Risk insurance premiums: Stepping up to the plate

A frequent debate in the financial planning arena is over which premium structure should be used when putting in place a risk insurance solution. When is one better than the other, and are there guidelines upon which the adviser can rely when making the recommendation?

Premium definitions

It has long been accepted that there are two types of premium: stepped and level. These are generally defined this way:

• Stepped premiums — The premium rate is dictated by the age of the life insured when the policy starts and each subsequent policy anniversary date. In other words, the premium increases as the life insured grows older; and

• Level premiums — The premium rate is dictated by the age of the life insured when the policy starts but it does not change as the life insured grows older. In other words, the premium stays the same throughout the life of the policy.

Notwithstanding the above definitions, in describing how premiums will operate, it should be remembered that factors other than age can affect the premium being charged (eg, both stepped and level premiums will increase if the policy fee or government charges increase).

Non-cancellable risk insurance policies also contain a premium rate guarantee: the rate for a particular policy cannot be increased as a result of the claims experience of the life insured under that policy.

On the other hand, there is usually a review provision within the policy that provides for the premium rate of a group of policies to be increased if the claims experience of the group as a whole is not in line with the original actuarial pricing assumptions.

For example, if the claims experience of the income protection insurance product range of insurer ABC was worse than that provided for by the pricing actuary, insurer ABC may well make an appropriate increase in the premium rates for all those policies.

This facility generally applies to both stepped and level premium contracts.

Thus, a level premium policy may start, for example, when the life insured is age 40 at a rate of $10 per $1,000 of cover. Although if the overall claims experience of the portfolio was poor, this rate might be increased to, say, $12.50 per $1,000 of cover several years later.

But not all level premium policies have this provision, and some level premium policies provide that the original level premium rate can never be increased — even if the portfolio experience is poor.

While this provision is good news for the in-force policy owner, it effectively means that new lives insured will not only bear the burden of their appropriate risk premium but they may also bear the burden of subsidising the under-funded cover on in-force lives insured.

While the ‘guaranteed’ level premium facility is not available in any current retail products, it does exist in a small range of legacy products. Advisers reviewing in-force policies may need to be careful to check if any such guarantee is present when making a recommendation to replace or retain.

A further distinction within level premium insurance policies is the treatment of consumer price index (CPI) increases in cover.

Again, for example, a policy may start when the life insured is 40 years old for a benefit amount of $500,000 with a premium rate of $10 per $1,000 of cover.

On the first policy anniversary, the cover may automatically increase by 5 per cent CPI to $525,000.

Generally, the $25,000 increase in cover would attract the level premium rate that applied at the time of the increase (ie, age 41) which might be $11 per $1,000 of cover.

On the other hand, some policies boast a ‘true’ level premium for which even CPI increases are charged the original level premium rate of, in this case, $10 per $1,000 of cover.

This provision can make a significant difference to the total accumulative premium cost as set out in table 1, which shows accumulative premiums payable from entry age through to age 65.

All other factors being equal, one would expect the premium rate for ‘true’ level premium policies to be higher for a given benefit amount as a greater reserve would need to be set up to cover the funding of future CPI age increases.

So a more precise definition of level premium would be something like this:

• Level premiums — The premium rate for the original benefit amount is dictated by the age of the life insured when the policy starts. However, the insurer may or may not have the facility to increase this rate based on the claims experience of the portfolio of policies and the premium rate for indexation increases may or may not be the same as the premium rate for the original benefit amount.

Moving on from any differences in definitions, the question to be asked next is: When is one premium type better than the other, or more accurately, when is one more appropriate than the other?

In simple terms, if the risk insurance need is relatively short-term, a stepped premium is likely a better option.

And, conversely, if the risk insurance need is relatively long-term, a level premium is likely a better option.

The above is naturally contingent on other influencing factors such as:

• Premium affordability — While a level premium may be a more appropriate option, is the client able to afford the higher initial premium cost); and

• Opportunity cost — While the client may be able to afford the level premium costs for, say, a long-term income protection insurance need, would this compromise the client’s ability to afford the necessary amount of trauma and TPD cover required?

Also, subjectivity surrounding the words short-term and long-term should be considered. A 35-year-old retaining an income protection policy for 10 years is relatively short-term; however, a 55-year-old retaining income protection for 10 years is relatively long-term.

Premium comparisons

Table 2 is a standard comparator for stepped versus level premiums. It sets out, for various ages, how long it takes before the stepped premium charged will exceed the level premium. The numbers are indicative only as they will likely vary by insurer and by product. Table 3 shows the number of years before the total stepped premiums paid will exceed the total level premiums paid.

If a more accurate comparison were required, the present-day value of future premiums would need to be taken into account.

One final and lesser-known wild card (assuming a need for level premium exists) is: when is the best time to put it in place, when the client is young or when the client is older?

In the past, there has been a view that initially, and especially for younger lives insured, stepped premiums should be used because up to age 45 the annual increments in the stepped premium rates are relatively small. Only when these increments start to be larger would a move to level premium have merit.

