Putting insurance premiums on the right level

Stepped premiums are the most common premium type in life insurance, but level is becoming more popular.

Although the level premium may initially be up to three times more than the equivalent stepped premium, the advantages include long-term cost savings and a high degree of certainty in terms of price.

Level premiums are not recalculated each year based on the insured’s increase in age whereas stepped premiums are. From around age 55, the age-based increases can be steep, particularly for trauma and TPD cover.

However, there’s a lot of misinformation around about level premiums.

A simple Google search on ‘level premium’ brings up the definition as a type of insurance policy “for which the premiums remain the same throughout the duration of the contract”.

But level does not mean fixed or guaranteed.

To guarantee rates, an insurer would require a large amount of capital to maintain APRA capital adequacy ratios. Also, to generate an adequate return on capital, the premium they would have to charge the customer would often be prohibitive.

A level premium rate is just the equalisation of the stepped rate. The higher premiums in the earlier years builds up a reserve which the insurer earns interest on to support the lower premiums in the later years. Consideration is also given for the fact that the lapse rate on a book of level premium business will be slightly lower than stepped.

To calculate level premiums, actuaries assume a rate of interest.

With interest rates currently at record low levels and no sign of a change any time soon, premium rates must increase accordingly.

If an insurer experiences higher-than-expected claims (or poor industry claims are passed on to them via their reinsurer), the result is a reduced return on capital and premium rates must be increased. The underlying claims cost is the same regardless of premium type, therefore both stepped and level rates must be increased.

From a pure cost of doing business perspective, level premium rates should increase more than stepped because paying commission on a level premium costs more than it does for a stepped premium.

From an insurer’s perspective, income protection has been the least profitable cover type in recent years. The life industry has only made a profit on income protection in two of the last eight years, according to APRA data.

Until recently, the industry has been dragging its feet when addressing the problem. There is no first mover advantage for an insurer when it comes to increasing rates.

It may be viewed by advisers and customers as being uncompetitive. The irony is, responsible pricing helps ensure the long-term viability of the book of business and protects all policyholders.

To ‘pass on’ or ‘not to pass on’ premium rate changes to existing policyholders is an issue some insurers struggle with, especially when faced with strong opposition from advisers.

The preferred approach is to apply changes to all policyholders, not only new clients. This means one product and pricing series, thus eliminating the creation of a legacy book.

By doing so, insurers can reduce operational complexity and drive efficiency. The benefit for the client is that the insurer continues to invest in the product.

Important advice

The main reason why an adviser would recommend a level premium over a stepped premium is because they believe it will be cheaper for the client in the long run.

Given the savings will only be realised after the policy is held for many years, advisers need to educate clients upfront that a level premium rate may increase in the future but even if it does, they’ll still pay less total premium and come out on top.

Renee Hancock is head of product at ClearView