Level premium insurance is just what the name implies�a plan of insurance under which premiums do not increase from year to year but, instead, remain constant throughout the premium-paying period. It does not imply that the insured must pay premiums as long as he or she has insurance protection, only that all premiums required will be of equal size.

It must be apparent that if premiums that have a natural tendency to increase with each passing year are leveled out, the premiums paid in the early years of the contract will be more than sufficient to meet current death claims, while those paid in the later years will be less than adequate to meet incurred claims. This is a simple concept, but it has manifold ramifications and far-reaching significance.

With the level premium technique the redundant premiums in the early years of the contract create an accumulation that is held "in trust" by the insurance company for the benefit and to the credit of the policyowners. This accumulation is called a reserve, which is not merely a restriction on surplus as in the ordinary accounting sense, but an amount that must be accumulated and maintained by the insurance company in order to meet definite future obligations. Since the manner in which the fund is to be accumulated and invested is strictly regulated by law, it is usually referred to in official literature as the legal reserve. Technically the reserve is a composite liability account of the insurance company, not susceptible to allocation to individual policies, but for present purposes it may be viewed as an aggregate of individual accounts established to the credit of the various policyowners.

From the standpoint of an individual policy, the excess portions of the premiums paid in the early years of the contract are accumulated at compound interest and subsequently used to supplement the inadequate premiums of the later years. This process can be explained most simply in connection with a contract that provides protection for only a temporary period, as opposed to one that provides insurance for the policyowner�s whole of life. Figure 2-1, shows the level premium mechanism in connection with a term policy issued at age 25, to run to age 65. The level premiums to age 65 are based on the 1980 CSO Female Table and an interest assumption of 4.5 percent. In other words, it is assumed, with respect to the level premium calculations, that the reserves are invested at 4.5 percent, and with respect to the yearly renewable term premiums, that each premium earns 4.5 percent for one year before being disbursed in the form of death benefits.

In this example no allowance is made for expenses, which makes it easier to understand. It also conforms to the legislative and regulatory approach of setting reserves strictly on the basis of interest and mortality without consideration of other operating costs.

In figure 2-1 the curve AB represents the premiums at successive ages that would be required to provide $1,000 of insurance from age 25 to age 65 on the yearly renewable term basis. The premium ranges from $1.16 at age 25 to $14.59 at age 65. The line CD represents the level premium that would be required to provide $1,000 of insurance from age 25 to age 65 on the level term basis. The amount of this level premium that would be paid each year through age 64 is $2.99. This exceeds the premiums that would be payable on the yearly renewable term basis prior to age 44 but is smaller than those payable thereafter.

The triangle AXC represents the excess portions of the level premiums paid prior to age 43; the triangle BXD represents the deficiency in premiums after that age. It is apparent that the second triangle is much larger than the first. The disparity in the size of the two areas is attributable to the fact that the sums represented by the triangle AXC, which constitute the reserve under the contract, are invested at compound interest, and the interest earnings are subsequently used along with the principal sum to supplement the inadequate premiums of the later years. The reserve is completely exhausted at age 65 (the expiration of coverage), having been used to pay the policy�s share of death claims submitted under other policies, which is another way of saying that the reserve, including the investment earnings derived therefrom, is gradually used up after age 44 in the process of supplementing the then deficient level premium. The reserve under this particular contract�term to 65, issued at age 25�reaches its maximum size at age 53, diminishing thereafter at an accelerating rate until exhausted at the expiration of the policy.

The functioning of the level premium plan is even more striking�though more difficult to grasp�when applied to a policy providing insurance for the whole of life. A comparison of the level premium required under an ordinary life policy with that required on the yearly renewable term basis is presented in figure 2-2. As in the case of figure 2-1, the age of issue is 25, and the premiums are based on the 1980 CSO Female Table and 4.5 percent interest, with no allowance for expenses.

In this case, an annual level premium of $6.09 per $1,000 paid as long as the insured lives would be the mathematical equivalent of a series of premiums on the yearly renewable term basis, ranging from $1.16 per $1,000 at age 25 to $956.94 at age 99.

The 1980 CSO Female Table assumes that everyone who survives to age 99 will die during the year, producing a net premium on the yearly renewable term basis equal to the face of the policy, less the interest that will be earned on the premium during the year. In figure 2-2 line CD bisects the curve AB between the ages of 53 and 54.

The disparity between the areas bounded by AXC and BXD is very much greater in this case than in figure 2-1. Even more amazing, however, is the fact that the excess premiums (area AXC) in the early years of an ordinary life contract (or, for that matter, any type of insurance contract except term) will not only offset the deficiency in the premiums of the later years when the term premium is in the hundreds of dollars, but with the aid of compound interest will also accumulate a reserve equal to the face of the policy by the time the insured reaches the terminal age in the mortality table. This is in contrast to the level premium term contract, under which the reserve is completely used up at the expiration of the contract. The difference is because the risk (probability of occurrence) under a contract providing protection for the whole of life is one "converging into a certainty," while the risk under a term policy is a mere contingency�one that may or may not occur. Under a whole life contract, provision must be made for a death claim that is certain to occur, the only uncertainty being the time it will occur.

