All insurance operates by collecting premiums from a pool of insureds to pay benefits to a small portion of those insureds who experience some peril during any particular year. In most instances, this risk can be estimated and appropriate premiums can be set using the law of large numbers. However, in the case of permanent life insurance policies meant to cover insureds until death, the risk of any insured experiencing a peril during the policy term effectively approaches 100% within the pool of insureds (the only guarantee in life is inevitable death). This poses a problem of setting premiums for a guaranteed eventuality while preventing those premiums from becoming prohibitively expensive.
Consequently, permanent life insurance premiums are structured in two parts:
- Premiums for endowment policies meant to mature at the face value of the policy at some specified advanced age (historically by age 100, more recently by age 121 to reduce the probability of the insured outliving the maturity period). These premiums are invested to allow the policy to endow at face value upon reaching the end of the maturity period.
- Premiums for term policies meant to cover an annual insurance death benefit. These premiums capture the mortality risk of the insured prior to reaching the end of the specified maturity period.
Premiums for the endowment policy are derived utilizing time value of money calculations such that the insured’s contributions plus investment growth allows the policy to pay out its face value at the end of the specified maturity period (e.g., age 100). Accrual of these premiums and their investment growth represents the account value or “cash value” of the policy.
In addition to this endowment premium component, permanent life insurance policy premiums must include an annual insurance death benefit premium to account for annual mortality risk prior to the end of the specified maturity period (e.g., before age 100). This is because the insurer assumes risk for potentially paying out the face value of the policy (or some portion of the face value) prior to the end of the endowment policy’s maturity period.
Thus, the premium of the endowment policy is meant to accrue to the policy’s face value over the specified maturity period, while a term policy premium must also be applied to cover the risk of the insured’s death prior to reaching the end of the specified maturity period. The aggregate of these two premiums produces the actual permanent life insurance policy premium.
While addition of a term policy premium to the endowment policy premium would normally be prohibitively expensive as mortality risk approaches 100% over time, as is normally the case with term policies, this permanent life insurance policy premium structure resolves the problem of prohibitively expensive term premiums. Over time, the term premium must be applied to a decreasing annual insurance death benefit as the cash value of the policy approaches its face value.
Stated another way, as the cash value of the permanent life insurance policy approaches its face value, the insurer’s contribution to the death benefit correspondingly decreases. Thus, increasing mortality risk of the insured is offset by a declining insurer contribution to the death benefit (face value), resulting in term policy premiums (which are added to endowment policy premiums, in aggregate producing actual permanent life policy premiums) that are more affordable than pure term life insurance policies would require to reach the end of the same specified maturity period (e.g., age 100).