Ic92 Actuarial Aspects of Products

IC-92
Actuarial Aspects of Product Development
ACKNOWLEDGEMENT
This course is prepared with the assistance of:

Gopal V Kumar
MBE, CFP, DBF, FIAI
Allons Insurance Research & Consultants Pvt Ltd
Reviewed by
Dinesh Pant
B.E, LLB, PGDM, MBA, AIII, FIAI
G – Block, Plot No. C-46, Bandra Kurla Complex, Bandra (E), Mumbai – 400 051.
Actuarial Aspects of Product Development
IC-92
Revised Edition: 2016
ALL RIGHTS RESERVED
This course is the copyright of the Insurance Institute of India, Mumbai. In no

circumstances may any part of the course be reproduced.
The course is purely meant for the purpose of study of the subject by the
students appearing for the examinations of Insurance Institute of India and is
based on prevailing best industry practices. It is not intended to give
interpretations or solutions in case of disputes or matters involving legal
arguments.
This is only indicative study material. Please note that the questions in the
examination shall not be confined to this study material.
Published by: P. Venugopal, Secretary-General, Insurance Institute of India, G-

Block, Plot C-46, Bandra Kurla Complex, Bandra (E) Mumbai – 400 051 and
Printed at
PREFACE
This course is designed for the use of candidates appearing for the Fellowship
Examination of the Insurance Institute of India and who want to gain working
knowledge and develop skills to effectively apply actuarial techniques in various
steps of product design and pricing.
This course mainly deals with the product design from actuarial perspective and
also various actuarial assumption & parameters including expense, mortality
and profitability.
Product development is one of the key functions of any insurer and creates and
builds the company’s competitiveness in the market place. This course is
designed to introduce the students to concept and process involved in designing
insurance products and also setting assumptions.
Though the course material is designed to meet the needs of the students who
are appearing Institute’s examination, this would also be useful for the general
readers who wish to know how insurance products are developed
The main topics covered in the course include
 Pricing of Products
 Types of Insurance Products
 Premium Bases – Interest Rate, Mortality / Morbidity Rates, Persistency /
Withdrawal Rates, margin and expenses
 Reinsurance Support
 Financial Viability – Profit Margin and Solvency Margin
Although the course covers the syllabus prescribed for the examination, it is
desirable that candidates should read additional material to further enrich their
knowledge of the subject.
CONTENTS
Chapter no. Title Page no.
1 Insurance Product 1
2 Importance of Product Design 18
3 Pricing of Products – I 42
4 Types of Insurance Products – Individual 79
5 Pricing of Products – 2 119
6 Types of Insurance Products – Group 139
7 Premium Bases – Interest Rate 168
Premium Bases – Mortality And Morbidity

8 189
Rates
Premium Bases – Persistency/Withdrawal
9 214
Rates
10 Premium Bases – Commission Rates 234
10B Premium Bases – Margins 246
11 Premium Bases – Expense Rates 264
12 Reinsurance Support 286
Financial Viability – Profit Margin and

13 304
Solvency Margin
14 Glossary 312
CHAPTER 1
INSURANCE PRODUCT
Chapter Introduction
This chapter aims to provide you with an understanding of history of insurance,

insurance products, the various characteristics of an insurance product (such as
physical attributes, legal aspects, utility and financial aspects), the different
parties associated with an insurance product and their relationship with each
other.
Learning Outcomes
A. History of Insurance
B. Definition and characteristics of insurance products
C. Parties involved in insurance product transactions
IC-92 Actuarial Aspects of Product Development 1

Look at this scenario
If risk is like a smoldering coal that may start a fire at any moment, then
insurance is our fire extinguisher.
Insurance is a method of distributing the risk. The Chinese were among the first
ones to employ methods of risk distribution. The Chinese traders would
redistribute their wares across many ships to limit the losses caused as a result
of a single ship capsizing.
The first written insurance policy was found on a Babylonian obelisk monument
along with the code of King Hammurabi carved on it. The insurance product
then was basic in nature, and offered that for a small additional payment on the
loan, the debtor did not have to pay back his loan(s) if some personal
catastrophe made it impossible.
Insurance products have evolved a great deal since then, and we will be
examining the nature and attributes of modern insurance products.
2 IC-92 Actuarial Aspects of Product Development

A. History of Insurance
The story of insurance is probably as old as the story of mankind. The same
instinct that prompts modern businessmen today to secure themselves against
loss and disaster existed in primitive men also. They too sought to avert the evil
consequences of fire and flood and loss of life and were willing to make some
sort of sacrifice in order to achieve security. Though the concept of insurance is
largely a development of the recent past, particularly after the industrial era –
past few centuries – yet its beginnings date back almost 6000 years.
Life Insurance in its modern form came to India from England in the year 1818.
Oriental Life Insurance Company started by Europeans in Calcutta was the first
life insurance company on Indian Soil. All the insurance companies established
during that period were brought up with the purpose of looking after the needs
of European community and Indian natives were not being insured by these
companies. However, later with the efforts of eminent people like Babu
Muttylal Seal, the foreign life insurance companies started insuring Indian lives.
But Indian lives were being treated as sub-standard lives and heavy extra
premiums were being charged on them. Bombay Mutual Life Assurance Society
heralded the birth of first Indian life insurance company in the year 1870, and
covered Indian lives at normal rates. Starting as Indian enterprise with highly
patriotic motives, insurance companies came into existence to carry the
message of insurance and social security through insurance to various sectors of
society. Bharat Insurance Company (1896) was also one of such companies
inspired by nationalism. The Swadeshi movement of 1905-1907 gave rise to
more insurance companies. The United India in Madras, National Indian and
National Insurance in Calcutta and the Co-operative Assurance at Lahore were
established in 1906. In 1907, Hindustan Co-operative Insurance Company took its
birth in one of the rooms of the Jorasanko, house of the great poet
Rabindranath Tagore, in Calcutta. The Indian Mercantile, General Assurance and
Swadeshi Life (later Bombay Life) were some of the companies established
during the same period. Prior to 1912 India had no legislation to regulate
insurance business. In the year 1912, the Life Insurance Companies Act, and the
Provident Fund Act were passed. The Life Insurance Companies Act, 1912 made
it necessary that the premium rate tables and periodical valuations of
companies should be certified by an actuary. But the Act discriminated between
foreign and Indian companies on many accounts, putting the Indian companies
at a disadvantage.
The first two decades of the twentieth century saw lot of growth in insurance
business. From 44 companies with total business-in-force as Rs.22.44 crore, it
rose to 176 companies with total business-in-force as Rs.298 crore in 1938.
During the mushrooming of insurance companies many financially unsound
concerns were also floated which failed miserably.
The Insurance Act 1938 was the first legislation governing not only life insurance
but also non-life insurance to provide strict state control over insurance
business. The demand for nationalization of life insurance industry was made
repeatedly in the past but it gathered momentum in 1944 when a bill to amend
the Life Insurance Act 1938 was introduced in the Legislative Assembly.
However, it was much later on the 19th of January, 1956, that life insurance in
India was nationalized. About 154 Indian insurance companies, 16 non-Indian
companies and 75 provident were operating in India at the time of
nationalization. Nationalization was accomplished in two stages; initially the
management of the companies was taken over by means of an Ordinance, and
later, the ownership too by means of a comprehensive bill. The Parliament of
India passed the Life Insurance Corporation Act on the 19th of June 1956, and
the Life Insurance Corporation of India was created on 1st September, 1956,
with the objective of spreading life insurance much more widely and in
particular to the rural areas with a view to reach all insurable persons in the
country, providing them adequate financial cover at a reasonable cost.
Some of the important milestones in the life insurance business in India are:
1818: Oriental Life Insurance Company, the first life insurance company on
Indian soil started functioning.
1870: Bombay Mutual Life Assurance Society, the first Indian life insurance
company started its business.
1912: The Indian Life Assurance Companies Act enacted as the first statute to
regulate the life insurance business.
1928: The Indian Insurance Companies Act enacted to enable the government to
collect statistical information about both life and non-life insurance businesses.
1938: Earlier legislation consolidated and amended to by the Insurance Act with
the objective of protecting the interests of the insuring public.
1956: 245 Indian and foreign insurers and provident societies are taken over by
the central government and nationalised. LIC formed by an Act of Parliament,
viz. LIC Act, 1956, with a capital contribution of Rs. 5 crore from the
Government of India.
2000: Indian insurance industry privatised and several private players including
banks came into life insurance sector. E.g. ICICI prudential, HDFC Standard life,
Birla Sun life etc. 26% of foreign stake was allowed.

B. Definition and attributes of insurance products
1. Concept of an insurance product
Definition
An insurance product is a ‘promise’ sold by an insurer to a policyholder either

through an agent/broker or through his direct sales force which sets terms and
conditions between the insurer and the policyholder with regard to payment of
specified benefits on the happening of specified event(s) such as death.
An insurance product is a finished good (or service) designed to meet the needs
of a customer. Mobile, for instance, is a consumable product, because it meets
the communication needs of a customer.
2. General product categories
We observe that certain products are consumed for day-to-day use, such as
tooth brush, tooth paste, bath soap, water, food, etc. Certain products are used
to produce some utility such as happiness, entertainment, security (financial or
otherwise), travel, etc. Some are used temporarily to satisfy a specific need and
are of perishable nature, such as a banana, apple, cooked food items, petrol,
diesel, kerosene, etc.
All products are designed to meet the need and/or wants of a person. Thus,
every product has some utility.
While nature produces certain products (plants, trees, animals, etc.), some
products are made by man for consumption, to meet the necessities of life.
Manufactured products require some resources, which are either from nature or
made from nature. For instance, ‘cement’ is a product used in constructions of
buildings. For manufacture of cement, raw materials are needed such as water,
stone, etc.
3. Attributes of a product
The primary attributes of a product are as follows:
a) Shape (physical form) of product
An insurance product is not seen physically, unlike a bar of soap or a TV

set, which one can see and feel. An insurance product is only a piece of
paper (legal document with insurance stamps). It looks similar to a paper
ticket for travel in a train or an aeroplane.
Just like a bus ticket gives the holder right to do the particular journey on
that bus, an insurance product is a legal document which gives the holder of

the document legal rights with certain conditions. The document enables
one to get compensation or fixed sum under specified circumstances. If such
document is lost, it can be replaced with a duplicate one subject to certain
conditions imposed by the insurer.
b) Term of the product
Most of the products start giving benefit as soon as they are purchased. For
example, Television, which can be used to satisfy entertainment needs can
be used from the day it is purchased. However, the price can be paid in
lumpsum or as EMI every month if available. These products can have a long
life like fixed assets or short life such as orange.
Life insurance products are just opposite to this. Price or premiums start
much before the payment of actual benefit. Even it is not known when the
benefit will be paid for e.g death benefit. It is a very long term contract
which requires commitment to pay the premiums on time to get the benefit.
One exception to this is the immediate annuity contracts, where the benefit
starts as soon as the single premium is paid.
In general insurance products, even the premium is paid every year, there is
no certainty of benefit payment. E.g. motor insurance paying on accident.
c) Utility of product
Every insurance product has utility, similar to any goods, such as pizza,
which is useful to satisfy hunger. People buy insurance products to meet
their need for financial security of their family or of themselves in their old
age. Money is needed to meet basic needs of life, even while a person is
unable to earn it.
A man feels financially secure if he could satisfy his basic and other needs of
life. A person earns income (money) not only to satisfy his needs/wants, but
also to meet the needs of his dependants who cannot earn or do not have
any resource.
An insurance product is useful to the customer because it secures monetary

compensation for the customer on the occurrence of certain untoward
events. The monetary compensation can be used by the customer or his
legal heirs to somewhat restore the financial status to the position that
existed before the event occurred.

The following table explains how certain events can cause financial concerns for
a secure life:
Table 1.1
Occurrence of event in the case of a life assured – and the financial problem
Event Financial Problem

a) Funeral Expenses – to bury or cremate the dead body and
meet the expenses for ceremonies which ensue after
death.
b) Flow of regular income to family gets stopped, but the
Death family requires money to live. (Family could be spouse
and children who are dependent on the life assured’s
income).
c) There can be loans which need to be honoured leading to
sale of estates of died person, leaving family in distress.
Accident which a) Hospital expenses for treatment.
causes injuries b) Flow of regular income to the family gets stopped
to body temporarily.
Accident which a) As in item 1, but there could be legal expenses too since
causes death accident may involve litigation.
a) Flow of regular income gets stopped - it is necessary to
have financial support to take care of old age needs.
Old Age b) Funeral expenses to be paid in case of death due to old
age.
c) Higher chances of falling ill needing money for treatment
Sickness As in item (2)
Such events are not covered per se, but provided by insurers
by offering monetary benefits at certain intervals during the
period of contract (called Survival Benefits, Partial
Other Financial
Withdrawals/ Surrenders to provide some liquidity to a
Needs
customer) so that these could meet certain needs such as (a)
Education Expenses for children (b) Marriage Expenses (c)
Purchase of certain capital items needed for family, etc.
Note: Utility expected is referred to as ‘economic value’ - usefulness to the

individual/person in terms of money.
d) Types of Product Utilities
Every product has five types of utility. Insurance product also provides all
these utilities.

i. Political utility
The social power granted by a product refers to its political utility e.g. a
costly car may improve the social acceptance of the owner.
ii. Economic utility
The financial power granted by a product refers to its economic utility

e.g. gold ornaments and diamonds increase the financial stability of an
individual.
iii. Social utility
The social benefit granted by a product refers to its social utility e.g. a
solar panel providing electricity to an entire village is of great social
utility.
iv. Philosophical utility
The social morality decides the philosophical utility of the product e.g. a
bottle of wine has less philosophical utility as compared to a religious
book.
v. Aesthetic utility
The sensory appeal of a product decides its aesthetic utility e.g. a

colourful vase with a beautiful shape is of greater aesthetic utility
compared to a black vase.
e) Legal aspects of a product
Insurance products are legal contracts. A legal contract is a stamped paper

duly signed by the insurer, setting out terms and conditions. This is referred
to as ‘policy bond’, ‘insurance contract’, or ‘insurance policy’.
i. Issues related to the policy document
 The policy document is legally negotiable.

 Language used in the contract is not easily understood by a
layman. Many terms such as non-forfeiture conditions, definition
of accident, etc. are complex in nature.
 Font size is small, and one would find it difficult to read.
 If there is any dispute over settlement of claim, courts interpret
the terms mentioned in the contract.
 In some countries, standard text/wording is used in insurance
contracts but in many other countries, the insurance contract
language is written by the insurer, and rarely gets vetted by
insurance regulators.

 Efforts are being made by consumer associations, insurers’
associations and regulator to make such contracts as simple and
understandable as possible.
ii. Appellate authorities for insurance disputes
Not all beneficiaries of insurance policies would go to court. Many prefer

to go to consumer grievance cells in the offices of insurers, and knock on
the doors of the insurance regulator and insurance ombudsmen for
justice. Some approach consumer forums. Very rarely, beneficiaries go
to courts for justice.
Throughout the world, consumer grievances are predominant. Hence it is

necessary to have a serious look at the design of insurance contracts
with comprehensive terms and conditions. This is, however, easier said
than done.
iii. Documents related to insurance products
 In most countries, the application for insurance (called the

proposal form) is part and parcel of an insurance contract.
 This is the basis on which insurance would be granted.
 In the case of lives assured that are subject to medical
examination, the medical examiner’s reports and medical reports
would be part of the proposal form along with the insurance
contract.
iv. Commencement of an insurance contract
 An insurance contract is a concluded contract if the first

premium is realised by the insurer.
 Risk is not assumed by the insurer unless the insurer receives
premium which is realised into cash.
 Some insurers issue insurance contracts with a condition that, in
case of payment by cheque, the contract is valid only if the
cheque is realized.
 When a cheque is dishonoured after the date of policy but before
the death of the life assured, such insurance contracts are in
dispute.
 Even though many precautions are taken by insurers, they face
problems with regards to ‘unconcluded’ contracts.

v. Persons competent to contract
A proposer (the applicant or the prospect who wants to buy an

insurance product) can enter into a contract if he/she:
 Is a legal person – i.e. an individual whose age is at least 18 years

at the date of proposal (application for insurance product) and
mentally sound, or a corporate entity who can enter into a
contract by law (as per the Contract Act).
 A major – i.e. a minor person cannot enter into a contract as a
proposer. A minor can be life assured – life insurance cover can
be obtained for him. A minor can be a beneficiary under the
contract, provided a legal guardian is appointed.
 An illiterate person - who is also a legal person provided a
declaration is obtained from a person known to the illiterate
person that he has understood the consequences of entering into
the contract.
 Is an individual who is mentally stable. A mentally unstable
person cannot enter into a contract. He can be a beneficiary
under the contract, provided a legal guardian is appointed.
 A person who cannot sign in view of a physical deformity - (e.g.
one who lost both hands or whose hands do not permit him to
sign due to health grounds) can also enter into a contract,
provided that he holds a power of attorney granted by a court as
per the Contract Act.
Test Yourself 1
Who among the below is not allowed to buy an insurance product?
I. A senior citizen
II. A person above 18 years of age
III. A person below 18 years of age
IV. An unmarried woman

C. Parties involved in insurance product transactions
1. Parties to a life insurance contract
A life insurance contract is a contract between the proposer and the insurer
over the life of the assured. The insurer, proposer and life assured are all bound
by certain conditions as per the contract of insurance.
Relationship between proposer and life assured
When the proposer and the insurer enter into a life insurance contract, the
following scenarios can occur:
 The proposer and life assured are two different persons

 The proposer and life assured are the same.
A proposer is usually referred to as ‘policyholder’, and ‘policy-owner’ indicating

that the he/she/they entered into a contract with an insurer to own the
contract (policy).
Life assured can be an individual on whose life insurance cover is being granted.
Life (lives) assured can be of a group of individuals. There can be more than one
life assured – e.g. two lives – husband and wife, individual A and individual B, a
family consisting of husband, wife and children, employees of an employer.
An insurer would ensure ‘insurable interest’ between proposer and life assured,
otherwise, he might end up dealing with financial frauds and disputes.
2. Concept of insurable interest
Insurable interest means that the proposer (or the life assureds’ family
members - could be referred to as ‘beneficiary’) could face financial problems
in the event of death of the life assured since the beneficiary is dependent on
the earning of life assured.
A wife has insurable interest in her husband and vice versa. An employer has an
insurable interest in his employees. A lender has an insurable interest in his
borrowers to the extent of outstanding loan amount. An individual has insurable
interest in his/her life to the extent of financial support to his/her family or to
himself/herself in old age.
Insurable interest stresses financial dependence earnings, but not unearned

income such as rents, interest, etc. which might be received with certainty.
Earned income such as daily wages, salary, etc. could only be received if earner
discharges certain functions; otherwise, he does not receive income. Therefore,
there is no certainty of flow of income in the case of earned income in the
event of sickness/death.
Therefore, insurable interest has properties of:
 Definite relationship between two parties

 Financial commitments if future earnings cease
Most insurance contracts are individual contracts (only one life assured is
involved) and group contracts (where more than one life assured is involved.
Example
Mr. George is aged 40 and gets a salary of Rs.10 lakhs p.a. He has dependents
i.e. his wife and two children. He takes a policy on his life to protect his family
from the financial hardships arising in the event of his death.
Let us try and understand the above situation carefully.
Mr. George has insurable interest in his life so he can buy a policy on his life. If
he dies, insurance proceeds go to his wife who would take care of the family. If
he survives the maturity date, insurance proceeds go to him which would take
care of his old age.
3. Rights of Nominees, Assignors and Legal Heirs
a) In the case of contracts where policyholder and life assured are the
same, the beneficiary is usually the policyholder on maturity, and in
case of death before the expiry of the contract, it is the nominee or
legal heir.
b) ‘Nominee’ is created in law for the purpose of discharging the insurer’s

liability, so that the nominee could pass the policy money to the legal
heirs who have a right over the estate of the policyholder.
c) An assignor has a right over the policy monies to the extent of his/her
interest [assignors would be usually banks, housing loan companies,
insurers, and lenders who wish to have security against the loan granted
to the policyholder] and this right can be exercised only if assignment is
registered as endorsement in the insurance contract.
4. Who would buy insurance products?
Insurance products are rarely purchased...these are sold in the market through
soliciting by distributors (agents, brokers, insurer’s sales men). Distributors
need to convince customers to purchase insurance products by explaining the
importance of ‘protection’ as well as saving.
This is different from other basic products which are needed every day for
consumption, such as tooth-paste, soap, cloth, houses, milk, transport, etc. An
individual is forced to come to a shop or a store to purchase the basic product.
Life insurance products are generally not given priority by individuals. Reasons
for this could be:
a) Lack of awareness: Customers are unaware of such products and their

utility. People are not aware of their need for insurance.
b) Even though they are aware, priorities are different in view of limited
savings and financial capabilities.
c) Complexity of insurance products: Insurance products are complex;

language in the insurance documents - sales literature, proposal form,
insurance contract etc. - is full of technical jargon, and not easily
understood and also not explained.
d) Service rendered by distributors and insurers (including settlement of

claims) after sales is not as expected.
e) Unavailability of right products to meet the needs of the customers.
f) People may not have trust in insurers and the products designed by
insurers.
g) Alternative savings instruments: Other instruments of savings may be

through to be more attractive such as mutual funds (expected high
return), fixed deposits (liquidity), government bonds or public provident
funds (security).
h) Facilities for purchase of contract not easily available– [no sales counters
in the offices of insurers, no distribution person (agent) available to
render advice etc. However, this not the major issue now because of
plenty of information and sale on internet.
It is necessary to have a wide range of insurance products to meet the insurance

needs of all types and segments of people - children, youth, old, married,
single, men, women, fixed income groups, self-employed groups, un-organized
groups, farmers, casual workers, etc.

Normally, we expect the following persons to buy insurance products:
Table 1.2
Type of persons Type of products Reasons

To get payments on vesting to
Children Deferred Assurances meet education expenses,
marriage expenses etc.
To get payments (periodic
Deferred Assurances, payments) on vesting to meet
Students
Money Back Plans education expenses, marriage
expenses etc.
Employees with
Endowment Assurances,
fixed incomes, To provide savings for family
Money Back Plans, Unit
self-employed (dependants), for old age or to
Linked Plans, Deferred
persons with meet funeral expenses.
Annuity contracts
regular incomes
Retired
employees Immediate Annuity As old age income and also to
(retiring Contracts meet funeral expenses.
employees also)
Casual workers, Term Insurance To get lump sum payments for

Unorganised Contracts with Accident dependants or to meet funeral
workers Benefits expenses.
Deferred Annuity
Old age income or to meet funeral
Single Persons Contracts, Immediate
expenses.
Annuity Contracts
Term Insurance Lenders need security for the

/Decreasing Term outstanding loan in case of death
Borrowers
Insurance (Mortgage or permanent disability of the
insurance policies) borrower.
Test Yourself 2
Which of the below statement is false?
I. A person can buy insurance for himself

II. A husband can buy insurance for his wife
III. A wife can buy insurance for her husband
IV. A person can buy insurance for his friend

Summary
a) Insurance is a promise given by the insurer that grants protection to the

insured against a specific loss under certain conditions.
b) Insurance contracts are legal contracts designed to meet the customer’s

need of a secure financial future.
c) Only persons of sound mind, majority age and those permitted by law can
enter into an insurance contract.
d) Insurable interest ensures that the proposer does not gain undue financial
advantage by effecting a contract of insurance.
e) Insurance products are mostly sold and rarely purchased mainly because of
lack of awareness and several other factors.
Answers to Test Yourself
Answer 1
The correct option is III.
A minor cannot enter into a contract of insurance. He can only be the

beneficiary.
Answer 2
The correct option is IV.
A person has no direct insurable interest in his friend and hence cannot buy
insurance for his friend.
Self-Examination Questions
Question 1
Insurance is purchased to ______________.
I. Obtain financial security

II. Invest money
III. Place a bet
IV. Lower tax liability

Question 2
A contract of insurance concludes when ____________.
I. The proposal form is signed by the proposer

II. The duly filled proposal form is received by the insurer
III. Premium is received by the insurer
IV. Proposer decides to buy insurance
Question 3
1. Employer can buy insurance for his employees.

2. A husband can buy insurance for his wife.
Look at the two statements above and choose the correct option:
I. Statement 1 is true and statement 2 is false

II. Statement 2 is true and statement 1 is false
III. Both statements are true
IV. Both statements are false
Question 4
Economic utility refers to ____________.
I. Usefulness in terms of money
II. Usefulness in terms of power
III. Usefulness in terms of society
IV. Usefulness in terms of beauty
Question 5
Which of the below statement is correct with regards to who can enter into an
insurance contract?
I. A person whose is age is at least 18 years
II. A person who has at least passed 12th Standard from any board
III. A person who known at least the national language
IV. Any person can enter into an insurance contract without any terms and
condition
Answers to Self-Examination Questions

Answer 1
The correct option is I.
Insurance is primarily purchased to obtain financial security or to secure the
financial capital of the assured.
16 IC-92 ACTUARIAL ASPECTS OF PRODUCT DEVELOPMENT

Answer 2
A contract of insurance concludes when the premium is realised in the books of
the insurer.
Answer 3
An employer has insurable interest in his employees and a husband has insurable
interest in his wife. Hence, both the statements are true.
Answer 4
Economic utility refers to usefulness in monetary terms.
Answer 5
To enter into an insurance contract a person should be at least 18 years of age.
IC-92 ACTUARIAL ASPECTS OF PRODUCT DEVELOPMENT 17

CHAPTER 2
IMPORTANCE OF PRODUCT DESIGN
Design links creativity and innovation with needs/wants. It helps in shaping

ideas to become practical and valued by the end users. In the insurance
industry, it is important to match customer expectations and needs and design
products accordingly since new product launches directly impact sales and
profitability of insurance companies.
This chapter aims to provide you with an understanding of the importance of

product design and the various factors that influence design of insurance
products.
Learning Outcomes
A. Product design explained

B. Why product design
C. Factors affecting product design
D. Meaning of profitability
E. Role of regulations in product design
F. Understanding stakeholders’ concerns

Look at this Scenario
Delta Insurance Corporation aspires to be one of the leading insurers in life
insurance. The company is aware that in order to compete in the insurance
marketplace, it needs to enhance its ability to meet changing customer needs.
The company has identified that a robust product design is one of the essential
factors that would enable the company to achieve success over the long term.
Insurance companies throughout the world are constantly looking for new areas
/ opportunities to sell insurance. Having an excellent product design is an
important factor in achieving consistent and organic growth in revenue and is
being practised by most companies today.
A. Product design explained
Design of an insurance product refers to features of the product in terms of

benefits offered and price charged. Benefit can be offered on uncertainties
such as death, survival, sickness etc or it can comprise of certain timely
payments such as payment every 5 years.
Various guarantees, choices and options offered to the customer also come
under the preview of product design. One of the examples of guarantee offered
in a product is the guarantee that maturity benefit will not be less than some
percentage of total premiums paid. This percentage can be 100%, making sure
that at least premiums paid are returned. These guarantees are common in unit
linked design, making it a marketable product. Examples of options and choices
are surrender options, policy loan, switching of funds for unit linked insurance,
premium discontinuance etc.

B. Why Product design?
The question that arises now is why is new product design required at all?
In the market place all firms are trying to get more and more customers and
thereby targeting more and more profits. This leads to an introspection of their
own products and finding out what is lacking or what could have been better.
This introspection could lead to the following reason of looking at product
design:
 Awareness of a gap in the existing product range. This might be the

result of looking at other companies’ products. It can also be as a result
of change in the market such as:
 The market awareness of a new product need or product feature.
For example, increase in risk aversion increasing the need for
guarantees
 A legislative or fiscal change making new product or feature more
attractive. For example, if any change in tax policy make unit
linked design more attractive, such as, lower service tax rates.
 The availability of new financial instruments making a new
product feasible. For example, inflation linked bonds by
government making possible inflation linked guarantees in unit
linked products.
 Awareness of an inadequacy in an existing product such as:
 Insufficient profitability and inefficient use of capital –
development of new improved profits testing matrices or change
in shareholder’s preferences making product unprofitable or
capital inefficient.
 Inadequate premium rates for non linked products or charging
structure for unit linked products. This may be because of
changes in demographics, change in future expense outlook and
changes in future investment outlook. Demographics refer to
mortality rates, morbidity rates or lapse rates etc.

