The Evolution of Life Insurance: Logic and Development

Quick Article Guide

Here’s what we'll cover in this post:

• Life Insurance Logic and Development
• Calculation of Premiums and Benefits
• The Evolution of Life Insurance
• The Role of Elizur Wright
• Understanding Whole Life Insurance
• Introduction of Universal Life Insurance
• Further Developments: Level Term
• Variable Universal Life
• Guaranteed Universal Life
• Indexed Universal Life
• Continued Evolution: Living Benefits
• How We Can Help

Life Insurance Logic and Development

The first life insurance company in the United States was established in Philadelphia by the Synod of the Presbyterian Church in 1759. Church members formed the Corporation for Relief of the Poor and Distressed Widows and Children of Presbyterian Ministers to support their less fortunate members, as no insurance companies sold life insurance at the time.

Calculation of Premiums and Benefits

If a group wanted to bypass insurance companies and provide a death benefit to its members, determining the charges to ensure payment of the promised benefits would be crucial. For example, suppose a group consisted of 1,000 healthy 30-year-old males, and they aimed to provide $100,000 to the families of deceased members. If two members died, the group would need $200,000, requiring each member to contribute $200.

For a group of 1,000 healthy 50-year-old males, the death rate might be higher, with an average of ten members dying. To cover the $1,000,000 in claims, each member would need to contribute $1,000.

If the group consisted of 99-year-old males, the mortality rate would be significantly higher. If 900 members died, the group would need $90,000,000 to pay the benefits, requiring each member to contribute $90,000.

This simple example illustrates how life insurance rates are calculated based on the age and health of the insured group, ensuring that sufficient funds are collected to cover the promised benefits.

The Evolution of Life Insurance

Annual Renewable Term premiums are not arbitrary figures; they are calculated based on the probability of the insured dying within that year. As the insured grows older each year, the premium increases because the probability of dying increases exponentially. This transparent system ensures that premiums are fair and reflect the actual risk involved. The rates might look something like this:

Recognizing that no one could afford such premiums at older ages, insurance companies naturally developed products offering a premium that always stayed the same. These level premiums would need to be higher than the annual renewable premium at the purchase age, but how much higher?

In the nineteenth century, companies often made unrealistic promises about their products, which they couldn't keep and remain solvent. As a result, policyowners who were too old to work and could no longer afford the premiums would auction off their policies to investors. This raises the question: what would be the fair value of such a policy?

The Role of Elizur Wright

The mathematician Elizur Wright played a pivotal role in reforming the insurance industry during the mid-nineteenth century. Often hailed as the “Father of Life Insurance,” Wright campaigned vigorously for fair practices, advocating for insurance companies to provide equitable “surrender values” and maintain adequate reserves to support policies.

Recognizing the potential for abuse within the industry, he developed precise formulas for calculating reserves and pushed for statutory capital requirements.

Serving as the Massachusetts insurance commissioner, Wright successfully lobbied for legislation mandating that policyholders receive a surrender value in cash or paid-up insurance if they couldn’t pay premiums as scheduled.

His efforts culminated in the 1861 non-forfeiture provision, which set a precedent across states, enhancing surrender values and ensuring that policyholders retain ownership of cash value reserves.

Understanding Whole Life Insurance

This excess is invested to build reserves that will support the payment of claims in later years when the cost of insurance exceeds the premiums received. To ensure the adequacy of the premiums collected, conservative assumptions are crucial. This includes assuming a modest return on investments, typically around 2 to 3 percent, and being cautious in estimating mortality rates.

Whole Life insurance exemplifies this approach, guaranteeing that premiums are sufficient to cover the death benefit even as the insured ages. If assumptions about investment returns or mortality are overly optimistic, the insurance carrier absorbs the additional costs.

Ownership structure influences how profits are managed. Stock insurance companies are owned by shareholders who benefit from company profits. Whole-life premiums from stock insurance companies are often lower than those of mutual companies.

In contrast, mutual insurance companies are owned by policyholders, who receive dividends from company profits over time, offering better long-term value. The reserve for a Whole Life policy grows exponentially to match the death benefit by the time the insured reaches age 100.

Mutual vs. Stock Life Insurance Providers

Introduction of Universal Life Insurance

Universal Life insurance, which emerged in the 1980s, introduced a revolutionary approach to life insurance compared to traditional Whole Life policies. Unlike Whole Life, which offers fixed premiums and guaranteed cash values, Universal Life provides flexibility in premium payments and potential cash accumulation through an accumulation fund.

