When purchasing insurance, you are faced with a myriad of choices with regards to your policy. One choice you have to make when purchasing long term insurance (i.e. insurance that pays if you die, cannot work, or are diagnosed with a critical illness) is your premium pattern. The premium pattern that you choose determines how your premiums change every year. Premium pattern choice is a significant decision for your insurance cover, but it often does not get the full attention it deserves.
For the most part, there are three main types of premium pattern. These are:
- Level premium patterns: Every year your premium remains the same for as long as your cover remains the same.
- Compulsory increases: Every year your premium increases by a compulsory percentage (this is usually 5%) for as long as your cover remains the same.
- Age Rated: Every year your premium is adjusted to allow for the fact that you are a year older. The change in premium is in proportion to how much more likely you are to claim at this older age. As such, age rated premiums don’t have as predictable a development as the other two premium patterns.
Consider this simple example. You want a quote for life cover and need to choose your premium pattern. Your options are:
- A level premium pattern, which costs R400 per month initially. Your monthly premium will remain at R400 for as long as your cover remains the same.
- A compulsory increase premium pattern of 5%, which costs R300 per month initially. When the policy commences your premium is now R300, but every year it will increase by 5%
- Finally, an age rated premium pattern. When the policy commences the premium is now R270. Every year premium increases in proportion to how much more likely you are to have a claim now that you are one year older.
So, from the above examples you may have noted that level premium patterns are usually more expensive when the policy commences, but you will see bigger increases to your premium on the other premium patterns. We can compare the different premium patterns on a typical policy below.
Premium patterns are ultimately a decision around how you want to structure your payments for your insurance cover. Basically, the more you pay now, the less you pay later.
When deciding on premium patterns, policyholders often choose compulsory increase or age rated premiums in order to enjoy cheaper cover when the policy commences. However, as seen above, compulsory increase and age rated premium patterns can quickly become unaffordable as the policy runs its course. For age rated premiums this problem is compounded as you get older because your likelihood of having a claim increases exponentially. This means that your premium increases get steeper the older you get.
Choosing age rated premiums in order to save money when a policy commences can lead to unaffordable premiums when you are older and are most likely to need the cover.
Let’s look at one final example using the actual premiums of a recognised South African insurance company to illustrate this point. Consider a 50 year old man, earning R50 000 per month. His financial advisor calculates that he needs R2 000 000 critical illness cover. The financial advisor also recommends that he selects the option for his cover (note: not premium) to increase by 5% every year in order for his benefits to keep pace with inflation.
As you would expect, the cover on the age rated premium pattern is cheapest initially. But what about in the future? In the table below, we compare the different premium patterns in the first and fifteenth year. We can see both the monthly rand amount of the premium, and the premium as a percentage of his earnings before tax:
So, while the age rated premium is initially 3.3% of his earnings, after 15 years his age rated premium would be an eye watering 8.4% of his earnings before he pays tax. The level premium patterns starts off more expensive, but the premium after 15 years is a lot more manageable.
One final point to note when considering the above. Fifteen years might seem like a long time, but in life insurance it is not uncommon for you to have a policy for double that amount of time. If the above table does not make you feel a little uneasy about age rated premiums, you should note that the longer the above policy runs the bigger the gap between age rated and level premiums becomes.
So in summary, you should always consider all your premium pattern options when choosing a premium pattern. A projection of your premiums over the lifetime of your policy is shown on every long term insurance quote. Don’t be swayed just by the initial premium. Ask your advisor to draw a quote for you on each premium pattern, and use the premium projections to choose the best premium pattern for you.
Special thanks to my friend Tyrone Morris for suggesting this as a blog post.