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Life insurance linked with investment

Investment-linked insurance policies (ILPs) have both life insurance and investment components. Your premiums are used to
pay for units in investmentlinked sub-fund(s) of your choice. Some of the units you buy are then sold to pay for insurance
and other charges, while the rest remain invested.
ILPs provide insurance protection in the event of death or total and permanent disability (TPD), if included. Depending on the
policy, the death or TPD benefit may comprise the higher of the sum assured or value of ILP units or some combination of the
sum assured and the value of ILP units. How much is paid depends on the value of the units of the sub-fund at the time.
Some consumers prefer ILPs because they want more exposure to investments than other life insurance products may
provide. But if you are more concerned about getting insurance coverage, make sure the product you buy meets this need.
You may need to consider other life insurance products.
ILPs can be classified into two categories:
Single premium
ILPs

You pay a lump sum premium to buy units in a sub-fund. Most single premium ILPs provide lower
insurance protection than regular premiums ILPs.

Regular premium
ILPs

You pay premiums on an on-going basis. Regular premium ILPs may allow you to vary the level of
insurance coverage you need.

Unlike whole life or endowment participating policies, ILPs usually do not have guaranteed cash values. The value of the ILP
depends on the price of the units in the sub-fund which in turn depends on the sub-funds performance.
Some investment products have been categorised as Specified Investment Products (SIPs). Do check with your financial
institution whether the product you are considering is an SIP. For information on the requirements in place when
transacting SIPs, please refer to the Consumer Guide on SIPs requirements.

While the premiums of an ILP remain constant throughout the life of the policy, the cost of insurance coverage increases year
by year as you get older. This means more units may be sold to pay for the insurance charges, leaving fewer units invested
to accumulate cash values under your policy.
Investment-linked sub-funds
ILP sub-funds have different features and risks, catering to different consumer preferences. The sub-funds invest in portfolios
of assets according to the stated investment objective for the fund. The sub-fund may be managed by the insurer or the
insurers appointed third party fund manager(s).
What are the benefits?
Some consumers prefer ILPs because they want more exposure to investments than other life insurance products may
provide. There is a range of sub-funds to choose from and most regular premium ILPs give you the flexibility to vary the
insurance coverage and investment mix according to your changing financial needs.
What is the difference between an ILP and other life insurance policies?
The key differences between ILPs and other life insurance policies, such as participating whole life and endowment policies
and term insurance policies, are summarised in the following table:
ILPs

Whole Life, Endowment & Term Plans

Investment Mandate

Part of your premiums is invested in units in


your chosen sub-fund. Returns are directly
linked to the value of the underlying
assets.
You can track the sub-funds performance
via the daily publication of unit prices.

For participating policies, all of your premiums go


into the insurers participating fund. The insurer
decides the investment objective and approach for
the fund taking into account the insurers overall
liabilities.
The funds performance depends on its investment
performance, claims experience and expense levels
of the fund.
Term insurance policies do not provide investment
returns.

Bonuses

There are no bonuses. The ILPs value


depends on the performance of your
chosen sub-funds.

For participating whole life and endowment policies,


bonuses depend on the performance of the fund.
They are not guaranteed, but once declared by the
insurer, they become vested and are guaranteed.
Non-par and term policies do not pay bonuses.

Returns from policy


track the ups and
downs of investment
markets?

Yes, the returns are directly linked to the


value of the assets in the sub-funds.

For participating whole life and endowment policies,


the smoothening of bonuses means that the returns
from your policy will not necessarily track the ups
and downs of investment markets

Assets of
policyholders
identifiable?

Assets for each ILP policyholder are


identifiable in the form of units held.

Assets of participating policyholders are maintained


at the fund level.

Cash Value

You may withdraw the cash value of the


units allocated to you, subject to possible
surrender charges. Early termination of the
policy may be costly and the cash value
payable may be less than the total
premiums paid.

Whole life and endowment policies build up cash


value after a few years. Early termination of the
policy may be costly and the cash value payable
may be less than the total premiums paid.

Are cash values


guaranteed?

No, cash values depend upon the value of


the sub-funds units and are usually not
guaranteed.

A part of the cash values under a participating policy


will be guaranteed.

Investment Risk

The investment risk is borne entirely by


you.

There are two categories of benefits those which


have been declared and are guaranteed and nonguaranteed benefits. For guaranteed benefits, the
insurer bears the investment risk. But nonguaranteed benefits (i.e. potential benefits arising in
the future) depend on how the insurers participating
fund performs.

Term insurance policies do not have any cash value.

Premium Breakdown

The amount of the premium used for


insurance coverage, charges and buying
units are unbundled and transparent. They
are disclosed in the Product
Summary, Benefit Illustration and Policy
Contract.

