Who Will Carry the Load
When one is faced with how best to protect future earnings against an untimely death, it’s no wonder life insurance products are at the forefront of such discussions. The reason for their being in the limelight is they are the only financial products designed specifically to replace future earnings in the event of an untimely death. Other ways of replacing or increasing income can be used to assist in that replacement but carry with them the element of needing time to bring them to fruition. They need that element along with a reasonable rate of return on investment to be able to step in to replace present income requirements.
Life insurance truly is the vehicle best suited to redistribute risk. With filling out an application for coverage, meeting financial needs and medical requirements, signing the application, and making the necessary premium deposit, an individual can transfer risk of loss of future earnings to a life insurance company willing to take on that obligation immediately. This amount of transfer of risk is only limited by one’s ability to pay and by the insurance company’s agreement to shoulder the amount paid for.
Premium Calculation Factor
The primary goal of a life insurance company is to provide a guaranteed death benefit to its policyholders. This guaranteed death benefit requires careful planning on the part of the insurance company since this guarantee has to span the lifetime of the insured and that of the beneficiary. One cannot go back to recoup a financial miscalculation. A contract which must span over a century has little to guide the company on how to assure it can meet the obligation at any given year of the contract.
Using sophisticated actuarial tables and probability charts, the insurance company assigns a premium to each potential client to cover the claims which will be incurred during a specific period of time. This is not an exact science due to the inability to determine exactly how many will die at any given time, and other expenses, so it is a “best guess” calculation. With the use of life insurance to redistribute risk, the intent then is for each potential recipient to pay for the death benefit outlay they may receive.
For example, if we had a group of 1000 people with each being covered for a $1,000 payout and we expected two would die in any given year, a premium of $2.00 would be collected from each person the first year. If we had in the next year five people expected to die, we would need to have collected $5.01 from each of the 998 people still alive. Let’s say in the third year we had 12 people expected to die with each of their beneficiaries receiving $1,000 at the beginning of the year, each of the 986 people remaining in the group would need to “pony up” $12.17. If we followed this group all the way until there were only two people left to receive a $1,000 benefit and one were to die, then each of the remaining participants would have to pay 500.00 to cover that $1000 payout.
The last guy standing would receive nothing for the whole period of time he paid premium. He would only have the peace of mind knowing he helped alleviate the financial burden of someone else and the knowledge he could have been one of the recipients.This would be the pure premium calculation required in order for redistribution of risk to work.
Sophisticated Method of Premium Calculation
When one considers the commitments of a life insurance policy must stand the test of time for more than a century, one can see a simple mathematical calculation of mortality doesn’t work. Factors like pandemics, realities of war, medical advancements, health behaviors, tragedies of drug abuse, marketing distribution adjustments, product competition, etc. also bear weight in modified premiums. Companies rely heavily on its actuaries to incorporate all these factors in developing income flow to allow the company to remain solvent and capable of keeping contractual promises.
Having said all that, the calculation of premium brings in a tremendous amount of cash which the insurance company must put to good use in order to provide the future benefits promised in the insurance policy contracts.
Even term insurance premiums, which are calculated to cover death benefits expected on a yearly basis, have some flexibility in them due to unexpected drop in mortality, better-than-expected return on investments, overhead savings, etc. so those premium savings have to be accounted for.
Whole life insurance due to its actuarial projections brings in more premium than what is required in the first years in order to allow the premium to be level over the lifetime of the contract. These dollars must also be invested wisely to meet future obligations. All of the circumstances surrounding excesses in term policies apply to whole life products as well, so maintaining a healthy investment strategy is also at work for these contracts.
Insurance companies have over the years normally avoided higher risk investment tools like individual stocks in a particular company or speculative ventures like wind and solar markets; because even though these markets hold out the hope they will make excess returns, they also have the downside risk of losing even the principal being invested. This goes against the nature of the insurance contract which is to preserve a death benefit at any given point in time. They cannot just fulfill this part of the contract when the insurance company is profitable but at any time along the time frame of the policy.
Consequently, the investment managers for insurance companies look to reduce their credit risk and rate of return risk by choosing to invest. Some of the most popular are:
- government securities, i.e. treasury notes and savings bonds
- corporate debt, i.e. bonds and commercial notes
- banking, and large real estate investments.
Some financial portfolios include preferred stocks as a way of increasing the return on the underlying investments but then only with the intent of holding them in the portfolio for a short period of time.
Guaranteed Future Earnings
It has been and still is tempting for a life insurance company to push the return boundaries of their investments due to the market pressure for the consumer dollar. The idea of making money on your money spills over when consumers are confronted with limited resources to either go for a sure return as promised in a whole life policy or by taking those same resources and putting them in an instrument like mutual funds, stocks, and bonds which project (with no guarantee) a rate of return, whetting the interest of the consumer.
A point of advice on priorities comes from a Merrill Lynch sales brochure from some time ago when it addressed the issue of whether you should invest. In essence it posed the question, should you invest? and then answered with yes, If you first have an emergency fund, a way to replace your earnings if you are disabled and can’t produce, and you have instruments which guarantee rate of return, and then–if you have the stomach for it–consider investing.
Life insurance should not be considered an investment instrument to compete with stocks, bonds, or mutual funds for optimum interest returns; but,it can be looked upon as a safe venue for cash accumulation, with time being required to allow for accumulation. However, it can be considered an investment instrument because it can immediately be determined what the return would be if death occurred at any given time. By a simple process of applying for, qualifying for, and paying a deposit, your future earnings are secured and guaranteed.