Chapter 5

Life and Health Insurance

• Life Insurance
Life insurance is a contract between the policy owner and the insurer, where the insurer agrees to pay
a sum of money upon the occurrence of the insured’s death. In return, the policy owner agrees to pay a
stipulated amount called a premium at regular intervals or in lump sums.
Life Values
A human life has value for many reasons. Many of these reasons are philosophical in nature, and would
lead us into the realm of religion, esthetics, sociology, psychology, and other behavioral sciences. Of
greatest interest here are economic values, although it is very difficult to separate the discussion in
such a way that an economic analysis would have no implications or overtones for other viewpoints. A
human life has economic value to all who depend on the earning capacity of that life, particularly to
two central economic groups-the family and the employer. To the family, the economic value of a
human life is probably most easily measured by the value of the earning capacity of each of its
members. To the employer, the economic value of a human life is measured by the contribution of an
employee to the success of the business firm. If one argues that in a free competitive society a worker
is paid according to worth and is not exploited, the worker`s contribution again is best measured by
earning capacity. It develops that earning capacity probably the only feasible method of giving
measurable economic value to human life

There are four main perils that can destroy, wholly or partially, the economic value of a human life.
These include premature death, loss of health, old age, and unemployment.

Premature Death
Premature death can be defined as the death of a family head with outstanding unfulfilled financial
obligations, such as dependents to support, children to educate, a mortgagee to be paid off, and other
installment debits. Premature death can cause serious financial problems to the surviving family
members because their share of the deceased family head`s future earning is lost forever. If
replacement income from other sources is inadequate, or if the accumulated financial assets available
to the family are also inadequate, the surviving family members will be exposed to great
economic/financial insecurity.
Costs of Premature Death
There are certain costs associated with premature death. Firstly, the family`s share of the deceased
breadwinner’s future earnings is lost forever. Second, additional expenses are incurred because of
funeral expenses, uninsured medical bills, and estate settlement costs. Third, because of insufficient
income, some families will experience a reduction in their standard of living. Finally, certain
noneconomic costs are incurred, such as intense grief, loss of a parental role model, and counseling and
guidance for the children.
Economic Justification of Life Insurance
Life insurance can be used to alleviate the financial consequences of premature death. The purchase of
life insurance is economically justified if the insured earned income, and others are dependent on those
earnings part or all of their financial support. If a family head (breadwinner) dies prematurely with
dependents to support and outstanding financial obligations, the surviving family members are exposed

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to great economic insecurity. Life insurance can be used to restore the family’s share of the deceased
breadwinner’s earnings.
It should be noted that a life insurance policy is a valued policy that pays a stated sum to a named
beneficiary and is not a contract of indemnity. The insured event is the uncertainty of the time of death.
We must all die, but the time of death is uncertain.

Life Insurance
As a social and economic device life insurance is a method by which a group of people may cooperate
to ameliorate the loss resulting from the premature death of members of the group. The insuring
organization collects contributions from each member, invests these contributions, guarantees both
their safety and a minimum interest return, and distributes benefits to the estates of the members who
die. For many people, the risk management tool that is most appropriate for dealing with the exposure
of premature death is life insurance. There are many different types of life insurance, but the standard
arrangement is a contract specifying that upon the death of the person whose life is insured, a stated
sum of money (the policy’s face amount) is paid to the person designated in the policy as the
beneficiary.

Some Unique Characteristics of Life Insurance

Life insurance is a risk-pooling plan, an economic device through which the risk of premature death is
transferred from the individual to the group. However, the contingency insured against has
characteristics that make it unique; as a result, the contract insuring against this contingency is different
in certain respects from other types of insurance.
• The event insured against is an eventual certainty. No one lives forever. The insurer`s chance
of loss under a life insurance contract is greater the second year of the contract than it was the
first year, and so on, until the insured eventually dies. Yet life insurance does not violate the
requirements of an insurable risk, for it is not the possibility of death itself that is insured, but
rather untimely death. The risk in life insurance is not whether the individual is going to die,
but when, and the risk increases from year to year.
• There is no possibility of partial loss in life insurance as there is at the case of property and
liability insurance. Therefore, all policies are cash payment policies. In the event that a loss
occurs, the company will pay the face amount of the policy.
• Life insurance is not a contract of indemnity. The principle of indemnity applies on a
modified basis in the case of life insurance. In most lines of insurance, an attempt is made to
put the individual back in exactly the same financial position after a loss. For obvious reasons,
this is not possible in life insurance. Insurance cannot compensate for the loss of a loved one. It
can only help to replace the funds that are cut off by death.
• As a legal principle, every contract of insurance must be supported by an insurable interest,
but in life insurance, the requirement of insurable interest is applied somewhat differently
than in property and liability insurance. When the individual taking out the policy is also the
insured, there is no legal problem concerning insurable interest. Every individual has an
unlimited insurable interest in his or her own life and a person may assign that insurable
interest to anyone. The important question of insurable interest arises when the person taking
out the insurance is someone other than the person whose life is concerned. In such cases, the
law requires that an insurable interest exist at the time the contact is taken out.

