Understanding The Components Of Life Insurance Premium

Insurance, a product that covers life of the policy holder, is an essential investment for any working individual having dependents, because of the monetary support it provides to the family of the policyholder, in the eventuality of death. In order to encourage individuals to include this product in their financial plan, the government provides tax benefit on insurance premium paid under section 80C of the Income tax Act. Also money received from the insurance company with accumulated bonus, is tax free under Section 10 (10D).

On account of the tax benefit, most of us tend to have an insurance plan in our financial portfolio. We pay premium on the same, at various time intervals. But, do we understand how the insurance company has arrived at that premium amount?

How is the premium amount arrived at?

Premium is a composition of various charges put together depending on the type of policy and the insurance company selected. Mortality, policy administration charges will be common across all policies. Policies such as ULIPs and endowment among others, where fund management is involved, charges such as premium allocation, fund management and other charges will be applicable in addition to mortality and administration charges. The balance of which will be invested in the investment fund.

Here is a brief on the elements that determine the premium amount.  

• Mortality Charges (Charge for the risk cover): It is that part of the premium that goes towards providing protection upon death of the policy holder. It is essentially the cost of the insurance cover. These charges vary depending on factors such as
  • Age of life assured: Younger the person, lower the charges, as life expectancy is higher
  • Health of the life assured: No prior medical history will result in lower premium
  • Coverage amount: This is essentially the sum assured
  • Tenure of the policy: The longer the tenure, the lower the premium
  • Occupation of the life assured: Pilot will be charged higher premium as compared to somebody who is doing a desk job

Insurance companies use a mortality table prepared by LIC- the only company that has decades of experience in life insurance. However, some private sector insurers have altered the mortality table and have been using the same. Work is in progress on developing a new mortality table where data of all the companies put together will be taken into consideration.  Mortality charges would be sum assured multiplied by mortality rate (picked from the table).

E.g. The charges per Rs. 1000/- life insurance cover for some of the ages in respect of a healthy life are as under:

So if the coverage amount for a 25 year old categorised as healthy is Rs. 100,000, mortality charges would be Rs. 142

• Rider premium charge:  If you want to make your risk coverage comprehensive, you can opt for riders such as accidental death benefit, permanent disability, critical Illness rider etc. For the same, costs will be levied separately which will be part of the premium charged to you by the insurance company. E.g.: For accident benefit, Rs. 0.50 per thousand of the sum assured will be levied every month.

• Premium Allocation Charge: It is a percentage of the premium deduced from the premium paid towards charges. It primarily includes agents’ commission and is levied at the time of receipt of premium. The balance known as ‘allocation rate’ constitutes that part of premium which is utilized to purchase (investment) units for the policy. Example: If the premium allocation charge is 10%, and the premium paid is Rs 20.000, then premium allocation charge would be Rs. 2000 and the balance amount of Rs. 18,000 is utilised to purchase units for the policy.

• Fund Management charges (FMC): This is a fee charged as a percentage of funds under management for managing your investments. It will vary depending on the insurer and type of fund selected. As per the latest IRDA regulation, FMC on ULIPs have been capped at 150bps for policy with tenure of less than 10 years and 125bps for policy with tenure greater than 10 years. Example: If fund management charge (FMC) is 2% p.a. your fund value before FMC is Rs.100000/- and Fund after this charge will be Rs.98000/-. 2000 rupee will go as FMC.

• Policy Administration Charge: These are charges to meet the general administration expenses. It is over and above premium allocation charges and fund management expenses. It may be a fixed amount or a certain percentage of the premium or a percentage of a sum assured. It is levied at the beginning of each policy month by cancelling units for an equivalent amount. E.g. Rs. 40 per month increased by 1.5% on every anniversary of the policy.

• Service Tax Charge: This is levied on the fund management charge, premium allocation, mortality, policy administration, and on the rider premium. This is declared by the government. The current rate of service tax is 10.30% (Service tax of 10% along with education cess of 3%).

Other Charges: These are charges levied only on the exercise of an option such as surrender, switching, partial withdrawal and alteration to the contract such as increase in term of the policy among others.

• Surrender Charge: This is a charge levied on the fund at the time of surrender of the contract. It is usually expressed either as a percentage of the fund or as a percentage of the annualized premiums
• Switching Charge: This a charge levied on switching your investments from one fund to another available within the product. The charge will be levied at the time of effecting switch and is usually a flat amount per each switch. Example: Rs.100 per switch.
• Partial withdrawal charge: This is a charge levied on the fund at the time of part withdrawal of the fund during the contract period
• Miscellaneous charge: This is a charge levied for any alterations within the contract. This would include change in the term of the policy and increase in the coverage amount among others. E.g.Rs.50 would be charged for any alteration.

