SP2 Life insurance principles

英国精算师协会IFoA高级课程SP2思维导图，包含Products and risks、With-profits and the general environment、Product design、Modelling。

SP2

• Products and risks
  • Purpose of offering products
    • Make a profit from the contract Profits are maximised when the utility of the products to the consumer is also maximised Economies of scale would be maximised when seek to take on further profitable risks within available capital Already offer a similar product and hence does not have significant development expenses Cross-sell other products Gain experience in the new market. Diversify and control the overall risks.
  • Products
    • Main types
      • Endowments assurance
        • Features pays a benefit on survival to the end of the chosen term. may also provides a significant benefit on the death of the life insured before that date. a surrender value would also be available. premiums are usually level annual or monthly, though single is possible can be issued on a single or joint life basis might be sold to individuals or to groups Basis Written on a unit-linked or with-profits basis, with new conventional without-profits business being rare. Needs of consumers The need may be for savings, for protection or a mixture of the two. operate as a saving vehicle, eg provide a lump sum on retirement or repay the capital on an interest-only loan. operate as a vehicle for providing protection for dependents a group version would enable an employer to provide benefits for employee at retirement and also on death in service Risks Investment risk A greater investment risk than for a term assurance, but the extent depends on whether it is unit-linked, index-linked, without-profits or with-profits Mortality risk A significant death benefit (e.g. a without-profit contract where the benefit on death equals that payable on survival). There will be a significant mortality risk at the start of the contract, but this will reduce as duration in force increases. associated with this will be an anti-selection risk Return of premiums of fund. The mortality risk is likely to be insignificant except near the start of he contract. No death benefit. There will be a longevity risk, the significance of which will increase with duration in force. Expense risk There is an expense risk in that the actual marginal costs of administering the contract need to be met. Persistency risk At times when the asset share is negative, there is a financial risk from withdrawal. At other times, whether there is such a risk depends on how any withdrawal benefit paid compare with the asset share. Group contract risk Group version adds no additional risks and any anti-selection risk is likely to be much reduced, particularly if it is compulsory for all eligible members to join. Capital requirements Depends on: design of the contract frequency of payment of the premium relationship between the pricing and supervisory reserving bases additional solvency capital requirements level of the initial expenses
        • Eg: Reasosn for purchasing UL EA
          • Policyholder may have wanted a savings contract with an element of death benefit, which could be paid to dependants Policyholder may have a loan (e.g. mortgage) that was repayable, needing a contract that paid out on death to the value of the loan and provide an amount at maturity Policyholder may have wanted exposure to investment market but with a guarantee of a minimum sum assured in the event of death They may have had a previous policy that performed well, or may consider this one to be good value for money Unit linked contracts tend to be cheaper and more flexible than non-linked products, this may suit the policyholder They may have received financial advice recommending this product
      • Whole life assurances
        • Definition: A contract that pays a benefit on the death of the life insured whenever that might occur. Typically a surrender value would be available. Basis: Written on a unit-linked or with-profits basis, with new conventional without-profits business being rare. Needs of consumers: provide for funeral expenses or for meeting any liability to tax provide long-term protection to dependents no consumer need for a group version Risks: the significance of investment risk depends on the age at entry and the duration in force the significance of mortality risk depends on the age at entry, duration in force and selective withdrawals for contracts of long duration in force, expense risk can be led to by the effects of inflation with regard to the expense loadings in the premium payable and the size of the premium itself a withdrawal risk at times when the asset share is negative and at other times depends on how the withdrawal benefit compares with the asset share Capital requirements: Similar to those for an endowment contract Distribution channel (E.g. Unit-linked) An insurance intermediary is a likely channel as the product is fairly complex and so advice is needed. Given the guarantee offered, there will be a requirement for underwriting, which again suggests requiring some research and advice A tied agent may have been used, e.g a bank, but this would limit the choice of products available An own sales force may have been used if the customer have already had other policies with a particular insurance company, Direct marketing is less likely to have been used as the product is fairly complex and so the associated need for advice would be greater. (E.g. Without-profits) The product is relatively simple, with guaranteed benefits and premiums, and so may not erquire face-to-face sales advice Absence of underwriting allows it to sold by direct marketing. And direct marketing should have relatively low levels of anti-selection For insurance intermediaries and tied agents: the simplicity of the product and no underwriting provide little scope for face-to-face advisers to add value the policies are small so that the insurer could not afford much remuneration for sales, so seller may find it difficult to make money Possible tied agents could be supermarkets or trade unions
      • Term assurances
        • Features: General points fixed sum assured paid on death within the specified policy term no maturity benefit typically no surrender benefit usually without-profits, so benefits and premiums are fully guaranteed Individual contracts sum assured and policy term are chosen at the outset sum assured may be level or decreasing for decreasing term assurance, the sum assured might decrease by level amounts each year, or in line with the capital outstanding on a repayment mortgage level premiums may be payable, annually or monthly in advance with level benefits, premiums may be paid for the full policy term with decreasing benefits, premiums may be paid for a limited period alternatively, a single premium could be paid can be taken out on a single life or joint life basis can include guaranteed insurability options to renew the contract at the end of the term or to convert into a whole life / endowment assurance on certain dates typically extensive underwriting as sum assured is large Group contracts typically one-year with guaranteed renewal taken out by employers for their employees sum assured paid on the death of an employee during the year, may be different for each employee yearly premium rates based on current age and sex premiums paid by employer, sometimes shared by employees paid by recurring single premiums premium rates not guaranteed, or guaranteed for 2-3 years periods amount of underwriting is typically lower than on an individual policy as there is less concern about potential selection Basis: Only on a conventional without-profits basis. Needs of consumers: provide protection against financial loss for dependants at a lower cost than under an endowment or whole life assurance a decreasing term assurance can be used to repay the balance outstanding under a repayment loan and to provide an income for a family with dependant children. provide protection against the financial loss that might arise on the death of a key person within the corporate body a group version can be used by an employer to provide a benefit to dependants on the death of an employee or used by a credit card company to provide a benefit on death equal to the balance outstanding on a credit card Capital requirements: The basic reserves are relatively small but solvency capital requirements can be more significant in some jurisdictions. Initial capital strain can also arise for regular premium policies due to high initial expenses. Distribution channels Term assurance is a relatively simple product and so can be purchased via any distribution channel An insurance intermediary could provide the best deal for the customer from across the whole market. They could also offer advice if the customer was an unusual case. If the term assurance was associated with a mortgage, then it may have been purchased from the lender which could be a tied agent. The term assurance may have been bought from an own sales force if the customer already had other policies with that insurance company. Direct marketing could have been used as the product is simple, especially if only simple underwriting was needed
        • Convertible and renewable term assurance
          • Definition: These contracts combine the attractions of a term assurance (low cost death cover) with the certainty of being able either to convert to a permanent form of contract when it can be afforded or to renew the original contract for a further period of years, all without health evidence being provided (unless the benefit is increased). Surrender values would not normally be paid pre-conversion. Risks: The existence of the option to convert or renew gives rise to a significant additional anti-selection risk at the date of exercise. Capital requirements: May be higher than a basic term assurance, depending on the extent of any additional reserve required.
        • Eg: Reasons for purchasing key person policy
          • The 'Key Person' policy is sold to employers providing benefits to the employer on the death of certain employees. This product is sold through independent intermediaries. Explain why an employer may purchase a Key Person policy. A key person policy would provide the employer with protection against the financal loss that might arise on the death of a key person within the organisation. Key people might include the chief executive and company directors The policy may cover the recruitment costs of a suitable replacement the cost of buying out the key person's shares protecting profits from loss of or delay to major projects
      • Immediate annuity
        • Main features: can be written on a single life, joint life first death and joint life last survivor basis usually without-profits, but can be with-profits or unit-linked a single premium is payable at outset the premium may be the proceeds of another contract the benefit is a regular income the frequency of payments is usually monthly, quarterly or annually the payments start immediately without a deferred period payments may be made in advance or in arrears the income is payable as long as the policyholder is alive can be whole life or a temporary term benefits may be guaranteed to be payable for a minimum years,irrespective of insured's survival in that period group and individual contracts exist impaired life annuities offer enhanced terms to policyholders with lower life expectancy benefits can fixed or variable, eg. increasing at a fixed rate or with some index surrender values are not normally available Needs of consumers: This contract convert capital into lifetime income and remove the uncertainty of how quickly capital should be spent. An immediate annuity ensures that the individual provides for a regular pension in retirement rather than allowing the capital to be otherwise spent in the short term. Joint life second death annuities can provide an income for a spouse. Temporary annuities can be used to pay for school fees. A group version can be used by an employer to fund for pensions for employees at or after retirement. Capital requirements: Significant capital requirement, depending on the relationship between the pricing and supervisory reserving bases and on the additional solvency capital requirements. Distribution channel (E.g. Index-linked) An insurance intermediary may have been used as they would search the whole market for the best annuity rate. Advice would also help to find the annuity best suited to the customer's health status and needs A tied agent or an insurance company's own sales force could have been used, particularly if the customer already had a working relationship with one of these. However, tied agents and own sales forces are unlikely to offer the best annuity rates Direct marketing is possible, especially as the annuity may have been purchased with the proceeds of a pension savings vehicle from the same insurance company. A financially aware customer may have looked directly at rates offered by different companies online
      • Deferred annuity
        • Definition: A contract to pay out regular amounts of benefits provided the life insured is alive at the end of the deferred period when payment commence, and subsequently alive at the future times of payment. Regular or single premiums may be payable up to the vesting data as there is a deferred period. Surrender values are not normally available post vesting but may be payable during the deferred period. Basis: Mainly written on a conventional without-profits basis, also available on an index-linked basis or with-profits basis Needs of consumers: For individuals, the contract enables them to build up a pension payable on their retirement from gainful employment. An alternative lump sum may be offered in lieu of part or all of the pension at the vesting date, thereby meeting any need for a cash sum at that point, eg. a house purchase loan. A group version can be used by an employer to fund for employee pensions. Risks: The contract can be decomposed into a combination of an endowment and an immediate annuity, the risks are the combination of those risks. Additional investment and mortality risk at the vesting date if the terms for converting between a pension and a lump sum are subject to a guarantee. Capital requirements: Capital requirements are as for an endowment assurance contract in so far as covering the lump-sum benefit. Additional capital may be required to cover any guaranteed terms for converting between a lump sum and a pension.
    • Bases
      • Conventional without-profits
        • Definition: Fully guaranteed benefits and level regular premium (except for immediate annuities) Risks: To the insurer: Significant risks due to the high level of guarantee provided. To the insured: The amount of benefit provided, which is fixed and guaranteed, turns out to be insufficient. The risk is exacerbated by the effects of inflation over time given the long-term nature. The insurer becomes insolvent and unable to meet the guaranteed benefits in full. The inflexibility of the product to keep pace with the changing disposable income and the changing amount of benefit needed throughout the financial life cycle Unable to maintain premiums due to accident, sickness, redundancy or other loss of income
      • With-profits
        • Definition: A policy where the policyholder has an entitlement to part or all of any future surplus which arises under the contract. The policy may be conventional with-profits or accumulating with-profits. Extent of risks: To the insurer: Lie between those of the conventional without-profits and unit-linked basis. To the insured: Less risk of insurer insolvency than a conventional without-profit contract as the future surpluses can now be used to maintain solvency. Additional risks: Risk depends on how much of the liability was expected to be covered by future discretionary benefits (future bonuses) Bonuses may be lower than expected due to poor investment performance high expenses high deductions due to death benefit payments other deductions being too high, such as surrender losses or losses on without-profits business Inflation may erode the value of the benefits particularly for the guaranteed benefits less so for the discretionary benefits, which will match inflation to the extent that real assets used to back the policy
      • Unit-linked
        • Definition: A policy where the benefits are linked directly to the investment performance of a specified fund, and characterised by a lower level of guarantees on benefits and premiums. Need of consumers: A unit-linked contract enables consumers either to obtain a higher expected level of benefit for a given premium or to pay a lower expected level of premium for a given level of benefit. A unit-linked contract can offer flexibility in the types and levels of cover and the ability to vary premiums according to need. Risks: To the insurer The risks may be lower due to the reduced level of guarantee offered. The nature and extent of any financial risks from investment, expenses and demographic assumptions will depend on the nature and level of any guarantees given and any constraints imposed on the level of charges by marketing or legislative requirements. The anti-selection risk is the same as for the non-linked contract The selective withdrawal risk is likely to be higher due to the more open charging structures The withdrawal risk depends on the incidence of expenses relative to charges and on surrender value penalties. A marketing risk due to the higher variance of the level of benefit for a given premium To the insured Poor investment performance either long-term or at the point of benefit payment Minimum guaranteed death benefit will be vulnerable to erosion by inflation The risk of insurer insolvency Increases in minimum guaranteed death benefits may be declined or subject to special terms Charges may be increased as they are at the discretion of the insurance company. Capital requirement: Depend critically on the design structure of the contract.
        • Unit pricing
          • Internal unit-linked fund
            • Main features An internal unit-linked fund consists of a clearly identifiable set of assets (eg equities, fixed-interest securities). It is divided into equal units, consisting of identical subsets of the fund's assets and liabilities. Unit prices depend on the value of the underlying assets and are set by the company, subject to any relevant policy conditions / regulatory requirements. In principle, the company will aim to match units in issue with those allocated to unit-holders. However, for fund management purposes it may hold a 'box' of units in excess of those that are strictly necessary to cover unit liabilities. Unit prices could reflect costs, eg dealing costs. Management box Some companies create more units in their internal linked funds than is strictly necessary to cover the corresponding unit liabilities. This excess, or 'box', for any fund can be useful in its management, depending on the systems used by the company. However, it is also common for companies to match as closely as possible the number of units in issue with that allocated to unit-holders.
            • Eg: Reasons to use box management system
              • Suggest reasons why the company may wish to use a box management system for new internal unit-linked funds. The company may use a box management system to aid in the manangement of the fund in particular to avoid the need to trade small amounts of assets each day and so avoid incurring lots of dealing costs. e.g. if more policyholders are buying than selling, then the insurer can sell some of the units in the box to the policyholders so that it doesn't need to buy assets in the market. Similarly, on days when more policyholders are sellilng than buying, the insurer could buy the units and add them to its box. The company may have free assets to invest and so may wish to benefit from the investment performance of the unit fund. The creation of a box of units in a new fund enables the new fund to gain a unit price history and helps the company to test the processes involved in pricing the fund. This may help to avoid early unit pricing erros requiring policyholder compensation.
          • Basic equity principle
            • The interests of unit-holders not involved in a unit transaction should be unaffected by that transaction. For the holder of a unit the only relevant prices are those at which the unit is allocated and subsequently redeemed. The movement in price between these two events should depend only on the performance of the assets backing the unit and the charges deductible under policy provisions. It should not, therefore, be affected by the creation or cancellation of other units, otherwise cross-subsidies between unit-holders will arise.
          • Pricing
            • An expanding fund The company will be a net creator of units, and so will determine unit prices on an offer basis.and derive unit prices from the appropriation price. This is the amount that should be put into the fund for each unit created such that the net asset value per unit is the same after as before the unit creation. This preserves the interests of existing policyholders. The appropriation price can be calculated as: Net asset value of the fund on an offer basis equals the market 'offer price' value of the assets held plus expenses that would be incurred and any stamp or duty payable in respect of the purchase plus value of any current assets, e.g. cash on deposit or investment sold but not settled less value of any current liabilities, e.g. loans or investments purchased but not settled plus any accrued income, e.g. interest income from fixed-interest securities and deposits less any allowance for accrued tax Divided by the number of units existing at the valuation date gives the appropriation price, which is the unrounded bid price. An initial charge is added to give the (unrounded) offer price and this initial charge may also be referred to as a 'bid / offer spread'. Normally unit prices are quoted to a certain number of decimal places. Rounding could be done in the company's favour by rounding the offer price up and the bid price down. However, practice varies and there is a trend away from systematic rounding against the customer. A contracting fund The company will be a net canceller of units and will value the fund on a bid basis. So unit prices are derived from the expropriation price, which makes the existing unit-holders be in the same position after the transaction. The expropriation price can be calculated as: Net asset value of the fund on a bid basis equals the market bid price value of assets held by fund minus expenses incurred in selling assets other adjustments similar to appropriation price. Divided by the number of units existing at the valuation date, ie before creations of new units, gives the expropriation price, which is the unrounded bid price. A bid-offer spread is added to give the (unrounded) offer price. Change of bases In the above, it suggest that companies decide the pricing basis taking account of just that day's cashflow. However, in practice, companies are more likely to use a 'broad equity' approach under which the basis is only changed if there is a significant cashflow movement against the existing basis. Mainly due to: Net flow may be very small / within tolerance levels. Waiting to see whether change in direction is more than just a one-off, particularly if it has otherwise been stable for a long period. Changing the basis incurs costs and may require system changes. These costs may exceed the financial benefits from changing the basis. Frequent basis changes may cause changes in unit prices that generate customer queries or complaints. Company can use its management box to avoid frequent basis changes. This approach provides broad equity between different unitholders and reduces price volatility. Change of rounding approach The quote prices may round in favour of the insurer or the customer. The company may change the methodology for rounding mainly due to: Current method leads to a small loss for every unit transaction, whether buying or selling Could add up to significant overall loss if lots of transactions. May not be an issue if few transactions There may be a regulatory requirement that the company has to follow Rounding practice must follow policy conditions The company may be following market practice / competitors Customers may not be happy about rounding against them Compensation may have to be given if the practice was not clear in sales documentation, which would also be a burden
            • Eg. Considerations in increasing initial charges and amending rounding policy
              • A life insurance company is undertaking the daily unit pricing process for one of its internal linked funds. The fund has been expanding over the past few years. The company applies an initial charge of 2.5% within its offer and bid prices and rounds prices up to three decimal places. The company is reviewing the initial charge and rounding policy for all its funds. It is proposing to increase the initial charge to 3%, and to amend the rounding policy to always be in favour of the customer. Discuss the possible considerations the company is likely to consider before implementing these proposals. Likely impact on unit prices Increasing the initial charge to 3% will increase the offer price but not affect the bid price. Amending the rounding to always favour the customer would mean rounding the offer price down and rounding the bid price up. So the proposals affect only the offer price, which is likely to increase overall, as the impact of the initial charge increases is likely to be greater than that of the reduction in unit price caused by the rounding changes. Company actions The company would need to ensure the changes are permitted under existing contract terms. The company will need to contact all its unit-linked policyholders make changes to its admin and unit pricing systems make changes to policy documentation ... and fund literature and any marketing materials train staff These actions will incur costs. The company would need to consider the timing of the implementation of the proposals as offer price will increase by around 0.5% at the point at which the changes are implemented. Policyholder reactions As the proposal impact negatively on policyholders, they may attract adverse publicity and may lead to withdrawals from the funds. Competitors The company would need to consider whether the proposals are in line with competitors. For example, if the initial charge is currently lower than those of competitors then the proposed increase may be seen as bringing the company into line. If the proposed initial charge would be higher than those of competitors then it could lead to adverse publicity and potential surrenders and may have an adverse impact on new business volume.
          • Risks associated with unit pricing
            • Timing effects There will be a lag between the time that the policyholder requests an investment (or withdrawal) and the time that the money is invested into (or withdrawn from) the fund (eg due to the time taken to administer the policyholder's request and to transfer funds between bank accounts). The unit price will also only be known at discrete points in time, eg the unit price may only be calculated at noon each working day. The insurer could process each transaction using the last known unit price. Policyholders could then select against the insurer by selling (buying) units when shares have fallen (risen) in the market after the time the unit price is calculated. This risk may be made greater if insurance intermediaries actively recommend such a strategy to their clients. The insurer could remove this risk if it processed each transaction using the next known unit price after the funds have cleared. However, this may lead to policyholder complaints if the unit price has risen (fallen) after the policyholder has asked to purchase (sell) units. The longer the lag between the time of the policyholder request and the fund transaction, the greater the various risks described above will be. Errors The unit pricing process might fail leading to errors in the unit prices. For example: assets may be incorrectly recorded, eg some assets may have been missed from the valuation exchange rates may have been incorrectly applied to overseas assets the insurer may be incorrectly pricing on a bid (offer) basis when the fund is expanding (contracting) the expenses incurred when purchasing or selling shares may have been incorrectly allowed for the value of the assets may be incorrectly adjusted for accrued dividends and taxes. These failures may result in: financial losses for the insurer, eg paying too much to policyholders or paying compensation to disadvantaged policyholders regulatory intervention, eg fines reputational damage leading to lower sales and more withdrawals incorrect charges being paid to the insurer. Other Unquoted assets (eg property) do not have an observable market price, so it is difficult to set a unit price that is accurate and treats all parties fairly. Assets with low marketability (especially property) cause problems if there are a large number of withdrawals. If the assets have to be sold quickly there will be a sudden drop in the fund value (and hence the unit price) which may lead to policyholder dissatisfaction. The regulations that govern unit pricing may change, eg regulations may change the way that prices are rounded.
          • Correctness
            • Important of correctness Unit prices need to be correct so that they follow the basic equity principle. This principle states that the interests of unit-holders not involved in a unit transaction should be unaffected by that transaction. If units are created or cancelled at incorrect prices, cross-subsidies between unit-holders could occur. Errors in unit prices could mean, for example: if the unit price is higher than it should be, then not enough units would be allocated when a policyholder pays a premium if the unit price is tower than it should be, then any unit benefits paid out would be too little. The errors could occur in the 'other' direction, ie benefiting particular unit holders but leading to a loss to the insurance company. If errors occur frequently or are widely reported then the company's reputation will be damaged. Reputational damage could lead to higher withdrawal rates or lower future sales. These lead to a loss of expected future profits and less spreading of overheads. In cases where an error results in higher policy benefits, it may be difficult to correct the error, ie to reduce the benefits to the correct level. Correcting mistakes increases administration costs. Errors may lead to fines from the regulator. Compensation may need to be paid to customers Steps to correct errors The company will need to put in place resources to correct the error. The company will need to determine the size and extent of the error (eg how long the error has taken place for, how many funds are impacted ). If the error is not material then the company may decide not to correct it. If the error is particularly material then the company may need to inform the regulator and agree an approach to rectify the situation. The company will need to consider which policyholders have been affected including: those currently invested those who surrendered / claimed those who switched into other funds. Determine the value of the policy with the errors corrected, either now or at the time the policyholder surrendered / claimed / switched. Make a retrospective adjustment to the policyholder's unit funds. The company will need to determine whether policyholders were positively or negatively affected by the errors. Determine how to reimburse policyholders if negatively affected. The approach taken may vary between existing and previous policyholders (eg enhancement to units for existing, cash to previous). There may be a minimum tolerance level set at customer level, below which the customer is not corrected. Past communications and previous practice will need to be taken into account. Need to communicate the issues to policyholders. Consider impact on solvency of the company.
      • Index-linked
        • Definition A policy where the benefits are linked directly to a specified investment index or economic index, and are guaranteed to move in line with the performance of that index. Risks to the insurer may not be able to invest in a way that precisely matches the benefit guaranteed The risk is borne by the life insurance. Risks to the insured The selected index does not replicate the rate of spending inflation.
  • Product risks to the policyholders
    • Eg: Conventional with-profits immediate annuity
      • There is a risk that policyholders' needs are not fully met. There is a risk that the annuity income turns out to be insufficient, or less than the policyholder reasonably expected, due to one or both of: lower investment returns than expected lower mortality rates than expected as these both reduce the asset shares and hence the benefits payable. There is a risk that the annuity payments will not keep up with inflation, which will erode their real value for the policyholder. There is a risk from insurer insolvency, which would lead to a shortfall in benefit payments compared to expected. The policyholder may not understand the product as it is complex. There is no surrender value, so a policyholder would be unable to access their investment should their circumstances change. Nothing is payable following death, so dependants may suffer financial hardship when the policyholder dies. The policyholder may mismanage the money they receive and run out of cash between the annual payments. There is a risk that tax changes erode the benefit value.
    • Eg: Term assurance and UL endowment assurance
      • Insurer insolvency Policyholder may not receive the full amount of benefit. Future insurance cover and investment services may be lost. Loss could be large - eg if dies in the remainder of the original term. Inflation over time Benefit may not meet needs due to the fall in real values. Particularly for the guaranteed benefits Partly offset by reduced needs - eg of maintaining dependent children . Unit-linked contract creates less risk, particularly if: unit funds are invested in real assets premiums can be increased to maintain their real value over time. Other Contract does not meet needs the policyholder may not understand the policy the policyholders' needs may change and the product is not flexbile enough the policy may have been mis-sold and the risks were not adequately explained Premiums may become unaffordable, eg due to redundancy. Changes in future taxation can reduce the value of the policy. What else could go wrong - term assurance If premiums lapse, future cover will be lost without compensation. The contracts offered under the conversion option may be unaffordable. What else could go wrong - unit-linked endowment assurance Risk from worse than expected investment returns: anticipated savings targets won't be met, eg for loan repayment due to lower average returns over the policy term, and to volatility of unit fund values at claim date. Unreasonable increases in reviewable charges could reduce payouts. Contract flexibility should reduce impact of changes in circumstances. Poor return likely on early surrender, due to high initial expenses.
    • Eg: WP endowment assurance
      • Bonuses / dividends Policy payouts may not meet anticipated savings targets. This could lead to hardship (eg if policy is being used to repay a loan). The lower payouts could result from the insurer incurring: poor investment returns (as a result of adverse market conditions and/or its own poor investment management) higher expenses than expected worse mortality experience than expected depending on the profit distribution method. Insurer insolvency The company may become insolvent and be unable to pay the expected benefits in full. The relatively low guarantees reduce the likelihood of this occurring. On insolvency, the remaining life cover and access to the future returns from the with-profits fund would be lost. Inflation The benefit may not meet needs due to the effect of inflation. This should be offset to the extent that the policy provides real returns. Flexibility The product may not keep pace with the changing disposable income and/or benefits needed by the policyholder over time. Other The policyholder may be unable to maintain premiums due to accident, sickness, redundancy, or other loss of income. The policy may not meet needs due to being mis-sold, and so the policyholder may be paying for services that they do not need. Early surrender could result in a poor return to the policyholder. Changes in future taxation can reduce the value of the policy.
  • Product risks to the insurer
    • Data
      • Policy data One important use of policy data is to carry out a regular valuation of the liabilities. There is therefore a risk that the company will not maintain the adequate, accurate and complete records and hence the result of the valuation will not be accurate Similar points relate to policy data required for internal investigations to give appropriate advice to the company. Other data Internal data may not be adequate to provide reliable indicators of future experience, because of inaccuracy or insufficient volume. Similarly, external data used may be inadequate or unreliable, and even where it is reliable may prove to be inappropriate. Management Ensure the data provider provides an explanation of all the data items Check the data before using it, eg due diligence or a trial run Use an external reviewer to help with data checks include margins for adverse experience regular pricing so that new business pays charges consistent with the cost of matching risk at that time introduce reviewable charges that can be increased if experience is unfavourable The admin system should be developed to ensure that suitable data is gathered
      • Eg: Risks in relation to the data source
        • Data from company's past experience There may be inadequate volumes of data. It may be impossible to split the data into homogeneous groups while retaining a credible level of data in each cell. The data may be inaccurate. The data may be incomplete, eg individual details may be lacking. The data may be out-of-date, eg due to changes in target market. Data from other sources The data may be inaccurate, as this will depend on the processes of the various suppliers. There may be insufficient detail to divide the data into sufficiently homogeneous groups. The data may not be representative of the company's business, eg other annuity providers may use different distribution channels. For overseas data in particular, the mortality experience is likely to be quite different. The data may be out-of-date (particularly national statistics). Consequences of poor data Over-reserving , resulting in too great a demand for capital. Under-reserving, resulting in potential solvency problems in the future. Over-pricing, resulting in insufficient sales volumes. Under-pricing, resulting in insufficient profit. Actions taken to minimise risks in relation to past policy data Reconcile the current data with those used for the previous investigation. For each group, check that: data at previous investigation + business coming onto the books - business gone off the books = data at current investigation Check the systems for producing movements data to ensure that they are working correctly and that staff are following the required procedures. Check the movements data against the accounting data, especially for benefit payments. These checks might identify any problems with the recording of deaths, ie annuity payments ceasing. Perform consistency checks, eg that the average annuity amount for each group is consistent with the previous investigation. Check for any unusual values, eg very large or zero values or impossible dates of birth or retirement ages. Check the distribution of the data, eg an unusually high clustering of birth month may represent a data input error. Perform spot checks on random policies to check that paper records agree with the data held on the computer. Incorporate data checks into the admin system, and train staff who update records. Actions taken to minimise risks in relation to other sources of data Check that the experience underlying the data is sufficiently similar to the company's own experience, eg in definition of impairment for impaired life annuities. Ensure that the most up-to-date data is used. Adjust for any differences between the company and the data source and allow for any trends. Check that the volume of data is adequate and consider using additional data sources if it is not.
    • Mortality/Longevity
      • Risks associated with mortality assumptions a 'model' risk that the model, typically a probability distribution, chosen to represent future mortality, etc, may not be appropriate or may contain errors a 'parameter' risk that the parameters used with the model may not adequately reflect the future experience of the class of lives insured or to be insured, even though the underlying model may be appropriate a 'random fluctuations' risk that the actual future experience may not correspond with the model and parameters adopted, even though these adequately reflect the class of lives insured or to be insured. The first two risks always exist, as actuaries cannot predict the future with complete certainty. However, the extent of the risk will differ according to the reliability and applicability of any existing data. The 'random fluctuations' risk is most likely to arise if the numbers exposed to risk are not large enough for the 'law of large numbers' to apply. Management of mortality risk Risks shoud be much reduced by reinsurance Appropriate assumptions should be used A margin should be included in the pricing to allow for uncertainty The increased mortality risk can be mitigated by reinsurance Sensitivity analysis can be carried out to see how the profit varies in scenarios with varying mortality rates Management of longevity risk Allow sufficiently for future mortality improvements Ensure assumptions are tailored to the nature of the lives Keep up to date with the latest developments in projecting longevity improvements, eg with reinsurers' assistance Regularly monitor the longevity experience Use reinsurance or arrange a longevity swap Use industry data where the volume of scheme data is too small Random fluctuations could be reduced by increasing the size of the portfolio, ie accepting more annuity business
      • Anti-selection
        • Definition High-risk applicants tend to apply for higher death benefits
        • Eg: Methods of reducing anti-selection without underwriting
          • Methods to reduce anti-selection without underwriting include: low maximum sum assured make available to recipient of advertising letter (and spouse, perhaps) only no death benefit payable within, say, two years target at unsophisticated market limited time available in which to apply after a mailing or advert underwrite at claim stage exclude pre-existing conditions low maximum age at entry.
    • Investment
      • General can be due to poor performance in the investment markets or to poor investment management by the insurer maybe assets do not match cash outflows by nature, term and currency largely backed by suitable bonds, but bonds of appropriate duration may not always be available By types of products For products will small reserves, there is low investment risk For unit-linked products, if unit growth rates are lower than expected: fund-related charge income will fall sums at risk on policies with minimum death benefits will increase policyholders may become dissatisfied, leading to increased withdrawal rates, falls in sales and general reputational damage Management Improve matching by switching the assets it already holds Hedge any currency risk exposure using derivatives Monitor corporate bond performance and credit risk exposure Control credit risk by restricting the bonds it holds, eg to those with good credit ratings, and by using credit derivatives or credit insurance
    • Expenses and expense inflation
      • Expense risk of products General Significant risk of expenses being higher than assumed in pricing Higher than expected expense inflation will contribute to this Assumed benefits from economies of scale may not have materialised The premium in the first year may be insufficient to cover the initial expenses If premium rates are fixed, there is a risk that the expense loading is not sufficient to cover the renewal expenses By types of product Conventional without-profits products with level guaranteed premiums are most at risk Unit-linked contracts should create less risk from inflation because charges may be index-linked or linked to fund values charges may be reviewable but higher charges will reduce payouts, leading to reputational damage and so increase lapse rates and reduce sales Expense control Insurers should try to keep expenses and commissions w ithin the loadings received to cover them. To achieve this, the company can: monitor the position regularly monitor competitors' expense ratios to ensure expenses are at a competitive level have monitoring procedures in place to pick up (and prevent) any upward slippage in commission levels control staffing and salary levels to be consistent with the work required (and hence consistent w ith business volume), especially for new business/ sales effort impose budgetary constraints and targets attempt to sell more business without increasing the (overhead) cost base improve operational efficiency, eg through automation increase premium loadings and/or charging rates, provided still competitive.
    • Persistency
      • General Risk on early withdrawal when the asset share is less than the surrender value Withdrawals reduce the volume of business in force, increasing the per-policy cost of overhead expenses Risk that withdrawals are selective, invalidating the mortality assumption By types of product Term assurance higher risk on TAs as premiums are smaller relative to initial expenses very high for decreasing TAs because high early claim costs slow the growth of the asset share positive asset shares on level TAs at later durations, lead to a risk from fewer lapses than assumed risk from selective withdrawals is high for individual TAs because of the high sums at risk and non-reviewable premiums UL policies withdrawals at later durations usually reduce profits through the loss of future charges increasing charges at any time on UL could increase withdrawals, this limits the size of any charges increases risk reduced on UL by up-front charges or surrender penalties risk from selective withdrawals is high on UL policies that have large sums at risk Persistency management Insurers should aim to minimise the volume of lapses and surrenders. To achieve this, the company should monitor experience, especially by distribution channel, to identify problem areas. Distribution channel Monitor persistency rates by distribution channel and by the specific salesperson or broker. The level of commissions or other remuneration can be designed to encourage better persistency and penalise early lapse and surrenders. Identify systematic reasons for the lapses and surrenders and to invoke suitable management strategies to avoid the trend continuing. For those where the insurer incurs the costs of acquiring business - eg. quotations systems - the number of quotations produced versus the actual business acquired should also be monitored and managed. Customer relationship Ensure that the product sold is suitable to meet the policyholder's needs. Maintain or improve the quality of ongoing administration and contact with the policyholder. Sales adviser Discuss the issue with the adviser. Stop selling through the adviser. extend the surrender penalty period introduce loyalty bonuses at longer terms extend commission clawback to beyond the surrender penalty period pay renewal commission rather than initial commission ensure that charges are lower or benefits are better than those of major competitors. Investigate whether the adviser is giving bad advice to policyholders and, if so, report this behaviour to the regulator.
    • New business volume and mix
      • There is a risk to profitability if volumes of sales are too low overheads will be less well covered by the per-policy loadings reduced total profits may lead to an inadequate return on capital There are risks if volumes of sales are too high excessive capital strain should lead to insolvency over-stretching admin could produce eg errors and poor service Mix of business is a risk if there are cross-subsidies sum assured males and females smokers and non-smokers Mix by source of business could affect mortality and withdrawal rates Management A company must ensure it has adequate capital and administrative capacity to sell its new business. It must monitor volumes and mix compared with pricing assumptions: excess volume can indicate inadequate capital low volume will reduce total profit and increase the per-policy cost of overhead expenses lower than expected case size may uncover per-policy expenses. It needs to monitor the mix of business from a capital efficiency point of view, especially: extent of mismatch between charges/ loadings and expenses premium frequency valuation strain. Volume and mix can be controlled by: appropriate marketing, especially with regard to remuneration and targeting of distribution channels product design (eg matching charges, premium frequency, minimum premiums, guarantees).
    • Guarantees and options
      • The cost of offering guarantees and options may be overestimated or underestimated due to parameter and model risks. Experience under the options could be worse than expected, eg higher mortality for those taking up the renewal option. Risk of higher than expected take-up rates The extra premium will be an additional reason to cancel the policy prior to its end date. The option may not be attractive to prospective policyholders so the additional premiums received may be insufficient to justify the development costs. Additional expenses will be incurred (eg. updating systems) and these may be higher than expected Mis-selling risk if policyholders do not realise that the option is available or if it is misinterpreted There is reputational risk if the option is not as expected. Management Options are either financial or health related. It is vital to monitor how much the exercising of existing options is costing, or is expected to cost, the insurer, compared with the charges received to pay for them. Items to monitor include take-up rate, and profit/ loss arising following take up. The decision to provide options depends on the extent to which they are appreciated by the policyholder, and hence contribute to successful sales, and the burden of cost they place on the company. Control measures include: increase charges/ loadings that are paid for the option alter the benefits or terms of the option remove the option from new business. Option costs occur after a considerable time lag after sale, and may have the capacity of being extremely onerous (especially financial options). Possible mitigation for existing options include: appropriate reserving using derivatives buy back from policyholder.
    • Competition
      • General Risk that premium rates are not competitive or product features are out of line with competition This could lead to higher withdrawals or reduced new business volumes Undercharging to meet competitive pressure could cause large losses May prevent charges being increased enough on UL reviews Management Ensure the premiums are competitive relative to those charged by competitors Monitor competitors' offering Advertise / market the product Impose a maximum new business target
    • Actions of the board of directors
      • Risk from detrimental actions of board of directors, eg push to offer benefits at unsustainable premium rates to gain market share The directors do not have to follow actuary's recommendations due to: competitive reasons strategic company goals maximise shareholder earnings
    • Actions of distributors
      • General Distributors may take actions against the company's interest, eg encourage business to lapse and re-enter where there are no exit penalties and no clawback of commission payments take advantage of loopholes in product design take advantage of opportunities that arise due to timing effects in unit pricing practices Distributors may not fully understand the product Introducing new product to the distributors may increase operational risk as no experience Management Distributors should be trained on the product
    • Failure of management systems and controls
      • General Poor underwriting may lead to errors in risk classification and pricing The insurer's monitoring and control mechanisms may be inadequate Inadequate systems and processing could result in data errors unclear policy wording Any failure of controls may lead to: financial losses for the insurer regulatory intervention reputational damage Management Test and document all systems and processes Staff training Use experts Maintain claims management process with active checks The sales literature should be clear and not mis-leading
    • Counterparties
      • General Reinsurers may default, exposing the insurer to gross claim costs Any corporate bonds backing the products may default, with loss of value Distributors could default with monies owing to the insurer Management The company could hold government bonds rather than corporate bonds to minimise the credit risk Use highly rated reinsurers or several reinsurers
    • Legal, regulatory and tax developments
      • General Any breach of regulations could lead to court actions against the insurer, leading to heavy fines or serious reputational damage. Losses can arise from future changes in the insurer's taxation Changes in policyholder taxation can alter demand for the products Management Keep up to date with regulatory and tax changes, responding to consultations on proposed changes and lobbying where appropriate Ensure watertight wording of the contract and obtaining legal advice
    • Fraud
      • There is a risk from fraud applicants withholding significant information during underwriting fabricated claims over-insurance Directors, staff, policyholders and even external parties can all perpetrate fraud and so cause loss to the insurer
    • Aggregation and concentration of risks
      • General If the insured are in the same industry, they are unlikely to be a well-diversified group The company may already have significant business in force and the new business may add to existing risk exposure Management Diversify by writing blocks of business exposed to risks that can hedge the original risk The risk could be transferred, eg using reinsurance or a securitisation
    • Climate risks
      • Climate risks for financial companies are categorised into physical, transition and liability risks: Physical climate risks are the first-order effects of environmental changes such as greenhouse emissions, pollution and land use. Eg, an increase in mortality or morbidity due to global warming or pollution. Transition risks refers to economic, political and market changes as a result of efforts to mitigate climate change. Eg, policy changes designed to reduce fossil fuel consumption (eg taxes, subsidies, limitations) resulting in investments in fossil fuels and carbon-intensive industries losing value. Climate liability risks can arise from injured parties seeking compensation for the impacts of climate change. Eg, a link established between air pollution and adverse health conditions, resulting in a new class of latent claims.
      • Eg: Identify climiate-related risk
        • A life insurance company has been considering the impact of climate change and has concluded that the following are the top four climate-related risks for its portfolio of liabilities: policyholders requesting investment in Environmental, Social and Governance (ESG)-friendly investments impact on property prices from increased flood risk tax changes to limit levels of fossil fuel consumption affecting the value of unit-linked funds reduced longevity in cities due to higher air pollution. Discuss which of the three main categories of climate-related risk each of the areas identified by the company falls into. Policyholders requesting ESG-friendly investments This will fall under 'transition risk'.. as this is a result of efforts to mitigate climate change. Impact on property prices from floods This will fall under 'physical climate risk'.. as flood risk is a physical event caused directly by climate change impacting expected future experience. Tax changes to limit fossil fuel consumption affecting asset values This will fall under 'transition risk'... as this is a result of efforts to mitigate climate change. Reduced longevity due to pollution This will fall under 'physical climate risk'... as higher air pollution is a direct impact of climate change.
    • Example
      • Eg: Without-profits term assurance
        • Mortality Biggest risk for insurer. Higher mortality rates than assumed in pricing due to: random fluctuations, pricing and modelling errors catastrophe events, eg pandemic. aggregations or concentrations of risk, eg group business. Anti-selection Applicants with higher mortality risk are more likely to seek insurance and to choose higher death benefits. Anti-selection is worse for individual business as the assured is actively choosing whether to insure and the level of benefits. It is less of a risk with group term assurance if the employer makes these decisions for all staff. Expenses and expense inflation Higher expenses than assumed in pricing. Higher expense inflation than assumed in pricing. Big risk as expenses are a relatively large proportion of the premiums. Expense inflation is a bigger risk for individual business as premiums are normally level and non-reviewable. Investment Lower investment returns than expected in pricing. Risk is very low as reserves are small. Persistency Early withdrawals cause a loss as asset share will be negative (premiums are low but expenses are high). This may continue longer for decreasing term assurances, unless premium-paying term has been shortened, because claim costs are highest at early durations. Risk of selective withdrawals, as those in worse health are less likely to withdraw. Risk of low withdrawals at later durations as mortality costs often exceed premiums. Higher withdrawals mean overheads are spread over fewer policies. Data Inadequate mortality data resulting in inadequate premiums. Data may not be relevant to insurer's target market. New business volumes Risk of low new business volumes. So overheads may not be covered by the per-policy loadings in premiums. Risk of high new business volumes. So high new business strain and hence high capital requirements. New business strain can be significant due to guarantees, high initial expenses and small regular premiums. Higher volumes could also overstretch admin, leading to errors, poor customer service and reputational damage. New business mix Risk that business mix is different than expected, eg risk of smaller average sum assured if large policies subsidise small policies. Third-party default Risk of reinsurer default. Risk that distributors do not pass on premiums. Risk of default on assets backing reserves, though this risk is small as reserves are small. Fraud Applicants may withhold information during the underwriting process. Fabricated death claims could be made. Regulation Failure to follow regulations, eg regulations covering treating customers fairly, could lead to fines and reputational damage. New regulations might be introduced, eg maximum premium levels. Tax Amount of tax paid is higher than expected, eg higher tax rate. Changes to the taxation of benefits or premiums could lead to reduced demand. Options Worse than expected experience on renewability or conversion options. Failure of systems and controls Risk of systems failures, eg problems with the claims payment systems. Operational risks, eg poor pricing models leading to pricing errors. Actions of board of directors Risk that the board will cut premium rates to an unprofitable level. Actions of distributors Distributors may encourage clients to lapse and re-enter. Mis-selling could lead to higher withdrawals and reputational damage.
      • Eg: Conventional with-profits endowment assurance
        • Investment Savings contract, so high risk. Low returns mean less money available to pay bonuses. Risk that the maturity guarantee bites and product makes a loss. Low returns can be due to: poor performance in the investment markets generally poor investment management by the insurer relative to competitors. Shareholders' returns can be affected to the extent that dividends are linked to policyholder bonuses and profits. Assets may need to be sold at depressed prices to meet policy payouts. Mortality Mortality rates may be higher than assumed in pricing. Expenses and expense inflation Expenses may be higher than assumed in pricing. Higher expense inflation than expected will contribute to this risk. Persistency (withdrawals) Risk of loss if asset share is negative, eg on regular premium policies at early durations. At other times, loss made when withdrawal benefit exceeds the asset share. Since surrender values usually equal smoothed asset share, this risk should be small at later durations. At later durations, withdrawal may cause a loss of future profits. Withdrawals will reduce the volumes of business in force, uncovering overheads. Selective withdrawals could worsen the retained mortality experience. New business mix Wherever cross-subsidies exist, there is a risk from the mix of business being different from assumed in pricing. Differences from expected in the source of business could adversely affect the mortality and withdrawal experience. Paying lower bonuses or dividends This can occur as a result of the above risk factors. This can lead to: policyholder dissatisfaction and reputational damage, particularly where the policy disappoints relative to expectations/illustrations, or fails to meet its required purpose (eg mortgage repayment) increased withdrawals and falls in sales. New business volumes Profitability will reduce if volumes of sales are too low, due to: uncovering the overhead expenses insufficient returns on the capital used for the business. If volumes of sales are too high: the strains may exhaust the capital available and cause insolvency admin capabilities may be over-stretched, leading to errors, poor customer service and reputational damage. Competition Sales may fall if policy payouts look low relative to those of competitors. Actions of directors The company may overpay bonuses (where discretionary) to match competitors' rates, leading to losses. There is a risk from inadequate and/or ineffective financial monitoring and control processes being in place. Actions of distributors Distributors could cause risks, eg by: encouraging policyholders to replace existing policies with new contracts, purely to increase commissions mis-selling the company's contracts mis-representing the product or company to its clients. Smoothing and meeting policyholders' expectations These may limit the insurer's ability to reduce payouts where adverse experience has occurred, so retaining more of the direct risks incurred.