C. Factors affecting product design
Primary and most important factor affecting the product design is the customer
needs. Product design acts as a bridge between the creativity and customer
needs. Customers desire various features in the products, which is then made
possible by innovation in terms of product design. Other important factors
affecting product design are:
 Profitability: A company will want to ensure that the premiums charged

for non-linked contracts and charges of unit linked contracts will be
sufficient to cover the benefits to be provided and the expenses to be
incurred in future, and provide a profit margin. After all a company can
survive only if it is profitable in the long run.
 Sensitivity of profit: This factor is mainly relevant to unit linked design

where different charges can be designed in a way to reduce sensitivity of
profits to particular risk. For instance:
o Investment return: if there are no investment guarantees then

most of the investment risk is borne by the policyholder.
o Mortality: make the charge for this variable at the company’s
discretion.
o Expenses: make the charge for this variable at the company’s
discretion.
o Withdrawal rates: don’t offer any guaranteed surrender values.
o Matching: try to match income (the charges) with outgo
(expenses and benefit costs) as closely as possible by duration,
especially with regard to the initial expenses.
Similarly for non linked products it may be possible to reduce the

exposure of profit to unpleasant variations in future experience (for
instance by not offering, or at least minimising, any guaranteed
surrender values). The sensitivity of profitability to high withdrawal
rates could also be reduced by using a commission system whereby there
is some “clawback” (return) of commission for early withdrawals.
 Marketability: There is no use of product design if the product is

unattractive to prospective customer and hence, difficult to sell in
market. Product design needs to be attractive to the market in which
the product will be sold. Marketability is greatly enhanced by innovative
design features and additions of options and guarantees. There should be
a balance between attractive product design and making the product
simple to understand. Analysis of target market will provide an
indication of required level of simplicity in the product. A financially
sophisticated target market allows a complex and attractive design,
where as targeting lower income group customers with less financial
knowledge would make simple design more attractive.

 Competitiveness: Usually products of the company are comparable to
the products offered by other market participants. Premium rates or
charges should not be too high or low when compared to competitors. In
case product is unique and have features which can not directly be
compared in the market, higher price can be offered. In that case also,
care should be taken to ensure timely monitoring of market place to see
when that price becomes uncompetitive and then take suitable
corrective action. This factor will also depend upon how the products
are marketed and should be looked at along with with marketing aspect.
 Level of risk: Consideration will need to be given to the acceptability of

the level of risk associated with a proposed contract design. The level of
risk that may be acceptable will depend upon the company’s ability or
willingness either to absorb risk internally or to reinsure or hedge it. All
the risks cannot be hedged or reinsured. For example, risk of higher
surrenders or lapses is difficult to hedge, the design should discourage
surrenders or lapse by suitable penalties when premium is not paid and
by encouragement to pay premium. One important aspect related to
level of risk is the level of guarantees offered in the product. Higher the
guarantees higher the risk. Guarantees improve the marketability of the
product and increase the risk too. Hence, there should be a balance
between the two.
 Administration systems: The system requirements of a new product may

limit either the benefits to be provided or the charging structure to be
adopted. For example if the company’s computer policy administration
system cannot cope with administering a waiver of premium option, the
product should not have one (unless it is so important that it is worth
spending money on enhancing the system). This aspect is also linked to
the aspect of simplicity particularly for company’s staff. A complex
administration system also increases the chances of errors and
associated losses.
 Consistency with other products: Consistency is required because a

major change will result in significant systems development, which will
take time. There are benefits in terms of saving time and cost with such
things as training administration and sales staff, printing marketing
literature and so on. There is also a possibility that a design, which
appears much more attractive or favourable to policyholders, may seem
unfair to existing policyholders and may lead to some dissatisfaction and
possible marketing risk. The old customer may surrender their policies in
dissatisfaction.
 Regulatory requirements: All the above factors would only possible if it

is allowed by the regulations imposed on the company. In India, there
are several restriction directly or indirectly on the level of charges,
commissions, benefits etc., which has to be followed while designing any
product.
For designing a product, the insurer has to keep in mind the customer need,
preferences, appropriate delivery mechanism, regulatory requirements and
knowledge of local conditions because there is no “one size fits all” solution.
Apart from above important factors, in order to achieve higher sales, the
product design should also consider the following factors:
a) How comprehensive are the features?
b) Whether distributors need special training to sell the product?
c) Whether sales illustrations are simple and clear to the prospective

customer?
d) Whether distributors (and sales team of insurers) could explain about

other products in the market, and how these differ from the products of
the insurer?
One of the main issues associated with product design is proper communication
to a lay customer. In addition, there are other issues to be considered such as
concerns of shareholders and regulators. These are explained later.
Other factors significant in product design
1. Target Population
It is important to identify the target market and the needs and demands of the
target market. This is needed in order to identify groups of potential customers
who have similar needs. E.g. the needs of persons living in rural areas will be
different from the needs of the urban population. An insurer should keep this
factor in mind before designing insurance products. This would assist the
actuary in applying proper mortality rates.
2. Eligibility to buy
In order to purchase insurance, there are certain conditions to be fulfilled so

that a potential customer can be eligible to buy insurance. These are:
a) Age
Insurance companies offer plans right from childhood to old age. In some
plans the insurance company may specify a minimum age after which
insurance may be given. For example an insurance company may say, to
avail a term insurance plan the minimum entry age is 18 years. In case of
some plans the insurance company may specify a maximum entry age after
which an individual may not be able to buy that plan. For example an
insurance company may say the maximum entry age for a particular

insurance plan is say 65 years. So individuals will not be able to buy that
particular plan after the age of 65 years.
b) Income
A person seeking insurance should be able to pay for the premiums in the
long term. The insurance should be affordable as per his /her income. E.g.
the person seeking insurance should earn a specified income per month or
annual income as may be determined by the insurer. The insurer may ask
income proof wherever necessary based on declarations and amount of
insurance cover asked for by the customer.
c) Health
Insurance should not be used as a medium of committing any fraud.

Customer knows facts about their health which they can hide and take
insurance in order to profit at the expense of the company. The person
seeking insurance should be in good (normal) health at the time of purchase
of this product. The insurer may ask for medical examination and reports,
wherever necessary, based on declarations and amount of insurance cover
asked for. However these days’ insurers offer cover even if a person is
suffering from some disease, but at a higher premium as compared to other
people with good health.
3. Other Conditions
a) The customer should be an Indian citizen or a foreign national resident in

India.
b) The customer should choose a period of insurance cover (policy term)

that covers a minimum and maximum period.
Example
The policy could state that the cover should be for at least 5 years, but not
exceeding 25 years.
c) The customer should choose a period of premium payment that covers a

specified duration, say; at least 5 years. Alternatively, he/she can
choose to pay a lump sum amount (Single Premium) with the application
(proposal form).
d) The customer can select any frequency of payment of premium, i.e.

monthly, quarterly, half-yearly, etc.
e) During the period of contract, the customer can change frequency of

payment of premium from one mode (i.e. monthly) to another mode
(i.e. half-yearly), according to his/her convenience.
f) The sum assured cannot be changed during the period of contract.
Sometimes, insurers allow alterations for increase in sum assured,
subject to approval of regulator. Such freedom to policyholders would be
subject to actuarial considerations since increase in sum assured is
suspected to be a moral hazard.
g) The customer should not engage in occupations such as divers, stuntman,

etc. Some insurers may put conditions on occupation, though they may
grant cover.
4. Provision of benefits
These could be paid in any of the following circumstances:
a) Death
If the life assured dies during the tenure of the insurance contract, the sum
assured is payable. Death might be due to any reason. However, this benefit
is not be payable if death is on account of suicide during the first year of the
policy.
b) Maturity
If the life assured survives till the date of maturity (expiry of policy term),
the sum assured with bonuses or guaranteed additions is payable.
c) Early Termination
If the insurance contract is terminated due to any reason, the benefits that
would be payable would depend upon the applicable terms and conditions
related to the termination.
5. Beneficiaries
Beneficiary is the person named in the insurance contract. Usually, the person
nominated by the policy holder is entitled to receive the benefits. If there is a
dispute, the legal heirs would be entitled to receive the benefits.
6. Remedies available in case of any problem/litigation
a) Non-payment of premiums
In certain cases, an insurer may not receive premium by way of installments

(or other methods) on the respective due dates and within days of grace
(specified by insurer). In such cases, the insurance cover ceases from the
due date of premium installment unpaid.

Insurers may allow reinstatement / revival of such contract within a
specified period subject to certain terms and conditions. These relate to
arrears of premiums with interest, evidence of health, etc. (Insurers address
this issue by sending premium notices in advance by post, SMS, etc.; and
also by means of wide publicity through agents, advertisements and revival
campaigns.)
b) Suppression of information
If it is found that age is under-stated or over-stated, an insurer might re-

calculate premiums (if age is understated) and ask the policyholder to pay
the differences in premiums with interest, as if the policy was issued with
the corrected age at entry. If it is discovered that the life assured is not
insurable with such corrected age, the insurer may return the premiums
paid after deducting administrative expenses and cancel the policy. In such
cases, the Act or directions of the regulator may prevail.
If any information that is material to insurer is suppressed in the original

application (proposal form at time of issue of contract), the insurer may
cancel the contract. The Act or directions of the regulator may prevail.
Section 45 of the Insurance Act, 1938 as amended from time to time would
prevail in such cases.
c) Loss of original policy due to fire, theft, or any reason
In such cases, a duplicate policy might be issued at the expense of the

policyholder. Conditions as applicable may be prescribed by insurers in such
cases.
d) Consumer grievances
These could arise due to delays in settlement of policy monies, non-

provision of services to the policyholder, etc. Such grievances could become
disputes requiring intervention and settlement by the Ombudsmen.
However, the policyholder can access the consumer forums and courts. The
Act or directions of the regulator may prevail in this regard.
e) Assignment facility
Insurer may state the procedure for assignment of policy.
f) Loan facility
Insurer might offer loan facility with certain terms and conditions.
There may be other terms according to the needs of the industry—which

could arise on account of insurers’ associations and regulator.

7. General Observations
Product design should address the following:
a) Language used in description of terms
This should be simple to understand. Though the insurance contract

contains legal language, the sales literature should be simple so that the
customers can understand it.
b) Fine print
This should be avoided. Inclusion of restrictive clauses might create

problems and could possibly destroy the image of insurers.
c) Complex design
There should not be too many conditions in granting a benefit. Too many
riders in a product cause confusion and hence, should be avoided.
d) Definitions
These should be capable of being understood by the users of insurance

products. Different insurers would use different definitions for the same
event.
Example
A terrorist attack might not be called accident. The death of a driver caused
due to hitting a tree might not be called accident.
e) Use of paper
Since insurance contract is an important document, the quality of paper

used should be of good. The contract should also be available in
electronic format.
f) Arrangement of clauses in orderly manner
Clauses, endorsements, etc. should be numbered in an order that makes

it easy to refer to by the reader. The document should be genuine in
appearance and form.

Test Yourself 1
Which of the following does not qualify as eligibility criteria to buy insurance
products?
I. Age
II. Gender
III. Health
IV. Marital status

D. Meaning of profitability
Profitability drives most businesses. Insurance is also a type of business and so

profitability drives the business of insurance also. In the case of manufacturing
business, the sale of goods depends upon the demand that exists for such goods,
and eventually the profitability. It does not make any commercial sense to carry
out production if the products cannot be sold profitably. The same logic applies
to insurance products.
One of the important variables affecting profitability is the volume of sales.

Products should be capable of being sold in the market without much difficulty.
This, in turn, depends upon on whether there is a market that exists for the
products. For this purpose, target market segmentation should be done. The
product should be designed such that it meets the needs of the target
population. Only then, the product will be able to generate profits in the long
run.
1. Selling insurance products
Selling insurance products depends upon several factors. A few of these are:
a) Distribution network
This has an impact on the sale of insurance products. The wider the network
of distributors, the better is the market reach. However, it is not merely
the number of distributors; it is their productivity that impacts the sale of
insurance products.
b) Marketing and advertising

These are useful in creating awareness of products. The effectiveness of
advertising can be measured in terms of the reach i.e. how many people
viewed the adverts. The mass media such as TV, press, radio or newspapers
might be used as well as more traditional forms such as posters, billboards
and fliers.
c) Efficiency of administrative staff
This is one of the most essential considerations for any financial services
company. Efficiency can be measured as reduction in turnaround time by:
 Speedily granting insurance by the underwriters

 Disbursing commission payments to distributors
 Issuing insurance contracts in time and
 Providing ‘after-sales’ customer service.
The administrative staff should possess decent communication skills in order to

carry out their functions efficiently.

Components of profitability:
At a general level, a life insurance product can be broken down into three
components: savings, protection and administration. This brings into focus the
true nature of a product: it is the provision of certain services to the
policyholder by the insurance company. What is important is that the product
be profitable in its entirety, but ideally every product should be profitable in
each of these dimensions:
 Savings: The company will want to make a profit on investment income.

For non-linked business, while deciding the premium appropriate
interest rate should be used. For unit linked business, most of
investment risk is passed on to customer, but fund management charge
should be adequate to cover any residual investment risk and provide for
some profit.
 Protection: The mortality assumptions used for premium calculations

should cover the risk involved. Similarly for unit linked products
mortality charge should be adequate.
 Administration: The expense assumption used in premium calculations

should be appropriate and must cover the acquisition and administration
costs involved. Further to this, the company will require that its total
expenses be covered by total expense charges for unit linked products.
In unit linked business, the most critical influence on profitability will be
the adequacy of the expense charge since, investment risk is primarily
borne by policyholder and mortality risk is not that large. Mortality risk
is small in unit linked because sum at risk keeps on reducing as time
progresses. This is true for products where death benefit is maximum of
sum assured and unit fund.
Test Yourself 2
Selling insurance products depends upon which of the below factors?
I Distribution network
II Marketing and advertising
III Efficiency of administrative staff
IV All of the above

E. Role of regulations in product design
Each country is unique and therefore insurance regulations vary from country to
country. Little regulation means more freedom for companies to innovate while
designing insurance products and perhaps a more competitive market. More
regulation may restrict innovation but could possibly prevent insurance
companies from making critical mistakes.
1. Regulatory systems
Different countries use different regulatory systems. The extent of regulation

also varies by the experience level of the market.
Diagram 1: Regulatory systems
a. ‘File and use’ system
Under this system, insurers are required to file the product in an

application form that adheres to the instructions of the regulators, and
file with the regulator. Once the regulatory clearance is obtained, the
product can be introduced in the market.
A file and use document is prepared and filed with regulator which
explains the features of products apart from all other technical details
such as:
 Event on which benefits and payments are made under the

product
 Type of premium payment with the modes allowed
 Maximum and minimum entry age, maturity age, policy terms,
premium payment terms
 Commission levels payable to agents or other channels
 Withdrawal terms and charges
 Financial projections including assumptions used for pricing the
product along with scenarios testing

 Loans and other facilities if available
 Options and guarantees offered by the product
 Target market
 Distribution channel used
 General Policy Provisions such as suicide claim provisions,
Exclusions, Grace period, nomination requirement, policy
alterations, revivals approach
 Other miscellaneous information
Along with the application form and file and use document, the insurer
would need to enclose the following while filing the proposal:
I. Specimen proposal form (application form for insurance)
II. Specimen policy contract
III. Specimen sales literature
IV. Specimen benefit illustration
V. Profit testing results for sample model points
VI. Cashflow projections for sample model points
VII. Premium tables and so on
Profit testing is the process of checking the premiums to see if its

affordable and satisfies the internal profit criteria.
Benefit illustration is a document used to show the premiums and benefit

structure of the product to prospective policyholder.
Purposes of the file and use system
The main purposes of this system are:
 To ensure that the products manufactured by insurers suit the

interests of the public so that buyers can be attracted; and
 To ensure that the products are capable of generating enough

profits so that the solvency of the insurers can be ensured.
The regulators may check out technical analysis in order to ensure that
products benefit the common man in terms of affordability.

b. ‘Use and File’ system
Under this system, insurers can introduce the product in the market
after it is designed. Later on, the product can be filed with the
regulator.
If, after passage of time, the regulator feels that the product is no
longer in the interest of public, it may require the insurer to stop selling
the product henceforth.
In this model, the insurer is given freedom with restrictions. The

objective here is to provide an opportunity to the insurer for innovation
in the product design. Another reason is to ensure speedy launch of the
product in the market.
Here, no technical analysis may be done by the regulator. The regulator

would act when he receives complaints from the public in respect of the
product. However, the primary disadvantage would be that the product
might lead to mis-selling and insolvency issues.
c. Free system
Under the ‘free’ system, insurers design products and sell these without
any intervention from the regulator. This may be regarded as ‘freedom
with responsibility’. The regulator may monitor the insurer through
‘solvency test’, ‘asset-liability matching’ test, etc. However, the
regulator may require the insurer to stop new sales, if he thinks that the
insurer’s operations are not in the interest of the public.
This system ensures survival of the fittest. The philosophy behind this
method is that the insurers in the market could offer products for sale at
prices determined by the market. However, this system could create
issues for the regulator if the solvency of insurer is not monitored by the
regulator at regular intervals.
Focus of all above methods
In all the above methods, the main focus lies on the customer. Customers
should be able to choose amongst a wide range of products that should be
affordable. In India currently “File and Use” method is prevalent. However,
there are some discussions about “Use and file” system also for some simple
product, which is not yet launched.

Test Yourself 3
Which of the following is / are the main purposes of the file and use system?
I. To safeguard interest of the public

II. To ensure solvency of the insurers
III. Both I and II
IV. None of the above
Other regulatory impacts:
Apart from above, in India there are two product regulation, Linked product
regulations and Non linked product regulations, issued by regulator in year
2013. These regulations directly or indirectly impact the product design:
Some of the provisions of these regulations impacting product design are listed
below:
 Minimum death benefit: To ensure that protection component of the

insurance product remains high, regulation stipulates minimum amount that
should be payable on death. In case of death due to suicide, within 12
months from the date o f inception of the policy, the nominee of the
policyholder shall be entitled to at least 80% of the premiums paid.
 Minimum policy term and premium paying term: To ensure that the products
remain fairly long term to protect the interest of policyholders, regulation
stipulated minimum policy term and premium paying term for insurance
products.
 Commissions or remuneration in any form: Commission or remuneration in

any form for the procurement of all individual policies, group term
insurance, group credit insurance and group saving variable insurance
policies in respect of all the Distribution Channels except the Direct
Marketing shall not exceed the stipulated limit in the regulation.
 Surrender value calculations: As per the regulation surrender value in most

of the cases would be higher of guaranteed surrender value (GSV) and
special surrender value. GSV is precisely defined in the regulation. Also,
guidance is provided for the calculation of SSV. Regulation also defines the
time period of when the policy will acquire surrender values. There are
limits on surrender charges for group products as well.
 Advance Premium: Collection of advance premium shall be allowed, if

premium is collected within the same financial year. The premium so
collected in advance shall only be adjusted on the due date of the premium.
The commission shall only be paid on such due date.

 Level premiums:
• Except for group products, the premium chosen at the outset
shall become payable throughout the premium paying term of the
policy and shall not be altered during the term of the policy. Such
premium shall be level / uniform and shall not vary over the term
of the policy.
• The insurer shall not accept any amounts less than the due
stipulated regular premium payable as stated in the policy.
• Any additional payments made on ad hoc basis shall be
considered as top-up premium and treated as single premium for
the purpose of providing insurance cover.
• Service tax, if any, shall not be included in the contractual
premium and shall be collected from the policyholder separately
as over and above such premium.
 Misleading names: As per the regulations, the misleading and

misrepresenting the benefits through the name of the products shall not
be allowed.
 Benefits offered on Maturity:

• The product literature shall clearly indicate whether the product
is protection oriented or savings oriented or a combination of
the two.
• Where the products offer the maturity benefit as return of
premiums paid or a percentage of return of premiums paid or
a meager amount in excess of return of premiums paid, these
products shall not be termed as savings products.
• The maturity benefits shall closely reflect the asset share in case
of par products.
At the most generic level, the asset share for a life insurance policy is the
accumulation of monies in less monies out in respect of that policy. In other
words, the accumulated cashflow in respect of a policy.
 Approval of innovative product: Any product design, which is not

approved so far by the Authority, shall be treated as innovative product.
The approval of these products would be subject to the conditions as
stipulated in the regulations.
All these provision as mentioned above are discussed in details in the pricing
chapters.

F. Understanding stakeholders’ concerns
Different stakeholders would have different interests. Shareholders and

regulators’ concerns have been discussed earlier. The other stakeholders are
discussed hereunder.
1. Policyholders
They purchase insurance contracts since these meet protection needs of

policyholders and their dependants. They also would be interested in knowing:
a) Whether the insurers are financially capable of meeting the claim

commitments; and
b) Whether insurers would offer prompt services during the period of

contract and after sales, particularly in settlement of claims.
Policyholders expect good consumer education before and after they purchase
the insurance contract. Such education could relate to:
 Salient features of products

 Settlement procedures
 Tax incentives and
 Other facilities the product has to offer
2. Distributors
They earn remuneration by soliciting and procuring insurance business for

insurers. The distributors are paid commission for handling customers before
and after sales.
Distributors should be thoroughly knowledgeable about the features of the

product and capable of providing insurance advice to individual clients, whether
solicited or not.
Distributors need to be honest in selling insurance products as it is an ethical

aspect of business. The distributors are regulated by regulators, and supervised
by insurers.
Certain issues may arise due to distributors sharing their commission with
customers, wrong selling, wrong advice, etc. These problems may persist even
after providing training and education.
3. Insurers’ Associations
These associations focus on protecting the interests of the insurance industry

through market discipline and ethics. Insurance companies that are a part of the

associations meet at regular intervals to solve the common problems & issues
faced by them. They would be interested to control:
 Commission scales
 Sales illustrations
 Poaching and
 Other bad practices
Insurers’ Associations also provide advice to the regulator to take suitable

action to redress industry complaints.
4. Consumer Forums
These forums protect the interest of the beneficiaries against insurer’s actions
in settlement of claims and other customer services related issues. These
forums might suggest changes in the language used in the insurance contracts so
that the interpretation would be easy and there is no ambiguity in the terms
and conditions that lead to problems for customers later. In general, the
industry faces problems with regard to glossary of terms used in insurance
contracts, definition of events in the contract, etc. An efficient product design
should consider this so as to avoid litigation later on.
Test Yourself 4
Which of the following is the main reason for considering consumer forums as
stakeholders?
I. These forums protect the interest of the beneficiaries.

II. These forums protect the interest of the regulators.
III. These forums protect the interest of the regulators and beneficiaries
IV. These forums provide consumer education.

Summary
a) For insurance products, product design is an important factor to be

considered.
b) Product design is required to fill the gap or inadequacy in the existing

product range.
c) There are various factors affecting product design, most important being
profitability and its sensitivity, marketability and competitiveness, level of
risk, administration system, consistency with other products and regulation.
d) Products should be capable of being sold in the market profitably.
e) Sale of insurance products depends upon various factors such as distribution

network, marketing and advertising, efficiency of administrative staff etc.
f) While designing insurance products, various other factors should be

considered. These are: target population, eligibility to buy, provision of
benefits, beneficiaries and remedies available in case of litigation.
g) An insurance product design should incorporate use of simple language in

description of terms and definitions, avoiding fine print and complex design
and arrange information in a logical flow for the consumer.
h) Regulations play an important role in insurance product design. Regulatory

systems can be of three types: File and use system, use and file system and
free system. Further, regulatory requirement of death benefit, maturity
benefit, commission etc. impact the product design
i) Lastly, stakeholders’ concerns need to be addressed by insurers. These

stakeholders are policyholders, distributors, regulators, employees of
insurers, insurers’ associations and consumer forums.

Answer 1
Selling insurance products depends upon several factors like: Distribution

network, marketing and advertising, efficiency of administrative staff etc.
Answer 2
The main purposes of the file and use system are to safeguard the interest of
the public and to ensure solvency of the insurers.
Answer 3
Consumer forums protect the interest of the beneficiaries hence they are
considered as stakeholders.

Question 1
If the life assured dies during the tenure of the simple insurance contract,
which of the following is payable?
I. Sum assured
II. Sum assured with premiums paid
III. Sum assured with guaranteed additions
IV. Sum assured after appropriate deductions
Question 2
The term ‘freedom with restrictions’ best describes which of the following
regulatory systems?
I. Use and File system

II. File and use system
III. Free system
Question 3
If any information that is material to the insurer is suppressed in the original

application (proposal form) at the time of issue of contract, the insurer may:
I. Cancel the contract

II. Require the policyholder to pay penalty
III. Demand further details from the applicant
Question 4
Distributors earn their income by which of the following methods?
I. Profit sharing
II. Interest
III. Commission
IV. Percentage of sales revenue

Answer 1
If the life assured dies during the tenure of the insurance contract, the sum
assured is payable.
Answer 2
The correct answer is I.
Use and file systems provide an opportunity to the insurer for innovation in the
product design.
Answer 3
If any information that is material to the insurer is suppressed in the original

application (proposal form) at the time of issue of contract, the insurer may
cancel the contract
Answer 4
The correct answer is III.
Distributors earn income by way of commission on sales.

CHAPTER 3
PRICING OF PRODUCTS – I
For prospective customers apart from other important factors that play an
important role in taking decision to buy an insurance product, price of the
product also plays a very important role. As a result, right and competitive
pricing of insurance products is the need of the hour. Competitive pricing helps
insurers to gain an edge in today’s competitive market. Pricing of insurance
products is technical and requires complicated calculations.
This chapter aims to provide you with an understanding of pricing insurance

products and the various factors that influence pricing and determination of
premium rates.
Learning Outcomes
A. Meaning of price and premium

B. Methods of pricing and price determination
C. Components of premium
D. Issues in determining premium
E. Regulatory influences on pricing

Wellman Insurance Corporation is facing stiff competition in the market for its
products. The company’s product team has been continuously studying the
behavior of buyers who buy insurance.
The team carried out an extensive research and found that more than 70% of
the buyers purchased insurance based on price/premium considerations.
The pricing of insurance products is unique and largely differs from pricing of
tangible products and services, where input-costs are known. From the
perspective of the insured, pricing is a major differentiating factor while
purchasing insurance.
From an insurer’s perspective, it is important to charge adequate prices for its

products in order to maintain its long-term financial health and performance.