There is a gamut of products floating in the market from which one can choose from. Some of them include

• Term insurance: It is a traditional insurance product, which provides only coverage and no cash back. This is the cheapest available product. Premiums increase as you increase in age. If you’re looking for only insurance protection and not a savings product, term insurance is the product you should buy. You can customise term life insurance with the addition of riders, such as accidental death and critical illness among others

• Endowment Policy: This is another traditional product where lump sum is paid out at the end of the pre-specified term, or when the policyholder dies whichever is earlier. Since it provides additional benefits, it is more expensive than a term product.
• Whole life Policy:  The policy does not have a fixed end date. Death benefit exists and is paid to the named beneficiary. The policy holder is not entitled to any money during his or her own lifetime, i.e., there is no survival benefit. Primary advantages of Whole Life Insurance are guaranteed death benefits, guaranteed cash values, and fixed and known annual premiums.
• Money-Back Plan: Here you regularly receive a percentage of the sum assured during the lifetime of the policy. Money-Back plans are ideal for those who are looking for a product that provides both – insurance cover and savings. It creates a long-term savings opportunity with a reasonable rate of return, especially since the payout is considered exempt from tax except under specified situations.
• Pension Plan: The policy is basically a savings contract, which is designed to provide an income for life from retirement, with an option to take the lump sum elsewhere to buy the annuity, provided it is permitted by the prevailing regulations. On maturity this corpus is invested for generating a regular income stream, which is referred to as pension or annuity. The option of receiving monthly/quarterly/half-yearly pension is available with most life insurance companies. Life insurance companies bundle life insurance cover with the pension plan just in case you need a cover too.
• Unit-linked Insurance Plans (ULIPs): Introduced by the private players, this product is a blend of insurance and investment akin to mutual funds. A certain part of the premium is invested in listed equities/debt funds/bonds, and the balance is used to provide for life insurance and expenses. It satisfies the individuals need for an insurance cover and investment. This particular product has gained so much popularity, that significant portion of the business of life insurance companies comes from this product.

This product is promoted by the most insurance agents because of attractive commission on the same, especially in times where they do not earn any commission on mutual fund products. After several consumer complains this product is now on the watchful radar of IRDA and steps have been taken to make expenses charged on this product transparent. The first step in the direction being, a cap levied by IRDA from October 1, 2009 on the total expenses that can be charged by insurance companies. For products with tenure of less than 10 years, expenses have been capped at 300 bps i.e. the difference between gross yield and net yield. For products with tenure greater than 10 years it has been capped at 225 bps.

Investor stand to benefit as reduction in expenses mean higher available corpus for investment. Here is an illustration which quantifies the benefit.

Old Method

Arun, 29 years, has bought an ULIP with tenure of 20 years, the premium to be paid each year being Rs. 15,000. He is charged with administration expenses of Rs. 160 per month for the entire term of the policy and fund management expenses of 1.75%. Mortality charges for a healthy individual are 0.389% per month. The premium allocation charges would be 30% in the first year, 20% for the next three years and 10% for the remaining term of the policy. We assume that the fund would grow 10% p.a.

His fund value at the end of the tenure would be Rs. 5.5 lakhs after taking into account the expense and without expenses would be Rs. 9.45 lakhs

His gross yield is 10% and net yield is 6.41% on this investment which means 3.59% is going towards expenses.

New Method

Since the expenses are capped at 2.25%, the rise in yield for Arun would be 3.59%-2.25%= 1.34% which equates to ~Rs.80,000.  

Latest update on ULIPs

Off late, this product has been hitting headlines, because SEBI believes that since this product has an investment portion which is invested in equity markets, the SEBI Act requires ULIP products to be under the preview of SEBI. This led to a tiff between IRDA- the insurance regulator and SEBI.

This matter will now be taken up in the court of law where both parties will seek a binding ruling on who will regulate ULIP’s. In the meanwhile, SEBI has altered its previous order of not allowing 14 insurance companies to either market or sell existing or new ULIPs, to only making it mandatory for insurance companies to seek approval from SEBI for new ULIPs to be launched after April 9^th, 2010.

Investors, while looking for an insurance product, make sure you know the objective for which you want this product to be part of your financial portfolio. Having understood your need, have a detailed look at all the expense heads of the products available. Pick not the one that is being sold to you but the one that will serve your need.