Words on wealth: understand these basics before buying life cover

When you take out a life insurance policy, you need to take particular care that you get it right the first time. The trouble with life insurance is that it becomes more expensive as you age, and that, if you put it off until later, there is the possibility you’ll have health issues that may even prevent you from being covered at all.

Many people are under the misconception that life cover is easily replaceable, like short-term cover (the insurance of things), where, if you are not happy with an insurer, you can shop around. They are not aware of how it differs from short-term cover and the pitfalls of treating it in the same way. 

Advisers and brokers have a responsibility not only to fully inform their clients about the policies they are signing up for, but to ensure they understand the implications going forward. Unfortunately, too many advisers are primarily interested in making the sale, with the result that too many people are sold policies they don’t fully understand, with unhappy outcomes in many instances.

The aim of this and next week’s article is to tell you what a competent adviser acting in your interests would tell you when discussing your life cover.

I chatted to Verlyn Troskie, head of retail distribution at Sentio Capital, a boutique asset manager. Although Troskie has more recently focused on investments, he has a long track record as a financial adviser and broker consultant and is an accredited Certified Financial Planner. He has a deep knowledge of the risk-product side of financial services.

Before we examine how life insurance works, there are three basics you need to understand up front about pricing and premiums:

1. If you take out a policy with an escalating cover amount and include an annual premium escalation, the cover may eventually become unaffordable owing to the compounding effect of the escalations.
2. Whether you choose an escalating-premium option or the initially more expensive level-premium option, your premium may increase in excess of the expected annual escalations at some point in the future once the “guarantee period” has expired. (More on the “guarantee period” below.)
3. Cheap is cheap for a reason. You get what you pay for.

The underwriting pool

“Underwriting” is the insurance term for assessing risk. The insurance company needs to have a reasonable idea of the risk you pose before it can determine your premiums. 

Troskie explains that there are two levels of underwriting: first, at a group level, where you are placed in a pool of people with the same generic risks, and, second, at an individual level, where your personal health profile contributes to your overall risk to the insurer.

“In underwriting, just by your generic attributes – such as your age, gender, income, qualifications, job description, and whether you are a smoker or non-smoker – you form part of a specific underwriting pool. Based on their best assumptions, actuaries will then calculate the baseline premium for that risk pool. 

“Then they will send you for personal underwriting for your health: you’ll need to answer a medical questionnaire and may need to go for blood tests and a medical examination. So you actually get underwritten twice – in the pool and as an individual,” Troskie says.

The guarantee period

To determine the baseline premium for the underlying risk pool, actuaries need to make a number of assumptions concerning the investment returns on the premiums coming into that pool and the amount it will pay out in claims. The ratio of money paid in claims to the total amount in the pool is known as the claims ratio, and the assumptions about a pool’s claims ratio are based on past claims experience.

“They take the premium money and invest it, calculating the potential return. They then calculate the projected claims ratio, based on the insurance company's claims history. The larger companies have a longer history, so they tend to make better assumptions when it comes to underwriting,” Troskie says. 

However, the assumptions become less reliable the further into the future you go, so insurance companies put a limit on the number of years they can guarantee the contracted premium. This is known as the “guarantee period” and it may typically be for five, 10, or 15 years. 

Says Troskie: “The longer the guarantee period, the higher the premium, because there is higher risk for the insurer – many things can happen over a longer period, so the assumptions become less certain.”

Taking the Covid-19 pandemic as an example, he says: “If, in 2018, you had taken a policy with a guarantee, it’s likely that in 2020 the insurer was faced with larger-than-anticipated claims expenses. Then you could expect, come the end of the guarantee period, a sizable premium increase to compensate for the unexpected Covid claims.”

Troskie says that at the end of your guarantee period, say after 15 years, the insurer will reassess the risk of the underwriting pool in which you fall. “They’ll say this is what we earned in investment returns, and we paid out so much in claims. Is that in line with our expectations? Were the claims in excess of what we expected? Were the returns on the invested premiums lower than we expected? And then, based on that, they will re-underwrite the pool of which you form a part and adjust the baseline premium for the pool if necessary.”

• Next week we’ll look at premium pricing, level versus escalating premium patterns, and how life cover fits into your long-term financial plan.

Note: This article is for general information purposes only and should not be construed as financial advice in the legal sense of the term.

* Hesse is the former editor of Personal Finance.

PERSONAL FINANCE