A. Meaning of price and premium
1. Price
Definition
Price is expressed in terms of money at which one can exchange for goods or
services.
Pricing of products is directly linked to revenue levels and hence setting prices
is an important task for any commercial company.
Pricing, therefore, needs to meet both the company's financial and marketing
aspirations.
2. Premium
Definition
In the insurance market, ‘premium’ is exchanged for future benefits which are
paid on happening of events mentioned in the insurance contract.
The payment schedule of premiums is stipulated in the contract with regard to

time and mode of payment.
Pricing and premiums:
In an insurance parlance, pricing is generally understood in terms of calculating

the premiums to be paid for stipulated benefit amount.
However, this is true for traditional insurance products mainly non participating
where benefits are fixed.
For unit linked products, pricing has much wider meaning. For example, when
sum assured and premiums are not fixed and customer can choose both, pricing
will be used to find out charges that will be deducted from premium or from
fund. Hence, in this case charges rather than premium are determined by
pricing.
In unit linked products, normally premiums are chosen by the policyholders and
sum assured benefit is a fixed multiple of that premium. It is the level and
frequency of charges which separates the products of two different companies
and two different products within one company.
Even for traditional participating products, determination of both bonuses to be

paid along with premium to be charged is the subject of pricing. Two companies
with otherwise similar structure can have very different premium for same
guaranteed level of benefits depending upon how much bonus is expected to be
paid in future.
For example, one company can have sum assured of 10 times of premium with
expected bonus rate of say 3% per annum, while other company can have sum
assured of 15 times of premium, with bonus rates of say 1.4% of sum assured per
annum.
Moreover, recently there are innovative products being offered in non

participating framework, where apart from fixed benefits on maturity and
death, guarantee additions are given periodically. Here also, pricing will be
more focused on calculation of guaranteed additions rather than actual
premium to be charged.
For example, premium can be set at 1/12th of sum assured chosen or vice versa,
guaranteed additions being dependent on premium payment term, policy term
and premium size.
Example
Mr. X has taken an insurance policy for a sum assured of Rs.100,000 which is
payable on death if it happens any time after the date of commencement of
policy. For this benefit, he is required to pay premium of Rs. 1,000 on 1st
January every year.
In case he dies in the second year of the policy term, his beneficiary is entitled
to receive Rs. 100,000.
In this case, price is the ‘premium’ of Rs.1,000 p.a.
Test Yourself 1
Pricing of insurance products is directly related to which of the below?
I. Income of the individuals

II. Revenue levels of the insurance company
III. Guidelines of the Finance Ministry
IV. Tax benefits provided by the Government

B. Methods of pricing and price determination
An equation of value which equates inflows and outflows is used to price the
insurance products.
In the case of any product, the equation of value can be expressed as:
Price = Benefit (attached to the product) + Expenses (to be incurred for sale and
service)+ profit margin
The benefit could be monetary or non-monetary.
In the case of insurance products, the equation of value can be expressed as:
Present Value of Premium(s) = Present Value of Benefit(s) + Present Value of

Expenses (including profit to shareholders).
This is the basic rule of determination of price. As discussed above this price
can be premium or charges or bonus of guaranteed additions.
In case of premiums, goal will be to calculate, left hand side of the equation
while keeping right hand side fixed. However, if the premiums are not
competitive or too low, right hand side also will be altered and premiums
recalculated, till the time they are at desired level.
In the case of charges, guaranteed addition and bonus, it will be the profit
margin that will be targeted while keeping premium fixed. Charges and
benefits will vary to ensure desired level of profits.
This equation of value can be solved using two different methods known as
method of pricing:
1. Formula method
In the formula method, a formula or formulae are used to determine the

premium(s). This means using the equation of value as it is without going into
every year and looking at the benefits. This is done with the help of discount
factors used to calculate the present value of payment to be done in future.
This method cannot be used to price products with diverse and complex
benefits like unit linked product. For such type of product cash flow method is
used as described below.
2. Cash flow method
In the cash flow method, expected incomes and outflows are projected into the
future, and the best premium rate or charges or other variables are

determined. This method is best suited for complex product and where
premium is not the only desired variable.
Earlier, there were less computational power and hence formula method was
used. With the ever increasing speed of computational power cash flow method
of pricing has gained remarkable popularity. Now complex models and tools are
available which can project all the cash flows of the product for all future
years. As a results formula method is not used now and where it is used it is
used just as an indicator of premium to start with. Then the resultant premium
is profit tested using cashflow model and using the discount rate as risk discount
rate to see if it satisfies the profit criteria.
These methods are discussed in details in pricing part 2 chapter.
Example
Freeman Life Insurance Corporation intends to offer for sale, temporary

assurance contracts (valid for one-year) to males aged 40 nearest birthday. The
Premium per 1000 insurance cover can be calculated as follows:
Let’s assume that the company issues 2000 such contracts. The insurance cover
for each contract is Rs. 1000 per life. Ignoring all expenses and investment
earnings and assuming 2 deaths in a year per 1000 such lives,
Present value of Premium = Present value of benefits

Present value of benefits = 4 x 1000 = 4000
Present value of premiums (for all 2000 contracts) should be equal to Rs. 4000.
Hence the premium required per contract is Rs. 2 per 1000 insurance cover (Rs
4,000 divided by 2000 contracts).
This is a simple example since it is assumed that there are 2 deaths per 1000
lives in a year. Additionally, it is also assumed that there are no expenses and
no investment income. Time value of money in not considered in the example.
If expenses and investment income are considered, the premium per 1000
insurance cover will be different.
The insurer’s Income and Expenditure Statement would appear as follows:
Income Rs. Expenses Rs.

Income 4,000 Claims 4,000
4,000 4,000

The insurer’s fund will appear as follows:
Rs.
Opening fund 4,000
Outgo (4,000)
Closing fund NIL
[Assuming payments are made in the same year.]
Test Yourself 2
Present value of premium is equal to which of the below?
I. Present value of expenses minus present value of benefits

II. Present value of benefits and expenses
III. Present value of claims expected to be made in future
IV. Present value of investment earnings

C. Components of premium
In the previous learning outcome, we looked at a simple example of pricing of

insurance products. However, in practice, premium calculation is not as simple
as discussed in the above example. Premium calculation requires the calculation
of the following:
 Cost of benefits
Cost of benefit is the pure premium that meets just the amount of benefits, as
explained in the above example.
For traditional products benefit can be simple fixed sum assured or periodic
guaranteed additions or periodic bonus. Hence, present value of each of the
component will be required to calculate cost of benefits.
However, cost of benefits also include another important component refer to as

present value of change in reserves. Reserves are required to be kept as liability
to ensure that company is able to meet the claims as it arises. These are
normally invested in or backed by secured assets for traditional type of products
and in assets desired by policyholders in case of unit linked products.
These assets earn less than what is required by the shareholders, for example, if
assets are earning 9% per annum and risk discount rate is 12% per annum then
there is a cost of holding reserve for shareholders. This cost will be 3% return
lost as a result of holding the reserve. This cost should also be considered while
deciding the price.
For unit linked products there is one additional dimension of change in reserve.
Since, charges are deducted from the funds; change in funds will reflect the
amount of charges deducted from the fund. This will be a key variable when
other components such and premiums are known in advance.
 Cost of expenses
a) Procurement expenses: These are by and large commission payments

and incentives are usually related to the premium.
b) Underwriting expenses: These are expenses involved in assessing the

health status of life assured and the financial status of policyholder.
c) Administrative expenses: These are incurred for handling all

administrative jobs related to preparing all documents at the time of
issue of insurance contract and rendering service to the policyholders
for:

i. Premium payments
ii. Settlement of claims, and
iii. Resolving doubts posed by the policyholder (this would include payment
of salaries to staff employed by the insurer)
d) Legal expenses such as stamp duty and litigations costs.
e) Miscellaneous expenses such as advertisements, reinsurance, and taxes.
Test Yourself 3
In pricing of insurance products, taxes are considered as an example of which of

the following category of expenses?
I. Administrative expenses
II. Legal expenses
III. Miscellaneous expenses
IV. Procurement expenses

D. Issues in determining premium
While pricing products, a new insurer would find it difficult to estimate the
expenses that would be incurred at present and also in future. In such
situations, the new insurer would depend upon the experience of the insurance
industry and reinsurer.
An established insurer, on the other hand, would be in a comfortable position to

estimate expenses.
The usual practice of estimating expenses is to relate their calculation to:
 Premiums
 Per Policy, and
 Per 1000 Sum Assured
Let us discuss how expenses could be related to premium, sum assured and per
policy.
1. Premium related expenses
These are usually commission payments and incentives. Certain administrative

expenses such as collection of premium are also added.
Diagram 1: Types of premium payment
The types of payment of premium are:
a) Single premium payment
This involves a onetime payment of premium.

Example
Mr. Pawar purchased an insurance policy for a period of 10 years for a sum
assured of Rs. 100,000 from Delta Life Insurance Company. For this purpose, he
paid Rs. 80,000 as single premium.
The commission paid is 2% of the single premium amount i.e. Rs.1600. The
commission payment is made to compensate the intermediary for procurement
of business.
Hence, in this case, the commission payment amount to Rs. 1600.
b) Limited premium payments
In this case, the number of premium payments is more than one but limited
to two or more annual premiums. However, the premium payments cease
much before the expiry of contract.
Example
Assuming in the above example, Mr. Pawar chose to pay premiums for three
years, amounting to Rs. 30,000 annually.
The commission payment structure as a percentage of premiums paid is as

follows:
 30% of the premium paid in the first year
 7.5% of the premium paid in 2nd and 3rd years
The calculation of commission in each of the three years is as follows:
Year 1 2 3
Commission (Rs.) 9,000 2,250 2,250
Hence, the total commission payment is Rs 13,500.
c) Regular premium payments
In this case, the number of premium payments is more than one. These
payments cease just before the date of expiry of contract.
Example
In the above example, the term of premium payment is the same as that of the
policy term. Mr. Pawar would be required to pay premium for ten years
amounting to Rs. 10,000 annually. The commission payment structure is as
follows:
 30% of premiums paid in first year,

 7.5% in years 2 and 3; and
 5% thereafter.
The calculation of commission in each of the ten years is as follows:
Year Commission (Rs.)

1 3,000
2 750
3 750
4 500
5 500
6 500
7 500
8 500
9 500
10 500
Hence, the total commission payment is Rs 15,500.
2. Initial fixed expenses
The initial fixed expenses incurred to procure business would be very high.
Examples of such expenses are transport expenses, media expenses, salary and
other expenses for underwriting.
These expenses can be expressed as a flat amount e.g. Rs. 1400 per policy. If
policies are issued with small premiums, such policies would cause loss. Such
loss may need to be compensated by higher premium policies. The reason for
this loss is that the initial expense could be over 100% of premium. In addition,
the insurer would have to wait for about 2 to 3 years (or more) to get initial
expenses recovered by way of premium income. This is also an important reason
why insurers are reluctant to sell small premium policies. This will be discussed
later.
The expenses incurred in the first year, related to collection and notices of
premiums, preparation and maintenance of records and so on are expressed as a
percentage of premiums, say 60%.
Underwriting expenses are usually expressed as a percentage of sum assured.

Example
If the premium income in the first year is Rs. 10,000, the expenses in the first
year could be Rs. 6000.
3. Stamp duty
Stamp duty is the cost of stamps which are required to be affixed on the policy
bond (Insurance Contract) and this is levied by Government. This is usually Re.
0.20 every 1000 sum assured or part thereof. This means that for a contract of
Rs. 10,000, it is necessary to affix stamps of value of Rs. 2.
4. Medical expenses
Medical expenses are borne by the insurers to assess the mortality risk of the
life assured. A life assured may need to undergo medical examination as
required by the insurer. For this purpose, certain medical reports, such as ECG,
TMT, Echo, etc. may also be required.
Some insurers determine this expense as Rs. 4 per 1000 sum assured. Depending
upon medical requirements, medical expenses could be more or less for a
contract.
In the long run, the medical expenses would be included in the initial expenses.
Insurers would insist on medical examination and reports in the following

situations:
 Where the sums assured are very high, and

 Where the age of assured is very high.
A high sum assured case assumes importance because the insurer has to incur
higher outgo in case of adverse claim experience. Lives aged 40 or over could be
subject to medical examination because their health would affect mortality
risk.
An underwriter may also choose a non-medical case for medical examination

because of answers in the non-medical proposal form / questionnaire (for
instance, smoking, bad family history, drinking liquor, bad habits, etc.)
Initial expenses include procurement costs such as advertisement expenses,

development expenses for a sale, (all pre-sale expenses), etc. These costs are
required to be incurred by every new policy.
Shareholders finance this cost at the outset, in the first few years of life of a
new insurer. This cost is recovered by them in the form of dividends on their
equity. Later on the existing business would help in recovering this cost
perhaps, after 10 or 15 years.
For new companies, it is necessary to advertise about their commitment to the
market. Advertisement costs could be more than the premium income in the
first few years.
5. Claim expenses
Claim expenses include costs involved in settling claims by maturity and death
of life assured. If there are legal cases against insurers, these costs could
increase on account of court expenses and fees paid to lawyers.
In case of early claims by death, expenses might need to be incurred to meet

investigation costs. These costs are incurred in order to find out whether the
death claim is genuine. Following are instances of claims made that were not
genuine based on the past experience of insurers:
a) Where the life assured did not disclose at the time of buying insurance
that he suffered from diabetes, cancer, or heart ailment, the claims are
not genuine. If this would have been disclosed, the insurer would have
either declined insurance cover or granted the cover at a different
premium cost.
b) Claims in cases where the age of the life assured is misstated are also
not genuine.
c) If the insurable interest did not exist with regard to evidence of income,
the insurer could possibly have granted lower insurance cover had he
known about the income levels. However such cases are rare.
d) Where the insured did not disclose income and the insurance cover and
the income do not match, the claim is not genuine. (E.g. An insurance
cover of Rs. 1Cr, for a life whose income is Rs. 10000 p.a.)
Though the resisted claims are few, some fraud-claims could have been settled.
Courts could give decisions against insurers which could lead the insurer to incur
higher claim expenses. In view of these, the insurers would exercise lot of
caution in designing various documents.
In a nutshell, the expense equation would appear as follows:
E = FE + RE
Where FE = First Year Expenses
FE can also be represented as I + x% of P + C + K
I = Initial costs of procurement, etc.

P = Premium receivable in first year
x% of P represents initial premium related expenses
C = Constant expenses per policy of unit sum assured
K = Costs independent of premium and sum assured, but per policy
RE = Renewal expenses
RE can also be represented as y% of P1 + C + K
P1 = Premium receivable after 1st year

C and K are same as above.
E is the value of expenses discounted to the date of commencement of the

policy. While discounting, the probability that the expense would be incurred is
also considered, since the expenses would cease on termination of the contract.
Cost of benefit is the expected value of benefit in mathematical terms. It can

be calculated by discounting the value of AB, where B is the amount of benefit
and A is the probability that the benefit is payable at that point of time.
As discussed earlier in this learning outcome, insurers are reluctant to sell

smaller premium policies. The reason for this can be understood with the help
of an example.
Example
An insurer incurs expenses in the first year, per policy, of Rs. 400. The insurer
would not be willing to issue a contract that fetches him an annual premium of
Rs. 100 as such contracts would eat other policyholders’ monies.
For smaller premium policies, the volume of business required should be large
enough which might not be easy. If volumes do not support the insurer, he
might stop selling the product, as it would not fetch him the desired returns.
6. Optimum size of policy
Insurers consider the following while determining the minimum and optimum
size of policy (generally in terms of premium and also in terms of sum assured):
a) The expected volumes of business in the next few years
b) The expected financial strain resulting from generation of the new

business. The expected financial strain is the amount of loss that is
required to be financed at the outset. This loss would arise on account
of procurement expenses and expenses that are required to be recouped
in future.
c) Factors affecting the expected volume of business such as:
 Competitors’ rates
 Availability of similar products
 Age and income profile of people
 Competency of distribution channels and sales staff to sell the
product
d) Expected profit (return on shareholder’s funds)
e) In addition to the above mentioned factors, a few more factors that

affect the expected volume of business are:
i. Design of product
The design of insurance product should be simple to understand. If either

the benefit structure or the commission structure (or both) is/are
complicated, the insurer would find it difficult to increase sales. This is
despite the premium rate being highly attractive.
If the event is not well defined, sales volumes would reduce. For instance,
the event ‘accident’ definition might be ambiguous. Too many riders and
too many options for bonus payments could also lead to ambiguous product
design.
ii. Size of population that would be eligible to buy.
For instance, if the age at entry is restricted to between 18 to 30 years and

maturity age is restricted to 55 years, the insurer is limiting the volume of
sales.
iii. Size of cover / premium
If the minimum limits are not appropriately fixed, it might deter buyers
from buying the product.
Example
Suppose the minimum sum assured is Rs. 10 lakhs and/or the minimum premium
p.a. is Rs. 1 lakh, only a few customers would be able to afford the premium.
iv. Service provision
The past track record of the insurer in providing services to policyholders

would impact sales. For instance, an insurer who takes unjustifiably long
time to grant cover, to issue policy bond/premium receipt, to respond to
queries of clients, to settle claims, etc. might not be able to get good
business.
An insurance company should create an image of trust and good market

standing. This, in turn depends upon:
 The efficiency of distributors

 The efficiency of sales staff
 The efficiency of administrative staff and
 The level of financial assets
If an insurer does not have competent team, it would be difficult for him to
withstand competitive pressures. Provision of prompt services by insurers
would not only help in increasing sales in the long run but also helps in
getting repeat business.
Test Yourself 4
In which of the following cases would insurers insist on medical examination and
reports?
I. Where the sums assured are very high

II. Where the age of assured is very high
III. Both of the above

E. Regulatory influences on pricing
In the product design chapters we discussed about the three regulators systems:
 “file and use”,

 “Use and file” and
 “free system”.
Apart from these, in India there are two product regulation, Linked product
regulations and Non linked product regulations, issued by regulator in year
2013. All the provisions of regulation must be adhered to when pricing any
product. These regulations directly or indirectly impact the product pricing.
Some of the provisions of these regulations impacting product pricing are

detailed below:
 Product structures: The product structure shall be classified as

participating products and non-participating products.
Under the par products, the bonus accruals during the term shall be as
follows:
a. Regular bonus shall be declared only on an annual basis;

b. Interim bonus shall be declared at the annual valuation period which shall
become payable during the inter-valuation period.
c. Terminal bonus, if any, declared shall become payable on the specified
events agreed in the policy or at the end of the term of the policy.
Non-par products may be offered either under a linked platform or a non-

linked platform.
Linked and Non linked variable insurance products are also allowed and can
be offered in any of the following manner:
Non Linked variable insurance:

 Individual Non-par;
 Group Savings Non-Par;
 Fund based Group Non-par;
 Individual Par;
 Group Saving Par;
 Fund based Group Par.
Linked variable insurance:

 Linked Individual Non-par;
 Linked Fund based Group Non-par

Where the benefits under the products depend on regular interest rate
credits, all such products shall fall under variable insurance products. These
interest rates credits should not be negative.
These products look more like bank accounts where there are regular
interest credits.
In non linked variable insurance products, benefits accrued at the specified

frequencies of be linked to any index or benchmark and shall be explicitly
stated at the outset.
In linked variable insurance products the benefits are partially or wholly

dependent on the performance of an approved external index/benchmark
which is linked to the product.
 Frequency of accrual of interest rates/bonus: For all modes of premium

payment (viz., single premium, annual, half-yearly, quarterly and monthly)
the non-zero positive additional interest rate to be credited shall not be less
than quarterly frequency.
For all modes of premium payment (viz., single premium, annual, half-
yearly, quarterly and monthly) the bonus with respect to the par products
shall be declared once a year immediately after the annual actuarial
valuation i.e., as on March 31st of each year, with respect to the par
products.
 Policy account Value: Every variable non-linked insurance policy shall have
a corresponding policy account whose balance shall depict the accrual to the
policyholder. The policy account shall be credited with premium net of
charges as applicable to variable insurance products. The additional interest
rate shall be applicable to the balance of the policy account.
Shadow policy account value shall be maintained on a daily basis. Such

shadow policy account shall be computed based on the actual accruals of all
income elements like premiums, top-up premiums, income from investments
as and when received and all actual debits i.e. partial withdrawals to the
policy account value as and when debited, to arrive at the actual gross
investment return and reduction in yield to the policy account value
(because of charges), at the end of each year starting from policy year 5.
The policy account value shall comply with the maximum reduction in yield
requirements as discussed later.
 Minimum death benefit: To ensure that protection component of the

insurance product remains high, regulation stipulates minimum amount that
should be payable on death. In case of death due to suicide, within 12
months from the date of inception, the nominee of the policyholder shall be
entitled to at least 80% of the premiums paid.

Except for variable insurance products, for all the non-linked individual life
insurance products, the minimum death benefit during the entire term of
the policy shall not be less than the sum of Sum Assured on death and
Additional Benefits, if any:
For the purpose of this provision the minimum Sum Assured on death shall
be as per Table 1:
Table 1:
S. Type of Age of the life assured
N product less than 45 years 45 years and above
1 Single Highest of 125% of the Highest of 110% of the single
premium single premium or premium or minimum
products minimum guaranteed sum guaranteed sum assured on
assured on maturity or maturity or any absolute
any absolute amount amount assured to be paid on
assured to be paid on death.
death.
2 Other Non participating products
than Highest of, 5 times the annualized premium or 105% of all
single premiums paid as on date of death or minimum guaranteed
premium sum assured on maturity or any absolute amount assured to
product be paid on death.
where Participating products
the Highest of, 5 times the annualized premium or 105% of all
policy premiums paid as on date of death or minimum guaranteed
term is sum assured on maturity or any absolute amount assured to
less than be paid on death.
10 years
3 Other Non participating products
than Highest of, 10 times the Highest of, 7 times the
single annualized premium or annualized premium or 105% of
premium 105% of all premiums all premiums paid as on date
product paid as on date of death of death or minimum
where or minimum guaranteed guaranteed sum assured on
the sum assured on maturity maturity or any absolute
policy or any absolute amount amount assured to be paid on
term is assured to be paid on death.
equal to death.
or more Participating products
than 10 Highest of, 7 times the Highest of, 7 times the
years annualized premium or annualized premium or 105% of
105% of all premiums all premiums paid as on date
paid as on date of death of death or minimum
or minimum guaranteed guaranteed sum assured on
sum assured on maturity maturity or any absolute
or any absolute amount amount assured to be paid on
assured to be paid on death.
death.
For the participating products, in addition to the minimum sum assured on
death as stipulated in table 1, the bonus/additional benefit, if any, as specified
in the policy and accrued till the date of death shall become payable on death,
if not paid earlier. However, for other than single premium products, the
minimum death benefit shall be at least 105% of all the premiums paid as on
death.
The provision for minimum sum assured on death shall not be applicable to
reduced paid up policies, pension products, all types of immediate annuity
products and decreasing cover term insurance products. However, for non
linked individual pension products, the minimum death benefit payable on
death shall not be less than 105% of all premiums paid as on death.
For linked insurance products, the minimum sum assured shall be at least equal
to as listed in table 2 below:
T is Policy Term chosen by the policyholder for any product except for whole
life products.
For whole life products, T shall be taken as 70 minus age at entry.
AP is Annualized Premium selected by the policyholder at the inception of the

policy excluding the service tax.
SP is the Single Premium which is chosen by the policyholder at the inception of

the policy, excluding the service tax.
Table 2:
Type of Products Minimum Sum assured Minimum Sum assured
for age at entry below 45 for age at entry of 45
years years and above
Life Single Premium (SP) 125 percent of single 110 percent of single
Products premium. premium.
Life Regular Premium 10 times the annualized 7 times the annualized
(RP) including Limited premiums or (0.5 X T X premiums or (0.25 X T X
Premium Paying (LPP) annualized premium) annualized premium)
Products whichever is higher. whichever is higher.
Health Regular Premium 5 times the annualized 5 times the annualized
(RP) including Limited premium or Rs.100,000 premium or Rs.100,000
Premium Paying (LPP) per annum whichever is per annum whichever is
products higher. higher.
In respect of linked pension products and immediate annuity products, the

minimum sum assured as in above table 2 is not mandatory.
The death benefit for variable insurance product can be

 higher of policy account value or sum assured.
 Sum of policy account value or sum assured.
 Minimum policy term and premium paying term: To ensure that the
products remain fairly long term to protect the interest of policyholders,
regulation stipulated minimum policy term and premium paying term for
insurance products.
The minimum policy term:
a. For individual products, shall be at least five years and

b. For fund based group products, shall be on annually renewable basis.
Except for single premium payment products, the premium payment term
for all other individual products shall not be less than 5 years.
 Commissions or remuneration in any form: (A) Commission or remuneration

in any form for the procurement of all individual policies, group term
insurance, group credit insurance and group saving variable insurance
policies in respect of all the Distribution Channels except the Direct
Marketing shall not exceed the stipulated limit in the regulation.
Other than Pension Products:
(1) In case of single premium, 2% of the single premium;

(2) In case of other than single premium, the Table 3 shall apply.
Table 3:
Premium Maximum Commission or remuneration in any form as % of
paying terms premium
1st year 2 and 3 years Subsequent years
5 15 7.5 / 5 (*) 5
6 18 7.5 / 5 (*) 5
7 21 7.5 / 5 (*) 5
8 24 7.5 / 5 (*) 5
9 27 7.5 / 5 (*) 5
10 30 7.5 / 5 (*) 5
11 33 / 30 (*) 7.5 / 5 (*) 5
12 33 / 30 (*) 7.5 / 5 (*) 5
Note: (*)The maximum commission or remuneration:

(a) For brokers shall be
(i) 30% in the first year for policies with premium paying term of 10
and above; and
(ii) 5% in the subsequent years for all premium paying terms.
(b) During the first ten years of a life insurer's business for all
intermediaries, except for brokers, shall be 40% in first year for policies with
premium paying term of 12 and above.

Pension Products:
(1) In case of single premium, 2 per cent of single premium.

