What is Cost of Insurance? Costing of Life and General Insurance, Methods

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What is Cost of Insurance?

The cost of insurance refers to the premium amount that an individual or a business pays to an insurance company in exchange for coverage and protection against specified risks. Insurance is a contract between the policyholder (the person or entity purchasing insurance) and the insurer (the insurance company) where the insurer agrees to provide financial compensation or benefits for covered losses or events in return for the premium payments.

Determining the cost of insurance is one of the important aspects of underwriting. The cost of insurance is not determined based on the cost of production and distribution or demand and supply, but by aptly assessing the risk.

As discussed earlier, insurance can be classified as life insurance and general insurance. The cost would also depend on the type of insurance to be provided. As the value of humans cannot be estimated as in the case of the value of any non-living object, the procedure to set the cost of insurance would also be different. Let us understand how to calculate the cost of life insurance and general insurance in the next sections.

Costing of Life Insurance

Various factors are taken into consideration to determine the cost of life insurance. Some of these factors are explained as follows:

Mortality table

Insurers deal with the probability of risk or death under the life insurance segment. The probability of risk is estimated based on the historical data. To understand the probability of death, insurers look at the mortality table of a particular period. A mortality table can be either a census mortality table or insured lives mortality table.

The census mortality table provides information on the general population and it is constructed based on births and deaths in the 10 years. Another is the insured lives mortality table, which provides numerical data on the deaths of insured people. The insured lives mortality table is formed by life insurance providers as it is their basic requirement to comprehend the probability of death.

The matrix of the mortality table is based on the selected group. Grouping can be done based on standard lives and substandard or impaired lives. The grouping of the population is required to assess the equality of risk. An individual added to the group should have a similar risk as the risk of other listed individuals. Insurers generally like to qualify for standard lives as the risk involved is lesser than the risk of substandard lives.

To determine whether it is a standard life proposal or a substandard one, the following points are noted:

  • The life to be insured is healthy.
  • It does not have any physical impairment.
  • It is not addicted to anything.
  • It is not involved in a risky occupation.
  • It does not get engaged in risky activities as a hobby.
  • It does not have any unfavorable medical history, i.e. surgery, operations, or critical disease.
  • It does not reside at a location that can be hazardous to health.
  • It carries a normal physical stature.

If the life to be insured does not adhere to the abovementioned points, it may be called impaired or substandard life.

Proposal form

It is the main source of pricing insurance as it contains the details of the applicant with key risk areas. The form helps the insurer to ascertain possible events of risks and the severity of those risks.

Insurable interest

The insurer should have the insurable interest in the life he/she wants to insure. If the insurable interest is missing, the proposal cannot proceed and it is rejected. Insurable interest signifies that the proposer would be in a state of a financial loss if something unfortunate happens to the life insured. The amount of insurance sought should also be appropriate as the cost of insurance would be determined based on this amount.

Medical reports

Reports about the health conditions of the applicant from the authorized medical examiner are attached to the proposal form. These reports are necessary to record particulars like age, weight, and other measurements to verify the identity of the person. These records are required to ascertain possible health issues the applicant might be suffering from.

Any difference in the details provided by the applicant and the medical reports can call for further investigation through laboratory tests to remove any kinds of doubts. Any pre-existing disease or the possibility of disease is counted as a significant risk and taken into consideration to ascertain the cost of insurance.

Confidential reports from other sources

Other sources can include agents and third parties that can help to find information about the applicant. Given that the insurer has to follow the principles of insurance, he/she calls for confidential reports of the applicant through other sources. The insurer has to ensure that the funds are managed efficiently and when the sum insured is high enough, he/she may investigate even the minute details of the case.

Financial status

Even if all other aspects are acceptable, the financial status of the applicant cannot be ignored in the pricing of insurance. The applicant would only be able to avail of any insurance service if he/she can pay the cost of insurance. To ascertain this, not only the information about the income of the applicant is required but his/her need for insurance, the proposed nominee, estimated human value, and the sources of income are also taken into account.