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Major Types of Life Insurance Contracts
There are four basic classes of life insurance contracts: (1) term, (2) whole-life, (3) endowment, and
(4) annuities. Other classifications, based on method of premium payment, period of coverage, method
of distribution of proceeds, and combinations of these basic contracts, are possible, but the
classification above seems sufficient as a background for understanding the various life insurance
contracts available. 1) Term Insurance
A term policy in life insurance may be defined as contract that furnishes life insurance protection for a
limited number of years, the face value of the policy being payable only if death occurs during the
stipulated term, and nothing being paid in case of survival. Tem insurance provides temporary
protection. It is called term because the coverage is for a limited term. Common types of term life
insurance are 1-year term, 5-year term, 10-year term, 20-year term, and term to age 60 to 65. Term
insurance protects the beneficiary if the insured dies within the term specified in the policy. If the
insured lives to the end of the term, the policy expires and no payment is made by the insurer. Term
life insurance is similar to property insurance in this respect. If there is no loss to a home or automobile
while a policy is in force, the insurer makes no payment. This is also the case with term life insurance.
Unlike the risk of losing a home or automobile, death is a certainty. The time of death is, not, however.
Most insureds do not die at early ages. Thus, many people pay term life insurance premiums and
receive no payment from the insurer. Some people make only a few premium payments, however,
before their beneficiaries receive proceeds that greatly exceed the sum of the premium payments.
Again, this is like fire insurance, for which many insureds pay premiums and suffer no losses. But a
few insureds collect for losses far larger than the premiums they paid. Most people would much rather
be among those who pay term insurance premiums but receive no proceeds. Yet to say such people
have received nothing for their money is a serious error. Who can measure or ignore the precious peace
of mind term life insurance has provided such people?

Types of Term Life Insurance

Insurers sell several types of term life insurance policies including the following:
Decreasing term: A decreasing term policy provides the beneficiary with less proceeds each year
the policy is in force. It is a form of term insurance where the face amount gradually declines each
year. However, the premium is level throughout the period. That is, if death occurs in the first
policy year, the beneficiary receives the face amount. If death occurs in a succeeding year, the
proceeds will be less. In a decreasing term policy, the premiums remain the same each year but
purchase less insurance. That is, the amount of death benefit decreases because the chance of death
increases with age. In some policies, the premiums are structured so that the policy is fully paid for
a few years before the coverage expires. For example, a 20-year decreasing term policy may
require premium payments of 17 years. This method avoids paying a relatively large premium for
only a small amount of insurance near the end of the term period.
Increasing term: An increasing term policy provides proceeds that increase each year. If death
occurs in the first year, the insurer pays the face amount of the policy, for example, $20,000. In
twentieth year, perhaps $35,000 would be paid to the beneficiary. Such policies are attractive in an
inflationary economy. Premiums for these policies increase at each renewal.
Level term: A level term policy pays the same amount of benefits if death occurs while the policy is
in force.

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 Renewable term: Renewable term policies allow the insured to continue the coverage up to
specified age regardless of the status of the insured’s health or other relevant factors including
occupation. If, for example, a five-year term policy is not renewable, an insurer could end the
insurance at the end of any five–year period. Coverage could not be ended by the insurer if the
policy were renewable. Although renewable term polices cost more, the guaranteed renewal feature
is worthwhile for many people because it transfers the risk of becoming uninsurable to the
insurance company. It should be understood each time a term insurance policy is renewed, the
premium increases because the insured will be older. An increase will follow at each renewal until
the policy can no longer be renewed.
Convertible term: Convertible term polices allow the insured the option of converting the policy to a
whole life policy. This privilege can be valuable if the term insurance is about to expire and the
insured wishes to continue the coverage on a permanent basis. When the insured makes the
conversion the premium increases.

Uses of Term Insurance

Term insurance is appropriate in three situations: First, if the amount of income that can be spent on
life insurance is limited, term insurance can be effectively used. Because of mortality improvements
and keen (intense) price competition, term insurance rates have declined sharply in recent years.
Substantial amounts of life insurance can be purchased for a relatively modest annual premium outlay.
Second, term insurance is appropriate if the need for protection is temporary. For example, decreasing
term insurance can be effectively used to pay off the mortgage if the family head dies prematurely.
Finally, term insurance can be used to guarantee future insurability. A person may desire large
amounts of permanent insurance, but may be financially unable to purchase the needed protection
today. Inexpensive term insurance can be purchased which can be converted later into a permanent
insurance policy without evidence of insurability.