      • Eg: Investment guarantee
        • The cost of the guarantee may be higher than expected. Profits will fall, and/or losses will rise. Depends on the type of investment guarantee or option provided, eg: for a guaranteed maturity value, the risk is that investment returns are lower than expected for a guaranteed annuity option (GAO), the risk is that interest rates are lower than expected at annuity conversion for a GAO on the maturity of a unit-linked policy, risk is increased by higher unit-fund growth leading to more money being converted. Risk is increased if the guarantee cannot be matched either by suitable assets or by derivatives. This could result from insufficient assets of long enough duration, and/or suitable derivatives, being available. Derivatives, where used for hedging: may cost more than expected, will introduce a potential counterparty risk may create additional operational risks. The added complexity of administering the product could lead to additional operational risk. The expenses incurred on take-up of the guarantee could be greater than expected. Lower mortality and/or higher persistency than expected may lead to increased take-up of the option. Lack of data for costing the option may increase the pricing risk, due to mis-estimation of parameters and/or mis-specification of the stochastic model (eg assuming unrealistic correlations or volatilities). Losses will result if an inadequate price is charged . The additional uncertainty may lead to: additional margins being used in the pricing basis: this may make the product less competitive and reduce sales, so the expected share of overheads or development costs may not be covered additional reserves and/or solvency capital being held, which increases the new business strain and hence increases the risk of supervisory insolvency. Policyholder behaviour may change adversely, eg: withdrawal rates may reduce when a future guarantee or option appears to be coming into the money holders of unit-linked policies with maturity guarantees may invest in more volatile funds, increasing the frequency and cost of the guarantee biting surrender rates may increase if there is a guaranteed surrender benefit or option and investment returns have been low lapse and re-entry may occur amongst existing policyholders. A GAO will also increase the company's exposure to longevity risk. There may be additional mis-selling risks relating to the guarantee, and these may also increase the risk of reputational damage. There is a risk from regulatory changes, eg a change in the methodology required for supervisory reserving.
      • Eg: Conventional with-profits immediate annuity
        • Risks to the insurer Investment There is a risk from lower investment returns than expected: this may disappoint policyholders, causing reputational damage it might lead to lower future new business volumes expense charges will be lower than expected, which will reduce shareholders' profits if investment returns are very low, the guarantee will bite, causing significant losses to shareholders. There may be problems if there are insufficient assets of long enough duration to match the guarantee. There will be a default risk if corporate bonds are used. Longevity Most longevity risk is passed on to policyholders. If policyholders live longer than expected, the annuity amount would reduce, leading to disappointed policyholders and reputational risk. There is a risk of anti-selection, by more healthy lives than expected taking out the contract, which will increase the above longevity risk. Increased longevity results in more payments, which will cause asset shares to fall. Shareholders will bear some longevity risk, which will occur if asset shares fall below the value of the guarantees as a result of the higher number of annuity payments being made. New business There is a risk from higher than expected new business due to: capital strain caused by the extra reserves/ solvency capital needed to cover the guarantees administration strain. However, there may be a limit on the size of the tranche, which would reduce this risk. There is a risk of lower than expected new business volumes, which would result in fixed costs not being met. Cross-subsidy exists between large and small policies, as the expense charge is proportionate to asset share. Risk is that average policy size is smaller than expected, so the per-policy expenses (including fixed expenses) are less well covered than expected. High commission incentive leads to a mis-selling risk. Complex policy so policyholders may not fully understand it, eg: their exposure to longevity or investment risk there is no death or surrender benefit the annuity payments could reduce. Lack of policyholder understanding, especially if policies are mis-sold, could lead to reputational damage. This could also potentially lead to regulatory intervention. Competition Competitors' products may be more attractive, eg they may offer: better guarantees higher bonus rates higher initial annuity amounts, which could attract customers even if subsequent payments are lower. Expenses Expenses and/or expense inflation could be higher than expected, generating direct losses for shareholders. Data There is a risk of having inadequate actual experience data for pricing the product, particularly if it has not been written before. There may be inadequate or unsuitable data to determinate asset shares accurately, eg for calculating past investment returns. Management/operational There may be management pressure to declare higher bonuses than are sustainable, in order to maximise new business volumes. The company may have difficulties: administering the annuity payments calculating the bonuses correctly each year administering the changes to the annuity payment amounts meeting the 1 January launch date. Fraud The company is exposed to the risk of fraud, eg where it is not informed of the death of an annuitant. Regulation and Tax There is a risk from tax changes, eg: to the tax payable by the company, affecting profits to the tax payable by the policyholder ( eg a tax on the annuity payments), which could impact new business sales. There may be a regulatory risk, eg there may be changes to: annuity purchase legislation solvency capital requirements which could each reduce the volumes of new business sold.
      • Eg: Option of simple underwriting for lower premium
        • Mortality Parameter risk would increase as there now needs to be two sets of assumptions (standard and underwritten). The standard plan assumptions need to be revised because those with better mortality will select the option to be underwritten. So the standard plan mortality may be materially worse than the current assumption. Parameter risk may reduce, as those taking out the option may be more homogeneous. Expenses There is increased expense risk due to underwriting expenses. May need to include some underwriti ng at the claims stage. Competition / marketability Higher premiums for the standard plan could reduce new business volumes and so development expenses may not be recouped. This option may improve marketability to healthier lives and so increase new business volumes overall and reduce the risk of not recouping development costs. Adding underwriting may make direct marketing more difficult, potentially putting off new customers. Need to decide what happens if underwriting is failed - rejecting applicants could lead to increased reputational risk. Fraud Fraud risk will increase as applicants may deliberately give false answers to questions to get lower premiums.
      • Eg: Option of higher premium for sum assured linked to premium
        • Parameter / data There may be insufficient data for funeral expense inflation. Increased parameter risk as the funeral expense inflation needs to be projected into the future. Guarantee The indexation increases the cost of guarantees as there is a risk that funeral expense inflation is not in line with expectations. Competition / marketability The option may improve competitiveness and marketability. New business volumes may rise leading to: higher administrative and capital strain reduced expense risk as development costs will be spread over more business. The opposite may occur if premium rates are not in tine with competition. Reputation Actual funeral inflation may exceed the inflation index used to determine sum assured, leading to reputational risk. There could be an issue if there is negative funeral expense inflation - potentially increasing reputationat risk. Other It may be difficult to find assets to hedge against funeral expense inflation, leading to a mismatch between assets and liabilities. There may be increased expense risk if there is a need to communicate with policyholders each year regarding the increase in sum assured.
      • Eg: Outsource the administration
        • The company might lose direct control over the administration process, with the loss of visibility and issues with communication. May lead to reduced quality of customer service. The third party's response time may not be consistent with the company's required response time. For example, another company's business may be given a higher priority over this company's business. May lead to increased costs to resolve complaints and impact on reputation. The insurance company's own philosophy / beliefs may not be in line with the third party's, eg how customers are treated. The outsourcer may not have the same levels of security over protecting personal information. There may be data loss arising from the transfer of information. If policies are migrated to the third party's administration system, the company loses the ability to administer the policies. Achieving outcomes not set out in the original servicing agreement will be difficult. Risk of ill will as staff will either be made redundant or transferred to the third party. Loss of expertise if staff are made redundant / transferred to third party. Risk that third party defaults on the servicing agreement, leaving the company with no administration support. The company then needs to set up alternative arrangements in a short time period. The outsourcing fee may increase faster than it would if the business had been administered in-house. The expense escalation rate is likely to be set in the agreement. Fees are normally set for a fixed period after which a renegotiation is required - the fees after this renegotiation period will be unknown. The cost of the initial outsourcing (eg data migration, contract setup) may be higher than expected. Managing the outsourcing arrangement may involve more resources than expected. Increased operational risks, eg fraud, contract disputes.
      • Eg: Annual charges increased 5% per annum in a UL contract
        • The charge may be insufficient to cover expenses. In particular, there is a risk of future expense inflation exceeding 5% pa. If the charge is a percentage of units, then the risk of charge income being insufficient to cover expenses is higher if investment returns are low. The charge increases may reduce marketability, so lower volumes of new business than expected may be sold, ... ... particularly if the clause is out of line with competitors. The clause may be unpopular with distributors, and there is the potential for reputational damage. Lower new business volumes would have implications for per policy expenses, due to fewer policies over which to spread overheads. The charge may be seen as failing to treat customers fairly. There may be mis-selling risk if the clause is not appropriately explained to customers. A fixed rate of charge increase may be unacceptable in certain regulatory regimes. There is the risk of future regulatory changes w ith the result that the charge breaches future regulations. There is an operational risk that the company does not increase the policy charge and/or fails to deduct it on a policy anniversary. This may make it more difficult to increase or deduct the charge in future . The clause could be seen as being imprecisely worded and open to interpretation, eg whether the charge is expressed as a monetary amount or as a percentage of units. If the charge is a monetary amount and policyholder units have been subject to low investment returns, then the charge will significantly reduce the policyholder's unit fund. A fixed monetary charge may adversely affect smaller policies more than larger policies, which may lead to adverse reputational issues.
      • Eg: Guaranteed annuity rate option
        • A life insurance company sells a conventional without-profits endowment assurance product which is written with a maturity age of 70, but which also allows the policyholder to take a discounted lump sum benefit at either age 60 or 65, these amounts being defined at the start of the contract. The product also offers guaranteed rates for conversion of the lump sum benefit to an immediate annuity at ages 60, 65 and 70. The risks lie with the company as the product is without-profits and the benefit amounts are guaranteed. Investment performance Investment risk exists as assets cannot be found that precisely match the benefits. The difficulty is that we do not know which option the policyholders will take. The company could invest to match the guaranteed annuity rate payments, but there is a risk that the lump sum benefit is more valuable and that more policyholders than expected take this option. The lump sum option will be more valuable when interest rates are high. The company could invest to match the defined lump sum benefits, but is then at risk of low interest rates making the guaranteed annuity option more valuable. It could invest in derivatives to hedge the guaranteed annuity option, but there are still the risks of mis-estimating the proportion exercising the option at each age and counterparty risks. Counterparties There is a risk of counterparty default on any derivatives held, particularly if they are over-the-counter. Option take-up rate There is a risk that the proportions of policyholders taking the conversion option at each of the 3 ages are different from those assumed. Longevity There is a risk that policyholders who exercise the option live longer than assumed when setting the guaranteed conversion terms. As well as potentially inaccurate base mortality, the company may have underestimated the extent of future longevity improvements. Withdrawals (persistency) There is a risk that withdrawals are lower than assumed so that a greater number of policyholders can exercise the more valuable option. Selection Policyholders may select against the insurer when deciding whether to take the lump sum or the annuity. Those in poor health with tow life expectancy would be more likely to take the lump sum, whilst those in better than average health would be more likely to choose the annuity. Although the company will have assumed a degree of selection, it may have underestimated its extent. The extent of selective behaviour may be dependent on economic conditions, for example if the guaranteed annuity rate option is in-the-money there is a risk of tower than expected withdrawals prior to the option date. Expenses (including inflation) There is a risk that the future expenses of administering the annuities is greater than the company allowed for in the annuity rates offered. A particular risk is that of inflation of expenses being higher than the company assumed, given the long-term nature of these contracts. Reputational There is the risk of reputational damage, eg if customers did not understand that the guaranteed annuity rates only applied at the 3 ages specified.
      • Eg: UL endowment assurance
        • A life insurance company sells unit-linked endowment assurance policies. The maturity value is the value of the units at the maturity date. On death before maturity a lump sum is paid to the dependents, with the death benefit equal to the higher of the value of the units held at the time of death, or the sum of the premiums paid by the policyholder up to the date of death. A policy can be surrendered at any time prior to maturity. The surrender value is equal to the value of units held at the date of surrender, and a surrender penalty is applied if the surrender is made in the first 5 years of the policy. A policy charge equal to a percentage of the fund is deducted from the policy value each month. Describe the main risks the insurance company is exposed to under this product. Mortality risk There is mortality risk from deaths occurring when premiums paid exceed the unit fund So the risk is that investment returns have been lower than the policy charge Expense risk Expense inflation may be higher than expected Higher expenses will reduce the profit from the excess of charges over expenses Investment risk Charges received may not cover the expenses ..as the charges are a percentage of the fund value which will vary as the unit fund varies Poor investment returns may also lead to reputational risk and will increase the likelihood of the premium guarantee biting early in the contract Lapse risk There may be more lapses than expected leading to a loss of future income and losses where expenses incurred are higher than the charges received
      • Eg: Risk from reinsurance arrangement
        • A life insurance company is launching a new impaired life annuity product. A policyholder pays a lump sum upfront upon becoming a resident of a care home for the elderly, and the policy pays the annual fees to the care home. It can be assumed that upon moving to the care home, policyholders stay there for the rest of their lives. This is a new market for the company and it sells no other impaired life annuities. The life insurance company has entered into a reinsurance arrangement whereby the reinsurer pays the life insurance company 80% of the annual care home fees until the policyholder dies. The life insurance company pays a fixed premium per annum to the reinsurer for a duration that is equal to the reinsurer’s view of the policyholder’s life expectancy. Discuss the risks that: (a) the life insurance company is exposed to from the reinsurance arrangement (b) the reinsurer is exposed to from the reinsurance arrangement. Risks to the life insurance from the reinsurance arrangement Counterparty risk Risk that the reinsurer becomes insolvent and defaults on the payments to the insurer in which case the insurer still has to pay all of the annuity benefits Legal risk Risk that the reinsurance treaty does not cover what the insurer expects for example care home fees inflation may not be covered Risk of dispute with the reinsurer, resulting in costly legal bills for the insurer Operational risk the insurer has to pay the care home fees on time, which will require the reinsurer paying the insurer promptly there is reputational risk if late payment from reinsurer leads to fees being paid late Mortality risk if the policyholder dies sooner than expected in which case the insurer still needs to keep paying the reinsurance premium based on the expected life expectancy Expense risk e.g. risk that maintaining the reinsurance agreement is more costly than the insurer had assumed Regulatory risk e.g. the regulator changes regulations so that this reinsurance arrangement is no longer permitted. Risks to the reinsurer from the reinsurance arrangement Longevity risk that the policyholder lives longer than assumed in the reinsurance contract pricing due to developments in medical treatment so the reinsurer continues paying the care home fees beyond the last reinsurance premium date from the insurance company Risk of poor underwriting leading to worse longevity experience than expected. Inflation risk The inflation assumption in the pricing may be lower than actual inflation Expense risk risk that maintaining the reinsurance agreement is more costly than the reinsurer had assumed risk that care home fees are higher than the level reflected in the premium due to fee increases or inflation Operational risk insurer does not provide up-to-date information on risks. Investment risk the reinsurer now has the risk that assets are not available to match the long term liabilities New business risk NB is higher/lower than expected
      • Eg: Box management system
        • When launching new internal unit-linked funds the company operates a box management system, whereby it will create more units in the fund than is strictly necessary to cover the corresponding unit liabilities. These excess units are referred to as the 'box'. The company will invest a $50,000 'box' when a new fund is launched, and this will form part of the free assets of the company. The 'box' will be redeemed by the company when the level of policyholder investments in the fund reaches $1,000,000. Describe the risks the company is exposed to in operating a box management system. Investment risk There is investment risk in relation to the performance of the unit funds and so the value of the units that the company is holding for its own account. The free assets held in the box may also represent a liquidity risk as these assets are effectively locked in. Expense risk There is higher expense risk due to the additional work for the company in administering the box system. The annual management charge may have been set to only cover policyholder administration rather than extra work for box management. Failure of appropriate management system and controls There is a risk that the company's unit pricing process does not have appropriate controls and systems in relation to the box management. For example, the company may not correctly separate policyholder units from box units. Data risk There will be additional risk in maintaining records of box investments in unit funds. There may be an increased risk of unit pricing errors due to the additional administration of the box assets. Regulatory risk The use of box system may not be permitted by regulation or there may be regulatory restrictions. Volume of new business risk There is a risk of lower than expected new business into the funds with the result that the new funds take longer to reach the 1m threshold and hence the box remains tied-up for longer and requires administration for longer so incurs additional costs Aggregation and concentration of risk If the company launches a number of new funds then the aggregation of box investments may lead to solvency issues if free assets are limited.
      • Eg: Risk change as a result of purchase
        • A life insurance company, Company A, currently sells individual immediate annuities. Another life insurance company, Company B, currently has a block of group immediate and deferred annuities that is no longer open to new business. Company A is thinking of buying this block of immediate and deferred annuities from Company B. If this purchase takes place, Company A will receive the assets from Company B, and in return Company A will pay a one-off premium to Company B in respect of the block of immediate and deferred annuities being transferred. Discuss how the risks Company A is facing could change as a result of this purchase. More data risk introduced as: Company A is dependent on Company B for the quality of the data transferred There is a risk that the data has error or is lost or is an unfamiliar format and the meaning of certain data iterms is not known The concentration of risk may be greater: as a result of taking on additional longevity risk Longevity parameter risk will be greater: as it is more likely that the actual experience will differ from assumed as the assumptions may not adequately affect the future experience of the transferred policies and there will be more uncertainty around the rate of mortality improvements because of the deferred annuities. Investment risk may be introduced or increased: as it may be more difficult to find matching assets for the deferred annuities, which may have a long deferred period and so require assets of a very long duration Operational risk may be increased as a result of greater strain on the company's resources. Expense risk may increase: if the amount of admin required is more than expected Withdrawals risk may be introduced: by the deferred annuities as policyholders may transfer their funds to another provider pre-retirement Model risk may be increased Company A's models may need to be modified because of differences in the product features, e,g, the group nature or the deferred annuities.
• With-profits and the general environment
  • Asset share
    • The asset share is the accumulation of premiums less the deductions associated with the contract, all accumulated at the actual rate of return earned on investments. The asset share is a key tool in the determination of with-profits bonus rates. The asset share will, over a period of time and allowing for smoothing, be the upper limit on a policy's surrender value.
    • Calculation
      • Calculate for an individual policy or for a group of similar policies. Retrospective accumulation of past premiums less deductions: Accumulations include: premiums investment return, based on actual earned rates of return share of profits from without-profits contracts contribution from free assets eg due to attribution or restructuring. Deductions include: commissions and expenses (net of tax, if appropriate) cost of all benefits in excess of asset share, possibly smoothed cost of meeting guaranteed payments or options any tax on investment income, including deferred tax liabilities transfers of profit to shareholders costs of any capital used to support contracts in the early years contribution to free assets, to support the smoothing of bonuses and increase investment freedom. Analyse past experience in homogeneous groups, eg policy size, term. Can calculate recursively: start with an initial asset share of zero add first year's net cashflows accumulate to year end using the historical investment return repeat from year-end value for all subsequent years. For example, a whole life assurance contract. Defining: Pt = premiums received during year t Et = the policy's share of the actual expenses during year t S = sum assured payable on death At = policy asset share at the end of year t qt = actual proportion of policyholders dying over year t it = actual rate of return over year t The value of the assets that build up by the end of year 1, from one policy issued at the start of the year, is (P1-E1)(1+i1)-q1S The policy's share of these assets at time 1 is A1 = [(P1-E1)(1+i1)-q1S]/(1-q1) The next year's cashflow will accumulate with the existing asset share to produce next year's value A2 = [(A2+P2-E2)(1+i2)-q2S]/(1-q2)
    • Eg. Impact of each experience observation on asset share
      • Higher investment returns than expected for both term assurance and endowment assurance asset share (if positive) will be significantly higher than previously projected due to the higher investment returns earned on it the term assurance business will generate higher profits thus also increasing the asset share. However, this will be less significant because reserves, and therefore investment earnings, are low for such business Lighter term assurance mortality than expected the term assurance business will generate higher profits due to fewer claims, thus increasing the with-profits asset share relative to expected the impact may be significant, since mortality has been 'much' lighter than best estimate, but it depends on relative volumes of business Higher term assurance lapse rate than expected higher lapse rates at later durations will generate higher profits, since the cost of outstanding life cover would likely exceed the value of the outstanding premiums. This would increase the asset share. the extent of the profit arising depends on the reserving basis used (the more prudent, the greater the profit release) and the extent to which the contracts were priced to make a profit higher lapse rates at early durations may generate higher losses, as initial expenses will not have been recovered. This would reduce asset share. the overall magnitude may be low, as the difference is only 'little' Higher endowment assurance surrender rates than expected The impact depends on whether surrender profits/losses are allowed for in the asset share calculations whether there is a profit or loss depends on when the surrender occurs and whether the surrender value is lower or higher than the asset share at that time at early durations, surrenders are likely to generate a loss at later durations, a surrender profit would be expected if the surrender value is less than the asset share and a surrender loss if the surrender value is higher than asset share if the surrender value equals asset share, there is no impact even in other cases the overall magnitude may be low, as the difference is only 'little' Higher endowment assurance paid-up rates than expected Asset share will be lower than expected due to receiving fewer premiums the overall magnitude may be low, as the difference is only 'little'
    • Eg: Reasons why payout from a WP policy differs from its asset share
      • The asset share may be less than the guaranteed amount, eg guaranteed bonuses may be higher than asset share at maturity guaranteed death benefits may exceed asset share. The benefit may have been smoothed so that it is higher or lower than the unsmoothed asset share. The benefits may have been set by reference to an average or sample policy that differs from the individual policy in question. Payouts may be net of any policyholder tax due. The payout on surrender may be different to asset share because: a simpler approach is used a prospective valuation method is used there is a surrender penalty the policy is surrendered early in the term when the asset share is negative an alternative approach is used when the asset share is low, eg return of premiums. The company may distribute its estate or profits via a method other than asset share enhancement, eg by paying a demutualisation bonus by the revalorisation method. When setting final bonus rates, assumptions will be made about the investment return achieved from the time the bonus rates are calculated to the time the payout is likely to be made - actual investment returns reflected in the asset share at the point of claim may differ to those assumed. There may be a lack of data which leads to a need to approximate the asset share. There may be an error in the payout calculation that causes it to differ from the asset share.
    • Eg: Actions following reduction in asset shares
      • A life insurance company sells a conventional with-profits endowment assurance product. The asset shares at the end of the year for this business have been calculated and they are lower than the equivalent figures at the previous year end. The company uses the additions to benefits method to distribute the bonuses for its with-profits business. Suggest possible actions the company may take following the reduction in asset shares since the last year end. The company should check the calculation for errors If individual asset shares have reduced, then the action to be taken will depend on the cause of this so the company should determine what this is If expenses have been high, then ways to reduce these should be investigated e.g., possibly even outsourcing if it is being driven by a reducing number of policies overall If the surrender pay-out is higher than asset share the company could investigate whether there is the ability to change this or charge for it If there have been losses on without profits business in the fund, then the cause of this should be investigated and appropriate action considered If investment return has not been positive, then this should be considered against the overall market If investment return is out of line with market, then the underlying asset approach should be considered for change If the investment return is in line with market movements, then the asset class allocations should be considered for reasonableness and stability against the profile of the business May need to match guarantees more closely if asset share has fallen to a point where there is a danger that the guarantees will bite Depending on the driver for the reduction the company could consider reducing reversionary bonus or more likely terminal bonuses Or the company could consider whether it needs to adjust its smoothing approach Dependent on policyholder expectations and ensuring actions are taken that treat all policyholders fairly and are in line with regulations And possibly competitor practice if it is market driven It may be appropriate to take no action (with suitable justification e.g. reduction is in line with expectations, or not material, or assumed to be a one-off)
  • Profit distribution methods
    • Cash bonus and premium reduction
      • Cash bonus The policyholder receives a regular income, but they will vary from over time in line with the surplus arising Premium deduction Can be viewed as a form of cash bonus, but can not be used for single premium products
    • Additions to benefits method
      • Profits are distributed in direct relation to the current benefits under each contract. It is used for UK with-profits business and part of Asia. The initial guaranteed sum assured (basic benefit) may be increased by bonuses of three kinds: regular reversionary bonuses, added throughout the contract term. Once declared it becomes attached to the basic benefits and is guaranteed a special reversionary bonus, added as a 'one-off' from time to time. Eg triggered by an unusual event such as a takeover, a restrucutring of the fund or demutualisation. a terminal bonus, paid when the contract reaches maturity and possibly on death or surrender. the amount is determined when the insured event occurs and a company will not guarantee to maintain it at any particular level. It may be specified in a different ways such as can be expressed as a percentage of total attaching reversionary bonuses. The percentage may vary depending on duration in force and original term of contract can be expressed as a percentage of the total claim amount. The percentage may vary according to duration in force
      • Conventional
        • A conventional with-profits contract is a policy to which bonuses are added in relation to the basic benefit or previously declared bonuses. Under a conventional with-profits contract, RB are either simple - can be expressed as a percentage of the basic benefit compound - can be expressed as a percentage of the basic benefit + attaching bonuses super-compound - can be expressed as a percentage of the basic benefit + a higher percentage of attaching bonuses when comparing the different approaches, consider policyholde expectations, competition, smoothing, sources of surplus, discretion, equity and deferral Advantages of super-compound approach the greatest deferral of distribution of surplus lower build-up of guaranteed benefits over time the least capital intensive approach, especially if the company is not financially strong reduce the risk of company insolvency increase investment freedom may be more marketable due to the higher returns available Disadvantages of super-compound approach Policyholders may value the security of more early guaranteed benefits offered by the compound and, especially, the simple bonus approaches. The relatively lower level of guarantees may reduce the marketability of the product, resulting in low sales volumes. As the super-compound system involves two bonus rates: setting bonuses and updating systems may be more complex it may be more difficult to communicate clearly to customers it may be less comparable with other companies' bonus rates, making comparisons of competitiveness more difficult. The low bonus rate on the sum assured may look uncompetitive when compared to other companies' bonus rates. However, this downside may be offset by the attraction of the high attaching bonus rate. There may be reputational or mis-selling risks as a result of difficulties in communicating the super-compound approach to customers. If the company is a proprietary, shareholders may not like this approach as it defers profit distribution to them.
        • Eg: Considerations in launching new super-compound product
          • A mutual life insurance company currently sells conventional with-profits policies that use an addition to benefits approach and provides a reversionary bonus using the simple approach, plus a terminal bonus. The company is considering launching a new conventional with-profits product that uses a super-compound approach to reversionary bonus instead of a simple approach. Suggest possible issues associated with launching the new product. In practice customers generally prefer higher bonuses up front so super-compound bonuses are likely to be unpopular with the majority of customers. The company is not experienced with this type of bonus distribution, so there is a risk that the bonus rates are not set appropriately. There is a risk that this will not be seen as equitable with the existing with-profits products ... and so potentially this may not be seen as treating customers fairly. Use of this approach may require regulatory approval which the company may not receive. There will be initial set up / development costs associated with the new product. If new business volumes are low, then the costs associated with the product may not be fully covered.
      • Accumulating
        • An accumulating with-profits contract is a policy to which bonuses are added annually in relation to the premium payable to date plus previously declared bonuses.
        • Unitised
          • Regular reversionary bonus The most common form of an accumulating with-profits contract is a unitised with-profits contract. It looks like a unit-linked contract. There are two ways in which the unit part of the contract could operate: Creation of additional units - The price of a unit remains constant. Bonuses are added by allocating additional new units. Number of new units cannot be negative. The number of bonus units allocated could be calculated as a proportion of the total number of units currently held as different proportion applied to units bought by premiums and those relating to bonuses Addition to unit price - The price of a unit changes. The company changes the price of a unit daily instead of allocating additional units. The increase is made up of a guaranteed part and a bonus part. Special reversionary bonus and terminal bonus Special reversionary bonuses are treated similar to respective regular reversionary bonus. There may also be a terminal bonus. Surrender value For unitised accumulating with-profits contracts, the company retains the right to apply a market value reduction, the size of which is at the discretion of the company. Charging structure The charging structure may be as for unit-linked business, which is any combination of: policy charge or fee percentage allocation during an initial period different percentage allocation after the initial period bid-offer spread charge for risk benefits annual management fee The charges could be taken implicitly through the bonus rate with no explicit charging structure. UWP VS UL Discretion Under unit-linked (UL), the unit price is linked directly to the investment performance of the assets in the unit fund. The company has very little discretion in determining the unit price. Under a unitised with-profits (UWP) contract, the benefits are related to the performance of the fund, but are at the discretion of the company. In particular, returns are likely to be smoothed. Deferral There is no deferral in distributing returns with a UL contract - the unit price reflects the full extent of the movement in the underlying assets. UWP policies typically have some deferral of distribution: part is paid as regular bonus 'interest' part is paid only at the point of claim, in the form of terminal bonus. The terminal bonus is at the discretion of the company. Charging structure and sources of profit Under UL, there are explicit charges, eg annual management charges. Under UWP, there may be explicit charges. Alternatively under UWP, charges could be taken implicitly by deducting from bonus rates. Policyholder shares not just in investment returns but also in any expense (and possibly mortality) surplus that arises. Operation of unit fund Under UL, the unit price changes to reflect the performance of the fund. However, there are two basic ways a UWP contract can operate. The unit price may stay constant and bonus units are allocated. These are normally allocated annually at the discretion of the company. Alternatively, the company could allocate bonuses by increasing the unit price, normally on a daily basis. These increases would be made up of a (possibly zero) guaranteed part and a bonus part. Surrender benefits Under UL the company has no discretion over the surrender value. The surrender value will normally be the bid value of the units less any surrender penalty specified in the contract. For UWP, the company may additionally have discretion to apply a market value reduction (MVR): the size of the MVR is at the discretion of the company there may be one or more dates on which the MVR is guaranteed not to apply. Investment choice There can be a wide variety of unit funds to choose from under UL, usually just one fund for UWP. Guarantees Lower guarantees are provided on UL than on UWP. In particular, the unit price of a UL policy can go down. The unit price of a UWP contract cannot go down.
          • Eg: Product features of a UWP bond
            • These include: permissible terms (ie policy durations from entry to maturity of the bond) permissible entry ages any required minimum or maximum premium whether to permit switches between unit-linked and with-profits funds the terms for switches - eg maximum number, whether to apply MVR whether to add bonuses as new units or by an increase in the unit price the regular bonus structure - compound or possibly super-compound whether a terminal bonus will be included amount of smoothing that the insurer intends to apply maturity benefit - probably unit fund plus any terminal bonus death benefit - probably unit fund plus any terminal bonus withdrawal benefits: whether and when to include any terminal bonus a surrender penalty an MVR (to keep surrender value within the asset share) any permitted partial withdrawal benefits, eg without MVR applying option to surrender without MVR at specified times (eg every 5 years) have explicit charges, or cover costs through bonus rates the types of charge to include, if applicable, eg: regular policy charge percentage allocation of the single premium bid-offer spread annual management charge (consistent with unit-linked product) whether charges (if any) are to be reviewable or guaranteed.
        • Non-unitised
          • A non-unitised accumulating with-profits contract looks like a conventional with-profits contract with recurring single premiums. Regular reversionary bonus may be incorporated via the recursive relationship: Ft+1 = (Ft+Pt-ct)(1+bt) where F is the policy benefit, P is the premium, c is the charge, b is the regular reversionary bonus. The main difference between non-unitised accumulating with-profits contract and conventional with-profits contract is that: there is an explicit relationship between each single premium paid and the addition to the benefit for accumulating with-profits contracts the guarantees under conventional with-profits are likely to be greater
      • Eg: Determine the TB rates for maturities
        • Distribute profits to policyholders, allowing for shareholders' interests, cost of capital etc. This is achieved by giving a maturity payout based on a target percentage of asset share (which may be slightly more or less than 100%). Consider policies coming up for maturity. Project asset shares over the (short) period to the average maturity date of these policies. Perform calculation in total for groups of similar policies, rather than on an individual policy basis. Set terminal bonus equal to the difference between the target percentage of asset share and guaranteed benefits (sum assured plus reversionary bonuses). Express the terminal bonus rate as a percentage of either sum assured or sum assured plus reversionary bonuses. Smooth the payouts, to reduce the impact of fluctuations in investment markets and to avoid unacceptable discontinuities between policies of different terms. This may be done by smoothing the terminal bonus rates, by smoothing the asset shares or by smoothing the investment returns. The extent of smoothing will depend on PRE. Consider any terms and conditions that relate to terminal bonus. Consider competitors' terminal bonus rates and maturity payouts.
      • Eg: Actions with regard to TB rates if the equity market falls
        • Investigate the extent to which it has been affected by the fall in worldwide equity values. This depends on the extent of its equity investment, and how this is distributed across different equity markets. Other assets may also have fallen in value, but to a different extent. The impact may be reduced if derivatives were used to hedge this risk. So, it is likely that the fall in the value of the company's assets is less than the fall in worldwide equity market values. If the market falls have resulted in a fall in the value of the company's assets, then asset shares will have fallen. The impact on terminal bonus rates will depend on how current payouts compare with the new level of asset shares. If, prior to the market fall, payouts were below asset shares as a result of smoothing, then payouts may still be lower than or at the level of the new asset shares. The terminal bonus rates may then remain unchanged. Alternatively, if payouts were above asset shares as a result of smoothing, then a fall in asset shares will make payouts even more above asset shares. It is more likely that terminal bonus rates will be cut in this case. If terminal bonus rates were already zero, then they cannot be reduced further. Consider the influences and constraints on how much terminal bonus rates can be cut, eg PRE. PRE will be set by policyholder disclosures, the company's past practice and the actions of competitors. Bad publicity may occur if the company is the first to cut bonus rates. The company's smoothing policy should be considered, eg this may restrict the extent that payouts can change from one year to the next. The strength of the company's capital position should be considered. The greater the level of the company's free capital, potentially the less it may reduce terminal bonus rates and the greater the time it can take before doing so. The company needs to decide when to implement any cut in bonuses. The terms of the contract may not allow changes before the next 'regularly scheduled' bonus declaration, eg quarterly. It may be possible / desirable to cut terminal bonus rates sooner for surrenders than for deaths/ maturities. This would protect the company from policyholders selecting to surrender when surrender values were above asset share. The timing of the change will also depend on any systems constraints. The change in terminal bonus rates will need to be communicated to policyholders, sales channels and the market.
      • Eg: Discuss the proposal of High RB and high equity backing ratio
        • Advantages of high RB policyholder will prefer RB to TB RB increases the policyholders' guarantees Greater transparency, as policyholders can see that the contract is growing in value with RB, but cannot see how potential TB is changing. Shareholder transfers are faster under RB than TB May mean that this company has a larger RB rate than the competition A high RB rate may attract new business. Growth will lead to economies of scale. However, high growth rates will increase new business strain. Disadvantages of high RB High RB brings forward the distribution of surplus so generally leads to high reserves. However, it is possible that TB does not need to be reserved for. An increase in reserves will lead to lower free assets and may threaten solvency TB is not guaranteed so can be reduced if experience is adverse This flexibility is particularly important to the company with low free assets to absorb risk RB rates could be cut following adverse experience, but this approach cannot be used close to maturity, and its effectiveness is limited by policyholders' expectations of smoothing. Advantages of high equity backing ratio Equities have a higher expected return This leads to higher expected bonuses and payouts High payouts compared to the competitors should lead to higher levels of new business High investment return should also lead to higher transfers to any shareholders The company may be not large enough to invest in property, but large enough to invest in a highly diversified basket of equities Disadvantages of high equity backing ratio Poor diversification would lead to greater risk Share prices can be volatile and the dividend income is not guaranteed Higher risk investments may lead to higher reserving or solvency capital requirements High volatility in investment returns will feed through to volatility in payouts, especially if the low level of free assets limit the amount of smoothing of payouts With-profits policyholders are generally looking for less volatile payouts than a unit-linked fund. Policyholders also value guarantees and smoothing If a stock market crash occurs close to maturity then it is possible that the payouts would be more than asset share even if the TB is cut to zero. The company may become insolvent if the low level of free assets fail to meet a significant cost of the guarantees biting.
      • Eg: Reasons for difference in projected maturity values
        • There are a variety of possible reasons for this. Higher accrued asset share Mr A's policy could have a materially higher accrued asset share than Mr B's, for any of the following reasons. Investment experience Different investment strategies could result in higher overall investment returns for Company A: Company A may have invested more in equities, which would have been likely to produce a higher average return Company A may have made better individual stock choices. Company A may have had a higher level of free assets, so having more freedom to invest in (more risky) higher-yielding asset types. Company A may have switched into less-risky assets, such as fixed interest or cash, just prior to a recent market crash. Expenses and commissions Company A may have lower investment expenses than Company B: may be a result of economies of scale, eg if Company A has more funds under management or due to whether in-house or external fund managers are used. Other expenses (initial, renewal, termination) might have been lower for Company A. This might result from having more efficient systems and processes. Commissions (initial, renewal) might have been lower for Company A: eg due to a difference between the sizes of the companies, which can influence distributors or due to using different distribution channels (eg own salesforce as opposed to independent financial advisors ). Mortality The average mortality rates used for Mr A's asset share calculation may have been lower than for Mr B. Possible reasons include: Mr A may be younger and/or healthier (eg non-smoker) differences in the companies' target markets or sales channels differences in underwriting or risk classifications used random fluctuations in the actual mortality experience. Surrenders Surrender values could be lower for Company A. Fewer surrenders may occur at early durations for Company A. Deductions for the cost of guarantees and options Company A might make smaller deductions for the cost of guaranteed benefits and/or options than Company B. May be due to lower expected volatilities or hedging approaches used. Taxation The cost of taxation may be more onerous in Company B. May be due to the mix of other business written by the companies. Other adjustments to asset shares There may have been higher profit transfers to shareholders in Company B. This may be because: shareholder proportion of the fund is higher (eg 20% vs 10%) Company A might be a mutual. The charge for cost of capital may be lower (or zero) for Company A: Company B might have been a newly established company and so more capital constrained than Company A. Company A may have more profitable without-profits business contributing to the asset share than Company B. The contribution to free assets may be lower for Company A. Company A might be distributing more of its free assets to its withprofits policyholders over time. Bonus distribution strategy Overall strategy Company A might be paying a higher overall percentage of asset share. Company A may be expecting to declare a one-off 'special' bonus, eg as a result of restructuring its with-profits fund. Cross-subsidies between policyholders May be different terminal bonus structures, with different degrees or directions of cross-subsidies between different groups of policyholders Smoothing over time The companies might smooth terminal bonuses differently over time. Eg, a recent period of high returns will be more likely to be paid out by a company that uses less smoothing. Future projection basis Company A may have projected its future experience more optimistically than Company B, resulting in a higher projected terminal bonus. The two companies may employ different projection approaches for the final year. Other One (or both) of the policy statements may be wrong.
    • Revalorisation method
      • The profit to be given to a particular contract is expressed as a percentage r% of the supervisory reserve. The benefit and premium are also increased by r%. The option of a constant premium is available, the sum assured will increase less in this case. Where this method is used (parts of continental Europe), company profit can be divided into a savings profit and an insurance profit. the savings profit represents the profit from investment return of assets and can be distributed in whole or in part to policyholders. the insurance profit arises from actual experience being better than expected for all other sources of profit and is typically distributed to shareholders Advantages simple to apply mechanically defined so is cheap to administer use asset book values and smoothing adjustments Disadvantages the company has no discretion in profit distribution discourage equity investment as there is no deferral of profit distribution not sharing insurance profit both constant and revaluable premium options can be difficult to explain
    • Contribution method
      • This method evolves in the United States. Formula Surplus is distributed according to a prescribed formula, which is applied to groups of contracts rather than the whole business. Dividend = (V0+P)(i''-i)+(q-q'')(S-V1)+[E(1+i)-E''(1+i'')] V0 and V1 are the value of contract at the beginning and end of the year P and S are the gross premium and sum assured i and i'' are the valuation and actual basis rate of interest q and q'' are the valuation and actual basis rate of mortality E and E'' are the valuation and actual basis expenses Main features The premium remains unchanged throughout the contract Surplus is divided among policies in the same proportion as those policies have contributed. All sources of profits are generally distributed, including assets, mortality and expense profits. The dividend can be paid in cash, used to reduce premiums or converted into a paid-up addition to the benefit A terminal bonus can be distributed and depending on balance between regular and final dividends. Main advantage equitable distribution but careful judgement is still required in deciding on the proportion of total surplus to be distributed and formulating homogeneous groups of policyholders. have more flexibility in terms of when bonuses are distributed the proportion of the total surplus distributed each year will vary and this gives the insurer discretion and allows for smoothed dividend.
      • Eg: Reasons why dividend may not exactly reflects the profits
        • A company uses the contribution method to allocate bonuses (also referred to as dividends). Suggest possible reasons why the dividend may not exactly reflect the profits made by the company. The dividend calculated might differ from the profits made by the company There may be differences between the sum of the individual items in the dividend calculations and the aggregate items in the company's profit e.g. the sum of investment return amounts in the dividend calculations may not equal the company's total amount of investment return. This could be due to differences between actual and expected timing s of cashflows e.g. expense which are assumed in the formula all to occur at the start of the year The profits made by the company may include other items beyond the investment, mortality and expense profits included in the formula e.g. tax, commission, profits or losses from other area of the business The company's actual expenses may not be the same as the sum of the individual policy because of policy grouping. The company's actual death claims may not be the same as the sum of the individual policy perhaps because the mortality rates are smoothed or it is not possible to fit the actual deaths exactly to a mortality table. The dividend actually paid by the company may differ from the dividend calculated The company may be deferring the distribution of some of the profit to allow it to pay a terminal dividend and to protect against adverse future experience The dividends paid may also differ from those calcuated by the formula because: dividends paid may be adjusted because of competition dividend paid may be smoothed of the company's need to treat customers fairly and meet policyholders' reasonable expectattions The dividend may reflect surplus brought forward, or over-declaration of past surplus.
    • Comparison
      • Additions to benefit: Equity and smoothing: Deliberate smoothing of asset share volatility over time. Sharing of mortality and expense experience is only very broadly equitable. Flexibility: Maximum flexibility (how much and when) Simplicity: Simple to tell policyholders what the insurer is doing but difficult to justify Investment freedom: can be lots especially if conventional Revalorisation: Equity and smoothing: Equitable distribution of investment profit. Mortality and expenses not usually included. Some smoothing over time achieved by valuation method. Flexibility: No discretion Simplicity: Simple both to apply and to present to policyholders Investment freedom: very little because surplus is distributed as it arises Contribution: Equity and smoothing: very equitable with regard to investment, mortality and expense surplus. Some smoothing Flexibility: Considerable flexibility for total distributed; total is split by fairly fixed rules, although some judgement as to groupings for application of the formula. Simplicity: Complex to apply and to explain Investment freedom: Intermediate, some surplus may be held back for terminal dividend but limited by transparency.
      • Eg: Suitability of method to allow flexibility to alter the premium and take withdrawals
        • Cash bonus or premium reduction It is unnecessary to allocate surplus in this way as the policyholder is able to withdraw funds and reduce premiums anyway. However, given the flexibility of the contract, the company could give this as an option. Addition to benefits - conventional with-profits This is unlikely to be suitable. The bonus is added to the benefit, assuming that this then remains fixed. But the benefit will change in the future if a withdrawal is made or the premium is changed. Allowing for the flexibility of the contract using this approach would be complicated. Addition to benefits - accumulating with-profits This approach would be suitable. Bonuses are added in relation to the premiums paid to date plus previously declared bonuses (or equivalently bonuses are added to the current fund value) which means that bonuses are not dependent on having a fixed basic benefit. So this bonus method suits a product design like this, which has a variable underlying basic benefit amount which increases as benefits are added and reduces as withdrawals are taken. Revalorisation method This is unlikely to be suitable. This method requires there to be a level premium and benefit level which does not change on which to base the bonus allocations, which is not the case here. To distribute the surplus, the benefit under the contract and the premium payable by the policyholder are increased by the same amount, but the policyholder could then opt to reverse the premium increase. Contribution method This is unlikely to be suitable. To distribute the surplus, the benefit under the contract is usually fixed and the allocation of the profits is linked to this fixed benefit. A cash payout approach (if used} is not a desirable feature as the policyholder is already permitted to withdraw from the contract.
  • Use of bonus distribution in financial management
    • Margins for future adverse experience
      • The existence of profit distribution to policyholders may mean that the premium rates charged will contain implicit or explicit margins to generate that profit (particularly for conventional with-profits business). These margins for profit could equally be looked at as margins against adverse future experience. How far they may, in practice, be viewed this way may depend on the expectations of policyholders in this respect.
    • Business objectives of the company
      • A life insurance company is likely to have as one of its business objectives the maximisation of the profit distribution to policyholders to improve its competitive position. The actuary advising the company on its distribution of profit needs to balance this with other objectives.
    • Policyholder expectations
      • Policyholders may have expectations about the form of the profit distribution and the level of the bonuses or dividends given. Such expectations may be built up from: documentation issued by the life insurance company the company's actual past practice general practice in the life insurance market. Failure to meet these expectations will lead to policyholder dissatisfaction and the risk of losing existing and/or new business. It may also be deemed to be failure to treat customers fairly, which in some countries is grounds for intervention by the insurance supervisory authority.
