In the first of a series John Woodford offers a guide to the elements going into the pricing of protection products
In all honesty it is easy to talk about how protection products are priced with an actuary. Most of them understand the way that premiums are broken down and the impact that those different elements have. But what about those of us without actuarial qualifications? How much of that pricing knowledge can we understand?
The purpose of this article, the first of a series, is to provide a simple guide to protection pricing. We will begin by looking at what goes into a premium, how rates have changed over the last 10 years and what has driven those changes.
Not surprisingly, the majority of the premium - typically between 55% and 65% - is set aside to pay for claims. This is split into two sections: the first is the reinsured portion, and the second is the insurer's retained portion. The reinsured portion is often up to 90% of the total claims cost which is why reinsurers are thought to have such an impact on an insurer's pricing.
The insurer's expense assumption - those charges it needs to take into account to meet the costs incurred in underwriting and administration, and any other overheads - can range from between 5%-15% of the premium.
An additional 20% of the premium is used up meeting the costs of commission - remember this is a figure that can vary depending on factors such as the distribution channel used and the term of the policy.
The final element is the profit margin. The insurer is required, for the interest of the policyholder, to set aside capital to meet any unexpected claims and, naturally, will seek a return on this. This makes up the profit margin in the premium. Typically, this figure can range from between 5%-10% of the premium.
Tracking change
Those are the main elements that make up the premium that customers pay for their cover. So how have premium rates changed?
In the last two years, premium rates have fallen by 15%-20% for term assurance in the UK, and 10% for critical illness: the second time in the last ten years that market prices have tumbled. Between 1998 and 2003, term assurance rates fell by 30%. Amid those periods, there was a stage of relative stability, with premium rates in 2006 matching those of 2003.
So why have rates fallen? There are a number of reasons.
The industry has seen a corresponding fall in reinsurance premium rates over the last 10 years and rates are about half the level they were in 2000. It could be argued that this is the work of market forces - with the number of reinsurers in the UK life and health market having more than doubled and reinsurance of protection becoming more price driven and easier to compare, reinsurers invested more time and expertise in understanding risks better so they could price accordingly.
At the same time, the increasingly competitive reinsurance market influenced reinsurers to use their expertise to better manage their capital, utilising different regulations in variant countries. With less capital needed to support the risks managed, it becomes easier to justify a lower profit margin.
Other main areas that have seen downward pressure include expenses and profit margins. There has been a significant consolidation in the UK life market over the last decade, which has meant economies of scale, spreading overheads over a larger base of business. New entrants, unburdened by legacy IT systems, processes and costs, and which can price on a marginal basis, have also become apparent.
With the growth of protection sales, the industry has got better at writing it too, as seen in the last five years when the market has begun to move away from paper applications towards electronic underwriting, making it easier and cheaper for the insurer to get the applicant on-risk. Electronic engines are doing more of the medical underwriting, resulting in potential reductions in the costs of human involvement and manpower for insurers.
Finally, a word about profit: insurers, like reinsurers, have seen downward pressure on margins. Changes in regulations towards realistic reporting have meant that providers can justify lower profit margins on the basis of having to maintain lower capital requirements.
Pricing protection business is a complicated area and it is important that we have the opportunity to understand the influences. This will enable the industry to participate in a more open debate in future, rather than just making the odd comment about rate wars.
John Woodford is head of new business services at Munich Re (UK Life).