This flexibility appealed to many as interest rates soared in the late 1970s, allowing policies to credit interest at these high rates initially. However, unlike Whole Life's guaranteed premiums and cash values, Universal Life shifts risk to the insured, who must ensure that chosen premiums are sufficient to cover future mortality charges.

As interest rates fluctuate, premiums may need adjustment to maintain coverage, making it crucial for policyholders to monitor their policies closely.

One way of picturing a Universal Life policy is as a bucket. The insured controls the spigot at the top, representing the premium flowing into the bucket. At any time, the insured can turn the spigot up to increase the premium flow or tap it down to decrease the flow.

The insurance company deducts mortality charges and expenses from the bottom of the bucket. Whatever remains in the bucket is credited with interest. The interest credited in the original and traditional Universal Life policies is set by the insurance company and will change year by year, depending on the interest rate environment.

The mortality charge deducted is based on the amount at risk to the carrier and the probability of the insured dying at each age. The amount at risk to the carrier is the difference between the death benefit and the cash reserve. If the death benefit was $100,000 and the company had already set aside $30,000 in reserves, the amount at risk is $70,000. The amount charged for the risk to the company is like the annual renewable term cost of a $70,000 policy.

The charge for a 30-year-old would be minimal, but the charge for a ninety-five-year-old might be $35,000. A ninety-five-year-old with a $100,000 traditional universal life policy and a cash value of $30.000 would likely lose their coverage. The $35,000 mortality charge would wipe out the $30,000 cash value, and an additional $5,000 would be needed out of pocket to cover the balance.

A Whole Life plan guarantees coverage for a lifetime because the insurance company sets premiums so that the cash value grows exponentially and the amount at risk shrinks over time. You can see that in the graph above. The amount at risk, the difference between the yellow and blue lines, is zero at age 100.

The Universal Life policyholder must set their premium and monitor the policy to ensure that the cash reserve grows exponentially. Otherwise, they are likely to lose their coverage at some point.

Further Developments: Level Term

The life insurance industry continued to evolve, introducing innovative products to meet diverse needs. In the mid-1980s, 10-year term insurance emerged, which averaged the Annual Renewable Term (ART) premiums over ten years and charged a flat premium during that period.

However, in the 11th year, the premium would skyrocket if the insured chose to continue the plan, increasing annually thereafter. This model quickly competed with ART, leading to the introduction of the 20-year level term plan, which became as popular as the 10-year plan by 1997.

Subsequently, 30-year term plans were introduced around the same time, and today, a few companies offer 40-year term coverage.

Variable Universal Life

In the mid-1980s, Variable Universal Life policies were introduced. These policies, like all Universal Life plans, featured a term component and an accumulation fund. Unlike traditional Universal Life, the accumulation fund was invested in various subaccounts similar to mutual funds.

Variable Universal Life gained popularity in the 1990s during a strong stock market. However, as with all Universal Life plans, the cash value and premiums had to cover potentially exponentially increasing mortality costs, or the coverage would lapse.

It's important to note that the cash value could decrease during market downturns, a crucial consideration for those purchasing Variable Universal Life policies.

Guaranteed Universal Life

In response to lapsing Universal Life policies, companies developed no-lapse provisions guaranteeing the death benefit for a certain number of years, even if the cash value is zero. The pinnacle of these plans, Guaranteed Universal Life, became popular in the 2000s.

These policies guarantee coverage to a specified age, such as 90, 100, or 121. The premiums are relatively low compared to Whole Life plans because they accumulate little or no cash value. The reserve in such a plan is a “shadow account” not accessible to the policyholder.

Indexed Universal Life

While no-lapse provisions focused on guaranteed protection, Indexed Universal Life was developed in the late 1990s to offer a more attractive accumulation vehicle. The mechanics of Indexed Universal Life are similar to those of Universal Life, with interest credited based on the performance of selected indexes, such as the S&P 500.

Unlike Variable Universal Life, the interest credited in Indexed Universal Life can never be negative. These plans offer more upside potential than traditional Universal Life without the risk associated with Variable Universal Life.

Indexed Universal Life became popular in the late 2000s, and over time, these plans have become more complex with companies offering synthetic indexes that are difficult to understand.

These advancements in life insurance reflect the industry's ongoing efforts to cater to varying consumer needs, providing a range of options from traditional guarantees to flexible, market-linked products. Each type of policy serves distinct financial objectives, offering tailored solutions to safeguard individuals' futures.

Continued Evolution: Living Benefits

The life insurance industry continues to evolve. Carriers now offer living benefits, such as long-term care and critical illness benefits, that are tied into the death benefit. New products will undoubtedly be developed as needs change.

How We Can Help

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