    • Provision of capital
      • If the surplus distribution method permits deferral of bonus, such deferral may increase the company's free assets. Any 'extra' free assets can, until needed for policyholder benefits, be used to increase investment f reedom and to finance new business. Additions to benefits For a given total amount of bonus allocated to a contract, the more that is allocated in terminal form the greater the deferral of profit distribution. Within the reversionary bonus element of a conventional with-profits policy, super-compound will defer the distribution of profit more than a compound bonus, which in turn defers more than a simple bonus. Comparing the regular annual bonuses for conventional and accumulating with-profits, the distribution of profits will tend to be deferred more for the former than the latter, but in practice this will depend on the bonuses actually declared. The present values of the bonuses could be very similar. Revalorisation method There is less scope for deferral of profit with this method. Contribution method Depending on the balance between regular and final dividends, this method may also lead to significant deferral of profit distribution, although typically this will be to a lesser extent than under the additions to benefits method for conventional with-profits contracts.
  • General business environment
    • Propensity of consumer
      • The likelihood of a consumer to purchase depends on the combined forces of their own natural inclination to buy and the power of the insurer to sell. In the long run, a life insurer can only operate successfully if its sales effort is aligned to selling products with useful benefits to consumers. If not, there will be a persistency risk and reputational risk. These risks can be minimised if the sales process are clearly documented and the policy literature is clearly explained. Changes in consumer prospensity can result in new business risk.
    • Distribution channels
      • Main types
        • The choice of distribution channel will depend on the: financial sophistication of the target market level of remuneration required.
        • Insurance intermediaries
          • must act independently of any insurance company. aim to find the contract that serve the best interest of their clients. earn commissions from the companies or receive fees from their clients. It's often the client who initiates the sale so very likely to be used by financially sophisticated target market Intermediaries are also likely to promote themselves actively to existing clients. able to service the long-term relationship To be successful, products must stay competitive to use this channel.
          • Eg: Suitability of selling individual TA through intermediaries, in addition to the internet
            • Benefit A new distribution channel should increase sales and hence profits. The company should also benefit from economies of scale. However, this will depend on whether competitors also enter the market. The systems and staff are already in place to support intermediaries. This reduces the cost of launching a new sales channel. Intermediaries are already aware of the company and are happy to recommend its group products. This sales channel targets wealthier policyholders, so contracts may have larger sums assured and possibly larger profit per policy. Insurance intermediaries provide advice so that their clients take out the most suitable contracts available. This should lead to lower withdrawal rates as the policyholder should have a policy that meets their needs. Details Also consider other distribution channels, ie tied agents, own sales force, or other forms of direct marketing. The company needs to decide the level and type of any commission to pay. If sums assured are larger then more reinsurance may be required. Wealthier individuals often have lighter mortality, so premiums may be lower. Insurance intermediaries can help their clients to understand complex products, so selling renewable or convertible term assurances may be possible. As insurance intermediaries have access to many insurers, this company will need to be amongst the cheapest to gain any business. More underwriting will be needed (than for internet selling) to give the cheapest possible rates and due to the larger sums assured. The company needs to consider whether it has the experience and systems in place to perform this additional underwriting. Risk However, these intermediaries may specialise in advising employers. So the company may have to invest resources into building a relationship with intermediaries that advise individuals. Paying commission will add to the cost of the contract which may make this sales channel uncompetitive compared to internet selling. Existing data will not fit the new target market, so there is a risk of mis-pricing the contract. Low premium rates reduce the profitability of this sales channel. The costs of underwriting and initial commission may mean that this sales channel incurs higher new business strain than internet selling. The intermediary will exploit any differences in underwriting between insurers which increases the impact of anti-selection. The impact of selective withdrawals may also be greater. The company is exposed to additional counterparty risk, eg the intermediary may fail to pass on the premiums it has collected. The company also has less control over the advice being given.
        • Tied agents
          • Tied to one or more insurance companies, typically employees of a bank or other financial institutions. They only offer the products from tied insurers. When tied to more than one insurer, their product ranges are sometimes mutually exclusive but more often be overlap. They are remunerated by commissions or salary plus bonus from tied insurers. Clients often initiate the sale but the agents also actively sell. Could reach financially sophisticated clients if these are the target market of the bank Could be successful if product can be sold in conjunction with the agent's main business.
        • Own salesforce
          • directly employed by an insurance company. They only sell products of that company. They may be remunerated by commission or salary. Salesforce initiate sales, relying on client lists or purchase leads. Once a rapport has been established, it will then be the client who initiate subsequent sales. So this channel is also good for establishing long-term relationships with clients, so that future product servicing can be carried out. Has high overhead costs for the insurer, including significant training costs. Clients lists may not include very many high net worth individuals
        • Direct marketing
          • Main forms: mailshots (company initiates the sale) could be used to reach individuals such as members of clubs or societies likely to include the people of the target age group existing customers who are of targeted age telephone selling (either insurer or client initiate) could use phone lists focused on the target age group use lists of potential customers provided by external companies press advertising (debatable who initiates the sale) could be used in magazines frequently read by the target age group around local community hubs used by people of the appropriate age on television or radio during programmes targeted at the market on website targeted at the market Internet (client initiate) could be used for follow-up, eg for giving more information and for online application on product comparison websites social media mainly limited to simple products can be used to generate initial client contact or interest these leads can then be followed up by the insurer's salesforce
        • Eg: Possible distribution channels for a without-profits WLA
          • The product is relatively simple, with guaranteed benefits and premiums, and so may not require face-to-face sales advice. Absence of underwriting allows it to be sold by direct marketing, eg: telephone sales mailshots TV advertising press advertising internet. As the target market is likely to include older/retired people: telephone sales may be intimidating or confusing the propensity to buy financial products online may be low TV advertising might concentrate on cheaper daytime periods. Direct marketing should have relatively low levels of anti-selection. In relation to a direct salesforce, insurance intermediaries or tied agents: the simplicity of the product and no underwriting provide little scope for face-to-face advisers to add value the policies are small so that the insurer could not afford much remuneration for sales it would be difficult for sellers to make money from the product exceptions might include where business volumes are high and/or there is a narrow geographical spread of policyholders a face-to-face sales process might be intimidating to the potentially vulnerable target market this could lead to mis-selling complaints and reputational damage. Possible tied agents could be supermarkets or trade unions. With regard to insurance intermediaries: the target market for the product may be very different from typical customers of this channel intermediaries may encourage anti-selection by recommending this company's product to lives who are in poor health.
        • Eg: Appropriateness of each distribution channel to sell UL EA
          • Insurance intermediaries Insurance intermediary clients typically have higher wealth and are more financially sophisticated. This complex product with lots of customer decisions (eg choice of unit funds, level of guaranteed death benefit) fits well with this channel as the customer needs advice. The ongoing flexibility, eg active switching of funds and reviewing premium and death benefit levels, also provides opportunities for ongoing financial reviews and advice. These customers are likely to be able to afford the fees for advice and to appreciate the value of advice. Typically there is a need for competitive terms for a product to be successfully sold via this channel. However, the unique features of this product should mean that it does not have to compete solely on the level of charges. Innovative features and product flexibility should fit well with this well-informed and well-advised customer population. However, training about the product and its unique features can be harder to provide to insurance intermediaries than to other channels. Tied agents Tied agents are salespeople who are 'tied' to one, or sometimes several, life insurance companies; that is, they offer to their clients only the products of those companies. It will be difficult to put in place a tie where agents sold only this company's products, especially as it offers only one product. Agents tied to a single company would want a more complete product range. A tie where the agents can sell other companies' products (eg without-profits protection contracts and annuities) is possible. This complex product with lots of customer decisions is a good fit with this channel as the customer is advised. Own salesforce Members of an own sales force are usually employees of the company. A salesforce would be expensive and difficult to establish for a new company. For example, the salesforce would have to be recruited and trained. The company would need to find the capital to do this before it could sell the product (and so before it received any premium income). A new company may be less likely to have the necessary capital. An own salesforce sells only the company's products, so is most suited to a company with a complete product range and is not appropriate for this company selling a single product. The complexity of the product may not suit this target market. Direct marketing Direct marketing includes mailshot, internet, telephone sales and press adverts. It does not typically involve providing the customer with tailored advice. So is often limited to simple products. But the complex features of this product would be best explained face to-face. However, direct marketing can also be used to provide information leading to sales via other channels. So direct marketing could be useful to promote brand and product awareness. The company could also look to promote itself via social media.
        • Eg: Justify the choice of distribution channel of level TA
          • A life insurance company currently sells three types of individual level term assurance products. The 'Basic' policy is sold to individuals, providing benefits to their dependants on the death of the policyholder. This product is sold via the internet and has a limit on the level of sum assured, and is available to only a limited age range. The 'Standard' policy is sold to individuals, providing benefits to their dependants on the death of the policyholder. This product is sold through tied agents, and is available for a wider range of sums assured and age ranges than the Basic policy. The 'Key Person' policy is sold to employers providing benefits to the employer on the death of certain employees. This product is sold through independent intermediaries. Justify the choice of distribution channels used by the company for selling each of the products. Basic The basic policy is a very simple product and so does not require the advice of a salesperson. The online processing will limit costs and there will be no commission to be paid as no salesperson and so the internet is a good distribution option. Customers may favour a quick and simple application process and so again the internet is a good option. The market for basic term assurance is competitive and use of the internet makes it easy for customers to look for the best deal, e.g. via price comparison sites. Standard The standard policy is slightly more complex, with its wider choice of sum assured, and so may require some level of advice, which a tied agent could provide. The tied agents may be staff of a bank or building society and they may sell the term assurance alongside a bank or building society product such as a mortgage or other loan. This would extend the potential target market of the insurance company. The wider range of sum assured for the standard policy will mean that some policies have higher sum assured and so require a level of underwriting that needs a face-to-face sale. Key person The key person product may be more complex again and may require the most comprehensive advice, making it appropriate for sale via independent intermediaries. Independent intermediaries can advise companies on appropriate levels of cover and choose the best product from across the market. The target market for this product is employers, ie businesses and partnerships who may be more able to afford the higher costs of an independent intermediary.
        • Eg: Suitability of the internet to distribute individual TA
          • The internet is unsuitable for selling complex products, but term assurances are very simple. Advice is difficult to provide on the internet, but the simplicity of term assurances mean they require little advice. Internet selling requires the policyholder to initiate the sale, but many people will be searching for cover (eg following the birth of a child). People are likely to use this company's website as it has a well-recognised brand. By using internet selling the company may be able to keep costs down and enhance its competitiveness. Internet applications will be fast if the insurer has an automated underwriting system that can accept a large number of applicants based on the response to simple yes or no questions
      • Considerations in setting up a distribution channel
        • Effect of distribution channels Demographic profile Different channels are likely to appeal to different people, according to their level of financial sophistication and level of income. These differences will then be reflected in the resulting demographic experience of the lives taking out contracts through each channel. Contract design The higher the level of financial sophistication, the greater the complexity of the products. Products sold via direct marketing are typically uncomplicated. A company using more than one distribution channel may therefore sell different versions of the same product varying by channel. Contract pricing Effect on demographic assumptions The stringency of underwriting follows intermediaries > tied agents > own salesforce >direct marketing. This will be reflected in the demographic assumptions used for pricing. Withdrawal rates are affected by the level of financial sophistication and whether the customer initiated the sale. Effect on the need for competitive terms The competitiveness of premium rates follows intermediaries > tied agents > own salesforce >direct marketing. But competitive rates are not everything. Differentiation comes from innovative features, excellent investment performance and first class customer service or administrative support. Factors to consider in product design Key issues of life insurance company management profit risk capital Practicalities
        • Eg: Impact of moving to a direct marketing on company's risk profile
          • Overall The risk profile of the company and experience will change for the business written through the new approach. The changes will become increasingly more significant as business from the new distribution approach becomes more prevalent over time. Types of contracts sold Less complex policies will tend to be sold. This will change the mix of business, eg from savings to protection, increasing the exposure to mortality risk. There may be a reduced risk from mis-selling of contracts: contracts are simpler and so less likely to be mis-understood the direct salesforce may have been giving poor advice if the policyholder is more likely to initiate the sale (eg via internet). Alternatively, mis-selling risk could increase, eg: if more aggressive cold-calling techniques (such as telephone sales) are used due to lack of advice, leading to reduced customer understanding. Removing advice could make the company appear less professional, ie damaging the company's reputation. Average policy size may reduce, which means: reduced per-policy risk (eg from mortality) increased risk from low sales volumes, as there is more reliance on volumes to cover fixed costs and generate profits the cross subsidy from large to small policies is reduced, so there is a reduced mix-of-business risk. Total risk exposure could increase if large volumes are sold. The lapse and surrender experience is likely to change, eg greater persistency as policies will tend to be smaller and more affordable. Competitiveness The selling environment might become more competitive: eg if internet sales are used and the customer has access to product-comparison websites sales will be more price sensitive, leading to increased parameter risks for all pricing assumptions, due to smaller margins used the risk of having low sales volumes would increase. Competition may reduce, eg if other companies do not use direct marketing so much. Type of person taking out the contract The target market will change, reflecting the change in both the contract type, and the kinds of customers that will use direct marketing. Mortality may reduce if more affluent customers are targeted. Persistency rates may improve, if sales are now largely initiated by the customer (eg online). Many direct marketing methods target a less financially sophisticated, and less affluent, customer base, leading to an increase in mortality rates and a reduction in persistency rates compared to before. The lack of advice could also lead to worse persistency than before. Underwriting To sell well, direct marketing generally requires less intensive and less detailed underwriting. This will mean: less accurate assessment of individual risks less effective screening for poor risks, eg non-disclosure of relevant information will be less easy to detect, whether unintentional or deliberate (hence increased risk from fraud) increased risk of accepting policies on standard terms when they should be rated or declined mortality experience will both worsen and become more variable. However, policies will tend to have lower benefit levels so this reduces the impact of the increased underwriting risk. Persistency may worsen if the level of financial underwriting used reduces. Expenses High risk that initial development and other one-off costs could be under-estimated, eg for: setting up admin systems and processes, including staff training, marketing and printing of literature dismantling the direct salesforce (eg redundancy payments). Equivalently, the company may over-estimate the volumes of sales that it will achieve in order to recover these costs. The direct initial costs of each sale should reduce, as there is no commission, and underwriting costs are lower. Overhead costs will change, in order to administer and support one or several direct marketing systems instead of a direct salesforce. Once established, the direct regular expenses should be lower (there is no renewal commission, and the marginal cost of administering each policy should be very small). Per-policy expenses will differ due to the expected differences in persistency and mortality experience. Overall, the ongoing expenses should be lower than before, with a greater proportion of the per-policy costs coming from overheads. Data risks Changes in contract type, target market, underwriting and the sales process will mean there is very little relevant data available for pricing. Will have to use industry data and/or seek assistance from reinsurers. This results in a significant pricing assumption risk, in particular for mortality, persistency, expenses, and new business volumes and mix. Other Higher mis-selling risk if new policy and sales literature is badly worded. There is an increased risk of lapse and re-entry from existing policyholders, if premiums on the new policies are cheaper than before. The salesforce may persuade their clients to lapse their existing policies and take out new contracts with the new companies they now work for. Direct marketing may involv e the use of third parties, eg internet hosting sites, which would increase counterparty risks. Regulatory risk exposure may worsen if the regulator is more active in regulating direct marketing. There is greater operational risk due to changes made to systems.
        • Eg: Considerations in setting up a direct sales force
          • Costs of setting up the DSF the capital costs of setting up a DSF and the funds available whether the DSF will provide sufficient return on the capital used the ongoing additional costs, eg salaries, accommodation, travel any mandatory training costs required for staff by legislation Operational issues the availability of suitable staff to employ for the DSF the remuneration package to adopt, eg mix of salary plus commission: needs to be competitive, in order to attract good quality staff how and by whom the sales staff will be trained the accommodation and equipment to provide the DSF staff how many sales staff the company is going to need the geographical area over which the DSF will operate where the individual staff need to be based (branch network) the factors affecting the above, such as: what the insurer's target market is for the DSF the size of the target market in the various geographical areas what the competition is doing the volume of sales the DSF needs to achieve. Products whether products need to be redesigned, eg: to suit a less financially sophisticated target market to comply with the appropriate legislation, eg on the selling process to allow for smaller average policy sizes sold through a DSF how to treat products that will be sold through both channels: policyholder needs to feel he or she is being treated fairly product needs to be an attractive sale through both channels whether premium rates should be the same for both channels how much cross-subsidy it wishes to accept Marketing how the target market will be reached, eg by advertising, phone, or mail where and how it can compete effectively within the DSF market: by exploiting niche opportunities outcompete other players by superior marketing toning down its underwriting, in order to reduce sales barriers Impact on the insurer's experience • the impact on: lapse rates, which are likely to worsen (require high-quality sales practices to minimise this effect) sales, which should increase if the proposal is successful expenses, which will include a higher proportion of fixed costs so that profit will become more sensitive to sales volumes mortality, which is likely to worsen Pricing how the mortality and lapse assumptions may need to be changed the changes to the commission and overhead expense assumptions reflecting these changes in the relevant reserving bases the difficulties in assessing the revised assumptions: it will have no own relevant experience from sales through a DSF industry data is possible but may not be split by sales channel probably obtain advice from actuarial consultants or reinsurers renegotiating its reinsurance treaties, eg to reflect increased uncertainty how its premiums will be affected by any revised reinsurance terms increasing margins in its premium bases to reflect the higher uncertainty whether it can sell in sufficient volumes to meet required profit levels: higher premium rates in the DSF will make this harder DSF is not very price-sensitive so could still be achievable Other benefits its ability to develop closer relationships with its DSF customers: increased selling to existing policyholders in the future develop increased trust and so reduce lapse risks over time that using a DSF will avoid certain problems with brokers, who can: cause delays in passing premiums to the insurer unfairly damage the insurer's reputation Risks that the admin and advice provided might worsen compared to brokers the much increased risk from mis-selling how future sales through the broker channel could be adversely affected the risk of making errors when updating its admin systems the cost of complying with regulations being higher than expected the risk that all expenses could be higher than expected that future sales, lapses and mortality could be worse than expected the major risk of the DSF channel failing, with complete loss of capital the overall effect on profits, which might be worse than if the company had not developed a DSF at all, or had tried an alternative option Alternatives whether any alternative sales channels could provide a better option: tied agents require almost no infrastructure so are much cheaper direct marketing could be cost effective for simple products. Total profitability modelling total profitability from all sources: allowing for all development and ongoing costs of the DSF, the cost of capital, and any negative impact on broker channel sales including a full range of sensitivity tests, so that the risks to its profitability can be fully taken into account in coming to a decision.
        • Eg: Consideration in introducing social media platforms
          • A life insurance company currently sells without-profits products over the internet using price comparison websites. It is now considering direct marketing using social media platforms as an additional alternative distribution channel. Discuss the factors the company would need to consider in introducing this additional distribution channel. Target market / marketability Social media may enable the company to access a different target market than that using price comparison sites, which may boost sales The target market needs to be sufficiently distinct so that the new sales channel does not simply reduce sales from the comparison websites Product design The company should consider whether to revise its current without-profit product offering Simple without-profits products still suit this channel given the lack of policyholder advice ..although the company may want to differentiate the products offered from those sold using price comparison websites. Pricing / Demographics The company should consider how the pricing of the products for the new channel compares with that for the comparison websites, e.g. may need to be competitively priced unless different product terms and conditions are used. The company will not have any directly relevant past experience data to use in pricing for the new channel It may be able to use its existing experience data with suitable adjustments .. depending on the similarity of the target market demographics Competitiveness The level of competition may be less for the social media sales than the price comparison sites if the proposed new channel is not as used by competitors however, if the market is already saturated, competition may be high and scope for sales limited. Underwriting The company may need to use a different level of underwriting in comparison to its price comparison website sales Profitability The company should consider whether business from the new channel will meet its minimum profitability requirements ... considering overall profitability, i.e. sales volumes and per-policy profit Capital requirements The company will consider the initial setup costs in researching social media platforms and arranging advertising agreements.. and the cost of setting up the company's systems and processes to deal with the new sales channel, given the company only sells via comparison sites at present Risk The company should consider potential reputational risk from association with variou social media platforms, arising from the actions of a platform or how it is perceived. There may be lapse and re-entry risk if existing policyholders could obtain better terms through the new channel Regulation Regulation may limit or restrict the ability of the company to use this approach, either now or in the future
    • Expenses
      • Commssion Initial commission may be payable on the acquisition of a new policy, with renewal commission payable each time a renewal premium is paid. If a policy lapses, part of the initial commission may be recoverable and there will be a risk of non-recovery. Management expenses Management expenses consist of: Expenses incurred directly when new policies are written (new business) Expenses incurred to maintain existing policies (in-force business) Termination expenses Overheads incurred regardless of the amount of new or in-force business and claims. (e.g. costs of IT, HR and accommodation).
    • Economic environment
      • The state of the economy will carry risks for an insurer. The availability of asset types, and their short- and long-term expected yields, will determine how well an insurer can choose investments and the probability of securing the return assumed when setting premium rates. Volatile investment markets will lead to expensive products and typically lower sales. The insurer tends to have higher capital requirements due to increased volatility. Insurer investing in risky market tends to seek a greater return on capital, leading to a greater investment risk.
    • Legal environment
      • In a politically stable environment where legal process operate efficiently, legal risk need not be a significant concern to insurers. However, care needs to be taken in areas where the insurer has discretion. Some principle related to PRE acting favourably to the insurer - eg. the flexibility in declaring bonus across with-profits policies may be constrained. Unfair contract terms voiding clauses of the contract - eg. a right increase charges on unit-linked may be considered unfair and the legal process may act to void the clause. The long term nature exacerbate these issues.
    • Regulatory environment
      • Regulatory restrictions are imposed to protect policyholders and foster trust. If not, the industry may fail and consumers are denied a vital social service. But restrictions may limit innovation and reduce the benefits. Common regulatory restrictions include: restrictions on types of contract that can be sold restrictions on premium rates / charges requirements relating to terms and conditions, eg calculation of surrender values restrictions on sales channels or sales procedures restrictions on underwriting, eg banning the use of separate rates for males and females indirect constraints on the amount of business that may be written by setting minimum reserving and solvency capital requirements which limit the capital available to write new business limits on investment strategy: types of assets that can be held, e.g. not allowing overseas assets a certain quality of assets that can be held, e.g. a certain credit rating amount of each asset type that can be taken into account to demonstrate solvency, e.g. restrict investment overseas to a certain percentage concentration of assets holdings in a particular area, e.g. maximum exposure to a particular counterparty extent to which mismatching is allowed, e.g. require an explicit investment mismatching reserve the method used to value assets for regulatory purposes, e.g. use of book value rather than a market-based approach the way to hold assets, e.g. be held under custodianship or not permit indirect investment regulations on investment assumptions used to value liabilities which influence the choice of assets restrictions on which institutions are allowed to transact life insurance business climate change related regulations consider climate risks in existing business planning, investment management and risk management processes effectively disclose and report on climate-related risks and opportunities adopt a consistent and reliable means of assessing, pricing and managing climate-related risks. Influence of restrictions on product design contracts should be designed to meet all regulatory requirements contracts should be designed to treat customers fairly only the permitted contract types can be designed simplified contracts may be required to keep costs down if premiums or charges are limited prescribed terms and conditions should be included the design should allow for regulations concerning the sales process, eg the complexity of the design will depend on the level of advice given the design should reduce the impact of anti-selection If underwriting is restricted capital efficient products will reduce the impact of new business strain on the amount of business that can be sold investment restrictions may limit the ability to hedge and hence affect the investment guarantees offered the contract design needs to be competitive wh ich will depend on the restrictions imposed on competitors
      • Eg: Impact of regulatory restrictions on product design of UL EA
        • Contract types Regulation may restrict the types of contract an insurer can offer. There may be restrictions on the range of unit funds or a minimum level of death benefit for this to be classed as an insurance contract. The product combines both savings and protection elements which might increase the regulatory constraints and may not even be allowed. Regulation of other investment providers, such as banks and unit trusts, could have an impact on the product design. Expense charges The company should comply with any restrictions on charges from the unit fund. There may be a maximum permissible annual management charge. There may be restrictions on the form of charges, eg whether surrender penalties are allowed. Restrictions on expense charges may leave the company unable to meet its profit targets with its current product design. Rating factors The rating factors permitted may be restricted , eg the ability to apply charges for the death benefit that vary by gender or age. Restrictions on rating factors would apply to all companies, so they should not affect the competitiveness of the product design. Terms and conditions There may be restrictions on terms and conditions, eg: the calculation of paid-up policy and surrender values how much flexibility in premiums and death benefits is allowed how often switches can be made between funds. Sales channels and procedures Restrictions on sales channels may impact the product design. There may also be requirements about sales procedures. For example, if it must be sold via a well-qualified insurance intermediary, then a wider range of unit funds may be appropriate. Requirements to provide details of all options as part of the sales procedure could lead to the company choosing a simpler design. Testing, eg underwriting Possible restrictions on the ability to underwrite include banning the use of the results of genetic tests, past claims history or medical history. Underwriting restrictions could have an impact on the guaranteed death benefit part of the product. But this may not be significant as the product is likely to be primarily savings rather than protection. Reserving and solvency capital requirements Most countries have regulations regarding the minimum level of reserves to be held, often combined with minimum solvency capital requirements. The company may wish to choose a product design that minimises the reserves and capital requirements. Reserves and capital requirements tend to increase if: benefits or charges are guaranteed there is a mismatch between the timing and level of expense outgo and charge income. Investment There may be restrictions on the following: the types of assets that the company can invest in the amount of a particular type of asset that can be taken into account for the purpose of demonstrating solvency. The above restrictions may impact the product design as they may affect the range of funds offered and the amount of risk they can take. The following restrictions are less likely to impact on contract design (eg as the unit fund can be matched ): the derivation of the valuation rate of interest the extent to which mismatching is allowed the extent of any mismatching reserves required .
      • Eg: Regulations to reduce investment risk
        • Reduce investment risk taken by the life insurer Regulations could restrict the types of assets in which a life insurance company is allowed to invest. The government could regulate to restrict the extent of investment in particular asset classes, e.g. a maximum percentage in certain high risk classes or to limit investment in individual assets, e.g. by introducing counterparty limits The government could introduce admissibility limits, i.e. restrictions on the amount of any type of asset that can be taken into account for the purpose of demonstrating solvency Regulations could require investment mismatching reserves or could directly limit the extent to which mismatching is allowed Regulations could influence the choice of assets indirectly, by specifying the means of determining permitted valuation discount rates, meaning that certain asset allocations lead to lower liabilities or via restrictions on the method used to value assets for regulatory purposes The government could introduce minimum solvency capital requirements against investment risk The government may use tax rules to influence the relative attractiveness to insurance companies of assets with different levels of risk. Reduce investment risk taken by the policyholder Pre-sale The government could introduce regulations on product design, for example limiting the type of investment contract that can be sold restricting the range of investment funds that can be offered within a contract Point of sale The government could introduce regulations to ensure the investment risks are highlighted to the customer at the point of sale, for example: specifying information that insurance companies must provide at the point of sale limiting the sales channels through which investment products may be sold Post sale The government could introduce regulations specifying a level of post-sale communications with policyholders that is required e.g. regular policyholder statement providing measures of investment risk
    • Taxation regime
      • Ways to tax Tax on annual profits (excess of change in the value of the assets over the change in the value of the liabilities). The insurer is treated as a company trying to make a profit. Tax on investment income / gains less. The insurer is treated as a group of individuals investing their pooled resources. Tax on premium income Effects Different types of life insurance business may be taxed on different methods. Where a particular benefit can be classified under more than one type, that benefit may be more cheap as one type. The taxation treatment may make life insurance more or less attractive than contracts from other institutions subject to different tax regime. Tax concession to individuals may make sales of some contracts easier. Tax treatment of policy proceeds can distort buying habits. Product design will want to make the best use of the taxation policy Insurers are at risk of making less profit due to future taxation change.
      • Eg: Actions to reduce papaer usage in admin and sales to meet tax on paper usage
        • General Need to understand current use of paper Hence need to do an audit of usage Then needs to understand potential tax liability To measure against any extra initial costs of reducing paper usage If the tax liability from paper usage is less material than the costs of change, then the company may decide not to take further action or to take a slower, phased approach to removing paper usage than it would if the liability was higher Administration Likely areas of use are: Letters to policyholders to confirm details of policy Including letters confirming any increases for indexed or increasing annuities Including letters confirming annuitants are alive Cheque payments for annuities Company needs to understand how many policyholders already use online methods for updating details May need to send out letters initially to all those who are not online to see if they can encourage more use of online for administration initially by getting email addresses, and by emphasising phone and email call centre details This would initially increase paper usage maybe prior to tax being implemented The company could reduce the frequency of regular communications and statement Company would need to identify policyholders who currently do not get annuity payments via bank transfers Encourage annuitants to provide bank details to enable setting up of bank transfers / standing orders Need to recognise many annuitants are older, and hence may not be keen on online methods of communication/payment Any new annuities should be set up with all online details of policyholders The company can look at potential ways to receive and certificates of existence online via scanning, or confirming details by phone/email Notification of death would need to be scanned and sent through to the insurance company Administration within the company would need to be conducted where possible without use of paper Potentially remove/restrict printer access Sales Likely areas of use in sales are: Product literature Policy documentation Marketing material Communication with intermediaries and policyholders Policyholder identification documents The company can provide online annuity product literature to intermediaries via websites Application forms should collect details of email addresses and bank details All communication with intermediary and policyholder would be electronic or via phone However, there may be a need to still send out formal policy documents to obtain “wet” signatures Birth and marriage certificates and any identification documents can be scanned and attested by appropriate individuals Commission payments are probably already made electronically, but company may now insist on it
    • Professional guidance
      • Actuarial associations issue professional guidance to actuaries in order to maintain professional standards as they carry out their responsibilities. This guidance should not be unduly restrictive and may provide protection to policyholders. Guidance may be issued on the interpretation of government regulations. Typically where the government does not want to be overly prescriptive and looks to the profession to set the standards on acceptable behaviour. This additional safeguard acts to further promote the insurance industry.
    • Eg: Actions to encourage purchase and sale of insurance products
      • Potential actions will depend on the cause of the decline in sales, eg: a lack of suitable products a lack of insurance companies customers not being aware of or willing to buy products poor economic conditions reducing consumers' level of wealth. Tax Change insurance company taxation. This may be effective if: the cost of these products was causing low sales, and reduced company taxation is passed on to customers via lower premiums. Taxation of individuals could be changed (eg increasing tax relief on premiums and/or reducing the tax payable on benefits received). This is likely to be effective as: Customers will want to take advantage of tax breaks if they can afford to. The tax breaks may be used in marketing. However, this will depend on the taxation of life insurance compared to similar, competing products, eg unit trusts and other savings vehicles. Compulsion Make insurance products compulsory, for example: require workers to purchase a pension savings product require an annuity to be purchased from pension savings require individuals to take out life cover with any mortgage. Large customer numbers may help with economies of scale. However, premiums may need to be low in order to be affordable to the customers compelled to buy the product. Alternatively, employees could be automatically enrolled in to various insurance products unless they took the deliberate step of opting out. Encourage product innovation and new product designs Remove restrictions on the types of products that can be offered. May increase product innovation, eg using products successful overseas. May increase sales if new products are better at meeting customer needs. Distribution channels and the selling process Reduce restrictions on the types of distribution channel allowed. May improve customer access to insurance products. Could also change the rules governing the amount and type of information provided to customers at point of sale. May be effective if it was a lack of information (or too much information) that was preventing customers from buying insurance products. Investment freedom Reduce investment restrictions on insurance companies. May enable investment in riskier assets with higher expected returns. May improve sales if higher returns lead to lower premiums and if high premiums had been a cause of the decline in sales. Premium or charge caps Introduce measures to make products cheaper, eg capping charges. May be effective if insurance has been too expensive. However, may lead insurers to withdraw from the market and so reduced the availability of certain insurance products. Rating factors Reduce restrictions on rating factors, eg allow gender as a rating factor. May lead to lower prices on average (as reduces uncertainty about mix of business). Using more rating factors would result in insurers dividing customers into more groups for pricing purposes. Some groups will gain and some will lose out, eg allowing gender as a rating factor would make annuities more attractive to males. So this change may increase sales to groups that benefit from lower premiums, but could change the mix of policyholders. Underwriting Relax restrictions on underwriting, eg allow genetic tests to be used. Tighter underwriting should reduce premiums and so increase sales. Reserving and capital requirements Relax reserving and solvency capttal requirements. May increase sales, particularly as products with marketable features, eg more guarantees, may be especially capital-intensive. Alternatively, could increase reserving and capital requirements if a lack of consumer confidence in the industry was deterring sales. Commission Remove restrictions on the level of commission that is allowed. May boost sales by incentivising advisers to sell. However, this higher commission is likely to be paid for by customers. Policies could be more likely to lapse as there is a greater risk of customers being sold products they don't really need. Other actions Government could subsidise life insurance products directly. Government could educate the public on the benefits of insurance. Reduce the level of State benefits, eg State pension. Increase competition, eg by reducing barriers to entry. Help insurance companies, eg collecting data to aid product pricing. Improve economic conditions to increase disposable income.
  • Supervisory reserves and capital requirements
    • Purposes of reserves and capital
      • Purposes of reserves Demonstrate solvency A minimum valuation standard is involved to ensure the capability of meeting guaranteed liabilities. Investigate the truth realistically Help determine the sustainable profit distribution rates Provide relevant information to shareholders Inform financial management decisions Reasons to require capital The company is likely to require capital to carry out its business plans such as: financing new business strain funding 'external' growth (acquisitions) funding 'internal' growth projects...eg development of new products or investing in company infrastructure. The company will also want to hold capital to enable it to withstand adverse conditions: to ensure it has enough free assets to allow investment freedom to meet regulatory solvency capital requirements to demonstrate financial strength, which could improve the company's credit rating. Capital may also be required as working capital to provide day-to-day liquidity, eg to pay salaries. Purposes of solvency capital requirements Supervisors require life insurers to maintain at least a specified level of solvency capital, providing additional protection to policyholders. against the reserves being underestimated against a drop in asset values. The level may be specified as a formula, e.g. 1% of the sum at risk or based on risk measure e.g. VaR at 99.5%. Purpose of raising capital Company is recently established so may have low available capital. May need additional capital to support new business strain on existing product. Products like term assurance can be relatively capital intensive due to: high solvency requirements high initial costs, eg underwriting. Will need additional capital to support new business strain on the new product. Might be able to offer a relatively capital efficient design, eg using initial charges, but reserves may still be high due to the guarantees and options. Strain also arises due to any prudence in the reserving basis and the need to hold additional risk capital. Could sell very high volumes (therefore high capital strain), particularly if there are no similar products currently available in the market. Capital is also needed to meet the costs of designing and launching the new product, which could be high. The costs could include: setting up a new distribution channel, since the product is complex and therefore unlikely to be suitable for the existing direct marketing approach training administrative and sales support staff system changes, or even a new system as the existing one may not be able to cope with the flexibility of the new product design new product literature marketing/ advertising campaign.
    • Liability valuation - GP approach
      • Definition A method for placing a value on a life insurance company's liabilities that explicitly values the future office premiums payable, expenses and claims, with the latter possibly including future discretionary benefits. So the reserves for any policy are EPV of future claims + EPV of future expenses - EPV of future premiums. Features Explicit allowance is made for expenses and bonuses Actual future gross premiums are used Difference between pricing and reserving bases are immediately taken as profit Reserves may initially be negative for non-linked business, due to initial expenses and capitalising the expected future profit Reserves tend to be quite sensitive to changes in the basis.
      • Formula method
        • Under the formula method, the liability can be expressed as a formula. Contracts are typically priced such that the expected PV of premiums exceed that of claims and expenses. Best estimate reserves should be negative at contract inception. Since initial expenses typically outweigh the regular premium, the best estimate reserve should be even more negative just after contract inception. Prudent reserves may always be positive.
      • Discounted cashflow method
        • A discounted cashflow method can be used for determining reserves for non-linked policies and must be used for determining non-unit reserves for unit-linked policies. Under the discounted cashflow method, the reserve can be calculated by considering the EPV of all future net cashflows. Advantages include: It can identify whether net cashflows in any particular period are positive or negative. The method can allow more easily for withdrawals. It can more easily cope with complex charging and benefit structures (eg unit-linked). It can more easily cope with charges and benefits which depend on future assumptions. It is easier to incorporate assumptions that vary over time, including stochastic assumptions. The risk discount rate can take account of the term structure of interest rates. It is easier to allow for the impact of reinsurance. Tax can be allowed for more appropriately.
        • Eg. UL contracts
          • Ensure that the local reporting regulations are followed throughout. For each policy in force, a unit reserve and a non-unit reserve is needed. Unit reserve Unit reserve generally equals number of units times current bid prices. Non-unit reserve The non-unit reserve is the present value of the excess of non-unit outgo (eg expenses, benefits in excess of the unit fund) over non-unit income (eg charges, unallocated premiums). Need to consider yearly (and possibly monthly) non-unit cashftows, so a discounted cashflow method must be used. Cashflows will be projected, policy by policy, on the reserving basis. First project the unit fund values, allowing for allocated premiums, expected fund growth, full and partial surrenders, and deducting all charges. Non-unit cashftows will include eg all charges, expenses, commission, and (non-unit) death payments and surrender penalties. The non-unit reserve can then be calculated as follows: Identify the last future period in which the net cashflow is negative. An amount is set up at the start of that period which, allowing for investment return, is sufficient to 'zeroise' this negative cashflow. This is the non-unit reserve req uired at the start of the period. Multiply this reserve by the probability of a policy staying in force over the previous time period. This amount is then deducted from the net cashflow projected for the end of this previous time period (= adjusted cashflow). If this adjusted cashflow is also negative, then zeroise this cashflow by calculating a non-unit reserve as at the beginning of this year. If the adjusted cashflow is positive, then the start year non-unit reserve is set to zero. Repeat this process all the way back to the valuation date, zeroising all the negative cashftows on the way. Once complete, identify whether the next adjusted cashflow as at the valuation date is negative. If negative, calculate the amount required as at the valuation date to cover this negative cashflow. This is then the non-unit reserve required at the valuation date. It may be possible to hold a negative NUR provided: it is not greater than the amount of surrender penalty enough positive non-unit reserves exist to offset it against the non-unit profit remains non-negative in future.
          • Unit reserve
          • Non-unit reserve
            • Prudential valuation The non-unit reserve is typically calculated such that future liabilities are met without recourse to further financing. The insurer cannot take credit for future income to meet present expenditures. The insurer may rely upon future income to support present reserves. Long story short: reserves are not allowed to be negative. The algorithm for determining prudential non-unit reserves: Project forwards non-unit cashflows on the reserving basis. Start with the last negative net cashflow. The reserve one period before should be sufficient to cover this cashflow, allowing for investment returns. Take the difference of the preceding cashflow and the reserve, capping it at zero if positive The process continues to work backwards towards the valuation date, with each negative being zeroised in this way. When the process has been completed, if the adjusted cashflow at the valuation date is negative then a non-unit reserve is set up equal to its absolute value. Best estimate valuation Under a best estimate valuation, it would generally be the case that negative non-unit reserves can be held. In such circumstances, the calculation would value all future non-unit cashflows, ie it would not disregard cashflows occurring after the last projection period in which there is a net outflow, and there would be no other restrictions. Negative non-unit reserve A negative non-unit reserve can be held for a policy where future non-unit income is expected to be more than sufficient to meet future non-unit outgo. The negative reserve represents a ' loan' from other contracts which have positive non-unit reserves. The 'loan' will be repaid by the emerging future profits from the policy for which the negative non-unit reserve is held. Regulations may specify that: The sum of the unit and non-unit reserve for a policy should not be less than any guaranteed surrender value. The future profits arising on the policy with the negative non-unit reserve need to emerge in time to repay the loan. In aggregate, the sum of all non-unit reserves should not be negative.
          • Eg: Implications of higher growth rate on reserves
            • Unit reserve A higher than expected unit growth rate will result in the unit reserve increasing more than expected. Non-unit reserve The non-unit reserve is the amount required to ensure that the company is able to pay claims (in particular when benefits are in excess of the unit fund) and meet its continuing expenses without recourse to further finance. The movement in the non-unit reserve will therefore depend on the relationship between the positive non-unit cashflows (eg charges) and the negative non-unit cashftows (eg expenses). Impacts that will act to reduce the non-unit reserve are: any annual management charge will have increased the cost of any death benefits in excess of the unit value will have decreased the cost of any guaranteed minimum maturity value will have decreased. Impacts that will act to increase the non-unit reserve are: any investment management expenses which are related to the size of the unit fund will have increased any mortality charges that are expressed as a percentage of the sum at risk will have decreased. any commission that is related to the size of the unit fund will have increased. Some of the non-unit cashflows are probably unaffected: any charges or costs that are related to the premium any charges which are fixed monetary amounts, eg policy fees ongoing renewal expenses (as these are likely to be fixed monetary amounts per policy). Overall, it is likely that the net effect will have been beneficial for the company, so the non-unit reserve will be lower than previously expected. However, the likely reduction in the non-unit reserve is probably smaller than the increase in the unit reserve. Therefore, it is likely that the total reserve will have increased.
          • Eg: Reasons for inadequacies
            • Possible inadequacies There may be problems with the in-force data policies may be missing, or included in error the number of units for a policy may be missing or incorrect the date of birth, term, entry date, premium, guaranteed sum assured or surrender penalty for a policy could be wrong or missing the reinsurance details held for a policy could be wrong, or inconsistent with the company's reinsurance treaty. Some significant product features may have been ignored. Any automated processes may include errors, eg due to lack of testing. The unit-pricing calculation could be wrong. There may be errors made in estimating the assumptions used in the calculation of the non-unit reserves, for example: the unit growth rate assumption the non-unit interest rate assumption mortality assumption expense and inflation assumptions lapse rate assumption. These could arise from: errors in the historical experience data errors in any external data that might have been used errors of judgement occurring when the reserving basis was set not allowing for trends or known changes in the experience. Any approximations used could be inappropriate, eg model points. Lack of adequate documentation may lead to mistakes. Regulatory changes may not have been noticed and/or followed.
      • Market-consistent methodology
        • Assets Market values are used for assets, if market prices exist. Liabilities To determine the liabilities, future unknown parameter values and cashflows are set to be consistent with market values, where a corresponding market exists. Future investment returns are based on a risk-free rate of return, irrespective of the type of asset actually held. Discount rates are also based on risk-free rates but may adjust for an illiquidity premium and for the uncertainty associated with non-hedgeable risks via a risk margin. Risk-free rates may be determined based on government bond yields or on swap rates. Generally only be appropriate to use swap rates if there is a sufficiently deep and liquid swap market 'Deep' means that the market is of sufficient capacity that large trades would not materially affect the prices. In either case, it may be appropriate to make a deduction to allow for credit risk. Risk-free rate would usually be term-dependant Consider bonds with durations matching those of the liabilities Illiquidity premium It may be possible to derive the market-consistent discount rate from corporate bonds rather than government bonds. Corporate bonds typically have a higher yield than risk-free bonds, where this reflects both the greater default risk and the relative illiquidity of such assets. The latter contributes the 'illiquidity premium' to the yield. Even under a market-consistent approach, it may be possible in some jurisdictions to take credit for the illiquidity premium and thereby discount liabilities at a higher yield than the risk-free rate. This would normally be restricted to long-term predictable liabilities for which matching assets can be held to maturity. Therefore the insurer is not exposed to the risk associated with the sale of illiquid assets although is still exposed to default risk. The liabilities under annuities are more predictable than other products as they are paid until the member dies. Also annuities cannot be surrendered and do not pay a sum assured on death. Where this practice is permitted, there would normally be strict rules about how and when it can be applied. Risk margin For elements of the basis for which a deep and liquid market does not exist, the liabilities should be valued using best estimate assumptions with a risk margin The risk margin reflects the compensation required by the market in return for taking on the uncertainty of the liability cashflows Mortality, persistency and expenses are non-hedgeable basis elements The risk margin could be calculated by adding a margin to each of these assumptions Alternatively, an overall reserving margin in respect of these risks could be determined using the 'cost of capital' approach We must first project the required capital at each future time period. Required capital is the amount in excess of the projected liabilities. It may be a fixed percentage of reserves or sum at risk Multiply the projected capital amounts by the cost of capital rate The rate can be considered to represent the cost of raising incremental capital in excess of the risk-free rate. The rate can represent the frictional cost of locking in this capital to earn a risk-free rate rather than invest freely. Discount using market-consistent discount rate to give the overall risk margin.
