A life insurance company�s operating expenses fall into the two broad categories of investment expenses and insurance expenses. Investment expenses include all costs to make, service, and safeguard the company�s investments. Accountants recognize these expenses as a reduction of gross investment income. (Since these expenses are not covered by an explicit loading of the net premium, they are not considered in the remainder of this chapter.)

Insurance expenses include all items of costs not related to the investment function. Among the various expense classifications insurers use, the most meaningful for calculating gross premiums organizes insurance expenses into

Items that vary with the premium rate are commissions to agents, state premium taxes, acquisition expenses other than commissions, and agency expenses. The first two items are defined directly as percentages of the gross premium involved, while the last two items may be expressed as percentages of either the premiums collected or the commissions paid. Some agency expenses and acquisition expenses other than commissions may be charged on a per-policy basis. Agency renewal expenses may be assessed entirely per policy, as illustrated later in this chapter.

Several expenses relate to the amount of insurance. Selection costs are the most sensitive to the size of the policy. For example, companies issue policies for less than a certain size without a medical examination. If an application warrants, a paramedic exam for small and moderate-size policies will usually run from $50 to $100. When a larger amount of insurance is involved, the company requires an electrocardiogram, X-rays, blood tests, and other expensive diagnostic procedures. In this event the examiner�s fee may be $200 or more. Occasionally, the company may require two or more independent medical examinations. Investigation of the applicant�s other characteristics, such as lifestyle, financial status, and character, is also more thorough for larger policy sizes. Therefore a larger policy often incurs a larger inspection fee. Other expenses that may vary with the size of the policy include those associated with the issue, maintenance, and settlement of the policy.

Examples of expenses assessed per policy include the costs of issuing policies, establishing the necessary policy records, sending premium notices, accounting for premium remittances, settling routine claims, and general overhead. As indicated above, certain agency and acquisition expenses may also be assessed per policy.

Based on this classification scheme, the typical loading to a net premium has three parts:

Using all three of these elements produces a premium rate per $1,000 that decreases with an increase in the face amount of the policy. This happens because per-policy expenses, by definition the same for each contract, are smaller for each $1,000 of the face amount. Called grading of premiums, such prices that decline with policy size are a general practice today. Grading can be accomplished by setting broad amount classifications called bands and setting a uniform rate of expense loading per $1,000 within each band. To assess per-policy expenses on a band basis, the actuary must assume an average size policy within each band.

A more commonly used method for dealing with per-policy expenses�and the one illustrated in this chapter�is the policy-fee approach. The policy fee is designed specifically to cover expenses that are roughly constant per policy. The resulting composite rate varies incrementally with each $1,000 of insurance.

A common modification of the policy-fee system is to charge a smaller fee on policies below a certain size, such as $50,000, in the interest of minimizing the expense charge on small policyowners. Above the specified size, the per-policy charge is constant, ranging from about $25 to $50. A combination of the two methods uses bands for policies below some level, such as $1 million, and a policy fee for policies over that amount.