Sunday, March 05, 2006

Death Series: Life Insurance


I was born in Hartford, Connecticut, which used to be called -- and, as far as I know, still is called -- the Insurance Capital of the World. The engine of Hartford and its insurance industry is the power of actuarial science. Armies of actuaries crunch away at probabilities every day in Hartford, determining exactly how much the insurers must demand in premiums for various categories of individuals, sorted by age, health, lifestyle, and travel habits, among other things. On the day I was born in Hartford, an actuary down the street could've consulted a mortality table and read off my odds of dying at 25, my odds of dying at 65, etc. With each passing year, with the steady accumulation of medical and lifestyle history, the actuary's prediction becomes more and more precise, until virtually guaranteed.
The insurer (i.e., life insurance company) prices the policies with an intent to recover claims to be paid and administrative costs, and to make a profit.

Claims to be paid are determined by actuaries using mortality tables. Actuaries are professionals who use actuarial science which is based in mathematics (primarily probability and statistics). Mortality tables are statistically based tables showing average life expectancies. Normally, the only three considerations in a mortality table are the insured's age, gender, and whether they use tobacco. The current mortality table being used by life insurance companies in the United States and their regulators was calculated during the 1980s. There is currently a measure being pushed to update the mortality tables by 2006.

The current mortality table assumes that roughly 2 in 1000 people aged 25 will die during the term of coverage. This number rises roughly quadratically to about 25 in 1000 people for those aged 65. So in a group of one thousand 25 year old males with a $100,000 policy, a life insurance company would have to, at the minimum, collect $200 a year from each of the thousand people to cover the expected claims.

The insurance company receives the premiums from the policy owner and invests them, using the time value of money and compound return principles to create a pool of money from which to invest, pay claims, and finance the insurance company's operations. Despite popular belief, the majority of the money that insurance companies make comes directly from premiums paid, as money gained through investment of premiums will never, in even the most ideal market conditions, vest enough money per year to pay out claims. Rates charged for life insurance are sensitive to the insured's age because statistically, an insured person is more likely to pass away and trigger a claim as they get older.

Since adverse selection can have a negative impact on the financial results of the insurer, the insurer investigates each proposed insured (unless the policy is below a company-established de minimis amount) beginning with the application, which becomes part of the policy. Group Insurance policies are an exception.

This investigation and resulting evaluation of the risk is called underwriting. Health and life style questions are asked, answered, and dutifully recorded. Certain responses by the insured will be given further investigation. Life insurance companies in the United States support The Medical Information Bureau, which is a clearinghouse of medical information on all persons who have ever applied for life insurance. As part of the application, the insurer receives permission to obtain information from the proposed insured's physicians.

Life insurance companies are never required by law to underwrite or to provide coverage on anyone. They alone determine insurability, and some people, for their own health or lifestyle reasons, are uninsurable. The policy can be declined (turned down) or rated. Rating means increasing the premiums to provide for additional risks relative to that particular insured discovered in the underwriting process.

Many companies use four general health categories for those evaluated for a life insurance policy. A proposed insured can move down the scale easily, but moving up the scale is difficult if at all possible. These categories are Preferred Best, Preferred, Standard, and Tobacco. Preferred Best means that the proposed insured has no adverse medical history, are not under medication for any condition, and his family (immediate and extended) have no history of early cancer, diabetes, or other conditions. Preferred is like Preferred Best, but it allows that the proposed insured is currently under medication for the condition and may have some family history. Standard is where most people fall, allowing for everybody who doesn't fall under the previous tiers. Profession, travel, and lifestyle also factor into not only which category the proposed insured falls, but also whether the proposed insured will be denied a policy. For example, a person who would otherwise fall under the Preferred Best category will be denied a policy if he or she is employed in or makes regular travel to a high risk country.
From Wikipedia at Life Insurance.

I've always found the foundation of Hartford's industry on mathematicians working out probabilities fascinating: in some ways, Hartford is the bizarro twin of Las Vegas. The life insurance industry makes its money playing the odds; the insurers rely on their actuaries to figure the odds of their insureds dying early, determining who is a good bet, how much to wager, how much security to demand. The insurance industry thrives when it bets well, when it has got the odds covered.

It is interesting to note that the insurance industry in general has a vested interest in people living healthy lives and not getting into accidents. They make money when everyone lives a long, healthy, happy life. (I wonder if they spend a lot of money to help people do so.) The odd thing about life insurance is, of course, that it works out in the insured's favor only if the insured meets an untimely end. Of course, insurance agents don't want us to think of it that way.
"People often say, 'When I buy life insurance I'm betting against myself.' That's the worst expression I've ever heard," Evans says. "When you purchase insurance, you're betting you'll live but providing an assurance in case you're wrong."
From Basics of Life Insurance.

1 comment:

Anonymous said...

Wheeler's Theorem:
The insurance industry has a near perfect business model.

Proof:
1. Insurer collects expensive premiums for years.
2. Upon filing of a claim, insurer refuses to pay.
3. If pushed, insurer negotiates a settlement substantially favorable to insured.
4. Insurer (usually) further decreases loss by requiring payment of deductible.
5. Following payment of claim, insurer initiates suit against some third party (e.g., tortfeasor) and recoups loss.
6. Insurer raises already expensive insured's premiums.