        • Eg: Impact of reinvesting in corporate bonds with shorter duration
          • Assets No change to value of assets (other than a small reduction due to any dealing costs) Liabilities The move to higher yielding bonds does not affect the risk-free rate used to value the liabilities A liquidity premium adjustment will no longer be appropriate as the asset will no longer match the duration of the liabilities So the discount rate should be based on the risk-free return along with no illiquidity premium adjustment Therefore, the discount rate used to value the liabilitieswill be lower and so the value of the liabilities will increase If no illiquidity premium was being used originally, then the value of liabilities would be unchanged Free assets With an unchanged (or slightly lower) asset value and an increased liability value (if the illiquidity premium no longer used), the free assets will reduce If no illiquidity premium was being used originally, then the free assets would also be unchanged (save for the impact of any dealing costs)
    • Solvency capital requirements valuation - VaR approach
      • Value at Risk (VaR) is normally expressed at a minimum required confidence level (eg 99.5%) over a defined period (eg one year). For regulatory disclosures the confidence level and period may be pre-defined, or they may be determined by the company's risk appetite. The supervisory balance sheet is subject to stress tests (or 'shocks') on each risk factor at the defined confidence level and over the defined period. This balance sheet would typically be on a market-consistent basis. Examples of such shocks are interest rate movements, market crash and mortality. The surplus is then recalculated at the end of the period. The 'shocked' surplus at the end of the period is discounted back to time zero using an appropriate discount rate. Applying stress tests to each different risk factor gives a capital requirement for each separate risk in isolation. These separate stresses need to be combined to give an aggregate capital requirement reflecting any diversification between the risks. This may be done using correlation matrices or copulas. Correlation matrices may be specified by the regulator. Under the extreme event conditions being tested, correlations may differ from those observed under 'normal' conditions. The aggregated capital requirement allowing for diversification will usually be less than the sum of the capital requirements for individual risks. A combination of a subset of events happening at the same time, with an overall probability level of 1 in 200, may produce a higher capital requirement than combining all of the individual capital requirements for separate 1 in 200 events using a correlation matrix. This is caused by the 'non-linearity' and 'non-separability' of risks. Non-separability refers to the ways in which risk drivers interact. Allowance needs to be made in the VaR calculation for these effects. Typically, stochastic models are used to quantify the VaR for economic risks. The probability distribution used should reproduce the more extreme behaviour of the variable being modelled, both in the size of the tail of the distribution and in the path taken during the simulation period. A 'real world' asset model would be used and should be arbitrage free. These models are usually calibrated to actual historic values, but advanced techniques may be required to ensure appropriate fit to the tail of a distribution to ensure that the frequency of extreme outcomes is not understated. Other possible methods of calculation may exist, such as the 'run-off' method which looks at the amount of capital needed at outset to ensure a firm's ability to cover its liabilities until the last policy has gone off the books, allowing for suitable stresses to the risk factors.
    • Interplay between reserves and solvency capital requirements
      • In considering the adequacy of the reserves, it's important to do this within the context of the solvency capital requirement and not in isolation. Practice on the relative balance varies between countries and regulatory jurisdiction. Normally it will be one of two cases: strong reserving, with a small solvency capital requirement weak reserving, with a large solvency capital requirement where weak means a basis close to best estimate
    • Passive VS active valuation
      • Passive valuation approach Use a valuation methodology which is relatively insensitive to changes in market conditions Use a valuation basis which is updated relatively infrequently. Assumptions may be locked in, they remain unchanged from what was first written. Non-economic assumptions may be required to be updated if experience worsens. Solvency capital requirements may be determined using a simplified approach such as holding a percentage of mathematical reserves. Advantages straightforward to implement involve little subjectivity result in relatively stable profit emergence Disadvantage A passive valuation is at risk of becoming out of date and may provide a false sense of security Example: NP valuation method This is a method for placing a value on a life insurance company's liabilities that involves calculating a present value of the liabilities and deducting the value of future net premiums, allowing in each case only for mortality and interest. the calculation ignores expenses the net premium is calculated on the valuation basis ignoring expenses If the valuation interest rate decreases, the assurance factor increases more than the annuity factor does. But this is tempered by an increase in the net premium Active valuation approach The basis of an active valuation approach is updated frequently and uses a methodology that is relatively sensitive to changes in market conditions. Active valuation approaches are more informative in terms of understanding the impact of market conditions, but are volatile and subject to procyclicality. In a stock market crash, an active valuation approach would indicate higher capital requirements and lead to liquidation of equities, which exacerbate the market condition Examples market consistent valuation approaches for assets and liabilities risk-based approach to solvency capital requirements Combination A combination of passive and active approaches can be adopted, but this can result in greater volatility. If a passive approach is adopted for liabilities and an active for assets, the mismatch in the valuation of assets and liabilities can be overstated.
      • Eg: Impact of changing from passive to active on insurer
        • The regulator in a country has historically prescribed a passive approach for determining the statutory reserves of life insurance companies in that country. Discuss the implications of this proposal for the life insurance companies within this country. Practicalities Life companies will need to redesign their liability valuation systems. Life insurance companies will need to change their analysis of surplus processes and conduct more frequent experience analysis. These changes will inur extra costs, e.g. for: additional staff staff training IT system changes Overall valuation approach In addition to reserving for liabilities, companies need to consider how the method of asset valuation might change. The solvency capital requirement regime will likely also change to be more risk-based. This would result in more useful management information and enable more informed decisions although Transition At the point of implementation, there will be a one-off change in life insurance company's solvency results, which will need to be explained to shareholders and analysts. At the point of implementation, valuations on both the existing passive approach and the new active approach may be needed. Impact As a result of their changed solvency results, companies may need to raise additional capital. After the proposal is implemented, companies' results will be more volatile. Companies may therefore change their investment strategies to control this volatility, e.g. by increasing their investment matching.
• Product design
  • Factors to consider
    • Profitability
      • The insurer wants to ensure that the premiums and charges are sufficient to cover the benefits and expenses as well as provide a profit margin. For non-linked, premiums should cover benefits and expenses. For linked, there is a large focus on charges covering expenses. The required profit margin depends on the risk appetite of the company
      • Sensitivity
        • Consider the sensitivity of profit to variations in future experience. Consider controls to reduce sensitivity, eg reinsurance. A unit-linked product can minimise the sensitivity of profit by: investment return: no investment guarantees mortality: make the charge at the company's discretion expense: make the charge at the company's discretion withdrawal rates: no guaranteed surrender values matching: match income with outgo as closely as possible by duration
    • Marketability
      • Benefits need to be attractive by incorporating innovative design features or add loads of options and guarantees. The charging structure under a unit-linked contract needs to be attractive by considering whether the charges should be guaranteed.
    • Competitiveness
      • For unit-linked products, the insurer wants charges similar to competitors. For distribution channels with high price elasticity, insurers may set charges slightly higher than marginal costs. The usual competitiveness considerations do not apply if no other companies are allowed to sell this contract
    • Financing requirements
      • The insurer wants the design of its benefits and charges to minimise its financing requirements, particularly for newly established insurers with a small amount of free assets. There is more scope under unit-linked contracts to achieve this. The capital strain of non-linked contracts can be reduced by: reducing initial acquisition expenses reducing initial administration expenses reducing valuation strain via increasing valuation interest rate / reduction of guarantees
    • Risk characteristics
      • Consider the level of risk associated with the proposed contract design An acceptable level of risk depends on the company's ability or willingness either to absorb risk internally or to reinsure it.
    • Onerousness of guarantees
      • Examples of guarantees to consider include: surrender values interest investment return accrued to date expenses mortality annuity option renewability without medical evidence Offering guarantees results in two problems: suffer an unexpected cost have to reserve for this from the outset
      • Eg: Reasons to offer guarantees or options
        • To meet customer needs for the product (eg by making it more adaptable to changing personal circumstances). To make the product generally more attractive to customers, and so increase the volume of sales. To maintain, or enhance, the competitiveness of the product, in order to maintain or increase sales. To create a niche product design that distinguishes it from any current competitor product. To help intermediaries to sell the policies more easily, so again further increasing marketability. The higher volume of business should enable overheads and other perpolicy costs to be better covered, so increasing overall profitability. To make additional profits from the guarantees or options themselves, from the margins included in the prices charged. To improve persistency rates: by making the policy more valuable once in force, so that policyholders will be less likely to discontinue the exercising of a renewal option will extend the duration of an existing policy and so maintain higher volumes in force for longer. Regulation may require particular guarantees or options to be included. To address past problems, eg policyholders may have suffered losses, leading to dissatisfaction and reputational damage for the company.
    • Distribution channel
      • The company will need to consider the sophistication of the target clients of a particular distribution channel. The distribution channel the product is sold through will impact on the likely level of wealth and financial sophistication of prospective policyholders as well as affecting the amount of advice that they receive.
    • Extent of cross-subsidies
      • A company needs to decide on the extent of any cross-subsidies between, for example, large and small contracts. Cross-subsidies leave the company at risk of the mix of business being different from that assumed.
    • Administration systems
      • The system requirements of a new product may limit either the benefits to be provided or the charging structure to be adopted.
    • Consistency with other products
      • The insurer may wish for some form of consistency with other products so that it can use existing systems, staff, marketing literature.
    • Regulatory requirements
      • A company must adhere to any regulatory requirements, eg maximum (capped) charges, treating customers fairly.
    • Sustainable investment options
      • Increasing focus is being placed on the Environmental, Social and Governance (ESG) issues. The drivers for this are a combination of regulatory, marketing, and social responsibility. A company needs to consider the sustainability of investment options when designing products.
    • Example
      • Eg: Introduce a SA increase option to new business
        • The option The policyholders can increase the level of the sum assured at any time. The total level of increase is limited to be no greater than the original sum assured. No further underwriting is required. The premium charged for the increase will be based on the premium rates which were effective when the original contract was sold, and the age of the policyholders when the option is exercised. Marketability and distribution channels The option makes the product more attractive to both potential customers and the company's distribution channels. Sales may be improved (depending on how the product, including the option, compares to the products offered by competitors). Premiums will have to increase to cover the cost of the option, and this may reduce the attractiveness of the product to some. The lack of further underwriting under the option is likely to be attractive. This also reduces the expenses associated with offering the option (ie no underwriting expenses at that point) which should help to minimise the impact of the option on premium rates. The underwriting performed at policy outset will need to be amended to be performed on the assumption that the option is exercised. Profitability If sales increase, this should increase the company's profits (provided it charges appropriately for the option). Risk characteristics There is the risk of anti-selection, as those policyholders in worse than average health will be more Iikely to exercise the option. This risk is further increased as: there is no further underwriting benefits can be increased at any time. However, the increased risk is restricted by: limiting the increase to be no greater than the original sum assured offering the option only on new business. Financing Reserving and solvency capital requirements will increase. This capital strain could be particularly onerous if the option is successful in increasing the sales of this product. Onerousness of guarantees Using the premium rates that were charged at the time the original contract was sold is a type of guarantee. There is a risk that the experience underlying the premium rates has worsened in the time since the policy was sold. As it is a whole life product, the policy may have been sold many years ago, thereby increasing this risk. Administration systems Expenses will be incurred in changing administration systems to allow for the option. Sales may be too low to recoup these fixed costs. Alternatively, sales may be too high, leading to administrative and capital strain. Consistency with other products Offering the option only on new business might be unpopular with existing policyholders, potentially leading to higher surrender rates and complaints. Reinsurance Need to consult reinsurers to confirm continuation of reinsurance cover and the cost of reinsuring the option. Alternatives Attempt to determine the reasons for reducing sales and consider whether there are alternative ways to improve sales. Ways in which the proposal could be improved Limit the points at which the option can be exercised, eg on every 5th birthday, or for certain defined events such as the birth of a child. Impose a maximum age at which the option can be exercised. The policyholder could be restricted to only have a single increase in the sum assured and this may be limited to less than 100% of the original sum assured. Place an absolute monetary limit on the increase in sum assured to reduce the risk from large policies. Perform some type of underwriting when option is exercised, eg require the policyholder to complete a declaration of continuing good health. These restrictions would reduce the popularity of the new product. Base the increase in premium on the premium rates current at the time the option is exercised. This suggestion requires the company to continue to sell this business (and so to have 'current' premium rates).
      • Eg: Add a minimum surrender value guarantee
        • A life insurance company writes a unit-linked endowment assurance product. The benefits on surrender and maturity are the value of the units held at the time of claim. It has been proposed that a minimum surrender value guarantee be added to the product for all future new business. The surrender value would now be the greater of the value of units or the sum of the premiums paid up to the surrender date, with no surrender penalty applied. Marketability and distribution channel Adding a surrender value guarantee should improve marketability. This should lead to higher sales and higher profits. But, any charge for the cost of the guarantee will reduce marketability. The overall impact will depend on the perceived value of the guarantee compared to this extra charge. Consider the distribution channel used and how competitive it is. Competitiveness Consider whether competitors' products offer surrender guarantees. Introducing a surrender guarantee should give a competitive advantage if other companies do not offer one. If other companies already offer such guarantees, then adding the guarantee may be necessary to maintain sales. Onerousness of guarantees Consider cost of proposed guaranteed minimum surrender value. Consider whether to increase charges for this guarantee. Cost will be greater the more volatile the unit funds selected. Consider offering the guarantee only on less volatile fund selections or varying the guarantee charge by fund. Financing requirement Consider the financing requirement of the product and the company's capital position. Introducing the guarantee and removing the surrender penalties is likely to increase the company's reserving requirements . Lack of experience may increase the need for margins in assumptions. So there may be insufficient capital to support new business strain, especially if new business volumes increase. Profitability Profitability depends on how charges compare to the guarantee cost. Consider both per-policy profit and total profit (which depends on sales volumes). Higher sales allows overheads to be spread over more policies and so increases profits. Risk characteristics and sensitivity of profit Introducing the guarantee may increase persistency (withdrawal) risk. Risk of higher than expected withdrawals when the guarantee bites. Risk of higher withdrawals due to the removal of the surrender penalty. Risk of not recouping initial expenses on early withdrawals. Investment risk as guarantee bites when fund value falls below the premiums paid. Increased risk of selective withdrawals as those in good health have more incentive to surrender. Risk of selling insufficient business to recoup development costs. Increased operational risk due to more complex product design. Reputational risk, eg if existing customers are not treated fairly. Extent of cross-subsidies Cross-subsidy between those in more and less volatile funds unless guarantee charge reflects the different levels of risk. Such cross-subsidies increase new business mix risk, ie company might attract a greater proportion of business into the more volatile funds. Guarantee costs more for policyholders with additional life cover as the mortality charges reduce the value of their units. Consistency with other products Proposal is to introduce guarantee only for future new business. Existing customers may be unhappy leading to higher withdrawals. Existing customers may lapse and re-enter to get the new guarantee. Guarantee could be added to existing policies too at no charge, but this introduces significant risk particularly if guarantee is already biting. Admin systems Admin systems need to be changed, eg to check if the minimum bites. Sales literature and other customer communications need to change. Regulatory requirements Company should comply with regulations, eg maximum charge caps.
      • Eg: Determine charges for a new product
        • A life insurance company is pricing a new single premium, unit-linked bond product, which has the following features: A maturity term of five years. A benefit payable on maturity, death or surrender (at any time) equal to 100% of the bid value of the unit fund. The charges applied will be a combination of an allocation rate for the single premium, an annual management charge applied as a percentage of the unit fund and a monthly policy fee. Marketability and distribution channel In order to have a successful product launch, the company will want the charges to appear attractive in the market. This will include: the level of charges (lower charges are more attractive) how charges may be varied (guaranteed charges are more attractive) how easy the charges are to explain the balance between the different charges, eg lower allocation rates may be harder to sell than higher policy fees. It is particularly important to have attractive charges, as the product has a very simple structure with few distinguishing features. The charges and charging structure may depend on the distribution channel used. Competitiveness The structure and levels of charge need to be in line with those of competitors. A low annual management charge may be particularly important, as it is easy to compare with those of other companies. The need for low charges in order to be competitive may depend on the target market and the sales channel. Competitiveness in other areas (eg past fund performance) may reduce the need for charges to be low. Onerousness of guarantees In deciding whether to make any charges guaranteed, the company needs to consider the onerousness of: the increased risks the extra capital requirements and the cost of that capital. Financing requirement Unless the company has substantial capital resources, charges (and benefits) should be designed to minimise the capital requirement. The absence of surrender penalties may increase reserves, unless the allocation rate is sufficiently low to recover the initial outgo immediately. Mis-matching between charges and expenses will increase reserves. New product increases capital requirements due to extra uncertainty. Capital resources may be inadequate if new sales volumes are too high. Profitability The charges overall will need to cover expenses, commission and tax, and to provide adequate profit. An adequate profit is one that meets the required rate of return of the capital providers, eg shareholders. Possible profit measures include net present value, internal rate of return, discounted payback period. No future premiums will be received, so the only ongoing income will be the annual management charges and policy fees. Allowance should be made for expected mortality and withdrawals. Must ensure that switching and termination expenses are covered, as there are no explicit charges for these. Need to decide the product's share of the company's general overheads and how quickly it aims to recoup the product development expenses. The company will need to estimate future expenses, mortality and withdrawals, which may be difficult as this is a new product. It will also need to estimate the new business volumes to help allocate overheads and development costs. Risk characteristics and sensitivity of profit The company should consider how the charges might cause risks. As the AMC is a percentage of the unit fund, there is a risk that poor investment performance will reduce the charges received . The absence of any surrender penalty may lead to a persistency (withdrawal) risk. A low allocation rate wilI tend to reduce this risk, compared to having high AMCs and policy fees (and hence high allocation rates). The matching between charge income and expense outgo, in terms of their nature, timing and amount, need to be considered: better matching leads to less sensitivity of profit mis-matching increases risk the scope for mismatching depends on the company's risk appetite. The AMC may: be a good match to any investment expenses be a good match to any fund-based commission provide a broad hedge against inflation of ongoing policy expenses. The policy fee could be a good match for ongoing expenses, especially if the policy fee increases in Iine with inflation. The company should test sensitivity of profit to key items of experience, eg unit fund performance, persistency, new business mix. Extent of cross-subsidies The cross-subsidies in the charging structure need to be considered. The allocation rate and AMC are proportional to premium/fund size, so there will be a cross-subsidy from larger policies to smaller ones. Cross-subsidies leave the company at risk from changes in the mix of business, eg selling fewer large policies than expected. The company could reduce this cross-subsidy by applying a higher allocation rate to larger policies than to smaller ones. There may also be cross-subsidies between different unit fund choices, eg because some may be more expensive to manage. Different AMC rates could be applied to different funds to deal with this. Consistency with other products The company should aim for a charging structure that is consistent with its other products, so that existing policyholders are not disadvantaged. Eg, if charges were lower on the new product, existing customers might feel unfairly treated, and decide to surrender their policies. Admin systems The company's systems would need to be capable of administering the types of charges proposed. This may include its ability to handle variable charges and those that vary by choice of unit fund. This will depend on how similar the product is to the company's current products. Regulatory requirements The company should comply with any relevant regulatory requirements and professional guidance, eg: maximum charge caps treating customers fairly. Overall The company should aim for a balance between conflicting pressures on charges, eg marketability and profitability.
      • Eg: Determine a suitable product design and price for a funeral cost insurance
        • A large multinational company is in negotiations with the government of a country to write a scheme to provide child funeral costs. A significant population is low income, and the infant and child mortality rates are relatively high. The scheme would provide cover for all children of the policyholder, and the premium would be the same irrespective of the number of children covered . The benefits would be to provide all the basic funeral costs on the death of each insured child if this occurs before age 18. The policy would continue after the death of a child if there are other alive children. Underwriting would be on a health questionnaire basis only. The policy would automatically include all new-born children. The government would endorse the insurance company and would allow tax relief on premiums. The insurance company would be the only company allowed to provide this type of insurance. The company does not currently write this type of contract in any other country. Profitability Need to ensure that premiums will be sufficient to cover benefits and expenses in most foreseeable circumstances, and provide a profit. The required profit margin depends on the risk appetite of the company. The expenses to be covered include the costs of administering the business, a contribution to overheads and recovery of the development costs of this new product. Consider profitability on an aggregate basis, ie based on assumed sales volumes and mix, as well as on an individual policy basis. A higher premium can be charged as there are no competitors in this market. Strict underwriting could be applied to avoid anti-selection from parents of sick children. The company may retain the right to review premiums in adverse circumstances. The above three features may improve profitability but may mean that the government would not endorse the product. Many potential policyholders have low incomes, making it harder to charge a sufficiently high premium to cover expenses. The high child mortality rates will increase claim costs. Lapse rates may be high if policyholders cannot afford their premiums. Marketability Need to offer benefits which are attractive to the target market. The relatively high infant and child mortality rates suggest there is a need for this product. Coverage for all children, including new-borns, is an attractive feature. The government endorsement should increase marketability. Cover is provided until each child is 18, but a lower age would be cheaper, and may fit needs better, and so would increase marketability. Should consider what guarantees should be given, eg that premiums will not increase on the birth of further children. Should consider the premium frequency (regular premiums may be more affordable) and premium payment method. Competitiveness The usual competitiveness considerations do not apply if negotiations are successful so that no other companies are allowed to sell this contract. If the negotiation process is competitive, then the company will need to consider its attractiveness to the government, eg product design, price and financial strength. Financing requirement The contract design should minimise its financing requirement. There is limited scope to achieve this given the guaranteed nature of the benefits. Risk characteristics Consider the level of risk associated with the proposed contract design. An acceptable level of risk depends on the company's ability or willingness either to absorb risk internally or to reinsure it. The main risk is higher than expected claims, eg multiple claims due to large family size. The risk of anti-selection is high as underwriting can only use a health questionnaire and all new-born children are automatically covered. The risks are greater because the company does not write this type of contract in any of the countries in which it operates. Other risks include smaller than expected average policy sizes, and higher than expected funeral costs. Higher funeral costs may arise because of inflation or because of poor wording leading to uncertainty about what is included in 'basic funeral costs'. Onerousness of any guarantees Given the simple nature and desired low cost of this product, further guarantees are unlikely to be offered. Consider cross-subsidies as these leave the company at risk of the mix of business being different from that assumed. Smaller families cross-subsidise larger families as the premium is the same irrespective of the number of children covered . Administration systems System requirements may limit either the benefits to be provided or the charging structure to be adopted. The administration system needs to be able to cope with the addition of extra lives to the cover mid-term and to allow for a death claim without the policy ending. The distribution channel, including the level of advice given, will influence how complex the product and available options may be. Given the rationale for this product and the fact that there is a single government-endorsed provider, the product is likely to need to be simple. It is also in the interests of the administration system, policyholders and the company's staff that the product be simple. The company may not have systems in place to cope with this type of product as it does not offer this contract in any other country. Consistency with other products Consider consistency with any similar products sold in this market. Meeting regulatory requirements Follow any regulatory requirements, eg maximum premiums, treating customers fairly, permissible rating factors. There is a risk that regulations might change, particularly if there is a new government. The policy will benefit from the tax relief that is available on premiums. Consider how the policy will be treated in the company's tax calculations.
      • Eg: Add a minimum death benefit guarantee
        • A life insurance company is developing a conventional without-profits whole life product. The product has a relatively low maximum sum assured and customers will be accepted without any underwriting. It has been suggested that the policy terms be altered so that the benefit paid on death is the higher of the selected sum assured and the total premiums paid to the date of death. Discuss this suggestion. The benefit is unchanged at younger ages, increased at older ages. This increase is increasingly significant the older the age at death. Marketability may be improved, and so sales volumes may increase. The increased death benefit will increase costs for the company. So profits could be reduced considerably. The company could increase its premiums, but this would offset the increased marketability of the added benefit. This would also bring forward the point at which the guarantee bites (ie where the total premiums paid first exceeds the sum assured). This will increase costs further. The mortality assumptions need to be high due to no underwriting. This will also lead to high premiums and hence the guarantee to bite earlier. The impact on profits of higher volumes but potentially lower per-policy profit would need to be estimated. Policyholders who currently pay in many years' premiums may receive a benefit that is lower than the total amount of premiums paid. So the suggestion may make the policy fairer. The risk of complaints and the costs of dealing with them should reduce. The risk of reputational damage, and of regulatory interventions relating to the possible unfairness of the policy, should reduce. The new feature may be needed to match competitors' products, or to provide differentiation. New business strain could increase, due to the higher reserves needed for the higher death benefits, and the potentially higher sales volumes. So the company's level of available capital should be considered. Higher sales volumes might also strain the company's admin resources. The systems requirements will be more complicated than before.
      • Eg: Reduce surrender penalty scale
        • Financing Need to consider financing requirements. Surrender values have increased, and if reserves need to be as high as surrender values, the reserves will also increase. The non-unit reserves will increase if surrender penalties are explicitly allowed for. Need to consider whether there is sufficient capital to support these increased reserves. Regulatory issues Ensure that the change does not contravene any regulations. Ensure that it meets requirements to treat customers fairly. The proposal would appear to treat existing customers fairly compared with new customers. Not implementing could cause significant reputational damage. The policy conditions would need to be checked to see if this change could be made part way through the term. The existing surrender schedule is likely to have been included in the original policy documentation. It would be unusual under a unit-linked policy to change policy conditions part way through the lifetime of the policy. Would need to write to all existing policyholders to inform them of the new structure. However, as the change is to the benefit of policyholders at all policy durations, there may not be any issue. Offering the same improved benefits to existing as to new policyholders may be seen positively by the regulator. May be complaints from customers who surrendered before the change. Consistency with other products There may be pressure to make equivalent changes to the company's other product types. Extent of cross-subsidies There will be increased cross-subsidies between maturities (ie the continuing policyholders) and surrenders, so the surrender basis is less fair to the continuing policyholders. Sensitivity of profit Would need to test the sensitivity of profit to changes in the key assumptions, in particular to changes in: surrender rates expenses unit growth. Competitiveness and distribution channel Ensure the change does not bring the company out of line with other companies, so as to remain competitive. More pressure to make the change if competitors are doing the same. Level of competitiveness needed also depends on distribution channel. Competitors' actions can also affect surrender experience. Risks There is likely to be an increased risk from surrenders. The company would need to look at recent surrender experience. However, future surrender rates may be different from previously, and will need to be estimated. Doing this will be difficult as there will be no data for the new situation. The impact of the change may not be too onerous, eg if : surrender rates are generally low surrender rates are low in the last five years of the policy duration. Surrender rates may particularly increase in the last five years of the contract, as there is now no penalty. The change may trigger a spate of surrenders, where policyholders might take advantage of the one-off increase in surrender values. No benefit is gained by existing policies who lapse and re-enter, so this should not be an issue. Policyholders would be more likely to surrender in order to purchase a competitor's product or an alternative type of savings vehicle. Admin systems and expertise Computer systems, marketing literature , policy documentation and admin processes would need amending. The risks and costs involved would need to be considered. All the costs would need to be reflected in the cost/benefit analysis for the project. However, the admin and other systems will be no more complex than before, as the two product designs will be consistent. Marketability The impact on the attractiveness of the product should be considered. Marketability should be enhanced, as higher surrender values are being paid to existing as well as to future new business. Over the longer term, persistency experience on the existing business should improve, and sales of new business should increase. Profitability The overall impact on profits would need to be assessed. The impact of competitors' actions on profits should be allowed for. Profitability is likely to reduce in the short term due to: the one-off surrender rate increases the additional reserve requirements the costs of admin and system changes. The ongoing profitability of the existing business would be expected to fall, everything else being equal. Alternatively, ongoing profitability could improve if persistency improves and new business volumes rise. Will need to consider how the revised profitability will vary with duration in force, and whether the overall charging structure remains profitable. The company could consider increasing charges to cover the increased costs, but this is unlikely to be possible.
      • Eg: Determine a suitable product design and price for an annuity product
        • A proprietary life insurance company has historically only written unit-linked business using a direct salesforce. The company is considering developing and launching a new conventional without-profits immediate annuity product. It intends to sell this product using direct marketing. Marketability Need to consider the marketability of the product. The product needs to be attractive to the target market in order to sell in the required volumes. Attractive features may include a low price, and a choice of benefit features such as: index-linked or level better terms to impaired lives spouse's benefit surrender value. Distribution channel Consider how the target market will change when moving from a direct salesforce to direct marketing. Given that this is a new product and new distribution channel, the company will need to research the likely market. The company will need to consider which direct marketing type to use. Products will need to be relatively simple, but may vary according to which type(s) of direct marketing is/are used. Competitivenes The price and design of this company's product should appear at least as attractive as any competitor products sold through the same channel. The immediate annuity market is typically competitive, having frequent (and published) league tables. Competitiveness may vary by type of direct sales channel, eg internet will be competitive due to the presence of product comparison websites. Profitability and pricing Need to consider the profitability of the product. Total premium income over whole business needs to cover all benefits and expenses, including required share of overheads and development expenses, and make at least the required level of profit. Optimise between increasing sales (by lowering the price) and increasing the per-policy profit margin (by increasing the price). Aim is to maximise total profit, allowing for the cost of fixed overheads and development expenses. Need to meet shareholders' requirements, so consider the relevant profit criteria, such as: increase in embedded value (or net present value) obtained return on capital employed discounted payback period. Consider the pricing assumptions, including mortality, investment, expenses, inflation, new business volume and new business mix. The assumed mix of business will be important in order to set risk factors and model points. The costs of setting up the new distribution channel need to be covered. The target market will need to be considered in order to set the mortality assumption. An appropriate projection of future mortality improvements will need to be made, and included in the basis. It is particularly important to reflect the level of longevity risk in the price. With no relevant own data, will need to consider whether to use some relevant external (eg industry) data and/or seek advice from reinsurers. Consider the pricing margins needed as a result of having limited data. Higher risk margins will be needed at least until the company gains sufficient credible experience of its own. The company is also unlikely to have experience in estimating future longevity improvements. Consider the intended backing assets, which are crucially important to annuity pricing: typically fixed-interest or index-linked bonds as appropriate possibly including use of corporate bonds to gain higher yields. The cost of any reinsurance used will also affect the pricing. Extent of cross-subsidies The company needs to consider the likely extent of cross-subsidies in the business, and their implications, eg: between the new product and the unit-linked product between large and small policies each of which create mix-of-business risks. The company may need to institute size limits, or differential pricing, if it wishes to reduce these cross-subsidies. Sensitivity of profit Consider the sensitivity of profit to variations in experience. This will include sensitivity to changes in mortality, investment return, expenses, inflation, and new business volume and mix. Sensitivity tests, involving these factors, would need to be carried out. Risk characteristics The risk characteristics of the product will need to be considered. Consider the relative risk characteristics of particular designs, eg the combined effects of longevity and inflation for an index-linked version. As new product and channel, without existing data, there is a high risk that the pricing and reserving assumptions will be inappropriate. High risk from future mortality being lower than expected, and/or future mortality improvements being greater than expected. There is an anti-selection risk, as the policy will be most attractive to more healthy people. The anti-selection risk will depend on the extent to which underwriting is used and whether impaired life annuities are offered . Risk from high new business sales if there is a new business strain. Risk of making large overall losses if the launch is unsuccessful and very few policies are sold. There are likely to be investment risks due to: default risk if the backing assets include corporate bonds extent to which the assets and liabilities are not matched by term. The availability of bonds of long enough durations to match the liabilities will contribute to this. Reinsurance might be used to help reduce any capital requirements or to mitigate some of the longevity or expense risks. Consider any other mitigation techniques that could be used. Financing Consider the capital required for the contract, and if there is enough capital available to cover this without risking supervisory insolvency. Bear in mind any differing capital requirements for a conventional product compared to the existing unit-linked products. Unit-linked policies are likely to be relatively capital efficient, so current finances may not be able to cope with a large capital requirement. So the company may need to be careful to limit the rate at which policies are sold over any given time period. Aim to minimise the capital required to sell a policy. Combination of no initial commission and the large single premium should help reduce the initial capital requirement. Some designs (eg those with guaranteed payment periods) may be more capital intensive than others. The guarantees and high parameter risks lead to high reserves and/or required solvency capital, so a significant capital strain is still likely. The cost of capital should be factored into the price. Any restriction on sales volumes caused by capital requirements may have implications for the chosen pricing level. Guarantees Consider adding further guarantees or options to the contract, eg: return of any balance of premium on death guaranteed minimum payment period. These should reduce the likelihood of complaints from recipients of the estate following the early death of an annuitant. These might increase marketability, but should be considered against the increase in risks and the extra cost of capital caused. Administration systems and other expertise Consider whether administration systems can be in place, along with any other expertise required, to manage the new product adequately. Processing regular payments will be new. As the company currently has nothing in place, there should be no administrative constraints on the chosen design. Certain design features are more difficult to implement than others. Consider whether administration should be outsourced. The cost of these changes should be factored into the product pricing. Regulation Need to consider whether there are any regulatory constraints or limitations on the design and/or price of the product. For example, it may not be permitted to charge different premium rates to males and females . Need to consider regulatory requirements for treating customers fairly. Consider whether there are any regulatory opportunities associated with adopting certain designs, eg particular tax benefits or allowances. Consistency with the existing unit-linked product The two contract types are very different and therefore hard to compare directly, so this should not be a big issue.
      • Eg: Considerations in launching a new internal UL fund
        • A life insurance company has an established portfolio of unit-linked products and a wide range of internal unit-linked funds available to policyholders. The company is considering offering a new internal unit-linked fund in the near future. Discuss the issues the company may consider prior to launching the new internal unit-linked fund. we need to be careful to restrict our answer to the launch of a new unit-linked fund, not a new unit-linked product. Profitability Consider the charges for the fund and whether it will cover the admin expenses and meet the company's profit criteria. Consider whether there will be sufficient volume of investment in the new fund for it to be profitable. Consider the expected business mix in the new unit fund, e.g. size of fund per policy. Marketability and competitiveness Carry out market research to investigate demand for the proposed fund. Consider whether the new fund is sufficently different from the company's existing funds and whether the addition of the new fund choice improves the marketability of the company's unit-linked products. Consider whether competitors offer similar funds, e.g. would the new fund give the company a competitive advantage? Whether the new fund is being asked for by intermediaries Financing requirement Consider the impact of the asset classes on the company's reserving and capital requirements. Risk Consider whether the fund is appropriate for policyholders and their attitude to risk. Consider whether the intended assets are sufficiently liquid to meet the need for withdrawals from the fund. There may be ethical reasons that make the asset class unattractive to customers and be inconsistent with the company's brand or would cause reputational damage. Administration systems Administration systems will need to be updated to include the new fund and there may be some staff training required. Other funds Customers may select the new unit-linked fund in preference to an existing fund. In this case any extra income may not justify the extra costs involved. Similarly, offering the new fund may encourage more switching from other funds, with associated extra expenses. Meeting regulatory requirements There may be regulatory restrictions, eg on assets permitted within unit funds. Consider the tax treatment of the asset classes in the proposed fund. Fund operation Consider the likely asset mix of the new fund. Consider whether the company has sufficient expertise to manage the fund. The company will need to determine the details of the fund's operations, eg when priced , how frequently, by whom
      • Eg: Advantages & disadvantages of UL annuity product
        • For the policyholder Advantages More control over the investment strategy. Conventional annuities usually invest in fixed-interest bonds. The new product allows a riskier investment strategy to be adopted. The policyholder would then expect their income to increase over time. This will be attractive to policyholders with a high risk appetite, or those with other guaranteed income sources. The ability to change funds will help the policyholder to manage their investment risk as circumstances change. Higher returns may help to mitigate the effects of inflation. Disadvantages The policy is complex and may be misunderstood. This may lead to inappropriate investment decisions and poor returns. As policyholders age they may become less able to manage the policy. Investment freedom is limited to choosing one fund at a time. The policyholder no longer has certainty over the amount of income. There is a risk of lower than expected income, particularly for policyholders where this is their only source of income. Income will be more variable and may lead to differences in tax from year to year. If charges relate to the unit-price, the policyholder may end up paying more in charges. Policyholders may require advice and this will come with a cost. For the company Advantages The product may be popular with high net worth customers. Unit linked policies could be more profitable to the company due to : higher charges larger policy size (eg high net worth clients) larger business volumes, reducing per policy cost. Good investment returns may attract more policyholders. The investment risk is passed to the policyholder, so capital requirements may be lower. Disadvantages Marketing effort will be greater due to the complexity of the product. There is a higher potential for mis-selling. The market for such a product may be small. Sales will be low if funds perform poorly. This product will involve considerably more cost to run. New business administration will be greater due to fund choice. Ongoing administration will be greater, due to the switch facility. The tax treatment of annuities may be different to pensions requiring differently priced unit funds. Administration systems will be more complex. The complexity of the product may lead to errors. There is a greater risk of mispricing unit funds, given there are now more unit linked products. There may be complaints due to poor investment performance. So there is greater risk of reputational damage. There is a risk of adverse regulatory scrutiny, particularly if issues arise. There will need to be significant system development and training. These costs may not be recouped. Whilst investment risk is passed to the policyholder, some risk is retained if charges are linked to fund value. Capital management will have to be in terms of units not cash, so changes in capital requirements will be less predictable. The company retains longevity risk, but this risk is now in terms of the units. So rising unit values increases the longevity risk.
      • Eg: Add a new unit-linked fund to the range
        • Profitability Consider whether the new fund would increase profitability. Consider the fees that the external investment bank will charge. Marketability Consider whether this new asset class would be appropriate for the target market, eg the expected return and level of risk. Ethical reasons might make the asset class unattractive to customers and could cause brand damage. Consider whether the asset class would be understood by the target market. Carry out market research to investigate demand for the proposed fund. Consider any experience of this asset class being sold in other jurisdictions. Competitiveness May give the company a competitive advantage as competitors do not invest in this asset type. May generate new business by attracting new customers from different target markets. May also lead to increments to existing business. Compare the charge for the fund with other funds. Financing requirement Consider the impact of the asset class on reserving and capital requirements. Consider whether the company has sufficient capital resources to cover these requirements, including any costs or strain associated with increased new business volumes. Risk Consider whether the company has sufficient expertise to invest in the new asset class. Consider the reputation of the investment bank. Consider the reliability of the bank's advice. Consider the counterparty risk introduced through the use of an external investment bank. Consider whether the asset class is sufficiently liquid to meet the need for withdrawals from the fund. Distribution channel Consider whether the asset class would be appropriate for the distribution channel(s) used by the company. An unusual asset class might be appropriate for face to face channels, especially insurance intermediaries. The unusual nature of the assets makes it unlikely to be appropriate for direct marketing. Administration systems Administration systems will need to be updated to include the new fund. There will also be costs associated with amending marketing literature and extra staff training. Other products Customers may select the new fund in preference to an existing fund. In this case any extra income may not justify the extra costs involved. Meeting regulatory requirements Regulatory restrictions may prevent the company from using the new asset class. In is not unusual for regulators to restrict the asset types in which an insurance company might invest. There may also be restrictions imposed by the investment bank, eg maximum fund size. Consider how the asset type would be taxed.
      • Eg: Considerations in comparing two designs
        • A life insurance company that primarily sells term assurance business is looking to introduce a new version of the product. This version would be offered online and via insurance intermediaries. Option A: A term assurance with a simplified underwriting process whereby customers are accepted provided they can answer a series of basic questions. The minimum term of a policy is 5 years. Option B: A term assurance using the company’s standard underwriting process, but offering the option to convert the policy into a whole of life assurance at the end of the term with no further underwriting at that stage. The premium will be revised at the point of conversion to reflect the policyholder’s age and the original underwriting decision. Profitability The company will want to assess each design against its profitability criteria, such as discounted payback period internal rate of return and net present value Expected volume of business would also be an important factor Sensitivity of Profit: Sensitivity of profit should also be considered with a lower sensitivity being preferable Marketability / Distribution channel: Benefits offered need to be attractive to the market in which they are to be sold A is likely to be more attractive as an online offering due to its simplicity and potential for low premiums B is more complex and less suited to online sale and would be more appropriate for sale via insurance intermediaries B would also require a higher premium for the same profitability due to the guarantee However, the guarantee offered could be attractive for a certain target market Competitiveness: Premiums should not depart too much from competitors A is likely to be operating in a very competitive space and this may limit the level of premium that can be charged, affecting profitability But this also means the generation of high volumes is possible. A’s competitiveness depends on how restrictive the limited underwriting is, as policyholders may be rejected B is likely to be less common in the market, which gives more leeway in setting premiums But may limit overall volumes Financing requirement: The company will want to minimise its financing requirement Both products will incur setup costs to put into production, market etc. B is likely to have higher costs to produce due to more complex design Per policy costs for A should be lower Total cost could be higher due to volumes though And any increase in reserving requirements as a result of limited underwriting. B will have higher per policy setup costs due to initial underwriting requirements Plus further costs on enacting the guarantee Onerousness of guarantees: The company needs to consider the onerousness of any guarantees This is not an issue for A which does not offer any substantial guarantee The conversion option under B has the potential to be onerous As it introduces potential for anti-selection Risk characteristics The level of risk associated with the product design must be acceptable to the company Both A and B have limited sensitivity to market risks But are sensitive to changes in mortality risk and changes in lapse rates Both A and B have potential for anti-selection due to how underwriting is applied A has a larger risk of fraudulent responses by applicant due to the lack of underwriting A could lead to lapse and re-entry on existing product due to lower premium (at lower ages) B is also sensitive to take-up rates on the guarantee And becomes more sensitive to market risk post-conversion If the risk is deemed too high it would be possible to reinsure the business to reduce some of the risks Although this would reduce profitability Cost and availability of reinsurance should also be considered Extent of cross subsidies: For both designs the company needs to decide on the level of cross subsidies between contracts of different age, term, and sum assured This may be more important for A due to the high competitiveness of the market And the need for the marketing advantage of a simple premium structure Administration systems / Consistency with other products in the company: Any revision to administration systems will affect profitability / premiums Consistency with other products in the company should be considered A should be consistent with the existing term assurance offering And would require less adaption of administration systems than B. B may be a new product for the company, and it may have limited expertise Regulatory requirements: The design must adhere to regulatory requirements
      • Eg: Considerations in comparing two designs
        • A life insurance company is considering entering the single premium unit-linked savings market in a particular country. It is considering two possible contract designs. Both designs have annual fund-based charges expressed as a percentage of the value of units and have no other charges. The charge is reviewable. Design A pays the value of units on death or surrender. Design B pays the value of units on death or surrender and guarantees to pay 110% of the premium on the 10th, 15th and 20th policy anniversaries. The charges under both designs have been set so that they each achieve the same level of profitability using the company's required rate of return on capital. Neither design includes a surrender penalty. All assumptions used in the pricing are the same for both designs. Among other things, the company is considering the following factors to help determine which design to choose: profitability sensitivity of profitability competitiveness and marketability financing requirements risk characteristics. Discuss these five factors in relation to the two designs. Profitability As set out in the question, both designs achieve the same level of profitability using the company's required rate of return on capital. In addition to the per policy profitability, the company should consider aggregate profitability allowing for expected new business volume. The company may also want to consider other profitability measures, for example, the net present value and the payback period. Sensitivity of profitability The company should carry out sensitivity tests on the major assumptions to assess the variability of profit with changes in experience. Both designs will be sensitive to investment returns as the only income is from the fund-based charge which depends on the value of units. For both designs this charge is reviewable and so the sensitivity will depend on whether charges can be increased sufficiently when required. Design B will be more sensitive to investment returns due to the guarantees which will cost more if investment returns are poor. Competitiveness and marketability The main features affecting the marketability of both designs are the benefits provided to the policyholder and the level of charges. The simplicity of design and comprehensibility of literature will also be relevant features. In order for the two designs to have the same profitability, Design B would have a higher charge, due to the cost of the guarantees Design A has a higher surrender value, due to the lower charges, unless the Design B guarantee is in the money The level of guarantees offered by the competitors will need to be considered: It might be easier to sell a contract that is more clearly in line with other companies alternatively different levels of guarantee may lead to a marketing advantage Financing requirements Design B will have higher capital requirements until 20 years have passed. This may be an important factor if the life insurance company's capital is limited Risk characteristics Both designs are exposed to expense risk due to poor investment returns, the extent of which depends on how easy it is to vary the charges if investment returns are poor. There may be a risk that whilst charges are reviewable they may not be able to be applied due to competitive or regulatory issues. Design B is heavily exposed to poor investment returns due to the guarantees Design B may suffer from poor sales due to its higher charges, leading to the risk of inadequate business volumes leaving it unable to recoup initial costs
  • Assumptions
    • Purpose of the basis
      • The guiding principle in constructing any basis is consistency. This means that the relationships between the assumptions in a basis are realistic, reflecting the correlations that exist between variables.
      • Pricing
        • Principle of consistency Ensure that we make realistic allowance for the way that variables behave together, where correlations exist between them: sometimes the relationship between two parameters will be more important than the absolute values of those parameters. Investment return and inflation The long-term relationship between the rate of expense inflation and the rates of return on different types of asset must be valid. Tax If the company is taxed on 'I-E' type taxation then the investment return assumptions and the expense assumptions should both reflect the same tax treatment. In profit testing the product, the profits should be measured net of tax. New business and expenses If developing a new product, then the development expenses w ill need to be recouped, and the product should be designed to make an appropriate contribution to the company's fixed expenses. Investment return and bonus loading These must be consistent in situations where bonus needs to be loaded for specifically. Persistency rates and investment return Persistency rates can be affected by the general economic climate, which will be one of the major factors behind the investment return assumption. Persistency may also be affected by bonus levels, discontinuance terms and renewal commission levels. Other products The basis should normally be consistent with that of related products. Margin Where a cashflow model is being used to price a life insurance contract, the risk to the company from adverse future experience may be allowed for through: the risk element of the risk discount rate using a stochastic approach assessing what margins to apply to the expected values. If a formula model is being used for pricing, the first two approaches above are not available and the risk of adverse future experience would be allowed for by taking margins. However, such a model does not help the actuary to quantify what these margins might be and they must use judgement based on their experience.