The amount of premium used for insurance


coverage, charges and investment are bundled.
They are not separately identified in the Product
Summary and Policy
Contract.

VALUATION OF A LIFE INSURANCE BUSINESS


Life Insurance is a unique business. Unlike many other businesses and even
Non-life insurance where value is measured using one or several of the
familiar metrics in investment analysis such as net asset value, price-toearnings ratio and profitability, an indispensable tool for ascertaining the true
value of a life insurance business is Embedded Value.
Generally, insurance business is about the underwriting of short to long tailed
liabilities in return for a fractional charge (Premium) today. In other words, the
business model accepts to carry risks, few of which will crystalise in the future
with resultant multiples in the liability relative to the premiums received much
early on.
The challenge posed therefore to many investment analysts in the valuation
of the insurance business is that while the company under reference could be
seemingly doing well today according to universally accepted valuation tools,
how do you advise a potential investor in the insurance business of the
soundness of the investment desire when it is almost certain that some of the
risks for which premium has been received could result into losses and in
some cases, near catastrophic losses to the business after the investment
decision has been made? Embedded Value is the inherent and innate value in
the business of Life Insurance. It is a measure of the distributable profits to
shareholders and/or the cost of capital in the insurance business. This tool has
gained prominence across the World in the measure of the real performance
of a Life Insurance business. To appreciate this concept, we will look at how
profits emerge in every insurance business. Profit in the insurance business is
the aggregation of both the Underwriting Performance of the business and the
Investment Income. The Underwriting Performance is the measure of the
performance of the core business and the Investment Income is the outcome
of its investment activities which is driven by the Shareholders Funds (Equity
+ Insurance Funds + Premium). Embedded Value is a tool which has the
ability to determine the long term profitability of a Life Insurance company. It
is the summation of the valuation of the current in-force value of the existing
and active policies of the company and the value of its free capital. Earlier, we
mentioned about the measure of profits in the insurance business.
This is arrived at using the following formula: (Premiums (P) +
Investment Income (I)) (Claims (C) + Expenses (E) + Change in
Statutory Actuarial Reserve (+ Tax (T))

2 ARM Life Plc is licensed and regulated by the IRDA to underwrite Life,
Annuity and Health insurance. Embedded Value could be calculated using
either the Profits to Shareholders Method or Cost of Capital Method Where as
the former calculates the distributable profits to the shareholders within a
calendar period and then takes the present value of those profits, the latter
quantifies the cost of capital at the end of a period. Embedded Value is also a
useful tool in setting the compensation of the senior management of a
company. Being the decision makers, it could be useful to align their
management decisions and career horizon to the long term goals and
objectives of the company. This can be achieved by tying the impact of those
decisions to the impact on the embedded value of the Life insurance
company. There should also be a correlation between the stock market
valuation of a Life Insurance company and its embedded value. This tool is
highly useful in identifying potential bargains in the stock market
valuation/pricing of insurance company stocks. Furthermore, the embedded
value tool is also applicable and highly effective in actuarial appraisal. This is
the inclusion of potential future new sales in the valuation of a life insurance
company for the purpose of determining a fair and accurate acquisition value
of a life insurance business. The embedded value is another tool that can be
used by investment managers and financial advisors in the valuation of a life
insurance asset in addition to other tools such as price-to-earnings ratio,
return on equity and net asset value. Before you make that decision to
acquire a life insurance company or indeed advise a client to invest in one,
you must amongst other factors take cognisance of this tool and its outcome
by leveraging the services of actuaries and skilled investment
managers/financial advisors.

