Page 161 - DCOM205_ACCOUNTING_FOR_COMPANIES_II

Accounting for Companies – II

notes Recurring single premium: Neither the timing nor the amount is determined in advance. Pension
policies are often structured in this manner so as to allow the policyholder maximum flexibility in
making contributions, for example by reference to the level of his/her income in any year.
The calculation of the premium: Insurance companies need to set a price for the cover given
which is sufficient to pay:
(a) The cost of any benefits which may be paid to the policyholder,
(b) The commission paid to salespersons or intermediaries,
(c) The costs of administering the policy, and

(d) The target profit.
Calculating the level of premium for a particular type of policy involves the expertise of a
company’s actuary. There are four main factors the actuary must consider when setting the level
of premium:
Mortality: The actuary will refer to ‘mortality tables’, and from these, on the basis that the policy
will be sold to a sufficiently large number of policyholders, the actuary can determine the
appropriate premium to be charged to someone of a given age, sex and state of health.

Example: Statistically women have a higher life expectancy and generally pay lower
premiums for life cover.
Thus for a person aged 55 who requires ` 2,000 cover for a period of one year, the premium
required for purely mortality risk might be ` 23. However for a person aged 25, the premium
required might be only ` 4. Thus the 55 year old policyholder pays a higher premium because of
the increasing probability of death with advancing age.
So if life assurance was taken out an annual basis, premiums would have to increase year by year
as the risk of the policyholder dying increases. In practice such a system would be unworkable
since (a) as the policyholder gets older the annual increases in premiums would get greater and
greater until they eventually became prohibitive; and (b) in order to assess accurately the life
assured’s risk of dying in the next year other factors would be relevant, for example: the general
health of the policyholder. Thus the insurance company would have to require the policyholder
to submit to a medical examination prior to yearly premiums being set. This would substantially
increase the costs of administering the policy and premiums would have to be boosted still
further.
Investment Income: Premiums received by the company earn investment income in the form
of dividends and interest from the shares and other investments owned by the company and
additional profit may result from eventually selling the shares at a higher price than they
originally cost. Thus the actuary will need to consider likely future rates of interest and allow for
this within the calculation of the premium.
Expenses: Some margin must be added to cover the life assurance company’s future expense levels
to be experienced in administering the policy. These include: agents’ and brokers’ initial and
renewal commissions, overhead expenses, staff salaries, advertising, etc. The expense loading
to a premium is not simply a matter of sharing out the total expenses to each policyholder since
each policy does not give rise to the same types or amounts of expenses. Therefore the expense
loading must reflect in some equitable manner the expenses the particular type of policy gives
rise to.

Did u know? Life assurance companies have generally adopted the practice of writing
long-term contracts whereby a level premium is paid throughout the duration of the
policy.

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