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01/08/1997

What Determines the Price of Life Insurance? The Trend Toward Detailed Risk Selection

Munekazu Kawachi 

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1. Introduction

In addition to age and sex, another important factor determining life insurance premiums is health condition−medical examinations can raise premiums or even result in policy cancellation.

Life insurers perform risk selection−that is, they assess the risk level of policyholders−to stabilize their risk exposure. They also believe that setting premiums based on the risk level is fairer to policyholders. This risk selection is based on age, sex, and health condition.

 



2. Increasingly Detailed Risk Selection in the U.S.

Recently, a new development has emerged that originated in the U.S. Until 1980, premiums in the U.S. were based on risk selection according to age, sex, and health condition as in Japan. Then risk selection criteria became increasingly detailed, and premium rates were applied accordingly. From the 1980s, different rates were applied for smokers and nonsmokers, and in the1990s, preferential rates were given to applicants deemed particularly healthy. More recently, the industry has been discussing whether premiums should reflect genetic testing results.

(1) Smoking and Premium Rates (1980s)

The Surgeon General report on smoking and health in 1964 raised public awareness of the health risk of smoking by indicating that smokers had a higher death rate than nonsmokers. The life insurance industry also focused on the report, and State Mutual was the first to introduce premium discounts for nonsmokers on the basis that charging the same premium was unfair to them. Thus policyholders who were deemed to be equally healthy in medical examinations paid different premiums based on whether they smoked. In the 1970s, the discount for nonsmokers spread across the country. By the 1980s, premiums sometimes differed among smokers based on the type of tobacco they used.

(2) Preferential Rates for Healthy Persons (1990s)

The next issue taken up after smoking was whether to offer reduced premiums for people in particularly good health. This group has not only passed the required medical examination but judged to be extremely fit and posing a small risk. The assessment is based on personal medical information derived from rigorous examinations and tests including blood tests. Information on lifestyle such as smoking and drinking habits, as well as family medical history are also reviewed. The introduction of reduced premiums for extremely fit persons became widespread in the U.S. in the 1990s.

(3) Controversy Surrounding Genetic Testing

Developments in genetic engineering have stirred up a new controversy regarding risk selection and premium rates. The rapid advances in genetic engineering are being applied in medicine and other fields. The life insurance industry is also interested in genetic testing because it offers new information on potential risks not obtainable by conventional methods. Access to genetic testing results has prompted life insurers to argue that premiums should be set by taking into account any risks detected through genetic testing. One concern behind this argument is that if people discover any abnormal conditions through genetic testing, they will rush to buy life insurance, thereby endangering the financial condition of insurers.

The American Counsel of Life Insurance (ACLI) favors using genetic testing to measure risks and setting premiums accordingly as a necessary measure to ensure fair treatment of all policyholders.

However, since genetic testing raises privacy issues by make it compulsory to expose previously concealed risk factors, the use of genetic testing by life insurance companies has met with stiff opposition.

Consumer groups are opposed to genetic testing on the basis that premiums should not be dependent on the questionable accuracy of genetic testing. In addition, they cite the danger of generating genetic discrimination.

The controversy surrounding genetic testing is compounded by the fact that, unlike Japan, there is no public health insurance system in the U.S. Since medical insurance is provided by the life insurance companies, people who are turned down for life insurance may be barred from receiving medical coverage either.

 



3. Premiums as the Price Associated with Risk

Premiums can be interpreted as the price that a life insurer charges policyholders for accepting to cover their risk; that is, the price associated with the risk level of policyholders. As we have seen, risk selection in the U.S. is based not only age and sex, but on medical examinations, superior health condition, lifestyle habits such as smoking, and genetic testing. However, the method of classifying the risk level of policyholders can also involve a variety of other factors.

(1) Many Factors Affect Mortality

It is common knowledge that moderate exercise is good for the health, risk selection could take this into account and apply different premiums accordingly. Diet also has a major impact on health. In fact, the relationship between diet and lifestyle diseases has been frequently observed. Alcohol consumption also affects health. Thus it would be reasonable to set premiums according to diet and alcohol consumption. In addition, regional differences in mortality rates and morbidity rates are also known to exist. We could focus on the large effect that climate and local lifestyles have on mortality and consider location as a factor in risk selection. Social factors such as occupation should also not be ignored. In fact, premiums are raised for dangerous occupations such as boxing and race car driving compared to other occupations.

Thus if we were to list all the risk selection factors that might affect mortality, they would include not only personal health condition, but lifestyle habits, social environment and background, and more.

However, just because a particular factor poses a risk does not mean that it should be taken into account in risk selection. In accepting life insurance risk, some factors need not or should not be considered. Moreover, evident differences in risk cannot easily be incorporated into risk selection.

(2) Single Males with Short Life Spans...

Life insurance contracts usually last for long periods of 20 to 30 years. In most cases coverage during the entire period is provided at the premium rate set when the contract is signed. Under this situation, it is difficult to determine the premium using factors whose conditions are likely to change during the life of the contract.

For example, there are clear differences in mortality rates depending on marital status. According to a mortality table prepared by the Ministry of Health and Welfare's Population Center, people with spouses live longer on average than people without spouses.