Limitations of Term Insurance

Term insurance has two major limitations: First, term insurance premiums increases with age at an
increasing rate and eventually reach prohibitive levels. Thus, term insurance is not suitable for
individuals who need large amounts of life insurance beyond age 65 or 70. Second, term insurance is
inappropriate if you wish to save money for a specific need. Term insurance policies do not accumulate
cash values. Thus, if you wish to save money for a child`s college education or accumulate a fund for
retirement, term insurance is inappropriate unless it is supplemented with an investment plan.
Decreasing term insurance also has several disadvantages. If you become uninsurable, you must
convert the remaining amount of insurance. If the policy is not converted, the insurance protection
continues to decline even though you are uninsurable. Moreover, decreasing term insurance does not
provide for changing needs, such as birth of a child. Nor does it provide an effective hedge against
inflation. Because of inflation, the amount of life insurance in most families should be periodically
increased just to maintain the real purchasing power of the original policy.
2) Whole Life Insurance
If the insured wants lifetime protection, term insurance is impractical because the coverage is
temporary, and the premiums are prohibitive in cost at the older ages. In contrast, whole life insurance
is a cash value policy that provides lifetime protection. A stated amount is paid to a designated
beneficiary when the insured dies, regardless of when the death occurs. In other words, whole life

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insurance provides for the payment of the face value upon the death of the insured, regardless of when
it may occur. Whole life insurance policies promise to pay the beneficiary whenever death occurs.
Whole life policies also promise payment if the insured reaches age 100. When insurers make a claim
payment, they say the policy has matured. The insurer knows for a certainty it must eventually pay a
claim on every whole life policy remaining in force. This circumstance is different from both property
insurance and term life insurance policies. Because claims are a certainty with whole life policies, the
insurer must collect enough premiums to pay them. This is one explanation of why whole life
insurance premiums initially are larger than term life insurance premiums.

Cash Values
Whole life insurance contracts contain savings elements called cash values. The cash values are due to
the overpayment of insurance premiums during the early years. As a result, the policy owner builds a
cash equity in the policy. If the owner of a whole life policy decides to terminate it prior to the
insured’s death, then the cash value can be refunded. This is in contrast to term insurance, where
discontinued policies simply cease to provide coverage without any type of refund for the policy
owner.
The cash values are relative small during the early years, but increase over time. For example, in a
whole life policy, a $50,000 policy issued at age 20 may have $25,000 of cash value at age 65.

Types of Whole Life Insurance

The principal types of whole life insurance policies are:
1. Ordinary life insurance 2. Limited payment life insurance
Ordinary life insurance (also called continuous premium whole life and straight life) is a level
premium policy that provides lifetime protection to age 100 and the death claim is a certainty. If the
insured is still alive at age 100, the face amount of insurance is paid to the policy owner at that
time. In addition, premiums do not increase from year to year but remain level throughout the
premium paying period.

Basic Characteristics of Ordinary Life Insurance

Ordinary life insurance has several basic characteristics. First, as stated earlier, premiums are level
throughout the premium-paying period. As a result, the insured is actuarially overcharged during the
early years and undercharged during the later years. The premiums paid during the early years are
higher than is actuarially necessary to pay current death claims, whereas those paid in the later years
are inadequate for paying death claims. The excess premiums paid during the early years are
accumulated at compound interest and are then used to supplement the inadequate premiums paid
during the later years of the policy. A second characteristic is the accumulation of cash-surrender
values, which is the amount paid to a policy owner who surrenders the policy. As noted earlier, under a
system of level premiums, the policy-owner overpays for the insurance protection during the early
years, which results in a legal reserve and the accumulation of cash values.

Uses of Ordinary Life Insurance

An ordinary life policy is appropriate in two general situations:
1. When lifetime protection is needed. This means that the need for life insurance will continue
beyond age 65 or 70. Some financial planners and consumer experts point out that the average

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 person does not need large amounts of life insurance beyond age 65, because the need for life
insurance declines with age. This view is an oversimplification of a complex issue and can be
misleading. Some persons may need substantial amounts of life insurance beyond age 65.
i. Ordinary life insurance can also be used to save money. Some insureds wish to meet
their protection and savings needs with an ordinary life policy. As stated earlier,
ordinary life insurance builds cash values that can be obtained by surrendering the
policy or by borrowing the cash value.