Solvency of insurance Market


One of the principal concerns underlying the regulation of the insurance
companies is the need to protect the interest of and secure fair treatment to
policyholders. While life insurers are considered as financial intermediaries,
general insurers are perceived as risk takers. Increasing liberalization in the
insurance industry, coupled with the uncertain economic conditions the world
over, requires that the insurers finances are in a sound condition and is being
properly managed. The linchpin of insurance regulation is the use of earlywarning systems designed to identify high-risk and troubled insurers for closer
scrutiny and possible intervention. This is done to ensure speedy and orderly
growth of the insurance industry, along with providing benefit to the common
man, and provide long term funds for accelerating growth of the economy.
In a period of less than half a century, the Indian insurance sector has come a
full circle from being an open competitive market (pre 1956),tocomplete
nationalization (1956-2000)and then back to a liberalized market(post 2000).1
The Indian insurance industry was characterized by the presence of only
public sector players devoid of even little competition. In non-life sector, in
December, 2000, the subsidiaries of the General Insurance Corporation of
India (GIC), viz., National Insurance Company, New India Assurance Company,
Oriental Insurance Company and the United India Insurance Company, were
restructured as independent companies and at the same time GIC was
converted into a national re-insurer. In order to encourage competition and
improve insurance penetration, to innovate insurance products which suit
customers better, to improve servicing standards in the industry, to allocate
resources efficiently by dynamic management of portfolios and to bring about
a change in consumer outlook, the insurance sector was re-opened in 1999. A
hybrid model of privatization with an efficient regulatory mechanism was
adopted which led to the constitution of IRDA in 1999, an autonomous body to
regulate and develop the Indian insurance industry. There are twenty-seven
general insurers including the specialised insurers and standalone health
insurers in India as on 30th September 2012. Several private players apart
from the public general insurers have completed ten years of existence.
2. INSURANCE MARKET GLOBAL AND INDIAN SCENARIO
The global insurance industry is one of the largest sectors of finance. The
major insurance markets of the world are obviously the US, Europe, Japan,
and South Korea. Emerging markets are found throughout Asia, specifically in
India and China, and are also in Latin America. In 2012, the global insurance
market is forecast to have a value of $4,608.5 billion, an increase of 24.9%
since 2007. The insurance market in India has witnessed dynamic changes
including entry of a number of global insurers in both life and general
segment. The Indian general insurance sector witnessed a significant growth
of 13.5 per cent during 2011-12. The share of Indian non-life insurance
premium in global non-life insurance premium increased slightly from 0.57 per
cent in 2010- 11 to 0.62 per cent in the year 2011-12. India stood at 19th rank
in global non-life premium income. As per the World Insurance Report,
published by the reinsurance major Swiss Re, the global direct premium in

non-life insurance business grew by 1.9 per cent with Latin America reporting
a high growth in 2011. The public sector insurers exhibited growth of 21.50
per cent and the private sector general insurers registered a growth of 28.06
per cent in 2011-12. Insurance penetration of the non-life insurance sector in
the country has remained near constant in the range of 0.55-0.75 per cent
over the last 10 years. However, the insurance density of non-life sector
reached the peak of USD 10.0 in 2011 from its level of USD 2.4 in 2001.2
3. SOLVENCY MARGIN & REGULATIONS IN INDIA
Solvency Assessment
'Solvency' is defined differently by different users. Broadly, it is the ability of
an insurer to meet all its liabilities whenever they fall due. Simplistically, it is
represented by the excess of an insurer's assets over its liabilities.
One of the many uses of the risk management process is to determine the
solvency requirements or standards. These standards can be set from internal
management perspective or from regulatory perspective.
Internal From the management's point of view, having identified the total
capital requirements from the risk management process, the capital
representing the 'tail' events (i.e. the risk of the high impact, low frequency
events) would essentially be the capital required to ensure that the company
remains solvent even under adverse circumstances. This assumes that low
impact, high frequency events are covered by the prudent margins in the
reserves. If we move towards a realistic valuation of liabilities (as under the
IAS), capital requirements would need to cover all types of deviations from
best estimate assumptions. In any case, given that there may be various
approximations used in the estimation of the total capital and that the model
& the parameters used may always have an element of error, in practice, the
desired level of solvency may be higher than that represented by the 'tail'
events.
In the absence of any regulatory requirement, the capital actually held by the
company to support these 'tail' events may then depend upon the risk taking
appetite of the shareholders and the cost of capital.
Regulatory
The regulators' primary role is to protect policyholders' interests. They have to
ensure that insurers always have sufficient funds to meet the policyholders'
dues under any circumstances (i.e. even under most of the extreme
circumstances).
It is important to consider the circumstances under which regulators may
want to ensure solvency of a life insurer. They may be either on a break-up
basis/close-down (i.e. to ensure that the insurer will be able to meet the
liabilities of the in-force business) or on a going concern basis (i.e. to ensure
that the insurer will be able to meet the liabilities of the in-force business as
well as the new business that may be written in future). The level of 'solvency
capital' required under these two circumstances may be very different.
From the regulatory point of view, the 'solvency capital' is required
for various reasons

