Its a commonly held belief that the pricing of life insurance is as much art as science. Given the fiercely competitive nature of the life insurance market today, however, such art has been raised to Rembrandt-like levels.
The question is, why? Certainly, some pricing differences between companies are attributable primarily to different views of sufficient returns for a given product. Even so, most carriers target 2% to 5% after-tax profit margins and/or a 10% to 14% return on investment on most of their new life policy pricing.
If carriers have similar profit targets, what, then, can explain differences in price competitiveness they often display? To outside observers, this can be one of lifes greatest mysteries!
I suggest the answer lies in the varying approaches to pricing that insurers can use. Here are some examples:
Expense allocations. Choosing whether expenses should be allocated on a per policy, percent of premium, or per $1,000 of insurance basis may seem to be a trivial decision. However, judicious choices here can alter a carriers competitive position. These “brush strokes” are most evident when comparing particular pricing cells–the price for a specific combination of gender, risk class, and issue age.
Carriers that feel comfortable in their ability to predict future business mix by age, risk class, etc., may effectively force certain pricing cells to pick up a greater expense burden than other key competitive cells.
Capital allocations. Such allocations between pricing cells can be shifted in the same way as expenses, provided that overall capital requirements (rating agency, National Association of Insurance Commissioners, or internal) can be met.
As an example, smokers and older-age insureds may be priced with a heavier mortality (C-2) risk capital component than nonsmokers and younger ages, helping to improve nonsmoker and younger-age pricing.
Further, when you view capital requirements at the company level, not product level, you may find additional reductions in capital are possible in product pricing.
Modal premiums in pricing. Recognizing these premiums can improve profit results, particularly if expenses associated with the increased processing costs have already been “baked” into the companys expense assumptions.
Future profits associated with the premium tail. In term life insurance pricing, recognizing these future profits beyond the level premium period can be a source of distinction between carrier pricing.
Many companies today choose to ignore any profits or losses after the level current premium period. One of the outgrowths of Regulation Triple-X is that the steeply rising yearly renewable term premiums normally charged after the level premium period may be less helpful in mitigating reserves than in pre-X days. Therefore, less severe YRT premium jumps may lead to better business retention at that point and increased future tail profits.
DAC tax credits. Profitability can improve if a carrier recognizes the DAC tax credits that remain at the end of the pricing horizon due to payment of premiums in the last years of the pricing model. This is especially important for the life insurance business, where the DAC tax burden is large.
Consider this example: If a life carrier prices its contracts over a 20-year horizon, premiums paid in years 11 through 20 may continue providing federal tax relief to the insurer in policy years 21 through 30. These are real economic benefits that should be recognized in pricing, even though the pricing horizon ends at year 20.
Optional riders and benefits. Some companies view these as policy additions, but they dont build the revenues associated with them into profitability expectations. But, if the companies have numerous people opting for these riders and benefits, there is no reason why they shouldnt factor the profitability the features generate into the overall product pricing. Some companies already do this.
Non-lump-sum settlement options. For insurers committed to encouraging such options at death or surrender, additional investment earnings on the retained assets can strengthen base plan profitability figures if the retention rate is material.
Future mortality improvements. Some insurers choose not to reflect these improvements, due to philosophical issues or perceived constraints of illustration or reserve rules.
However, history has shown that mortality has improved; and improvements in underwriting techniques and general medical advances are likely to continue. Therefore, it is difficult to see how most types of death benefit-oriented life insurance can be priced competitively today (pre-reinsurance) without some degree of anticipated future improvement in mortality.
Future commissions. Some insurers assume not all such commissions will be payable. Perhaps thats due to vesting rules of the agent compensation program or to the prediction that some percentage of the in-force business will eventually become orphaned. Meanwhile, other carriers do not price by making such assumptions.
Profit subsidies between pricing classes. This is common, especially for term life insurance. The most visible pricing cells (Male, Preferred Non Tobacco, Age 35 or 45) are frequently loss leaders for a competitive term carrier. But how much profit subsidy is acceptable? For some insurers, no pricing cell can be projected to lose money on its own. For others, no cell can be projected to lose more than $X or X%.
Above are only some of the mechanisms that account for pricing variations between life contracts. Many more exist. Rest assured, pricing artists will continue to be creative.
Timothy C. Pfeifer, FSA, MAAA, is a principal at Milliman & Robertson, a Chicago actuarial consulting firm.
Reproduced from National Underwriter Life & Health/Financial Services Edition, July 20, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.