How Life Insurance Premiums are Determined

Many people have bought life insurance plans mainly for investments, tax benefits and the life cover that they offer. They have rarely tried to understand how their life insurance plan works for them or for that mater, how their premium is determined.

In this article, I will give you an overview of how premiums are determined and which life insurance plan proves to be a better option.

First and foremost , the primary purpose of life insurance is to insure the financial future of the nominees in case of an eventuality to the insured. It does so by paying a 'sum assured' to the nominees.

The sum assured is decided upon at the time that you buy the life insurance plan and the premium is paid accordingly. The premium consists of three important elements which you need to know in order to choose the right insurance plan.

1. Mortality charges
Mortality charges are incurred by the life insurance company to cover the risk of an eventuality to the policyholder. The mortality expenses vary based on the age of the individual and the sum assured. The higher the age and sum assured, the higher the mortality expenses.

2. Sales and administration expenses
These expenses are incurred by the insurance company for operational purposes and recovered from the premiums that the policyholder pays towards his or her policy. Agents' commissions, sales and marketing expenses and the general overhead costs incurred to run an insurance comapny every day are examples of sales and administrative expenses.

3. Savings component
This part of the life insurance premium is invested by the insurance company in various investments such as bonds, government securities, money market instruments and equities.

The savings component generates a portion of the returns that insurance companies pay to a policyholder by way of bonuses and the maturity amount.

Two Basic Types of Life Insurance

Now that you have a better understanding of the basic premium structure, I encourage you to evaluate their own needs and buy insurance coverage accordingly. To do this, you need to understand the two basic types of life insurance plans - term life insurance and endowment life insurance plans.

Term life insurance plans are pure risk cover plans. The premiums charged by term plans cover only the mortality charges and sales and administration expenses, not the savings component. With no savings element in the premium; there is also no maturity amount accrued. For this reason term life insurance plans are the cheapest form of life insurance coverage available.
Unlike with term plans , the premium towards an endowment type plan also includes a savings component. As already explained earlier, the savings component is what helps the insurance company in generating a corpus over the tenure of the policy.

But it is also for this reason that the premium paid for an endowment plan is a lot more than what you would have to pay for a comparable term plan.

A major portion of the premium difference between the term plan and endowment plan is the savings component, which is invested by the insurance company to generate returns for the policyholder.

What this also means is that the term plan premium works out approximately 87% cheaper than the endowment plan premium every year. Or in other words, the individual has to pay 7.5 times more premium for an endowment plan for the same amount of coverage!
In my view, you should ideally keep their life insurance needs and investment needs apart. Consider buying a term life insurance plan for the desired amount of life insurance coverage and devote the remaining 'investible surplus' to other investment avenues like mutual funds for instance.

You should therefore be certain that they have done you homework on understanding your life insurance needs. This will not only help you in making wiser decisions, it will also lead you to a better and more prosperous future.