An expense ratio represents a company's operating expenses divided by the average dollar value of its assets. This ratio is generally used in reference to a mutual fund company. Life insurance policies are not measured in terms of an expense ratio. However, they do have a cost index, and knowing how much your policy costs can help you determine whether or not you are making a good purchase.
A cost index may be thought of an an expense ratio for a life insurance policy, although there are important differences between an expense ratio and a cost index. The cost index was developed as a way to compare different kinds of life insurance policies. Life insurance companies keep a cash reserve to pay for the death benefit claims of the policy. The insurer uses the investment returns on the policy plus the calculation of all of its expenses to determine the cost index. This number represents what you pay for your death benefit on a per $1,000 of death benefit basis, assuming an interest rate factor. The interest factor gives you the inflation-adjusted cost.
The cost index for life insurance varies according to policy type. Term life insurance policies will have a cost index which is low in the early years and may either rise over time or stay flat for the term of the policy. Whole life and other forms of permanent life insurance have a cost basis which starts high and normally decreases over time.
The cost index represents a clear indication of how much the policy costs you, so you don't have to do any complex mathematical calculations. Instead, the insurer gives you the cost for the policy -- adjusted for inflation -- so that you may make an accurate and meaningful comparison across multiple policy types. This is beneficial since it's often difficult to assess the cost effectiveness of a term policy and a whole life policy when making a comparison between the two. A term policy does not build a cash value, while a whole life policy does. The cost index takes into account the investment component of the whole life and allows you to see the true cost of ownership of the whole life when compared to a policy you may only carry for several years.
The cost index is a useful way to compare policy costs, but it might not tell the whole story in certain instances. Whole life policies that pay dividends, for example, will show a cost index which does not assume dividends are reinvested into the policy to purchase additional paid-up life insurance death benefits. If you choose to reinvest dividends in such policies, your cost will be lower than the cost index figure shown in the policy's illustration.
- "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition"; Sid Mittra, et al.; 2007
- "Life Insurance"; Kenneth Black, Jr., et al.; 1994
- "Actuarial Aspects of Individual Life Insurance and Annuity Contracts"; Albert E. Easton, et al.; 1999