To reduce the likelihood of the insurer not meeting liabilities when they
fall due
To provide a cushion to limit the losses, in the event of insolvency
To provide an early warning system for regulatory intervention and early
corrective action
To promote the confidence of the general public
The solvency of an insurance firm refers to its ability to pay claims. An insurer
is insolvent if its assets are inadequate or illiquid to pay the claims arising.
The solvency of insurance company or its financial strength depends chiefly
on whether sufficient technical reserves have been set up for the obligations
entered into and whether the company has adequate capital as security
(Kansal 2004)3. Solvency margin is the excess of assets over liabilities that
the insurance company has to maintain in the form of a safety margin. The
minimum solvency margin and the methods of valuations of assets and
liabilities of an insurer are prescribed in the insurance regulations. Pentikainen
Helsinki (1967)4 highlighted the importance of evaluating the assets and
liabilities in a reliable way.
Solvency ratio is an important indicator of the financial health of an insurance
company and indicates the ability of the firm to survive in the long run.
Insurance Regulatory and Development Authority (IRDA), the apex body in
India, has prescribed methods of valuation of assets and Liabilities of general
insurance as: a) Available Solvency Margin means the excess of value of
assets (furnished in IRDA-Form-AA in accordance with Schedule I) over the
value of general insurance liabilities (furnished in Form HG as specified in
Regulation 4 of Insurance Regulatoryand Development Authority (Assets,
Liabilities, and Solvency Margin of Insurers) Regulations, 2000)5.b) Solvency
Ratio (SR) means the ratio of the amount of Available Solvency Margin (ASM)
to the amount of Required Solvency Margin (RSM). Every general insurer shall
determine the RSM, the ASM and the SR in Form KG. Table 1 portrays the
solvency ratio maintained by the Indian general insurers (Refer Appendix for
the list of general insurers in India) during 2005-06 to 2011-12. It is clear from
the table that the SR maintained by SBI was the highest (12) in 2010-11 and
Shriram was the lowest (0.92) in 2011-12.

1. What is 'Risk Management'?


'Risk Management' is an integrated process that identifies, classifies, analyses
& quantifies the
financial impact of various risks involved in running a business. It is a tool that
recognises the
potential threats to the business's objectives and allows management to make
informed decisions on the appropriate course of action, be it to mitigate,
transfer or allocate capital to the risk.
Risk management is a fundamental business practice and, for it to be truly
effective, a company
must ensure that risk management is embedded within its culture.
Risk management is not a new concept in life insurance and many of the
basic principles are as old as the insurance industry itself. The majority of
companies already have some form of risk
management process in place. However, over recent years, there has been
significant progress in
developing and formalising these processes and even in using them for
regulatory purposes.
2. Description of the Risk Management Process
There are many ways in which the risk management process can be and is
defined and carried out within different organisations. Given below are the
steps involved in one possible approach a. Set up the risk management function
In larger organisations, it is common to form a separate risk management
function staffed by a

multi-disciplinary team. At a minimum, the purpose of this team is to provide


sufficient challenge
to the risk management practices of the rest of the organisation, but in many
cases the risk
management function's responsibilities extend far beyond this. The work of
this team is facilitated by nominated personnel in each of the various
departments such as Underwriting, Legal / Compliance, Actuarial, Finance,
Marketing & Sales, Policy Owner Servicing, Claims, MIS etc. For smaller
insurers, an independent risk management function may not be practical and
the task may be assigned to senior individuals with other responsibilities.
However, consideration should always be given to the possible dangers in
combining risk management and risk taking roles.
b. Identify risk areas

This is an important step and involves the collection of data from various
sources and extensive
discussions within the team. Frequently, the risks faced by a life insurer are
not isolated and one
risk may trigger another risk event. Each department has to carefully consider
the risk areas they are subject to and also whether the areas identified by
other departments would affect the smooth functioning of their own
department. Care will be required to ensure that risks are neither missed nor
double counted.
It is often convenient to adopt a questionnaire-based approach to gather
information from various levels within a department. The key personnel
should then decide whether the issues identified in the questionnaire would
really form a risk and this process is often facilitated through a workshop.
Consolidated risk summaries from each department would then be discussed
with the risk management function. At this stage, duplicate or similar risks
could be grouped and some additional risks may be identified as a result of
these discussions.
Alternative approaches to identify risks may include using standard templates
currently available in some insurance markets or for some other financial
industries (e.g. banking) and identify risks
fitting into these templates. Care will be required not to exclude the risk areas
that may be unique to the individual company or market (if templates from
other markets are used) or the life insurance industry (if templates from other
industries are used).
c. Classify risks and assign responsibilities

There is no single generally accepted classification system of insurance


company risks. Indeed, the insurance companies or the supervisory groups
around the world adopt different terminology or summarise risks in different
ways. In some countries, the supervisory authorities have an integrated risk
classification system for the insurance and banking industries. Some of the
classification systems in use are
A] India (Reserve Bank of India)

