Insurance companies are in the business of making money. And, although they offer a very important service in our society, each carrier’s goal is to collect more premiums and earn more money on its portfolio than it has to spend on expenses and death benefit payouts. Thus, it is important to understand and acknowledge that selecting a policy from the right company is critical.
To ensure you purchase a policy from a credible carrier, there are several service providers that rate life insurance companies, such as Moody’s, Standard & Poor’s, and A.M. Best. These companies analyze more information than what these carriers present in their annual statements. Strong ratings are Aaa, Aa1, Aa2, or Aa3 from Moody’s, AAA, AA+, or AA from Standard & Poor’s, and A from A.M. Best.
This being said, there are three main risks affecting a carrier’s profitability, which therefore impacts a carrier’s ability to meet the expectations they illustrate to you through their insurance agents. These factors are experienced Mortality/Claims, Investment experience, and Lapse Rates.
Mortality/Claims
Mortality or Claims experience refers to incidents of death, which is critical in estimating what an insurance company will have to pay out on its issued policies. Although you cannot predict individual mortality, group morality can and with great accuracy. For example, it is 10 percent likely that a healthy 40-year-old non-smoking male will die within 20 years, whereas the likelihood of a healthy, 60-year-old non-smoking male will die within 20 years is 50/50.
Thus, it is important to determine whether the illustrations accurately reflect the mortality experiences of the insurance company. If the illustrations use different data points, you should ask why because if mortality is worse than illustrated, the insurer’s increased costs are generally passed along to the insured.
Investment
The insurer’s investment experience directly affects the interest or dividends it pays out to its policy holder’s cash value. Thus, a term policy does not depend on the insurance company’s investment performance because there is no cash value accumulating (although investment performance can affect the insurer’s continued viability, and, therefore, will not be able to payout death benefits if it goes bankrupt caused by poor investments).
This being said, you should be aware that life insurance agents typically use higher investment performance estimates when illustrating a policy’s performance.
Policy Lapses
Lapse rates look at the rate of removal or expiration of an insurance policy due to the passage of time or inaction by the insured. Low lapse rates increase profitability because insurance companies front load its expenses (such as underwriting and commissions) rather than amortize those costs over time.
Thus, insurance companies actually lose money in the first year, but are able to recover those losses (if the lapse rate is low) by collecting premiums for long periods of time.
Final Point
The insurer’s overhead is the least important of the risk factors. Mortality and investment performance have a greater impact on product performance. Poor management practices may, however, result in a decreased crediting rate. The insurer’s expenses are reflected in the discussion of earnings in most rating reports.
