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How Life Insurance Premiums Work

Insurance companies work on a combination of risk assessment and financial investment. They work out the likelihood and costs of payouts and determine premiums based on a factor that ensures that the total sum of all premiums well exceeds total expected payouts during given periods. Premiums are centrally accumulated and invested, so as to make a profit on the premiums. This profit is added to the premium pool and used to finance payouts and client bonuses. All policies are paid out from this premium fund.

There are usually three types of premiums available when you take out life insurance. These are:

  • Fixed premiums - this is where your premiums are fixed for the term of the policy (although this may sometimes be inflation linked - in other words, there will be annual nominal premium increases to ensure that the full amount of your policy can be properly funded by your premium. It helps to guarantee that the insurer will be able to pay you out in full).

  • Escalating premiums - this is where you agree to pay lower premiums for the first few years of your policy, with premiums increasing as you get older. One of the main reasons for this is that when you are younger and are still establishing yourself financially, you will be more easily able to afford lower premiums. To ensure that the lump sum you have insured for is covered by your premiums, you catch up the slack later, so to speak, in the form of increased premiums. It's a good way of taking out a larger insurance policy than you may be able to afford at the time, and paying for it later, when you can better afford it.

  • Reviewable premiums - this is where you can regularly review your premiums, in agreement with your insurer. This allows you to have more ongoing control of your insurance policy and to make sure that your insurance policy keeps pace with your ongoing lifestyle needs.

So which one do you choose?

It may be obvious that an escalating premium type of policy is the one to go for when you are first establishing yourself financially, but want to make sure that you have sufficient life insurance.

But what about the other options, or what if you are already on a sound financial footing when you want to take out an insurance policy? There's a general rule of thumb that you can follow - although it's always wise to speak to an insurance expert at an insurance company, or to a broker that you can trust.

The basis premise is this - in the beginning, it will obviously be cheaper to take the reviewable premium option. However, there can come a time when your premiums will increase to a point where they become pretty expensive - and more importantly, when the total amount that you will pay in premiums will be more than the total that you will be paid out. Insurance companies have started to address this, by building in an option for you to swap to a fixed premium policy at certain points in the life of your insurance policy. However, this is usually subject to a full health review and, if you have suffered any serious illness, you may find that you are unable to swap policies, and you will be stuck with the higher premiums.

So for this reason, fixed premiums provide more security and more of a guarantee that you will be able to afford future premiums. On the surface, fixed premium policies generally seem to work out cheaper in the long term. However, your budget may not allow for this, in which case it's better to have the life insurance, even if it's on a reviewable premium policy.


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