        • Eg: Assumptions for the launch of a UWP bond
          • The following assumptions will be needed, primarily for pricing: expenses: lower than for unit-linked, as less-complex unit-pricing bonus management will increase costs development costs ultimately need to be covered by cashflows inflation of expenses: generally similar to current contract new business volumes: to spread the development and overhead expenses new business mix where any cross-subsidy exists eg between large and small policies the commission that the company intends to pay mortality: unlikely to be important as there is little death strain probably use same assumption as for unit-linked lapse rates: important and may differ from current if the class of life is different adjust to allow for effect of any differences in surrender penalties, and for any durations at which no MVR applies partial withdrawal rates: similar to current adjusting for any differences in product design adjust for any financial selective effects (eg if allowed without MVR) selective impact of withdrawals: important if death benefits are much higher than surrender values investment returns: may differ from current if backing assets are different may need stochastic model, eg if there are non-MVR withdrawals risk discount rate - may differ from current due to: new product (more risky) having more stable per-policy cashflows {less risky) having different risks (eg associated with bonus payments) profit criteria - may differ from existing product: could have lower profit requirement until sales are established to reflect different competitive pressures.
        • Eg: Assumptions for setting prospective SV and considerations
          • A company operates in a market where it is not currently possible to surrender an in-force immediate annuity for a cash sum. Legislation is being proposed that would allow surrenders of in-force immediate annuities in exchange for a cash sum from the original annuity provider. It would not be mandatory for life insurance companies to offer surrenders to their annuity policyholders, but the change in legislation would mean that it would now be possible to do so. Assumptions needed interest rate longevity future longevity improvements regular expenses expense inflation surrender expense benefit inflation (if the annuity is index-linked). Factors to consider Consider including a margin in each assumption for uncertainty. As surrender values have not been offered before, the level of uncertainty about future experience will be high. Interest rate Set interest rate assumption by reference to future returns on assets backing annuities. These assets are likely to be a mix of government and corporate bonds. The term of matching bonds for those surrendering in worse than average health will be shorter than the average term of bonds backing the annuity portfolio as a whole. Or the company could use its pricing assumption. Yield on index-linked bonds may be used for index-linked annuities to avoid the need for a separate benefit inflation assumption. A higher interest rate assumption will result in a lower surrender value. Longevity Assumption should reflect the expected future experience of the lives who will surrender. Consider the likely extent of selection. Policyholders who surrender are likely to be in worse health than those who do not. Severely ill policyholders are most likely to surrender as the cash sum is more valuable for them than a short series of future annuity payments. Those in ill-health may also have more need of a cash lump sum now. Important not to overstate assumed longevity as this leads to higher surrender values. But also need to consider responsibility to treat customers fairly. Assumption can be set as an adjustment to a standard mortality table. The adjustment could be derived by analysing the company's own experience with the data divided into relevant homogeneous groups, subject to adequate levels of data being retained within each cell. The pricing assumption is much less relevant here due to selection. Distinguish between standard and impaired annuity experience. Those with smaller annuities may be more likely to want to surrender as the annuity amount may make little difference to them. So consider mortality experience split by annuity size. Monitor and refine the assumption over time as experience emerges. Future longevity improvements Consider future expected improvements in mortality. Assumed improvements should be specific to the population who are likely to surrender. Whether these are allowed for may depend on industry practice. May decide not to allow for any future improvements. Regular expenses Analyse company's recent experience for annuity business. May split expenses into per policy amounts and proportional to benefit. Avoid overstating expenses as it results in higher surrender values. Could use pricing assumptions if annuity was sold recently. Per-policy expenses could be increased to allow for lower expected volumes in force if surrenders happen. Expense inflation Consider expected future rates of inflation. Consider both price and earnings inflation. Assumption may be based on the differential between the yields on government fixed-interest and index-linked bonds. A higher inflation assumption will result in a higher surrender value. Inflation and interest rate assumptions should be consistent. Could use pricing assumptions if annuity was sold recently. Surrender expense Reflect the expected cost of processing the surrender request and making the surrender value payment. There is no directly relevant past experience. May use company's surrender expenses on other types of business if the costs are expected to be similar.
        • Eg: Reasons for reduced premium rates
          • A life insurance company sells without-profits term assurance policies with level sums assured to individuals. The premium rate charged by the company varies by the policyholder's age at entry and their selected level ofsum assured and term. Premium rates in 2011 were 25% higher than those charged in 2021. There have been no changes to the company structure over this period, which would have impacted the premiums. Suggest possible reasons for the reduction in premium rates between 2011 and 2021. The company's assumption for future term assurance mortality may be lighter This may due to general population mortality improvements in the country concerned or to a change in the company's term assurance target market to experience lighter mortality The company's assumption for future expenses may be lower This may due to the company improving the efficiency of its admin systems over the ten years or to higher business volumes allowing more spreading of fixed expenses and lower per policy expense assumptions. The company's assumptions for future expense inflation may be lower reflecting a general market fall in inflation. Commission levels may be lower if the company has made changes to its sales channel's remuneration. The company's assumption for future investment returns may be higher although the impact of investment returns is reduced as reserves for term assurance are small. The company may have changed its profit criteria to accept lower levels of profit perhaps due to an increase in the level of competition in the market since 2011. The company may have had higher margins in its assumptions in 2011 especially if it was new to the term assurance market at that time. The solvency capital requirements may be lower than in 2011.
      • Liability valuation
        • The basis for a valuation should reflect: expected future experience margins to ensure adequacy of reserves legislation / regulation (for published reserves) the need for consistency The basis for a valuation will depend on whether the accounts are to be published or are only for internal use. Any published accounts may be subject to legislative constraints, in particular regarding: whether a going-concern or break-up basis is to be used whether the accounts have to be true and fair whether assumptions should be best estimate or include margins Internal aacounts are usually based on best estimate assumptions. Supervisory reserves may require prudential margins or may be calculated using a market-consistent approach. Pricing basis VS reserving basis In some countries, calculate premium rates using prudent assumptions and use the same assumptions to calculate the supervisory reserve. suitable for with-profits contracts as surplus will emerge from actual experience better than assumed in the prudent assumptions. less justifiable in the case of without-profits contracts. In other countries, calculate premium rates using real world assumptions broadly reflected expected future experience, with an appropriate allowance for profit and risk. Supervisory reserves can be based on market-consistent or prudent assumptions, with allowance for risks covered by an appropriate amount of solvency capital. If the reserving basis had been used for pricing, this may not have produced a sufficiently competitive product. In other regimes there has been a move towards using best estimate or market-consistent assumptions in reserving. In this case the basis for pricing and reserving could be quite similar. Consistency The start point in selecting a valuation basis will be the basis used for the previous valuation. Any deviation from that must be justifiable. However, it would be appropriate to change the basis if new evidence was available. Changing the basis for a supervisory valuation can have a significant impact on the published financial results of the company. A weakening of the basis may require justification to the regulatory authorities that there is some real justification and that it has not been done just to accelerate the distribution of profits to shareholders or to improve the reported solvency position. A strengthening of the basis may require justification to the fiscal authorities that it has not been done to delay profits and hence delay the payment of tax.
        • Eg: List assumptions for non-unit reserves and factors to consider when setting the assumptions
          • Assumptions needed include: Mortality rates Surrender rates Partial surrender rates Paid-up rates Renewal expenses (eg renewal commission) Claim expenses Switching expenses Switching frequency between different funds Investment expenses Expense inflation Investment return on each unit fund Tax Valuation discount rate Rates of fund switching Consumer price index inflation Assumed future fund mix (to determine average annual management charge) Future levels of premium Volumes and mix of new business (for allocating overheads) The general factors to consider when setting the assumptions are: the degree of prudence required for supervisory reserving the margin (if any) that should be included for adverse deviations the company's past experience on similar contracts allowance for future trends and anticipated changes in experience (where prudent do so) assumptions used last time, in order to avoid arbitrary changes assumptions being used by other companies assumptions being used by this company for other purposes, eg pricing any relevant regulation and professional guidance. For the assumed investment return on unit funds consider: the assumed asset mix in each unit fund (alternatively the actual asset mix held at the valuation date might be used) the expected returns on those assets a low unit growth assumption would be prudent alternatively may use a risk-free rate (eg based on Government bond yields). For the demographic assumptions: Look at company's past experience in respect of similar contracts. Mortality is not an important assumption given the small size of the sum at risk, and rates would be expected to be low. The mortality assumption should be based on a standard table for the correct location, adjusted to reflect company's own experience. A high mortality assumption would be prudent. A high surrender assumption would probably be prudent, assuming future charge income exceeds future expense and benefit outgo. A high partial surrender assumption would be prudent, as partial surrenders reduce the fund size and hence the expected charges. For the expense assumptions: Use a recent company expense analysis as a base. The expenses should include an appropriate share of overheads, which may involve considering future new business volumes. Allow for expense inflation. High assumed expenses would be prudent. For the expense inflation assumptions: The company should consider the sources of its expense inflation, eg salary inflation. Base the assumptions on market data and economic indicators. Should be consistent with assumed unit growth and discount rates. High assumed expense inflation would be prudent. For future annual management charge {AMC): Average AMC will depend on the mix of funds held. The assumed mix could be based on eg the actual mix as at the valuation date or the average over a recent time period. A low average (AMC) would be prudent. A low rate of inflation of the consumer price index (to inflate the policy fee) wouId be prudent. For the valuation discount rate: May be based on a risk-free rate, eg based on swap rates or government bond yields. A low discount rate is prudent. For the switching assumptions: Look at recent rates at which policyholders' switch funds. If switch costs exceed switch charges, it would be prudent to assume more than two switches per annum. Tax assumptions should be based on current tax rates and allow for any known or expected changes.
        • Eg: Assumptions for the reserves of immediate annuities
          • The assumptions used should take into account any rules and guidance issued for supervisory valuations. The assumptions should be prudent by including a margin for adverse experience. Investment return Required to discount the future cashflows. Set with reference to the intended investment mix and the current return on these investments. Allow for the risk of default of these assets. Allow for reinvestment risk if asset proceeds occur before benefit payments. A margin should be taken by decreasing the investment assumption. Mortality Required to estimate the number of future payments that will be made. Set to reflect the expected experience of the annuitants. Use data from company's own annuity business (and other sources if own data is insufficient, eg CMI reports or reinsurers). Separate data into homogeneous groups, eg age, gender and location. Allow for expected improvements in longevity. A margin should be taken by decreasing the initial mortality rate and allowing for faster mortality improvements. Expenses Assumption needed for future regular and termination expenses including a contribution to the overheads of the company. The company should analyse its own past expenses. A margin should be taken by increasing the expense assumption. Inflation Required for inflation of expenses and inflation of index-linked benefits. These rates of inflation may be different, but should be consistent with each other (and with the investment return assumption). Consider current and expected future rates of inflation, both for prices and earnings The market's expectation of inflation can be derived from the difference between the yield on government fixed-interest and index-linked bonds. Consider also recent actual experience of the life company or industry. A margin should be taken by increasing the inflation assumptions. Tax Any tax on investment return, and tax relief on expenses, must be allowed for. This can be done explicitly or by reducing the investment and expense assumptions.
        • Eg: Whether change the supervisory valuation assumption
          • A large life insurance company has a portfolio of without-profits term assurance policies. The results of the most recent experience investigations for these policies have been summarised in the table below. The results compare the actual experience across the whole portfolio over the last year and over the last 5 years, with the equivalent assumptions used in the supervisory valuation.  General comments Supervisory valuation assumptions are long-term assumptions and hence need to reflect expectations of the long-term future The assumptions may also include an element of prudence. Mortality The long-term experience would appear to be in line with the assumptions. The long-term experience is slightly better than the assumption, indicating a degree of prudence, which may indicate that there is no need to change the assumption. But there has been a one-off increase over one year ...in which case the company may not want to change anything but only monitor ...or it could be a rising trend over recent years from a low base ...in which case the company may want to consider changing the long-term assumption for future years. Surrender The long-term experience appears to be higher than the assumption The short-term experience is significantly ahead of assumptions and when combined with long-term experience it would make sense to review this assumption. Expenses The long-term experience is significantly above assumption although the short-term experience is in line. The company may have reduced expenses over the 5-year period ...and the results are only noew coming through in the short-term experience We would expect the actual expenses to be lower than the assumptions if the basis was prudent Given the long-term experience, the company will probably want to review these assumptions. Investmen return Both the short-term and long-term experience are well below the assumptions We would expect the actual investment returns to be higher than the assumptions if the basis was prudent So the company may want to review the assumption But given the materiality of this assumption it will probably not be a priority to change it.
        • Eg: Issues when set assumptions for supervisory valuation reserves
          • A life insurance company has recently started selling a 10-year term assurance product. The product includes an option to renew the policy for a further 5 years for the same sum assured at the end of the term, without providing additional evidence of health. The premium rates charged for the renewal would be those applicable for the age of the policyholder at the time of renewal. The option is available only once, at the end of the original term assurance policy. The company is in the process of setting its assumptions for its supervisory valuation reserves. Discuss the issues the company is likely to consider when setting the extra assumptions required to value the option. As the company recently started selling the product, it will have only limited past experience data to use in setting assumptiongs. So when considering data to use in setting the extra assumptions the company may consider its available expertise and data on any other similar products may look for assistance from a reinsurer It may use its pricing assumption as a reference point for its supervisory reserving assumptions The assumptions should comply with the relevant supervisory reserving regulations and, depending on the regime, a degree of prudence in the assumptions may be required. Any prudence in the assumptions may be explicit or implicit Assume option take-up rates: will depend on the terms and conditions of taking up the option ... such as the communications with policyholders at the 10-year point could be assumed to be worst-case scenario ie that 100% of eligible policyholders exercise the option Mortality assumption for those who take up the option should be heavier the lower the assumed take-up rate should be heavier than the mortality of those who do not take up the option e.g. by assuming a higher percentage loading of a standard table or by applying an n-year addition to the policyholder age Additional expenses of the option need to allow for increased administration associated with processing the option and additional policyholder communications
        • Eg: Issues when set assumptions for supervisory valuation
          • A life insurance company has been selling a particular product for many years. New regulations are due to be implemented in 2 years' time and the company expects a temporary increase in the number of withdrawals from its product for the first few years after the regulation change. The size of the increase in the number of withdrawals is currently not known. The company is about to set its withdrawal assumptions for the annual supervisory valuation at the end of this year. Discuss the issues the company might consider when setting the withdrawal assumptions for this product. The assumptions should reflect the best estimate expected withdrawal experience, possibly with a margin for adverse experience depending on the basis of the reserves. The starting point for the expected withdrawal experience will come from an analysis of the company's past experience on this product, though this experience will not include any allowance for the expected temporary increase in withdrawals as a result of the regulation change. So the company may look to increase the assumptions for years 3 onwards to allow for expected increase in withdrawals. It will need to estimate the size of the temporary increase in withdrawals for years 3 onwards how long it will last for whether the long-term rate after this temporary increase will change There may also be an adjustment made to the withdrawals assumptions for years 1 and 2 if the company believes that knowledge of the regulation changes may change customer behaviour in advance of the change coming into force. For example, if the regulation will result in customers receiving better withdrawal benefits then customers who may otherwise have withdrawn in years 1 or 2 may wait until year 3. To help make these assumptions in respect of the impact of the regulation change, the company may have data from a previous time that regulatory changes happened. If the company does not have data relating to this product and country, it may have data about a regulation change for a different product or country which it could use, with adjustment for any differences in the customer profile or product involved this time. Alternatively there may be industry data or estimates that could be used, as presumably other companies are also affected by the regulation change. Other issues the company might consider in setting the assumptions include: whether a surrender will lead to a release in reserves, ie whether higher withdrawals rates would increase or reduce reserves any management actions planned in response to the regulation change, e.g. use of surrender penalties relevant regulations any relevant professional guidance
      • EV valution
        • Embedded value is calculated as the sum of : PV of future shareholder profits stream arising from existing business the proportion of net assets owned by shareholders Therefore, we will need two different bases to calculate an EV a reserving basis: know the reserves now to calculate the net assets and know the reserves in the future to calculate the PV of future shareholder profits a projection basis: calculate the PV of future shareholder profits, and has no impact on the shareholder-owned share of the net assets For published accounts or internal management accounts, the principles to be applied in setting the assumptions are as outlined in setting assumptions for valuing liabilities. If an appraisal value is being prepared as a sale value, then it is likely to be based on realistic assumptions w ithout margins. A purchase value may be based on cautious assumptions that include margins. Risk can be allowed for by using a risk discount rate that is higher than the risk-free rate, or by deducting a risk margin. Consistency The start point in deciding on a suitable basis will be the basis used for the previous embedded value calculation. Any differences w ill immediately cause some movement in the embedded value. Thus any such change must be justifiable, especially if the embedded value is being used to report externally on a company's real worth. However, if best estimate assumptions have changed since the previous embedded value calculation, a basis change may well be appropriate and the effect of that change on the company's value should be reported .
        • Eg: Impact of mortality assumption change on EV
          • Term assurance business if the realistic mortality assumptions were increased in isolation Increased realistic mortality assumptions would result in more projected deaths, so more claim payments, which would lead to lower profits, and so a lower present value of future profits (PVFP). The net assets, being assets minus statutory reserves, are unaffected by a change in the realistic mortality assumptions. Therefore, the overall impact is to reduce the company's embedded value. if the reserving mortality assumptions were increased in isolation The future profits are made up of premiums plus investment income less claims and expenses, plus the release of solvency reserves. Increased reserving mortality assumptions will increase the reserves. The increased margins for prudence then lead to a higher release of these margins as profits. These higher profits will increase the PVFP. The net assets will be lower as a result of the higher level of statutory reserves. The overall impact on the company's embedded value depends on the relative sizes of these effects. If the discount rate used to determine the PVFP is the same as the assumed investment return, then the movements in the two component parts will have the same magnitude, resulting in an unchanged embedded value. If the discount rate used to determine the PVFP is greater than the investment return assumption, then the net impact will be to reduce the embedded value. both sets of mortality assumptions were increased Increased reserving mortality assumptions will increase the reserves, so the net assets will be lower as a result of the higher level of statutory reserves. The PVFP will be largely unchanged if we increase the reserving assumption and realistic assumption by a similar amount (as future profits are released as the difference between these two bases). Therefore, overall, the embedded value will fall (as we could see by adding parts (a) and (b) together).
    • Best estimates
      • Mortality
        • Base mortality The values assigned to mortality rates should reflect the expected future experience of the lives who will take out the contract, which depends on: the target market (dependent on distribution channel) underwriting control applied (or not) any expected change since last historical investigation These values will most likely be based on an adjustment to rates from a standard mortality table. If the company has adequate data, the adjustment would be derived by analysing the company's own experience for the type of contract concerned. Alternatively, the experience of a similar class of business could be used as a substitute. The data would relate to an appropriate period of years, such that the volume of data is adequate, but excessive heterogeneity due to trends over time is not introduced. The analysis would divide the data into relevant homogeneous groups, subject to adequate levels of data being retained within each cell. If the company has insufficient data to product reliable results, or has no appropriate data at all, industry sources, reinsurer data and population statistics may be relied upon. If applied to a class of lives with a different experience, further adjustments may need to be made. Mortality trends This is a particular issue for annuities where Increased longevity is a risk, especially when premiums are guaranteed, so it is important to project future expected future improvements. There are several approaches to determining future rates of mortality improvement, which are often used in combination: Expectation approaches: based on expert opinion and subjective judgement of future scenarios, which include all relevant knowledge but subject to bias Extrapolation approaches: based on projecting historical trends into the future, which also requires some subjective judgement Explanatory approaches: model trends from a bio-medical perspective, which is only effective to the extent that the processes are understood and can be mathematically modeled. Multi-factor predictive modelling techniques, e.g. generalised linear model, combine internally held customer data with external drivers, allowing for correlations and interactions between them. Stochastic mortality projections, such as Lee-Carter or P-spline method.
        • Eg: Actions to reduce volatility in mortality assumption
          • A small life insurance company writes a variety of conventional products that provide a lump sum on death. The company reviews its mortality assumptions annually based on mortality experience split by sex, age band and product. The company includes 3 years of historic data in the analysis. The company has observed volatility in the mortality assumptions suggested by the analysis. It has performed an investigation and has determined that the number of lives exposed to risk in each cohort is not statistically credible. Describe approaches the company could take to reduce the volatility in the mortality assumptions. Smooth the rates over time to avoid large fluctuations year by year. Only change rates where there is a material reason to do so. Increase the number of years data included in the investigation to improve the credibility. Reduce the number of cohorts by: combining products with similar features or that are sold to similar types of policyholder using wider age bands Use external data to improve volume / credibility of existing data. Seek the help of experts. Use reinsurance data / expertise to improve reliability of rates.
      • Investment return
        • Factors affecting the value assigned the significance of the assumption for the profitability of the contract, which will depend on the level of reserve built up and the investment guarantees given. the extent of the investment guarantee given under the contract - this will affect the types of assets in which the premiums from the contract will be invested. the extent of any reinvestment risk and the extent to which this can be reduced by a suitable choice of assets - the less important the reinvestment risk, the less account needs to be taken of future investment yields. the intended investment mix for the contract, as affected by the above, the current return on the investments within that mix and where appropriately, the likely future return. Market consistency If a market-consistent approach is used, either deterministically or stochastically, then the expected investment return can be set as the risk-free rate, irrespective of the actual underlying assets held. However, if the stochastic approach is adopted, then the investment return volatility and correlation assumptions do remain dependent on the actual underlying asset types. Allowance for taxation and future bonuses Appropriate rates for investment income and capital gains should be used. With-profits contracts have higher premiums; the insurer assumes a lower investment return in anticipation of providing regular bonuses
      • Expenses and commissions
        • The parameter values for expenses should reflect the expected expenses to be incurred in processing and subsequently administering the business to be written under the product being priced. Marginal expenses include: initial acquisition (eg initial commission and related sales costs) initial medical underwriting initial administration renewal administration renewal reward to sales channel investment withdrawal / paid-up expenses claim / maturity administration (often known as termination expenses) The values will be determined after analysing the company's recent experience for the type of business concerned. The result of this analysis will be a division of the expenses by function, as appropriate, and possibly by whether the level of expense is expected to be proportional to the level of premium or benefit, or can be expressed as an amount per contract. If the company has insufficient recent experience to provide meaningful results, or suitable recent experience is not available, the parameter values may be based on a similar type of business and, if this is not available or not reliable, on any industry data or data from a life reinsurance company. Deal with per-policy expenses The pricing process will usually lead to a premium rate, expressed per unit of benefit, such that for the average sum assured the correct per-policy expense loading will be made. However, in practice the expense loading is in proportion to the size of the policy actually taken out Large policies are subsidising small policies and the degree of overpayment by large policies could make them poor value for money, going against principles of equity and making them uncompetitive. Possible ways of correcting for this inequity include individual calculation of premium rates or charges policy fee addition to the premium or deduction from regular benefit payments Inflation of expenses An inflation assumption is required for expenses incurred in the future. Earning inflation is of primary interest because the majority are staff costs. The value of the parameter can be set by considering: current rates of inflation, both for prices and earnings expected future rates of inflation differentials between the return on government fixed-interest and index-linked securities recent internal or industry actual experience
        • Eg: Impact of outsourcing admin on expense assumptions
          • Policy administration expenses covered by the agreement should be as per the costs in the outsourcing schedule. Non-administration expenses will be allowed for as before. Expenses for products not covered by the agreement will also be allowed for as before. The inflation rate should be as specified in the outsourcing agreement. A different rate of inflation may be used for expenses not covered by the agreement. Expense assumptions will vary with premium frequency. Expense assumptions will also vary with the number of policies sold. Expense assumptions should allow for the initial costs of setting up the outsourcing agreement. Expense assumptions should also allow for the ongoing costs of managing the relationship and monitoring the performance of the outsourcing company. Expense assumptions are required for the period after the agreement has stopped, ie after 10 years. The company could assume the agreement continues on revised terms or could assume that policy administration is taken back in house. An allowance should be made for the failure of the outsourcer to deliver on the agreement during the 10 years.
      • New business volume/mix
      • Persistency
        • The persistency assumptions should reflect the expected future experience in respect of the contracts that will be taken out. This will be based on analysis of recent experience of related contracts. Similar contracts would be analysed if no such experience exists. Industry-wide experience could be used if no adequate data. The data should be assessed for: special factors such as adverse economic situations changes to the prospective policyholder due to changes in policy structure, target market or distribution channel. Persistency rates are notoriously uncertain so it's important to perform a persistency sensitivity analysis.
      • Risk discount rate
        • Risk discount rate An investor will demand a higher return in the excess of the risk-free rate to compensate for the risks of default, commercial failure and so on. The risk-free rate plus the risk premium is referred to as the risk discount rate. One way of determining the appropriate RDR is by using CAPM. The idea behind the CAPM is that a well-diversified portfolio of shares cancels out the risks of investing in individual shares. short-term deposits can be chosen to represent risk-free assets risk premium can be estimated as the yield on a diversified portfolio of shares less the risk-free rate. The question then be asked as to how risky a company's shares are compared with the diversified portfolio. CAPM shows that the proper risk premium for any share is in proportion to its beta. However, CAPM provides an overall RDR of the insurer's entire business. not all projects are equally risky. not even all cashflows within one project are equally risky. Features thay may make a product design riskier include: lack of historical data high guarantees policyholder options overhead costs complexity of design untested market It is not easy to assess these risks, but the level of statistical risk could be assessed by: considering the variances of the individual parameter values using deterministic sensitivity analyses using stochastic models comparison with any available market data Market-consistent valuation If a market-consistent approach is used then the expected investment return can be set as the risk-free rate (regardless of the actual assets held). However, the investment return volatility and correlation assumptions depend on the actual assets held. The discount rate would also be set as the risk-free rate. A margin is likely to be included in the other parameter values to allow for the risk in their estimation.
  • Monitor experience
    • Reasons
      • Experience will be monitored as part of the control cycle to: develop earned asset shares monitor any trends in experience update the pricing basis revise product design change the product mix / launching new products revise the underwriting processes revise reinsurance arrangements implement or improve retention activity change the marketing message, target market and/or distribution channel revise sales procedures in terms of training and selection of distributors, wording and format of sales literature and the mechanics of any commission payments and clawback improve the wording of policy contracts improve the adequacy of staffing resources (numbers and competence) improve systems and data recording processes improve actuarial models change the investment strategy change the with-profits surplus distribution approach update the reserving basis raise capital alter the capital allocation methodology improve risk management governance and controls.
      • Eg: Reasons to analyse data using big data methodologies
        • A large bancassurer that sells all types of protection business, and has done so for many years, is considering analysing its data using 'big data' methodologies. Suggest possible reasons why the company may be considering this course of action. The bancassurer is likely to have lots of available data on its customers as it is large and has sold lots of product types for many years. The bancassurer can take advantage of recent technical developments in the analysis of data to make improved use of this data. Using big data techniques may allow better risk classification, allowing more accurate rating for each individual customer. The bancassurer also then has greater ability to select the preferred risks. Monitoring the available data may also allow the insurer to drive better experience through early identification of changes in individual insured risks or potentially through being able to intervene and influence customer behaviours.
    • Data required
      • Requirement The basic requirement is that there is a reasonable volume of stable, consistent data, from which future experience and trends can be deduced. 'consistent' means in a similar form, from the same source, grouped by the same criteria and equal in terms of reliability The data needs to be divided into sufficiently homogeneous risk groups, but the a balance between homogeneity and credibility needs to be achieved. An appropriate time interval must be selected for investigation. To have reasonably sized cells, we want an interval as long as possible and normally greater than one year To investigate recent experience not ancient experience, we place an upper limit on the time interval. In practice the level of detail in the classification of the data, therefore, depends upon the volumes of data available. It would, however, at least be desirable to separate different classes of contract.
      • Eg: Importance of high quality policy data
        • Data is used to: administer the business, eg paying benefits determine solvency reserves and capital requirements calculate premiums and charges perform projections, eg future solvency position perform experience investigations make decisions, eg investment strategy, reinsurance arrangements assess profitability, eg embedded value calculations. So high quality data is important so that: business is administered correctly, eg correct benefits are paid the company has confidence in the accuracy of its calculations and is able to make decisions based on them data risk is minimised lower risk margins can be held against errors ... ... improving capital efficiency and reducing premiums/ charges ... ... and so increasing business sold and profits regulatory requirements to have data checks and controls in place are complied with.
      • Eg: Approaches to reducing volatility in the mortality assumption
        • A small life insurance company writes a variety of conventional products that provide a lump sum on death. The company reviews its mortality assumptions annually based on mortality experience split by sex, age band and product. The company includes 3 years of historic data in the analysis. The company has observed volatility in the mortality assumptions suggested by the analysis. It has performed an investigation and has determined that the number of lives exposed to risk in each cohort is not statistically credible. Describe approaches the company could take to reduce the volatility in the mortality assumptions. [6] Smooth the rates over time to avoid large fluctuations year by year. Only change rates where there is a material reason to do so. Increase the number of years data included in the investigation to improve the credibility, but put more weight on recent years’ experience to ensure the experience is relevant. Reduce the number of cohorts to increase the exposed to risk, and improve the credibility in each cohort. For example: Combine products with similar features/sold to similar types of policyholders Or merge age bands Use more expert judgement to reduce reliance on data alone Use external data to improve volume/credibility of existing data Seek the help of experts Use reinsurance data / expertise to improve reliability of rates
    • Experience analysis
      • Mortality
        • Sources of data Company's past experience on this line of products Company's past experience on any similar products Industry sources, eg Continuous Mortality Investigation reports and working papers Reinsurance company data Data from overseas Standard tables National statistics Medical research and reports Subdivide the data Mortality data should be subdivided by: type of contract age sex duration from entry smoker / medical status source of business Consideration must be given to the time interval used. Too short: seasonal influences and lack of data may cause issues. Too long: unable to capture recent changes in trends
        • Eg: Actions following identifying mortality loss
          • Check analysis to make sure conclusions are correct. Check whether similar mortality loss on other product lines. Investigate cause, if possible, eg split analysis by rating factor (age, sates channel etc). Determine whether exceptional loss for that year or whether likely to continue. If exceptional (eg due to epidemic or deaths amongst very high sums assured) then no action may be needed. If not, may still wait to see how future experience develops before taking any of the following actions. Reserving: consider strengthening valuation basis, including increasing prudential margins. Pricing: consider changing pricing basis, introducing more mortality rating factors and increasing pricing margins. Reinsurance: seek advice from reinsurers (or other external sources), take out new reinsurance (eg excess of loss or stop loss to reduce mortality volatility), reduce retention limits on existing reinsurance. Underwriting: change approach, review quality Distribution: change distribution channel, target a different market to avoid high risk groups. Product design: change product design for future new business, eg introduce variable premiums or mortality charges, reduce maximum sum assured. Put in place ongoing mortality monitoring processes. Stop selling protection business.
      • Persistency
        • Data required Need a reasonable volume of stable, consistent data Will be analysing last year's data, alongside results of previous years In force data records will be needed as at the start and end of the year Divide into homogeneous risk groups, subject to the volume of data remaining credible in each data cell. This may restrict the level of detail possible in the data classification. Subdivide the data The data could be analysed by: Type of contract: healthy policyholders are more likely to lapse a term assurance than a with-profits endowment Duration in force: persistency rates are generally lower near the start of a contract Sales method and target market: the more suitable the product, the better will be the persistency experience Frequency and size of premium: monthly premiums have more opportunities to stop paying premiums but a larger annual premium may be less affordable. A high premium relative to income will be harder to afford but a small one may be not worthwhile continuing to pay. Premium payment method: paid in cash are more noticeable than paid from a bank account and so lead to lower persistency rates. Original term of contract Premium-paying or paid-up Unit-linked fund Sex and age The process Full withdrawal rates For each homogeneous group: Divide the number in-force at first policy anniversary, by the number of contracts issued in previous year This calculates the first-year persistency rate. The first-year withdrawal rate can be determined as one less the persistency rate. Deaths and maturities should be excluded from the calculation. A similar procedure can be adopted to obtain the rates for other years. Rates of making paid-up and reducing premiums For paid-up rates, divide the number of policies made paid-up during the year by the number of premium-paying policies at the start of the year. To calculate premium reductions, divide amount of premium reduction at end of period by total premiums in force at start of period. Analyse by policy duration (as for full withdrawal) if data are sufficient, excluding first policy year. Possible reasons Charges Other companies may have lower charges for similar products, due to : recently launching new competitive products recently reducing their (reviewable) charges this company recently increasing its charges (if reviewable). Company's charging structures may be out of line with the market. Investment performance Fund performance might be poor, absolutely and/or relative to market. Competitiveness Competitors may have introduced new products with more attractive product designs, including more attractive unit-fund links. Competitors may have more effective marketing or offer through distribution channels that customers prefer Reputation The company may have recently suffered bad publicity, eg due to: a recent fine by the regulator poor financial strength poor customer service. Any uncertainty over company ownership can lead to worse persistency. Distribution Products may not meet customers' needs as a result of mis-selling. Mis-selling could be due to: offering financial advisers high commission to sell the product over-inoentivising a salesforce to sell as much new business as possible a salesforce having insufficient training in the product. Intermediaries may be incentivised to encourage customers to replace this company's products by substitute contracts. Economic situation Adverse economic conditions may make premiums unaffordable Policyholder may surrender in expectation of a market fall An economic downturn means policyholders needs access to existing funds and are less likely to begin saving Other High first-year withdrawal rates may distort the overall picture If recent sales have been unusually high. The higher surrender rates may be partly due to random fluctuations.
        • Eg: Appropriateness of risk factors
          • A life insurance company writes unit-linked endowment assurance business which is designed to be used as a method of saving for a pension at retirement. Under legislation, the contract cannot be surrendered for cash before the chosen date of retirement, but it can be transferred to another insurance company or made paid-up. The company has a large volume of experience data and is about to conduct an investigation into the persistency experience of this business. Age Persistency experience is likely to be dependent on age. Younger customers may be more likely to: transfer their policy to another company, eg if they move job make their policy paid up if their circumstances change, eg buying a house with a resultant mortgage being a higher priority. Customers approaching retirement age may: be less likely to make the policy paid-up as they are more aware of the importance of providing for their retirement be more likely to make the policy paid-up if they decide that their savings are sufficient make their policy paid-up if their pension savings have reached the maximum amounts which attract favourable tax treatment. be more likely to transfer to another insurance company as they become more aware of the size and importance of their contract. As the company has a large volume of data, it will probably analyse by age as an important risk factor. Smoker status It is unlikely that the smoker status of a customer will influence their decision to transfer their pension or to stop paying premiums. So it is unlikely to be appropriate to analyse persistency by this factor. As this is a savings policy, the insurance company may not even have recorded the smoker status. It is possible that smokers may experience more ill-health and so may retire earlier and so may be more likely to make their policy paid-up. So perhaps could analyse experience by smoker status if data allows. Distribution channel This is likely to be a key risk factor affecting persistency experience. The distribution channel is likely to affect the degree of care taken in ensuring that a suitable product is sold. The more suitable the prod uct the better the persistency experience. Distribution channel will affect the customers' understanding of the policy and its benefits. The more well-advised and financially sophisticated customers may experience worse persistency experience as they may be more likely to transfer to another provider in pursuit of better investment performance or lower charges. Distribution channel will affect the target market, eg customers' wealth. The more affluent customers are more likely to be able to continue to afford their policies. The more financially sophisticated customers will be more aware of the value of providing for their retirement and so are likely to experience better persistency. Distribution channel is particularly relevant to persistency early in the policy term. The company will incur significant initial expenses, eg commission. So need to check that the persistency of business sold through each channel is in line with pricing assumptions, especially if expenses are recouped only gradually. If experience from a particular channel is very bad, the company might change its terms or stop using that channel. If experience from a particular channel is better than assumed, the company will make higher than expected profits. As the company has a large volume of data, it should analyse by distribution channel as a key risk factor.
        • Eg: Response to worse experience
          • Check high level analysis and conduct a more detailed analysis Check data for errors, eg by performing spot checks on unusual values. Check the analysis for errors, eg other decrements (deaths, maturities and paid-ups) being included mistakenly in the withdrawals. Perform a more detailed analysis by subdividing the data by the factors in part (i), if there are sufficient volumes of data. A more detailed analysis will help identify whether withdrawals have been higher across all policies or only for particular groups. It may also help to identify the causes of the adverse experience. Compare actual with expected experience for each group separately. If comparisons are done at the aggregate level, then changes in the mix of different groups over time could be the reason for the result, rather than changes occurring to the withdrawals themselves. What was the expected withdrawal experience? The experience appears to be significantly worse than expected. The reasonableness of the expectations should be checked. Check actual experience against both the valuation assumptions (which include margins) and the best estimate assumptions. Expectations should allow for particular features of the company's products, eg if withdrawal penalties apply only up to a certain duration, then a spike in withdrawals should probably be expected at the duration at which penalties cease. Could perform more frequent withdrawal analyses in the future. Investigate the cause(s) of the experience Identify the causes of the high levels of withdrawals. Possible causes include: particular intermediaries encouraging their clients to withdraw changes in regulation or tax that reduce the attractiveness of certain products increases in the company's premium rates or charges decreases in competitors' premium rates or charges changes in economic conditions, eg entering a recession resulting in more policyholders being unable to afford their premiums poor customer service and/or bad publicity for the company. Consider assumption changes Consider updating assumptions, eg for valuation, embedded values and pricing. Assumptions should reflect expected future experience, so need to consider whether the higher withdrawals are expected to continue. Consider whether experience was just a one-off deviation. Consider data over a longer time period. Some sets of assumptions need to be disclosed, eg in the company's accounts, and so any change needs to be justifiable. This is also true of the reserving basis, which should not be subject to arbitrary changes. Consider other sources of withdrawal data, eg industry data, to see whether similar experience has occurred . Consider the company's past practice in updating assumptions in the light of actual experience, including any documentation on assumption setting.
        • Eg: Actions to reduce surrenders of TAs
          • Over recent years, a life insurance company has experienced an increase in the number of surrenders of its term assurance policies. Discuss possible actions that the company may take to reduce the number of surrenders To enable targeted action the company may analyse results to determine the cohorts where the high lapse rates are arising and to understand if the business lapsing is profitable, which may help target further actions to take The company may undertake some market research to understand reasons for cancellations, maybe by contacting leaving customers to ask about reasons and to see if there are similar issues across the market although this would rely on other companies participating could use information from industry bodies or reinsurers If the company determines the underlying cause is temporary then may take no action The company could proactively contact customers who cancel direct debits to remind them of benefits of cover The company could actively market the benefits of term assurance to existing customers A general brand awareness campaign may help mitigate any negative publicity The company may want to undertake a review of premium rates or revise product design to be more competitive and possibly look at offering opportunities for existing customers to move to new policies recognising that this would be a lapse and re-entry issue, but the customer would be retained Alter sales renumeration / process to remove incentives for early lapses Review insurance intermediaries and stop using those that generate high rates of early lapse Improve staff training / customer service if this is an issue Introduce automatic payment to reduce lapses
        • Eg: Possible reasons for pattern of lapse rates
          • A lapse investigation has recently been completed for a with-profits life insurance product. The results of the investigation are shown in the table below.  Years 1 and 2 The high lapses in these early years, particular in year 1, may be caused by the product being mis-sold. and customers lapsing as they realise that the product does not meet their needs or is affordable Alternatively these high early lapse rate may be due to churning of business by advisers if the product is sold on commission Year 4 There is a spike of lapses in year 4, which may be a result of early surrender penalties being removed at that point Year 10 There is a spike of lapses in year 10, which may be a result of a guaranteed surrender value that is in-the-money at that point. A valuable surrender value guarantee at the 10-year point could also explain the slightly lower lapse rate in year 9 as policyholder maintain their policy in order to benefit from that guarantee at year 10. Overall Some of the variation in lapse rates may be due to random fluctuations particularly if policy volumes in a given cell are low. In addition, we would expect a base level of lapses throughout due to changing policyholder circumstances.
        • Eg: Reasons for higher surrender rate and lower sales volume
          • A life insurance company has recently experienced higher than expected surrender rates and lower than expected new business volumes on its unit-linked pensions product. Suggest possible reasons why this might have occurred. The expected surrender rates and new business volumes may not have been realistic. The product's charges may be high compared to similar products on the market. The company may recently have increased the product's charges. Investment performance on the unit funds may be poor as a result of a general economic downturn or else may be low relative to competitors. Competitors may: have introduced new innovative pension products have more effective marketing be using distribution channels that the target market prefers have better relationship with insurance intermediaries The company's reputation may have suffered after recent negative press level of customer service may be poor solvency position may be a concern Higher surrenders and lower sales could be a result of mis-selling Regulatory changes or tax changes
        • Eg: Possible actions to take
          • A life insurance company has recently performed an analysis of surplus and discovered a large loss related to surrenders, mainly arising from one product that has a guaranteed surrender value. Suggest possible actions the company could take. Initial actions The company could check the analysis of surplus to confirm that it is correct and that the loss related to surrenders is genuine. The company could investigate further to determine the cause of the loss, e.g. causes of higher surrender rates or causes of low asset shares if the cause is considered to be exceptional and not expected to occur again, the company may take no further action. The company may consider whether the assumptions need to be changed and so should source data to set appropriate new assumptions. Management actions If the loss is due to the surrender value guarantee, then the company could consider changing product design for new policie in particular by reducing or removing the guarantee for future new business or increasing or introducing a charge for the guarantee. For existing business, the company may increase the charge for the guarantee, if the charge is variable. The company could review its investment strategy in an attempt to better hedge the risk. The company could stop selling the product.
      • Expense
        • Subdivide the data Start from recent expense data and adjust any older data for inflation to bring it up to date. Expenses can be divided into direct and overheads expenses: direct expenses - the expenses that can be attributed directly to a product or a policy. They are typicall variable (depend on volumes of new or in-force business) overheads - the balance of the expenses. They relate to general management and service departments, independent of volume. unlikely to be a clear dividing line between them and so some judgements have to be made Commission is normally excluded as its format is known and can be allowed for explicitly. Break down other expenses into initial, renewal, termination and investment expenses. The first three types can be further broken down into whether they are proportional to the number of contracts, amount of benefit or amount of premium. Most expenses are proportional to the number of contracts written or in force Marketing expense (may be related to the amount of initial commission paid) Underwriting expenses (may be related to the size of benefit) In order to allocate the expenses in this way, policy volumes, benefits and premium levels need to be measured. Having been separated by type, the expense will need to be further split down and analysed into the required cells, eg by: accounting fund product line single premium or regular premium The choice of cells will vary across companies depending upon the types and volumes of business written and the requirements of the analysis. The cells chosen should not be so small that the analysis becomes unreliable. The process Salary and salary-related expenses Staff can be split into three groups: whose work comes entirely within a single cell (department, task or product) - these salaries can be directly allocated to appropriate cells whose work comes within more than once cell - staff timesheets can be used to split between appropriate cells other staff - the split between overheads and direct expenses is likely to be made pragmatically. Property costs If the company owns any of the buildings it occupies, a notional rent needs to be charged to the relevant departments. The rent, plus property taxes, heating, lighting, cleaning costs can be split by floor space occupied, between departments and then allocated in accordance to salaries. Computer costs The cost of purchasing a new computer could be amortised over its useful lifetime and then added to the ongoing computer costs. These can then be allocated according to computer usage. Investment costs These costs (investment department, stamp duty, commission etc) would be directly allocated to investment expenses and hence allowed for in assessing the investment return to use for pricing etc. One-off capital costs The large one-off capital costs needs to be amortised over the expected useful lifetime of the item purchased. The amortised cost may then simply be treated as part of the overheads. Exceptional items, which are not likely to recur, would be excluded completely from the analysis. Possible checks Check that the expenses total to the correct amount, ie that the total per policy expenses on each policy sum to the company's aggregate expense figure. Check that the total assumed expenses over the next year are similar to the total expenses from the current year, adjusted for inflation and any budgeted changes. Check that the new assumptions look reasonable in comparison with the previous assumption, eg check that differences can be explained and that the new total expense assumption looks reasonable in comparison to the sum of the direct and overhead expense assumptions from the old approach. Check the relationship between assumptions for different policies looks reasonable. Perform spot checks and checks on any unusual values, eg check particularly large or small expense assumptions. Check that any necessary adjustments for trends have been made, eg to allow for expense inflation. Check that any other necessary adjustments have been made, eg due to changes in distribution channel, target market or underwriting.