Limitation of Ordinary Life Insurance

The major limitation of ordinary life insurance is that some people are still underinsured after the
policy is purchased. Because of the savings feature, some persons may voluntarily purchase or be
persuaded by a life insurance agent to purchase an ordinary life policy when term insurance would
be a better choice. For example, assume that Mark, age 30, is married with two dependents to support.
He estimates that he can spend only $500 annually on life insurance. Based on the rates of one insurer,
this premium would purchase about $56,000 of ordinary life insurance. The same premium would
purchase more than $600,000 of five-year term insurance from many insurers. It is difficult to justify
the purchase of ordinary life insurance if it leaves the insured inadequately covered.

ii. Limited Payment Life Insurance

A limited payment life insurance policy is another type of traditional whole life insurance. The
insurance is permanent, and the insured has lifetime protection. The premiums are level, but they are
paid only for a certain period. For example, Shannon, age 25, may purchase a 20-year limited payment
policy in the amount of $25,000. After 20 years, the policy is completely paid up, and no additional
premiums are required even though the coverage remains in force. A paid-up policy should not be
confused with one that matures. A policy matures when the face amount is paid as a death claim or as
an endorser. A policy is paid-up when no additional premium payments are required.

The most common limited-payment policies are for 10, 20, 25, or 30 years. A paid-up policy at age 65
or 70 is another form of limited-payment insurance. An extreme form of limited-payment life
insurance is single-premium whole life insurance, which provides lifetime protection with a single
premium. Because the premiums under a limited-payment policy are higher than those paid under an
ordinary life policy, the cash values are also higher. A limited-payment policy should be used with
caution. It is extremely difficult for a person with a modest income to insure his or her life adequately
with a limitedpayment policy. Because of the relatively high premiums, the amount of permanent life
insurance that can be purchased is substantially lower than if an ordinary life policy were purchased.

3) Endowments Insurance
Endowment insurance is another traditional form of life insurance. Endowment policy pays the face
amount of insurance if the insured dies within a specified period; if the insured survives to the end of
the endowment period, the face amount is paid to the policy owner at that time. For example, if
Stephanie, age 35, purchased a 20-year endowment policy and dies any time within the 20-year period,
the face amount is paid to her beneficiary. If she survives to the end of the period, the face amount is
paid to her.
Endowment contracts provide death benefits for a specified period of time, just as term insurance does.
However, unlike term insurance, endowment insurance has cash value, and the policy owner is paid
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the contract`s face amount at the end of the protection period if the insured is still alive. Endowment
insurance may be a useful way for some persons to accumulate a specified sum over a stated period of
time whether they live or die. The objective may be to pay living expenses during retirement, or to
retire a debt.

VARIATIONS OF WHOLE LIFE INSURANCE

Some important variations of whole life insurance include the following:
Variable Life Insurance: Variable life insurance is fixed premium policy in which the death benefit
and cash surrender value vary according to the investment experience of a separate account maintained
by the insurer. The entire reserve is held in a separate account and is invested in equities or other
investments. The cash surrender values are not guaranteed.
Universal Life Insurance: Universal life insurance is another variation of whole life insurance.
Theoretically, universal life can be viewed as a flexible premium policy that provides life time
protection under a contract that separates the protection and saving components. Universal life
insurance has following features:
• Unbundling of protection, savings, and expense components
• Two forms of universal life insurance
 Pays a level death benefit during the early policy years.
 Provides for an increasing death benefit.
• Considerable flexibility.
• Cash withdrawals permitted.
• Favorable income tax treatment.
Variable Universal Life Insurance: This is similar to universal life insurance with two major
exceptions. First, the cash values can be invested in a wide variety of investments. Second, there is no
minimum guaranteed interest rate, and the investment risk falls entirely on the policy owners.
Current Assumption Whole Life Insurance: Current assumption whole life insurance is a
nonparticipating whole life policy in which the cash value is based on the insurer’s current mortality,
investment, and expense experience. An accumulation account is credited with a current interest rate
that changes over time.
An Indeterminate Premium Whole Life Policy: This is a policy that permits the insurer to adjust
premiums based on anticipated future experience. The initial premiums are guaranteed for a certain
time period and can then be increased up to some maximum limit.
Modified Life Policy: Modified life policies are whole life policy in which premiums are lower for the
first three to five years and are higher thereafter.

