Here is a very surprising fact that essentially no one knows. All life insurance is actuarially equivalent. Actuarial science is the art and science of pricing risk. That basic, underlying formula for pricing life insurance is the same for term insurance or permanent insurance. The cost is directly related to the chance of dying in the given time frame that the life insurance covers. The likelihood of a death occurring in one day is less than in ten years. A death in ten years is less likely than if coverage were for twenty years and so forth.
The chance of dying is called mortality. We all have it, no one lives forever. The certainty of our demise is strangely the reason that insurance companies can accurately predict risk because there is a 100% chance of the final outcome. The likelihood of dying increases everyday, as an example, a 16 year old has less likelihood of dying than an 85 year old, however, there are still 16 year olds that die and 85 year olds that turn 86. Eventually though everyone dies. In actuarial terms, there is a specific likelihood of all people to at a certain age. Again most 16 year olds do not die but there is still a chance. Actuarial science can not pinpoint who will die but as a nation and world as a whole, actuarially you can say that out of 1,000,000 16 year olds, a certain number will die. As we age the number of people in each age category will have a higher likelihood of dying. For instance, of 99 year olds, 25% will not see 100. This science is what is used to calculate our overall life expectancy.
Life insurance in the most simple terms is the actuarial likelihood of dying within the time frame of insurance coverage. The likelihood of a 45 year old dying in 10 years is less than a 95 year old dying in 10 years. Therefore there is a lesser cost to insure the 45 year old for 10 years than a 95 year old. The likelihood of a 45 year old dying in 10 years is less than the same 45 year old dying in 30 years. Therefore 10 year term insurance is cheaper than 30 year term insurance.
So why do insurance companies charge different rates for the same time frame of coverage? Well, the one component of the formula that is left open to insurance company interpretation is the rate of return that the insurance company will earn on your premium dollars on the likelihood you do not die when the policy is in force. A little known fact is that less than 1% of term insurance policies actually result in a death claim. That means in 99% of the time the insurance company takes premiums and does not pay a claim. The rate of return on the 99% of policy premiums that are not paid in claims is one of the only factors in the formula that is open for interpretation. Some companies are more aggressive with their pricing because they assume a greater return on their money. Some carriers also tweak the actuarial assumptions of dying to accurately reflect their own history and risk tolerance when their own history is large enough to be actuarially sound.
For everyone who actually wants to look at and break down the actual formula please read the article “The Math of Death.” For a break down of all the different types of insurance and how they relate actuarially, please read the article “Term or Permanent or I Would Know the Right Kind of Insurance to Buy if I Knew the Day I Was Going to Die.”
© R. Allen Greer, Jr., 2007
