Premiums, Payment Modes and Dividends
A life insurance premium is a price built from three estimates: how many insureds will die, how much the insurer will earn on the money it holds, and what it costs to run the business. Dividends are what comes back to the owner of a participating policy when those estimates turn out to be cautious. A premium is built here from its parts, a payment mode is priced for what it really costs, and one dividend is worked from its sources and compared across the ways it can be taken. Michigan’s rules on premium payment, the grace period and participation in surplus are applied where they change the result. Names and figures are invented, and the mortality and interest figures are not taken from any actual table.
Building a Premium From Mortality, Interest and Expense
A premium has a net part and a loaded part. The net premium pays for the expected claims, after allowing for the interest earned on money held until claims are paid. The gross premium is the net premium plus the insurer’s expense and margin loadings. The owner pays the gross premium.
The Net Premium
The net premium starts with a mortality rate for each year of age, which is the chance an insured at that age dies within the year. It then discounts each year’s expected claims for interest, because the insurer collects the premium before it pays the claim.
Consider a five-year level term policy of $100,000 issued at age 40. The invented mortality rates for years 1 to 5 are 0.0010, 0.0011, 0.0012, 0.0014 and 0.0016 per insured, and the insurer assumes 3% interest. Claims are assumed paid at the end of the year of death. Premiums are paid at the start of each year by those still living.
The first step is the expected cost of each year, discounted to the day of issue.
| Year | Chance alive at start | Mortality rate | Expected claim, discounted at 3% |
|---|---|---|---|
| 1 | 1.0000 | 0.0010 | $97.09 |
| 2 | 0.9990 | 0.0011 | $103.58 |
| 3 | 0.9979 | 0.0012 | $109.59 |
| 4 | 0.9967 | 0.0014 | $123.98 |
| 5 | 0.9953 | 0.0016 | $137.37 |
| Total | $571.60 |
The total of $571.60 is the net single premium, the one sum at issue that would pay for the whole term. Almost nobody pays that way, so the insurer converts it to a level annual premium. The premium is collected at the start of each year only from the insureds who are still alive. The present value of $1 paid at the start of each year to a person who is alive is 1.0000, then 0.9699, 0.9406, 0.9121 and 0.8843, which sum to 4.7069. Dividing the net single premium by that figure gives the level net premium.
$571.60 divided by 4.7069 equals $121.44 a year.
The level premium is greater than the first year’s cost of $97.09 and less than the last year’s of $155.34, each measured per insured alive at the start of that year and discounted to the start of the year. The insurer holds the surplus from early years to pay the larger claims of later years, and that money is the policy’s reserve. This is the reason that a level premium for a term policy that lasts longer must start well above the risk of the first year.
Why the Level Premium Builds a Reserve
The level premium overcharges early and undercharges late, and the insurer has to hold the difference. At the end of each year the reserve is the present value of the claims still to come minus the present value of the net premiums still to come. Run on the same figures, for a policy still in force, the reserve per policy is:
| End of year | Reserve per policy in force |
|---|---|
| 1 | $25.11 |
| 2 | $40.99 |
| 3 | $47.35 |
| 4 | $33.90 |
| 5 | $0.00 |
The reserve climbs while the premium exceeds that year’s claim cost and falls once the claim cost passes the premium. It reaches zero at the end of the term, when no claims remain to pay. On a whole life policy the same effect lasts for life, which is why the reserve behind a permanent policy grows large and why its cash value can be a meaningful sum. The owner of a five-year term policy has no cash value even though the insurer holds a reserve, because the reserve is a liability for later claims and the contract does not return it on surrender.
The Gross Premium
The insurer adds the cost of doing business. Suppose the policy fee is $40.00 a year, the other issue and maintenance costs are $0.25 per $1,000 of coverage, or $25.00 on this policy, and taxes and commissions together take 12% of the gross premium. The loadings that are a percentage of the premium are in the premium itself, so the gross premium is found by dividing, not by adding 12%.
gross premium = ($121.44 + $40.00 + $25.00) divided by (1 minus 0.12) = $186.44 divided by 0.88 = $211.86
| Component | Amount | Share |
|---|---|---|
| Net premium (mortality and interest) | $121.44 | 57.3% |
| Policy fee and per-$1,000 expense | $65.00 | 30.7% |
| Percentage loadings, 12% of gross | $25.42 | 12.0% |
| Gross premium | $211.86 | 100.0% |
Three points follow. A higher assumed interest rate lowers the net premium, because the insurer expects to earn more on the money while it holds it. A longer period of coverage or an older insured raises the net premium. An expense is a cost, not a risk, so it does not depend on how long the insured lives. For a large policy the fixed fee spreads over a large face amount, and that is one reason a larger policy costs less per $1,000.
