In view of the life insurance industry’s circumstances and the tight competition among industry players, the proponents were unable to obtain a detailed breakdown of the costing methodology from Ayala Life’s Actuary Unit. In any case, however, it is still possible to analyze the principles of costing in a life insurance company by reviewing the nature of its operations and implementing a generic approach applicable to any going-concern aimed at generating a profit.
THE PRODUCT AND REVENUE GENERATION
Traditional life insurance products are unique simply on the business premise that human life is unquantifiable. Therefore, life insurance plans are usually constructed with a monetary sum amount in mind at the end of a pre-specified period or duration. As most insurance companies would practice, pooled premiums under a classified type of business risk are considered a risk portfolio; separate and distinct from other lines. These risks are equivalent to SKU’s (Stock Keeping Units) in retailing, although quite different in form since insurance policies are not always homogeneous as standardized products/output of manufacturing are.
In practice, there are various ways to refer to an insurance SKU – that is an insurance policy. Policies can be taken per piece as each is attributed to a unique assured with unique conditions, circumstances and other givens. Policies can also be treated as portfolios under a certain classification or line of insurable risk. Policies can also be referred to in terms of amount, type of insurable interest, degree of risk, probability of loss, the location of the risk insured, among other ways of organizing the pools of risks that an insurance company has agreed to take-on on and thereby hedging the insured.
As already mentioned, life insurance policies are issued for a predetermined sum of money once the insured dies. Computation for premiums varies from product to product, though in general, regular life policy premiums are based on a mortality table. Upon application, an underwriter evaluates the total mortality risk represented by a proposed insured, and assigns positive or negative values to each risk factor that may impact a person's mortality risk. This very process already subjects the assured to scrutiny, as his health and lifestyle, among other highlighted factors, provide a somewhat objective scale by which the life insurance company can assess the probability of death prior to the mean mortality age of a locality's populace. The proposed insured is then placed in a risk class (preferred, standard, substandard, or declined) and his premium rates are computed accordingly.
Unlike the objects of coverage of non-life insurance products, more specifically property, life insurance products do not have a benchmark by which forum-shopping assureds would refer to; again, simply because human life is priceless. It is this very nature of a life insurance policy’s object of coverage that the proponents’ are led to opine that potential life insurance clients do not possess as much bargaining power as non-life insurance clients do. Life insurance clientele are usually presented with rates based on the life insurance sector’s prevailing rates, which are contrarily pliable in the non-life sector.
Legally, for purposes of elaboration, under Title 7 (Rating Organization and Rate Making) Section 356 of the Insurance Code of the Philippines the law states that,
“No member or subscriber of a rating organization, and no insurance company doing business in the Philippines, or agent, employee or other representative of such company, and no insurance broker shall charge or demand a rate or receive a premium which deviate from the rates, rating plans, classifications, schedules, rules and standards, made and last filed by a rating organization or by or on behalf of the insurance company, or shall issue or make any policy or contract involving violation of such rate filings.”
The proponents are encouraging the readers to take the assertion, on the non-life insurance sector’s practices in adhering to prescribed premium rates, at face value, since further exploration on this issue would be moot and a more thorough study would be more relevant for another topic. In any case, though, the proponents are predisposed to believe that rates are also tweaked in the life insurance sector, but perhaps at realistic degrees of haggling, as any competitive industry would experience. Returning to the flow of discussion, the non-life insurance sector does not have as much luxury in enforcing rates in a competitive market due to the existence of referable market values of insurable properties. Costing and the quantification of value, as such practiced in the profession of accounting, are achievable when dealing with objects/property.
Proceeding further with the discussion on costing, the proponents wish to again highlight the luxury by which rates are quoted by life insurance companies when determining the premiums due from an assured. Perhaps there exists a point where an assured is disconnected from assessing the accuracy of a human life’s value (i.e., on what he/she must pay for the sum in contention). A good way to illustrate the case is when a premium is quoted for the risk of loss of a car (which normally has a fair market value – a price that another would pay for the object), while another quote is made for the loss of human life. Again, the distinction is absolutely apparent.
Pricing usually has two parts: 1) the cost of benefit (which is the insurance or mortality charge) and 2) the loading charges, which takes care of commissions, taxes, operating expenses, etc.
With this concept in mind, the proponents can now point-out that costs can easily be covered as long as overhead expenses and mortality frequencies are covered (with the risk portfolio not hitting the asymptotic tail events, i.e. more deaths in a given time interval than expected). To elaborate this further, actuarial calculations in determining the rates to charge the life of the assured usually have a profit factor. Therefore, as long as the assumed probabilities in the mortality levels of the market manifest at the desired degree of confidence, then it is unlikely that losses would be attributable to deaths and more likely so to operating expenses. The proponents wish to emphasize that even if premium rates are derived from statistics, profit is already intrinsic when quoting a price to the assured. At this point of the discussion, it can already be deduced that life insurance is indeed a very profitable business, with the risk of loss or ruin only likely to occur at the tail ends of a normally distributed bell curve.
Another factor to a premium’s pricing is the loading charges. Loading charges are usually factored in when calculating the premium chargeable to the insured in the insurance industry, which is also priced in the non-life insurance sector, although again waivable if the tightness of competition warrants it. Interestingly, loading charges were designed to answer for all other miscellaneous charges outside of the mortality risk (i.e., the amount payable when all deaths have been added).
Although it would simply be hard to imagine that a single life policy sold could produce enough funds to answer for both the risk of death and other attributable expenses in the operation of an insurance business, it can be deduced that a life insurance company can easily project a hurdle amount for a given financial interval. This simply means that a life insurer intends to sell as much insurance policies as it can, knowing that its cost of benefit factor in the premium kicks in upon the application of the law of large numbers and that corollary to it are the loading charges factor in the premium that should answer for all other expenses to be incurred.
For purposes of discussion, a life insurer does not only have to contend with the technical aspect (i.e., underwriting and claims management) of its business, but also the financial aspect (i.e., investments). Therefore, other costs, albeit indirectly attributable, are opportunity costs and the effect of inflation, which affects the real rate of return in investments. Without delving too much on the intricacies of capital markets, the benchmark policy rate of the Bangko Sentral ng Pilipinas (BSP), which is the most basic of rates in pricing overnight lending, interbank call loans, repos and government securities, always puts into consideration the influence of inflation. The stability of consumer prices, is after all, at the heart of monetary policy. With this in mind, it can be said that investments that have minimal risk premiums simply shield the value of the original sum of money (inflation-adjusted returns). On the other hand, opportunity costs and even the risk of loss are present whenever the asset management section of a life insurance company exposes its funds to the commercial bond market, equities market, foreign currency market and other financial instruments available to investors. With the exception of the more risky asset classes, risk-free securities such as government securities allow the investment professionals or the treasury of the life insurance company to project the most probable investment returns that they expose to financial markets. In any case, however, any investment returns realized are normally projected at the most conservative levels. In the interest of prudence and sound business practice, it would be hard to imagine a life insurance company relying on investment return projections or forecasts to answer for both death claims and operating expenses and so again we must defer to what had been emphasized all along, that the pricing mechanism of the life insurer already factors in all probable expenses as it conducts its business. A hurdle rate or revenue level must simply be achieved to assure that the company does not incur a net loss, barring of course statistical tail events.
During the operating year of 2007, about Php60.2 billion of expenses were incurred by the company. This represents the hurdle amount that must be exceeded by topline revenues, investment income, among other income generating activities.