Costing Method Used in Life Insurance

The cost to be paid by an applicant for purchasing a life insurance policy is determined by the level of risk the applicant carries. Insurers generally use the numerical rating system to estimate the cost in an efficient and timely manner.

The numerical rating system originated when medical experts from various countries engaged in an investigation with actuaries and developed valuable data. They worked on various factors like insurability, life expectancy, and mortality rates. Values were assigned to these factors and their correlation and impact on each other were studied. The outcome of these studies evolved into a method to calculate the risks and costs.

When insurers employ the numerical rating system, they assign a standard mortality rate of 100% to the applicant. Then debits or credits are given as per the risks which increase or decrease the mortality rate. Debits are given when there are unfavorable factors that decrease life expectancy; credits are given when factors are found to be favorable. Combining and deducting the rates result in the net rate. The excess rates above 100 are termed extra mortality rates.

When insurers employ the numerical rating system, they assign a standard mortality rate of 100% to the applicant. Then debits or credits are given as per the risks which increase or decrease the mortality rate. Debits are given when there are unfavorable factors that decrease life expectancy; credits are given when factors are found to be favorable. Combining and deducting the rates result in the net rate. The excess rates above 100 are termed extra mortality rates.

Costing of General Insurance

Before the cost is determined and the final insurance contract is handed over to the proposer, the insurer examines various factors through documents like the proposal form and the certificate of insurance submitted by the proposer. Let us discuss these two major documents in brief:

Proposal form

It contains a set of questions regarding the asset or the liability that the applicant needs to insure. The proposal form for each class of asset or liability differs as per the possible risks and losses. For example, while proposal form is being filled for fire insurance, questions will be related to the construction, location and occupancy as well as the details regarding other buildings in the area. On the other hand, for personal accident insurance, que- ries are regarding age, gender, height, weight and impairments if any.

Certificate of insurance

It is the basic requisite for purchasing a motor insurance policy. By law, a motor policy will not come into effect until the proposer has the certificate of insurance.

It contains the details of the insured vehicle, such as registration number, engine number, model and manufacturing of the vehicle, and cubic capacity. These details are mentioned in the certificate along with the details of the insured and the effective period for which the certificate will be valid.

General insurance business in India is undertaken in compliance with the Insurance Act, of 1938. The Tariff Advisory Committee (TAC) is empowered to regulate the pricing of general insurance products. Thus, general insurers cannot charge the rates on their own instead they have to comply with the statutory standards.

However, in any case, the rates are reasonable enough and insurers do not have to suffer losses due to regulations. Pricing encompasses claims cost, administrative costs, margin for fluctuations in claims, and margins for profits for the insurer. Rates under the general insurance sector are subject to change from time to time as insurers take their experience under consideration to fix the prices for the future.

Costing Method of General Insurance

Insurers can apply three methods to determine the cost in the general insurance segment. These methods include:

Class rating

A rating that is based on a class or assets of similar characteristics is called a class rating. The cost is determined by taking an average loss into account. Similar kinds of risks result in similar kinds of losses. Moreover, factors that can cause loss are also similar. It is easy to identify the risk as there is reliable statistical data is available. The rates are specified in rating manuals. Thus, the class rating method is also called the manual rating method.

Judgment rating

The method is applicable where risk is individually evaluated as it is not easily quantifiable due to the absence of historical data. The exposure of risk is also diverse and loss from each type of risk needs to be measured.

Merit rating

Merit rating is based on the risk-taking and claim-raising propensity of an applicant. The premium is charged as per the applicant’s paying capacity.

Article Source
  • Elliott, C., & Vaughan, E. (1972). Fundamentals of risk and insurance. New York: Wiley.

  • Rejda, G. (2008). Principles of risk management and insurance. Boston: Pearson/Addison Wesley.

  • Trieschmann, J., Gustavson, S., & Hoyt, R. (2001). Risk management & insurance. Cincinnati, Ohio: South-Western College Pub.

  • Williams, C., & Heins, R. (1976). Risk management and insurance. New York: McGraw-Hill.

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