Rating a Higher Risk
The mortality rates above are for a standard insured. An underwriter who finds an elevated risk, such as a health condition, can charge more by rating the policy as a percentage of standard mortality. At 150% of the standard rates, each mortality rate is 1.5 times the figure in the table, so the net single premium becomes $857.40 and the level net premium becomes $182.16, exactly 150% of $121.44. The expense loadings do not change because the cost of issuing the policy is the same. The gross premium is ($182.16 + $65.00) divided by 0.88, or $280.86, which is 32.6% above the standard $211.86 and not 50% above it. A preferred insured is rated the other way, with mortality below the standard table, and the premium comes down. The producer who understands that the mortality part is the one that moves can explain to a rated applicant why the price rose by less than the rating.
Michigan’s Premium Rules
Michigan requires every life insurance policy to provide that premiums are payable in advance, either at the insurer’s home office or to an agent upon delivery of a receipt signed by one or more officers named in the policy (MCL 500.4010). A producer who takes a premium should give the receipt the policy names. Michigan also requires a grace period of 1 month for every premium after the first year. The grace period may be subject to an interest charge, and the policy may provide that if the insured dies during it, the overdue premium is deducted from the settlement (MCL 500.4012(a)). Before coverage ends for nonpayment, the insurer must send written notice to the owner’s last known address at least 30 days before termination, except an insurer that collects most of its annual premium in person (MCL 500.4012(b)).
The cash values that the policy guarantees are computed from what the law calls adjusted premiums, which are built on a mortality table and a maximum interest rate the statute sets (MCL 500.4060(5)). The mortality and interest in the owner’s own premium are the insurer’s choice, but the minimum cash value that comes out of them is not.
Payment Modes and What They Cost
The mode is how often the owner pays. Premiums are quoted on an annual basis, and the owner may pay annually, semiannually, quarterly or monthly. Ordinary life insurance is sold with premiums payable no more often than monthly, so all four modes are available.
A more frequent mode costs more in total. The insurer receives the money later, so it earns less interest. It handles more billing and collection. And owners who pay in small installments lapse more often, so the insurer prices in some of that expense. The insurer expresses the extra cost as a modal factor, a percentage of the annual premium charged for each payment. The factors below are invented.
| Mode | Payments a year | Modal factor | Each payment on a $1,000 annual premium | Total for the year | Extra over annual |
|---|---|---|---|---|---|
| Annual | 1 | 1.0000 | $1,000.00 | $1,000.00 | $0.00 |
| Semiannual | 2 | 0.5100 | $510.00 | $1,020.00 | $20.00 (2.0%) |
| Quarterly | 4 | 0.2600 | $260.00 | $1,040.00 | $40.00 (4.0%) |
| Monthly | 12 | 0.0875 | $87.50 | $1,050.00 | $50.00 (5.0%) |
The True Cost of Paying Monthly
The extra $50 looks small, which is the reason monthly payment sells well. The right test is the interest rate being charged on the money the owner is not paying up front.
The owner who chooses monthly payment keeps $1,000 minus the first $87.50, or $912.50, for the first month and gradually pays it back. Setting the present value of 12 payments of $87.50, each due at the start of a month, equal to $1,000 and solving for the rate gives an effective annual interest rate of about 11.35%. That is 10.8% nominal, compounded monthly. The semiannual mode costs about 8.33% a year and the quarterly mode about 11.15%.
If the owner could earn 3% a year on idle cash, paying annually is the better choice. At 3%, the twelve monthly payments are worth $1,035.91 today, so paying monthly costs $35.91 more in present value than paying annually. Some owners cannot raise $1,000 at once and are right to choose monthly. The producer’s job is to show the difference, and not to quote the monthly figure as the price of the policy.
The mode also changes what happens at a death.
Dara Lindqvist owns a $100,000 policy with an $87.50 monthly premium due on the 1st. She dies on the 20th without having paid that month’s premium. She was within the grace period, so the policy was in force. If the policy says the overdue premium is deducted from the settlement, as MCL 500.4012(a) permits, the beneficiary receives $100,000 minus $87.50, or $99,912.50. Some policies on a modal plan also deduct the unpaid balance of that policy year’s premium. The policy states which applies, and a producer should read it before telling a beneficiary what to expect.
Dividends
A participating policy is one that shares in the insurer’s divisible surplus, the portion of its earnings the insurer’s board decides to distribute to those policies. A nonparticipating policy does not. Michigan requires the participation provision. A participating policy must say that, beginning not later than the end of the fifth policy year, the company will determine and account for the portion of divisible surplus accruing on the policy, that the owner has the right to have the current dividend paid in cash, and that this accounting and payment happen at periods of not more than 5 years (MCL 500.4020). A nonparticipating policy need not have the provision. The statute does not guarantee that any dividend will be paid. The amount is the board’s decision, and an illustration of dividends is a projection.
Where a Dividend Comes From
A participating policy’s premium is set with cautious assumptions. If the insurer’s real experience is better, the difference is surplus. The three sources are the same three parts that built the premium.
- Interest. The insurer earned more than the rate it assumed in the premium and in the reserve.
- Mortality. Fewer insureds died than the table assumed.
- Expense. The insurer spent less than the expense loading.