Aaa

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4) Annuities
An annuity can be defined as periodic payment to an individual that continues for a fixed period or for
the duration of a designated life or lives. The person who receives the periodic payments or whose life
governs the duration of payment is known as the annuitant.
In one sense, an annuity may be described as the opposite of life insurance. Life insurance creates an
immediate estate and provides protection against dying too soon before financial assets can be
accumulated. The fundamental purpose of a life annuity is to provide a lifetime income that cannot be
outlived to an individual. An annuity is designed to liquidate a principal sum and provides protection
against the loss of income because of excessive longevity and the exhaustion of one’s savings. The
“loss” an annuity insures against is living a long time. This sounds like a loss most people may like.
Old age without money can be a tragedy, however. An annuity insurance operation transfers funds
from those who die at relatively early age to those who live to relatively old ages. That is, some
annuitants will live to take out much more than they paid in as a premium. Other annuitants will not
live long enough to take out as much as they paid in premium. An insurance company earns interest on
all the money in the pool. Thus, the annuitant’s payments come from three sources:
 Liquidation of the original premium payment, or principal  Interest earned on the principal
 The unliquidated principal of annuitants who die early

Types of Annuities
Insurers classify annuities using the following five criteria.
 Method of premium payment: If an annuity is purchased with a single-premium payment, it is
called a single-premium annuity. An annuity purchased by a series of annual (or more
frequent) payments, much like level-premium whole life insurance, is known as an annual–
premium annuity.
 Time when benefits begin: The annuity payments to the annuitant can be made monthly,
quarterly, semiannually, or annually. The payments or benefits can start immediately or be
deferred until some later date. An immediate annuity is one where the first payment is due one
payment interval from the date of purchase. If the income is paid monthly, the first payment
starts one month from the purchase date, or one year from the purchase date if the income is
paid annually. A deferred annuity provides an income at some future date. Insurers call the
period during which the annuitant is paying premiums to the insurer the accumulation period.
Insurer call the period during which the insurer makes payments to the annuitant the
liquidation period. With most deferred annuities, if an annuitant dies during the accumulation
period, a beneficiary is entitled to the return of the premiums, often with interest. A deferred
annuity can be purchased with a lump sum, or the contract may permit flexible premiums and
installment payments. A deferred annuity purchased with a lump sum is called single premium
deferred annuity. A deferred annuity can also be purchased with flexible premiums. A flexible
premium annuity is a contract that permits the annuity owner to vary the premium deposits.
There is no requirement that a specified amount must be deposited each year. Thus, the annuity
owner has considerable flexibility in the payment of premiums. The amount of retirement
income will depend on the accumulated sum in the annuity at retirement.
 Promises purchased: Annuities can also be classified in terms of the insurer`s promises or
obligations under the contract. A straight life annuity is an annuity that pays benefits only
during the lifetime of the annuitant. If the annuitant dies the day after purchasing the annuity,
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 there is no obligation for the insurer to return any of the purchase price. A straight life annuity
provides a lifetime income to the annuitant only while he or she is alive. No further payments
are made after the annuitant dies. A life annuity with guaranteed payments is one that pays a
life income to the annuitant with a certain number of guaranteed payments. If the annuitant dies
before receiving the guaranteed number of payments, the remaining payments are paid to
designated beneficiary. An installment refund annuity pays the annuitant a lifetime income.
However, if the annuitant dies before receiving total payments equal to the purchase price of
the annuity, the income payments continue to the beneficiary until they equal the purchase
price. Another version of this option is the cash refund annuity. If the annuitant dies before
receiving total payments equal to the purchase price of the annuity, the balance is paid in one
lump sum to the beneficiary.
 Number of annuitants covered: An annuity may be purchased to cover one or more lives. A
single-life annuity covers one life. A joint-life annuity covers two lives. With this contract,
payments cease at the death of either annuitant. A joint-and-survivor annuity provides
payment to two annuitants, with the payments continuing for as long as either annuitant is alive.
If the payments are reduced by one-half (or two–thirds) after the death of one annuitant, the
contract is called a joint-and-one-half (or joint–and –two –thirds) survivor annuity.
 Type of benefits: Annuities can also be classified in terms of fixed or variable benefits. Under a
fixed annuity, the periodic payment is a guaranteed fixed amount; during the accumulation
period, the premiums are invested in bonds, mortgages, and other fixed income securities with a
guaranteed return. In contrast, a variable annuity is an annuity that provides a lifetime income,
but the periodic income payments will vary depending on the level of common stock prices.
The fundamental purpose of a variable annuity is to provide an inflation hedge by maintaining
the real purchasing power of the periodic payments during retirement.

Rate Making in Life Insurance

Life insurance rates are influenced by three major determinates:
1. Expected mortality rates in the insured population, 2) Investment income earned by the
insurer on invested premium income, and
3) Expenses incurred in operating an insurance enterprise and in providing insurance-related
services.
The procedure in this section illustrates how these determinants are incorporated into rates for standard
or traditional life insurance coverages, in which the insurer promises a stated Birr benefit in return for a
stated premium.