        • Eg: Reasons to review expense assumptions due to reduced sales
          • Expenses are likely to change due to reduced sales. So the previous expense analysis and pricing assumptions will be out of date. If the expense assumption is too low, then the company may make losses and ultimately its solvency may be threatened. Initial expenses are likely to reduce, but reduced economies of scale are likely to lead to higher initial expenses per policy. Volumes of in-force business will fall, but overheads will be largely unchanged. So the loading for overheads in the renewal expenses will increase for all lines of business. Redundancy costs may increase expenses in the short term. But commission may be cut to reduce the expenses. The proportion of new business coming from each product line will change substantially so any cross-subsidies will need to be reviewed.
        • Eg: Reasons for an increase in the renewal expense assumption
          • Future per-policy assumption depends on: total expected expenses and numbers in force expected rate of future run-off of expenses expected rate of future run-off of policies The current investigation may have indicated that the total expected future renewal expenses should be higher. May reflect planned increases in spending eg due to: change in administration outsourcer increased regu latory burden. Could reflect increased expense inflation expectations. May be due to some one-off capital costs occurring, which have been spread over future years. There may be fewer policies in force at the end of the year This may have been caused by higher actual deaths, surrenders or retirements over this year than were allowed for . The assumed rate of future run-off of pension policies might have been increased at the year end. This could reflect higher future surrender, mortality, or retirement rates. The assumed future new business could be lower, increasing the per-policy share of renewal expenses in future years. The previous basis may have assumed the company continued to sell new business in future, the current basis may have assumed it did not. If reserves are calculated on prudent assumptions, the prudential margin used in the valuation might have increased, eg due to: a change in the regulations between the two years increased uncertainty over the future per-policy expenses. Mix of business might have changed, either in this year and/or expected in future , eg an increased proportion of regular-premium business. There may have been a change in the methodology used. There may have been a calculation error in producing the valuation assumption.
        • Eg: How to make allowance for the expenses
          • Relocation to a new office The cost of the property is converted into a notional rent. If part of the office is rented to a third-party, their rent should be deducted from the cost. The remaining rent is charged to the relevant departments. The rent (plus running costs) can be split between departments by floor space occupied and then allocated in accordance to salaries. Depending on the work performed by each department, the cost is included in either the initial, renewal or claims expenses. The split may be carried out at a more granular product level based on the work performed on each product. Allowance for relocation costs should be included. If the old and new offices are far apart, then this would include staff relocation costs. Allow for the costs of the old offices up to the relocation date and the cost of the new offices thereafter. Purchase of a new administration system Allow for the existing computer costs up to the migration date and the new system costs post migration. The cost of purchasing the new computer system could be amortised over its useful lifetime and then included with existing computer costs. The amortised cost would be split into new business, on-going administration costs and claim costs. The cost would then be included in either the initial, renewal or claims expenses, respectively. The split may be carried out at a more granular product level based on the work performed on each product. Allowance would be made for the migration costs incurred for the new systems, eg staff costs. These would be in addition to the pure cost of purchasing the system. Outsource of the client administration to a third party Outsourcing will change the expense assumptions for valuation and pricing. Amortise the initial set-up cost of the outsourcing arrangement over the expected life of the arrangement. Renewal expenses will reduce to the remaining ongoing activities not being performed by the third party, eg directors and human resources. In addition, there will be the explicit per policy outsourcing cost. The outsourcing cost will include any frictional cost from the arrangement (eg tax) plus any margin to allow for risk. Any new business or claims administration taken on by the outsourcer will also need to be reflected in the expense assumptions, with a lower in-house expense assumption. An explicit outsourcing expense inflation assumption is required if this is different to that assumed by the company for the renewal cost. An assumption is needed for the expenses after the initial fixed term of the outsourcing arrangement expires and expenses are renegotiated.
        • Eg: Assess an expense allocation method
          • A new employee of a life insurance company has suggested an approach to allocating direct expenses in the company’s expense analysis. They have suggested that all direct expenses are split by product type, and then allocated equally across all policies within that product type. Split all direct expenses by product type Direct expenses are those that apply direct to a specific product and so it is reasonable that these expenses are split by product type. Allocate direct expenses equally across all policies within a product type Allocating expenses equally across policies is reasonable for those expenses that are proportional to the number of policies in force and the approach is simple to calculate and understand. However not all expenses are proportional to the number of policies. For example, underwriting expenses are likely to be dependent on the size of benefit as policies with larger benefits are likely to require more underwriting. Product types may not be a sufficiently granular split for an effective expense analysis. For example, regular and single premium variants of a product may incur different levels of expense If used in pricing, this approach would have implications for the premiums charged and the company's profitability and may expose the company to the risk of changes in business mix.
      • Investment
        • The experience is likely to be analysed by main asset types and may be done both gross and net of investment expenses.
    • Surplus analysis
      • Reasons for analysis of surplus show the financial effect of divergences between the valuation assumptions and the actual experience, exposing which assumptions are the more financially significant show the financial effect of writing new business provide a check on the valuation data and process, if carried out independently identify non-recurring components of surplus, thus enabling appropriate decisions to be made about the distribution of surplus to with-profits policyholders give management information on trends in the experience of the company comply with regulatory requirements assist with setting executive remuneration Reasons for analysis of embedded value profit A company may analyse the change over a year in its embedded value (the sum of net assets and the present value of the expected future profit from existing business). This will allow the company to: validate the calculations, assumptions and data used reconcile the values for successive years provide management information provide data for use in executive remuneration schemes provide detailed information for publication in the company's accounts or those of any parent company, in particular the value of new business taken on by the company.
      • Eg: Reasons for difference between actual and expected profit
        • A life insurance company sells unit-linked individual pensions and term assurance products. The company has identified that the new business profit from the business it sold in the last year was different from the new business profit expected in its business plan. Suggest possible reasons why the actual new business profit was different to that expected in the business plan. The volumes or mix of new business may have been different from those expected at the start of the year. Other items of experience during the year could also have differed from expectations, in particular: expense / commission investment returns / investment-linked charges persistency mortality The premium rates and charges on the products may have changed during the year with the change being unanticipated at the start of the year. Premium rates or charges may have been changed if the company changed the profit margin on one or both products. The company may have purchased or changed reinsurance on the term assurance. There may have been unanticipated regulatory or tax changes that affected the profit.
      • Eg: Actions to TA not meeting the profitability requirement
        • A life insurance company sells unit-linked individual pensions and term assurance products. The company has identified that the new business profit from the business it sold in the last year was different from the new business profit expected in its business plan. The analysis has also indicated that the term assurance product no longer meets the profitability requirements of the company. Suggest possible actions the company could now take. The company could re-price, ie increase term assurance premium rates to achieve its profit requirements. The company could not re-price and instead revise its profitability requirements, ie accept that a lower return on capital is now appropriate. The company could keep both its pricing and its profitability requirements unchanged, and instead try to meet the requirements by taking actions to improve elements of the future experience by, eg: achieving operational efficiencies to reduce expenses implementing actions to improve future mortality expense, such as increasing underwriting implementing actions to improve future persistency, such as improving customer service The company could look to improve its business mix by analysing profits by distribution channel and targeting increased volumes from those that are more profitable. The company may seek to increase business volume at the cost of a reduced profit margin, to increase overall probability, e.g. by improving or extending distribution channel. The company could review its term assurance reinsurance arrangements to improve profitability. The company may choose to stop selling term assurance business.
      • Eg: Actions to large loss related to surrenders
        • A life insurance company has recently performed an analysis of surplus and discovered a large loss related to surrenders, mainly arising from one product that has a guaranteed surrender value. The company could try to determine the cause of the loss (i.e. cause of higher surrenders or cause of gap between guaranteed value and AS) A loss would have arisen if the surrenders have been higher than expected if there is a guaranteed surrender value A loss could have arisen due to a gap between the guaranteed value and the asset share Make sure this is a genuine loss and not an error – review analysis of surplus to confirm loss. If the cause is a true one-off and not expected to occur again the company may take no further action If it is not a one-off the company may take further action of: Consider whether the assumptions need to be changed. If the loss has arisen when surrenders have been higher than expected and the loss is expected to continue then the expected surrenders assumption should be increased The company would need to perform an experience analysis exercise and source relevant data to suggest an appropriate new expected surrender rate If the loss is due to market conditions the company may perform further investigations possibly using a stochastic model, to determine when the guarantee will cost them money The company may need to review their investment strategy The company may consider changing the product design for new policies if the loss is due to the surrender value guarantee They may remove the guarantee for new policies, or introduce a charge/increase the charge for it If there is a charge on the existing policies for the guarantee and it is reviewable, they may look to increase this The company may introduce, for new policies, claw-back of commission from intermediaries on surrender The company could improve their customer service Make adjustments to product design – e.g. loyalty bonus, surrender penalty in early years, changes to charging structure (suitable example) Review their customer communications and make any required changes subject to TCF The company could stop selling the product
    • Using the results
      • The results of analysing the experience, the surplus arising and the change in the embedded value will be used by the actuary to reassess their view of the future with regard to the company. This may result in changes to the assumptions or models used for pricing or reserving, or changes to the ways in which the business and its risks are managed. updating the pricing basis revising product design changing the product mix / launching new products revising the underwriting processes revising reinsurance arrangements implementing or improving retention activity changing the marketing message, target market and/or distribution channel revising sales procedures in terms of training and selection of distributors, wording and format of sales literature and the mechanics of any commission payments and clawback improving the wording of policy contracts improving the adequacy of staffing resources (numbers and competence) improving systems and data recording processes improving actuarial models changing the investment strategy changing the with-profits surplus distribution approach updating the reserving basis raising capital altering the capital allocation methodology improving risk management governance and controls
      • Eg: Actions to make use of surplus
        • As the company is proprietary, it may want to increase dividends. It could consider using the surplus to: increase business volume (eg by reducing charges) sell more capital intensive business develop new channels or products. The company may look to acquire another company. The company may want to change its investment strategy potentially allowing more freedom to mismatch. Company may increase bonuses to staff. It may retain some of the capital to maintain financial strength. Additional points pay a special dividend buy back some of its shares repay some of its borrowing invest in company infrastructure eg IT projects, new offices cover cost of known future regulatory changes invest in new business reduce use of reinsurance increase prudence in assumptions, which doesn't 'use the surplus' but would increase prudence in the projections invest in corporate responsibility initiatives
• Modelling
  • Models
    • Objectives and uses
      • The prime objective in building a model is to enable the actuary advising a life insurance company to give that company appropriate advice so that it can be run in a sound financial way. Models will therefore be used to assist in the day-to-day work of the company and to provide checks and controls on its business. A model is one of the tools the actuary has available to ensure that the advice he or she provides is as good as possible. The various uses to which models can be put include: product pricing and design valuing existing business assessing the return on capital assessing the profitability of existing business (including embedded value calculations) assessing capital requirements projecting future solvency costing options and guarantees determining the terms for alterations and surrenders.
    • Deterministic VS stochastic
      • Deterministic Important variables are assigned a single value and the actuary will proceed with this. There are situations where deterministic approach is appropriate: If an expectation-type result is required or a specific scenario is being tested and it is believed a stochastic approach would yield similar results If a quick, independent test is required to verify a stochastic projection. To avoid having a nested stochastic model. A series of deterministic calculations may in simple cases be used to provide upper and lower bounds on the stochastic result, as a check. Stochastic Advantages The method allows a probability distribution to be assigned to one or more of the unknown future parameters. A positive liability can be calculated where a deterministic approach may produce a zero liability The future parameters may be assumed to vary together as a dynamic set, particularly useful for with-profits business. Disadvantages Unrealistic results may be produced if a very simplified version of the model is produced due to time and computing constraints. The distributions have to be chosen and will require parameter. This introduces model and parameter risk. For economic assumptions that vary, common approaches to the setting (or 'calibration') of these parameter are as follows: Risk neutral calibration - The focus is to replicate the market prices of actual financial instruments as closely as possible, using an adjusted probability measure. Typically used for valuation purposes, particularly where there are options and guarantees. Real world calibration - The focus is to use assumptions which reflect realistic long-term expectations and observable 'real world' probabilities and outcomes. Typically used for projecting into the future, e.g. calculate the appropriate level of capital to hold to ensure solvency under extreme adverse future scenarios at a given confidnce level.
      • Eg: Assess the use of deterministic/stochastic model
        • A life insurance company is considering entering the single premium unit-linked savings market in a particular country. It is considering two possible contract designs. Both designs have annual fund-based charges expressed as a percentage of the value of units and have no other charges. The charge is reviewable. Design A pays the value of units on death or surrender. Design B pays the value of units on death or surrender and guarantees to pay 110% of the premium on the 10th, 15th and 20th policy anniversaries. The charges under both designs have been set so that they each achieve the same level of profitability using the company's required rate of return on capital. Neither design includes a surrender penalty. All assumptions used in the pricing are the same for both designs. Assess whether the company should use a deterministic or stochastic model to price Design B. A stochastic approach allows a probability distribution to be assigned to one or more of the future parameters. This will be important in pricing Design B due to the guarantees in the design as a positive cost of the guarantee can be calculated where a deterministic approach might otherwise produce a zero cost. The model may need to allow for dynamic behaviour of assumptions for example lapse assumptions depending on whether or not the guarantees are biting. Therefore it is likely that a stochastic model should be used to price Design B. The company would need to consider the availability of expertise to do the stochastic modelling.
    • Basic features
      • Basic features of a generic model The model should be adequately documented. The workings of the model should be easy to appreciate and communicate. The results should be displayed clearly. The model should exhibit sensible j oint behaviour of model variables. The outputs from the model should be capable of independent verification for reasonableness and should be communicable to those to whom advice will be given. The model must not be overly complex so that either the results become difficult to interpret and communicate or the model becomes too long or expensive to run, unless this is required by the purpose of the model. The model should be capable of development and refinement. A range of methods of implementation should be available to facilitate testing, parameterisation and focus of results. The more frequently the cashflows are calculated the more reliable the output from the model, although there is a danger of spurious accuracy. The less frequently the cashflows are calculated the faster the model can be run and results obtained. Basic features of a life insurance model Involves projecting cashflows; need to allow for all cashflows that may arise, including discretionary benefits. Cost of setting up supervisory reserves and required solvency capital needs to be allowed for in order to calculate profit flows. Proper allowance must be made for guarantees and options: it is likely that a stochastic modelling facility will be necessary for this, particularly for financial guarantees. Allow for intera ctions (dynamic links) and correlations between variables.
    • Sensitivity
      • Results from the models will need to be looked at in conjunction with sensitivity tests to show the vulnerability of the results to unexpected future experience. Outcomes w ill be analysed for sensitivity to variations in: model point assumptions (if applicable) parameter values. Used for pricing - Sensitivity testing, on a deterministic basis, can be used to help determine the margins that may be necessary in a basis. Such margins in each parameter assumption can be a way of allowing for risk in a pricing model, as an alternative to risk margins in the risk discount rate. Used to assess return on capital and profitability of existing business - Sensitivity analysis can help to determine the variance of profit, or of the return on capital, for any business being modelled. Alternatively stochastic simulation techniques can be used to assess profit variance.
      • Model point
        • If an adequate set of model points has been chosen, it should not be necessary to test for the effect of model point error. However, situations may arise where a less than ideal number of model points must be used, in which case the effect of a different choice should be assessed.
        • Eg: How to set MP for pricing
          • large multinational proprietary life insurance company is in negotiations with the government of a particular country to write a new government-backed scheme to provide child funeral costs. A significant proportion of the country's population is low income, and the infant and child mortality rates are relatively high. The scheme would provide cover for all children of the policyholder, and the premium would be the same irrespective of the number of children covered. The benefits would be to provide all the basic funeral costs on the death of each insured child if this occurs before they reach age 18. The policy would continue after the death of a child if there are other children of the policyholder who are still alive. Underwriting would be on a health questionnaire basis only. The policy would automatically include all new-born children. The government would endorse the insurance company and would allow tax relief on premiums. The insurance company would be the only company allowed to provide this type of insurance. The company does not currently write this type of contract in any other country. Choose model points to represent the expected new business. Consider the profile of any similar existing product and advice from the marketing department. However, this might not be possible as this is an unusual contract that the company has not sold before. The government might be a useful source of information, eg target market and volumes, national statistics on family sizes. Need data to reflect the risk factors of the business, eg the age profile of the children insured, as mortality rates may fall with age. Need data on the number of lives covered, so data on birth rates, numbers of children per family and the age gaps between children will be useful.
        • Eg: Possible risk factors in setting MPs
          • A life insurance company uses a deterministic model to price its without-profits immediate annuity products. The pricing model uses model points, based on the key risk factors, to represent expected new business. List possible risk factors that the company may use when setting the model points. age of annuitant gender (where regulation allows) size of premium ∕ initial annuity single life / joint life first death / joint life last survivor level of indexation (eg level, fixed increases or price inflation) smoker status occupation/ socio-economic status impaired life status
        • Eg: Differences in MP for pricing and reserving
          • Pricing Model points will be chosen to represent the expected new business under the product. For an existing product, the profile of the existing business, modified to allow for any expected changes in the future, can be used. The profile of any similar existing product, combined with advice from the company's marketing department, could be used. Reserving Real data on policies held will be used. The policy data could be ungrouped (ie policy by policy). Or the data could be grouped using model points that are representative of the full data.
      • Parameters
        • The effect of mis-estimation of the parameter values can be investigated by carrying out a sensitivity analysis. This involves assessing the effect on the output of the model of varying each of the parameter values. When doing this, any correlation between different parameters should be allowed for.
        • Eg: Possible sensitivities likely to reduce profit of annuity business
          • A life insurance company uses a deterministic model to price its without-profits immediate annuity products. The pricing model uses model points, based on the key risk factors, to represent expected new business. The company conducts a full sensitivity analysis. (ii) Discuss possible sensitivities that are likely to show a reduction in expected profit for the annuity business. Mortality A lower mortality rate will result in more lives assumed to be living longer, leading to reduced profit due to more annuity payments and more expenses If the annuity has a guaranteed period or return of premium option, a higher mortality rate in the option period will reduce profit An increase in the rate of mortality improvement rate could be considered, as well as a flat change in the mortality rate. Investment Return The annuity has a guaranteed benefit, which relies on a certain level of investment return A reduction in the investment return will reduce expected profit New Business Volumes The level of new business will determine the aggregate profit for the product if assumed new business is too low then the development and initial expenses will not be recovered and potentially regular expenses will not be covered by premium loadings. Mix of new business The expected split of policies between risk factors will influence profit If there are assumed to be more smaller policies, then the fixed expenses may not be covered by charges Depending on the age/sex split and the target market, more new business in certain categories may reduce profit Expenses A higher level of regular administration expenses will reduce profit as will an increase in initial set up expenses/development expenses Inflation A higher level of inflation will reduce profit through increased expenses and potentially increasing the rate at which indexed annuities grow Other A change in distribution channel costs (e.g. commission) may reduce profits Changes in tax rates or regime
        • Eg: Use result of sensitivity to help price and design annuity contracts
          • A life insurance company uses a deterministic model to price its without-profits immediate annuity products. The pricing model uses model points, based on the key risk factors, to represent expected new business.The company conducts a full sensitivity analysis.Discuss how the company may use the results of the sensitivity analysis to help determine the pricing and design of the annuities. The analysis will help identify the key risk factors that may require more of a margin in the assumptions The key factors are likely to be mortality and investment return Margins could be applied to different assumptions at different levels Additional margins in the assumptions may make certain model points unattractive in the market hence this may lead to the company deciding to introduce a minimum or maximum age or adjusting its target market to encourage new business from those profitable segments The company may introduce a minimum size of initial premium to ensure initial expenses are covered, and reduce sensitivity to increasing maintenance expenses The company may decide to adjust the initial expense assumption in the pricing basis The company may remove or adjust options e.g. guaranteed period e.g. adjust indexed option to be a fixed rate rather than inflation linked The investment sensitivity may help the company decide on its investment return assumption for matching the annuity liabilities including any margin for default if corporate bonds are assumed to back the annuity liabilities.
    • Eg: Considerations in deciding between amending existing model and purchasing new model
      • Initial costs - compare cost of amending existing model to cost of new external model (eg purchase price, amendments to make standard model appropriate for this company and training). Resources - compare resources required for both models to the resource available within the company. Ongoing costs - compare future costs of each model, eg development costs, audit, documentation, annual usage fee. Time - compare the time needed to implement each model, eg will the model be ready for the product launch or the next valuation date? Speed - consider which model is the fastest to run . Complexity - compare how complex the two models are to understand and to use. Flexibility - consider whether the external standard model is able to cope with changes to the product design. Can the model perform stochastic simulations? Data - consider how well the new model can link to the company's existing database. Expertise - greater expertise is required in developing the existing model than buying a new model, but staff will need to be trained to use the new model. Reputation - consider the reputation of the external company and how using its model would impact on the insurer's reputation. Risk - developing the existing model leads to the risk of errors, but using the external model leads to counterparty risk.
  • Embedded value
    • EV can be calculated as the sum of: The shareholder-owned share of net assets (excess of assets held over liabilities) Assets may be valued at market value or may be discounted to reflect 'lock-in', eg if they required to cover solvency capital requirements The PV of future shareholder profits arising on existing business For conventional without-profits business, future profits at each future times are premiums + investment income - claims - expenses + releases of solvency reserves For unit-linked business, future profits are charges (including surrender penalties) - expenses - benefits in excess of the unit fund + investment income earned on non-unit reserve + release of non-unit reserves For with-profits business, future profits are future shareholder transfers, eg as generated by bonus declarations. There is no embedded value from the with-profits fund if all future profit belongs to the policyholder For conventional without-profits business and unit-linked business, EV is effectively the release of any margins within the solvency reserves relative to the assumptions used within the embedded value calculation. Assumptions used are likely to be prudent for solvency reserves and realistic for profit projections. Tax is allowed for within the calculation as appropriate. The model points chosen to represent in-force business can be: the actual full policy data the model points from previous assessments and appropriately modified newly generated based on the current policy portfolio The suitability of model points should be checked, e.g. to determine the supervisory reserves and compare with published value.
    • Eg: Impact of increasing prudence in the reserve on EV
      • Unit-linked contracts The unit reserves would be unchanged. Non-unit reserves would increase, reducing the free surplus. The extra non-unit reserves will be released back over the remaining life of the policies. If RDR is higher than the return on assets PV of future releases will be lower than the initial cost of increasing the reserves So overall the EV will decrease If RDR is lower than the return on assets PV of future releases will be higher than the initial cost of increasing the reserves So overall the EV will increase Conventional with-profits contracts Current asset shares and cost of guarantees should be unaffected, so the free surplus should be unchanged. If assume regular bonuses are unchanged, their projected (reserving) cost would rise causing an increase in projected shareholders' transfers. The higher transfers will reduce later asset shares and so later transfers would be reduced. Overall, transfers would be paid out earlier, but may be similar in total amount to before. If RDR is higher than the earned rate, this change in timing would increase the PVIF, and hence increase the EV. If RDR is lower than the earned rate, this change in timing would decrease the PVIF, and hence increase the EV.
  • Pricing products
    • Determine premiums or charging rates
      • The model can be used to determine a premium, or charging, structure for a new or existing product that will meet a life insurance company's profit requirement. Existing business needs monitoring to indicate if pricing basis is still valid. Model points are required. For existing products, the profile of existing business, modified to allow for any expected changes, can be used. For new products, the profile of any similar existing product combined with advice from marketing department can be used. For each model point, cashflows are projected using base parameter values, allowing for reserving and solvency capital requirements. The net projected cashflows will then be discounted at the risk discount rate to give the EPV of future profits. The RDR should take into account: the return required by the company (risk-free rate is not enough) the risk attached to the cashflows (the greater the variation, the greater the required risk premium) in theory, each component of the cashflows should have a separate RDR but in practice an average risk premium is applied to all cashflows. It is possible for the desired level of profitability to be reached in aggregate without requiring every single model point to be profitable. However, if certain model points are unprofitable, the aggregate profitability is exposed to changes in mix.
    • Profit criteria
      • A single figure that summarises the capital efficiency of contracts with different profit signatures used for the purpose of ranking alternatives. Typically, NPV is relied upon as the primary criterion and the discounted payback period is applied as the secondary criterion. Net present value Discounting the profit signature at the risk discount rate produces a 'net present value' (NPV). NPV can be expressed as a percentage of initial commission, a reflection of sales effort the PV of all premiums due, a reflection of market share Given a choice between two different investments, economic theory states that an investor should choose the one with the higher net present value. This is the optimal choice as it achieves the first priority for the managers of any company of maximising the net present worth of the company. NPV is the best profit criterion to use, but depends on: there is a perfectly free and efficient capital market each alternatives is discounted at its appropriate RDR NPV is subject to the law of diminishing returns and says nothing about competition. Internal rate of return Internal rate of return is defined as the rate of return at which the discounted value of the profit signature is zero. A higher internal rate of return is usually preferred. But the internal rate of return does not address the riskiness of alternatives and its rankings may be in favor of riskier contracts. Further points IRR may not be unique if more than one change of sign in the stream of profits in the profit signature. IRR may not exist if a policy makes profits from the outset. This may be attractive if the company has limited available capital. IRR cannot be related to useful indicators like the sales effort or market share. Discounted payback period The discounted payback period is the policy duration at which the profits that have emerged so far have a present value of zero. ie it is the time it takes to recoup the initial investment with interest at the risk discount rate. A company with limited capital might prefer to sell contracts with as short payback periods as possible. Risk is incorporated in the discounted payback period, but cashflows after this period are ignored. So it may not agree with the NPV or IRR.
    • Marketability
      • Marketability might lead to a reconsideration of the design of the product ( include new features to enhance differentiation or remove risk) the distribution channel (permit changes to the assumptions) the profit requirement whether to proceed with marketing the product
    • Capital requirement
      • The actuary can further assess the impact in capital management terms (either on a regulatory or economic capital basis) of writing the product, by observing the modelled amount and timing of cashflows. This may, if capital is a problem, lead to a reconsideration of the design of the product to reduce, or amend the timing of, its financing requirement.
  • Capital management
    • Assess solvency
      • Solvency is measured by comparing the value of assets against the value of liabilities, on a supervisory or economic basis. If the supervisory basis is stronger then supervisory solvency becomes the predominant criterion.
    • Project solvency
      • Future solvency will need to be projected in order to measure the impact of future variations in experience not allowed for in the supervisory reserving basis. The modelling of such future variations will involve dynamic solvency tesing DST tests if the company's solvency can withstand future changes in its experience and in the economic environment. Project the revenue account and balance sheet, for enough years to identify full effect on solvency of altering the future experience. Assumptions can be varied one at a time or together. Aim is to identify the key factors that can lead to insolvency, so that actions can be taken to avoid it actually occurring. Can look at the impact of different management strategies. A full model office, using realistic model points, is required. May or may not include expected future new business. Include new business, as likely to be most useful, unless company intends to close to new business in future. Can project deterministically on expected assumptions, with and without margins to test the effect of adverse future experience. Or use stochastic model to assess probabilities (eg of insolvency). Build in dynamic links, including management decision algorithms. Test insolvency on a supervisory values or an expected values basis. Solvency projections may also allow for management actions (such as changes in bonus and investment policy) where appropriate. The projection can be done on either a deterministic basis or a stochastic basis, and may be on an ongoing basis or consider just the existing portfolio.
      • Eg: Impact of events on the solvency position
        • A life insurance company sells a wide range of protection, savings and annuity products. The company has an investment portfolio of 40% corporate bonds, 30% equities, 20% government bonds and 10% cash. The life insurance company has recently experienced the following: a reduction in sales of 25% of the previous year's level worsening lapse experience on its unit-linked savings portfolio, with lapse rates increasing from 6% pa to 10% pa; and a fall in equity markets of 25% and a fall in corporate bond prices of 30%. Reduction in sales Sales incur new business strain, due to expenses and the prudence of the reserves and solvency capttal requirements relative to the premium basis. New business strain will therefore reduce. The current solvency position will therefore improve, or will worsen by less than if no change had occurred. The actual change in solvency wiII also depend on the extent of surpluses arising from the continuing in-force business. The reduction in new business strain may not be 25% if the mix of business written has changed. The strain may even increase. The impact will also depend on any mitigation factors (eg reinsurance). Reduced volumes will increase per-policy expenses, due to overheads. Per-policy reserves might then rise, worsening solvency. This will be more likely, or will be more severe, if there is no immediate prospect of a recovery in sales. Increased lapses on unit-linked policies A lapse will cause a profit if total reserves plus associated solvency capital is greater than the surrender value. So an increase in lapse rates could improve solvency (or have no effect where reserves and surrender values are equal). Volumes will reduce, increasing per-policy expenses and reserves (as above), worsening solvency. Fall in prices Using the given asset mix, the insurer's assets will reduce in value by: 0.4*0.3+0.3*0.25=19.5% The impact on solvency will depend on the degree of matching. Unit reserves will be closely matched, and so will fall with asset values. Future fund-linked charges will fall, so non-unit reserves will increase. Cost of guarantees will rise (as unit funds are smaller), so non-unit reserves will increase. Reserves for non-linked business may fall, to the extent that increased yields can be taken into account in the valuation interest rate. The extent of this will be limited by the degree of matching, by the need to be prudent, and by any specific regulatory restrictions. Eg corporate bonds have high default risk, so it would be imprudent to take credit for the full increase in yield. Significant effect, as company has high exposure to corporate bonds. A higher valuation interest rate could also red uce the non-unit reserves on unit-linked policies, but this is likely to have a relatively small impact. The required minimum solvency capital may reduce in line with any reduction in reserves, and so help the company's current solvency. But overall it is very likely that the solvency position will worsen.
      • Eg: Role of solvency projections
        • Solvency projections enable a company's management to look at the ability of the company to withstand changes caused by risk factors or management actions. Future solvency can be assessed, particularly the probability of insolvency. The profile of the liabilities can be determined in terms of type, amount and duration. Projections may be performed on a realistic (economic) basis or on a supervisory basis. Supervisory solvency calculations often only look at the risks currently run, but solvency projections will show how risks change over time. This is especially important where risks are increasing. The sensitivity of the company to certain risks can be assessed by looking at a range of deterministic stresses or stochastic simulations. Solvency projections are used to help management in their decision making for the business. For example: setting limits for new business volumes setting product mix setting investment strategy, eg choosing matching assets setting bonuses and determining smoothing policy investigating need for future capital raising\ determining run-off plans for closed funds, eg ensuring an appropriate balance between capital being distributed to policyholders and shareholders and being retained in the fund. Solvency projections are used to help in risk management by assessing the efficiency of proposed risk management actions, eg reinsurance. There may be a regulatory requirement to perform solvency projections
      • Eg: Why project solvency position
        • to be confident that the company will continue to be solvent in the future to protect the interests of policyholders and other stakeholders it may be a regulatory requirement to assess the impact of future adverse events: one-off shocks, eg market crash or flu pandemic more gradual changes, eg demographic trends to improve risk management. to assess its ability to write new business, eg to cover new business strain to determine investment strategy, eg the stronger the projected solvency position, the less constrained the investment policy may be to plan for any future capital raising that is required to plan any returns of capital to its capital providers, eg dividends to assess its ability to exploit future opportunities, eg buying another company to maintain a high credit rating to inform management decision making to assess the effectiveness of risk management, eg reinsurance to assess possible bonus strategies for with-profits business to assess the run-off of the business if the company is closed to measure the probability of ruin.
      • Eg: How to determine future solvency
        • Use a model to project future assets and liabilities, ie project revenue items and balance sheets. Specify future solvency objective, eg on a regulatory basis or on an economic capital basis. A regulatory (or supervisory) basis would determine solvency as for supervisory reporting purposes and would assess the company's ability to meet the regulatory requirements in future. An economic capital basis would determine solvency using a best estimate or a market-consistent approach and would enable the company to understand its ability to withstand future adverse experience. In some jurisdictions, the two approaches may be equivalent or very close. Decide whether to use a deterministic or a stochastic model. A deterministic model could be used with best estimate assumptions combined with scenario or sensitivity tests. Or some of the variables may be modelled stochastically in order to look at a range of outcomes, particularly adverse scenarios. Assumptions would be required for volatilities and correlations. These would be calibrated to real world scenarios. Future solvency might be assessed by looking at the average result across all simulations and/or at percentiles. Investment returns on various asset classes and economic variables, such as inflation, are likely be modelled using stochastic simulations. If mortality or longevity risk is important to its contracts, mortality may also be modelled stochastically. Assets and liabilities should be projected on a consistent basis. Ensure that assumptions are consistent with each other. Decide how many simulations to run. Decide a risk tolerance, eg probability of insolvency in 1 year to be less than 0.5%. Decide the time horizon to project future solvency for, eg a fixed planning horizon of 5 years, or until all the existing business has run-off. Decide the frequency of the projection, eg monthly or annual cashflows. Decide whether, and to what extent, to include future new business. Including only the existing in-force business is more objective and may be sufficient to satisfy regulatory solvency requirements. Including future new business requires subjective assumptions, but will provide a more realistic assessment of future solvency. As a full projection of future solvency might require nested stochastic calculations, the company may adopt a simplified approach, eg a proxy model or a closed-form solution. Model points may be used rather than doing the projection on a policy by policy basis. Solvency projections should allow for management actions. Solvency levels could be determined as the excess of assets over liabilities (and required capital) or as a ratio of assets over liabilities (and capital requirements).
    • The need for capital
      • Capital is needed to withstand unexpected adverse experience and reflects the company's ability to: write new business adopt a less restrictive investment policy smooth surplus distribution and dividend payments to shareholders reduce the need for reinsurance seize profitable business opportunities. However, if not efficiently used, it will lower the rate of return. Capital is normally provided on a day-to-day basis by the company's free assets but in effect the capital is provided by with-profits policyholders, by shareholders or both.
  • Alterations
    • Surrender
      • Principles
        • Take into account policyholders' reasonable expectations There is no generally accepted definition of PRE, but it will be influenced by the past practice of a company and any literature issued. At early durations, it is natural for policyholders to compare surrender values with premiums paid. However, the asset share at such durations are typically less than this and even may be negative, a loss may be unavoidable. The insurer may try to recoup this loss on later surrenders. At late durations, it is natural for policyholders to compare surrender values with maturity benefits. Treat both surrendering and continuing policyholders equitably Not exceed earned asset shares, in aggregate, over a reasonable time period Take account of surrender values offered by competitors (and possibly also auction values, where available) Not be subject to frequent change, unless dictated by financial conditions Not be subject to significant discontinuities by duration Not be excessively complicated to calculate, taking into account the computing power available Be capable of being documented clearly Avoid selection against the insurer. Not make it advantageous for the policyholder to discontinue the policy and take out a new policy.
        • Eg: Extent of satisfying principles
          • A proprietary life insurance company sells a conventional without-profits endowment assurance product. When a policy is surrendered, the company pays a surrender value equal to the sum of the premiums paid up to the surrender date. Surrender values should: take into account policyholders' reasonable expectations at early durations, not appear too low compared with premiums paid, taking into account any projections given at new business stage at later durations, be consistent with projected maturity values. Paying premiums paid to date on surrender should meet PRE at early durations (provided it is consistent with previous projections given). At later durations it is unlikely to be consistent with projected maturity values as it ignores the investment return earned on premiums. Surrender values should treat both surrendering and continuing policyholders equitably. This is unlikely to be achieved as late surrenders may receive considerably less than those maturing shortly afterwards. Surrender values should not exceed asset shares, in aggregate, over a reasonable time period. This approach will overpay on surrender at early durations (as asset shares are reduced by initial expenses) and underpay at later durations. Surrender values should produce a fair contribution to company profit. This objective is difficult to meet, since profits made may be excessive for later surrenders and losses may be made on early surrenders. Surrender values should take account of surrender values offered by competitors (and possibly also auction values, where available). Whether this principle is met depends on surrender values offered in the market. Auction values are often determined prospectively and so surrender value may be inconsistent with these, especially at later durations. The suggested approach will meet the following general principles: not subject to frequent change, unless dictated by financial conditions not subject to significant discontinuities by duration not complicated to calculate capable of being documented clearly. This approach could give a lapse and re-entry risk at early durations. Despite satisfying some principles, the approach is unlikely to be suitable as it fails to meet some of the most important principles.
        • Eg: Extent of satisfying principles
          • A life insurance company has sold a regular premium unit-linked ten year savings product for a number of years. Premiums are paid monthly. A surrender value, expressed as a percentage of the unit fund value at the time of claim, is payable over the full term of the policy. The percentage is 90% at outset, increasing linearly each month to reach 100% over ten years. The general principles of setting surrender values (SVs) are that they should: take into account policyholders' reasonable expectations not exceed earned asset shares, in aggregate, over a reasonable time period be consistent with projected maturity values at later durations not be subject to significant discontinuities by duration treat both surrendering and continuing policyholders equitably not appear too low compared to premiums paid in early years, taking into account any projections given at the new business stage be capable of being documented clearly not be subject to frequent change, unless dictated by financial conditions take account of SVs offered by competitors and possibly also auction values, where available not be excessively complicated to calculate. Meeting policyholders' expectations The projections at new business stage should have included the surrender penalty scale. Provided the details are clearly communicated to policyholders at the time of sale, then it should be possible to meet PRE easily. Later durations The SV does tend towards the maturity value (unit fund) as the penalty follows a regularly decreasing progression towards zero. The SV should become equal to the unit fund during the last month, the exact timing depending on the interpolation approach applied. Early durations How the SV at early durations compares to the premiums paid depends on how the charges vary by duration of the policy. With level charges, starting SV would be around go% of premiums paid. SVs at early durations should then appear reasonable compared with the premiums paid. This would not be the case if there are high initial charges (eg low first year allocation rates). A combination of high initial charges and the surrender penalty could mean SVs are significantly lower than premiums paid at early durations. The SV is a percentage of the unit fund, so poor early unit growth could also lead to an unfavourable comparison with premiums paid. Comparison with asset shares Asset share will be reduced by high initial expenses, and would be low or even negative near the beginning of the policy. Assuming level charges, the asset share is likely to be lower than the SV at early durations, and may take some time to overtake it. The discrepancy between the asset share and SV will be less if the policy includes some high initial charges. At later durations, provided the policy ultimately makes a profit, the asset share should exceed the unit fund (and surrender) value. Whether the principle is met on aggregate over time will depend on the pattern of surrenders with policy duration. Important to avoid lapse and re-entry at early durations when SV is greater than asset share. A policyholder is worse off after lapse and re-entry, so this should not be a problem here. Fairness of treatment of surrendering and continuing policyholders Assuming level charges, the surrender penalty at early durations plus charges to date would not cover the expenses incurred so far. The charges on continuing policies should cover all expenses incurred. So early surrenders are being treated more generously than continuing policies. A late-duration surrender is likely to pay more charges in total (ie including the surrender penalty) than a continuing policyholder. So late surrenders are penalised compared to continuing policyholders. The mix between early and late surrenders will determine whether overall there is a net subsidy to or from the continuing policyholders. Given that early surrenders are likely to be the most common, an overall inequity will exist in favour of surrenders. This inequity would be reduced if the policy has high initial charges. Discontinuities by duration The linear increase in penalty with duration means this principle is well met. Being in line with competitors The approach might well be consistent with competitors, but there is no explicit information available to judge this. Other principles The surrender value basis is very easy to document, and simple to calculate, meeting these principles easily. There is no apparent reason why the basis should require frequent changes, and so this principle is also met.
        • Eg: Asset share VS surrender value
          • Discuss why the asset share for a with-profits contract should, subject to smoothing, be the upper limit on a policy’s surrender value. The asset share is the accumulation of premiums less the deductions associated with the contract, all accumulated at the actual rate of return earned on investments So, if more is paid out on surrender over time, then the company would make a loss and this loss would then be passed onto other policyholders’ asset shares as a deduction. Bonus distributions should be consistent with policyholders’ reasonable expectations e.g. expecting surrender values to move broadly in line with the asset share. Bonus distributions should be equitable between different categories and generations of policyholders. Paying out more to surrendering policyholders would not be equitable to those remaining and if policyholders were made aware of this more might surrender meaning even more deductions to those remaining This would not be sustainable and so either surrender values would reduce or shareholders would make a loss In the early years of a policy the asset share could be negative due to high initial expenses. The surrender value would be 0, which would technically exceed the asset share, as you could not have a negative surrender value.
      • Method of calculation
        • Retrospective VS prospective method
          • Retrospective method Definition Accumulation of past premiums, less expenses and cost of cover. Use formula, with parameters based on actual experience (mortality, interest, expenses) to date. Or may use (or be similar to) earned asset share. Deduct cost of surrender. Formula  x - age of policyholder at date of issue t - duration at surrender G - annual premium S - sum assured I - initial expenses in excess of those occuring regularly each year e - level annual expenses f - normal claims experience C - surrender expense all determined using actual experience Advantages it represents the asset share, so it serves as good approximation for the maximum surrender value an insurer can pay without making a loss. at early durations, it compares reasonably to premiums paid. Disadvantages at very early durations, it may produce negative values. depends on the relationship between premiums, expenses and commission. does not allow for any loss of future profits, so may be unfairly generous relative to shareholders and continuing policies the surrender value will not run into maturity value - except if the pricing basis exactly matches the experience to date. may greatly differ from a realistic prospective value (auction value) - may develop bad reputation if surrender values are less than auction value. require historic information to determine suitable parameters. Prospective method Definition EPV of future benefits and expenses, less premiums and cost of surrender Use best estimates of future experience Formula  S - sum assured X - age of policyholder at date of issue t - duration of policy at date of surrender e - level annual expenses f - death claims expenses G - annual premium C - surrender expenses m - premium payment frequency Advantages Using a best estimate basis, the prospective method reproduces the worth of the contract to the insurer. The insurer can decide how much to retain as unrealised profit and hence maintain equity with continuing policyholders and any shareholders. Furthermore, the method replicates the maturity benefit and auction values. It does not require historic information but must project into the future. Disadvantages But, there is no guarantee that it produces surrender values that do not exceed asset share values. And the method could produce surrender values at early durations that look unreasonable from the policyholder's point of view. Equivalence of two method on the pricing basis An equation of policy value on the original premium basis takes the form: EPV of future premiums = EPV of future expenses + EPV of future benefits For a whole life contract, this gives the following equation of value:  P - annual premium amount I - assumed initial expenses on the pricing basis S - sum assured f - assumed claim expenses on the pricing basis e - assumed annual maintenance expenses on the pricing basis   Choice of method Tables of surrender values by duration are often a blend of retrospective and prospective values, subject to a minimum value of zero. At early durations, the retrospective method is more natural. in early years, the SV needs to reflect the actual expenses incurred and compare well with premiums paid, so retrospective SV is best for this a prospective SV is very sensitive to the interest rate assumption are early durations, so it is difficult to use in this situation At late durations, the prospective method is more natural. the prospective method is simpler to use it enables the loss of future profits to be incorporate it will blend smoothly into the sum assured at older ages the retrospective SV would not retain any profit on surrender
          • Eg: Impact on prospective SV
            • The size of the change in the surrender value would depend on the size of the assurance and annuity functions. These in tum depend on: how long the policy has been in force the age of the policyholder. Higher mortality rates Higher mortality rates increase the value of the assurance fu nctions in the equation given in part (i) due to the acceleration of the expected death benefit payment. Therefore: the value of the sum assured would increase the value of death claim expenses would increase. Higher mortality rates reduce the value of the annuity functions as payments are now expected to be paid for a shorter period. Therefore: the value of the annual expenses would decrease the value of the premiums would decrease. The overall effect is likely to be an increase in the surrender value, assuming it was positive before the basis change. Higher expenses Higher expenses than previously assumed will: increase the level annual expenses which will act to increase the surrender value increase the death claims expenses which will also act to increase the surrender value increase the surrender expenses which will act to decrease the surrender value. The overall impact depends on the relative size of the surrender expenses and the present values of the annual and death claims expenses.
        • Retention of profit
          • How profit arises on surrender When a policy surrenders, the retained profit is the excess of the asset share over the paid surrender value. In general, this can be split into AS - SV' + SV' - SV SV' is the surrender value calculated on the original premium basis AS - SV' represents all the past profits made on the policy to date the past profits reflects the difference between actual experiece and what was assumed in the original premium basis if actual experience was better than the premium basis, then the asset share will exceed the surrender value and a profit will be made SV' - SV reflects the difference between the values of the policy on the premium basis and the surrender value assumptions. This is capitalised value of the future profits if the future experience equalled the surrender value basis. Further profit might arise if a surrender charge is deducted from the surrender value and this exceeds the actual admin costs incurred. In a particular case where the surrender value basis is the same as the premium basis the future profit is zero the total profit made on surrender is equal to the total past profit earned on the policy the company is therefore taking the profit earned up to the date of surrender, but none of the future profit that might have been earned. Method and profit retained If the retrospective method is applied, no profit is retained If the prospective method is applied, the retained profit depends on the relationship between the assumed basis and the pricing basis. By a suitable choice of basis, somewhere between the best-estimate and pricing basis, the insurer can obtain the desired retention policy. A blended approach typically starts with the pricing basis and switches to best-estimate basis over time. The sooner the switch to the best-estimate basis, the more profit is retained. Care must be taken to ensure lapse and re-entry options do not arise.
