Step 1: Analyse Mortality Rates
Insurers begin by examining mortality tables, which provide statistical data on the probability of death across different age groups. These tables are developed using extensive population studies and historical demographic data.
Key aspects considered in this stage include:
- Age of the policyholder: Younger individuals generally have a lower mortality risk compared to older individuals
- Demographic trends: Mortality tables may consider gender, population health trends, and longevity improvements
- Probability of death: Actuaries determine the likelihood that a person within a particular age bracket may pass away during a specific year
This information helps insurers estimate the level of risk associated with issuing a life insurance policy.
Step 2: Determine the Sum Assured
Once the risk probability is estimated, insurers evaluate the sum assured.
Important considerations at this stage include:
- Coverage amount chosen by the policyholder: Higher coverage results in a higher expected claim value
- Financial protection objectives: The coverage may be designed to support dependents, repay loans, or meet long-term financial goals
- Policy structure: Some policies provide fixed coverage, while others may increase or decrease the coverage amount over time
The sum assured plays a crucial role because it determines the potential financial liability that the insurer may need to pay.
Step 3: Estimate the Expected Claim Cost
After assessing the risk probability and coverage amount, insurers estimate the expected claim cost. This is a key part of determining the net premium in insurance. The calculation broadly involves:
- Multiplying the probability of death by the sum assured to estimate the potential payout risk
- Evaluating claim likelihood across a group of policyholders rather than a single individual
- Determining the average claim cost per policyholder based on statistical modelling
For example, if the probability of death for a specific age group is low and the policy offers coverage of ₹10 lakh, the insurer estimates how much money must be collected from policyholders collectively to meet potential claims.
Step 4: Adjust for the Policy Term
Life insurance policies often last for many years, sometimes extending to 20 or 30 years. Since the probability of death increases as individuals age, insurers evaluate the expected claim risk for each year of the policy term. This step involves:
- Projecting risk progression over time as the insured person grows older
- Calculating claim probabilities for each year of the policy duration
- Aggregating the expected claim cost across the entire policy term
This process ensures that the premium calculation reflects the changing risk profile throughout the life of the policy.
Step 5: Consider Expected Investment Returns
Insurance companies typically invest the premiums they collect in financial instruments such as government securities, corporate bonds, and other regulated assets. These investments generate returns over time.
During insurance premium calculation, insurers consider:
- Expected interest earnings from invested premiums
- The time value of money, which means future payouts can be funded with smaller amounts collected today
- Long-term investment strategies that help insurers manage claim liabilities efficiently
Because insurers anticipate earning returns on the collected premiums, the amount required today to cover future claims may be reduced. This adjustment helps determine the final net premium in insurance before additional costs are added to arrive at the total premium payable by the policyholder.