Mortality Table
Mortality table is a table that shows the number of deaths per thousand and expectation of life at
various ages. For large numbers of people actuaries have developed mortality tables on which
scientific life insurance rates may be based. These tables, which are revised periodically, state the
probability of death both in terms of deaths per 1,000 and in terms of expectation of life.

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Table 5.1 illustrates the mortality experience in current use. It shows that male age 20 has an
expectation of living 52.37 years. At age 20 only 190 men (105 women) in every 100,000 are expected
to die before they become 21. The probability of death at age 20 is thus 0.19 percent. At age 96 the
death rate is slightly over 38 percent, since 384 per 1,000 are expected to die during that year. At age
100 it is assumed that death is a certainty. The probability of death expressed in mortality table is based
on insured lives and not the whole population.

Present Value Table

Since the insurance company collects the premium in advance and does not pay claims until the future
date, it has the use of the insured’s money for some time, and it must be prepared to pay interest on it.
The life insurance collect large sums of money, and since their obligations will not mature until
sometime in the future, they invest this money and earn interest on it.

In the example of net single premium calculation that follows, the insurer expects to pay benefits of
$190,000 at the end of the year. How much money should it have on hand at the beginning of the year
to fund the claims? Financiers use tables, called present value tables, to answer this question. Present
value tables combine interest rates, time periods, and an ending balance of $1 to calculate a beginning
amount, the present value of the $1. A present value table tells us if we invest $0.97087379 at the
beginning of the year, we will have $1 at the end of the year assuming we earn 3 percent interest.

Net Single Premium

Although most life insurance policies are not purchased with a single premium, the net single premium
forms the foundation for the calculation of life insurance premiums. The net single premium (NSP) is
defined as the present value of the future death benefit. It is that amount, which together with
compound interest, will be sufficient to pay all death claims. In other words, the net single premium is
the amount the insurer must collect in advance to meet all the claims arising during the policy period.
In calculating the NSP, only mortality and investment income are considered. A loading for expenses
will be considered later, when the gross premium is calculated.

To illustrate the general method of calculating the net single premium, we will assume that a given
insurer wishes to determine the premium for a one-year term insurance contract with a face amount of
$1,000 for a group of entrants, age 20. Reference to the CSO 1980 table of mortality reveals that the
probability of death at age 20 for a male is 0.0019. This means that out of 100,000 men living at the
beginning of the year, 190 will die during the year. The rate-maker in life insurance makes three
assumptions in calculation the necessary premium (i.e., the NSP is based on three basic
assumptions):
1) All premiums will be collected at the beginning of the year and hence it will be possible to earn
interest on the advance payment for a full year (i.e., premiums are paid at the beginning of the
policy year),
2) Death claims are not paid until the end of the year in question (i.e., death claims are paid at the
end of the policy year). In practice, of course, death claims are paid whenever death occurs.
Thus, the assumptions of the rate-maker are inaccurate, for on the average, one-half of a year`s
interest will be lost on the sums so paid. However, an adjustment for this loss of interest is
made in the loading formula.
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 3) The death rate is uniform throughout the year.

Certain assumptions must also be made concerning the probability of death at each attained age.
Calculation of the premium under these assumptions is simplified because insurer knows that if a
$1,000 policy is issued to each of the 100,000 entrants, death claims of $190,000 will be payable at the
end of the year. The problem then is one of discounting the sum for one year at some assumed rate of
interest. Thus, if the insurer is to guarantee earnings of 3%, $0.9708 must be on hand now in order to
have $1.00 at the end of one year. Therefore, to find the present value of $190,000 at the end of one
year, this amount is multiplied by 0.9708 obtaining $184,452.

Present value of $190,000 at the end of one year = $190,000 x 0.9708 = $184,452

The proportionate share of this obligation attached to each entrant is $184,452 ÷100,000, or $1.84. If
each entrant pays $1.84, the insurer will have sufficient funds on hand to pay for death costs under the
policy. The $1.84 is known as the net single premium.

The cost of each year’s insurance is determined by multiplying the probability of death by the amount
of insurance multiplied by the present value of $1 for the time period the funds are held.

Amount of Insurance x Probability of Death x Present value of $1 at 3 percent $1,000 x $ 0.0019

x $0.9708 = $1.84

Assume that the actuary must calculate the net single premium for $1,000 one–year term insurance
policy for a 35-year–old male at 3% interest rate and the 1980 table.

The net single premium under these assumptions is: $1,000 x 0.00211 x 0.9708 = $2.04

The net single premium for a $1,000 term policy of, say, three years is calculated in a similar manner,
except that the calculation is carried out over a three period instead of one. Table 5.2 illustrates the
method.