          • Eg: Reasons for lower profit per surrender
            • The profit retained by the company is the asset share less the SV paid. As the surrender value basis has not been reviewed, the fall in profits must reflect lower asset shares than expected. This will be a result of worse than expected experience in any of the following: Interest through lower investment returns on the backing assets, likely to be matching fixed-interest bonds might be due to increased risk-free yields, or increased defaults or a widening of credit spreads on risky bonds the SV scale may have been based on a flat yield curve, or single point on the curve, which was not reflective of reality Expenses and inflation incurring higher per-policy expenses than previously, possibly due to: higher price or salary inflation increased compliance or other one-off costs mismanagement or lack of efficiency uncovering of overheads due to lower volumes in force Mortality worse mortality experience than expected, as a result of : failing to project actual mortality accurately the mix of business turning out differently from expected Tax and other adverse tax changes data or model errors a change in the mix of surrenders, eg more early surrenders, more small policies surrendering a reduction in the premium rates for new business since launch.
          • Eg: Changes to SV terms to increase surrender profit
            • Limit SV to be less than 100% of asset share, with minimum of zero. Apply a level percentage reduction to all SVs. Use higher interest, lower mortality and/or lower expense assumptions to calculate the prospective SVs. Make the SV the lower of a retrospective and prospective value, subject to a minimum of zero. Analyse competitors' terms and auction values, to see where scope exists for reducing SVs without adversely affecting market position. The table of surrender values by duration could be more finely divided, in order to target profit better at each duration. Review the SV basis more often, so as to maintain surrender profits following changes in market conditions.
        • Basis
          • For retrospective value The basis for the retrospective method is rooted in actual past experience. This relates to all relevant factors, including investment earnings, expenses, mortality and tax, subject to some appropriate smoothing In order to retain some profit, the basis may understate investment return. To avoid embarrassingly low values, the basis may understate expenses. For prospective value Interest rate - May be given by an average yield of suitable fixed-interest securities. Expense - Recent expense investigation will indicate the level of renewal expenses. Allowance needs to be made for any renewal commission. Inflation - Chosen to be consistent with the investment return assumption. Mortality - Mortality assumptions should reflect the experience of surrendering policies, which one might expect to be lighter than average.
      • Unit-linked contracts
        • The terms for surrender and alteration of unit-linked contracts are normally specified at the outset. The surrender value is typically the bid-value of the units less any penalties. Penalties may be fixed, a percentage of the unit value or the premium; they are designed to recoup initial expenses, and therefore typically reduce over time.
    • Paid up
      • The simplest alteration is making a policy paid-up. A paid-up policy requires no additional premium payments. The sum assured is reduced. The surrender value is used to purchase a single premium policy, the basis underlying may differ due to costs and mortality. Paid-up sums assured should be supported by the asset share at the date of conversion on the basis of expected future experience. be consistent with projected maturity values at later durations, allowing for premiums not received be consistent with surrender values, so that the surrender values before and after the conversion are approximately equal be determined such that the expected profit from a paid-up policy is consistent with that of a non paid-up policy.
      • Proportionate paid-up values method
        • Definition For without-profits endowment assurances, the paid-up value may be calculated as the basic sum assured multiplied by the ratio of the total number of premiums actually paid to those originally payable throughout the total term. Values are only approximately correct. Of reduced value with the computing power available today. Meeting the principles The method does not fair well when compared to alteration principles. too high at short durations because do not allow for high initial expenses too low at medium durations because do not allow for investment earnings. unlikely to be consistent with surrender values simple to apply and explain to policyholder
    • General alterations
      • Over time, a mismatch between the cover provided by the policies and the risks faced by the policyholders may evolve. To remove the mismatch, policyholders may need alterations. Examples include changes to the term, sum assured or premium payable. There are links among the alterations. Increasing the sum assured is equivalent to buying an additional policy Reducing the sum assured such that no further premiums are required is equivalent to a paid-up policy. Reducing the policy term to zero is equivalent to surrender.
      • Unit-linked alterations
        • The terms for surrender and alteration of unit-linked contracts are normally specified at the outset. When converting to a paid-up policy, the units attached to the contract at the date of conversion remain, but may incur a penalty to recoup initial cost. It is common only to allow contractual alterations although more flexibility may be allowed. For pension products, increases and decreases in premiums and changes in retirement date are normally allowed. Some whole life policies allow changes, both increases and decreases, in premiums and sum assured.
      • Principles
        • Affordability - the terms after alteration should be supportable by the asset share at the date of alteration, on the basis of expected future experience. Fairness - Ideally the expected profit post alteration should be unchanged or alternatively the same Consistency with boundary conditions e.g. surrender is the limiting case of a reduction in policy terms. Hence as the outstanding term tends to zero, the premium charges should reflect the difference between surrender and maturity. e.g. paid-up conversion is the limiting case of a reduction in sum assured. Hence as the sum assured tends to the paid-up sum assured, the premiums charges should approach zero. e.g. increasing benefits should be consistent with buying an additional policy. Stability - Small changes in benefit should result in small changes in premium. Avoidance of lapse and re-entry. Avoidance of potential anti-selection by policyholders, eg increase in benefit may be subject to additional evidence of health, depending on the scale and time. Costs of alteration should be recovered. Ease of calculation and of explanation to the policyholder
        • Eg: Determine terms for altering an EA to a TA
          • General Allow for cost of carrying out alteration. Equating policy values Equate value of contract before alteration (prospective or retrospective basis) with a prospective value after alteration. Recognises some value from original contract and uses it to reduce premium that would otherwise be charged for the endowment. Method and basis chosen for before and after alteration values will affect the profit the company takes. If current premium basis is used to value the policy after alteration then this incorporates the normal profit margin for the endowment. A basis that retains the profit accrued to date could be used to value the pre-alteration policy. Charge usual premium for new contract The term assurance has a surrender value of zero, so it might be appropriate to assume the existing policy has no current value. The company charges the usual premium for a new endowment. This may be subject to some discounts, eg to reflect the lower costs of altering the policy compared to selling a new policy.
        • Eg: How to apply to IA and possible alterations
          • Alteration principles Alterations should be affordable, ie they should be supported by the asset share in order to avoid the company making a loss. But the company may not calculate asset shares for annuities. So it may base its assessment on the supervisory reserve for the policy before and after alteration. If the supervisory reserve for the altered policy is higher than for the original policy, then there will be a capital strain for the company. Some assumptions, in particular longevity, may be different for those likely to alter than for annuity customers as a whole. So the assumptions used to calculate alteration terms may be different to the supervisory reserving assumptions. Alterations should be fair, ie the company should make a suitable amount of profit, for example: profit that would have been made had the policy not been altered profit that is consistent with what wouId be made on a new policy. Alterations should comply with relevant boundary conditions, eg if an additional premium is required to provide additional benefits, this should be on terms consistent with a new policy for the additional benefits. Alteration terms should be stable, ie small changes in annuity payment terms should result in small changes to the benefit amount. Alteration terms should avoid the option of lapse and re-entry. Alterations should be easy to calculate, document and explain. The costs of administering the alteration should be allowed for. To avoid anti-selection the company may want to underwrite some alterations, particularly those where it faces increased risk. The cost of underwriting should also be included in the alteration costs. Possible alterations Conversion from single life to joint life annuity. Conversion from joint life to single life annuity. Change to annuity payment frequency. Change from level annuity to index-linked annuity. Change from index-linked annuity to level annuity. Change in the annuity increase rate (for annuities with a fixed rate of increase). Addition of a dependants' (eg children's) benefit. Increase in annuity benefit / addition of a top-up premium. Reduction in annuity benefit / partial withdrawal.
        • Eg: Fairness of alteration options
          • A life insurance company sells without-profits term assurance policies with level sums assured to individuals. The premium rate charged by the company varies by the policyholder's age at entry and their selected level ofsum assured and term. The following table shows sample monthly premium rates currently being charged in 2021 for a Anew single life policy.  Premium rates in 2011 were 25% higher than those charged in 2021. There have been no changes to the company structure over this period, which would have impacted the premiums. In 2011, a policyholder then aged 30 purchased a term assurance with a sum assured of $100,000 and term of 20 years. The policyholder has recently requested revised premium rates for two different alterations to their policy. Option A: Extending the term a further 10 years to 30 years, with the sum assured remaining at $100,000. The company has quoted a revised total premium of $16 per month for this alteration. Option B: Increasing the sum assured by $100,000 to $200,000 with the term unchanged. The company has quoted a revised total premium of $12 per month for this alteration. Discuss whether the premium rate under each of the alterations is fair to the policyholder, taking into consideration the alteration principles. Option A Replacement policy: The policyholder could lapse their existing policy and get the intended altered policy benefits by taking out a new policy with a term of a 20 years and sum assured of $100k for a monthly premium of $14. Additional policy: The monthly premiumthe policyholder is currently paying for their original policy is $7.5 and if they then add a further 10 year term for the same $100k benefit when they reach age 50 the monthly premium will change to $13. Comments: The proposed revised premium of $16 per month is not fair to the policyholder There is the risk of lapse and re-entry Option B Replacement policy: The policyholder could lapse their existing policy and get the intended altered policy benefits by taking out a new policy with a term of 10 years and sum assured of $200k for a monthly premium of $14. Additional policy: The premium for adding a further $100k sum assured for a term of 10 years for a 40 years old is $9, which could be added to the current premium $7.5 to give an overall revised premium of around $16.5 Comments: A premium of $12 per month is reasonable There is no risk of lapse and re-entry
      • Equating policy values method
        • Definition The value of the contract before alteration, on a prospective or retrospective basis, can be equated to a prospective value after alteration that takes into account the requested changes to the terms of the contract. New policy value + Alteration cost = old policy value Value of new benefits +value of new expenses + alteration cost = old policy value + value of new premiums Meeting the principles This method meets the principles well under the same basis, surrender values before and after alteration are consistent for an extension of term or increase in benefit, use of the current premium basis to calculate the before and after alteration policy values would ensure consistency there will be consistency between the terms for alterations, surrender values and conversions to paid-up status if the same basis are used lapse and re-entry options are not necessarily avoided, the premium charged for the alteration should be verified if it is more than the premium for a completely new contract. Expected profit from altered without-profits contracts The total profit expected from an altered contract depends on the relationship between the method and basis for calculating the policy value before alteration, which determines the profit released at the time of alteration the method and basis for calculating the policy value after alteration, which determines the profit expected to emerge over the remaining term of the contract The profit released at the time of alteration will be the full expected profit under the unaltered contract if a realistic prospective value is used before alteration no profit at all if asset share is used before alteration something between if a prospective value using a basis incorporating margins is used before alteration The profit expected to emerge over the remaining term will be no profit at if a realistic prospective value is used after alteration profit corresponding to the margins if a prospective value using a basis incorporating margins is used after alteration
  • Cost of guarantees
    • Investment guarantees
      • Examples include a minimum maturity value, in money terms or as a minimum return a minimum surrender value a lump sum into an annuity conversion factor Implication for the insurer The risk assumed by the insurer is that at specified times, the backing assets are insufficient to meet the guarantees. If the company has control over the investment policy, there is conflict between investing to meet the guarantees and investing for maximum performance. If the company chooses not to invest to match the guarantees, it must include the cost of the guarantee in the original pricing basis. If the company has no control over the investment policy, it must include the cost of the guarantee in the original charges.
      • Implications
      • Valuation
        • The liability created by an investment guarantee is the excess of the guaranteed amount over the incurred cost in the absence of the guarantee. The value of these liabilities can be determined using option-pricing techniques (market-consistent) stochastic simulation of investment performance (can include prudence) Option prices / market valuation techniques The market price of a matching derivatives can be used to price the options A guaranteed minimum maturity value corresponds to an European put option on the investment funds at an exercise price corresponding to the maturity guarantee. A guaranteed minimum surrender value corresponds to a similar American option or a series of options with different exercise prices which match the guaranteed surrender values. A guaranteed annuity rate corresponds to a call option on the bonds that would be necessary to ensure the guarantee was met. Alternatively, it can be mirrored by an option to swap floating rate returns at the option date for fixed rate returns sufficient to meet the guaranteed annuity option. Advantages quicker cheaper less modelling expertise required less computing power required less subjective (as it requires fewer assumptions) may not be worth the company investing in a stochastic model if the number of policies with the guarantee is small may be easier to explain to other stakeholders could help the company to find hedging assets. Stochastic simulation A stochastic model of rate of returns on investments can be used to simulate future asset values. The assumptions must be carefully evaluated to ensure that they correspond to the investment strategy. A large number of simulation is needed to obtain reliable estimates. For some guarantees the liability if the guarantee is taken is fixed, eg maturity guarantee. For some guarantees the liability depends on future market conditions, eg guaranteed annuity rates. In the latter case, factors influencing the value of the liabilities will need to be simulated. The company will need to make assumptions about future rates of exercising options, which would take into account expected policyholder behaviour and the size of the guaranteed amount relative to the alternative benefit (eg asset share). The present value of the liability can be determined by discounting the simulated cost of exercising the option at a suitable rate. Repeated simulation will generate the probability distribution of the present value of the cost of the option. The company can then charge a premium having a present value which reflects the 'market cost' of providing that guarantee; this could be the expected simulated cost plus a margin. Advantages may have to be adopted if suitable replicating options do not exist, eg the available options may not have a long enough term allows more sophisticated and flexible modelling, eg: duration-dependent demographic assumptions time-dependent risk-free rates and asset volatilities dynamic interactions between the assumptions may already use stochastic modelling for other purposes, eg assessing regulatory capital requirements allows for more sophisticated allowance to be made for correlations between asset types in the economic scenarios the Black-Scholes formula assumes a constant risk-free rate.
        • Eg: Methods of pricing an option
          • For a number of years a life insurance company has sold a unit-linked endowment assurance product designed to provide a savings policy for a child, which is taken out by the parents on the child's birth. The maturity proceeds are paid to the child on reaching age 18. The marketing manager has suggested adding an option to new policies. The proposed option would be to convert the endowment policy, at maturity, into a level temporary annuity payable for five years from that date, or until the earlier death of the child. A guaranteed annuity conversion rate would be specified at the outset of the endowment policy. The aim would be to fund the child's university fees and provide support during the first few years of employment. The policy may not be surrendered once the annuity had started. The annuity would only be available to children who were going to university. The option would be charged for by increasing the annual management charge. Option-prices / market valuation techniques The market price of a matching derivative can be used to price the option to convert the endowment proceeds into an annuity on guaranteed conversion terms. A guaranteed annuity rate corresponds to a call option on the bonds that would be necessary to ensure the guarantee was met, ie at an exercise price which generated the required fixed rate of return . Alternatively it can be mirrored by an option to swap floating rate returns at the option date for fixed rate returns sufficient to meet the guaranteed annuity option. Stochastic simulation A stochastic model of investment returns could be used to simulate the future price of assets. The model would need to be able to simulate the value of the assets in the unit fund for the first 18 years and also the yield of suitable bonds to match the annuity on the 18th policy anniversary. A large number of simulations is needed to obtain reliable estimates. The following steps are required to calculate the cost of the guarantee in each simulation: project the maturity value (as premiums less charges rolled up with the simulated investment return) convert the maturity proceeds to an annuity using the guaranteed conversion terms calculate the cost of the annuity by taking the guaranteed annuity amount and multiplying by an annuity factor using the simulated bond yield as the interest rate calculate the cost of the guarantee as the cost of the annuity less the maturity proceeds, subject to a minimum of zero discount the cost back for 18 years. The charge for the guarantee should be included in the above projection as it will reduce the value of the maturity proceeds. The expected cost could then be calculated by averaging the results from the simulations. Alternatively, the accumulated charges could be compared with the cost of the guarantee at maturity in each simulation to check that charges exceed the cost with sufficiently high probability. A closed form solution, similar to the Black-Scholes equation, might be an alternative to the simulation approach. General points The cost of the guarantee calculated for the methods above needs to be multiplied by the proportion of policyholders that exercise the option. This will primarily depend on the proportion of 18 year olds who go to university. Alternatively, the option take up rate could also be simulated. This could allow for a higher rate of take up if the option is significantly in the money. Finally, a margin would be added to the price to reflect the model and parameter risks in the calculation.
        • Eg: Methods of pricing a guaranteed annuity rate
          • A life insurance company sells a conventional without-profits endowment assurance product which is written with a maturity age of 70, but which also allows the policyholder to take a discounted lump sum benefit at either age 60 or 65, these amounts being defined at the start of the contract. The product also offers guaranteed rates for conversion of the lump sum benefit to an immediate annuity at ages 60, 65 and 70. Option pricing techniques Option pricing techniques assess the cost of an option or guarantee as the market price of a derivative that would mitigate the risk associated with it. A guaranteed annuity rate corresponds to a call option on the bonds that would generate the required fixed rate of return. Alternatively a swaption can be used, ie an option to swap floating rate returns at the option date for the fixed rate returns underlying the guaranteed annuity option. The number of call options or swaptions needed depends on the estimated number of policyholders taking their benefits at each age. This will require the company to make assumptions about withdrawal and mortality rates. The company may also make allowance for policyholder behaviour, eg policyholders may choose to take the lump sum if it is taxed more favourably than the annuity (even if the annuity would be more expensive for the company to provide). Stochastic simulation The key assumption in a stochastic model will be the probability distribution used to model interest rates. A large number of simulations will be performed. Assumptions are needed for option take-up rates, mortality etc to estimate the amounts involved at each age. The expected cost in each simulation is the excess, if any, of the value of the annuity payments over the amount of lump sum benefit, multiplied by the proportion of policyholders who exercise. The present value of the cost can be determined by discounting this simulated cost of exercising the option at a suitable rate. Repeated simulation will generate the probability distribution of the present value of the cost of the option. The company can then charge a premium for the option that has a present value which reflects the expected (ie average) simulated cost plus a margin.
        • Eg: Methods of pricing a guaranteed surrender value
          • A life insurance company writes a unit-linked endowment assurance product. Under the terms of this product, the customer pays regular premiums which can be invested in a wide range of unit-linked funds. The benefits on surrender and matu rity are the value of the units held at the time of claim. The benefit on death is also the value of units held, unless the customer has selected a specific additional amount of life cover. If selected, the additional life cover is charged for by a monthly deduction of units based on the sum at risk. Other than this mortality charge, the only charges are: an annual management charge, which varies by the unit fund(s) selected. surrender penalties in the first few years. It has been proposed that a minimum surrender value guarantee be added to the product for all future new business. The surrender value would now be the greater of the value of units or the sum of the premiums paid up to the surrender date, with no surrender penalty applied. Option-pricing techniques Surrender value guarantee corresponds to an American put option on the unit fund with a strike price of the guaranteed surrender value. Or consider as a series of European options with different exercise prices which match the guaranteed surrender values at different policy durations (as the guarantee increases each time a premium is paid). The above options can be valued using their market prices (if available). Or closed form solutions (such as Black-Scholes) can be used. Stochastic simulation Construct a stochastic model of future unit fund returns. Choose model points to represent the expected policies sold by choice of unit fund , policy size, age, size of death benefit. Project unit fund realistically, allowing for charges (including the guarantee charge), deaths and withdrawals. Choose a probability distribution for investment return and set its mean and variance. These should vary for the different unit funds available. Run a large number of simulations to obtain reliable estimates. Withdrawal assumption should take into account expected policyholder behaviour, ie higher withdrawals assumed when guarantee bites. Withdrawal and investment assumptions should be dynamically linked. At each future time, the simulated guarantee cost is the excess of the guaranteed value over the unit fund, where positive (zero otherwise). Calculate present value by multiplying the simulated cost of exercising the option by the assumed surrender rate at each future time, and then discounting at a suitable discount rate. Repeat simulations to generate the probability distribution of the present value of the cost of the option. Set charge to cover the cost of the guarantee with a suitable probability. Perform sensitivity tests, eg to the choice of probability distribution and to different deterministic assumptions including mortality rates.
        • Eg: Methods of pricing a guaranteed maturity vallue
          • A unit-linked savings product offers a fixed minimum guaranteed benefit at maturity. The company wishes to calculate a market-consistent liability for this maturity guarantee. For both methods, the calculations should ideally be done on a policy by policy basis in order to avoid cross-subsidies, ie to avoid policies where the guarantee is out-of-the money cross-subsidising those where the guarantee is in-the-money. Option pricing An option pricing approach assesses the value of a guarantee as the market price of a derivative that hedges the risk associated with the guarantee. This guaranteed fixed minimum maturity benefit corresponds to a put option on the assets in the unit-linked fund(s). As the guarantee applies only at one point in time, a European put option would be suitable. Consider options with maturity dates as close as possible to the maturity dates of the policies with the guarantee. Consider options that most closely represent the assets within the unit fund(s), for example market equity or bond indices. The strike price of the options should correspond to the fixed minimum maturity guarantee amount. The number of options contracts required can be red uced by allowing for expected mortality and withdrawals. The market-consistent value of the liability is the market price of these options, provided they are traded in a deep and liquid market. If such market prices do not exist, then an alternative approach is needed, eg the Black-Scholes formula with market-consistent assumptions. Market-consistent assumptions would use risk-free rates and market derived volatilities, eg implied volatilities from other option prices. If regular premiums are payable, these should be allowed for. Stochastic simulation With this approach, the unit fund is projected, net of all charges, to the maturity date, allowing for deaths and withd rawals. A stochastic model is used to simulate the future price of assets in the unit fund. As the valuation is market-consistent (ie a risk neutral calibration), risk-free returns will be used. These risk-free rates may be determined from government bond yields or swap rates if there is a sufficiently deep and liquid swap market. An appropriate deduction would be made to allow for credit risk. Investment return volatilities will be required and these should reflect the actual assets in the unit funds. The assumed volatilities should be calibrated to market observations as should the correlations between assets. Dynamic links between assumptions should be modelled, eg between lapses and investment returns. There is unlikely to be an observable market to help set the decrement assumptions. So, the starting point for the mortality and persistency assumptions would be best estimate. It may be decided to include a risk margin in each of these assumptions due to the inherent uncertainty. Alternatively an overall risk margin could be used to arrive at a market-consistent value, for example using a cost of capital approach. These margins are intended to reflect the compensation required by the 'market' in return for taking on the uncertain aspects of the liability cashflows. For each simulation, the model needs to calculate the excess of the fixed guaranteed benefit over the projected unit fund at maturity. The cost at maturity is then set as the higher of this excess and zero. The present value of the guarantee liability can then be determined by discounting these simulated costs of the guarantee. This discounting would use the risk-free rates. Simulations will be run in order to generate a distribution of the present value of the cost of the guarantee. The market-consistent liability is the average cost across all these simulations. A large number of simulations is needed to obtain a reliable estimate.
    • Mortality options
      • Examples include purchase additional benefits without providing further evidence of health at the normal premium rates at the point at which the option is exercised renew a policy at the end of its original term without providing additional evidence of health convert all or part of the sum assured from one contract to another, e.g. from term assurance to endowment assurance add a second life to a single life policy at the normal premium rates for the second life at the point at which added Implications for the insurer The term and conditions under which the option can be exercised need to be clearly set out in the original policy. They are designed to reduce selection against the office. The cost of an option is the excess of the full premium for the additional assurance if appropriately underwritten, over the charged normal premium. Healthy lives produce little cost Lives in poor health generate substantial cost Total costs depend on the proportion and health status of those who choose to exercise the option. The smaller the proportion, the worse the mortality experience.
      • Implications
      • Factors affecting mortality option values
        • Below are some factors that affect mortality option values the term of the option, the longer the option life, the likelier it becomes in the money the number of possible exercise times, the more chances to exercise, the more valuable the option the higher the potential benefit increase, the more valuable the option the fewer restrictions on converting, the better.
      • Value an option
        • Mortality options are normally valued using cashflow projections. These cashflows would include the additional benefits expected to be payable under the option and the additional premiums expected to be received. The additional premiums would be based on the expected premium rates that would be charged to standard lives for the additional benefit, as at the option exercise date. The projection should also allow for any additional expenses incurred in the administration of the option. If the purpose of the valuation is pricing the option then allowance should also be made for the additional reserves that should be held. Extra assumptions include probability that the option will be exercised additional benefit level that will be chosen expected mortality of the lives who choose to exercise expected mortality of the lives who choose not to exercise additional expenses relating to the option Option take-up rates The model may assume that all eligible policyholders will take up the option and that the maximum additional benefit will always be taken. If there is a choice from exercise dates or alternative options, the model may assume that the worst option is chosen. Alternatively, the model may use take-up rates assumptions that vary by exercise date or alternative options. Mortality rates Typically due to anti-selection, the expected mortality of lives who take up the option will be heavier.
  • Data checks
    • Data reconciliation checks
      • Where an investigation is carried out on a regular basis, a reconciliation can be attempted of the current data with those used for previous investigation. Group the data in a sensible way then check that 'data at previous investigation + business come onto the books - business gone off the books = data at current investigation' Examples of data items that might be validated For non-unitised business, check: number of contracts basic sum assured office premium amount of any attaching bonus For unitised business, check: number of contracts number of units allocated sub-divided by unitised fund current premium payable current benefits available Other relevant data items include: changes in the number of units allocated arising from switches between unitised funds changes in the premium payable and benefits under existing contracts The system must be checked periodically to ensure they are working correctly and the staff are following the procedures. The movement data should also be checked against any appropriate accounting data.
    • Consistency checks
      • For non-unitised contracts, the following items should be sensible and consistent with the figure for the previous investigation average sum assured average premium ratio of the basic sum assured to the premium payable persistency rates (as a check on the movement data) ratio of the total bonus to total sum assured For unitised contracts, check that the number of units purchased by premiums are consistent with the corresponding revenue account iterms the number of units encashed to pay benefits are consistent with the corresponding revenue account iterms internal unit movements are consistent with the surplus emerging during the year
    • Unusual values checks
      • Benefit values (eg sum assured or unit values) that are zero or negative. Benefit values that are unusually large. Unusually large premiums. Negative premiums. Impossible date of birth . Impossible retirement age (or date). Impossible contract start date. Impossible benefit payment date (eg maturity date). Other unknown or inappropriate value (eg numerical value for gender). Unusual clustering of data, eg a very high proportion of dates of birth in a particular month or year.
    • Spot checks
      • It is good practice to compare an extract of the computer held data with the information in the paper administration files. This can be done on a spot check basis by randomly selecting a number of policies.
    • Eg: Data checks on mortality experience investigation
      • Ensure that all the data items required are maintained and can be accessed in the req uired format. As this is an annual investigation, perform a reconciliation of the current data with those used for the previous mortality investigation. Group the data by rating factor, eg by year of entry and age. Check that the rating factors have been recorded accurately. For each group, reconcile the data between the previous and current investigations as follows: data at previous + policies on - policies off = data at current. Perform the above reconciliation check for: the number of contracts the sum assured the office premium. Compare the number of deaths in this investigation with the previous investigation. Investigate any records showing zero death benefit paid on death. Systems for producing the movements data should be checked periodically to ensure that they are working correctly and that the staff involved are following the procedures laid down. Movements data should be checked against any appropriate independent accounting data, eg death benefits for term assurances. Check that the following are consistent with previous investigation: average sum assured average premium ratio of sum assured to premium. Check for unusual values, eg very large death benefits. Check for impossible values, eg impossible dates of birth. Group items and took at their distribution, eg an unusually high clustering of birth month may indicate a data input error. Perform spot checks on random policies to compare the computer held data with the paper administration files. Compare the results of the mortality investigation with previous years. Large variations would not be expected from one year to the next under normal circumstances. If experience is very different from previous years, check there is an explanation, eg epidemic, change in underwriting / target market. Comparison can be done at an aggregate level or by smaller homogeneous groups, depending on the available data. Compare results of mortality investigation with any relevant industry information.
    • Eg: Possible data checks on sum assured data
      • A life insurance company sells a without-profits level term assurance product and is performing control checks around its year-end results. The following table shows figures used in the sum assured data checks for 31 December 2020 and 31 December 2021.  (i) Describe the data checks that could be performed with this information (ii) Perform the data checks that are possible using the figures in the table above. (iii) Suggest possible reasons for any discrepancies identified by the data checks conducted in part (ii) (i) Check that: sum assured at start year - sum assured left in the year + sum assured written in the year = sum assured at end of year It would be expected that the sum assured at the end of the year (calculated above) would be equal to the sum assured at start of the following year (given in the table). The sum assured lapsed could be checked against the persistency assumptions. The sum assured paid out could be checked against the mortality assumptions. The sum assured written could be checked against the previous year's new business (ii) Given the data for the prior year, the expected sum assured in-force at the start of the current year is 5,400 - 195 - 220 + 256 = 5,241. This compares to 5,295 in the table, which is 54 higher. Sum assured lapsed was 195/5,400 = 3.6% for prior year and 210/5,295 = 4.0% in current year. This looks fairly consistent year on year. [½] Sum assured paid out was 220/5,400 = 4.1% for prior year and 122/5,295 = 2.3% in current year. This seems like a significant movement year on year. (iii) The sum-assured in-force discrepancy could be due to a data correction discovered in the current year... ... or the difference could be due to adjustments to sums assured from any options. The reduction in sum assured paid out may be because the current year was a light year for mortality, or the previous year was heavier. The increase in new business sum assured seems a high increase and could be due to targeting a new segment of the market... ... or using a new distribution channel to access a wider market. There could be errors in the data.
• Risk management
  • The risk of insolvency can be reduced by holding adequate reserves putting in place suitable reinsurance arrangements following a suitable underwriting process adopting an appropriate investment strategy using an appropriate profit distribution strategy. A good way of evaluating any proposed strategy that incorporates the above three management tools is to look at the resultant effect on ongoing solvency.
  • Reinsurance
    • An arrangement whereby the reinsurer indemnifies the cedant against part or all of its liabilities under one or more policies or reinsurance contracts. if direct insurance policies are ceded, the transfer is known as a cession if reinsurance contracts are ceded, the transfer is known as a retro-cession
    • Purposes
      • Reinsurance is a risk transfer used by cedants to reduce the volatility and uncertainty of future claims. a reduction in risk implies holding less capital the transferred risk can be insurance, market, operational, financial risk Reinsurance can be used to limit the amount paid on a claim limit total claims payout. reduce claim payout fluctuations. receive experience data to help pricing receive technical assistance or expertise help design the product to reduce risk help with underwriting reduce new business strain. increase profits, return or risk-adjusted return on capital (by reducing risk cost or increasing volumes). reduce overall capital requirements by using a reinsurer's capital. separate out different risks from a product. Reinsurance can disaggregate these risks, allowing the cedant to optimise its risk management and capital requirements. allow aggregation of risks that the cedant cannot manage on its own, so allowing manufacture of product lines.
      • Eg: How a reinsurer can help the company
        • A life insurance company is launching a new impaired life annuity product. A policyholder pays a lump sum upfront upon becoming a resident of a care home for the elderly, and the policy pays the annual fees to the care home. It can be assumed that upon moving to the care home, policyholders stay there for the rest of their lives. This is a new market for the company and it sells no other impaired life annuities. Explain how using a reinsurer may help the company. The reinsurer can provide technical assistance to the insurance company, especially as this is a new product and the company lack relevant experience. e.g. the reinsurer can provide data to help with pricing The reinsurer may also help with underwriting the impaired lives. The insurer can transfer risk to the reinsurer in particular the longevity rsk associated with the annuity payments. Reinsurance may reduce new business strain or help finance new product development costs.
    • Main types
      • The type of reinsurance and the way in which the amount reinsured is specified (eg individual surplus/ quota share) will depend on: The reason the ceding company is using reinsurance The reinsurance costs The type of business For term assurances, original terms reinsurance or risk premium reinsurance may be used. It may prove difficult to obtain original terms reinsurance on with-profits business as the reinsurer would be obliged to follow the cedant's bonus rates. Reinsurance is not normally sought on individual immediate annuity business, unless it is a very large case. Catastrophe reinsurance can be very important for group business as there is an accumulation of risk. For unit-linked business, risk premium reinsurance is normally used. The legal conditions applying The forms of reinsurance coverage actually on offer in the market.
      • Facultative and obligatory
        • The term 'facultative' applied to the cedant's part of the agreement means that it is free to place the reinsurance with any reinsurer. The term 'obligatory' indicates the removal of this freedom of action. The agreement between cedant and reinsurer may be facultative / facultative: the insurer can choose whether or not to reinsure the risk and the reinsurer is not obliged to accept the risk. facultative / obligatory: the reinsurer is obliged to accept the risk if the insurer wishes to cede it obligatory / obligatory: the reinsurer must reinsure the risk and the reinsurer is obliged to accept it The latter two types will always be formalised in a treaty.
      • Original terms & Risk premium
        • Does the reinsurer share the insurance company's premium from policyholders or does it charge its own premium for the risk it takes on? Original terms The main feature of original terms reinsurance is that it involves a sharing of all aspects of the original contract. Outside the UK and the Ireland, it is known as coinsurance The premium is split between the insurer and reinsurer in a fixed proportion and claims is split in that same proportion. The cedant will provide the reinsurer with the premium rates it is using. These are known as the retail rates and the reinsurer can check its adequacy. Since the insurer did all the heavy lifting, the reinsurer pays it a reinsurance commission. this commission usually covers any agent commission as well as part or all of initial expenses the reinsurer wants to make a profit, and consider the insurer's likely future experience and scrutinize their underwriting procedures. competition and risk-return analysis largely determine the magnitude of the reinsurance commission There are two ways to specify the amount to be reinsured - individual surplus and quota share, a mixture of the above is typically adopted, retaining a percentage of each policy up to a maximum retention. Risk premium Rather than sharing the premium, the reinsurer charges a specific premium for the risk. the premium may be level or vary annually with the probability of a claim The cedant may reinsure part of the sum assured or the sum at risk. normally the latter, so risk premium reinsurance typically covers only the insurance risk if the sum at risk is used, how the reserves are determined must be specified The part to be reinsured can be on an individual surplus or a quota share basis. The reinsurer determines its risk premium rates by assessing the likely experience of the business and adding expense and profit margins. the rates may or may not be guaranteed for the term of the policy if the underlying business is on guaranteed terms, then the insurer will typically demand guaranteed reinsurance rates the reinsurer may also offer some form of profit participation changes in the insurer's premium rates will not necessarily require changes in reinsurance rates, it therefore gives the insurer greater freedom to respond to competitor changes in premium rates. Under a 'net level premium arrangement', the reinsurer spreads the risk premiums so that they are level over the term of the contract. This method has the advantage that the insurer can simply load the reinsurance charges to obtain the premium payable by the policyholder.
        • Eg: Contrast original terms and risk premium reinsurance
          • Original terms This method involves a sharing of all aspects of the original contract between the cedant and the reinsurer. The cedant provides the reinsurer with the premium rates it is using. A change in the insurer's premium rates will automatically result in a change in reinsurance premiums. The reinsurer determines the reinsurance commission it is prepared to pay to the cedant. To set the reinsurance commission, the reinsurer will consider the likely future experience and its knowledge of the quality of the cedant's underwriting. The reinsurance commission is likely to cover the commission paid by the cedant on the reinsured portion and part or all of the cedant's initial expenses. Risk Premium The reinsurer does not share in the office premium of the cedant, but charges a specific premium for the risk. Changes in the insurer's premium rates will not necessarily require changes in reinsurance rates. The reinsurance premium may: be level over the term of the policy vary annually with the probability of claim. The cedant reinsures part of the sum assured (eg term assurance) or the sum at risk (eg endowment assurance).
        • Eg: Suitability of risk premium reinsurance for group TA
          • A life insurance company sells a unit-linked savings product that has a death benefit equal to the higher of a fixed sum assured and the value of units at the date of death. If the fixed sum assured is higher than the value of units, then this element is subject to a reinsurance arrangement on a risk premium basis. The company is now planning to launch a new group term assurance product and is looking to use the same type of reinsurance arrangements with the same reinsurer for this new product. Positive points Taking out reinsurance on this new product is sensible to reduce the fluctuations in claims payouts and hence can help stabilise the profits of the insurer Taking out some reinsurance will help reduce overall capital requirements It may allow them to take on higher volumes and bigger risks Risk premium gives the insurer greater freedom to change the premium rates without impacting the reinsurance rate For term assurance this could be important as the market is competitive, so it allows premium changes in response to competitors changes As the company already has a relationship with the reinsurer there may be preferential rates available The company may not have relevant experience to base the pricing of the group term assurance product on and so the reinsurer could help provide this There could be the option to include financial reinsurance to help with new business strain for the new product Administratively it may be simpler to use only one reinsurer for premiums and claims Having used the reinsurer to date there would be less checking required to assess their creditworthiness and use as a third party Negative points A significant risk for the group term assurance product is concentration risk and there is no protection for this with risk premium insurance So the company may want to consider stop loss or catastrophe reinsurance in addition The reinsurer may not currently cover group term assurance business and so may not be able to offer reinsurance for this Sum at risk is completely different for unit linked product and group term, so using same type of reinsurance may not be appropriate [1] If there has not been a good experience with the reinsurer to date then they may not offer the most competitive rates [½] Counterparty risk to the one reinsurer will be greater if additional reinsurance is placed with them, and this may cause a breach of regulatory limits They will cede profits to the reinsurer and there will be expenses (premiums, increased, administration) It may be possible to find better reinsurance terms elsewhere
        • Eg: Reasons for increasing risk premium reinsurance rates and actions in response
          • Company A is a recently established reinsurance company and has just announced an increase in its risk premium reinsurance rates for new and existing business. Company B is a life insurance company that sells term assurance policies via online marketing. Company B has a risk premium reinsurance arrangement with Company A. (i) Suggest possible reasons why Company A may be increasing its rates. (ii) Discuss possible actions Company B could take in response to the increase in Company A's rates. Reasons Experience may have been deteriorating on their portfolio of business. Company A may have experienced large reinsurance losses from a single event and now seeking to recoup losses. E.g. due to covid Given Company A is recently established, the initial rates may have been set based on expected experience. The mix of business may have been different than expected. Company A has more data now and has a better understanding of the risks that it has taken on, compared to when it initially set premium rates. Initial rates may have been designed as loss leaders to generate business or could have been too low due to error or lack of understanding. Company A may have expenses higher than expected. For example administration expenses may have increased. Expectations of expense inflation may have changed. Company A may have experienced a loss of other business from ceding companies or higher than expected policy lapse rates, which means fixed expenses need to be spread across fewer policies. Company A may have solvency issues, and needs to boost income to help or may simply want to increase its profit margins. There may have been general changes in regulations or tax that require Company A to pass on any increases within reinsurance rates. E.g. an increase in capital requirements for reinsurers, or the reinsurer has had a capital add on There may be a general increase in rates across the market and company may have decided to follow the trend. E.g. due to an increased demand for reinsurance. Actions Company B may decide to change reinsurers. Company B may research the market to look for similar reinsurance from other companies. Company B may consider a range of factors in its market review, e.g. the availability of technical assistance, the potential to benefit from preferential rates due to an existing arrangement. Company B may discuss with Company A whether any changes to existing arrangement can be made to reduce new rates. E.g. changes to basic underwriting questions or tighten policy wording. Company B may decide to keep more of the risk or change to an original terms arrangement. The company may decide it does not need reinsurance anymore if it has grown large enough to self-insure or the benefits don't warrant the extra costs or want to retain all profit on the product. Company B may decide to accept the change in rates particularly if the increase is small or still represents good value or if other reinsurers have similarly increased their premium rates. If it accepts the rates it needs to agree if it is to pass the increase on to new customers or absorb the increase from within its own profit. Before increasing rates for new policies Company B would want to check competitor actions and the potential impact of prmeium increase on its sales volumes. The company would also want to do a re-pricing exercise to check the profit margins on online term assurance and whether there are margins elsewhere in pricing assumptions that can be reduced. The company may consider stopping selling the term assurance if changes to reinsurance rates mean the product is less profitable or continuing to sell but focusing on other products. It could also explore a coinsurance arrangement with another insurer. It may instruct its underwriters to limit the number of cases accepted by size of sum assured to limit its exposure to reinsurance costs.
        • Eg. Adv & disadv of taking out same type of reinsurance with same reinsurer
          • A life insurance company sells a unit-linked savings product that has a death benefit equal to the higher of a fixed sum assured and the value of units at the date of death. If the fixed sum assured is higher than the value of units, then this element is subject to a reinsurance arrangement on a risk premium basis. The company is now planning to launch a new group term assurance product and is looking to use the same type of reinsurance arrangements with the same reinsurer for this new product. Discuss the advantages and disadvantages of taking out the same type of reinsurance with the same reinsurer for the group term assurance product. Advantages Same types of reinsurance Risk premium reinsurance gives the insurance company greater freedom to change its premium rates independently of the reinsurance rate. This could be particularly valuable for the term assurance product if the market is competitive, as it would allow premium changes in response to competitors changing their rates. Same reinsurer The reinsurer may offer preferential rates as they already have a relatiionship with the company. It is simpler administratively to use a single reinsurer, e.g. making premium payments and claim recoveries. Reinsurance for the group term assurance The reinsurer could provide experience and expertise to help in the pricing of the new group term assurance product. There could be the option to include financial reinsurance to help with new business strain associated with the new product. Disadvantages Same type of reinsurance A significant risk for the term assurance product is the concentration of mortality risk because the lives in a group are not independent. Risk premium reinsurance does not protect against this risk. Same reinsurer The level of counterparty risk exposure to a single reinsurer may be too high Other reinsurers may offer better reinsurance terms Reinsurance for the group term assurance Taking out reinsurance will reduce the company's expected profits on the new product.
      • Quota share and individual surplus
        • How is the amount to be reinsured specified, as the same specified percentage for all policies or as the excess of a benefit amount over a retention limit?
      • Excess of loss
        • Excess of loss can be enacted on a risk basis, where the reinsurer pays any loss on an individual risk in excess of a predetermined retention. It can also be enacted on an occurrence basis, where the aggregate loss from any one occurrence of an event exceeds the predetermined retention. An excess of loss treaty can be organised into different levels, or lines. The cedant may retain the first Xm of losses. The first Ym over the Xm will have one price. The next Zm over (X+Y)m will have a different price and so on. Different reinsurers may then take different proportions of each line.
        • Catastrophe
          • Reduces the potential loss due to non-independence of the risks. Covers low frequency events that have a high impact. Usually excess of loss reinsurance, though could be quota share. Available on an annual basis and must be renegotiated each year. Pays out if a catastrophe occurs as defined in the reinsurance contract. Typically, a catastrophe will be defined as at least a certain number of deaths from a single event within a fixed time from the event. Insurer pays the first agreed amount of any such loss, the reinsurer pays at least some above this limit. Reinsurer may pay only a proportion above the initial amount. Reinsurer may pay up to a maximum amount. Any amount above the limit reverts to the insurer. Usually a maximum amount of cover per life. War, epidemics and nuclear disasters are usually excluded. Separate catastrophe covers may be available for excluded risks.
          • Eg: Importance of catastrophe insurance for group business
            • It is unlikely that the lives insured by individual business are linked. Individual business is likely to ensure that it has a spread by geographical location. Group business will have insured groups of lives that are linked, typically by employer. In particular many of the lives may work in a single location. A disaster at that place of work may lead to multiple deaths. Possible disasters include fire, explosion, building collapse. Groups of employees may travel together leading to the risk of multiple deaths from one travel related incident, eg plane crash. Employees will also be concentrated by geographical location. So any local disaster, eg at a sports stadium, could lead to multiple claims. So group business is more exposed to single events leading to multiple deaths of its insured lives than individual business. As catastrophe insurance would mitigate this risk, group business is more likely to consider it worthwhile.
        • Stop loss
          • Stop loss reinsurance means that the reinsurer pays the aggregate net loss over the predetermined retention for a portfolio over a given period. The loss to the cedant in any period is capped.
      • Fin Re
        • Financial reinsurance are devised primarily as a means of improving the apparent accounting or supervisory solvency position of the cedent. It intends to involve only a small element of transfer of insurance risk from the cedant to the reinsurer. Types Risk premium reinsurance Can use risk premium reinsurance, with enhanced initial reinsurance commission, on a block of business and/or for new sales. This creates a cash advance, or loan, related to the volume of business reinsured. Repayments are achieved by increasing the risk premiums payable. The reinsurer takes into account the expected lapse experience in determining the loan repayments. Contigent loan Requires supervisory reserves to be based on prudent assumptions. Reinsurer provides an explicit loan to the cedant. Loan repayments are made contingent on the future supervisory profits generated by the block of business.
        • Use risk premium reinsurance
          • Features Can use risk premium reinsurance, with enhanced initial reinsurance commission, on a block of business and/or for new sales. This creates a cash advance, or loan, related to the volume of business reinsured. Repayments are achieved by increasing the risk premiums payable. The reinsurer takes into account the expected lapse experience in determining the loan repayments. Implications The cash advance increases the size of the assets. The loan does not create an additional liability because repayments are contingent on the policy staying in force. This means the cedant may not need to reserve for the repayments within its supervisory returns. So the net assets increase and solvency improves.
        • Use contigent loan
          • Features Requires supervisory reserves to be based on prudent assumptions. Reinsurer provides an explicit loan to the cedant. Loan repayments are made contingent on the future supervisory profits generated by the block of business. Implications The loan increases the size of the assets. The cedant should not need to reserve for the repayments because they are paid out of future supervisory profits as they are earned. So the value of the liabilities should be unchanged. The net assets therefore increase and solvency improves.
