INSURANCE OF A LIFE Principles and Practice II First Edition 1989 Reprinted 2009 ISBN 0 948691 60 9 © Witherby Seamanship International Ltd British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library. Notice of Terms of Use All rights reserved. No part of this publication may be produced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the publisher and copyright owner. While the principles discussed and the details given in this book are the product of careful study, the author and publisher cannot in any way guarantee the suitability of recommendations made in this book for individual problems, and they shall not be under any legal liability of any kind in respect of or arising out of the form or contents of this book or any error therein, or the reliance of any person thereon. Published in 2009 by Witherbys Insurance 4 Dunlop Square, Livingston Edinburgh, EH54 8SB Scotland, UK Tel No: +44(0)1506 463 227 Fax No: +44(0)1506 468 999 Email: info@emailws.com www.witherbyseamanship.com INSURANCE OF A LIFE Principles and Practice by John Howe F.C.I.I V FOREWORD Insurances of the person embraces life assurance, annuities and personal accident and sickness insurance. Over the years, all three classes have progressed to a range of sophistication that can bewilder the uninitiated. Life assurance has come a long way from its earliest beginnings - when only death cover was available for a short period of time. Today there is a greater emphasis on investment return to the policy holder. As a result, life assurers deal with contracts that contain little or no life cover in the event of early death. The complexities that exist in the life assurance market have to be carefully explained and applied to certain contingencies, within the framework of well established principles and legality. Annuities provide the means of income for a limited period or for the rest of ones lifetime. Each type has to be understood as they apply to special needs. Personal accident business is perhaps the backward child of the insurance industry and has never really taken off to the extent its provisions justifies. To cover this subject is no mean task. The fact that life assurance underwriting, claims and reassurance and the more detailed aspects of pension business have been omitted from this book is justified, as each of these need to be covered in depth to make any worthwhile impact. What has been covered in this book is a wealth of information and knowledge, assembled with clarity. For once, this really is a book for both the general reader and the student. Aside from being a practitioner, John is an insurance lecturer of distinction. Both here and at a polytechnic, his classes command high student loyalty. His students greet him at result time with an enthusiasm normally reserved for football heros and, in his case, this is fully justified! This book of his will continue the invaluable assistance he gives to students studying this subject. It will also be a reference book of the highest order for all those involved in any way with insurances of the person. Mark Featherstone —Witty BA MEd Principal, The London School of Insurance VI AUTHOR’S PREFACE The purpose of this book is to give a wide comprehensive knowledge of life assurance, annuities and personal accident and sickness insurances on annual and permanent basis. It should assist students studying for examinations to which insurances of the person is relevant so that they can gain a greater appreciation of the subject. It can also be a reference book to those engaged in the administration or the selling of the classes of insurance business covered in the book. Life assurance covers a very wide field and embraces pension business. To include all aspects of the subject in one book would make it a large encyclopaedia. Consequently more detailed information in respect of life assurance underwriting, law, claims, taxation and pension law, design, administration and related benefits would be better served in books specialising in those areas. John Howe November, 1988 VII CONTENTS Page Foreword V Author’s Preface VI Introduction 1 1 Economic Value 5 2 Legal Aspects 11 3 Principles 15 4 Classification of Policies 21 5 Needs 29 6 Taxation 37 7 House Purchase 41 8 Children 47 9 Group Life Assurance 49 10 Occupational Pension Schemes 55 11 State Social Security 67 12 Added Benefits 73 13 Industrial Life Assurance 75 14 Premium Calculation 81 15 Profits, Surplus, Reserves 91 16 Bonuses 97 17 Cash Surrender And Paid Up Policies 103 18 Life Policy Document 107 19 Policy Endorsements 113 20 Annuities 115 21 Personal Pensions 131 22 Contracting Out 141 23 Personal Accident And Sickness Insurance 147 24 Permanent Health Insurance 159 25 Proposal, Rating And Underwriting Personal Accident Business 163 26 Risk of Accident And Sickness 171 27 Reinsurance 183 28 Personal Accident And Sickness Claims And Taxation 187 29 Special Schemes 195 Index 203 85 PREMIUM CALCULATION 5. Office expenses. 6. Any adverse mortality factor the actuary considers prudent. 7. Any adverse interest factor the actuary considers necessary. 8. Any other amount which the actuary feels is required to ensure solvency of the life fund and to provide profit. The more loading amounts are added the higher the premium becomes. The actuary has to ensure solvency but needs to keep the premium competitive. The resulting figure after all the calculation have been completed determines the per centum premium which can then be applied to a sum assured. M.I.L. So premium calculation can be expressed as MORTALITY less INTEREST plus LOADINGS (M.I.L.). If the policy is to be with profits for added bonuses a further loading factor may be used or a lower interest rate adopted to ensure a bonus can be declared regardless of the result of the other factors. The resulting extra cost than for a without profit policy will be expected to be much lower than bonuses eventually declared for a with profits policy as can be seen in the next chapter. PREMIUMS Premiums are normally calculated on a true annual, half-yearly, quarterly or monthly basis. Therefore the last premium paid before the end of the policy concludes the contract after claim settlement. Sometimes, however, premiums are calculated on an annual basis but paid in instalments. In such cases a claim by death of the life assured during the currency of any policy year will mean that an instalment or some instalments may be unpaid. In order to obtain any instalments not received because the premium was not paid for the year as an annual amount in advance, a deduction in respect of such outstanding instalments would be made from the proceeds of the policy from the claim. As no such deduction would