(2) In case of other than single premium:
(a) 7.5 per cent of the first year's premium, and.
(b) 2 per cent of each renewal premium.
(B). For all distribution channels, except direct marketing, the maximum
commission or remuneration in any form with respect to fund based group
products with respect to all premium payment modes, shall be:
i) 2 per cent of the premiums paid during the year with a ceiling of rupees on
lakhs per scheme for the entire year.
ii) At subsequent renewal 2 per cent of the premiums paid during the year with
a ceiling of rupees one lakh per schemes for the entire year.
(C). For single premium group term insurance and single premium Group Credit
insurance with long term, the maximum commission or remuneration in any
form shall be 2 per cent of premium with a ceiling of Rs.200000/ per scheme.
(D). For one year renewable group term insurance and One year Group Health
Insurance, the maximum commission or remuneration in any form shall be 2 per
cent of premiums paid during the first year and 2 per cent of premium paid
during the subsequent renewals with a ceiling of Rs.50000/- per scheme in each
year.
(E). Where the policies are procured by Direct marketing, no commission shall
be payable.
 Surrender value calculations: As per the regulation surrender value in most

of the cases would be higher of guaranteed surrender value (GSV) and
special surrender value. GSV is precisely defined in the regulation. Also,
guidance is provided for the calculation of SSV. Regulation also defines the
time period of when the policy will acquire surrender values. There are
limits on surrender charges for group and unit linked products as well.
All individual savings and protection oriented products such as non-linked

life insurance products, and non-linked pension products, other than pure
protection products such as term insurance, health insurance and immediate
annuities, shall acquire a guaranteed surrender value and special surrender
value, if higher.
The guaranteed surrender value shall acquire in the following manner:
 Products with a Premium Paying Term (PPT) of 10 years or more: If

all premiums have been paid for at least three consecutive years, the

policy shall acquire a guaranteed surrender value, to which shall be
added the surrender value of any subsisting bonus or guaranteed
additions, as applicable, already accrued to the policy.
 Products with a Premium Paying Term of less than 10 years: If all

premiums have been paid for at least two consecutive years, the
policy shall acquire a guaranteed surrender value, to which shall be
added the surrender value of any subsisting bonus or guaranteed
additions, as applicable, already accrued to the policy.
 Other than single premium products: The minimum guaranteed

surrender value shall be the sum of guaranteed surrender value and
the surrender value of the any subsisting bonus or guaranteed
additions, as applicable, already accrued to the policy. The
guaranteed surrender value shall be at least:
i) 30% of the total premiums paid less any survival benefits

already paid, if surrendered between the second year and third
year of the policy, both inclusive.
ii) Subject to (iii), 50% of the total premiums paid less any
survival benefits already paid, if surrendered between the fourth
year and seventh year of the policy, both inclusive.
iii) 90% of the total premiums paid less any survival benefits
already paid, if surrendered during the last two years of the
policy, if the term of the policy is less than 7 years.
iv) The surrender value beyond the seventh year shall be filed by
the insurer under the File and Use for clearance. Such surrender
value shall consider the premiums already paid and the possible
asset shares on such products.
 Single premium products: The guaranteed surrender value shall be

the sum of guaranteed surrender value and the surrender value of
the any subsisting bonus already attached to the policy. The
guaranteed surrender value shall be at least:
i) 70% of the total premiums paid less any survival benefits already
paid, if surrendered any time within third policy year.
ii) Subject to (iii), 90% of the total premiums paid less any survival
benefits already paid, if surrendered in the fourth policy year.
iii) 90% of the total premiums paid less any survival benefits already
paid, if surrendered during the last two years of the policy, if the
term of the policy is less than 7 years.

iv) The surrender value beyond the fourth year shall be filed by the
insurer under the File and Use for clearance. While determining such
surrender value the insurer shall consider the premiums already paid
and the possible asset shares on such products.
v) Surrender value of any subsisting bonus already attached to the

policy shall be filed and approved under the File and Use explicitly.
The special surrender value shall represent the asset share in case of the par
policies, where the asset share shall be determined in accordance with the
guidance or practice standards issued by the Institute of Actuaries of India. For
non-par policies the special surrender value shall reflect the experience of the
insurer and shall be determined as per the proxy asset share in accordance with
the guidance or practice standards issued by the Institute of Actuaries of India.
The special surrender value shall be filed with the Authority under File and Use.
The fund based group non-linked products may levy a surrender charge not
exceeding 0.05 per cent of the fund, with a maximum of Rs. 500, 000/-, if the
policy is surrendered within the third renewal of the policy.
In case of surrender of the group policy, other than fund based group policies,
the insurer shall give an option to the individual members of the group, on such
surrender, to continue the policy as an individual policy and the
insurer/intermediary if any, shall continue to be responsible to serve such
members till their coverage is terminated.
For linked insurance products, where a policy is discontinued, only

discontinuance charge and Fund management charge, which shall not exceed 50
bps per annum on discontinuance fund/policy account value, as applicable, may
be levied by the insurer and no other charges by whatsoever name shall be
levied.
Limitation on discontinuance charges for Linked insurance products is given in

Table 4 below:
Table 4:
Where the For annual premium policies
policy is Maximum Discontinuance Maximum Discontinuance
discontinued Charges for the policies having Charges for the policies having
during the annualized premium / single annualized premium / single
policy year premium up to Rs.25,000/- premium above Rs.25,000/-
1 Lower of 20% * (AP or FV/policy Lower of 6% * (AP or FV/policy
account value) subject to a account value) subject to a
maximum of Rs. 3000 maximum of Rs. 6000

5 & onwards NIL NIL
For Single Premium policies

1 Lower of 2% *(SP or FV/policy Lower of 1% *(SP or FV/policy
maximum of Rs.3000/- maximum of Rs.6000/-
2 Lower of 1.5% *(SP or FV/policy Lower of 0.5% *(SP or FV/policy
maximum of Rs.2000/ maximum of Rs.5000/-
3 Lower of 1% *(SP or FV/policy Lower of 0.25% *(SP or
account value) subject to a FV/policy account value)subject
maximum of Rs.1500/ to a maximum of Rs.4000/-
4 Lower of 0.5% *(SP or FV/policy Lower of 0.1% *(SP or FV/policy
maximum of Rs.1000/ maximum of Rs.2000/-
5 & onwards NIL NIL
AP- Annualised Premium

SP-Single Premium
FV- Fund Value
 Advance Premium: Collection of advance premium shall be allowed, if

premium is collected within the same financial year. The premium so
collected in advance shall only be adjusted on the due date of the premium.
The commission shall only be paid on such due date.
 Level premiums:
• Except for group products, the premium chosen at the outset shall
become payable throughout the premium paying term of the policy
and shall not be altered during the term of the policy. Such premium
shall be level / uniform and shall not vary over the term of the
policy.
• The insurer shall not accept any amounts less than the due stipulated
regular premium payable as stated in the policy.
• Any additional payments made on ad hoc basis shall be considered as
top-up premium and treated as single premium for the purpose of
providing insurance cover.
• Service tax, if any, shall not be included in the contractual premium
and shall be collected from the policyholder separately as over and
above such premium.

 Misleading names: As per the regulations, the misleading and
misrepresenting the benefits through the name of the products shall not be
allowed.
 Benefits offered on Maturity:

• The product literature shall clearly indicate whether the product is
protection oriented or savings oriented or a combination of the two.
• Where the products offer the maturity benefit as return of premiums

paid or a percentage of return of premiums paid or a meager amount
in excess of return of premiums paid, these products shall not be
termed as savings products.
• The maturity benefits shall closely reflect the asset share in case of
par products.
At the most generic level, the asset share for a life insurance policy
is the accumulation of monies in less monies out in respect of that
policy. In other words, the accumulated cashflow in respect of a
policy.
 Approval of innovative product: Any product design, which is not

approved so far by the Authority, shall be treated as innovative product.
The approval of these products would be subject to the conditions as
stipulated in the regulation.
The innovativeness in product design shall result in meeting customer

needs, better customer understanding and satisfaction and shall not result
in complexity of understanding the product, additional strain on the
company's infrastructure, which may result in increased cost to the
customer.
The insurer shall discuss with the Authority, the product design concept of
the proposed innovative product along with:
i) Market research inputs which identify the specific needs of customer
or meeting the existing needs in innovative manner through the
proposed product design.
ii) A separate note on how such new product will enhance the
satisfaction of customer and of any other stakeholder.
iii) Details on systems support that is being envisaged for execution of

the proposed product.
iv) Details on underwriting, claims settlement, investment strategies

for such new products.

v) Treatment for arriving at the reserves, solvency margin required for
such products.
vi) Market conducts requirements for such products.
Insurer shall also see whether any such products are available elsewhere
in other markets. If available, the general structure of such products,
the valuation requirements, market conducts and specific regulations on
such products should be disclosed.
 Revival period: This is the period of two consecutive years from the
date of discontinuance of the policy, during which period the
policyholder is entitled to revive the policy which was discontinued due
to the non-payment of premium.
 Lock-in-period: This means the period of five consecutive years from

the date of commencement of the policy, during which period the
proceeds of the discontinued policies cannot be paid by the insurer to
the policyholder or to the insured, as the case may be, except in the
case of death or upon the happening of any other contingency covered
under the policy. This is applicable for linked insurance products.
 Charges:
a. The life insurers shall use uniform definitions for charges under all the
linked products in accordance with this regulation.
b. Except for the single premium product in all other products overall
charges, in all linked products, in an even fashion during the lock-in
period such that the:
i) premium allocation charge and policy administration charge
shall be spread evenly during first 5 years of the policy contract,
without wide fluctuations;
ii) charges could change from year to year in a reasonably orderly

manner so that the difference between the maximum and
minimum charges during first 5 years shall not vary by more than
1.5 times,
iii) Charges during lock in period shall be so structured that the

cap on net reduction in yield is achieved without any further
additions to the fund value at any time during the first five years
of the contract. The provision is applicable to both single
premium products and other than single premium products.
c. For the purpose of this Regulation, the unit fund shall be read as the
policy account, In case of variable insurance products and the charges
shall be levied to the policy account, wherever applicable.

 The charges levies under the linked insurance products shall be:
a. Premium Allocation Charge:
This is a percentage of the premium appropriated towards charges from

the premium received. For unit linked products, the balance amount
known as allocation rate constitutes that part of premium which is
utilized to purchase the units of the fund in the policy. For variable
insurance products, the balance amount shall be credited to the policy
account. The percentage shall be explicitly stated and could vary by the
policy year in which the premium is paid, the premium size and the
premium type (regular, single or top-up premium).
i) This is a charge levied at the time of receipt of premium,
ii) Example: If premium = Rs.1000 & Premium Allocation Charge: 10% of

the premium; then the charge: Rs.100 and Balance amount of premium
is Rs,900
b. Fund Management Charge (FMC):
i) 'For unit linked products, this is a charge levied as a percentage of the

value of assets and shall be appropriated by adjusting the Net Asset
Value. This is a charge levied at the time of computation of NAV, which
is usually done on daily basis
ii) For variable insurance products, this is a charge levied as a

percentage of the policy account value and shall be appropriated to the
policy account value.
iii) Example: If Fund Management charge (FMC) is 1% p.a. payable

annually; Fund before FMC is Rs.100/- and Fund after this charge is
Rs.99/-.
c. Guarantee Charge:
i) For unit linked products, this is a charge levied as a percentage of the

value of assets and shall be appropriated by adjusting the Net Asset
Value.
ii) This is a charge levied at the time of computation of NAV, which is

usually done on daily basis.
iii) In case of variable insurance products, the insurer may levy

guarantee charge, if any, provided the guarantee offered throughout the
term of the policy is not less than 4% per annum..

d. Policy Administration Charge:
This charge shall represent the expenses other than those covered by
premium allocation charges and the fund management expenses.
This is a charge which may be expressed as a fixed amount or a
percentage of the premium or a percentage of sum assured.
i) For unit fund, this charge is levied at the beginning of each policy
month from the unit fund by canceling units for equivalent amount.
ii) For variable insurance products, this charge is levied at the beginning
of each policy month from the policy account value.
iii) This charge could be flat throughout the policy term or vary at a pre-
determined rate, subject to an upper limit. The pre-determined rate
shall preferably be say an x% per annum, where x shall not exceed 5.
iv) Example: Rs.40/- per month increased by 2%p.a. on every policy

anniversary.
e. Surrender Charge or Discontinuance charge:
i) This is a charge levied on the unit fund/policy account value where

the policyholder opts for complete withdrawal of the contract.
ii) This charge is usually expressed either as a percentage of the fund or

as a percentage of the annualized premiums (for regular premium
contracts).
f. Switching Charge:
For unit linked products, this is a charge levied on switching of monies

from one fund to another available within the product. The charge per
each switch, if any, shall be levied at the time of affecting the switch
and it shall be either a flat amount or lower of {a flat amount or
percentage of the fund value}.
g. Mortality /Morbidity charge:
This is the cost of life/health insurance cover. It is exclusive of any

expense loadings levied by cancellation of units. This charge, if any,
shall be levied at the beginning of each policy month from the fund.
i) The method of computation shall be explicitly specified in the policy

document. The mortality/morbidity charge table shall form part of the
policy document.

ii) Mortality/morbidity charge table shall be guaranteed during the
contract period.
iii) The mortality/morbidity charge for the mortality/morbidity risk

covered shall:
(1) only reflect the pure risk charges for the cover offered and shall
not include any allowance for expenses or any other parameters.
(2) be reasonable and consistent with the prescribed mortality tables
or morbidity tables, if any.
(3) be demonstrated with the support of insurer's own experience,
wherever applicable.
(4) be expressed as per Rs.1000 Sum at risk for each age.
h. Rider charge:
This is the rider charge which is exclusive of expense loadings and levied
separately to cover the cost of rider cover. The rider charge, if any,
shall be levied by cancellation of units. This charge is levied at the
beginning of each policy month from the fund.
i) The rider charge table shall be form part of the policy document.
ii) The rider charge shall:

(1) only reflect the pure risk charges for the cover offered and shall
not include any allowance for expenses or any other parameters.
(2) be reasonable and consistent with the prescribed
mortality/morbidity tables
(3) be demonstrated with the support of insurer's own experience,
wherever applicable.
(4) be expressed as per Rs.1000 Sum Assured for each age
iii) Only linked riders approved by the Authority shall be attached to

linked products.
i. Partial withdrawal charge:
For unit linked products, this is a charge levied on the unit fund at the
time of part withdrawal of the fund during the contract period.
j. Miscellaneous charge:
i) This is a charge levied for any alterations within the contract, such as,
increase in sum assured, premium redirection, change in policy term etc.
The charge is expressed as a fiat amount. For unit linked products, this
shall be levied by cancellation of units.
ii) This charge is levied only at the time of alteration.

iii) Example: Rs.100/- for any alteration such as increase in sum assured,
change in premium mode etc.
 Limitation on charges of unit linked products: The charges as filed

under the File and Use and approved by the IRDA shall not be modified
or changed without obtaining the prior approval of the IRDA.
All the charges other than premium allocation charge and mortality
charge shall have an upper limit, if any, specified in all the promotional
material and policy document.
All the charges, where upper limit is allowed, may be modified with
supporting data within the upper limits with prior clearance from the
Authority.
The cap on Fund Management Charges in respect of each of the

segregated fund shall be 135 basis points and cap on guarantee charge
shall be 50 basis points.
 Reduction in yield requirement for linked and variable insurance

products: This stipulates a requirement where in the difference
between gross and net yield cannot increase the limits as specified.
Gross yield is the yield earned on the fund and net yield is the yield net
of charges earned on the fund. If there is any difference, it will be
funded by company.
The maximum reduction in yield for policies from the fifth policy
anniversary shall be in accordance with the Table 5 below:
Table 5:
Number of years elapsed Maximum Reduction in Yield (Difference
since inception between Gross and Net
Yield (% p.a.))
5 4.00%
6 3.75%
7 3.50%
8 3.30%
9 3.15%
10 3.00%
11 and 12 2.75%
13 and 14 2.50%
15 and thereafter 2.25%
The net reduction in yield at maturity for policies with term:

i) less than or equal to 10 years shall not be more than 3.00% and
ii) above 10 years shall not be more than 2.25%.

The insurer shall ensure that the reduction in yield is complied for all gross
investment returns. However, only for the purpose of demonstration, the
insurer shall demonstrate in the File and Use Application the compliance of
reduction in yield in (a) and (b) for gross investment returns of 6% p.a., 8%,
and 10%p.a.
In the process to comply with the reduction in yield, the insurer may arrive
at specific non-negative additions, if any, to be added to the unit
fund/policy account value, as applicable, at various durations of time after
the first five years. In case of unit linked products, such specific non-
negative additions shall be called non-negative claw-back additions and
shall be filed in the file and use procedure for approval.
Computation of Net Yield:
a. Mortality and Morbidity charges may be excluded in the calculation of

the net yield.
b. Extra premium due to underwriting emanating from extraordinary health

conditions, cost of all rider benefits, service tax on charges (as applicable)
and any explicit cost of investment guarantee shall be excluded in the
calculation of net yield. The calculation of all charges shall be as per 'File
and Use' document as approved by the IRDAI.
c. The net yield shall be calculated based on the projection of end fund on
monthly basis at a specified gross rate of return assuming the mortality and
morbidity charges as zero throughout the term of the contract and
premiums are paid as and when due.
The equation of value concerning the gross premium paid by the
policyholder and the maturity fund value shall give the effective net yield
per annum expected to be earned on the contract at the point of sale.
d. As the policyholders' behavior with regard to options under Linked

products, for example, partial withdrawals, premium redirection etc.
affect the net yield; such options may be ignored throughout the term of
the contract of demonstrating the net yield.

Summary
a) As for other products, pricing is an important factor to be considered for

sale of insurance products. Price paid for buying insurance is called
‘Premium’.
b) Pricing should meet the insurer’s financial and marketing aspirations.
c) In the case of insurance products, the equation of value can be expressed

as:
Present Value of Premium(s) = Present Value of Benefit(s) + Present Value of
Expenses (including profit to shareholders).
d) Cost of benefit is the pure premium that meets just the amount of benefits
plus reserving cost.
e) Cost of expenses includes procurement expenses, underwriting expenses,

administrative expenses, legal and miscellaneous expenses.
f) The usual practice of estimating expenses is to relate their calculation to:

 Premiums
 Per Policy and
 Per 1000 Sum Assured
g) The types of premium payment can be
 Single premium payment

 Limited premium payment
 Regular premium payment
h) Commission payment is usually expressed as a percentage of the premium.

The regulator puts a cap on this percentage.
i) Regulations have direct as well as indirect influence on the pricing.
j) While determining the optimum size of policy, insurers consider:

 Expected volume of business in future
 Expected financial strain
 Factors affecting the expected volume of business; and
 Expected return on shareholder’s funds
k) While determining the expected volume of business, insurers consider:

 Design of product
 Size of population
 Size of premium/cover
 Service provision

Answer 1
The correct option is II.
Pricing is directly related to revenue levels of the insurance company.
Answer 2
Present value of premium is equal to present value of benefits and expenses
Answer 3
Taxes are an example of miscellaneous expenses.
Answer 4
Both I and II are cases when insurers would insist on medical examination and
reports.

Question 1
The creation of an image of trust and good market standing by the insurer
depends upon which of the following factors?
I. The level of financial assets of the insurer

II. The level of training provided to the sales staff
III. Rating provided by IRDA
Question 2
Medical expenses of a prospective insurance customer are borne by the insurers

as ________
I. It is a regulatory requirement
II. Insurers are committed towards promoting best health practices
III. Insurers are interested in assessing the chances that the life assured will not
survive
IV. Health check-ups reduce the premium income for insurers
Question 3
For insurers who have completed 10 years since registration as an insurer, the
commission payment on premium receivable in the first year shall not exceed
________
I. 40%
II. 30%
III. 45%
IV. 35%
Question 4
Under which type of payment of premium, the number of premium payments is

more than one but limited to two or more annual premiums?
I. Partial premium payments
II. Regular premium payments
III. Limited premium payments
IV. Neither of the above

Answer 1

The creation of an image of trust and good market standing by the insurer
depends upon the level of financial assets of the insurer.
Answer 2
Medical expenses of a prospective insurance customer are borne by the insurers

as insurers are interested in assessing the chances that the life assured will not
survive
Answer 3
For insurers who have completed 10 years since registration as an insurer, the
commission payment on premium receivable in the first year shall not exceed
35%.
Answer 4
Under limited premium payments, the number of premium payments is more
than one but limited to two or more annual premiums

CHAPTER 4
TYPES OF INSURANCE /PRODUCTS – INDIVIDUAL

A life insurance policy could offer pure protection while another variant could
offer protection as well as investment returns. In India, life insurance has been
used more for investment purposes than for protection in one’s overall financial
planning. However, the scenario is changing rapidly in favor of protection plans
because of availability of cheap online term insurance plans and increased
awareness of need for life insurance. In this chapter we will try to understand
various life insurance products offered by insurers.
Insurance / Assurance Contracts:
Life Insurance is a contract between an insured (policyholder) and an insurer

(life insurance company) where the insurer promises to pay the benefits to
insured in exchange for a premium on the happening of event as specified in the
policy. These contracts are meant to provide financial assistance to the insured
and to the dependents of the insured in the event of his death.
Premiums are considerations for insurance benefits. The policyholder typically

pays a premium, either regularly (annually, half-yearly, quarterly or monthly) or
as a lump sum (as a single premium). These are always payable in advance.
Premiums may be payable for a limited period (less than the policy term) or for
a regular period (equal to the policy term).
Insurance contracts satisfy protection or investment needs of the policyholder.
There is a difference between the insured and the policy owner, although the
owner and the insured are often the same person.
For example, if Rohan buys a policy on his own life, he is both the owner and
the insured. But if Riya, his wife, buys a policy on Rohan's life, she is the owner
and he is the insured. The policy owner is the guarantor and he will be the
person to pay for the policy. The insured is a participant in the contract, but
not necessarily a party to it.
Annuity/Pension Contracts:
A Life Annuity is a series of regular payments by the life insurance company to

the policyholder as long as he is alive in return of a single advance payment.
The Life Insurance company pays annuity on annually, half-yearly, quarterly or

monthly basis. The annuity payments may be made at the end of each period or
at the beginning of each period. In the former case it is an annuity paid in
arrears and in the latter case it is an annuity paid in advance (annuity due).
Annuity payments may be level or vary during the period. Annuities, under
which payment is made in a continuous stream, say weekly or daily, instead of
at discrete intervals (annually, half-yearly, quarterly or monthly basis) are
called continuous annuities. However this is rare in practice.
An annuity provides the lifetime income to the policyholders or to the

dependents of the policyholder after their death. It also removes the
uncertainty of variable income over the policyholder’s remaining lifetime.
When it is a pension contract along with option to receive annuity, amount is

usually available as a lump sum also, although taxable. While annuity is always
paid as a series of regular payments.
Learning Outcomes
A. Meaning of ‘Life Insurance Business’

B. Products offered by insurers
C. Concept of riders
D. Options and Alterations
E. ‘Guarantees’ offered by the insurers
F. With-profit contracts
G. Unit-linked contract
Mr. Phillip is very confused about the type of insurance products available in the
market. He meets an insurance advisor to enquire about the different products.
The different type of insurance products is the subject of this chapter.

A. Meaning of ‘Life insurance business’
Insurance legislation in each country defines the term “life insurance business”
(also known as long term business).
The purview of life insurance business may be different in different countries,

e.g. in some countries, it does not include:
 Accident insurance
 Sickness or disability insurance
 Health insurance
 Annuity-certain and capital redemption
However, it normally includes ‘Insurance’ and ‘Annuities’.
It also could mean ‘linked business’, which means some benefits are either
wholly or partly linked to the performance of specified investments.
It is therefore essential for the insurers to know the exact purview of the life
insurance business as per the Insurance Legislation governing the insurance
business in that country.
“Life Insurance Business" means the business of effecting contracts of insurance

upon human life, including any contract whereby the payment of money is
assured on death or the happening of any contingency dependent on human life,
and any contract which is subject to payment of premiums for a term
dependent on human life and shall be deemed to include:
a) Granting of disability and double or triple indemnity accident benefits, if

so provided in the contract of insurance
b) Granting of annuities upon human life, and
c) Granting of superannuation allowances and annuities payable out of any

fund applicable solely to the relief and maintenance of persons engaged
in any particular profession, trade or employment or of the dependents
of such persons.
The term ‘Long term business’ is defined in some country as under:
‘Long Term Insurance Business’, that is to say, the business of entering into or
maintaining contracts of assurance on human lives, such contracts including
contracts whereby the payment of money is assured on death or on the
happening of any contingency dependent on human life, and contracts which
are subject to payment of premium for a term dependent on human life, and
such contracts being deemed to comprise.

This includes the following sub classes:
i. Life insurance: A protection against the loss of income that would result if
the insured passed away. The named beneficiary receives the proceeds and
is thereby safeguarded from the financial impact of the death of the
insured. These are usually referred to as traditional products.
ii. Unit Linked Contracts: Unit linked contracts have benefits that are directly
linked to the value of the underlying investments. The benefits payable
depends on the performance of the underlying assets.
iii. Inflation Linked: Inflation linked contracts have benefits which increase in
value with respect to a inflation index or a constant inflation value.
iv. Annuities: An annuity is a contractual financial product sold by financial

institutions that is designed to accept and grow funds from an individual
and then, upon annuitization, pay out a stream of payments to the
individual at a later point in time. The period of time when an annuity is
being funded and before payouts begin is referred to as the accumulation
phase. Once payments commence, the contract is in the annuitization
phase.
v. Contracts for the granting of disability and multiple indemnity, accident

and sickness benefits if so specified in such contracts, but excluding
insurance business which is principally or wholly of any kind included in sub
paragraph (i), (ii), (iii), (iv), and (vi)
vi. Permanent health: Contracts of insurance providing specified benefits on

incapacity from accident or sickness which are both in effect for a period
of more than five years and cannot be cancelled by the insurer.
Two bases on which contracts are issued are:
i. Participative (with profit) Basis: On a participative basis, the benefits

under the contract can be varied to give an additional benefit to the
policyholder. The benefits under these contracts can be varied by
adding bonuses to the initial sum assured or by giving policyholders cash
refunds i.e. total benefits under the contracts consists of guaranteed as
well as non-guaranteed part. Where surplus is distributed so as to
increase benefits, additions to the sum assured are called bonuses.
These products are called participative as the policyholder participates
in the surplus of the company. In India, the participative rate is 90% for
policyholders and 10% for shareholders. Portion of shareholders cannot
go above 10% of total surplus distributed. Only traditional contracts are
issued on this basis.
ii. Non-Participative (without profit) Basis: On a non-participative basis,

the benefits under the contract are usually guaranteed and premiums

are usually fixed at the date of issue. The policyholder is not entitled to
any surplus of company, that is why these contracts are called non-
participative or without profit. Both traditional and unit linked
contracts are issued on this basis.
Therefore, the insurer has to comply with local laws in that country while
designing the products.
Test Yourself 1
Life Insurance Business means __________
I. Any contract where the payment of money is assured on the happening of

any contingency dependent on human life or death (except death by
accident only)
II. Business of effecting contracts of insurance upon human life
III. Any contract which is subject to payment of premiums for a term dependent
on human life
IV. All of the above

B. Products offered by insurers
Life insurance business is usually divided into two broad categories:
 Life Insurances
 Annuities
Life insurance business can include some indemnity type contracts too with sum
upper limit, such as:
 Health insurance
 Accident insurance
 Sickness insurance
 Investment linked contracts
In this chapter, we will deal with Insurances and Annuities.
1. Life insurance
A life insurance product is a one which provides benefit in the event of death,
besides other benefits, if any. It can be classified into two sub-groups:
 Pure death benefit contracts

 Endowment benefit contracts
a) Pure Death benefit contracts
These include death benefit only, if death occurs; otherwise the product
does not offer any benefit at all. (Known as ‘Term Assurances’) These are of
two types:
i. Term insurance contracts
Term insurance policy covers only the risk of dying. A premium is paid year
on year or as a single premium to the insurance company and in the event of
death, the insurance amount, called the Sum Assured, is paid out to the
nominees. And in case there is no death, nothing is paid, and the yearly
premium is retained by the insurance company
A Term insurance is a contract under which benefit amount (sum assured)

will be payable on the policyholder’s death to the beneficiary under the
contract within the term of the contract (chosen at outset). Generally, no
benefit is payable if the policyholder survives to the end of the contract.
A term insurance is particularly useful as a means of satisfying the

protection need of the policyholder. Normally, surrender benefit is not
payable.

Term insurance contracts may be issued on a participative or non-
participative basis. Generally, loan on the policy may not be available.
These contracts provide benefits at the lowest cost than under an

endowment or whole life contract for the same level of benefit.
For example: Mr. Mohan whose age is 25 years has taken an insurance policy
with sum assured of Rs. 1,000,000 which will be payable on his death during
the period of 10 years that is if he dies between ages 25 and 35. Premium of
Rs. 7,000 per annum is payable for 10 years.
ii. Whole life insurance contracts
The simplest life insurance contract is the whole life insurance. The benefit
amount (sum assured) under such a contract will be paid on the
policyholder’s death to the beneficiary under the contract.
Whole life insurance contracts are plans that provide cover throughout the
life. A policy holder is given an option to pay premiums till a certain age,
post which he has an option to continue the cover till death without paying
any premium. The intention of this contract is to provide a lump sum
payment to family members in the event of death of the life assured.
This is particularly useful as a means of satisfying the protection need of the

policyholder. Normally, a surrender value would also be payable.
Protection policies like these are designed to provide a benefit in the event
of specified event, typically a lump sum payment.
The whole life or term insurance doesn’t meet all the needs of the
policyholder as these policies do not provide survival benefits. People also
want secure future for themselves or family when they are alive. This desire
brought Endowment Insurance in the market, which are discussed below in
this chapter.
Whole life insurance contracts may be issued on a participative or non-

participative basis. Policy loans may be available until the insured's death. If
there are any unpaid loans upon death, the insurer subtracts the loan
amount from the death benefit and pays the remainder to the beneficiary
named in the policy.
For example: Mr. Sunil whose age is 25 years has taken an insurance policy
with sum assured of Rs. 1,000,000 which will be payable on his death during
his life. Premium of Rs. 10,000 per annum is payable for 10 years.
These contracts are cheap and provide high value to family members.