      • Eg: Appropriate reinsurance for certain products
        • Without-profits decreasing term assurance Surplus reinsurance Pays excess of sum assured over retention limit, same retention for each policy issued, specified by treaty. Reinsurance cover reduces (and possibly expires) as duration increases and sum assured reduces; small sums assured may not be reinsured. Quota share Pays a fixed percentage of the sum assured for all policies at all durations, specified by treaty. In both cases, the reinsurance premium could be calculated either on a risk premium or original terms basis. Risk premium Reinsurer sets the reinsurance premium rate. Cover could be based on sum at risk each year, the risk premium rate varying according to the age of the policyholder each year. Or can be a level regular premium, which the insurer can then use as a basis for its own premium rates (plus its own loadings). Original terms Reinsurance premium equals the reinsured percentage of the office premium. For level reinsurance premiums, the payment period is likely to be the same as for the office premium (ie shorter than the full benefit term). Unit-linked endowment assurance Reinsurance is unlikely to be used to cover the unit liability. Surplus reinsurance could be used to cover any large individual death benefits, ie significantly in excess of unit fund values. The reinsurance would cover the excess of the current sum at risk (sum assured in excess of unit reserve) over the insurer's retention level. Quota share might also be used if the product or market is new. Risk premiums would be used, on the recurring single premium basis. A life insurer with a low level of solvency It might be possible to use financial reinsurance to help the insurer improve its solvency (depending on the regulatory regime). Using the future profits in a block of existing business Requires supervisory reserves to be based on prudent assumptions. Reinsurer provides an explicit loan to the cedant. Loan repayments are made contingent on the future supervisory profits generated by the business. This means the cedant may not need to reserve for the repayment within its supervisory returns. So the net assets increase and solvency improves. Controlling the amount of new business strain Can use risk premium reinsurance, with enhanced initial reinsurance commission. This creates a cash advance, or loan, related to the volume of business reinsured. Repayments are achieved by increasing the risk premiums payable. The reinsurer takes into account the expected lapse experience in determining the loan repayments. The cash advance will increase the assets significantly. The loan does not create an additional liability because repayments are contingent on the policy staying in force. Alternatively, use original terms quota share, which may reduce the initial reserves (depending on regulation and the need to allow for the risk of reinsurer default). Payment of initial reinsurance commission helps to reduce capital strain. Adverse claims pose greater risk if solvency is low. Surplus, catastrophe and stop-loss reinsurance, depending on contract types, might be used. Catastrophe reinsurance Pays excess of total claims over a fixed retention limit, from total claims arising from one single event (eg workplace accident). Valid claims would be defined (eg at least 3 deaths, and must occur within a 72-hour period of the event). Reinsurance payment subject to a maximum limit for any single event. All amounts would be net of any other reinsurance recoveries. Stop loss reinsurance Reinsurer pays the total net loss in excess of a fixed retention, for the whole portfolio over a given time period (eg one year).
      • Eg： Appropriate reinsurance for the product
        • A relatively new life insurance company sells a single premium unit-linked whole life assurance product. The product is sold to very high net worth individuals for inheritance tax planning. It is sold using insurance intermediaries. The policyholder may choose from a wide range of internal unit-linked funds, and may switch between funds at any time. Benefits: On death the estate receives the value of the unit fund plus an additional fixed sum assured which is defined at outset, minus a deduction of any outstanding 'initial charges'. On surrender at any time, the policyholder receives the value of the unit fund, after deduction of any outstanding 'initial charges'. Partial withdrawals may be taken at any time, subject to a maximum amount per annum and a charge expressed as a percentage of the amount withdrawn. Charges: A per policy 'initial charge', which is applied quarterly for the first five years and taken by cancelling units. The charge is subject to inflationary increases based on an index specified by the company. A fixed annual management charge, expressed as a percentage of the value of the unit fund. A switch charge, based on the value of the unit fund being switched. Original terms The reinsurer receives a percentage of the premium and pays the same percentage of all the claims. So the reinsurer needs to pay a proportion of the unit fund as well as a proportion of the sum assured on death. The reinsurer also needs to meet a proportion of the surrender benefits. However, the reinsurer will not want to take on the investment risk of matching the unit fund. So, this form of reinsurance would normally be unsuitable. Risk premium The additional sum assured could be reinsured. Alternatively the sum-at-risk based on the excess of the additional sum assured over the non-unit reserve could be reinsured. The reinsurance premium is calculated on the reinsurer's risk premium basis, which can be annually reviewable or guaranteed. This reinsurance can be on an individual surplus or a quota share basis. Under the quota share basis the same proportion of the sum assured (or sum-at-risk) is reinsured on each policy. Quota share reinsurance will protect the insurer from losses due to bad mortality experience over the whole block of business. Under the individual surplus basis the amount reinsured is the excess of the sum assured (or sum-at-risk) over the insurer's retention. Individual surplus reinsurance will protect the insurer from large losses on policies with large sum assureds. Excess of loss Catastrophe reinsurance could cover all claims arising from a single event above the insurer's retention. Stop loss reinsurance could cover the total claims over the year in excess of the insurer's retention. Financial reinsurance It might be possible to use financial reinsurance to help reduce the impact of new business strain. Can use risk premium reinsurance, with enhanced initial reinsurance commission. This creates a cash advance, or loan, related to the volume of business reinsured. Repayments are achieved by increasing the risk premiums payable. The reinsurer takes into account the expected lapse experience in determining the loan repayments. The cash advance will increase the assets significantly, while there is no additional liability because repayments are contingent on the policy staying in force. So the net assets increase and solvency improves. Alternatively, a loan could be provided with repayments paid out of the insurer's future supervisory profits. The insurer's capital position is improved because its assets increase by the amount of the loan, but its liabilities do not increase because the repayments are contingent on future supervisory profits emerging. The supervisory reserves would need to be based on prudent assumptions for this alternative to be possible.
    • Amount to reinsured
      • There are two ways to specify the amount to be reinsured individual surplus - the reinsured amount is the excess of the original benefit over the cedant's retention limit on any individual life quota share - a specified percentage of each policy is reinsured A mixture of the above is typically adopted, retaining a percentage of each policy up to a maximum retention. The retention limit is the maximum amount of risk retained by the cedant on any individual risk. General factors to consider when setting the retention limit include the: average benefit level for the product expected distribution of the benefit company's insurance risk appetite level of the company's free assets and the importance attached to stability of its free asset ratio terms on which reinsurance can be obtained and the dependence of such terms on the retention limit level of familiarity of the company with underwriting the type of business involved effect on the company's regulatory capital requirements of increasing or reducing the retention limit existence of a profit-sharing arrangement in the reinsurance treaty company's retention on its other products nature of any future increases in sums assured. Approaches to determine the level of retention limit First method Set the retention limit at such a level as to keep the probability of insolvency (or ruin probability) below a specified level. An alternative approach is to aim for a probability that the loss in any one quarter or year does not exceed a proportion of the earnings of the business, if that is how the cedant determines its risk appetite. This can be done by using a stochastic model for projecting claim rates and a model of the business, so that claims can be projected forward together with the value of the company's assets and liabilities. By using simulation, a retention level can then be determined such that the company stays solvent, or earnings stay above a certain level, for 995, say, out of 1,000 runs. Second method Consider the total of: (a) the cost of financing an appropriate mortality fluctuation reserve, and (b) the cost of obtaining reinsurance - the reinsurer naturally incorporates an expense and profit loading in its reinsurance terms, and the ceding company incurs administrative expenses. As the retention limit increases, (a) will increase and (b) will decrease. A retention limit can then be adopted that minimises the total (a) + (b). To calculate (a), the simulation approach discussed above would probably need to be used to determine the reserve that the company needs to hold. Third method Another possible approach is based on the theory of efficient investment frontiers and looks at reinsurance as an asset class that allows the firm to optimise its risk and reward trade-off.
      • Eg: Factors to consider when setting the retention limit
        • A life insurance company writes individual term assurance business and is considering taking out original terms reinsurance on this business. The reasons behind the company taking out the reinsurance will influence the retention limit. If the purpose is to limit the loss on any individual death claim then the retention limit is likely to be high (as only the very largest claims are likely to represent an issue for the company). If the company is seeking technical assistance then the retention is likely to be much lower, especially if the company is fairly new to this market. If the purpose is to reduce claims fluctuations, then the higher the volume of business, the lower the likely claims volatility and the higher the likely retention limit. If the purpose is to reduce the parameter risk, the retention limit may be higher than that used to obtain technical assistance but lower than that used to protect against individual large claims. General factors to take into account when setting the retention limit include: the higher the average benefit level for the product, the higher the retention limit the lower the company's risk appetite, the lower the retention limit the lower the free assets, the lower the retention limit the more generous the reinsurance terms, the lower the retention is likely to be the less experience the company has, the lower the retention limit is likely to be the effect on the company's regulatory capital requirements of increasing or reducing the retention limit the existence of a profit-sharing arrangement might result in a lower retention limit. the company's retention on its other products the nature of any future increases in sums assured , eg options on the term assurance policies the extent of dependence or correlation in the mortality of the insured lives. The company's risk appetite will reflect: the company's risk policy the shareholders' requirements (if it is proprietary). The retention will depend on the marginal cost of increasing the limit compared with the cost of retain ing the risk and financing an appropriate mortality fluctuations reserve.
      • Eg: Factors to consider when setting the retention limit
        • A life insurance company sells a unit-linked savings product that has a death benefit equal to the higher of a fixed sum assured and the value of units at the date of death. If the fixed sum assured is higher than the value of units, then this element is subject to a reinsurance arrangement on a risk premium basis. The company is now planning to launch a new group term assurance product and is looking to use the same type of reinsurance arrangements with the same reinsurer for this new product. Suggest the factors the company could take into account when agreeing the retention limit for reinsurance on the group term assurance product As group term is a new product for the company, its experience is relatively uncertain and it is likely the initial retention limit will be lower than it would be for an existing product although the company may agree terms with the reinsurer so that as its experience with the product builds up the retention may increase. The company would also take into account: the average benefit level on the group term product the expected distribution of the benefit level its risk appetite in respect of mortality and counterparty risk its free assets and ability to absorb losses the reinsurance cost, including any dependence of the reinsurance terms on the retention regulatory influences such as minimum / maximum required retentions or the effect of the retention on the company's regulatory capital requirements the retention on its unit-linked business reinsurance arrangement The experience the company has in a product influences the retention limit As the company is new to this market it is likely the retention limit will be lower than it would be for an existing product they have experience in There may be adjustment of this retention limit as experience builds up, depending on what the contract with the reinsurer allows The company would consider the expected profile of the business e.g. average benefit level and expected distribution of the benefits As the product is new the company will have to estimate what it expects these things to be based on (market, existing data from their other products and reinsurer data applied to their target market) The company would consider its solvency position and ability to absorb losses The company will look to balance the cost of the reinsurance with the retention limit and the terms at each level, considering the outcome of modelling investigations and the net retained profit and the impact of the profit-sharing arrangement This will be impacted to the strength of the company’s underwriting Which would be greater if they already have experience of working with them The retention limit on the existing arrangement with the unit linked business may be considered The level of any financial reinsurance may also influence the retention limit required They must consider their risk appetite, and the balance between counterparty risk and insurance risk Consider the expected impact of new business strain The available terms from the reinsurer and any minimum retention limit Regulatory limits regarding retention and any minimum required level The need to charge competitive premiums – this may be impacted by typical retention limits in the market The opinion of rating agencies and the impact on the company’s credit rating
    • Considerations
      • Cost
        • The reinsurer intends to make a profit as well as meet its cost of capital and expenses. These costs will reduce the expected absolute level of profit for the cedant, though the risk reduction may leverage up the return or risk-adjusted return on capital.
      • Retention limit
        • The retention limit is the maximum amount of risk retained by the cedant on any individual risk. General factors to consider when setting the retention limit include the: average benefit level for the product and the expected distribution of the benefit company's insurance risk appetite level of the company's free assets and the importance attached to stability of its free asset ratio terms on which reinsurance can be obtained and the dependence of such terms on the retention limit level of familiarity of the company with underwriting the type of business involved effect on the company's regulatory capital requirements of increasing or reducing the retention limit existence of a profit-sharing arrangement in the reinsurance treaty company's retention on its other products nature of any future increases in sums assured. Methods of determining the level at which the cedant should set its retention limit First method Set the retention limit at such a level as to keep the probability of insolvency below a specified level. An alternative approach is to aim for a probability that the loss in any one quarter or year does not exceed a proportion of the earnings of the business, if that is how the cedant determines its risk appetite. This can be done by using a stochastic model for projecting claim rates and a model of the business, so that claims can be projected forward together with the value of the company's assets and liabilities. By using simulation, a retention level can then be determined such that the company stays solvent, or earnings stay above a certain level, for 995, say, out of 1,000 runs. Second method Consider the total of: (a) the cost of financing an appropriate mortality fluctuation reserve, and (b) the cost of obtaining reinsurance - the reinsurer naturally incorporates an expense and profit loading in its reinsurance terms, and the ceding company incurs administrative expenses. As the retention limit increases, (a) will increase and (b) will decrease. A retention limit can then be adopted that minimises the total (a) + (b). To calculate (a), the simulation approach discussed above would probably need to be used to determine the reserve that the company needs to hold. Third method Another possible approach is based on the theory of efficient investment frontiers and looks at reinsurance as an asset class that allows the firm to optimise its risk and reward trade-off.
      • Counterparty risk
        • The cedant retains liability to the policyholder for the benefits even if the reinsurer becomes insolvent and cannot meet claim payments as they become due. To reduce counterparty risk, the reinsurer may collateralise or deposit back its share of the total reserve to the cedant. This may be a supervisory requirement, but need not be in order to occur Generally applicable to original terms reinsurance on a level premium basis A deposit back agreement can benefit both parties. The cedant maintains the entire reserve and thereby maximises the fund it has to invest. The reinsurer need not match the insurer's benefits on with-profits or unit-linked business, thereby avoiding investment risk.
      • Legal risk
        • Reinsurance is usually governed by a treaty between the ceding company and the reinsurer. There are usually many clauses to be negotiated to cover numerous contingencies and risks, each one potentially impacting the price of the reinsurance. Due to the operational risks involved and the impact of disputes where contracts have not been finalised, regulators around the world are increasingly focused on ensuring that reinsurance treaties are complete and signed.
      • Type of reinsurance
        • The type of reinsurance and the way in which the amount reinsured is specified will depend on: the reason to use reinsurance the reinsurance costs - e.g. unrestricted catastrophe reinsurance is presently rather unaffordable the type of business for term assurance, original terms or risk premium reinsurance is typical. With-profits business may only reinsure some guaranteed elements; barring deposit back options, reinsurers are not keen to keep pace with bonus rate. individual annuities are not often reinsured excess of loss reinsurance is used for group business unit-linked business is often reinsured using risk premium reinsurance on a sum at risk basis. the applicable legal conditions the forms of reinsurance actually available in the market
  • Investment
    • Principles
      • In order to minimise risk, a company should select investments that are appropriate to the nature, term and currency of the liabilities. Investments should also be selected so as to maximise the overall return on the assets (which includes both investment income and capital gains). The extent to which the appropriate investments referred to above may be departed from in order to maximise the overall return will depend, amongst other things, on the extent of the company's free assets and the company's appetite for risk.
    • Strategy
      • A company’s investment strategy will be influenced by The level of free assets they have as high free assets allow greater investment freedom as they can absorb more losses if required The investments should be selected to maximise the overall return on the assets, taking account the company’s appetite for risk e.g. whether they would seek to mismatch investments to pursue a higher return e.g. or reduce investment in investments with poor credit rating The liabilities they have would influence the investment strategy the nature, e.g. guaranteed, discretionary or unit-linked the term of the liabilities the currency of the liabilities The company may consider reputational issues, e.g. investing in ethical investments Regulations will need to be considered, which may restrict certain assets Liquidity requirements/constraints may also influence the assets chosen Practical constraints - e.g. availability of assets, suitability of valuation
      • Assets match liabilities
        • The liability outgo consists of: benefit payments + expense outgo - premium income. The benefit payments can be sub-divided into four types Guaranteed in money terms Guaranteed in terms of an index of prices, earnings or similar Discretionary Investment-linked Expenses payments tend to increase. It is adequate to treat the rate of increase as price index. Premium payments are usually fixed in monetary terms. As a result, the liability outgo may be split into four categories: Guaranteed in money terms match with government bonds (and possibly some corporate bonds) of suitable term Guaranteed in terms of an index of prices, earnings or similar match with an index, if not possible, choose the nearest thing Discretionary invest in equities and properties normally heavily weighted towards equity because of the difficulties with property low to medium risk, typically 'blue-chip' companies or index tracking Investment-linked match with the assets underlying the benefit determination formula Having taken care of all liabilities, the free assets would normally be invested in equities and property. can adopt a slightly riskier stance in the equity selection could invest overseas without having to hedge the currency risk also common to have significant property investment in the shape of the company's own premises Modify the above strategy to invest sufficient cash to operate on a daily basis without needing to realise any non-cash assets.
        • Eg: Determine an investment strategy
          • Assets should be chosen that match the currency of each liability. Level immediate annuities The liabilities consist of a series of income payments. The liabilities are guaranteed in money terms and may be very long term. Can match with fixed-interest bonds of appropriate term. Exact matching or immunisation could be used. However, suitable bonds of sufficiently long term may be unavailable. Government bonds provide the highest security. Some corporate bonds might be used to increase the expected return, so that more competitive prices can be charged for the annuities. Index-linked immediate annuities Similar to level annuities, except that the liabilities are guaranteed in terms of a prices index. The most appropriate backing assets would be index-linked bonds (linked to the same index as the liabilities), if available. Alternatively use a mix of equities, property and fixed-interest bonds, but this wouId be a worse match. Term assurances The liabilities consist of lump sum payments. They are guaranteed in money terms and generally of shorter average term than annuities. Fixed-interest bonds of appropriate term would be the best match. Some cash might be used due to the relatively high cashflow uncertainty. Unit-linked contracts - unit reserves Unit reserves should be matched by exactly those assets upon which the liability (unit) values are based. Unit-linked contracts - non-unit reserves These consist of future expenses and non-unit (eg guaranteed) claim costs. They are generally short or medium-term liabilities. They will be a mixture of real and fixed-money cashflows. A mixture of cash and short-term fixed-interest and index-linked bonds would be suitable. Solvency capital requirement Solvency capital is there to provide an additional level of protection to policyholders. Likely to match with low risk assets, eg cash and fixed-interest bonds. Free surplus These assets that are not required to back the reserves or solvency capital requirement. So these assets are largely free from constraints and may be invested to maximise expected return. These assets also represent the working capital of the company which will be used to cover items such as adverse experience and new business strain. So part of the free surplus may be invested in cash for liquidity. Expenses Expenses will be part of the reserves under each liability type. Match with real assets, eg index-linked bonds. Liquid assets will also be needed to cover day-to-day expenses.
        • Eg: Determine an investment strategy
          • Index-linked immediate annuity The investments chosen should comply with regulations. Benefits The benefits are guaranteed in terms of an index. The index is most likely to be a prices index. So the nature of the liability is real. Government index-linked bonds would be a good match, particularly if the index used for the annuity and the bond are the same. However, there are many different price indices, so it is possible that a small mismatch will arise if different indices are used. Alternatively, index-linked corporate bonds could be used. These offer higher expected returns but have a greater risk of default. If index-linked bonds are unavailable, a diversified portfolio of fixed-interest securities and high-quality equities may provide a reasonable match. A more complex strategy would be to hold fixed-interest bonds with a swap (that swapped fixed payments for index-linked payments). Bonds should be chosen to match the term of the annuity payments. The timing of benefits can be estimated using the expected rate of mortality. However, it may be difficult to find bonds that have a sufficiently long term. Some cash should be held to meet the annuity payments due within the coming month say. Assets should be held in the appropriate currency. This will be the domestic currency unless the insurance company also sells annuities overseas. The insurance company may choose to mismatch in order to pursue higher expected returns, eg by investing in equities. However, a mismatched investment strategy carries greater risk. Even if the company has perfectly matched the expected benefits, it is still exposed to the risk that longevity improves faster than expected. Expenses The expenses of administering the annuity are also related to an index. The nature of the expenses will be real. They will mainly reflect wage inflation, but also some price inflation. Government index-linked bonds, if available, would again be the best match. However, it is unlikely that bonds linked to wage inflation will be available. Equities may be a reasonable match for wage inflation over the long term. The term of the expenses will be the same as the benefits, so bonds of similar term will also be required. Cash will be required for regular expenses due within the next month or so. Cash may also be required to help meet the initial expenses of new policies. Again, assets should be held in the domestic currency (unless policy administration is outsourced overseas). A 25 year conventional with-profits endowment assurance that has been in force for ten years, where surpluses are distributed under the 'additions to benefits' method. Benefits The benefits are a mixture of guaranteed in money terms and discretionary. The guarantees under the policy will consist of the sum assured and the reversionary bonuses declared over the previous ten years. As the guarantees are fixed in money terms they can be matched by government fixed-interest bonds. Corporate bonds could be used instead. Corporate bonds have higher expected returns but a greater risk of default. The future premiums are also an asset of the company and can be used to cover part of these guarantees. The benefits are payable on maturity in 15 years time or earlier death. So 15-year bonds might be a good match for these liabilities. Some cash should be held to meet the expected death claims within the next month or so. A discretionary terminal bonus may be paid on maturity or earlier death. The reversionary bonuses declared over the next 15 years are also discretionary. The investment strategy will need to take into account policyholders' reasonable expectations (PRE). PRE will be determined by product literature, past practice of the company and by the actions of competitors. The policyholders will want the discretionary bonuses to be as large as possible. So, assets will be chosen to maximise the expected return, eg equities and property. However, with-profits policyholders tend to have a tower risk appetite than say unit-linked policyholders. In particular, insurance compan ies attempt to smooth reversionary bonuses and payouts to remove some of the volatility of the stock markets. So, it is possible that the discretionary benefits will be backed by a mixture of high return and safer assets. The extent that the insurance company can choose to mismatch the guaranteed benefits and maximise expected returns depends on its risk appetite and the regulations in place. The higher the level of free assets, the greater the investment freedom. The more the company wishes to smooth, the more the company will need to invest in lower risk assets. The higher the proportion of terminal bonus, compared to the sum assured and reversionary bonus, the greater the investment freedom. As the policy nears maturity, the guarantees will increase with each reversionary bonus declared which may require a higher proportion to be invested in bonds. Expenses The expenses of administering the endowment are related to an index in a similar way to the annuity contract. So a similar investment strategy can be employed.
        • Eg: Determine an investment strategy
          • General points Consider nature, term and currency of liabilities. Consider diversification of assets held. Consider any regulatory restrictions. Conventional with-profits endowment assurance product, under which profits are distributed using the 'additions to benefits' method. Benefits are partly guaranteed in monetary terms, ie sum assured and past reversionary bonuses. Benefits are partly discretionary, ie future reversionary bonuses and terminal bonus. But future reversionary bonus is not entirely discretionary as it must comply with PRE. Benefits are medium to long-term. Guaranteed benefits can be matched with fixed-interest bonds of appropriate terms. Government bonds may be lowest risk, but corporate bonds may be used to seek higher returns. Alternatively, derivatives could be used to hedge the guarantees. For discretionary benefits, assets with high expected return will be chosen to maximise expected future bonuses. Also, policyholders usually want a real return. So equities and property may be used. A higher proportion of risky assets could be held if the asset share is large compared to the guarantees or if the company has a large free estate. Some cash may be held to meet uncertain outgo, eg death and surrender benefits. Conventional level immediate annuity product for seriously impaired lives. Benefit is guaranteed in monetary terms. Therefore invest mostly in fixed-interest securities. Bonds with a variety of terms shouId be chosen so that coupons and redemption proceeds meet the regular annuity payments. Mostly short-term bonds should be chosen reflecting the reduced life expectancy of these lives. However, the term will depend on the extent of the impairment. May invest in high quality corporate bonds as they offer higher expected returns than government bonds. But corporate bonds have higher default risk than government bonds. Proportion of corporate bonds will depend on level of free assets. The availability of bonds of suitable term may affect the choice of assets. Expenses are real in nature so some index-linked bonds or equities may be held.
        • Eg: Possible investment strategy differences
          •  Companies A and B have the same with-profits liabilities and solvency capital requirements. Assets Company A has more assets and so much higher free assets. Free asset ratio for Company A is 23,000/48,000 = 48%. Free asset ratio for Company B is only 2,000/27,000 = 7%. Free assets allow a company to mismatch to improve the return on assets and thereby declare higher bonuses and higher dividends. So Company A may invest a higher proportion in assets with higher expected return (but higher risk) such as equity or property. Company A may also have a higher proportion of corporate bonds in its fixed-interest holdings. Company B is likely to more closely match its liabilities given its lower free assets. Asset shares Company B's guarantees are likely to be heavily in the money, as asset shares are lower than reserves. Therefore policyholders are unlikely to get any terminal bonus. So Company B may be invested almost entirely in fixed interest. Need to carefully monitor how well asset cashflows match liabilities. Company A's asset shares are well above reserves which gives more scope to invest in real assets.
        • Eg: Determine an investment strategy
          • (i) A conventional immediate annuity with 50% spouse's pension payable on the death of the annuitant. (ii) A regular premium unit-linked bond with a term of ten years and 100% of the fund returned on death or at maturity. (iii) A conventional with-profits whole life assurance that has been in force for 15 years, where surpluses are distributed under the 'additions to benefits' method. The following points could be made for any of the three products: The assets should reflect the nature, term and currency of the underlying liabilities. Consider any regulatory restrictions. Consider whether the assets are allowed to contribute to solvency calculations. Consider the level of free assets. Consider mismatching to maximise overall return. The ability to mismatch will depend on its free assets and risk appetite. Investment strategy for immediate annuity The benefit may be: guaranteed in money terms if the benefit is fixed guaranteed in terms of an index if the benefit is inflation-linked. The term of the liability is until the death of the second of the policyholder and the spouse, although the benefit is reduced after the policyholder dies if the spouse survives. A fixed benefit can be matched by fixed-income bonds. An index-linked benefit can be matched by index-linked bonds. There will be expenses increasing with inflation. Expenses can be matched with index-Iinked bonds where the index they track is closest to what the expected expense inflation driver is. Choose bonds with a variety of terms to match the timing of the expected liability cashflows. The term would be based on the expected longevity of the first life for the full benefit and any expected additional longevity of the spouse for the 50% benefit. Assets of long enough duration may be unavailable. The younger the age of the policyholder, and hence the longer the expected term, the harder it will be to find matching assets. Could invest in government bonds. Alternatively, could invest in corporate bonds with: higher expected return higher credit risk. The company would also hold some cash for liquidity. Investment strategy for unit-linked bond The benefit payable on maturity and death is investment-linked. Most regulations restrict mis-matching on unit funds. So the assets held to back the unit fund are likely to be the assets in the fund selected by the customer. The assets backing the non-unit reserve will need to be liquid assets as the non-unit reserve covers any short fall between charges and expenses. So the assets held to back the non-unit fund are likely to be cash or suitably liquid bonds of terms up to ten years. Investment strategy for conventional with-profits whole life assurance The benefit is partially guaranteed in money terms, for the sum assured and any regular bonuses declared to date. Fixed-interest bonds would be suitable for these investments. The company could buy government bonds. Alternatively it could invest in corporate bonds with a higher expected return, but also higher credit risk. The term should match the expected term of the life assurance contract which is based on expected longevity. Some liquidity will be needed to meet guaranteed costs as they fall due. So the assets held should include an element of liquid assets such as cash or near cash instruments. The benefit is also partially discretionary, for any future regular and terminal bonuses. For these benefits, the main aim is to maximise investment return subject to the risk appetite. Policyholders' reasonable expectations (PRE) should be considered. PRE will be based on what the company has said in sales and other product literature. PRE will be based on what the company has said in product literature. Equities and property are likely to be chosen to back the discretionary benefits. Though the mix will change as the policy moves through its term and a greater proportion of the benefits are guaranteed. The assets backing the discretionary benefits will depend on the amount of free assets available, with higher free assets allowing greater investment freedom. There will also be expenses increasing with inflation. Expenses could be matched with index-linked bonds, where the index they track is closest to what the expected expense inflation driver is.
        • Eg: Compare likely investment strategies
          • Two life insurance companies sell similar unit-linked individual pensions and without-profits immediate annuities. Company A is a large company with significant free surplus and Company B is a small company with limited free assets. Compare the likely investment strategy of the two companies. Similarities Both companies are likely to invest in long-term fixed interest bonds to match the annuities or index-linked bonds for annuities with an inflation linked benefit, with term matching the term of the annuities where possible Both are likely to match the unit-linked liabilities with the underlying investments in the relevant funds The associated non-unit liabilities are likely to be invested in cash and bonds. Both are also likely to invest in index-linked bonds to match the expenses Both companies would have to consider cashflow and liquidity constraints And both would have to ensure there is sufficient assets held in case of liquid assets to meet short term liabilities Differences As Company A has higher free surplus, it could afford to mistch. which could be done by investing more heavily in corporate bonds to back the annuities, instead of government bonds to target a higher expected return but with higher risk Or potentially mis-matching the unit-linked liabilities to seek a higher return depending on regulation allowing this As Company A is larger it may also be able to offer a wider range of unit linked funds. Company A could also look to invest in equities to match the expense liabilities increasing risk but increasing potential return Company’s A’s larger size and so larger liabilities and investment potential may open up property as an investment option subject to illiquidity risk As company A has significant free assets and is less likely to be constrained from a cashflow and liquidity point of view In contrast, company B will have limited freedom to take more investment risk due to its limited free assets and will match assets more closely to liabilities It would be expected to invest mostly in government bonds to back the annuity book.and to have limited or no direct investment in equity or property outside of the assets matching unit-linked liabilities
      • Use of a model office
        • Using a model of the business in force, a model investment portfolio can be built up based on the company's proposed investment strategy and incorporating an appropriate proportion of the free assets. The liabilities and the assets would then be projected forward on assumptions that represent expected future experience, although the company will want also to consider the effect of variations from these. For the assets, stochastic investment models can be incorporated to project future investment income and changes in capital values. Inflation rate models can also be used to project future expenses on the liabilities side. The projected liabilities and assets can then be valued at the end of each year of the projection on the company's supervisory basis. The item of interest will be the excess of the value of the assets over the value of the liabilities. This will need to be sufficient to cover comfortably the level of solvency capital required by the company, which may itself depend on the investment strategy being investigated. What is 'comfortable' will depend on any regulatory requirements, the nature of the business, and the level of cover provided in other companies. Using a stochastic investment model and simulation techniques, the above can be extended to produce a statistical distribution of the amounts available each year to cover the level of solvency capital required. From this, the probability of potential future insolvency can be estimated for any given investment strategy. For valuing the liabilities, the company's current basis will most likely be chosen, but it could incorporate dynamic assumptions into the simulation exercise which take into account the simulated investment conditions. The simulations could also be used to determine the level of free assets that the company needs in order to support a particular investment strategy and keep the probability of insolvency below an acceptably low figure.
    • Asset characteristics
      • Government fixed-interest bonds offer nominal return normally with a coupon yield similar to market yields (although all of the return comes through the redemption value under zero-coupon bonds) return is not variable (although variable if not held to redemption) most secure other than cash commonest and most marketable dealing costs tend to be very low Government index-linked bonds coupon payments are defined with reference to some index or value less marketable than fixed-interest bonds Corporate fixed-interest bonds offer a return slightly better than government bonds return is not volatile running yields will normally be similar to prevailing interest rates security could be a problem if the issuing company is not AAA-rated value may fluctuate with the markets (not important if held to redemption) marketability is often poor dealing cost are often high Equities offer an income expected to increase in real terms running yields on equities are low market value of the share will be volatile even holding for long term underlying company might go bankrupt or just perform badly in some markets equity is highly marketable, in other markets equity may not be marketable because of the size and reliability of the local market Property normally associated with a relatively high return gives a low running yield but eventually increase in real terms normally secure although suffer occasional interruptions market value can vary significantly very unmarketable investment with significant dealing expenses very long-term investment and can be thought of as a perpetuity norminal term can be as long as required but the discounted mean term is finite direct property often comes in large chunks Cash most secure least variability of value very liquid and almost no dealing costs offer only a relatively low return and has discounted mean term of zero
  • Underwriting
    • Purposes
      • The main purpose is to manage risk, which can be done in the following ways: protect a life insurer from anti-selection help avoid accumulating poor risks enable life insurers to identify lives with a substantial health risk and specify the most suitable approach for dealing with them help ensure that all risks are rated fairly help ensure that actual mortality experience does not depart too far from pricing assumptions. help reduce the risk from over-insurance. Other related purposes include: reinsurer requirement or in order to reduce reinsurance regulatory requirement reduce the number of claims declined at claim stage, so reducing reputational risk
    • Determine the level of underwriting to use
      • In setting the overall level of underwriting, the insurer would need to ensure that the increased volumes that result from more relaxed underwriting outweigh the costs of increased anti-selection and any increased costs of obtaining reinsurance. The main benefits would be increased profits reduced underwriting expenses increased attractiveness of the product to the distribution channel concerned. The following factors will need to be considered: The expenses associated with the level of underwriting proposed. Underwriting involves a number of costs, such as salary of underwriter and medical reports, which will increase the overall costs to the company. The analysis should include the costs involved in obtaining further evidence at lower sums assured based on information disclosed in the application form. The extent, and the financial significance, of any potential anti-selection risk. If anti-selection is going to occur, it will present itself to the insurer with the least stringent underwriting requirements within the peer group offering that product. Therefore, offering the same product with less underwriting may mean that an insurer attracts a disproportionate share of the anti-selection risks (the 'Sentinel effect'). The interaction between the level of underwriting and the potential level of sales - the greater the level of underwriting the lower the mortality costs, but the expenses will rise. Also, people may be more inclined to take out contracts where there is a low level of underwriting. Furthermore, less underwriting leads to quicker processing of new business proposals. Claims underwriting may deter people from taking up a contract, due to the uncertainty as to whether a claim may be accepted. The effectiveness of the proposed underwriting - benefit exclusions may be difficult to police, or limiting medical evidence may make it difficult for staff to underwrite effectively. Non-disclosure also makes underwriting less effective. The more detailed the underwriting, the greater the homogenisation of risk that may be achieved. The impact of regulation, which might constrain the level and/or type of underwriting that is permitted, eg the use of genetic testing. The interaction between underwriting level and terms offered by the company's reinsurers. How to vary underwriting criteria by age, sum assured, target market and various other factors.
      • Eg: Discuss reducing underwriting to cut costs
        • The main purpose of underwriting is to manage risk. It involves collecting information and making decisions based on that information. Reducing underwriting will reduce the cost of collecting information, but it will also reduce the benefits derived from it. There will be an optimal amount of underwriting where the cost of any additional underwriting effort is not justified by the benefits derived. Underwriting will be relevant mainly for protection business. The costs of underwriting Medical reports, medical exams and specialist medical tests all cost money. Most underwriting is done via the proposal form, some using medical reports, with only very few policies involving medical testing. There are salaries and associated costs of the underwriting team. These costs are loaded for in premium rates. Implications of reducing the amount of underwriting The cost savings could be passed on to customers as lower premiums, making products more competitive. Alternatively, profits could be increased, all else being equal. Cheaper products might cause lapse and re-entry problems. This is particularly significant where the reduced underwriting allows a previously rated case to be accepted at standard rates. Acceptance of policies would be faster, which is popular both with policyholders and insurance intermediaries. Less medical underwriting would also be popular, since people prefer not to undergo medical exams. If new business increases, overhead costs per policy will reduce. Higher sales might put a strain on capital. If the company uses less underwriting than other insurers, it could attract a much increased share of anti-selection risk. The company's reinsurer should be able to advise on the market norm for underwriting. There would be a risk of anti-selection by those who could avoid disclosing relevant information. With less information, there will an increased chance of offering an unsuitable premium rate. For example, people with an adverse medical condition that they didn't know about might be more likely to get accepted at standard rates. This increase in pricing uncertainty might lead to: higher premiums, which would be unpopular higher reserves, increasing the capital strain. Advisers may encourage proposals from high risk applicants who now have a greater chance of being accepted at standard rates. The mortality experience may worsen, causing: premium rates to increase more healthy lives to withdraw, further worsening the mortality and so on, producing a spiral of worsening experience. Profitability would need to be monitored carefully, by analysing mortality experience. This be particularly difficult in the early years due to lack of data. Alternatively more people might be declined insurance. This is likely to be unpopular and may reduce the number of proposals coming in. Lower sales volumes would increase the per-policy overhead costs. Reducing underwriting at the claims stage might encourage false claims, reducing profitability. Reducing financial underwriting might lead to increased over-insurance. Reinsurance treaties may need to be renegotiated, as the overall experience would now be different. This extra reinsurance cost might be passed on to customers, affecting likely new business volumes. There would be costs of moving to a revised underwriting process. Alternatives Could look for efficiency savings in the current procedures, eg: use less experienced (and therefore less expensive) underwriters make processes more streamlined or more automated. Focus sales more on products that need less underwriting, eg savings. Other The company should ensure it still complies with minimum standards for underwriting, eg disclosure to applicants about the process.
      • Eg: Reasons to introduce online application process
        • A life insurance company sells an individual term assurance product and is thinking of introducing an online application process for this product that will include underwriting questions. This will replace the existing traditional paper-based underwriting process that the company currently uses. Suggest possible reasons why the company is considering the introduction of an online application process. Reasons include: to reduce costs to appeal to a different target market to keep up with competitors who may be using online forms already may be quicker and so more attractive to customers company believes approach is suitable for a simple product such as term assurance moving from paper-based to online process reduces scope for manual errors.
      • Eg: Compare the likely approach to underwriting
        • A life insurance company currently sells three types of individual level term assurance products. The 'Basic' policy is sold to individuals, providing benefits to their dependants on the death of the policyholder. This product is sold via the internet and has a limit on the level of sum assured, and is available to only a limited age range. The 'Standard' policy is sold to individuals, providing benefits to their dependants on the death of the policyholder. This product is sold through tied agents, and is available for a wider range of sums assured and age ranges than the Basic policy. The 'Key Person' policy is sold to employers providing benefits to the employer on the death of certain employees. This product is sold through independent intermediaries. Basic The underwriting for this product is likely to be very basic with just a few simple medical questions on the online form. Underwriting is potentially a barrier to sale online and so is likely to be simple for competitive reasons. The limited level of sum assured for the Basic policy may mean that there is no financial underwriting. There will probably be only limited claim underwriting. Standard Similar to the basic policy, the company will use some simple medical questions on the proposal form but application may also involve additional information, e.g. further details on medical history perhaps from a doctor's report. With the larger potential sums assured, this product may have some financial underwriting possibly checking the sum assured compared to any mortgage or loan from the tied agent. This product will probably have some claim underwriting. Key person The Key person policy medical underwriting process may be similar to that for the standard policy although possibly with the addition of a medical examination. This product is likely to involve the most financial underwriting to assess the sum assured against the likely financial impact on the employer of the death of the individual concerned.
    • Obtain the evidence
      • Medical underwriting
        • Definition Where a life insurer has mortality risk under a contract, it will obtain health evidence of the applicant to assess whether he or she attains the required health standard. For contracts only with longevity risk, health evidence could also be obtained if the life insurer intends to offer different terms according to the health of the applicant Sources Questions on the proposal form completed by the applicant. current health and medical history height, weight, gender, age contract applied for and size of benefit lifestyle: smoking / drinking habits, hazardous pursuits family history of disease and of early death occupation and income country of residence special terms applied by other insurers in the past Reports from medical doctors that the applicant has consulted. a confidential report written by the doctor. gives an account of the applicant's medical history and an opinion on the applican'ts future health cost-effective, but depends on availability and privacy issues Medical examination carried out on the applicant by a doctor. physical examination and discussion with standard tests costly and representative of a barrier of entry to healthy applicants resorted to if no past medical reports are available Specialist medical tests on the applicant. investigation about specific conditions: e.g. electrocardiogram, chest X-ray most intensive and expensive Reasons for not using all the information could include: to save on expenses when the opportunity for anti-selection is negligible (eg for a standard annuity) in order to be competitive and to increase sales (people don't like revealing medical information) if the amount of cover is small (so the financial effect of anti-selection is m inimal and would not j ustify the cost of obtaining the information) if group cover is being applied for (as anti-selection may be lower) if the cover is compulsory (as anti-selection is negligible) if such an invasion of privacy is not culturally acceptable if not allowed under legislation if earlier sources (eg proposal forms) suggest no problems, then further investigation may not be cost-effective if the product specifies that underwriting will not be performed (eg on the exercise of the option under a renewable or convertible term assurance) if the information is simply not available (eg medical reports, either due to data protection or because there aren't such things).
        • Eg: Impact of removing medical underwriting
          • On setting premium rates The initial expense assumption will be lower as there are now no medical underwriting costs. The per-policy expense assumptions should reduce if overheads are now to be spread over higher business volumes. Mortality assumptions will change, eg they may need to be higher if poor risks are no longer excluded. The mix of policyholders applying for new policies and/or the target market may change in future, leading to further changes in mortality. More frequent re-pricing may be necessary in future. Past experience data will be less relevant to setting the pricing mortality assumptions and there is more uncertainty about future experience. May need to increase the margins in the premium basis or increase the profit criterion to reflect this. This is a competitive, price-sensitive product, so the scope for premium increases is limited. In the absence of health information, the same premium will be charged for all policyholders irrespective of their health. Therefore, the company will need to price for the expected business mix in terms of the expected levels of health within each pricing model point. The assumed mix may need to be based on a worse case scenario with regard to applicants' health. On risks Anti-selection and mortality There will be a much increased risk of anti-selection. This will result from insuring lives it would otherwise decline, and accepting more lives in poor health on standard terms. This is made worse by competitors who use medical underwriting, who: would decline or offer worse terms to these applicants might actively target healthier lives by offering lower premiums so the insurer will receive more applicants who are in poor health. Risk is increased by the actions of distributors , who may deliberately encourage poor risks to apply to this company. Mortality risk will increase as the average health of policyholders worsens relative to the prices charged. The reduced risk classification increases model risk, and the increased uncertainty increases parameter risk. Expenses There is a risk that expense levels do not fall as much as expected. There is a risk that the costs of implementing the change (eg re-pricing) are higher than expected. New business mix The mix of business by levels of health may be different from assumed. In particular, there is a particular risk of insuring a higher proportion of unhealthy lives than assumed. There may be an increased risk from the mix of business by policy size, eg if worse health is correlated with smaller policy sizes. New business volumes too high Sales could increase by more than the expected, leading to problems of capital strain and a strain on the company's administrative resources. New business volumes too low Sales could increase by less than expected. Premiums might now be uncompetitive for healthy lives, who might be offered cheaper rates from competitors who still underwrite. Lapse and re-entry Risk of increased lapses from existing policyholders currently on special terms, who could potentially swap for a new policy on standard terms. Lapse risk may be reduced on new policies, eg as policies issued on special terms in the past may have had relatively low persistency. Operational The company will find it harder to set pricing and reserving assumptions based on its existing data, and so will be more prone to making errors. Non-disclosure Disclosure of health conditions during underwriting will no longer be required, so any fraud or non-disclosure risk is removed. Reputational May be reduced, as disputes at the claim stage over underwriting information or decisions will no longer occur. May be increased, eg if more causes of death are excluded in the standard policy terms than before.
      • Lifestyle underwriting
      • Financial underwriting
        • The company should ensure that the proposed policy is in keeping with the probable needs of such an insured life - in particular that the sum insured is not strangely high. This will help ensure that: The premiums payable by the person are affordable. Income of the person is needed, which is used to control the persistency risk. Imposed only on large levels of sums assured. The person concerned is not trying to commit fraud. An indication of this could be having higher levels of sums assured than could be justified by the applicant's current circumstances. The simplest level of such underwriting will involve aggregating the total sums assured across the proposed new policy and any existing policies held by the insurer. A more complicated level of underwriting, involving aggregating the total sums assured across all insurers.
      • Claims underwriting
        • A life insurance company may also decide to 'underwrite' at the claims stage, for example to ascertain whether the claim is subject to an exclusion clause, or if there is suspicion of nondisclosure.
    • Interpretation of the evidence
      • The proposal form will be reviewed by administration staff. Usually, the majority of forms will meet 'acceptable' criteria and be accepted at the company's standard premium rates. Even for applications not acceptable at standard rates, specialist underwriting software, often provided by reinsurance companies, may assess the medical evidence and make the premium-rating decisions. More complex applications will be dealt with by the insurance company's underwriters, who will use all the available evidence and their expertise to assess the level of risk and reach a decision on an application. The underwriters may seek advice from the insurance company's reinsurers and doctors in making these decisions.
    • Specification of terms
      • Applicants whose health reaches the company's required standard can be offered the life insurance company's normal premium rates. Other applicants may be offered special terms as follows: an increased premium (and/or reduced benefit) an exclusion clause deferral of a decision (if the medical status of the applicant will be clearer after a defined time period) decline an alternative policy a shortened policy term