This is a regulatory requirement aswell and capture as Section 64VB of the The Insurance Act, 1938. This section says – No insurer shall assume any risk in India in respect of any insurance business .. until the premium payable is received by him or is guaranteed to be paid by such person .. unless and until deposit of such amount as may be prescribed, is made in advance in the prescribed manner.
OK. So what do insurers do with the premium?
Insurance companies take this premium and deposit it in fixed income and safe instruments. The IRDAI prescribes where all the money can be invested in their regulations. This is generally restricted to instruments like short duration bonds, AAA rated paper, treasury bills etc.
Cool. How much do insurers make from these investments?
Currently, insurers make an yield of 8-9% per annum. But this might not be the case 10 or 20 years from now as interest rates and bond yields tend to swing over the years.
Great! So these were the four pricing variables.
By now, you must have figured by now that all these four pricing variables are assumptions running into decades.
It is now the actuary’s job to convert these multi-year estimations into a fixed annual premium that can charged from the policyholder throughout the entire term of the policy. This is far from easy and hence, actuarial sciences is a respected profession within the insurance industry.
Possible Reasons behind Term Insurance Premiums Increase
In this section, we look deeper at the pricing components. And understand why the need for premium increase has come up.
Increase in Mortality Rates
We discussed earlier that the mortality cost is the biggest expense component in determining term insurance premium.
The mortality cost itself is in two parts –
- Mortality cost of the reinsurer and
- Mortality cost of the insurer
You might be wondering what this is?
Since the coverage in term insurance plans is quite high (often averaging a payout of ₹1 crore, it becomes impossible for the insurance company to assume this entire risk. As a consequence, the insurance company transfers a large part of this risk to a reinsurer.
What is Reinsurance?
Reinsurance is the insurance that an insurance company purchases from another insurance company. This helps insurance company insulate itself from the risk of major claims events. This is definitely the case in term insurance where claims are often ₹1 crore or more in value. As a result, Indian life insurance companies reinsure (or ‘cede’) up to 80% of their term insurance risk to a reinsurer.
The IALM Table
OK. Now we know that 80% of the mortality cost is from the reinsurer and the remaining 20% is the insurer.
The insurer and reinsurer estimate the mortality cost by referring to a table called the Indian Assured Lives Mortality or IALM table. This table is published by the IRDAI.
Let’s see a sample table.
The IALM table records mortality or rate of deaths across different age groups.
For example. The mortality rate for a 30 year old male is 0.000977
This means for every one lac 30 year old males in India, 97.7 males are expected to die in a single year.
The same number jumps up to 443 per lac for a 50 year old
And just over 2,400 deaths per lac for a 70 year old.
Impact of conditions beyond the IALM table
In addition to consulting the IALM table, there are a few more conditions that are imposed by reinsurers in acquiring term insurance policies. This is done for two reasons –
- To control the claim experience so that adverse selection does not seep in
- To keep the premiums affordable
The last point might surprise you. So let’s talk about that.
The IALM table is a pure mortality rate i.e. it is for all Indian irrespective of geography, income, education, habits, lifestyle, occupation etc. When insurers add conditions on them based on customer profile, there is a big possibility of offering a discount.
For example, the mortality rate of a 50 year old male is 0.004436. This means the mortality cost for a ₹1 crore cover will be ₹44,360. And assuming this is 60% of total premium, the overall premium will come to ₹44,360 divided by 60% = ₹73,933. Plus an 18% GST, takes the overall annual premium to ₹87,241.
Wow! That’s high.
However life insurance companies don’t charge such a high premium
We see here that the actual premium charged from most player is 40-45% of the estimate we earlier did.
This means, insurers and reinsurers have been offering a discount on the IALM mortality rates by including controls. These discounts are anywhere from 25% to 50% depending on different age groups.
These controls are in term of visible customer profiles tagged by income, education, cities from where policies are sourced, acquisition channels like banks, agents & online etc.
It’s probable that the discount offered was too much which has led to an adverse claims experience. In other the number of deaths were more than the assumed number.
Underwriting accommodations did not operate effectively
In addition to claim experience, our research reveals that some process accommodations offered by industry players also did not pan out as expected.
Here’s an example
There is a practice of offering waivers on medical tests for select sum assured. This is done in some age groups or select income brackets.
Generally, I see that a few popular insurers waive off medical tests for upto 1 crore of sum assured. This is done if the proposer is less than 45 years of age and is a graduate.
OK. So what happened?
It is very likely that these calls too have not gone as expected and the insurers will have to relook at the controls.
Overall, my assessment is that the potential premium increase in term insurance plans is a mix of the mortality assumptions not panning out as expected and underwriting controls being overly relaxed
What to Expect from Life Insurance Companies Going Forward?
In this final section, we look at what to expect from the life insurance companies in the near future.
Let’s understand this by drawing up a classic P&L expense statement.
Currently, for every ₹100 of premium collected:
- Cost of mortality is ₹60
- Expenses is ₹30
- Therefore, the insurer makes a profit of ₹10
Now, let’s say the mortality cost increases by 20%.
The new mortality costs will thus be 72.
We now look at a few scenarios that the insurers can adopt.
Scenario 1 – Pass the entire increase in mortality cost to the customer by increasing term insurance premiums proportionately
While this is easy to do on an excel sheet, a move like this will keep the sales team jittery. This is possible that there might be a dip in sales in the short run.
Having said this, the insurer can also decide to partially increase the premium and compensate the additional mortality cost by foregoing some part of his profits.
Scenario number 2 – Keep premiums at more or less the same level with tighter expense management
Expenses at an insurance company have two components:
- Operational expenses and
- Distributor Commissions
A reduction in operational expenses will mean using more technology and online processes as opposed to branch infrastructure. This might also require a lower outlay on marketing & branding activities
A reduction in commissions paid to distributors will require renegotiating contracts with distributors which might have an impact on the product portfolio mix of insurers. It might also have a mild to drastic dip in sales of term insurance.
Scenario number 3 – Adopt tighter controls aimed at receiving better rates from reinsurers
A better input rate from the reinsurers might be available if the eligibility & underwriting criteria were tightened
For example. Insurers might look at pushing up the minimum income criteria from say, 3 lacs per annum to 5 lacs per annum
This helps because the data obtained from some insurers show that the claims experience in higher income groups.
Similarly, tight controls can include having a slightly higher minimum educational qualification such as graduation instead of an under-graduate or diploma certificate.
In totality, we see that there are a few scenarios that are available for insurers to work on. The next 2-3 months will see the insurers work out many permutations & combinations to get the best fit.
Going forward, I expect insurers to become more prudent in consumer profiling and the insurance industry investing in data structures & technologies to have a better assessment of risk.
To conclude, term insurance plans in India have one of the most competitive pricing from anywhere around the world.
And this current repricing should not come as a surprise to anyone as the fledging Indian term insurance industry is still in a “discovery” phase.
We can expect many more such pricing and process changes in the future as the industry matures.
Additional Resources You Might Like
- 5 steps on choosing the right term insurance plan
- Rakesh Jhunjhunwala and his secrets to investing (Part 1)
- Complete SIP Investment Guide (over 8000 words compedium updated until 2020)
- Six benefits of term insurance plans
- The trillion dollar index fund story that John Bogle started in the 1970s
- Best SIP for achieving long term goals