Explain how stepped and level premiums deal with the cost of risk rising over time.
Many people with more than one policy notice that some premiums rise over the years while others stay the same. They keep paying both without knowing why, or what the rising ones will cost at 60 or 70. Every policy in the course faces the same basic fact: the cost of cover rises as the insured person ages. What differs is how each policy passes that rising cost on to you, the policyholder.
Lesson 1.1, "Every premium pays for risk, costs and sometimes savings", split a premium into three parts: risk, costs, and sometimes savings. The risk part is the insurer's estimate of what it will pay out this year on people like you.
Take ages 30, 50 and 70 as an illustration rather than real data. In a large pool, few people die or fall seriously ill at age 30 in any one year, so the risk part of a 30-year-old's premium is small. At 50 the risk share is higher, and at 70 it is much higher. Insurers set prices using tables showing how often claims happen at each age, and those tables only slope upward.
If a policy charged you exactly the cost of your risk each year, your premium would rise every birthday: slowly in your thirties, faster in your fifties, and steeply after 60. That rising premium is the honest price of cover. Products differ only in how they bill it to you, and most use one of two methods.
A stepped premium is recalculated as you age, usually at set age bands such as every five years. You pay close to the true cost of your risk at each stage, so the premium starts low and climbs. Hospital plans and their riders usually have stepped premiums, as do many other riders and many one-year renewable covers, such as some group plans and personal accident plans.
A stepped premium can rise for two separate reasons. One is moving into a new age band. The other is the insurer changing the plan's premiums for reasons other than age. For Integrated Shield Plans, the insurer must first get approval from the Ministry of Health (MOH) before it can change premiums. Both show up as a higher figure on your renewal notice, but they have different causes.
Stepped pricing is fair in a narrow sense: you never pay for risk you do not yet carry. Its drawback is timing, because premiums are lowest while your income is still growing and highest when you may have stopped working. A stepped premium that is small at 34 can be a real cash bill at 70, and your current renewal notice gives no warning of this. Lesson 4.4, "Premiums at 30, 50 and 70: can you keep paying", works through what rising stepped premiums do to a retirement budget.
A level premium stays the same for the whole premium term. To set it, the insurer works out the total cost of cover over the term, adds its own costs, and spreads the result evenly. Whole life policies and most fixed-term term policies, for example cover to age 65, usually have level premiums.
With a level premium you pay more than your risk costs in the early years and less than it costs in the later years. The insurer holds the early surplus as a reserve, which carries the policy through the expensive years. In effect, you pay in your thirties for cover your older self will use.
This has two consequences. First, if you drop a level-premium policy after a few years, the early surplus has already gone on costs and the reserve. This is part of why early surrender values are low, and Lesson 7.2, "Why replacing a policy usually costs you", puts a number on that loss. Second, a level premium is not automatically cheaper or dearer than a stepped one, and over a long life the totals can be close. The real difference is when you pay: level premiums move the cost forward into your working years, while stepped premiums push it out to later life.
Jun Hao is a 34-year-old engineer, married to Mei, with a two-year-old daughter, Elise. He has a hospital plan with a rider. Each year the insurer sends a renewal notice, and every few years the premium goes up. He also has a whole life policy he bought at 26, which has cost S$2,400 a year since he signed (he, his family and his figures are invented). Over lunch he asks a colleague why one premium climbs and the other never moves, and neither of them knows.
The hospital plan and rider turn out to be stepped. The increases he has seen come from moving into a new age band. A change to the plan's premiums apart from age, which for an Integrated Shield Plan needs MOH approval first, would be a separate kind of increase. The whole life policy is level, which is why it has stayed at S$2,400. He also has group cover from work, which costs him nothing and ends when he leaves the job.
He sketches his premiums on paper. Whole life is a flat line at S$2,400 until the premiums stop, the hospital plan and rider form a stepped line that climbs, and the group cover gets no line at all. The flat line is easy to budget for. He realises he had never thought about the stepped line: because it was small, he had never looked at its premium table, and he did not know what it would be at 60 or 75. This is common, since a stepped premium is easy to overlook while it is small.
Policy documents usually say which kind of premium you have, but not always in those words. Look for these signs:
A premium table by age, or wording that premiums "are not guaranteed and may be revised", points to stepped pricing or reviewable rates. One fixed premium shown for every year of the premium term points to level pricing. A premium term shorter than the cover term, such as premiums for 20 years and cover for life, is level pricing compressed into fewer years. Any rider listed with its own premium needs checking separately, because a rider often follows different rules from the main policy.
Watch for one trap: a guaranteed level premium and a level premium are different things. For health insurance, the Life Insurance Association (LIA) explains that premium rates which are not guaranteed are adjusted from time to time, based on factors such as your age and the insurer's claims experience. Only the contract says which kind you have, so for any level premium, check the contract to see whether it is guaranteed.
Now do the same with your own policies, and make it a habit. List each premium you pay. For each one, ask whether it will stay where it is, and if not, what it will be when you are old. Exact figures can wait. A label against each policy, stepped or level, is enough to start, and module 4 fills in the numbers for your hospital cover.
For each policy you hold, write down whether the premium is level or stepped and what happens to it as you get older.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).