These contracts may be modified in one of the ways given below:
 Increasing term insurance
Insurance cover could be increased periodically to meet the insurance needs

of policyholder.
Example:
Death in Policy Year: Death Benefit (Rs.)
1 100,000
2 110,000
3 120,000
4 130,000
5 140,000
6 and later 150,000
 Decreasing term insurance
Insurance could be reduced periodically to meet the mortgages
Example:
Death Benefit (Rs.) [Outstanding
Death in Policy Year:
Loan]
1 100,000
2 70,000
3 50,000
4 30,000
5 10,000
6 and later 0
b) Endowment Insurance contracts
An Endowment insurance is a contract under which benefit amount (sum

assured) will be payable either on the policyholder’s death during the term
of the contract (chosen at outset) or on survival to the end of the term.
Endowment insurance is particularly useful as a means of satisfying both the

protection and investment need of the policyholder. Normally, a surrender
benefit would also be payable.
Endowment insurance contracts may be issued on a participative, non-

participative or unit linked basis. These contracts are the combination of
term and pure endowment insurance contracts. Policy loans may be
available until the insured's death or maturity whichever is earlier. If there
are any unpaid loans upon death or maturity, the insurer subtracts the loan
amount from the respective benefits.

These contracts are often used as a means of transferring wealth from, say,
parents to children. A parent would pay the premiums but the benefit would
be payable to the child. Endowment insurances are also useful for saving
money for retirement.
An endowment insurance is sometimes used for repaying the capital on an

interest-only loan. In this case, the borrower pays interest (only) to the
lender while the loan is outstanding. The borrower also takes out an
endowment policy, the proceeds of which are used to repay the debt.
These contracts can be broadly grouped into six categories:
i. Pure endowments
A pure endowment contract provides a sum assured at the end of the fixed
term, provided the policyholder is then alive.
A pure endowment contract is particularly useful as a means of satisfying

the investment need of the policyholder. Normally, surrender benefit is
payable.
Investment policies are designed to facilitate the growth of capital by

regular or single premiums.
These contracts may be issued on a participative, non-participative or unit

linked basis. Policy loans may be available during the term of the contract.
These contracts are rare these days.
Example
Mr. Sam buys a pure endowment contract for a sum assured of Rs. 100,000 with
a single premium of Rs. 90,000 for 10 years. If Sam dies at any time during the
period of contract, no benefit is payable and Rs. 90,000/- would be foregone.
On the other hand, if he survives the period of contract, he would be entitled to
receive Rs. 100,000.
ii. Endowment insurance
There is death benefit during the period of contract as well as a survival

benefit at the date of maturity.
Example
Mr. Mohan whose age is 25 years has taken an insurance policy with sum assured
of Rs. 1,000,000 which will be payable either on his death during 10 years or on
his survival for the period of 10 years that is if he is alive at the age of 35.
Premium of Rs. 20,000 per annum is payable for 10 years.
iii. Money back insurance
There is a death benefit (full Sum Assured) during the period of contract and
survival benefits at fixed dates during the period of contract.
Example
Mr. Sam buys a money back insurance contract for a sum assured of Rs. 100,000
with a single premium of Rs. 101,000 for 15 years. If Sam dies at any time
during the period of contract, Rs. 100,000 would be payable to his nominee. But
if he survives at the end of 5 years, he would be entitled to receive Rs. 30,000,
and if he survives at the end of 10 years, he would be entitled to receive
another Rs. 30,000. If he survives at the end of 15 years, he would be entitled
to receive the balance, i.e. Rs. 40,000.
Suppose he dies in the 12th policy year, total benefit payment would be Rs.
30000 + 30000 + 100000 = 160,000.
iv. Increasing (Decreasing) insurance in type (b)
In pure endowment insurance, death benefit can increase [decrease] during

the period of contract, instead of a fixed death benefit. (This is similar to
Examples 2a and 2b above)
v. Double endowment insurance
There is death benefit during the period of contract, and a survival benefit
(which is equal to twice the amount of death benefit) at the date of
maturity.
Example
Mr. Sam buys a double endowment insurance contract for a sum assured of Rs.
100,000 with a single premium of Rs. 150,000 for 10 years. If Sam dies at any
time during the period of contract, Rs. 100,000 would be payable to his
nominee; and if he survives the period of contract, he would be entitled to
vi. Double cover endowment
There is death benefit (which is equal to twice the amount of the survival
benefit) during the period of contract, and a survival benefit at the date of
maturity.

Example
Mr. Sam buys a double cover endowment insurance contract for a sum assured
of Rs. 100,000 with a single premium of Rs. 96,000 for 10 years. If Sam dies at
any time during the period of contract, Rs. 200,000 would be payable to his
nominee; and if he survives the period of contract, he would be entitled to
In fact, and in practice, there would be many combinations of death benefit and
survival benefit. As a bait to policyholders, insurers would also offer ‘bonuses’
along with benefits which are payable on the happening of specified events or
every year. Such contracts are referred to as ‘With-profit contracts’, which we
will understand in detail later.
A lot more innovative product combinations can be designed using the basic
structure as discussed above.
Three more category of insurance which are relatively new and innovative
includes:
Convertible or renewable Term Assurance:
A renewable term assurance is a term assurance which allows the insured to

renew the term assurance at the end of the original contract. The renewal can
be made without further medical underwriting.
A convertible term assurance allows the insured to convert the term assurance
into another type of contracts, such as a whole life. Conversion may be allowed
on only one date, on any of several dates or at any time during the original term
assurance contract.
A particular contract may offer the renewal and conversion option, only the
renewal option or only the conversion option.
Surrender benefit would not normally be paid before conversion.
Critical Illness Assurance:
Critical illness assurance is a contract, where the insurer is contracted to

typically make a lump sum cash payment if the policyholder is diagnosed with
one of the critical illnesses listed in the insurance policy.

The contract may also be structured to pay out regular income and the payout
may also be on the policyholder undergoing a surgical procedure, for example,
having a heart bypass operation. The contract may require the policyholder to
survive a minimum number of days (the survival period) from when the illness
was first diagnosed.
The schedule of insured illnesses varies between insurance companies. The

conditions covered by these contracts include heart attack, cancer, stroke,
coronary, blindness, deafness, kidney failure, terminal illness etc.
Typical critical illness insurance products refer to policies where the insurer
pays the insured a pre-determined lump sum cash payment if the policyholder is
diagnosed with a critical illness listed in the policy. However, alternative forms
of critical illness cover provide direct payment to health providers to cover the
high medical costs in treating critical illnesses such as cancer, cardiovascular
procedures and organ transplants. The maximum amount is set out in the
insurance policy and defined per episode of treatment.
These critical illness insurance products generally pay hospitals directly to avoid
policyholder’s incurring out of pocket expenses and lengthy reimbursement
processes. In most instances of this alternative to the lump sum critical illness
insurance, policyholders may decide where they will receive treatment among a
pre-selected group of hospitals.
Generally a number of diseases are listed in a policy and the benefit may be
available on a whole life or a term basis. These critical illness insurance
policies directly pay health providers for the treatment costs of critical and life-
threatening illnesses covered by the policyholder’s insurance policy, including
the fee of specialists and procedures at a select group of high-ranking hospitals
up to a certain amount per episode of treatment as set out in the policy.
For example: Mr. Ankit whose age is 30 years has taken a critical illness
assurance policy with sum assured of Rs. 200,000 for whole life. Single premium
of Rs. 40,000 is payable at inception. This sum assured will be payable if he is
diagnosed as suffering from a particular disease.
Deferred Assurances:
Deferred whole life assurance is a contract under which the death benefit (sum
assured) is payable if death occurs after some specified years in the contract.
The policyholder may pay limited, regular or single premiums up to the end of
the deferred period.
A deferred whole life assurance is useful as a means of satisfying the protection
need of the policyholder. Normally, a surrender value would also be payable.
Deferred whole life assurance contracts may be issued on a participative or non-

participative basis. Policy loans may be available until the insured's death. If
there are any unpaid loans upon death, the insurer subtracts the loan amount
from the death benefit and pays the remainder to the beneficiary named in the
policy.
For example: Mr. Sumit whose age is 25 years has taken an insurance policy with
sum assured of Rs. 1,000,000 which will be payable on his death, provided it
occurs after 10 years that is if he dies after age 35. 10 years is referred to as
deferred period. Premium of Rs. 10,000 per annum is payable for 10 years i.e.
during deferred period.
Basic as well as some variation below is discussed.
In all the examples below:
 Mr. Tom is the Life Assured;

 Ms. Sam is the Beneficiary;
 Sum Assured is Rs 100,000;
 All contracts terminate on death, if earlier, or on date of expiry of policy
term, if any.
Table 2.1
Type of
Features
Assurance
Term Assurance
Benefit payment on death only during a specified policy term.
Pure Term E.g. On Mr. Tom’s death during the policy term of 10 years, Ms.
Assurance Sam is entitled to Rs. 100,000/-. If Mr. A dies on or after the
policy term, the insurer is not required to pay anything at all to
Ms. Sam.
Benefit payment on death only during a specified policy term
which is 24 months or less.
Temporary
Term E.g. On Mr. Tom’s death during the policy term of 12 months,
Assurance Ms. Sam is entitled to Rs. 100,000/-. If Mr. Tom dies on or after
the policy term, the insurer is not required to pay anything at all
to Ms. Sam.
Benefit payment on death only during a specified policy term,
and return of premiums paid (with or without interest) on the
date of maturity
Term
Assurance
E.g. On Mr. Tom’s death during the policy term of 10 years, Ms.
with Return
Sam is entitled for Rs. 100,000/-. If Mr. Tom dies on or after the
of Premium
policy term, the insurer is not required to pay anything at all to
Ms. Sam. If Mr. Tom survives the policy term, then he is entitled
to receive the premium paid by him. (say, Rs. 1000/-)

Benefit payment on death only, and the amount of death benefit
gets reduced in a specified order according to year of death.
E.g. Policy term is 5 years; Sum Assured reduces every year by

Decreasing
Rs.20000/-. If Mr. Tom dies in the first policy year, the death
Term
benefit would be Rs. 100,000/-. If he dies in the second policy
Assurance
year, the death benefit would be Rs. 80,000 and so on. If he dies
in the 5th policy year, the death benefit would be Rs. 20,000/-.
If Mr. Tom dies at the end of or after the policy term, the
insurer is not required to pay anything at all to Ms. Sam.
Benefit payment on death only, and the amount of death benefit
gets increased in a specified order according to year of death.
Increasing E.g. Policy term is 5 years; Sum Assured increases every year by
Term Rs.20000/-. If Mr. Tom dies in the first policy year, the death
Assurance benefit would be Rs. 100,000/-. If he dies in the second policy
year, the death benefit would be Rs. 120,000 etc. If he dies in
the 5th policy year, the death benefit would be Rs. 180,000/- . If
Mr. Tom dies at the end of or after the policy term, the insurer
is not required to pay anything at all to Ms. Sam.
Whole Life Assurance
Benefit payment on death only.

Whole Life
Assurance E.g.: On the death of Mr. Tom, Ms. Sam is entitled to Rs.
100,000/-.
Benefit payment on death only, and survival benefits on

stipulated dates.
E.g. On the death of Mr. Tom, Ms. Sam is entitled to Rs.

Anticipated 100,000/-. If Mr. Tom survives at the end of 5 policy years, he is
Whole Life entitled to Rs. 10,000/- at that point of time. If Mr. Tom
Assurance survives at the end of 10 policy years, he is entitled to Rs.
20,000/- at that point of time.
If he dies at any time during the first 5 policy years, then
survival benefits would become void, and Ms. Sam would get the
death benefit of Rs. 100,000/-.

Endowment Assurance
Benefit payment on survival only on the date of maturity

On the death of Mr. Tom during the policy term of 10 years, no
benefit is payable. If Mr. Tom survives the policy term of 10
years, he is entitled to Rs. 100,000/-.
Pure
Endowment [Suppose he pays a single premium of Rs. 80000/- and dies
during the policy term, then no benefit is payable, unlike in a
fixed deposit scheme in a bank. These contracts are no longer
popular. However, they still exist in some countries since banks
do not offer long term (over 5 years) fixed deposits]
Benefit payment on death, if any, during the specified policy

term, and on survival - on the date of maturity.
On the death of Mr. Tom during the policy term of 10 years, Ms.
Endowment
Sam is entitled to Rs. 100,000/-. If Mr. Tom survives the policy
Assurance
term, he is entitled to Rs. 100000/-. [In this contract, Rs.
100,000 was assured by the insurer, so that the policyholder
would get something substantial. These contracts are the most
popular throughout the world]
Double Benefit payment of X on death, if any, during the specified

Endowment policy term, and 2X on survival on the date of maturity.
Double Cover Benefit payment of 2X on death, if any, during specified policy

Endowment term, and X on survival on the date of maturity.
Benefit X on death, if any, during specified policy term, and

Benefit Y on date of maturity. Also survival benefits of Z during
policy term where X can be increasing or decreasing at
stipulated times, and Y can be fixed or related to X and Z can
vary from time to time during the period of policy term.
Other There could be Deferred Assurances, usually policies on

children. There is a deferment period and also a vesting date.
During the deferment period, no insurance cover is provided
(except in some cases, return of premiums with or without
interest); ‘Assurance’ starts from vesting date on the life of
child. These are Deferred Endowment Assurance Policy and
Deferred Whole Life Assurance Policy.
In Assurances, we observe that insurers fundamentally cover two events,
namely, death and survival at a point of time. Insurers provide benefits on the
happening of these events in the contracts. Suitable names are given for the
contracts, such as Term Assurance, Whole Life Assurance, Endowment
Assurance, etc.
In Assurances, the amount of benefit is always fixed in advance, and known at
the time of issue of contract. This is referred to as ‘Sum Assured’, ‘Insurance
Cover’, ‘Basic SA’, ‘Face Value of the Contract’, etc. In some cases, the benefit
amount varies with the time scale. The amount of benefit depends upon the
time when the event happens.
In Assurances, Events are defined before the issue of contract. Definitions would
last long and are stable. Event ‘Death’ means death of life assured. Proof of
death is a certificate of death issued by the government agency, ‘Registrar of
Births and Deaths’.
‘Maturity’ means survival of the life assured on the exact date of maturity i.e.
date of expiry of contract. Discharge voucher duly signed by the life assured
would be enough for the insurer to verify the event. There are also other
events, such as ‘death due to accident’, ‘disability’, ‘sickness’, etc., which
would be defined by the insurer for application of the event. These will be
discussed later.
2. Annuities
An annuity product is one which provides benefit on the event of survival at a

stipulated time interval, besides other benefits, if any. It can be classified into
the following:
Deferred annuity
Deferred Annuity is a contract under which regular payments postponed for

a given period in the contract, provided that the individual is alive at the
end of the deferred period when payments commence.
The policyholder may pay regular or single premiums up to the end of the
deferred period. Annuity payments may be made in advance or in arrears
after the end of the deferred period.
These contracts may be issued on a participative or non-participative. A

participative deferred annuity will provide a guaranteed level of regular
income, and bonus additions to this income level may be made while the
policy is in deferred period.
Surrender benefit is not normally available after the end of the deferred
period but may be payable during the deferred period.
For example: Mr. Anil whose age is 60 years purchases an annuity by paying
Rs. 10,000 per annum for 5 years (deferred period). The annuity amount is
Rs. 5,000 per month. The insurance company will start paying this amount
every month after 5 years which is the deferred period, provided he is alive
after 5 years and in subsequent years.

Immediate annuity
An Immediate Annuity is a contract under which level payments are made

until the survival of the policyholder in return of a single advance payment
(purchase price of the contract). The first payment is made within the first
year, without a deferred period. These are also called whole life annuities.
Annuity payments may be made in advance or in arrears.
Immediate annuities may be purchased on single, joint life or joint survivor

bases. In joint life or joint survivor annuities payments stop upon the death
of one or both of the annuitants respectively. For example, an annuity may
be structured to make payments to a married couple, such that the
payments are ceasing on the death of the second spouse. In joint-survivor
annuities, sometimes the instrument reduces the payments to the second
annuitant after the death of the first.
These contracts may be issued on a participative, non-participative or

inflation linked basis. For a participative annuity the income paid to the
insured will be a guaranteed amount plus a bonus added by the insurer.
Normally, surrender benefit is not payable.
Example
Mr. A purchased an immediate annuity on 1st Jan, 2013, to receive a pension of

Rs 1000 per month at an age of 60. The first payment of Rs. 1000 would be on
1st Feb 2013, provided Mr. A is alive on that date, the next payment would fall
due on 1st March 2013, if he survives, and so on. Suppose he dies on 15th June
2014 then the contract ceases to exist on 15th June 2014 with no further
payments from that date.
Temporary annuities
Temporary Annuity is a contract under which level payments are made until
the survival of the policyholder for a specified period in return of a single
advance payment. These are same as the immediate annuities with a limited
period rather than whole life.
Annuity payments may be made in advance or in arrears. These contracts

may be issued on a participative, non-participative or inflation linked basis.
For a participative annuity the income paid to the insurer will be a
guaranteed amount plus a bonus added by the insurer.
For example: Mr. Mohan whose age is 55 years purchases an annuity for 10
years by paying Rs. 80,000 at inception. The annuity amount is Rs. 6,000 per
month. The insurance company will pay this amount every month for 10
years, provided that he is alive during this period.
Similar to Assurances, Annuity polices are of many types.
On the death of the policy holder:
 A lump-sum may be paid (usually the purchase price, in case of

immediate annuity policies or
 A fixed sum is paid in case of deferred annuity policies (the fixed sum
could be an absolute amount or return of premium(s) with or without
interest).
Immediate annuities could also be of increasing type or decreasing type.
Increasing Annuity is a contract under which annuity payments increases by

some specified amount until the survival of the policyholder in return of a single
advance payment.
Decreasing Annuity is a contract under which annuity payments decreases by

some specified amount until the survival of the policyholder in return of a single
advance payment.
These annuities may be payable on a whole life (Increasing/decreasing life

annuity) or term (Increasing/decreasing temporary annuity) basis. Annuity
payments may be made in advance or in arrears.
These contracts may be issued on a participative, non-participative or inflation

linked basis.
For example (Increasing life annuity): Mr. Sunil whose age is 50 years purchases
an annuity by paying Rs. 90,000 at inception. The first annuity payment is Rs.
5,000 and then subsequently increasing by Rs. 500 every month. The insurance
company will pay the increasing amount every month as long as he is alive.
For example (Increasing temporary annuity): Mr. Sunil whose age is 50 years
purchases an annuity for 10 years by paying Rs. 90,000 at inception. The first
annuity payment is Rs. 5,000 and then subsequently increasing by Rs. 500 every
month. The insurance company will pay the increasing amount every month for
10 years, provided he is alive during this period.
An Annuity policy can be for life or for a fixed number of years, whichever is
longer - it is known as annuity-certain and for life thereafter. Annuity policy can
also be on two lives (i.e. for a couple):

i. Joint life annuity
Where annuity is payable as long as both are alive and ceases to exist on the
death of any of the two.
ii. Reversionary annuity policy
Where on the death of the first person, the annuity payment would start to
the other, and it would be payable from the death of the first person till the
death of the second.
iii. Last survivor annuity
Here, annuity payments are made till the death of the second person and
the annuity payment to the second life would be x% of the annuity payment
to the first life (x% can be 100%, 75%, or 50%).
Such policies are used to provide widow’s pension in a pension scheme.
Types of deferred annuity are as follows:
Table 2.2
Type of deferred
Features
annuities
Immediate annuity would start from the date of expiry of

deferment period (called vesting date).
Ordinary deferred
annuity
If life assured dies during the deferment period, usually,
premiums are returned with or without interest.
Same as in #1, but there would be death benefit during the

deferment period, which could be a substantial amount.
Deferred annuity
with life cover The death benefit could further be used to purchase an
immediate annuity for the nominee, who is usually the
spouse.
At vesting, the policyholder can choose to receive a lump

sum payment (called notional cash option) or receive an
Deferred annuity immediate annuity.
with options at
the vesting date Usually in these contacts, the policyholder can have an
option to buy an immediate annuity from any other life
insurer, which would be arranged by the first insurer.

Deferred annuity could be purchased either with a single premium or with a
regular premium for a fixed number of years (where the fixed number could be
less than or equal to the deferment period).
Now we will understand the various types of ‘Immediate annuities’:
Table 2.3
Type of immediate
Features
annuities
Immediate annuity is of two categories, the first being

the Immediate annuity due and the other being the
Immediate annuity in arrears.
Ordinary immediate
annuity (due or in In case of immediate annuity due, the first payment
arrears) would be on the date of purchase and in case of
immediate annuity in arrears, the first payment would
be x months from the date of purchase; where x is
chosen before, such as ‘1’, ‘3’, ‘6’ or 12’ month(s).
Immediate annuity
with ROC
Same as in #1 above, except that there would be death
[ROC: Return of
benefit which is payable on death of annuitant.
Corpus or Purchase
Price]
Same as in #1 above, but there could be survival

benefits which are payable on survival at dates fixed in
advance.
Immediate annuity
with Survival Benefits
For instance, the annuity policy could provide survival
benefits (which are fixed and known in advance) at the
end of 5 years and 10 years.
Same as in #1 above, but the annuity amount could

increase every year by say 1% (simple interest)
Increasing immediate
For instance, if the annuity installment is 1, which is
annuity
payable at the end of each year, then it becomes 1.01
at the end of the 2nd year and 1.02 at the end of the 3rd
year and so on and so forth.

Same as in #1 above, except that annuity installments is
guaranteed for n years. This means, the annuity policy
assures payments for n years whether the annuitant (life
assured) is alive or not, and if the annuitant survives n
years, then he would receive for life.
The contract ceases on death, if it takes place after n

Annuity certain for
years. If death takes place during the first n years, then
n years and for life
the contract ceases at the end of n years.
thereafter
For instance, Mr. A purchased ‘annuity certain for 5 years
and for life thereafter’ which provides him an annuity of
Rs. 100 at the end of each year. If he dies in the first 5
years, the contract provides payments for 5 years; and if
he dies after 5 years from the date of commencement of
the policy, the contract ceases on death.
It can be viewed as combination of two immediate

annuity policies - the first annuity policy would start
immediately to the first person, and the second annuity
policy would start from the death of first person to the
second person.
Last survivor
annuity
For instance, A and B are two people, and annuity
installment is Rs. 100 payable at the end of each year. Rs.
100 would be paid to the first person ‘A’, as long as A is
alive, and B would receive Rs. 100/- only from the date of
A’s death, and is payable as long as B is alive.
In this case, it is same as in #1 above, except that annuity

Joint Life annuity is payable only if both persons are alive. The contract
ceases on the first death.
There can be combinations of annuity payment, survival
benefits, and death benefit.
In the USA and Canada, variable annuities are sold, under

which there is a minimum floor of annuity payment and an
extra amount which depends upon the performance of
investments. This means some portion of annuity payment
Other
risk is borne by the policyholder.
There are also annuities for impaired lives in some Asian

countries, under which higher annuity (more than that in
ordinary annuity, as the longevity would be shorter)
payments are made; and such contracts are issued subject
to underwriting.
Example
In a pension scheme, pension is payable to a member at the rate of Rs. 1000/-

p.m. as long as he is alive, and on his death, his spouse is entitled to a pension
of Rs. 500/- p.m., which is payable as long as the spouse is alive.
What annuities are suitable for this member?
Two annuity policies could be purchased:
a) Last survivor annuity (LSA) for both, the member and his spouse for Rs.
500/- p.m.
b) Single life annuity (SLA) for the member for Rs. 500/- p.m.
As long as the member is alive, Rs. 1000/- p.m. is received (Rs. 500 from LSA
and Rs. 500 from SLA). On the member’s death, SLA would cease, and Rs. 500
would be payable to the spouse from LSA as long as the spouse is alive.
If the spouse dies before the member’s death, the member would receive Rs.
1000/- from LSA and SLA as long as he is alive, and both contracts get
terminated on his death.
Test Yourself 2
When the sum assured is returned to the policyholder at periodic intervals, it is

referred to as _________
I. Deferred Assurance
II. Money Back Assurance
III. Pure Endowment Assurance
IV. Pure Term Assurance

C. Concept of riders
‘Riders’ or ‘Add-ons’ are additional benefits which are optional for the
policyholder and could be attached to the main contract.
For instance, if Mr. A purchased an Endowment Assurance contract, he can opt

for ‘Accident Benefit’ rider, which provides an additional benefit in the event of
death due to accident.
[Here, accident should be defined in the contract and death should take place
on account of the accident which the life assured has to face all of a sudden,
such as snake-bite, road accident, train accident, fall from a tree etc. - but not
self-inflicted, like suicide].
However, for additional benefits, additional premiums have to be paid.
Characteristics of riders are:
a) They are offered as an option along with main contract
b) The option is valid only if main contract is valid
c) They provide additional benefit only on the happening of a specified

event
d) The option can only be cancelled at any time when the main contract is
in force
e) The grant of the option could be subject to underwriting requirements.
The following is the list of riders, usually offered along with the main contract:
Name of rider Main feature
Event: Death due to Accident
Benefit: Usually 1 to 3 times of the Sum Assured

payable on normal death.
Accident Benefit Rider
For instance, if Sum Assured is Rs. 100,000 which is
death benefit, the Accident benefit could be Rs.
100,000 or less so that the total death benefit could
be Rs. 200,000, on death due to accident.

Event: Permanent Disability on account of an
accident or disease.
Permanent Disability
Rider
Benefit: Related to Death Benefit (e.g. 10% of Sum
Assured, and waiver of future premiums)
Event: Any type of death

Term Rider
Benefit: Additional death benefit.
Event: Affliction with specified critical illness
Critical Illness Rider
Benefit: Amount fixed in advance (usually related to
death benefit)
Event: On the death of the proposer in case of

insurance plans on children and also joint life plans;
on permanent disability in any insurance plan
Waiver of Premium Rider
Benefit: Future premiums are waived from the date
of event.
There could be many more riders that could be attached to the main contract
to provide additional benefits.
As per the IRDAI (Protection of policyholders Interests) Regulations, 2002, and

its amendment the total rider premium (excluding health or Critical Illness
riders in case of term or group product) cannot exceed 30% of the Basic Life
Insurance premium. In case of “Health or Critical Illness riders” in case of term
or group product premium cannot exceed 100% of the Basic Life Insurance
premium.
Also Rider Sum Assured cannot exceed the Sum Assured of Basic Life Insurance
Benefit.
Test Yourself 3
Which of the following is not a characteristic of riders?
I. The option is valid only if the main contract is valid.