(for the banking industry) In its October 1999 "Guidelines for Risk
Management Systems in banks in India", the Reserve Bank of India suggested
the following broad categories for risk classification
Credit Risk
Market Risk (which include Liquidity Risk, Interest Rate Risk, Foreign
Exchange Rate Risk, Commodity Price Risk, Equity Price Risk)
Operational Risk
The nature of some of these risks may differ in life insurance companies from
those in
banks. Also, the period over which a life insurer is considered to have
exposure to a risk may
also typically be longer than in banks. Some of the unique risks in life
insurance companies
(e.g. underwriting risk) will not be present in banks. Nevertheless, the above
risk
classification system can be used as a starting point to develop a
classification system that is
suitable for life insurance companies.
B] Canada (Office of the Superintendent of Financial Institutions)

(common for the insurance and banking industries)


Credit Risk
Market Risk
Insurance Risk
Operational Risk
Liquidity Risk
Legal And Regulatory Risk
Strategic Risk
C] UK (Financial Services Authority)

(common for the insurance and banking industries)


Credit Risk
Market Risk
Liquidity Risk
Insurance Risk
Operational Risk
Group Risk
D] The International Association of Insurance Supervisors (IAIS)

The

risks are classified according to their impact on the solvency of an insurer


Technical Risks (liability risks)
Investment Risks (asset risks)
Non-technical Risks

E] The International Actuarial Association (IAA) Working Party on Solvency

In its November 2002 report, the IAA Working Party on Solvency suggested
the following

system of broad categorisation of insurance risks


Underwriting Risk
Credit Risk
Market Risk
Operational Risk
Liquidity Risk
The various components of the risk categorisation suggested by the IAA
Working Party are briefly
described below 1. Underwriting Risk
These are the risks undertaken by life insurance companies through the
contracts they
underwrite. The risks within this category are associated with the perils
covered (e.g.
death, critical illness) and with the specific processes associated with the
conduct of life
insurance business. They include Underwriting process risk e.g. financial loss related to selection and
approval of risk to be insured
Pricing risk e.g. financial loss due to insufficient premium charged for
a risk undertaken
Product design risk e.g. exposure to events not anticipated in the
design and pricing of the life insurance contracts
Claims risk e.g. more than expected number of claims arising
Economic environment risk e.g. adverse affect on the company due to
change in socio-economic conditions
Net retention risk e.g. losses due to catastrophic or concentrated
claims experience arising due to higher retention of risk within the
company
Policyholder behaviour risk e.g. unanticipated behaviours of the
policyholders adversely affecting the company
Reserving risk e.g. inadequate provision in company accounts for
policy Liabilities
2. Credit Risk
These are the risks arising due to default by and change in credit rating of
those to whom
the company has an exposure. They include reinsurance companies,
companies in which
the insurer has invested its funds. These risks also include external events
affecting the
creditworthiness of these companies. Examples being Business credit risk e.g. failure of a re-insurer

Invested asset credit risk e.g. non-performance of invested assets


Political risk (affecting credit worthiness of securities held by the insurer)
Sovereign risk (affecting credit worthiness of securities issued by
government or government entities)
3. Market Risk
These are the risks arising due to movements in the level of financial
variables such as
interest rates, share prices etc. Examples being Interest rate risk e.g. losses arising due to change in interest rates
Equity and property risk e.g. losses arising due to drop in equity prices
Currency risk e.g. losses arising due to adverse movements in
exchange rates Basis risk arising because the yields on instruments of
varying risk quality, liquidity and maturity don't move together; affecting
the assets and liabilities ofthe company independently.
Reinvestment risk
Concentration risk
ALM risk
Off balance sheet risk losses arising from assets or liabilities not
shown on the balance sheet eg payments required under futures
agreements with zero value at the balance sheet date
4. Operational Risk
There are various definitions available for Operational Risk. The definition
used by the British Bankers' Association and adopted under Basle II is as
follows
Operational risk is the risk of direct or indirect loss resulting from inadequate
or
failed processes, people and systems or from external events.
In recent years, it has been widely accepted that Operational Risks are
significant risks and at the same time are difficult to identify and measure.
They include Human capital risk e.g. failure to attract and retain well-trained
personnel
Management control risk e.g. failed internal controls, disciplines etc.
Systems risk e.g. systems failures
Strategic risk e.g. management failure to implement appropriate
business plan, make decisions, allocate resources and adapt to changing
environment
5. Liquidity Risk
These are the risks of losses in the event that insufficient liquid assets are
available to meet the cash flow requirements of the policyholders' obligations
when they are
due. They include -

Liquidation value risk e.g. risk of having to realise assets in adverse


market conditions
Affiliated company risk e.g. risk of difficulty in realisation of interests
in an affiliated company
Capital market risk e.g. risk of inability to obtain funding from outside
the company or group.

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