One common way to apportion surplus, the contribution method, gives each policy its share of each source. The example is a $100,000 participating whole life policy in its tenth year. The reserve at the start of the year is $18,000 and at the end is $19,500. The invented experience is below.
| Source | Calculation | Contribution |
|---|---|---|
| Interest | (5.2% earned minus 3.0% assumed) times $18,000 reserve | $396.00 |
| Mortality | (0.00450 assumed minus 0.00300 actual) times $80,500 net amount at risk ($100,000 minus the $19,500 end reserve) | $120.75 |
| Expense | $150.00 loaded minus $120.00 actual | $30.00 |
| Dividend | $546.75 |
The interest source is the largest here, and that is typical of a policy with a large reserve. The mortality source depends on the net amount at risk, which falls as the reserve grows. This is the reason an insurer cannot promise a dividend. Each source can turn negative, and the board may also retain part of the surplus for the company’s own stability.
Comparing the Dividend Options
A participating policy lets the owner choose how to take the dividend. The examples assume a dividend of $500, used in the way each option describes.
| Option | What happens | Result in figures |
|---|---|---|
| Cash | The $500 is paid to the owner. | $500 received. |
| Reduce premium | The dividend is applied against the premium due. | A $1,200 annual premium becomes $700. |
| Accumulate at interest | The insurer holds the dividend and credits interest. | At 3%, five yearly dividends of $500 accumulate to $2,654.57, of which $154.57 is interest. |
| Paid-up additions | The dividend buys small single premium paid-up policies. | At an invented $420 per $1,000 of paid-up whole life at the owner’s age, $500 buys $1,190.48 of additional insurance that also earns its own dividends. |
| One-year term | The dividend buys one year of term insurance. | At an invented $3.10 per $1,000, $500 would buy $161,290.32 of coverage. Policies commonly cap the amount, often by the cash value, so a cap of $21,000 would cost $65.10. |
The options suit different owners. The cash option and the premium reduction help an owner short of cash now. Paid-up additions grow the death benefit and the cash value without evidence of insurability. Accumulation keeps the money available but earns a modest rate, and the interest is taxable income each year. The one-year term option is a way of adding protection temporarily, and it takes the owner’s attention each year.
Dividends and Tax
Federal tax treats a policy dividend as a return of the premium paid, not as income. A dividend is an amount not received as an annuity (26 U.S.C. 72(e)(1)(B)). For a life insurance policy that is not a modified endowment contract, an amount received before the annuity starting date is included in gross income only to the extent that it is more than the investment in the contract (72(e)(5)(A), (C)). The investment in the contract is the premiums paid, reduced by earlier amounts received that were not taxable (72(e)(6)).
A policy owner paid $1,250 a year for 10 years, or $12,500. Dividends of $60, $120, $180, $240, $300 and $360 for the policy years 5 to 10 total $1,260. That is far less than $12,500, so none of it is taxable income. The interest that an insurer credits on dividends left to accumulate is a different matter, because it is earnings and is taxed as income.
Participating and Nonparticipating Premiums
A participating policy has a higher premium than a similar nonparticipating one. The owner is paying for the cautious assumptions and expecting some to be returned. Suppose a nonparticipating policy costs $1,000 a year and a participating one $1,250. The illustrated dividend is $60 times the policy year minus 4, which pays $60 in year 5 and rises $60 a year to $960 in year 20. The 16 dividends total $8,160.
| Measure over 20 years | Nonparticipating | Participating, dividends as illustrated | Participating, half the illustrated dividends |
|---|---|---|---|
| Premiums paid | $20,000 | $25,000 | $25,000 |
| Dividends received | $0 | $8,160 | $4,080 |
| Net outlay | $20,000 | $16,840 | $20,920 |
At the illustrated dividends the participating policy is $3,160 cheaper. If the dividends come in at half the illustration, it costs $920 more. The producer who shows only the first column of results has shown a guarantee that does not exist, and the premium difference is the only part the owner is certain to pay.
Lesson summary
- A premium is built from expected mortality, assumed interest and expense. The net premium covers claims after discounting for interest, and the gross premium adds fixed and percentage loadings, so the gross figure is found by dividing by one minus the percentage loading.
- A level premium on a term policy exceeds the first year’s cost and falls below the last year’s. The difference is held as reserve.
- Michigan requires premiums payable in advance against a signed receipt, a grace period of 1 month after the first year, and 30 days’ written notice before coverage ends for nonpayment. The policy may deduct an overdue premium from the settlement when the insured dies in the grace period.
- A modal factor makes the annual cost of paying more often higher. In the example, paying monthly costs 5% more and equals an effective interest rate of about 11.35% on the money not paid at the start.
- A dividend comes from interest, mortality and expense experience better than the premium assumed. Michigan requires a participating policy to account for surplus by the end of the fifth policy year and at least every 5 years, with a cash option, but no dividend is guaranteed.
- The five dividend options are cash, premium reduction, accumulation at interest, paid-up additions and one-year term. Dividends are taxed as a return of premium until they exceed the investment in the contract, and the interest on accumulations is taxable.
- A participating policy costs more in premium. Whether it costs less overall depends on dividends that are not promised.