II. The grant of option could be subject to underwriting requirements.
III. The option cannot be cancelled when the main contract is in force
IV. It provides additional benefit only on the happening of a specified event

D. Options and Alterations
1. Options
Some contracts could offer the facility of options to convert the existing policy
into a different type of policy, or to alter the terms and conditions of the
existing policy. Such options would have a limited period of offer, and the
option would be required to be exercised during this period only.
Various types of options offered by insurers are as follows:
a) Convertible Term insurance plan: offers insurance cover in the first five
policy years and at the end of 5 years, the policy can be either
converted into an Endowment contract for a period of 15, 20 or 25 years
(however, the age at the expiry of the contract should not be over 65) or
into a Whole Life Assurance Plan.
b) Increase in insurance cover (for instance, from Rs. 50,000 to Rs. 75,000)
without medical examination during the period of contract.
c) Maturity proceeds could be used to buy any other plan without medical
examination or to receive the sum in 10 half-yearly installments.
d) Facility to purchase another insurance plan with or without medical

examination
e) Paid-up option (This means the policy would be made in-force for a
reduced sum assured with no further future premiums)
f) Changing the ownership of the policy (not the life assured) / nominee
g) Registering the assignment (with a prescribed notice from the

policyholder) – which means certain rights are made available to
assignee(s)
h) Surrendering the policy partially (splitting the policy)
i) In a group policy, if an individual member leaves the group, he can be

offered an individual policy with the same terms and conditions.
j) Backdating of policy (at inception of the contract)(usually in the same

financial year)
k) Discounting of policy in the last year (usually with no penalties)
l) Grace period i.e. allowing the policyholder to pay premiums late, this is
usually a policy condition; however, some insurers accept premiums
beyond the grace period with no or minimal charges.
m) Free look cancellation where the policyholder is allowed to cancel the
policy within 15 days of its issuance if he/she is not satisfied with the
policy provided. Some specified charges such as medical charges, are
deducted and remaining premium is paid back.
n) Conversion option of lump sum to annuity or vice versa in a deferred

pension plan.
Options can either enhance the value of the policy in monetary terms or provide
some non-monetary facilities (e.g. change in nominee, change in ownership).
2. Alterations
Insurers permit certain alterations which would not impact the financial
features of the product, while some permit alterations which could change the
main structure of the product too. These are:
a) From one mode of premium payment to another (e.g. from monthly

mode to yearly mode)
b) Reduction in policy term (increase in policy term is generally not

allowed, as it could cause reduced premiums)
c) Increase in sum assured (say, from Rs. 50,000 to Rs. 75,000), usually,
with medical examination
d) Change from whole life plan to endowment plan (these are rare, but
insurers do permit)
e) From without profit contract to with profit contract (allotment of

bonuses would be prospective, not retrospective)
Alterations are not free; the insurer would collect charges for alterations from
the policyholder.
Test Yourself 4
Which of the following is not an example of an ‘Option’?
I. Changing the ownership of the policy

II. Changing the mode of payment of premium
III. Partially surrendering the policy (splitting the policy)
IV. Backdating of policy (at inception of the contract) usually in the same
financial year

E. ‘Guarantees’ offered by the insurers
Insurers would offer certain guarantees on payment of benefits and premiums.

In life insurance contracts, death benefit is an assured amount which is known
in advance and it would be not altered. Similarly, the installment premiums
which are payable through-out the premium paying period are fixed in advance
and would not be altered.
The following benefits are generally offered as guarantees, explicitly or
implicitly:
Table 2.4
Description Guarantee offered
Death Usually a fixed sum assured which is known in advance in

benefit absolute terms, e.g., Rs. 100,000/-
Premiums payable would be fixed in advance in absolute terms

Premiums
and generally cease in case of death.
Usually a fixed amount related to premiums, for example 30% of

premiums paid, excluding the premiums paid in the first year of
the policy.
Guaranteed This is a minimum guarantee stated in the policy contract, if

Surrender policyholder terminates the contract. It is sometimes referred to
Value as ‘statutory surrender value’.
Insurers offer higher surrender values, generally known as

special surrender or cash values with the terms and conditions
stated before.
These are usually related to the sum assured and are payable in
the event of death or maturity.
Guaranteed
For instance, 2% of sum assured p.a. is guaranteed in addition if
Additions
the life assured dies in the 7th policy year, 14% of sum assured
would be payable in addition to basic sum assured, as an
additional guaranteed benefit.

In some contracts, the benefit is related to premiums.
Guaranteed For instance, a return of premiums with an effective interest @

interest 6% p.a. means that if the life assured dies in the 7th policy year,
rates the amount of death benefit (where P is the annual premium) is
the accumulated value of:
Ps= P× [(1.06^7) + (1.06) ^6+…..+ (1.06)] .
Guaranteed
Amount of benefit on the date of maturity is made known
Maturity
before, fixed (usually), and guaranteed.
Benefit
If the policyholder stops paying premiums from some point of

time during the contract premium paying period, then the policy
would be allowed to continue for reduced benefits which are
predetermined.
Paid-up
Benefits For instance,‘t/n’ of the Sum Assured, where ‘t’ is the number of
premiums paid and ‘n’ is the number of premiums payable.
E.g. If the sum assured is Rs. 100,000; t= 5; n= 10, then the

reduced sum assured is Rs. 50,000.
There could be some other guarantees too; for instance, increasing death
benefit by a fixed amount after some specified period.
Cost of guarantee and options (if any) are loaded in the premium for traditional
products or charged separately in unit linked products. Hence, more the
guarantee expensive will be the product.
Test Yourself 5
If sum assured is Rs.1,50,000/- and if number of premiums actually paid are 7

and number of premiums actually payable are 10, what is the reduced sum
assured?
I. Rs.1,50,000
II. Rs.1,05,000
III. Rs.50,000
IV. Rs.1,00,000

F. With profit contracts
Insurance contracts offer profits, bonuses, or dividends for some extra

premium. This is done in order to induce the policyholder to buy insurance
products so that some extra benefit is provided with certain amount of risk. In
includes some basic guaranteed benefit and some non guaranteed benefit.
Premium of participating product is more than non participating policy for same
level of basic guaranteed benefit.
The additional premium received is usually invested in high return asset classes
to provide higher expected return to policyholder in the longer term.
For instance, if Mr. X buys an Endowment Assurance contract with profits on

death or maturity, the contract would be entitled to bonuses. In such contracts,
the investment and (most of the times) insurance risk is shared with the
policyholders.
Example
Mr. X buys an Endowment Assurance contract with profits for a sum assured of
Rs. 100,000 Policy term is of 20 years.
He died in the 6th policy year (after payment of 6 annual premiums).
Insurer’s bonus declarations were (for this contract) per 1000 Sum Assured:
1st policy year: 40

2nd – 45
3rd - 40
4th - 50
5th – 55
6th - 60
Total vested bonuses would be:
Rs. 4000+4500+4000+5000+5500+6000= Rs. 29,000.
Benefit payable on death = Sum Assured + Vested bonuses for 6 years
= 100,000 + 29,000
= Rs.129,000
‘With profit contracts’ are entitled to some share of profits.
The share is referred to as:’ bonuses’; or ‘dividend’.

This is usually expressed as ‘x’ per 1000 Sum Assured (Face Value of Basic
Contract). Bonuses are generally declared every year. The actuary of the insurer
recommends what amount of bonuses could be declared on what types of
policies. Bonus once declared by an insurer is vested to the policy, as an
addition to Sum Assured; and this becomes a promise on the part of the insurer.
In the above example (F1), the insurer declared a bonus @ Rs. 40 per 1000 SA
(SA: Sum Assured). This means for every 1000 SA, Rs. 40 is attached (vested).
We will not go into the details of how profits would be arrived at here, and how
profits would be distributed to different types of policies with different policy
terms. We only understand what ‘bonus’ is and how it gets ‘vested’ and
payable. Insurers may also put conditions for payment of bonus, such that the
policy must be in force for a minimum number of five policy years or the vested
bonuses could only be payable on death or maturity but not on termination of
contract etc. It is necessary to understand what we mean by a ‘with-profit’
contract.
Bonuses are usually declared annually and once added to the sum assured these
becomes guaranteed benefits. Generally with profits policies are smoothed – so
in good years some surplus is kept back to still give a positive return in bad
years. This is known as smoothing.
A reversionary bonus (or annual bonus) is paid at the end of each year, say, x%.
This does not mean that an insurance company is actually distributing cash to
the policyholders rather it is promising that an amount of sum assured paid on
death or maturity (end of the term) will be x% greater than the previous sum
assured i.e. it is used to increase the sum assured.
The terminal bonus is payable when a policy matures or on the death of the life
assured. It is sometimes referred to as the final bonus. The terminal bonus
represents the policyholder’s entitlement to a proportion of the fund that has
been held back for the purpose of smoothing or for earning higher expected
return.
The insurance company has some freedom to decide what mix of bonuses to
pay. An insurance company may decide to pay low annual bonuses and a high
terminal bonus. Such a policy will protect the insurance company from falls in
the investment markets because annual bonuses cannot be taken away once
given. This also allows the insurer to choose investments that are expected to
be more profitable in the long term.
There are various methods of bonus payments:
 Simple Bonus
 Compound Bonus
 Super Compound Bonus
 Cash Bonus
 Paid-up Additions

 Discount in Premium
First three are the example of ways in which bonus is calculated or represented.
Last three are the different ways of payment of bonus.
1. Simple bonus (SB)
Under this method, bonus is declared as x% of Sum Assured (Face Value of basic
contract) (or x% of Premiums).
For instance, SRB is 4% of SA; this means Rs. 40 per 1000 SA.
2. Compound bonus (CB)
Under this method, bonus is declared as x% of Bonus declared in the preceding

policy year. Suppose last year the bonus was 4% of SA; in the current year it
could be 10% of the amount of bonus declared in the previous year.
For instance, if Rs. 40 per 1000 was declared as the vested bonus for a policy
year, then the vested bonus (CRB) for the current year is Rs. 44 per 1000/- (40
x (1.10) = 44) (which is the succeeding year).
3. Super - Compound bonus
Two bonus rates are declared every year; one applying to the original sum
assured and one to the bonuses previously added.
Consider a 15-year policy with the initial sum assured of Rs. 10,000. The
methods of allocating bonus are as follows:
Simple bonus at 5% per annum

Compound bonus at 4% per annum
Super compound bonus at 3% per annum on basic sum assured and 7% on

bonuses.
The sum assured at the end of year 1 and 2 in each case is:
Simple:
Year 1: 10,000 * 1.05 = Rs. 10,500

Year 2: 10,000 * 1.1 = Rs. 11,000
Compound:
Year 1: 10,000 * 1.04 = Rs. 10,400

Year 2: 10,400 * 1.04 = Rs. 10,816

Super compound:
Year 1: 10,000 * 1.03 = Rs. 10,300

Year 2: 10,000 * 1.03 + (10,300 – 10,000) * 1.07 = 10,621
4. Cash bonus (CB)
Under this method, the policyholder is entitled to receive cash as bonus for a
policy year. (This is just like a cash dividend in a manufacturing company).
5. Paid-up additions (PA)
Under this method, the policyholder is entitled to receive an additional sum

assured (in addition to the existing basic sum assured) as bonus for a policy
year. (This is just like a single premium contract).
For instance, Rs. 100 is PA; and this is the additional sum assured which is
payable on the happening of the events specified in the contract (death or
maturity).
6. Discount in premium
This is the same as the cash bonus method, except that the policyholder would
not receive any cash, only a premium notice which stipulates premium for the
current year. If P is the due premium as per the contract, the policyholder can
pay P - A, (where A is the discount allowed by the insurer). Suppose the
premium P is Rs. 1000/-. Discount is declared in the year 10. Then the
policyholder can pay Rs. 990/- instead Rs. 1000/-, as premium for that year.
7. Other
There could be other ways, for instance, a combination and simple and
compound reversionary bonus. Bonus could be related to premiums; and a paid-
up policy is also allowed to participate in profits.
8. Future bonuses
Future bonuses are never guaranteed in advance, as they will not be known. But
a policyholder could expect that the future bonus would not be less than the
current year’s bonus. This is merely an expectation; there is no guarantee.
Premiums for participating contracts would be higher than those for non-
participating contracts; the difference is the bonus element.
Purpose of participating contracts is to provide a good return on these

contracts, as the insurer could invest the bonus loadings (premium) in a
propitious way by putting these monies in financing the business of non-
participating contracts and other contracts (a gearing benefit ) or by simply
investing in higher return asset classes.

Various terms and conditions could be attached to a policy for payment of
bonuses. Let us have a look at a few of those:
a) Policy must be in-force for with profits.
b) Bonus vests only if policy has been kept in force for, say, 5 years (this
condition would not apply in case of claims by death).
c) Vested bonuses are attached to and payable along with the Sum Assured.
d) Bonus would be declared only if there are profits i.e. surplus available
for distribution after payment of taxes.
e) There is no guarantee that future bonuses would be maintained at the

current bonus declared rates.
f) Vested bonuses are payable on death or on maturity only if the policy is

kept in force on such event; and are not payable on surrender of policy
(this condition may also be varied to the advantage of the policyholder).
g) In case of paid-up policies, bonuses vested may be payable on death or

on maturity, along with reduced sum assured. (Here also the condition
could be varied (or not varied) to the benefit of the policyholder).
Recently, because of the tight regulations and lower profitability on unit linked
contracts, companies are shifting focus to participating contracts and non-
participating contracts.
Test Yourself 6
Which of the following is not a method of payment of bonus?
I. Simple reversionary bonus

II. Guaranteed interest rates
III. Paid-up additions
IV. Discount in premium

G. Unit linked contracts
Traditionally, insurance contracts bear various risks which are borne by the
insurer, particularly, fluctuating interest rates, claim experience etc. Promised
benefits are fixed in advance (at the time of purchase of the contract) and are
paid on specified events (death or survival).
Unit linked contracts are now offered by insurers with savings element, for
which investment risk is borne by the purchasers of contracts. Such contracts
provide insurance benefits as well as savings benefits.
The savings benefit is linked with the market index (SENSEX) or with the
underlying value of assets. Some insurers offer assured benefits in respect of
the savings portion too, by offering some growth rate (say 5%) of the
policyholders’ savings.
A unit linked contract has two accounts, namely:
 Unit account (seen by policyholder and belong to policyholder)

 Non-unit account (belongs to company)
In unit account, units are allocated at a specified price known as ‘Net Asset
Value’ (NAV). Portion of the premium that is allocated to unit account is
referred to as ‘allocated amount’ and the rate is ‘allocation rate’.
For instance, out of Rs. 100,000 premium p.a., in the first policy year, the
allocation rate could be 85% (that is, Rs. 85,000 is put into unit account) and in
the second and subsequent policy years, the allocation rate could be 95% or
97.5% or 98% (in some cases, it could even be 100%). The allocated amount is
used to buy x units at the prevailing unit price (NAV). So the unit account has x
units.
Rest of the money is paid into non-unit accounts and is used to meet charges
and commission. These charges meet the expenses of administration, mortality
and rider benefits, and other contingencies. The Charges in the unit linked
contracts are further explained in Pricing Chapter.
Unit-linked contracts provide flexibility in payment of premiums, insurance

cover, additional benefits, etc.
There are different funds which are offered ranging from secured funds who
only invest in secured government securities to risky high return funds investing
mostly in equities. Switching between different funds is also allowed. Some
switches are free during the year post which nominal fee is charged.
Top up premium payment is also allowed in the fund subject to condition such
as additional death benefit as specified in the regulations.

Partial surrenders are also allowed where policyholder can partally surrender
the units for the benefits.
Surrenders are allowed post few years of the policy inception as per regulation.
As per current regulation this is 5 years. If policy lapses before 5 years
surrender penalty will be levied. After 5 years there is no surrender charge.
Test Yourself 7
Investment linked contracts provide which of the below?
I. Investment Benefits
II. Saving benefits
III. Both I and II

Summary
a) Insurance and annuity products satisfy the protection and investment needs
of the policyholders.
b) Term insurance policy covers only the risk of dying.
c) Endowment Assurance contracts provide death benefit if death occurs, and

in the event it does not occur, a survival benefit is provided on the date of
maturity.
d) An annuity product is one which provides benefit on event of survival at a

stipulated time interval, besides other benefits.
e) ‘Riders’ or ‘Add-ons’ are additional benefits which are optional for the
policyholder and could be attached to the main contract.
f) Some contracts give the facility of option to convert the existing policy into
a different type of policy, or to alter the terms and conditions of the
existing policy.
g) Insurers would offer certain guarantees on payment of benefits and

premiums.
h) Insurance contracts offer profits, bonuses, or dividends for some extra

premium. This is done in order to induce the policyholder to buy insurance
products so that some extra benefit is provided with certain amount of risk.

Answer 1
“Life Insurance Business" means the business of effecting contracts of insurance

upon human life, including any contract whereby the payment of money is
assured on death (except death by accident only) or the happening of any
contingency dependent on human life, and any contract which is subject to
payment of premiums for a term dependent on human life.
Answer 2
When the sum assured is returned to the policyholder at periodic intervals, it is

referred to as Money back assurance.
Answer 3
The option cannot be cancelled when the main contract is in force is incorrect.
The option can be cancelled only when the main contract is in force.
Answer 4
To change the mode of payment of premium is not an option. Changing the

mode of payment is ‘Alteration’, not ‘option’.
Answer 5
Rs.105000
‘t’ is number of premiums paid and ‘n’ is the number of premiums payable.
t= 7; n= 10, then the reduced sum assured is Rs. 1,05,000.
i.e. Rs.1,50,000 x 7/10 = Rs.1,05,000/-

Answer 6
Guaranteed interest rates
Guaranteed interest rate is the ‘Guarantee’ given in an insurance contract, not

a method of bonus payment.
Answer 7
Both I and II
Unit linked contracts provide investment benefits as well as saving benefits.
Question 1
Mr. Sam buys an Endowment Assurance contract with profits for a Sum assured
of Rs. 200,000/- and a policy term of 10 years.
He dies in the 5th policy year (i.e. after payment of 5 annual premiums).
Total vested bonus for 5 years is Rs.32,000/-. What is the benefit payable on his
death?
I. Rs.32,000
II. Rs.2,00,000
III. Rs.2,32,000
IV. Rs.1,68,000
Question 2
Bonus declared in the last year was 3% of SA. In the current year, it is 10% of
the amount of bonus declared in the last year. If Sum Assured (SA) is Rs 1000,
what would be the Compound Reversionary Bonus (CRB) for the current year?
I. Rs 33
II. Rs 100
III. Rs 36
IV. Rs 30

Question 3
Which of the following is not an example of alteration?
I. Reduction in policy term (increase in policy term is generally not allowed, as

it could cause reduced premiums)
II. Change from one mode of premium payment to another (e.g. from monthly
mode to yearly mode)
III. Change from whole life plan to endowment plan (this is rare, but insurers do
permit)
IV. Discounting of policy in the last year [usually with no penalties]
Question 4
Pension is payable to a member at the rate of Rs. 2000/- p.m. as long as he is

alive, and on his death, his spouse is entitled to a pension of Rs. 1000/- p.m.,
which is payable as long as the spouse is alive. What annuities are suitable for
this member?
I. Immediate annuity with Survival Benefits & Increasing immediate annuity

II. Annuity certain for n years and for life thereafter
III. Joint Life annuity
IV. Last survivor annuity & single life annuity
Question 5
If Mr. Sam became permanently disabled due to an accident, which rider will
provide him additional benefits?
I. Accident Benefit Rider

II. Permanent Disability Rider
III. Term Rider
IV. Critical Illness Rider
Answer 1
Rs.2,32,000
Benefit payable on death = Sum assured + Vested bonus
= Rs.2,00,000 + Rs.32,000
= Rs.2,32,000
Answer 2
Rs 33
If Rs. 30 per 1000 was declared as the vested bonus for a policy year, then the
vested bonus (CRB) for the current year is Rs. 33 per 1000/- (30 x (1.10) = 33)
Answer 3
Discounting of policy in the last year [usually with no penalties]

This is an example of ‘Options’; others are examples of ‘Alterations’.
Answer 4
Last survivor annuity & single life annuity
As long as the member is alive, Rs. 2000/- p.m. is received (Rs. 1000 from LSA
and Rs. 1000 from SLA). On the member’s death, SLA would cease, and Rs. 1000
would be payable to the spouse from LSA as long as the spouse is alive. If the
spouse dies before the member’s death, the member would receive Rs. 2000/-
from LSA and SLA as long as he is alive, and both contracts get terminated on
his death.
Answer 5
Permanent Disability Rider

If Mr. Sam became permanently disabled due to an accident, then the
permanent disability rider will provide him additional benefits.

CHAPTER 5
PRICING OF PRODUCTS – 2
In this chapter, we will look at some methods used in the determination of

prices of various insurance products.
Learning Outcomes
A. Methods of determination of price

B. Formula method
C. Expenses
D. Cash flow method
Mr. Sam has bought a life insurance policy recently, from a wide choice of life
insurance products explained to him. He is wondering how all these products
were priced and what all calculations were done to price these products. He
refers to this book as told by his agent. Now, in this chapter, Mr. Sam will get
answers to all his queries.

A. Methods of determination of price
There are two methods of determination of price:
1. Formula method
In the formula method, a formula or formulae are used to determine the

premium(s). This means using the equation of value as it is without going into
every year and looking at the benefits. This is done with the help of discount
factors used to calculate the present value of payment to be done in future.
2. Cash flow method
In the cash flow method, expected incomes and outflows are projected into the
future, and the best premium rate or charges or other variables are
determined. This method is best suited for complex product and where
premium is not the only desired variable.
These two methods would be explained in detail later in this chapter.
In order to better understand pricing, it is important to first understand the

concepts of a life table and discounting.
Life table
In a life table, we draw a hypothetical population using mortality rates at every

age. First we select two ages;
 The starting age, and

 The end age
For instance, the starting age is 15. We assume a radix of a fixed number of
lives, say 100,000 and at the end age, say 100. The number of lives would be
zero, as there would be no survivors.
In an insurance company, a single decrement life table is used in the formula

method of determination of premiums.

The table would look like this:
Table 1.1
Age- Number of Death Number of Number of Death Number of

Age-x
x lives – lx rate deaths - dx lives – lx rate deaths - dx
15 100000.000 0.015 1500.000 58 20595.146 0.058 1194.518
16 98500.000 0.016 1576.000 59 19400.627 0.059 1144.637
17 96924.000 0.017 1647.708 60 18255.990 0.090 1643.039
18 95276.292 0.018 1714.973 61 16612.951 0.092 1520.085
19 93561.319 0.019 1777.665 62 15092.866 0.093 1403.637
20 91783.654 0.020 1835.673 63 13689.230 0.095 1293.632
21 89947.981 0.021 1888.908 64 12395.598 0.096 1189.977
22 88059.073 0.022 1937.300 65 11205.620 0.098 1092.548
23 86121.773 0.023 1980.801 66 10113.072 0.099 1001.194
24 84140.973 0.024 2019.383 67 9111.878 0.101 915.744
25 82121.589 0.025 2053.040 68 8196.134 0.102 836.006
26 80068.550 0.026 2081.782 69 7360.129 0.104 761.773
27 77986.767 0.027 2105.643 70 6598.355 0.140 923.770
28 75881.125 0.028 2124.671 71 5674.586 0.142 805.791
29 73756.453 0.029 2138.937 72 4868.794 0.144 701.106
30 71617.516 0.030 2148.525 73 4167.688 0.146 608.482
31 69468.990 0.031 2153.539 74 3559.206 0.148 526.762
32 67315.452 0.032 2154.094 75 3032.443 0.150 454.866
33 65161.357 0.033 2150.325 76 2577.577 0.152 391.792
34 63011.032 0.034 2142.375 77 2185.785 0.154 336.611
35 60868.657 0.035 2130.403 78 1849.174 0.156 288.471
36 58738.254 0.036 2114.577 79 1560.703 0.158 246.591
37 56623.677 0.037 2095.076 80 1314.112 0.240 315.387
38 54528.601 0.038 2072.087 81 998.725 0.243 242.690
39 52456.514 0.039 2045.804 82 756.035 0.246 185.985
40 50410.710 0.040 2016.428 83 570.050 0.249 141.943
41 48394.282 0.041 1984.166 84 428.108 0.252 107.883
42 46410.116 0.042 1949.225 85 320.225 0.255 81.657
43 44460.891 0.043 1911.818 86 238.567 0.258 61.550
44 42549.073 0.044 1872.159 87 177.017 0.261 46.201
45 40676.914 0.045 1830.461 88 130.816 0.264 34.535
46 38846.453 0.046 1786.937 89 96.280 0.267 25.707
47 37059.516 0.047 1741.797 90 70.573 0.270 19.055
48 35317.719 0.048 1695.250 91 51.519 0.273 14.065
49 33622.468 0.049 1647.501 92 37.454 0.276 10.337
50 31974.967 0.050 1598.748 93 27.117 0.279 7.566
51 30376.219 0.051 1549.187 94 19.551 0.282 5.513
52 28827.032 0.052 1499.006 95 14.038 0.285 4.001
53 27328.026 0.053 1448.385 96 10.037 0.288 2.891
54 25879.641 0.054 1397.501 97 7.146 0.291 2.080
55 24482.140 0.055 1346.518 98 5.067 0.294 1.490

56 23135.622 0.056 1295.595 99 3.577 1.000 3.577
57 21840.028 0.057 1244.882 100 0.000
The above life table shows the estimated number of deaths at every age. The
table is used to determine the premium rates.
Example
An insurer wants to sell 5-year temporary assurance products to lives aged 40,
and he uses the above life table in respect of mortality experience. If we ignore
all expenses of the insurer, the pure net premiums would be determined for a
sum assured of Rs. 1000 in the following way:
Equation of Value:
Present value of Single Premium = Present Value of Benefits (we ignore rate of
discount)
[1000 x (d40 + d41 + d42 + d43 + d44)] / l40 =
[1000 x (2016.428 + 1984.166 + 1949.225 + 1911.818 + 1872.159] / 50410.710
SP x l40 = 1000 x (d40 + d41 + d42 + d43 + d44)

SP = [1000 x (d40 + d41 + d42 + d43 + d44)] / l40
= [1000 x (2016.428 + 1984.166 + 1949.225 + 1911.818 + 1872.159] /
50410.710
= 193.10
If we receive single premium from each of l40 lives, the total premium receipt
should be equal to total death benefits.
In the above example, if we assume an effective rate of interest of 10% p.a.,

the benefits would have to be discounted in the equation of value.
The formula for SP would be = 1000 x [d40 v + d41 v2 + d42 v3+ d43 v4+ d44 v5] / l40
Where ‘v’ is 1/1.10 and the death benefit is payable at the end of policy year in
which death took place.
SP = [1000 x (2016.428/1.10 + 1984.166/ (1.10)2 + 1949.225/ (1.10)3 +

1911.818/ (1.10) 4 + 1872.159/ (1.10) 5] / 50410.710
= 146.9066
If we receive single premium from each of l40 lives, and earn a return of 10%
p.a. on single premium, the total premium receipt should be equal to total
death benefits.

We can display this in tabular form too:
Table 1.2
No. of Premium Claim

Age Total fund Balance
Lives Income amount
40 50410.710 7405666.01 8146232.61 2016428.00 6129804.61
41 48394.282 6742785.07 1984166.00 4758619.07
42 46410.116 5234480.98 1949225.00 3285255.98
43 44460.891 3613781.58 1911818.00 1701963.58
44 42549.073 1872159.93 1872159.00 0.93
45 40676.914
Notes:
Premium Income = 50410.710 x 146.9066

Total Fund = Premium Income x (1.10) in the first year;
‘Balance’ * 1.10 in the 2nd, 3rd, 4th, and 5th years
Claim amount = no. of deaths at each age x 1000.
You would observe that the money accumulated at the end of each policy year
is more than the claim amount, and in the 5th policy year, total fund is just
enough to meet the claim.
We can calculate the Annual Premium too in this contract. The present value of
annual premiums should be equal to the single premium received at the outset:
SP x l40 = AP x [l40 + l41 + l42 + l43 + l44], if we ignore interest.
AP = SP x l40 / [l40 + l41 + l42 + l43 + l44]
If receive annual premiums from all lives at ages 40, 41, 42, 43, and 44 the
total premium receipt should be equal to the total value of benefits payable on
death.
Test Yourself 1
In an insurance company, a single decrement life table is used in calculation of

premium in which of the following methods?
I. Cash flow method

II. Calculation method
III. Formula method
IV. Premium method

B. Formula method
In this method, actuarial formulae are used. Fundamental principle is the

equation of value:
Present value of premiums (Receipts) = Present value of benefits (Outgo) +

Present value of expenses (Outgo).
In actuarial formulae, commutation functions are used which would take into
account of probability of death (survival) and discount rates. This presumes use
of a life table with single or multiple decrements.
Usually single decrement table is used. In Life table, we have:
X = Age
lx = Number of survivors at age x
dx = Number of deaths from exact age x to exact age x+1
Deaths are determined using a set of mortality rates
(Mortality rates used are based on past experience and are standardized for the
purpose of determination of reliable realistic premium rates; ‘qx’ is the symbol
used to denote the probability of a life aged x would die before attaining age
x+1.)
1. Formulae are:
lx = Number of survivors at age x

qx = Probability of death of a life aged x in a year
dx = lx x qx
lx+1 = lx - dx
dx = l x - lx+1
Obviously, total deaths in a life table must be equal to the number of lives at
the start age.
Thus, lx = d x + d x+1 + d x+2 + ………………

Since q x = d x / l x ; q x = (l x - lx+1)/ l x = 1 - l x+1 / l x = 1 - p x
Where p x is referred to as probability of survival.
It is obvious: 1 = p x + q x.
If we have a set of mortality rates (q x), we can construct a life table.

