How does the traditional life business work?

January 25, 2019
How does the traditional life business of an insurance company work? What components can a premium be divided into? How do profits arise in the traditional life business?

What components make up the premium?

In traditional life insurance business, the premium can be broken down into the following three components that provide benefits for the customer:

  • Risk component – benefits payable on death or disability
  • Savings component – capital protection and guaranteed interest income
  • Cost component – for various services such as processing annuities

In the following example, which is illustrated above, the customer pays a premium of 1,000 (A3) for his or her life insurance policy. DThe premium consists of three elements: a ‘risk component’ (A2/ B2), a ‘savings component’ (A3) and a ‘cost component’ (A4). The savings component accounts for the largest amount because this is where the customer accumulates protected capital. In our example, 900 is invested in a high-quality portfolio of different assets (B3) in order to ensure that the promise of a guaranteed return is kept and to achieve surpluses over and above the guaranteed returns. 90 is used as a technical reserve for claims (B2) in the event of, say, the policyholder’s death. The final 10 covers the costs incurred by the insurance company for administering the policy (A4).

Graphic Traditional Life Insurance

How do profits arise in the traditional life business?

In order to guarantee that the risk-business benefits can be paid, the technical reserves are calculated according to the best estimate. Based on this estimate, the amount calculated in our example does not come to zero: the insurance company still has 10 remaining after the benefits have been paid (C1). This amount then goes into gross profit (C3). If insufficient reserves are set aside, a loss will be incurred here. Thanks to a broadly diversified investment strategy, the savings component generates a reliable return of 3 per cent. After deducting the minimum benefit paid to the customer (18, D3), the remaining investment gain of 9 (C2) is gross profit. Gross profit – i.e. the net total of all gains and losses arising from the savings and risk components – therefore comes to 19 (C3). The bulk of this amount is paid back to the customer in the form of surpluses.

In our example above, the surplus is 70 per cent, i.e. 13.30 (D4), but it can often be over 90 per cent, e.g. for occupational pension insurance schemes in Switzerland or in German individual life insurance. The final net profit comes to 5.70 (C4). This profit must be sufficient to provide adequate compensation for the shareholders as they bear the entire risk and supply the equity required for this business.