While the above thinking sounds logical, the maths flies in the face of it.

Assume there are three clients aged 30, 40 and 50. Each takes out a level premium policy through to age 60. Thus the 30-year-old has the policy in force for 30 years, the 40 year old for 20 years and the 50 year old for 10 years.

How much does each pay in premiums?

You would be forgiven for assuming the 30-year-old would pay much more than the 50 year old because the premiums would be paid for 20 years longer — but consider table 4.

The 30-year-old who takes a level premium policy and retains it for 30 years will pay considerably less in total premiums than the 50-year-old who retains the insurance for 10 years.

However, if the present day value (at 5 per cent) is considered (see table 5), the position becomes even more compelling because the longer the policy is in force, the greater the discount and the lower is the present day value.

The message is clear and compelling: level premium risk insurance implemented when the insured is young and retained for the long-term may make significant sense.

Level premium expiry age

Different types of insurance have different expiry ages:

• Income protection and business expenses usually expire at age 65;

• Trauma insurance expenses usually expire at age 70; and

• Term and TPD insurance can go through as far as to age 99.

But the level premium option usually expires at age 65 or 70, at which time the premium reverts to stepped.

The reason for this earlier expiry age is that the cost of a level premium policy through to an age greater than 65 or 70 may well be prohibitive. Also, in theory, few policies are retained past ages 65 or 70, so it would be potentially unfair to charge a level premium rate to a higher age because the level premium reserve is sacrificed if the policy is cancelled.

The effect of the level premium facility expiring may be dramatic. If a policy started when the insured was aged 30, for example, the premium may increase fifteen-fold if it reverts to a stepped premium at age 65.

It may well be a good defensive strategy for an adviser to prepare the client well in advance if it is reasonably believed the policy may be retained beyond the level premium expiry age.

Level premium and lapses

The rate of a level premium is affected by the lapse rate of the portfolio, but the effect is different compared to stepped premiums.

With level premiums, the premium excess of level over stepped enables a premium reserve to be built up within the policy. This reserve is drawn upon in later years in order to achieve a level premium.

If the policy is cancelled before the policy expiry date, the insurance company retains the premium reserve that has been built up (ie, there is no cash value for the insured when a level premium policy is cancelled.

In fact, the pricing actuary counts on lapses happening — and makes various assumptions concerning the average lapse rate of policies in the level premium portfolio. The lapse rate affects the amount of retained reserve, which in turn affects the level premium rate.

If the lapse rate is lower than expected, the retained reserve will be lower than expected and the pricing actuary may need to increase the level premium rate as a result.

Therefore, uniquely level premiums can increase, not simply because of a poor claims experience but also because of a good lapse experience.

Portfolio and policy splitting

Another factor to consider when weighing up the pros and cons of stepped and level premium is the facility to split the premium type between policies (ie, have some insurances on a level premium rate and others on stepped premium). It may even be possible to split the premium type within a policy (ie, part of the policy is stepped premium and the remainder is level premium).

Limited availability

A level premium may not always be available (eg, with some superannuation platform business or within industry funds).

Hybrid premiums

There is now a third premium option available — hybrid premiums, or what is termed ‘blended’ premiums by one insurer.

The theoretical thrust behind hybrid premiums is that the average age at which lives insured cancel their insurance with stepped premium is 45; however, the average age of a claimant is 47. In other words, on average, clients cancel their insurance two years before they might claim. And, of course, a major reason for policy cancellation is premiums becoming too expensive. Hybrid premiums seek to overcome this problem.

The premium at the start of the policy operates on a similar basis as a traditional stepped premium (ie, it is based on the age of the life insured with yearly increases as the life insured’s age increases).

Then, at a pre-determined age or after a set policy duration (depending on the insurer), the policy automatically converts to a fixed premium basis.

There are currently two insurers making available a hybrid premium option.

The way in which they each operate their hybrid option is similar in that the initial increasing premium is ‘loaded’ so that it is slightly higher than a standard stepped premium. This effectively builds up a premium reserve within the policy in much the same way that a standard level premium does.

After the policy automatically changes to fixed premiums, the premium reserve enables the subsequent fixed premiums to be lower than would otherwise be the case.

Hybrid premiums are also similar to traditional level premium in that at a subsequent date, for example, when the life insured turns 60, the premium will revert to yearly age-based increases.

The aim of hybrid premium is to provide a mid-range alternative between the extremes of stepped and level, in a similar way to hybrid commissions.

Whether a hybrid premium has merit will depend on the individual client, since there is no guarantee that the fixed premium charged will be less than would have applied had the client started a policy on a standard stepped premium basis and then, at an arbitrary later date, simply converted the policy to a level premium and paid the level premium rate that applied to their age at conversion.

As with most aspects of risk insurance, thorough investigation will often reveal subtle but fascinating aspects of the insurances that can be used to enhance and enrich the recommendation.

Col Fullagar is national manager, risk insurance, at RI advice.