2. Commutation functions
Dx = vx x lx
Cx = vx+1 x dx
Nx = Dx + Dx+1 + Dx+2 +...........
Sx = Nx + Nx+1 + Nx+2 +...........
Mx = Cx + Cx+1 + Cx+2 +...........
Rx = Mx + Mx+1 + Mx+2 +...........
Where v is 1 / (1 + i); i is the rate of interest used.
Ax = Mx / Dx ;
äx = Nx / Dx ;
ax = Nx+1 / Dx
Ax: n‫ך‬ = (Mx - Mx+n + Dx+n) / Dx
äx:n‫ך‬ = (Nx - Nx+n ) / Dx
ax: n‫ך‬ =(Nx+1 - Nx+n+1 ) / Dx
1
A x: n‫ך‬ = (Mx - Mx+n ) / Dx
1
Ax: n‫ך‬ = Dx+n / Dx
For all lives at entry age x (exact age x):
a) Ax is the present value of benefit of 1 payable on death at any age after

x.
b) Ax: n‫ ך‬is the present value of benefit of 1 payable on death at any age
after x but before x+n, and also 1 on age x+n if alive.
c) A1x: n‫ ך‬is the present value of benefit of 1 payable on death at any age
after x but before x+n.
1
d) Ax: n‫ ך‬is the present value of benefit of 1 payable on survival at age
x+n.
1 1
Ax: n‫ך‬ = A x: n‫ ך‬+Ax: n‫ך‬
Is the present value of 1 payable every year to a life aged x as long the
äx life is alive (the first payment of 1 is paid at the commencement of
contract).
äx:n‫ך‬ life is alive before age x+n (the first payment of 1 is paid at the
commencement of contract).
ax life is alive (the first payment of 1 is paid at the end of year 1 from
commencement of contract)
ax:n‫ך‬ life is alive before age x+n (the first payment of 1 is paid at the end of
year 1 from commencement of contract).
3. Various types of contracts that can be entered into are as follows:
a) Whole life contracts
Px = Ax / äx
Px is the Premium payable every year by a life whose age at entry is x, as

long as he is alive.
Suppose the premiums are payable for a limited period of n years in this
contract, then
Px = Ax / äx: n‫ך‬
Suppose the premium is payable only once as lump sum at the beginning of
the contract as Single Premium in this contract, then
SP = Ax
b) Term assurance contracts
Where premiums are payable every year for n years, then:
Px = A1x: n‫ך‬/ äx:n;‫ך‬
SP = A1x: n‫ך‬
c) Pure endowment contracts
Where premiums are payable every year for n years, then:
Px = Ax: n‫ך‬1/ äx:n‫ך‬
SP = Ax: n‫ך‬1
d) Endowment assurance contracts
Where premiums (each P x:n‫) ך‬are payable every year for t years, then:
P x:n‫ = ך‬Ax: n‫ך‬/ äx:t‫ך‬
SP = Ax: n‫ך‬
e) Annuity contracts
i. Deferred annuity contracts
Where premiums (each P x) are payable every year for t years, then:
P x = (Ax: n‫ך‬1 x ax+n)/ äx:t‫ך‬
SP = (Ax: n‫ך‬1 x ax+n)

Where n is the deferment period.
Here, first part represents the survival payment at the end of n years and
second part represents annuity payments whole life after year n.
ii. Immediate annuity contracts
The premium is payable only once as lump sum at the beginning of the
contract as Single Premium in this contract, then
SP = ax
Note: In all the above we have ignored expenses such as commission to agents,
and insurer’s administration expenses at inception and later in the first year,
and every year during the period of contract, and settlement costs that may be
incurred to pay benefits.
4. Limitations
Some of the limitations of formula method are as follows:
a) Formulae are very rigid and do not consider other risks while calculating
premium.
b) Formulae are constant for many years; various economic changes are not
considered while framing the formulae.
c) This method cannot be used to price products with diverse and complex
benefits like unit linked product. For such type of product cash flow
method is used as described below.
There are more limitations of formula method which are also the strength of
cash flow method which is discussed later in the course.

Earlier, there were less computational power and hence formula method was
used. With the ever increasing speed of computational power cash flow method
of pricing has gained remarkable popularity. Now complex models and tools are
available which can project all the cash flows of the product for all future
years. As a results formula method is not used now and where it is used it is
used just as an indicator of premium to start with. Then the resultant premium
is profit tested using cash flow model and using the discount rate as risk
discount rate to see if it satisfies the profit criteria.
Test Yourself 2
Determine the notation that is used for the present value of 1 payable every
year to a life aged x as long the life is alive before age x+n (the first payment of
1 is paid at the end of year 1 from commencement of contract).
I. Ax: n‫ך‬
II. äx
III. äx:n‫ך‬
IV. ax:n‫ך‬

C. Expenses
1. Office premiums
When we load expenses in the premium calculations, such premiums are called
Office Premiums. Suppose we wish to calculate Office single premium for an
Endowment assurance product, then this is:
Present value of benefits + Present value of expenses
If sum assured is 1,
SP = Ax: n‫ ך‬+ 0.02 SP + I + K Ax: n‫ ך‬+ c ax: n-1.‫ך‬
0.02 SP is the Commission payment

I is the ‘initial expenses’
K is the amount of expenses on settlement of claim of unit amount
C is the amount of renewal expenses p.a.
Similarly, Annual premium could also be determined.
AP = Ax: n‫ ך‬+ 0.40 AP + I + K Ax: n‫ ך‬+ c ax: n-1‫ ך‬+(0 .01 r AP) ax: n-1‫ך‬
AP is Annual premium;
0.40 AP is the commission payment in the first year

K is the amount of expenses on settlement of claim of unit amount
C is the amount of renewal expenses p.a.
(0 .01 r AP) is the renewal commission payable p.a.
Same principles would apply for other types of contracts.
2. Commission
Every insurer would have a predetermined set of commission scales which are
paid to agents and other intermediaries.
For such a determination, the insurer might refer to legislation on insurance and
to industry practices.
An insurer would have some policy on insurance commission which is

determined before for the procurement of business.
Commission is related to premium, usually, as r% in the first year, r1% in year 2

and later.
Where premiums (each P x) are payable every year for n years, then:

Present Value of Commission payments =
C = 0.01 r Px + (Dx+1 / Dx) x 0.01 r1 Px äx+1:n-1‫ך‬
(Dx+1 / Dx) is the survival probability after one year.
Suppose the premium is payable only once as lump sum at the beginning of the
contract as Single Premium in this contract, then
C = 0.01 r Px
If commission payments are of varying nature, they have to be valued

differently.
3. Initial expenses
Every insurer would incur expenses to procure business. These are fees paid to
medical examiners, fees to labs for reports, expenses for making
advertisements, expenses for underwriting and other administration costs
(preparation of policy document, issue of first premium receipt cum acceptance
letter, stationery, postage, premium notices and cost of collection of premiums,
if any, in the first year etc.), etc.
Initial expenses are broadly represented as fixed per policy expenses, premium
based or sum assured based. Since these are incurred at time of sale of policy
present value is equal to expense itself.
Present value of initial expenses = I
4. Renewal expenses
Every insurer would incur expenses to retain/maintain business. These are

usually administration expenses.
These expenses are related to (a) premiums, (d) Per policy.
If renewal expense is c p.a. for a period of n years and expense is incurred at

the beginning of each policy anniversary;
Present Value of Renewal Expenses = c ax: n-1‫ך‬
The present value of expenses related to premium will be calculated in a similar

way as present value of commission discussed above.
5. Claim expenses
Every insurer would incur expenses to settle claims. In case of early claims,
there would be investigation expenses to verify the genuineness of claim.
In some cases, the insurer has to bear litigation costs (lawyer’s fee, court fees,
etc.).
This expense is usually related to the benefit payment, such as X% of benefit

amount. It is not unlikely that it could be a fixed amount too. Suppose the
Claim Expense is e which is incurred at death or maturity, then:
Present Value of Claim Expenses = e x [A factor-- Ax: n‫]ך‬
All these expenses present value together with the desired profit present value
is also equated with premium along with cost of benefit.
General Comments
Certain expenses cannot be foreseen, for instance, escalation of various costs

for running the business, salary costs, investment expenses, penalties imposed
by courts in certain instances.
Any change in insurance legislation, or in tax laws, or in any other law, could
have effect on insurer’s expenses. In case of with profit contracts, it would be
not unreasonable to load margins for profits for shareholders.

D. Cash flow method
In a cash flow method, premium is determined using expected income and

expected outgo so that at an optimum premium or charges or guaranteed
additions, there would be profit.
This is explained in detail now.
1. Stages in cash flow method
In a cash flow method, the following are the stages:
a) Assumptions: These we will discuss in later chapters.
i. Premium is assumed, say, P1, (an arbitrary figure per 1000 SA) at a given
age x, for a given policy term.
ii. Life table is assumed (as explained above) in order to know expected
premium income and expected claim amounts.
iii. A set of commission rates (usually related to premium)
iv. Initial expenses
v. Renewal Expenses
vi. Investment returns
vii. Other assumtions
b) Expected Income for each policy year is determined
c) Expected Outgo for each policy year is determined
d) Net Cash Flow is determined for each policy year (profit)
e) Present Value of Net Cash Flow is determined at a risk discount rate

(which is the rate of return shareholders expect) – if this is made to
zero, it is the expected rate of return on such policy.
f) Item (e) is calculated for a base scenario (based on the best estimates of
assumptions); an optimistic scenario (based on the most favorable
assumptions—all growth), a pessimistic scenario (based on the most
unfavorable assumptions – all adverse).
g) Conduct profit testing
Hence, two interest rates are used, one is pricing interest rate used as
investment return on the assets and other is risk discount rate used to discount
the cashflows.
Profit testing: This is a process of testing the resultant premiums to see it

satisfy set profit criteria.

Pricing?
It was discussed in previous chapter on pricing that it is not only finding the
premiums as is generally understood. Pricing involves determining all of these
variables:
 Premiums, guaranteed additions and bonuses – traditional products
 Charges – Unit linked
 Others variables, as per product design
Cost of reserves and solvency capital:
Cost of benefits also include another important component refer to as present

value of change in reserves. Reserves are required to be kept as liability to
ensure that company is able to meet the claims as it arises. These are normally
invested in or backed by secured assets for traditional type of products and in
assets desired by policyholders in case of unit linked products.
These assets earn less than what is required by the shareholders, for example, if
assets are earning 9% per annum and risk discount rate is 12% per annum then
there is a cost of holding reserve for shareholders. This cost will be 3% return
lost as a result of holding the reserve. This cost should also be considered while
deciding the price.
Cost of reserving is also included in the expected outgo by taking change in

reserve as an item in expected outgo.
Similar to the cost of reserve there is one component of cost of capital that will
be tied up because of policy being inforce. That capital will also earn lower
amount ten risk discount rate and hence will be a cost. This capital needs to
support the solvency of the company and is required as per the IRDAI
regulations. There are also investment restrictions for the investment of this
capital.
The consideration of cost of capital in pricing is similar to the cost of reserve by

taking change in capital as one of the item of expected outgo.
Here we can distinguish between what we might refer to as physically real

cashflow, and notional cashflow. The real cashflow includes, primarily:
premiums and investment income as positives (from the company’s
perspective); payments to policyholders, commission to agents, expenses and
tax as negatives.
If there is a supervisory requirement to hold reserves (this can be safely

paraphrased as “always”) then the life insurance company will need to fund the
establishment of these reserves. This is done by contributing money to reserves
from the cashflow or, initially, from the company’s free assets or other source
of capital; this item is the “increase in reserves” and is a negative from the
company’s perspective. At maturity or earlier claim the reserves will be

released to help pay the appropriate policyholder benefit; this will be a
“decrease in reserves” (or “release of reserves”) and will be positive. These
flows are examples of notional cashflow, i.e. where the flow does not involve a
physical exchange of money. The real and notional cashflows together combine
to form the profit flow. The investment income from the supervisory reserve
will also be included as a positive contribution to the profit flow.
Profit Criteria:
A profit criterion is often a single figure that tries to summarize the relative
efficiency of contracts with different net cash flow streams. By applying a profit
criterion to different contracts with different profit signatures and ranking the
results in order, it may be possible to say with confidence which contract makes
most efficient use of a company’s capital.
The net cash flow stream of a contract is the sequence of net cash flows (profit)
over time from inception to termination. You would normally present it
graphically. It is also known as profit signature. This is itself is the “definitive
guide” to a product’s profitability but is unwieldy to use (especially when
comparing different products), and to present.
Among the profit criteria that could be used are:
 Net present value, expressed in different ways (NPV or profit margin)
Discounting the profit signature at the risk discount rate produces a “net
present value”. Given a choice between the future cashflows from two different
investments, economic theory states that an investor should choose the one
with the higher net present value. This choice is optimal, and cannot be
bettered. Another way to put this is that the first priority for the managers of
any company is to maximize the net present worth of the company.
This implies that net present value is the best profit criterion to use, and that if
any other profit criterion disagrees with it a company should go with the net
present value.
One approach is to express net present values in a way that reflects the effort
that would be expended on selling a policy. One such measure is the amount of
initial commission that rewards the salesperson.
However, the market for any insurance product is finite, and any one company
can probably capture only a small share of that total market. The policyholder
measures the cost of insurance in terms of the premiums that he or she pays,
and industry trade associations often measure the size of market in terms of the
premium income of insurance companies, among other things. So another useful
measure of profit is in terms of the premium income, since this relates to the
size of the market.
The net present value can, therefore, be expressed as a percentage of the
present value of the premiums that will be paid under the policy. This is usually

referred to as profit margin. All other things being equal, if a company can sell
the same volume of premiums, i.e. capture the same market share, for a higher
net present value then it should aim to do so.
 Internal rate of return (IRR)
This is defined as the rate of return at which the discounted value of the
cashflows is zero. All other things being equal, a company should prefer a
contract that has a higher internal rate of return. However, the internal rate of
return does not always agree with net present value.
Some of the limitations of using IRR and advantages of using NPV are:
o If there is more than one change of sign in the stream of profits in the
profit signature, the internal rate of return will not usually be unique.
o The net present value can be related to useful indicators of the policy's
worth to the company, in terms of sales effort or market share. There is
no way to do this with the internal rate of return.
o If a policy makes profits from the outset then the internal rate of return
may not even exist. The net present value always exists, however.
 Discounted payback period.
The discounted payback period is the policy duration at which the profits which
have emerged so far have present value zero, ie it is the time it takes for the
company to recover its 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.
Decision making?
Of the three criteria examined, the net present value is the most frequently
used. Its advantages over the internal rate of return have already been
mentioned. The discounted payback period does not by itself contain much
information.
A common approach would be to use the net present value (expressed in terms
of present value of premium) as the prime criterion, and also to make reference
to the discounted payback period. Hence, for a given net present value, you
would choose the product design which had the shortest discounted payback
period. The discounted payback period is therefore more use as a criterion in
product design than in product pricing, though in practice the two things (ie
design and pricing) would very often be performed at the same time, using the
same models.

2. Advantages of cashflow method:
Cashflow method has the following advantages which makes this method the
best choice of industry:
 It enables a company to measure the expected return that the providers of

capital will receive, or for with-profits contracts the expected contribution
to the free assets.
 The sensitivity of the profit to variations in experience can be investigated
so as to determine appropriate margins for the parameter values.
 The need to set up reserves and meet solvency requirements can be
explicitly allowed for.
 The cashflows can be used to assess the financing requirements for a new
contract
 The method can allow more easily for withdrawals and conversions to paid-
up.
 It can more easily cope with complex charging and benefit structures, in
particular where charges and benefits depend on future assumptions.
 It is easier to incorporate assumptions that vary over time.
 The risk discount rate can take account of the term structure of interest
rates.
 Tax can be allowed for more appropriately.
3. Limitations
Some of the limitations of cash flow methods are as follows
 This method is time consuming and costly as compared to formula method.
 There is a saying in the world of finance: "Garbage in; garbage out." That is,
the data you put into a financial model must be reliable in order for the
data output to be useful. In other words, the cash flow model is only as good
as the analyst building it.
 One cannot generalise the premium rates of all insurance products, which is
possible in formula method.
Test Yourself 3
Which of the following is assumed in the cash flow method?
I. Present value of net cash flow

II. Set of commission rates
III. Expected income for each policy year
IV. Expected outgo for each policy year

Summary
a) There are two known methods of determination of price:

i. Formula method: In this method, actuarial formulae are used.
Fundamental principle is the equation of value:
Present Value of Premiums (Receipts) = Present Value of Benefits (Outgo) +

Present Value of Expenses (Outgo).
Commutation functions are used to calculate premium.

ii. Cash flow method: In cash flow method, expected incomes and outflows
are projected into the future, and the best premium rate is determined.
Many types of expenses are taken into consideration, like initial expenses,
commission expenses, renewal expenses etc.
b) Present value of Ps = Present value of S + Present value of E(t)s
P = Premium
S = Sum assured
E(t)= Expense incurred in year t
c) Cost of reserving and solvency are important components of price.
d) Profit criteria used are net present value, Internal rate of return and
discounted pay back period.
e) Both methods have limitations and advantages but, cashflow method is now
mostly used.

Answer 1

In an insurance company, a single decrement life table is used in the formula
method of determination of premiums.
Answer 2

ax:n‫ ך‬is the present value of 1 payable every year to a life aged x as long the life
is alive before age x+n (the first payment of 1 is paid at the end of year 1 from
commencement of contract).
Answer 3

For computation of commutation functions, we need a life table and also a set
of interest rates.
Question 1
In life insurance product pricing, deaths are determined using a set of ________
I. Morbidity rates
II. Mortality rates
III. Combination of morbidity rates and mortality rates
IV. 50% morbidity rates and 50% mortality rates
Answer 1
In life insurance product pricing, deaths are determined using a set of mortality
rates

CHAPTER 6
TYPES OF INSURANCE PRODUCTS – GROUP

Insurance products can also be sold to a group of individuals. When sold to a

group, they are beneficial for the insurers as well as the buyers. Insurers can
benefit from higher sales and buyers benefit from reduced costs.
Group insurance products are distinct in many aspects when compared to other
insurance products. This chapter discusses the types of group insurance
products and their distinctive features.
Learning Outcomes
A. Features of group schemes

B. Types of group schemes
C. Pricing of Group Insurance Products
Life Insurance Corporation is a pioneer in life insurance products. The company

is a market leader in sales of individual as well as group insurance products. The
company offers competitive premium rates. It is also sensitive to the needs of
the market and regards customer satisfaction highly.
The company representative was asked to share his views about the company’s
success in group insurance category. He mentioned that group insurance
products are distinct in nature as they pay specific attention to the
requirements of a group of individuals and customised accordingly. He added by
saying, the need for such products stems from the fact that the common needs
of individuals can be addressed collectively by such products. These products
are also preferred by the insurers as they contribute to profitability and sales.
In this chapter we will learn about the features of group schemes and the types
of group schemes offered by insurers in the market. We will also touch upon the
pricing of group products.

A. Features of group schemes
Group insurance involves providing insurance to a group of individuals who share

some common attribute, through a single policy contract. Group insurance
policies offer life insurance protection to all types of groups such as:
a) Employer-employee groups
b) Professionals
c) Cooperatives
d) Weaker sections of society
e) Creditor – debtor group etc
Insurance coverage is provided for people as long their occupations are

approved and the rates of payable premium are fairly subsidised under social
security group schemes.
Group insurance plans may be of two types: contributory or non-contributory.

The employer either pays the premiums, if the plan is non-contributory, or
collects the funds through payroll deductions and advances the funds to the
insurance company if the plan is a contributory plan. Where the employer pays
the premiums for all employees (the non-contributory plan) it is assumed all
employees will participate. If the employee contributes to the premiums (the
contributory plan), some employees may not wish to participate because they
do not feel they can afford the smaller paycheck or because they have coverage
elsewhere.
A few of the key features why group insurance schemes are more advantageous
are:
 Low rates of payable premium that are based upon the ages,
combinations of members, occupations and working conditions.
 Simple insurability conditions such as employees not being absent from
duty owing to ill health at the commencement of the policy period.
 Easy administration since a single master policy is issued to cover all the
employee members.
The most important conditions for granting a group insurance policy that matter
to the insurance corporation are a requisite minimum group size and a minimum
participation number. As long as the "group" was not formed for the purpose of
obtaining insurance, almost any kind of group qualifies for group coverage.
How is Group Insurance beneficial to the Individual:
Group insurance plans have low premiums. Such plans are particularly beneficial
to those for whom other regular policies are a costlier proposition. Group
insurance plans extend cover to large segments of the population including
those who cannot afford individual insurance. As such the premia you need to

pay is comparatively lower and at the same time you can avail of insurance
benefits.
Insurers are able to provide relatively low-cost group coverage because of the
expense savings inherent in the operation of group insurance policies. These
savings result from the fact that the expenses an insurer incurs in administering
a group insurance policy are much lower than those incurred in administering
individual polices. Of course, the cost of administering one group insurance
policy is usually higher than the cost of administering one individual policy, but
the cost of administering one group insurance policy covering 50 people is lower
than the cost of administering 50 individual policies. For example, underwriting
and policy issue costs are generally lower for group insurance because the
insurer usually underwrites the group as a whole rather than each individual
member, and it issues a master policy rather than many individual policies. In
addition, sales costs are much lower for one group policy than for a number of
individual policies. Expenses are also lower because the group policyholder
often handles many of the clerical duties that the insurer must perform for each
individual policy.
Basic Features of Group Insurance:
Group Insurance vs. Individual Insurance:
 Individual Insurance is a contract between the individual and the

insurance Company (insurer). The decision to insure is voluntary and the
terms on which the insurance cover is granted depends upon the
appraisal of risk in respect of the individual by the insurance company.
 Group Insurance implies one contract covering a group of lives. The
terms on which insurance cover is granted depend upon the
characteristics of the group as a whole.
 A Master Policy is issued incorporating the contract between the
insurance company on the one hand and a legal entity like Employer,
Trustees, Association etc. on the other hand defining the group of lives
to be covered, benefits, contributions and terms and conditions on which
the contract is entered into.
 The underwriting unit is the group of lives, i.e. there is a group
selection of risks. The amount of cover is determined on the basis of a
formula and is not decided by individuals forming the group. Insurance
on the life of all members up to a limit called "Free Cover limit" is
granted on the basis of simple rules of insurability (e.g., "Not absent
from duty on grounds of sickness on the date of effecting insurance"
etc.) and no evidence of health is usually called for.
 Mass administration and simple underwriting practice result in low cost
of insurance for the group.
 The premium rates of a Group Scheme are adjusted periodically on the
basis of experience. This feature is known as 'Experience Rating'. For
medium and big sized groups, sharing of profits on the basis of actual
experience is a normal feature.
General characteristics of 'group' for 'Group Insurance':
i. The group is treated as an underwriting unit.

ii. Insurance must be incidental, i.e. the group must not be formed mainly
for the purpose of obtaining insurance.
iii. The group must have a single central administrative machinery to act on
behalf of all members.
iv. The group should be such that there is a steady stream of new entrants
from year to year, so that the group is not stagnant and is not likely to
lapse as a result of depletion of members. This feature also ensures that
an undue proportion of members of the group are not aged or impaired.
v. Another condition required for treating the group as an underwriting unit
is that a large proportion of eligible persons must join the scheme. This
would ensure that no adverse selection is exercised against the insurance
company and the proportion of impaired lives in a group is not unduly
high.
vi. A minimum size of the group is generally prescribed.
The most common contracts are group insurance contracts under which a death
benefit is paid. Others are
i. Superannuation schemes: Here the contributions are pooled in a fund

and benefits are paid out of fund in the form annuities
ii. Gratuity schemes: This is also similar to superannuation scheme, but

benefits are fixed and specified
iii. Savings linked insurance schemes: Where both insurance and savings
benefits are provided to members.
Different types of groups:
(i) Employer-employee Groups:

Here, the employer takes out a Master Policy for the benefit of his employees.
The Master policy may be taken out in the name of the employer or Trust
formed to administer the scheme.
Many Group Schemes for the employer-employee groups are taken out by the
employers to meet their statutory and other liabilities, such as, employees'
gratuity benefits, pension benefits and benefits under EDLIS (Employees' Deposit
Linked Insurance Scheme in connection with PF).
If the scheme is non-contributory, i.e. where the employees do not contribute

and the employer bears the full cost, all eligible employees must join the
scheme. If the scheme is contributory, i.e. where the employees also contribute
and the employer bears part of the cost, a high level of participation by the
eligible employees at commencement and compulsory participation of all new
employees thereafter is essential.

