How Life Insurance Premiums are Calculated

Looking at Particulars Which May Influence our Risk

Measuring risk is the primary goal of insurance companies, because they must bear the financial responsibility of the risks that they take on. Taking on risk is what insurance companies do, for a price, and that price needs to be both competitive enough in the marketplace and also provide a positive expected outcome for the company, where they stand to gain more than they stand to lose.

How Life Insurance Premiums are CalculatedInsurance companies work with information that is at least somewhat limited, meaning that they don’t usually know all of the particulars about your situation. Although they do seek to get a good amount of information about you, this will always be incomplete, and even you do not have all of the information that could be used to determine your risk.

For example, there may be things going on which concern your life expectancy that you may not know about. You may have an undiagnosed condition for instance, and we don’t usually learn about such things until it becomes bad enough to notice it, and even then, we often miss things.

We also may be doing things to improve our life expectancy that aren’t accounted for, for example those whose stress levels are very low tend to live longer, as we may expect, or people may be taking other positive steps to improve this that aren’t accounted for by insurance companies, as well as having some negative influencers that aren’t really accounted for much if at all.

How we manage things can differ as well, and an example of this is among type 2 diabetics, where some are much better managed than others, and therefore represent a lower or much lower risk. Insurance companies prefer to use broad categories though and will therefore treat all diabetics the same, even though we might be able to make some good distinctions and come up with a more efficient assignment of risk depending on the circumstances.

Insurance companies actually need to classify things broadly as we can easily get to the point where it becomes impractical to make certain types of fine distinctions. They also need to have a very good and reliable set of statistics on every distinction they make and there is no room for guesswork here.

The Role of Statistics in Life Insurance Premium Calculations

Insurance companies need to have a good idea of how much risk a policy presents to them if they are to price their policies appropriately. Without this knowledge, they will default to taking the broader view of risk, for example by classifying vapers the same way that they do with tobacco smokers simply because both are nicotine users, even though it’s pretty clear that it is not the nicotine itself which presents the major risks here, it is inhaling the products of combustion.

We might think that it would be more judicious for them to make further distinctions, like our example with well controlled diabetics versus the average, it’s just more practical to use averages, and this does end up lumping people together more than what may be desirable.

Age does play a huge role in calculating life insurance premiums, but one person of a certain age may not represent the same risk as another due to a number of differences, and we can say that one’s age may play a disproportionate role in one’s premium calculation. Age is quick and easy though and this demonstrates very well the reliance on simple data over more complex data when it comes to calculating all of this.

It is not that insurance companies do not want to make finer distinctions, but whatever ones they choose to make must be backed up by very solid statistics. If we do not have good data for something, we might intuitively claim that our risk may be lower, but without the numbers to back this up, it is of no use to insurance companies who do not rely on anything but the numbers.

If we are in a category which causes insurance companies to look less favorably upon our risk, which can mean being older or having a medical condition, we are going to be pretty much stuck paying more, since there is no appeal process and no human discretion is ever used here.

Rather, all of this is calculated these days by computer programs, and computers are binary instruments, all they know are 1’s and 0’s and there is no grey area here nor is one possible. We can say that perhaps those who decide upon the formulas used could show more latitude but this again is all based upon statistics, averages, and we have to accept the averages of the classifications that are assigned to us.

All insurance calculations simply go by the numbers using data that is readily available. There are limitations to how much in depth an insurance company will be able to go into when it comes to collecting data, and they will use ones that are readily available to them, ones that have enough data to be useful, like your weight or blood pressure, your age, and other medical factors.

As long as the statistics support something and the data needed can be easily obtained, insurance companies will use the data, and if it turned out that people with red hair represented more of a risk than they would use that to calculate premiums.

With car insurance, one’s credit score is even more important than one’s driving record, and it doesn’t bother insurance companies if this doesn’t make sense to us, if the statistics support this. Credit score does not play a significant role in life insurance though other than you can be denied if your credit history is very poor, a bankruptcy for instance, but it’s only because the correlation between credit scores and life expectancy aren’t strong enough, even though, oddly enough, this is seen to be a major determination with property and casualty insurance like home and auto.

Factors that Go into Calculating Life Insurance Premiums

Your age is the very big influencer of how much you will pay for life insurance, as we may expect it to be, but it is not the only one. This is the starting point for calculations though, and insurance companies will adjust up or down from here based upon factors that relate to your particular risk at your age.

Insurance companies know what the risk is of dying at any given age generally, and this does of course go up with age. We pay more as we get older and finally get to a point where we are not seen as worth the risk, and may then have to settle for small policies that only will cover such things as funeral expenses.

Aside from age, one’s heath matters, although insurance companies will use very broad classifications here. Perhaps in the future one’s individual circumstances will be accounted for more than they are now, but there will always be real limitations on this because one of the big requirements is that the data that is used be easily obtained and applied over a large number of people.

Any preexisting medical conditions will also be accounted for, and depending on the condition, this can disqualify us from obtaining coverage at all. When it does not, it will serve to increase the premium by the amount of risk that it is seen to add based upon statistical calculations.

The less things you have the better, although this is not something we have that much control over. Once you have been diagnosed, you’ve been marked so to speak, and it doesn’t matter all that much if you had high blood pressure but it is now completely under control, because once again, insurance companies are only interested in the easy stuff, the broad categories, and don’t want to go into figuring out all the complexities that looking at how well people manage conditions would involve.

Life insurance usually requires an examination by a medical doctor, for the purposes of full disclosure, and insurers want to have a good idea of at least the major risks that are present prior to issuing a policy. It’s not just the diseases that you suffer from that matters though, as they look at other metrics such as weight and blood pressure to help them assess their risk and your costs.

Lifestyle also factors into this calculation, and those who smoke or are heavy drinkers will pay quite a bit more since they are seen to be significantly riskier. One’s occupation also matters, and this is not simply a matter of working a job with a higher risk of dying. As usual, insurance companies use statistics, and look at the statistics of your occupation and price accordingly.

Occupation looks at longer term risk as well as shorter term, and someone who drives a race car for a living might have a lower risk overall than someone working in an occupation which has people getting sick and dying over the long run like someone working in a coal mine.

Those who have hobbies that are higher risk such as parachute jumping, rock climbing, hang gliding, and so on, can expect to pay more and this all makes sense since these activities are higher risk than hobbies such as gardening or fishing.

People who are more active and get plenty of exercise are also considered to be lower risk than those who are more sedentary, and this is one of the few ways that we can help ourselves, although this is not a category that is that substantially relied upon. There really isn’t much of a correlation between activity and weight management, even though popular culture holds the opposite belief, but managing the way we eat can matter a lot and this is something we can affect as well.

Family history is also relied upon, and quite substantially in fact. Insurance companies ask plenty of questions here and this is seen as modifying one’s risk and life expectancy quite a bit. How long your parents lived and what sort of family history there may be for things like heart disease pay a particularly prominent role.

For the most part, there’s not a whole lot we can do about many of the things that we get assessed on when applying for life insurance, although there are exceptions like quitting smoking, becoming more active, eating healthier, and managing markers such as one’s weight, cholesterol, and blood pressure better.

Ken Stephens

Chief Editor,

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

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