apply in respect of a true premium the life assurers might not receive the same monies as an annual premium paid in advance on a death claim during a policy year. Provision, therefore, has to be made for this in calculating true premiums of less than one year. INSURANCE OF A LIFE 86 Whilst an instalment premium could be a divisor of 2 (half-yearly), 4 (quarterly) or 12 (yearly) of the true annual premium, a true premium of less than one year would always be increased so that in any one year the amount payable exceeds that of the annual premium. Annual premiums are calculated on the basis that a full years premium is paid in advance each year and will earn investment income from the start of each policy year. There will be some loss of investment income each year compounded by the premium paid at the outset of each policy year being a lesser amount by premiums being paid more frequently during the year. Administrative costs are higher if premium payment is spread through a policy year and in the case of true premium there will be no deduction from a death claim in respect of the method of premium payment as already stated. NATURAL PREMIUMS Any policy of more than one year duration would have an increasing premium each year if calculations were made in accordance with the mortality table as the life assured became older because of the higher rate of mortality as illustrated in the table. This has several disadvantages. Firstly, the premium over a period of time would increase to such an extent that the policy could not be a viable proposition. At a time when death was more likely would be the time when the premium became too expensive. Secondly, there would be a tendency for the fitter lives to withdraw from the assurance as the premium rose leaving only the inferior lives. In later years the health of an individual is liable to deteriorate so a higher premium above that calculated from mortality basis would be charged making the cost even higher. The alternative would be for the life assurers to seek medical evidence each year (an added costing factor) of which many could then be unacceptable thus being denied assurance on their lives when they needed it most. If sufficient lives were assured at younger ages it might be possible to keep the average age fairly constant but this was not the experience of those life assurers who calculated premiums at an increasing rate in the past. This method, which is known as the natural premium system has now been discontinued. LEVEL PREMIUMS For many years it has been the practice of life assurers to charge a level premium throughout the life of a policy. This does not mean 87 PREMIUM CALCULATION that the mortality, interest and loading factors are changed but rather the actuary of the life assurers produces a premium which exceeds the mortality risk for a period of time and then the premium becomes inadequate in later years to cover the mortality risk. The following illustration should help to clarify the position: M65 Age 65 60 55 50 45 40 35 30M30 M = Mortality PremiumP = Level Premium P65P30 If, therefore, a person aged 30 next birthday effected an endowment assurance for a term of 35 years the premium will be seen to raise at each age in respect of the mortality premium whereas under the level premium the same premium will be charged in the final year as was in the first year. The lines that cross signify the only year when the premium equates to the mortality risk. The horizontal line does not represent the average of the mortality premium to be charged over the 35 years. The actuary of the life assurers decides the amount of level premium per cent by using certain calculations. It is not proposed to illustrate the method in detail as it is an actuarial exercise for which this book is not aimed. The basis of all level annual premiums is the corresponding single premiums that would be charged at the outset of the assurances to provide sufficient money to pay death claims expected from the mortality table used. From the mortality premium would be deducted the interest factor which has already been explained. INSURANCE OF A LIFE 88 The deaths in any year would be spread throughout the year but it could be reasonable to take an average of claims as falling in the middle of each year. The interest factor could now be applied as earning income in all cases for half of a year in the first year and subsequently for half a year on the survivors for the next single premium to be calculated. By applying this method for term assurance of more than one year a net single premium can be obtained. From the net single premium the corresponding net annual premiums have to be calculated. To do so consideration is given to a temporary annuity of £1 payable yearly in arrear so that the first payment falls due one year after the date of purchase. By using the mortality table and an assumed interest factor of say 5%, a premium can be obtained for the period of annuity payments corresponding to the term of the term assurance. Having ascertained the single premium to cover expected death claims (allowing for the interest factor) and the single premium to pay survivors the annuity (allowing for an interest factor of 5% so that £1 payable in one year’s time is 1/1.05 =£95238 (to five decimal places) and in two year’s time is 1/(1.05)2 = £.90702 (to five decimal places) and so on the actuary arrives at the level premium for TERM ASSURANCE over one year duration. The single premium obtained from the annuity calculations is related to the equivalent of an annual premium in advance over the term of the term assurance. Having determined that equivalent then that figure can be equated to the single premium calculated in respect of the expected deaths. If a single premium for the annuity was £2.90485 payable at the start of the policy and was equivalent to an annual premium of £1 payable annually in advance over say a three year term assurance then a single premium of £1 must be £.34515. If £.34515 was applied to the net single premium calculated for deaths in the first place then the level annual premium emerges. If the net single premium from the first calculations was £2.40 then the level annual premiums would be £.83% to nearest whole penny for the three year term assurance. The figures above are merely used for illustrative purposes. This is the method of finding the annual premium from the single premium. Premiums for whole of life assurance are established in the same way but more work is entailed because of the need to work right through the ages in the mortality table. The theory of calculating the level annual premium for endowment assurance is similar to that for whole life assurance but a number