Life Insurance Premium is of two types:
(i) Net Premium
(ii) Gross Premium
The two premiums are further sub-divided into two parts:
(i) single premium
(ii) level premium.
The net premium is based on the mortality and interest rates whereas the gross premium depends upon the mortality rates, the assumed interest rate, the expenses and the bonus loading.
Single premium is paid in one lump sum while the level premium is paid periodically in instalments.
The level premium may be yearly, half-yearly, quarterly and monthly.
Firstly, net single premium is calculated and other premiums are based on this calculation.
Net Single Premium
Net single premium is that premium which is received by the insurer in a lump sum and is exactly adequate, along with the return earned thereon, to pay the amount of claim wherever it arises whether at death or at maturity or even at surrender.
It does not provide for expenses of management and for contingencies.
Steps for Calculation of Net Single Premium
1. Determine what constitutes a claim (a) death, (b) survival or (c) both
2. Determine when claims are paid (a) at the beginning, (b) at the end, or (c) during the year.
3. Determine the number of insured.
4. Determine the duration of the policy.
5. Determine the probable number of claims per year.
6. Determine the value of claims per year.
7. Determine the number of years of interest involved and find the present value of a rupee.
8. Determine the present value of the claim for each year.
9. Determine the present value of all future claims.
10. Determine the net single premium, (i.e., present value of future claims) divided by number of assumed for buying policy.
The steps of premium calculation vary according to the nature of the policy which will be clear later on. When premium is calculated several questions emerge simultaneously.
Assumptions underlying Rate of Computations
There are certain variables which are to be assumed at a level for calculation and alterations in premium calculations are made at later stage according to the change in the variable.
The following factors are assumed while calculating the net single premium.
(i) As many policies of the given type are being issued as are the number of persons.
(ii) Premiums are collected in advance or in the beginning of the period.
(iii) All collections are immediately invested and will remain invested until money is needed for the payment of claims.
(iv) The insurer will receive an assumed rate of interest. The assumed rate should be conservative to avoid future decline in interest rate.
(v) The interest or dividend or any return of the invested funds is immediately invested for re-earning.
(vi) Mortality rate will be the same as given in the mortality table and will be uniformly distributed throughout the year.
(vii) All policies are of the same amount.
(viii) Claims will be paid only at the end of the period.
These assumptions may not be totally practicable, but they are taken as for making calculation easy. The changes in assumption can be adjusted accordingly.
The gross premium is the premium which is charged by the insurer to meet the amount of claims and expenses.
Thus, the gross premium includes the net premium and loading. Loading is the process to add the expenses to net premium.
The loading may add a certain amount to meet the bonus charges on participating policies. The policy-holders are required to pay this gross premium and they even do not know the net premium.
Therefore, the gross premium is also known as ‘Office Premium’. The policy-holder are, thus, required to pay amount to meet the cost or claim, expenses of business, and loading for bonus if the policy is participating one.
Allocation of Expenses
As has been made clear that the expenses of business are allocated amongst the net premiums. So, in allocation, the insurer faces two problems:
(i) Allocation of expenses over various policies and
(ii) Allocation of expenses over duration of the policy.
(i) Allocation of Expenses over Various Policies
The allocation of expenses over various policies should be equitable. It means that every policy should be allotted the due share of its expenses, some policies involve higher expenses than others and should, therefore, bear higher loading.
The policies involving lesser expenses should be lesser share of total expenses. The total expenses are, therefore, classified so that equitable distribution can be easily done.