By the time an insured has reached 99, the reserve under his or her policy must have accumulated to an amount that, supplemented by the final annual premium and interest on the combined sums for the last 12 months of the contract, will equal the face amount of the policy. This must be the case if each class of policyowners is to be self-supporting, since there are no other funds for the payment of the claims of the last members to die. In effect, such policyowners pay off their own death claims, in addition to paying their share of the death claims of all other members of the group. It should not be surprising therefore that the aggregate premiums paid by long-lived persons can exceed the face amount of the policy.

The manner in which the level premium arrangement makes provision for a risk converging into a certainty is explained more thoroughly in the next section.

Under a level premium type of contract, the accumulated reserve becomes a part of the face amount payable upon the death of the insured. From the standpoint of the insurance company, the effective amount of insurance is the difference between the face amount of the policy and the reserve. Technically speaking, this is the amount at risk. As the reserve increases, the amount at risk decreases. The significance of this relationship under discussion is that as the death rate increases, the amount at risk (the effective amount of insurance) decreases, producing a cost of insurance within practicable limits. This process is illustrated in table 2-1.

As stated earlier, the net level premium for an ordinary life contract on a female issued at age 25, calculated on the basis of the 1980 CSO Table and 4.5 percent interest, is $6.09. Since the death rate at age 25 is 1.16 per 1,000, about $5 of the first premium is excess and goes into the policy reserve. If the policyowner should die during the first year, the company would use the $5 in settling the claim and would have to draw only $995 from the premiums contributed by the other policyowners in the age and policy classification of the deceased. This would mean that each member�s pro rata share of death claims in the first year would be only $1.15 (1.16 x 0.995), instead of $1.16, the yearly renewable term premium for $1,000 of insurance at age 25 (with no allowance for interest). By the end of the 5th year, the reserve, or accumulation of excess payments, will have increased to $22 per $1,000, which sum would be available for settlement of a death claim under the policy. The net amount at risk would have decreased to $978, which would necessitate a contribution from the other policyowners (and the deceased) of only $1.27, instead of the yearly renewable term premium of $1.30. The reserve will have grown to $139 per $1,000 by the end of the 20th year, which would reduce the cost per $1,000 from $3.32 to $2.86. By the time the insured has reached 65, the reserve under the policy will have accumulated to $397, and the actual amount of protection will have shrunk to $603. A death claim in the 40th year of the contract would be settled by payment of the $397 in the reserve and $603 from the current year�s premium payments (of all the policyowners). The pro rata share of each policyowner for all death claims during the year would be only $7.99, as compared to $13.25 if no reserve had been available. The influence of the reserve on the cost of insurance is even more striking at the advanced ages.

The true nature of level premium insurance should now be apparent. Under the level premium plan, a $1,000 policy does not provide $1,000 of insurance. The company is never at risk for the face amount of the policy�even in the first year. The amount of actual insurance is always the face amount, less the policyowner�s own accumulated excess payments. The accumulation is the reserve for insurance company purposes but the cash value (slightly less in early years) for policyowner purposes. Since the excess payments may be withdrawn by the policyowner at any time through the cash surrender or loan privilege, they may be regarded as a savings or accumulation account. Thus a level premium policy does not provide pure insurance but a combination of decreasing insurance and increasing cash values, the two amounts computed so that in any year their sum is equal to the face amount of the policy. This is illustrated in figure 2-3 for an ordinary life policy of $1,000 issued at age 25, the calculations are based on the 1980 CSO Female Table and 4.5 percent interest.

The area below the curve represents the reserve under the contract or, as mentioned above, the policyowner�s equity in the contract. The area above the curve represents the company�s net amount at risk and the policyowner�s amount of protection. As the reserve increases, the amount of protection decreases. At any given age, however, the two combined will equal the face amount of the policy. By age 95 the protection element of the contract has become relatively minor, and by age 100�the end of the contract�it has completely disappeared. At age 100, the policyowner will receive $1,000, composed entirely of the cash value element.

This combination of protection and accumulated cash values is characteristic of all level premium plans with the exception of most term contracts. Fundamentally, one contract differs from another only in the proportion in which the two elements are combined. This basic truth should be kept in mind as the study of contract forms is undertaken.

Yearly term insurance is all protection and has no cash value, while single premium life insurance is at the other end of the spectrum with the highest cash values and lowest proportion at risk. Accumulated cash values should be thought of as some degree of prefunding. Single premium policies are fully prefunded, and lower premium policies that develop cash values are only partially prefunded. The shorter the premium-paying period, the higher the relative proportion of cash value to death benefit.

The impact of the level premium plan is felt by nearly all operations of a life insurance company. It accounts for a major portion of the composite assets of the United States life insurance companies that exceed $1.69 trillion and are increasing at more than $100 billion per year. The other main contributor to this asset growth is the reserve component for annuities and pension plans. The investment of these funds has presented the life insurance institution with one of its most challenging problems but, at the same time, has enabled the institution to contribute in a most material way to the dynamic expansion of the American economy. The level premium plan underlies the system of cash values and other surrender options that has made the life insurance contract one of the most flexible and valuable contracts in existence. It has caused the life insurance contract to be regarded as one of the most acceptable forms of collateral for credit purposes. Despite these positive contributions�and the complications introduced into company operations�the greatest significance of the plan lies in the fact that it is the only arrangement under which it is possible to provide insurance protection to the uppermost limits of the human life span without the possibility that the cost will become prohibitive.