 

 

For example, let us calculate the endowment insurance premium for a 35-year old male (30-year contract, face value ¥1 million). If he is married, it is ¥27,000 per year, and if he is single it is ¥31,000. Thus a married male pays 13% less in premiums than a single male. However, at present there are no cases in which premiums change depending on marital status. Factors such as marital status, which tend to change depending on a person's life stage, are not suited to long-term life insurance contracts. This is because life insurance contracts in Japan set premiums based on information at the time the contract is signed. The situation would be different if, for instance, marital status were checked regularly and premiums changed accordingly.

(3) Problems with Using Smoking as a Risk Factor

Needless to say, the choice of risk selection factors must be backed by objective statistics. But while their use must be based on objectivity and reasonable grounds, practical problems can also be raised. Consider smoking−there are clear differences in cancer rates between smokers and nonsmokers, ostensibly lending weight to the position that smokers should pay higher premiums. In applying different premiums for smokers and nonsmokers, risk selection is based on the individual's own declaration of whether they smoke.

However, since smoking is a volitional act, cases inevitably occur in which people quit temporarily before signing a policy and resume smoking later, or begin smoking after signing the contract. Since such deception or changes in habits are involved, the measurement of risk is difficult. Thus there is some reservation as to whether smoking is an appropriate factor for risk selection.

(4) The Trend Toward Detailed Risk Selection

Let us consider car insurance premiums, which have been in the news recently. Until now, car insurance premiums were not based on age and sex. However, under the bilateral insurance agreement signed with the U.S. last year, premiums will soon vary depending on such factors as age, sex, and location. For example, premiums will be higher in areas where accidents occur frequently.

 

 

This is nothing new in the U.S., where risk factors are increasingly being reflected in premium levels. For example, looking at actual premiums charged by an insurance company in New York, we see that premiums vary substantially depending on location. Policyholders living in the suburbs pay one-third the premium of city dwellers.

 

 

Turning to life insurance, what would happen to premiums if this trend toward increasingly detailed risk selection continues?

As risk selection becomes increasingly intricate, low risk groups would benefit from lower premiums, while high risk groups will pay more. Differences in premiums will become more pronounced as the trend continues. In some cases premiums may become prohibitively high.

Objections have arisen in the U.S. that risk selection has already reached the point where high risk groups who truly need coverage are unable to obtain it. This raises the broader social issue of whether insurance should be available at rational prices that correspond to individual risk levels, or widely available to as many people as possible.

However, from the viewpoint of managing the insurance system, excessive attention to detail in risk selection is not necessarily desirable. That is, since detailed risk selection will inevitably cause a flood of product information regarding premiums and the corresponding price of risk, consumers will be misled when choosing products. In addition, premiums are derived from statistical calculations and will settle to reasonable levels only if insurance risks can be adequately dispersed among a large enough number of policyholders. This is called the law of large numbers. Since detailed risk selection decreases the number of people in each risk category, it threatens this basic principle of insurance.

Even in the U.S., where prices are set according to risk level, selection is restricted when people buy medical insurance. Here we can see a compromise owing to the public status of medical insurance in the U.S.

(5) Protection of Privacy

Privacy issues cannot be ignored when discussing detailed risk selection. AIDS is a particularly serious issue since no remedy has yet been found. However, according to a report by the AIDS Surveillance Committee, the number of reported AIDS cases and HIV infections in 1996 was 610, low in proportion to the total population. While Japanese life insurance companies have not yet taken any concrete measures on AIDS, in the U.S., where AIDS is a serious problem, there are companies that test applicants for the HIV virus. In addition, according to a recent news report (Asahi Shimbun, April 25, 1997), Guaranty Trust Life in Illinois offers insurance to people who are HIV positive but do not have the AIDS virus. The premium is five times higher than for people who do not test positive.

In Japan, if the number of AIDS cases increases to the point of impacting the life insurance business, HIV testing may inevitably become required to obtain coverage. In preparation, life insurers are seeking access to confidential personal records to measure medical risks, and have already been careful in managing personal data. When this happens, the protection of privacy is sure to become an important issue.

 

 



4. Conclusion

In the U.S., serious debate is underway regarding the use of genetic testing in risk selection. Meanwhile, Japan continues to debate the propriety of offering reduced premiums for nonsmokers. Little discussion has occurred on genetic testing with regard to the determination of life insurance premiums, and the study of genetic testing is yet to be taken up. However, life insurers in the U.S. are seriously looking at this issues issue because they are convinced that genetic testing will significantly impact premium rates.

There are no national boundaries where advanced technology such as genetic testing is concerned. If genetic testing proves to have a significant impact, the issue will soon be taken up in Japan. It may already be time for Japan to begin discussing genetic testing. Moreover, as with the case of whether to offer discounts for nonsmokers, the issue of risk selection should be publicized to gain social recognition. There will be people who think that smoking should not be included in risk selection despite the overwhelming statistical evidence. In this sense, the already-determined risk selection scheme for car insurance and the ongoing debate over premium discounts for nonsmokers may be tests that portend the future of risk selection.

 

Munekazu Kawachi

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