The Case for Age Rated Premiums

Life assurance is one of the few necessities in life that has consistently got cheaper over the last decade. Improving mortality, better technologies and selling practices, more informed clients and more (aggressive) competition have all helped to bring about sustainable cost reductions.

Over and above this, the industry has devised a variety of pricing techniques, such as variable premium guarantee periods and an extensive choice of premium payment patterns, to enable your client (and you) to better control and manage the cost of insurance over the lifetime of the contract.

But these pricing options can, and do, cause confusion and often lead to inaccurate comparisons at quotation stage with the result that it’s often, what appears to be, the “cheapest” quotation which is favoured by the client. It goes without saying though, that reduced upfront premiums is likely to mean higher premiums later in the policy’s life and if future affordability isn’t adequately factored into the financial plan, the life policy may not have a very long life.

A Short history
Modern day life insurance started out in the 16th century using the fundamental concept of pooling risk and cross-subsidisation. In those twilight years, mortality risk was priced on a one-year renewable term basis with premiums increasing annually. The mathematics and complexity of the business led to the development of actuarial science which in turn led to the concept of charging a level premium for an increasing risk.

So the concept of age-rated premiums is not new - this is how it all started.

The case for age-rated and other non-level premium patterns in the modern era
Whilst the rationale for age-rated premiums in the early years of life assurance was due largely to a lack of actuarial skills to price the business any other way, today we use age-rated and other non-level premium pattern pricing to bring down the initial cost of life assurance.

Whilst level premiums have the advantage of providing more cash-flow stability, the client will, in effect, pay too much for their cover in the early years (excess premium) relative to the ‘true’ underlying cost of cover, and then too little in the latter years – as illustrated in the graph alongside.

The benefits of the age-rated and other non-level premium patterns are twofold:

1.Lower initial premiums
Initial premiums are lower and so a higher amount of cover can be purchased – an important consideration when affordability is an issue. For example, a 40-year old professional male could expect to get around R4.2 million life cover with Glacier for a level premium of R1 000 per month - whereas he would pay less than R500 in the first year for this same cover under an aggressive age-rated premium structure.

The lower initial premium also enables individuals and businesses alike to tie-up less cash flow in life assurance premiums at a time when these funds could be better applied to financing debt or business growth.

2.Premiums are more closely matched to the underlying cost of cover
Under a level premium policy, the “excess premium” paid in the initial period is not refunded in the event of early cancellation or death of the client. As such, under these circumstances, the client will actually have paid “too much” for the cover they had during the period. With age-rated and other non-level premium structures, the premiums are more closely matched to the underlying cost of cover and so any excess will be much less.

The table alongside illustrates the total premiums paid at various durations during the policy described above.

Ten years into the policy, total premiums paid under the age-rated premium structure are around R29 000 (24%) less than the level premium structure and after 15 years only about R1 600 (1%) more.

But these are just nominal values which take no account of the decreasing value of money due to inflation. And so for a more accurate comparison we should convert future premiums into present day money values.

But, even allowing for inflation, total premiums paid under the age-rated premium structure during the first 10 years is around 25% less than the level premiums paid and almost 8% less over the first 15 years.

Don’t place too much emphasis on premium comparisons
Consider the following example for the repayment options on a term loan. Suppose the loan is R50 000 for a term of 10 years and you have an option to repay a fixed monthly instalment of R648.88 or R535.91 increasing by 5% per annum. If you are advised of the interest rate (in this case a fixed rate of 10%), you could do a quick calculation to find out that the two options are equivalent. You might choose the increasing instalment option if finances were expected to be tight initially or indeed if you believed you could invest the difference between the instalments in the early years at a rate higher than what you were being charged on the loan. But what if you are given a third option of an instalment of R497 increasing at 8% per annum - only this time the interest rate is variable? Now the comparison becomes a little more complex and you have to start making a variety of assumptions about future interest rates.

With life assurance, comparisons are even more difficult and indeed it is almost impossible for you or the client to make accurate comparisons on price alone. And comparisons are made even more difficult by the fact that the premium and cover growth options offered by the various companies are not the same. In short, comparing quotations on price alone (particularly the initial price) can be very misleading and ultimately can lead to poor financial decisions.

After all, life assurance is not a commodity but an investment in your family’s future financial security. We are doing our clients an injustice if we do not pay proper regard to the long term financial impact of the decisions they take today.