Insurance premium and Anti-selection

Anti-selection is a term not many policy holders may have heard of. But it’s something that directly affects your premium. It helps determine the cost of your insurance. Basically what is insurance, it’s about transferring you risk to an insurer against  a price called premium. The insurer upon risk transfer, will pool all similar risks and according to the size of the pool an appropriate premium for your individual risk will be calculated. So now when we know that our risk is judged relatively with the other risks of the pool. So now with this background and understanding, lets understand what is anti-selection, adverse selection. These terms stand for a particular group of people with not so good risk trying to sneak into your risk pool, by hiding some information. Do in this case what happens is the insurer doesn’t know about these bad risks and lets them be part of a better risk pool. However this will soon be reflected in the claim ratio of your risk pool and thereby in the mortality charges being levied upon you by the insurer. So you end up paying higher premiums on behalf of the bad risks in your pool.

This situation usually arises when there is information asymmetry. An insurance contract is a classic case of information asymmetry. Insurance runs on the principals of “uberrima fides” and “caveat emptor”. By “uberrima fides” is a Latin phrase which means “utmost food faith”. So in an insurance contract the insurer has to have utmost food faith on the insured, that he/she is disclosing all information that might impact insurability. The insurer would not know everything and also not know what all to ask. Although the insurance application forms that we have today , are quite comprehensive. But to disclose or not is in the hands of the insured and the insurer has to have utmost good faith in the information provided to assess the insurability wrt to the information provided. Also the insured is only bound to answer what is asked from him.

However when we talk about “caveat emptor”  which means “let the buyer be aware” it is the insurer who is responsible for letting know the insured everything. So as a buyer the insured must be in a position to make an informed decision when it comes to buying the product. So with these two principle in place a condition called information asymmetry arises, wherein the insurer has less information wrt to the insurability as compared to the insured and thus comes in picture adverse selections. Those insureds who bring in bad risks can very well hide the true facts leading to information asymmetry and there by putting the insurer in a position where they are not able to correctly assess the risk. And thus the insured ends in  a risk pool where it doesn’t belong, it pollutes the risk pool and pushes the claim ratio proportionately higher thereby increasing the cost of insurance for the better risks. Which drives away the good risks from the insured. So in a way more than the insured it’s the insurer who will feel the setback thanks to anti-selection.

So as a prudent insured we must disclose all facts to the insurance company for them to be able to assess the risk in all possible ways, Thereby leading to a better experience for both us and the insurer.

And remember if its a choice between insurance and ignorance...do choose insurance

Insurance premium-broken up

We all buy insurance , and when we do that we have a million questions. The first question we ask is how much will I have to pay, more than the sum assured or the insurance amount we are interested in the amount that we will be charged for it. As that is the first thing that is going out of my pocket as the benefits are always a long time away in insurance and sometimes linked to not really desirable event. So it’s the premium that we are interested in. But all questions w.r.t to premiums start and end with “how much?”. We never think what makes our  insurance premium , what are the various components that add up to make our premium.

If we understand our premium split well we will also be eventually be able to choose products  better suited for our securing ourselves financial for an uncertain future.

So let’s see what are the most basic components of life insurance premium:

·         Mortality Charge: This is can also be termed to be the “true premium or natural premium” none of the other components get directly associated with the risk that we transfer to the insurer. So basically what’s Mortality? Mortality is the no. of death in a defined population and period per thousand individuals.  In simple terms the probability of how many people out of thousand  from an uniformly distributed group of individual may die in a period of a year. This probability helps insurer understand how many probable claims they might have  and so accordingly the true risk they are carrying versus the total transferred risk. Now mortality charge can be influenced by a lot of  things, the basic being gender and age. So the basic mortality rate for every individual is calculated taking into consideration these two factors. But here could be many more factors that can influence your mortality adversely so for all of those the underwriters individually assess the insurance applications and add extra charge to the premium with rates attached to extra mortality.

·         Administration cost: The company from which we buy insurance, has certain costs associated with issuing policies and administrating them all through the policy life cycle. And this cost includes everything from insurance company’s staff salary, infrastructure cost,  etc. So as a premium paying payer depending upon the sum assured or the insurance amount of our policy we have to pay our part of admin costs to the company. These days the insurance companies are involving more and more IT systems and automated processes to reduce the admin cost. This will eventually have effect on our premiums. One way in which we as a premium payer can reduce the admin cost is by having annual premium paying frequency, this reduces the no. of times we will receive premium notifications and the no. of times the insurance company will have to update their system, allocated our funds , calculate NAV etc. thus there by reducing the admin cost. And this will also get you a rebate on your premium amount and thus reflect the direct involvement of admin cost in your premiums. A lot may other things also come under admin costs which upon the event occurring are charged to you separately as they are not anticipated and so not charged for already, e.g. Policy surrender charges, any interest on late payment, etc.

·         Commissions: These eat up a major chunk of your premium. Commissions like insurance benefits differ from product to product. And this is where you have to be very careful when selecting a product, otherwise instead of securing your future financially you will end up securing you insurance agents financial future. Commissions at least in India are always in percentages, so basically they will tell what percentage of your premiums will be directly routed to your insurance agent as his remuneration. Certain insurance products that are driven towards investment, have higher percentage of your premium being diverted as commission. So beware when an agent tries to persuade you towards a certain type of product. And usually the first premium, or first few have a higher commission percentage as compared to renewal or subsequent premiums. That’s why sometimes an agent may persuade you to buy a policy and say you may surrender it after the initial few years, if not wishing to pay premium for an extended time.

·         Interest: Last but not the least this component plays an important role in deciding how much returns will your premiums fetch you, as bonus and or as Maturity claim. So if the predictions say that the market are going to be particularly good for the next decade the insurance company will expect good returns and in return may charge you less premiums for the same risk or let’s say you may get better returns for your money that you will put in. Also interest as a component is important , because to give you the required claim be it in form of an uncertain loss event or on maturity the company has to have a corpus and grow it. For which the company will invest it in the market and the returns from the market will decide how well the corpus grow and will the insurer be in a position to honor your claim as and when it occurs.

So here we have outlined the basic components that will help the insurance company structure your premium. But this information is particularly important for the premium payer to understand a product before buying.

Hope this helps some people if not many. And if this raises a lot of questions in your head….well nothing like that. The real purpose for this blog  and all its post, is to make you more and more curious about insurance. Do post your queries in comments and I will be glad to address them.

And remember if its insurance or ignorance…we better choose Insurance and be safe!