Table 5.2: Figuring the NSP for a three–year Term Insurance Policy
Number Assumed Number Amount of Present value Present Value To
be Living at Dying Death Claims of $1.00 of Death Claims
at 3% Interest

Age 20 100,000 190 $190,000 0.9708 $184,452

Age 21 99,810 191 191,000 0.9425 180,018
Age 22 99,619 189 189,000 0.9151 172,954
$537,424

The net single premium is then computed: $537,424 ÷ 100,000= $5.37

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It will be observed that each person must pay in advance the sum of $5.37 for three years of protection.
Alternatively the net single premium payable by an individual for $1,000 policy of 3 years term could
also be computed using the earlier formula.
NSP = Amount of Insurance x Probability of Death x Present Value of $1 at 3 percent
$1,000 x 0.0019 x 0.9708 = $1.8445
1,000 x 0.00191 x 0.9425 = 1.8001
1,000 x 0.00189 x 0.9151= 1.7295
$5.3741

While the calculation above is a simple one, it illustrates basic method of premium calculation in life
insurance. The net single premium for a whole life policy, for example, is figured in exactly the same
manner as the example above, except that the calculations are made for each year from the staring age
to the end of the mortality table.

Net Level Premium

It would be impractical to attempt to collect a net single premium from each member of an insured
group. Few people would have necessary funds for an advance payment of all future obligations.
Therefore, actuaries must calculate an annual premium.

If premiums are paid annually, the net annual level premium must be the mathematical equivalent of
the NSP. The net annual level premium cannot be determined by simply dividing the NSP by the
number of years of premium payments. Such a division would produce an inadequate premium for two
reasons. First, the NSP is based on the assumption that premiums are paid at the beginning of the
period. If premiums are paid in installments, and some insureds die early, there is a loss of future
premiums. Second, installment payments result in the loss of interest income because of the smaller
amounts invested. The mathematical adjustment for the loss of premiums and interest is accomplished
by dividing the NSP by the present value of an appropriate life annuity due of $1. More specifically,
the net annual level premium (NALP) is determined by dividing the present value of a life annuity due
of $1 (PVLAD) for the premium-paying period. Thus, we obtain the following:

NALP = NSP ÷ PVLAD of $1 for the Premium-Paying Period

If the annual premiums are paid for life, such as in an ordinary life policy, the premium is called a
whole life annuity due. If the annual premiums are paid for only a temporary period, such as five-year
term insurance, the premium is called a temporary life annuity due.

The present value of an annuity due of $1 a year for three years is the present value of a series of
payments of $1 each year, the first payment due immediately, adjusted for the probability of survival
each year. The calculation is shown in Table 5.3.

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Table 5.3: Present value of Life annuity due of $1 for a three-year term insurance policy
Age Present value of $1, Number of Entrant Discounted Value of
First payment due immediately, Group Still Living each Payment
at 3% interest
20 $1.0000 100,000 $100,000
21 0.9708 99,810 96,896
22 0.9425 99,619 93,891
$290,787

The value per entrant can then be computed: $290,787 ÷ 100,000 = $2.91
The PVLAD of $1 a year for three years can also be calculated in the following manner.
PVLAD = Payments of Each Year x PV of $1, first payments due immediately at 3% interest x
Probability of Survival
$1 x 1.0000 x 1.0000 = 1.0000
1 x 0.9708 x 0.9981 = 0.9690
1 x 0.9425 x 0.9962 = 0.9389
$2.91
The present value of an annuity due may be interpreted as follows: What is the present value of a
promise of a large group of people to a pay a sum of $1 each year for three years? As the first payment
is due immediately (corresponding to the fact that life insurance premiums are collected in advance),
its present value is $1. The second payment is due one year from now. If everyone lived to pay his or
her share, the present value of the second payment would be $0.9708. Not everyone will live, however,
and so the $0.9708 must be reduced to reflect this fact. The amount is therefore, reduced by a factor
that specifies how many may be expected to live to pay their share (i.e., the amount is multiplied by the
probability of survival of the original group of entrants). This process is continued, and we find that the
present value of the promise is $2.91. If the sum is divided into a present value of the total death claims
(i.e., the net single premium), the insurer knows how much must be collected annually from a specified
group of insureds in order to have a sum that will enable the insurer to pay all obligations. The net
level premium for the three-year term policy is, thus, $5.37 ÷ 2.91 = $1.85, which is, of course, greater
than the quantity $5.37 ÷ 3 = $1.79, determined by a division of the net single premium by the
premium-paying period.

Gross Premium
Gross premium is the premium charged for insurance that includes anticipated cost of losses, overhead,
and profit. The net level premium for life insurance represents the pure premium that is unadjusted for
the expenses of doing business. The pure premium is actually the contribution that each insured makes
to the aggregate insurance fund each year for the payment of both death and living benefits. The gross
premium is determined by adding a loading allowance to the net annual level premium. The loading
allowance must cover all operating expenses, provide a margin for contingencies, and, in the case of
stock insurers, provide for a contribution to profits. If the policy is a participatory policy, the loading
must also reflect a margin for dividends.

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Health Insurance
Health insurance may be defined broadly as the type of insurance that provides indemnification for
expenditures and loss of income resulting from loss of health. Health insurance is insurance against
loss sickness or bodily injury. Health insurers sell a wide variety of individual health insurance
coverages. The most important individual coverages include the following:
Medical expense insurance: Medical expense insurance provides for the payment of the costs of
medical care that result from sickness and injury. Its benefits help to meet the expenses of
physicians, hospital, nursing, and related services, as well as medications and supplies. Benefits
may be in the form of reimbursement of actual expenses (up to a limit), cash payments, or the
direct provision of services. The medical expenses may be paid directly to the provider of the
services or to the insured. Medical expense insurance includes:
 Hospital insurance: A hospital insurance contract is one of the basic health insurance
policies. A hospital insurance policy provides indemnification for necessary hospitalization
expenses, such as room and board while hospitalized, laboratory fees, nursing care, use of
the operating room, and certain medicines and supplies. Hospital contracts limit coverage by
stating a flat daily amount for a specified number of days such as 30, 70, 120, or 365.
Expenses in excess of the amount provided in the policy must be paid by the insured.
Exclusions under hospitalization contracts:
Like all insurance policies, hospitalization contracts offered by insures are subject to exclusions. The
following exclusions are typical of hospitalization contracts:
 Expenses resulting from war or any act of war.  Expenses resulting from self-inflicted
injuries.
 Expenses payable under worker’s compensation or any occupational disease law. 
Expenses incurred while on active duty with the armed forces.
 Expenses incurred form purely cosmetic purposes.
 Expenses incurred by individuals on an outpatient basis.
 Services received in any government hospital not making a charge for such services.

 Surgical insurance: Another type of basic health insurance is the surgical insurance
contract, which covers physicians` fees associated with covered surgeries. The surgical
contract provides set allowances for different surgical procedures performed by duly
licensed physicians. In general, a schedule of operations is set forth together with the
maximum allowance for each operation.
 Physician`s expense insurance: The third type of basic health coverage is physician`s
expense insurance (formerly called “regular medical expense insurance”), which is usually
is written in conjunction with other basic coverages rather than as a stand-alone contract.
Physician`s expense insurance provides benefits to cover a physician`s fees for nonsurgical
care in a hospital, home, or doctor`s office. The coverage is seldom written alone, but must
be included with one of the other medical expense insurance (hospital or surgical insurance).
Physician`s expense insurance pays for visits to a doctor`s office or for a doctor`s house

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 calls or hospital visits, usually with a limit per visit (e.g., $25 to $50) and a maximum
number of calls per sickness or injury.
 Regular Medical Contract: The regular medical expense insurance pays part or all of
physicians’ ordinary bills, such as his called at the patient’s home or at a hospital or a
patient’s visit to his office. It is contract of health insurance that covers physicians’ services
other than surgical procedures. Normally, regular medical insurance is written in
conjunction with other types of health insurance and is not written as a separate contract.
 Major medical insurance: Insureds often desire broader coverage than that provided by the
basic coverages just discussed. The major medical policy is the contract that is most
appropriate for the large medical expenses that would be financially disastrous for the
individual. The contract is issued subject to substantial deductible and with a high maximum
limit. A major medical policy might have a $100,000 maximum limit for any one accident
or illness, have a $500 deductible for any one illness, and contain all agreement to
indemnity the insured for a specified percentage of the bills, such as 80 percent over and
above the amount of the deductible. Without the coinsurance clause, there would be no
incentive for the insured or the doctor to keep expenses within reasonable limits.
Disability income insurance: Disability income insurance provides periodic income payments
to the insured while he or she is unable to work as a result of sickness or injury. Coverage may
be provided for disabilities resulting from accidents only or for disabilities resulting from
accidents and sickness. Disability income insurance policies are designed as either short or long
term, depending on the period coverage is provided. Short-term policies provide a specific
number of weeks of coverage, perhaps 30 weeks, after a brief (for example, one-week)
elimination period. An elimination period is a period that must elapse before an insured is
eligible to receive insurance payments. The purpose of the elimination period is to exclude
payments for minor illness. This provision helps keep premiums affordable. Long-term
disability income insurance policies provide a number of years of protection such as five or ten
years. Some long-term disability policies pay until age 65, and still others pay lifetime benefits.

“END OF CHAPTER 5”

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