(ii) Creditor-Debtor Groups:
The Master policy is taken out by the creditor to cover the outstanding amount
of loans granted to debtors. In case of death of a debtor, the claim amount
would be applied towards repayment of loan outstanding in his/her name. Here
the creditor may be an employer, an organization giving housing loans, a co-
operative credit society, etc.
(iii) Professional Groups:

These may be Associations of professionals like Doctors, lawyers, Accountants,
Engineers Journalists, Pilots, etc.
(iv) Others, such as cooperative, weaker section of society etc.
Test Yourself 1
Which of the following can be treated as groups for the purpose of insurance
contract?
1. A group of persons residing in a housing colony—where some of them are

tenants.
2. A trade union of taxi drivers in a city, e.g. Mumbai.
3. The members of a professional group, such as Institute of Chartered
Accountants of India.
4. The parents of students of a school.
I. Options 1 and 4
II. Options 2 and 3
III. Options 1 and 2
IV. Options 3 and 4

B. Types of group schemes
1. Insured group schemes
Definition
An insured group scheme is a group product (group contract) designed and

offered by insurer.
2. Types of group insurance contracts
The following are group insurance contracts offered by insurers:
a) Group term insurance contract
In this, each individual member is a life assured on whose death a specified

amount of sum assured is payable, if the death occurs during the period of
contract. Premiums are charged depending upon age, health, occupation,
and type of group.
b) Group health insurance contract
In this, each individual member is a life assured on whose if specified event

happens, a specified amount of sum assured is payable, if it occurs during
the period of contract. Premiums charged depend upon age, health,
occupation, and type of group.
c) Group gratuity contract

Usually the benefit is payable on death, resignation, or retirement; and the

benefit is related to the length of service and salary of individual member.
Example
Gratuity can be calculated as 0.5 x n x Sx

Where,
i. n is total length of service in completed years,
ii. Sx is salary (entitled amount) on date of cessation of service
iii. 0.5 is a fraction applied on salary for each year of service and the fraction
can vary for instance 15/26 at cessation of service with the employer.

d) Group superannuation (pension) contract

happens, a specified amount of benefit is payable, if it occurs during the
period of contract. Premiums charged depend upon age, health, occupation,
and type of group. Usually the benefit is payable on death, resignation, or
retirement; and the benefit is related to the length of service and salary of
individual member (e.g. 0.05 x n x Sx --- where n is total length of service in
completed years, Sx is salary (entitled amount) on date of cessation of
service, where 0.05 is a fraction applied on salary for each year of service)
at cessation of service with the employer.
e) Group savings linked insurance contract

Usually the benefit is payable on death, resignation, or retirement and the

benefit is a fixed amount in case of death and is payable only on death; and an
additional benefit is the accumulated amount of contributions (premiums
allocated to savings element) on the date of cessation of service. Death Benefit
can be in form of higher of specified fixed deals sum assured on policy accent
value whichever is higher.
There can be any other group contract designed either by insurer or by the
group policyholder.
In an insured group contract, the contract is basically between the insurer and
group policyholder. All the terms, conditions, and rates offered by insurer are
between the insurer and the group policyholder. The insured individual member
is not a party to the contract; he is only a life assured on whose life insurance is
taken by the group policyholder. Insurer does not deal with individual members,
and he only deals with the group policyholder, legally speaking. However, under
new regulation group saving linked contract is like a collection of individual
policies under a single master policy wherein individual member can enter
their individual policy on exist from master policy or enclosure of master policy.
Test Yourself 2
Which of the following is not a type of group insurance contracts offered by

insurers?
I. Group Gratuity Contract
II. Group Savings Linked Insurance Contract
III. Group Health Insurance Contract
IV. Group Benefit Contract

C. Pricing of Group Insurance Products
Pricing of Group Insurance Products:
The concept of insurance lies in spreading the risk. In Individual pure term
policies, the policyholder pays the premium for given sum coverage (sum
assured) and Insurer agrees to pay the sum assured in case the event happens as
per policy terms and conditions. In individual policies individual contracts
(containing the policy schedule, policy terms and conditions and other
documents) are issued. The group insurance is also not different. The
difference is that in group policies, a group of people are covered under a single
policy. This single policy is known as master policy and policy schedule and
master policy terms and conditions are not agreed with each member of the
group. Instead the master policy contract is between Insurer and master policy
holder. Thus the main attraction of group insurance is the ability to cover large
number of individuals in a cost efficient manner. Group insurance is cost
efficient because of the reasons- proportionally lower commissions to sales
intermediaries, lower acquisition expenses, by its nature pre-empts the need
for individual underwriting, makes use of a single contract with the plan sponsor
instead of having to issue individual policies to each member. In group business,
premiums are collected efficiently through payroll deductions or a single
payment from the employer. The insurance cover also has relatively simple data
requirements e.g. there are no cash values per employee and there is no need
for seriatim valuation (individual member wise valuation of liabilities).
The basic concept of group insurance is same for employer-employee group, non
employer employee group, voluntary group or group covered under Government
scheme(s). Other groups, such as multi-level sales associations, students’ group
or parents of students group, members of clubs or other organizations,
purchasers of certain items such as cars, credit cards also do exist. Post
liberalisation of insurance in India in 2000, the group insurance business has
become very complex. Following is the description for standard groups, however
fundamental remains the same for other groups.
Various Groups:
The concept of group insurance developed due to some of the employers’

parental approach towards their employees and availability of insurance in cost
effective manner. The employers had basic need to support the family of an
employee who deceased very early in his/her career. In initial years of their
career the employees could not save much and so life insurance cover as lump
sum amount came as rescue to the family members.
In later years the group insurance developed in India as solution provided by LIC
of India to various government schemes. Now private life insurance companies
have also joined their hands in line of LIC Of India or more options provided.
LIC of India provided group insurance solution to Act Employees deposit linked
insurance or covering outstanding loans provided by the employers to their
employees or used it as a tool to offer coverage to employees’ superannuation
schemes and group gratuity schemes. In whatever form the group insurance
solution is provided, the fundamentals of group insurance remain same.
Since group insurance was adopted first for employer –employee groups. The
concepts for group insurance in following section has been explained for
employer-employee group however as mentioned earlier these concepts would
be applicable for all types of group insurance- be it creditor-debtor groups,
professional group, voluntary groups or government sponsored groups, etc.
Employer-Employee Group
The subject is vast and so all the aspects may not be explained in depth
however fundamentals have been explained which may be applied to any group
and any variation in operation of group insurance business may be explained
using the fundamentals given. Group life insurance, within certain restrictions
and conditions, provides insurance to members of a group without requiring
evidence of insurability from majority of the members. There is a single policy,
called the master policy or master contract, a contract between the insurer and
the plan sponsor. Individual group members may also be provided with
“certificates of insurance” that outline the detail of the insurance cover. Other
variation in employer employee group may be of multiple employers, however
such group do not exist in India.
Some terms associated with Group Insurance have been explained below:
Evidence of Insurability- There may be typical requirement of evidence of

insurability. In employer –employee group insurer may put simple insurability
condition e.g. the member who joins the scheme should not be on sick leave on
date of joining. This is to avoid selection against the insurer by the sponsor and
also known as avoiding anti-selection. This condition of simple insurability is
laid down by the insurer since it is difficult to ascertain the mortality risk in a
group especially where there is no mortality experience available for the group.
The mortality risk is that insurer (Insurance Company) expects say ‘n’ deaths in
the group but in actual the deaths are more than ‘n’.
OYRGTA- Group insurance typically consists of one-year renewable term life

assurance (OYRGTA) that pays a fixed benefit to nominee (s) upon the death of
the employee. There are usually no exclusions for the basic life cover other
than for suicide in the first year of cover. The exclusions may be applicable for
riders attached with the group insurance basic contract. At the end of the
coverage year, the insurance automatically renews without employees having to
provide evidence. However the premium paid may be revised.
Riders- Riders are as add on to the base policy. IRDA (Protection of

policyholders’ interests) Regulations, 2002 states – The rider or riders attached
to a life policy shall bear the nature and character of the main policy, viz
participating or non-participating and accordingly the life insurer shall make

provisions, etc. in its books. The availability of various supplementary riders to
the basic life cover makes the group scheme more attractive and valuable to
employees. Insurers in India are often offering a few or all of the following
riders: accidental death cover (ADB); critical illness (CI) cover; accident only or
accident-and-sickness Total and Permanent Disability (TPD) cover which can
provide benefits either as a lump-sum or over several years; and some partial
disability benefits (containing schedules of benefits per event, such as for the
loss of one hand). The conditions and exclusions vary by type of rider. The CI
and disability riders may be either of an additional payment kind or may
accelerate (prepay) the base life insurance cover. The definition of TPD may be
very strict, such as the inability to earn any income for the remainder of a
lifetime. For a modest increase in the group premium, a terminal illness benefit
feature is also sometimes included that prepays the sum assured when it has
been ascertained that the life insured has fewer than six months to live. Finally,
insurers are offering health riders (e.g. daily hospital allowance) and savings or
pensions products.
Also as per the above regulations the CI rider premium cannot exceed 100% of
basic premium and 30% of basic premium for other riders.
Dependent Insurance An employee’s spouse and children can also be covered

under the group life insurance scheme. This is often called dependent insurance
and coverage levels are generally lower than for the employee. It is general
experience that the experience on dependents is worse than for employees.
This is more worse in group scheme covering loans in micro insurance. As
dependent insurance is almost always voluntary, there is a greater level of anti-
selection. As such, spouses may be asked to sign a health declaration or fill a
short-form questionnaire. Children may be automatically covered from, for
example, 1 month of age until age 17 with relatively small sums insured. The
rates for dependent insurance at least may be age-banded and generally be
more conservative than those for employees looking to the anti-selection
involved.
Free Cover Limit (FCL)- One of the main defining characteristics of employer-
employee group insurance is that there is no need, up to a certain level of
cover, for individual evidence of insurability except as defined above evidence
of insurability. Free cover limit is also known as No Evidence Limit or Automatic
Acceptance Limit. There are multiple reasons to allow for this feature;
 First, employees are generally healthier than the general population

since they must be fit enough to work full-time.
 Also, some employers require health screenings / medical examination
before offering permanent employment and would less likely employ ill.
Some employment would need only able lives.
 there is less anti-selection since employees normally cannot choose the
amount of basic insurance (the basic coverage amount is pre-determined
per employee)
 Individuals would not normally apply for employment at a specific
company for the specific purpose of obtaining insurance, especially as
there are barriers to becoming employed.
 Most important, the fact that all employees (in a compulsory plan) or a
certain minimum percentage of employees (in a voluntary plan) are
covered by insurance would mean that there is a good spread of the
mortality risk. It is well known fact that that roughly 95% of individual
insurance applicants are accepted without substandard ratings and that
in effect the entire cost of individual underwriting is to catch that 5% of
applicants who are then declined or rated basis underwriting decisions.
In the context of group insurance, that 5% of individual applicants would
either be unfit to work (and therefore not eligible to be covered) or, for
those who are working, the extra mortality risk they represent can then
be spread over the remaining lives of the group and thtough saving in
medical underwriting costs.
FCL helps in reduction in significant cost and is time saving feature. The
reinsurers have helped Indian market to offer very high free cover limits
however the problem associated with FCL is that it invites anti-selection and
thus careful consideration must be given in setting these limits. In theory, the
FCL could be set at the point where the cost of asking for evidence of
insurability is less than the overall increase in mortality rates.
This is difficult to determine in practice since the higher the FCL, the more
there is potential for selection against the insurer. The most significant
parameters in selecting the FCL are the number of employees that will be
covered under the life scheme and the average level of benefits among the
employees. Therefore, the insurer may try to vary the FCL by size of group and
the average benefit level amongst members of a group. Small groups will have a
lower FCL because the decision to obtain group insurance coverage, and
perhaps even the levels of coverage, may be influenced by top employees (e.g.
Directors and CEO) who may possibly be in higher age bracket and some may be
in poorer health. That is, the smaller the group, the more there is anti-
selection.
Employees who wish to avail themselves of cover above the FCL will have to
provide evidence of insurability. The insurer generally underwrite for the
amount exceeding the FCL, not the entire coverage amount including the FCL.
As such, the insurer may develop age and amount related underwriting evidence
requirements. For modest amounts above the FCL at younger ages, only a health
declaration or short questionnaire may be required; for larger amounts and for
older ages, the underwriting requirements may progressively become
comprehensive and eventually may include full medical and financial
underwriting. If a member is found to be substandard, the rating only applies to
the amount exceeding the FCL.

Compulsory and Voluntary Plans- Naturally, compulsory plans, that is, plans
where the employer pays the full premium, are much easier to administer.
Voluntary plans, whereby employees are expected to pay for a portion of the
insurance premium, are more difficult to administer and complicate the
enrolment process since individual employees must give consent to being
covered and minimum participating limits must be met.
The advantage of participating plans however is that they help discharging the
cost of insurance, and thus may provide coverage better suited to employees’
needs. The higher sums assured to higher salaried personnel may also be
offered. Employee contributions are normally automatically deducted from
payroll.
In India salary savings schemes are also popular for employer and employee
groups however the individual contracts are issued to individual members and as
in individual cases the plan may also differ. The only difference is that
contributions are deducted monthly by the employers and remitted to the
insurance office.
Design of Group Insurance scheme: It is important to design a scheme to avoid

anti-selection by individuals within a group. The basic characteristics are as
under;
 One of the basic requirements is that the group should not be formed to
obtain the group insurance. In other words insurance must be incidental
to the existence of the group. This is clearly the case for employer-
employee relationships.
 The determination of benefits per member should not be at the
discretion of the employer or employee. That is, there should be an
automatic basis to determine the level of coverage per employee. The
level of cover may be the same for all employees or may be a function of
employee rank (e.g. Worker, Manager, Senior management), salary,
years of employment, or a combination of these. The objective is to
avoid anti-selection by less healthy employees who would choose higher
levels of coverage given the chance to select the cover. Various scheme
designs can be discussed with employers to determine the more suitable
option. If benefits were linked to a variable, for example salary or years
of employment, an annual re-determination of the insurance cover may
be carried out.
 Only permanent full time employees should be eligible for insurance

cover. Employees should be actively at work on the date he or she
becomes eligible for insurance. Actively at work definition may change
insurer to insurer wise and need to be agreed with the Reinsurer (s). The

definition would especially vary when scheme as a whole transfers from
one Insurer to another.
 The extra eligibility conditions may also apply such as not having been
absent from work due to sickness for more than say 3 weeks per year
during the previous 2 years (that is, the employee should have been
working the normal hours required by the employer).
 Age restrictions may also apply, requiring that the employee be younger
than retirement age say 60 years and have been with employer’s service
for minimum period say at least 5 years of continuous service.
 New employees may need to satisfy a waiting period, usually a month,

before becoming eligible for insurance. In a voluntary plan, once they
have satisfied this probationary period, they must join the scheme
within minimum stipulated period say 30 days or otherwise have to
provide some evidence of insurability.
 Generally, coverage ceases after a grace period if the scheme sponsor

fails to pay the due premium within grace period; the employee reaches
certain age or retires; or employment is terminated. There may be
instances when the employer continues to pay the employee even if he
or she is temporarily off the job. It is important for the insurer to clarify
instances where this is allowed and for what duration. Also, the
employer should not employ its own discretion as to whether to continue
paying an employee who is not actively at work, but should follow an
established policy that is applied to all employees or certain classes of
employees. This need to be specified in terms and conditions. Hence
there should be no ambiguity about whether the insurance coverage is in
force when the employee is not actively at work, for example as a result
of illness or maternal leave. In some of the developed countries various
approaches are used to handle workers’ disability.
The least generous approach is to not offer disability provisions of any

kind, but to generally continue coverage if the employee continues to
receive a regular salary, but normally not beyond a period say 6 months
(since that would construe employee be permanently disabled).
Somewhat more generous be extended death benefit coverage, which

provides one year of continued life coverage if the insured’s insurance
terminates prior to retirement age say 60 and the insured is totally
disabled until death. Another approach could be to continue to provide
life coverage until age 60, and to waive the group life premium, for
employees who have been totally disabled for more than 6 months and
remain disabled until death.
Usually, annual proof of disability is required for continued waiver of

premium. The most generous approach would be to pre-pay a
percentage of the life benefit over a period, say 5 years, as long as the
insured is totally and permanently disabled.
Each of these various approaches may have a serious impact on the

levels of mortality rates used when pricing a scheme.
 If the scheme or employment terminates, it may be possible to extend

coverage by a month to enable employees to find the new insurance
cover.
Emergence of a new Group Term Plan
The pricing is a technical subject and better be left to the Actuaries. However
basic knowledge would be required for students of this subject that how a group
term plan comes to the fore.
IRDAI of India has prescribed Form IRDA-Life-Non Linked-NP to the insurers in

which they need to file a group term product to IRDA of India. NP stands for
New Product here. This contains various items viz-
 Name of the Life Insurer,

 Name of the Appointed Actuary,
 Brand Name of the Insurance Product (market name),
 Date of introduction of product (proposed in case of new products;
actual date in case of existing products)
 Date of change (proposed in case of existing products but not applicable
for new products
 Terms and conditions- asking whether the product is offered to
male/female or both, smokers/ non smokers or both, Individuals/groups
or all, standard lives/all type of lives including impaired lives, product
would be limited to specific geographical locations in India/all
geographic locations in India, meant for urban population/rural
population or both, who is the target section- i.e. whether targeted to
socially weaker section/any other/all and whether the product would be
marketed for limited period, if so then give number of months/unlimited
period.

 It further asks to State- minimum and maximum face amount/sum
assured/annuity p.a., minimum / maximum premium, minimum and
maximum entry age, minimum policy term, maximum maturity age,
specify whether terms and conditions include- restriction on travel
outside India/no restriction on travel, restriction on future
occupation/no restrictions on future occupation.
 General description of the product- asks to describe the various

contingencies under which the benefits would be payable and how these
would be determined,
 Product features- where various items would be described e.g. whether

the product would be participating/non participating, benefits payable
on death or survival, non forfeiture benefits (cash surrender value, paid
up value, automatic premium loans, etc), if the product is with profits
product, how the profits will be distributed, options available under the
product (e.g. to increase/decrease benefits, plan changes, conversion to
annuities at maturity, etc., limitations on minimum and maximum sizes
either sum assured or premiums, policy loan provisions, modes of
premiums permitted and the charges applied for different modes of
payment of premiums and quantum of sum assured, if any, scales of
commissions/remuneration payable to the agents/insurance
intermediaries, any other feature that may be relevant for the product.
 Target Market,
 Distribution channels that would market the product
 Treatment of different classes for the purpose of underwriting- Males

and females, smokers and non smokers, limitation on entry ages, sub
standard lives, any other classifications that may be relevant to the
product line (such as group of lives)
 General policy provisions-stating suicide claim provisions, exclusions, if

any (e.g. Occupational hazards, travel), grace period for non forfeiture
provisions, nomination requirements as per Act, general approach to be
used for revivals or reinstatements, policy changes/alterations, etc.
 Reinsurance asking to describe reinsurance arrangement, retention limits

of the insurers for the product filed, name of reinsurer (s), terms of
reinsurance (premium rates, commissions etc.), recapture provision

 Under heading financial projections, file and use asks to provide pricing
assumptions which Appointed Actuary has used while pricing the
product. This includes, rates of mortality assumptions, rates of morbidity
(rates of sickness), rates of policy terminations, rate of interest, bonus
rates, guaranteed cash values, commission scales, expenses split into –
first year expenses by sum assured related, premium related, per policy
related, renewal expenses (including overhead expenses) by sum assured
related, premium related, per policy related, claim expenses, allowance
for transfers to shareholders, if any, taxation, profit margins, volume of
new business, average sum assured assumed in pricing, any other
parameter assumed relevant for the product.
 The file and use asks to provide the results of financial projections
asking new business strain in each of projection years for next five years,
ROI (Return on investment) or profit margin giving basis to calculate
profit margin, profit test conducted, if any, the assumptions and results
for sensitivity analysis, proposal form and sales literature, policy bond*,
premium table (including rider premium tables) and certification from
Appointed Actuary and CEO & MD.
*IRDAI has in later years discontinue to submit the policy terms and
conditions to the IRDAI but again the insurers have been asked to submit
the terms and conditions of the policy to IRDA of India.
Some of replies to above questions may be Not Applicable for group term
product e.g. Bonus rate assumptions;
Different occupation classes
Though different Insurers may define different occupation classes and different
designations therein. However following table would give fair idea of different
category of people in different classes;
Occupational
Types of occupation
Class
It may contain Senior Management e.g. Chairman, Directors,

MDs, CFO, SVPs, VPs, AVPs, Senior Managers, Partners and
Class 1 Associates, and Professionals (like doctors/dentists, lawyers,
accountants, actuaries, engineers, teachers etc,) staff with no
exposure to outside office.
It may contains Middle or Junior-management, Secretarial and

clerical administrative staff, Business services (advertisement,
Class 2
employment, agencies, data processing, office equipment, etc)
or Senior Management, partners, associates and professionals as

above with some exposure to outside office involving some risk,
Professional salesperson (like without any travel or delivery job)
Retail business, etc.
It generally contains Light manufacture and assembly regular

salesperson involved in travel or delivery, Nurses, Real estate
Class 3
agents, insurance agents and brokers and attendants. Those in
whole sale business also form the part of this class.
Class 4 occupation may contain skilled craftsmen and tradesmen

whose duties involve only light manual work (e.g. electricians,
Class 4 plumbers, carpeting, home appliance repairs, etc.) ,
Maintenance workers, Janitorial workers etc, and those in
Chemical manufacturing, etc.
It may contain other occupation e.g. Auto and auto related

manufacturing, assembly, service and repair of
auto/engine/industrial equipment, heavy construction
contractors (roads, commercial-residential buildings, tunnels,
bridges, houses), farmers (Agriculture & Livestock), Long and
short haul trucking, Drivers-truck, taxi, bus and ambulance.
firemen, policemen, those working in Steel manufacturing. It
Class 5 may further include semi-skilled, manual and process workers in
light industries. stores personnel, service workers, security
personnel, above ground workers for mines, manual and process
workers in primary industries excluding primary metal
industries or cement),
supervisors in primary metal industries (foundries, including
rolling and drawing), etc.
Premium Calculations
Step 1 Pure Risk Premium calculation
Step 1 - Calculate the pure risk premium (expected claim cost) for the group.
This would be sum assured * expected mortality rate. The different classes
would experience different mortality rate and hence premium table would
differ by classes and by age.
Step 2 - Gross Premium calculation
Once the expected claim costs have been determined, the gross premium will
be the total expected claim cost loaded for expenses, commissions, taxes,
required risk and profit margin, and may include a discount for investment
income on reserves or cash flow.

Expenses
Handling of expenses will vary according to company philosophy and separate

expense factors for the group line of business. The expense study for group
business may be tricky and an important job for an Actuary. However it would
involve-
 A functional cost study to determine the expenses incurred for

supporting the group line survey of each employee to determine the
tasks and time spent on group business. The group line may involve
actuarial support (e.g. product development, research and experience
studies), accounting and billing, underwriting and quotations, systems
development, claims investigations, contract and certificate issuance,
contract administration, legal and compliance, marketing. Including
technical equipment, software, office supplies, furniture,
communication, and transport, rent and electricity, postage and
printing, general overhead expenses man power cost along with salaries
and benefits attributed to group business.
 Expenses can then be expressed in various ways, separate for first year
and renewal years as asked in file and use and per employee.
 Company may use a fixed expense that does not vary with group size and
a percentage of total expected claim cost that decreases with group
size, to the extent that it is possible,
 Expense loadings may match the actual occurrence of expenses but not
always. Large groups may incur specific expenses and these should be
reflected for each particular group. E.g. more time is taken in
negotiation, documenting the benefits etc.
 For new insurance company, a large part of expenses is generally
amortized over a number of years or determined according to projected
business growth. The projections of group business growth is difficult to
make and especially in competitive market where on renewal of group
business, large number of companies bid for the scheme. Even within the
existing group, business expansion or reduction may lead to increase or
decrease in number of employees.
 The Actuary compares actual incurred expenses and the expense
contribution of the premiums at the end of the year.

Commissions
Commissions may be;
 a simple percentage of the premium

 a fixed amount per contract
 or a combination of these.
 The commission structure and levels may vary between companies and
according to market practices. The commission scale is structured so
that high performers get rewarded.
 Commissions may be expressed as a flat percentage of premium (where
the percentage varies according to group size) OR it may be layered.
 The overriding principle is that commission rates used should not breach
the Insurance Act and IRDAI regulation limits or periodical
communication from IRDAI.
Tax - Stamp duty need to be accounted for. This duty, currently is 20 paise per
thousand (per mille) of sum assured for most of states and is payable only at
inception of the plan and thereafter on increased sum assured. The approach
may be:
- to fully and explicitly or spread over within a reasonable period (as a separate
item) charge the amount at inception of the plan and not charge it upon
renewal;
-the other approach may be to amortize the charge over 3 to 5 years, assuming
the plan will remain with the company for that time. This helps Insurer to be
competitive. In case Insurer pays the tax, then the insurer pays the full tax in
the year of plan inception. This approach helps insurer to quote a lower rate at
the inception or renewal of the group scheme, but there is the risk associated
that the group will not renew, and thus that the unamortised charge be paid by
persisting groups. IRDAI has allowed to quote at lower price than file and use
premium rates for OYRGTA plans. Insurers may also price on an after corporate
tax basis.
Risk and Profit Load
Finally, a risk and profit load will be required. The risk to the company
essentially is due to mortality mis-estimation. Actual deaths are higher than
expected. Some of this risk will have been taken into account when estimating
the claims cost by adding margin for adverse deviation but not all. Expenses
also might be inappropriately priced or estimated. Groups in a loss position may
not renew with the insurer, and this forms a sort of lapse risk where the insurer
is no longer able to recover these losses. All of these risks are difficult to
quantify, but should somehow be reflected in the final rate.

The required return
It will depend in part on the amount of required solvency that is taken up by the
group business. IRDAI has prescribed required solvency margin factors which are
given in IRDA (Actuarial Report and Abstract) Regulations, 2000 and
subsequently revised (Form K). The first factor applies on mathematical reserve
and second on sum at risk. The factor for reserve is higher than factor of sum
at risk.
Guaranteed Rates of premiums
Group life insurance rates on an annual renewable basis are not usually
guaranteed for more than a single year. The reason being for example a two-
year rate guarantee is given and the first year of insurance has elapsed. If the
group had good experience, it could always seek a new insurer which possibly
offering lower rates. If the group had poor experience, it would remain with the
insurer at the guaranteed rate. Therefore, an appropriate loading need to be
placed on any guarantees, and this loading may vary by the nature and length of
the guarantee, the size of the group, and the risk characteristics of the group.
Rate guarantees are generally less of a concern for groups have demonstrably
stable experience and where the risk of mortality mis-estimation is small.
However this would depend how long the group scheme has been with the
Insurer or with the reinsurer with whom the insurer has reinsurance
arrangement and to which extent reinsurer is open to divulge the information
to the Insurer, since reinsurer may have more than one insurer competing for
the scheme.
Retrospective Experience Rating or profit sharing
When estimating claims’ costs and determining the gross premium, the actuary
may want to either (or both) reflect the past experience of a particular group or
provide the group with the benefit of good and occasionally the poor future
experience.
In the context of group insurance, prospective experience rating refers to

setting a premium rate for the future coverage period by reflecting a group’s
past experience, to the extent that it is credible and is expected to continue
into the future. The larger the group, and has history of claims would help
Actuary to put his confidence in the group past experience. Thus the
prospective experience rating adjusts the premium based wholly or in part on a
group’s actual claims experience before inception of the insurance cover.
Retrospective experience rating refers to allowing the group to participate in

the good or adverse claims’ experience it will have at the end of the insurance
term. Thus, retrospective experience rating will, through the use of pre-defined
formulas, provide a group with some participation in the financial benefit or
financial cost of the group’s actual past claims experience over the coverage

term. Retrospective experience rating is carried out at the end of the period of
coverage and is often referred to as profit sharing.
There are many valid reasons why participating group insurance is attractive to
both the insured group and the insurer. Among these reasons are the following:
 A particular group may consider that it is obtaining better value for the
premium it is paying. That is, in the event of good experience, a portion
of the excess surplus is returned to the client. In the case of poor
experience, the client has received more than it has paid for.
 The opportunity to participate in excess profits may be attractive to

groups with expected better mortality. This may because such groups
may not be willing to cross-subsidize other poorer-risk groups by paying
the same class premium rates.
 If there is greater uncertainly about mortality, the insurer has a greater

security margin as a result of the extra loading to the par premium.
 The variance in claims distribution is lower for with-profit plans than for
without-profit plans having equivalent expected profitability; this would
reduce the insurer’s variations in annual profitability. IRDA of India has
issued a circular relating to profit sharing calculation given below
prescribing minimum mortality rate at which group has been priced and
minimum size. The advantages of longer review periods include the
following:
 They increase the number of life-years of exposure, and thus the
credibility of the group’s experience;
 They allow the insurer a better chance of discerning and
absorbing any negative trends in the developing experience;
 In the absence of any rate guarantees, they allow the insurer to
revise rates if the initial underwriting had not incorporated
certain information that was either ignored or unknown before
any profit is distributed.
Profit Sharing Formula
IRDA of India, with the objective of adopting a standard market practice in

respect of profit sharing, came out with guidelines vide its circular no.
IRDA/ACTL/FUP/Ver A/Aug.2003 dated 2.9.2003. The summary of these
guidelines is as under:
 Minimum number of life years covered under a Group Master Policy

should not be less than 1000 for considering profit sharing. Where for a
scheme year the available experience is less than 1000 life years; profit
sharing arrangement shall be deferred until the end of the scheme year
in which the minimum number of life years of 1000 in scheme is reached
on cumulative basis prospectively.
 Profit sharing shall not be allowed other than on a scheme year basis.
 Whether to carry forward losses or not shall be decided by the
Appointed Actuary having regard to related factors like pricing basis,
percentage of profit sharing formula and assumptions for profit sharing
etc.
 Profit sharing percentage shall not exceed 75% (seventy-five percent) if
number of life years for a scheme is less than one lac and shall not
exceed 90% (ninety percent) if the number of life years is one lac and
more for a scheme.
 Mortality assumption for this purpose shall not be lighter than 60% of
the rates under the standard mortality table prescribed for the pricing
assumptions i.e. currently IALM (2006-2008) ultimate mortality
experience.
 The experience rating profit sharing formula and related assumptions
should be furnished at the time of filing the product with the authority.
An example how the profit sharing may be carried out subject to regulations,
has been given below;
Example:
Premiums paid
+ Investment income (though less as reserve including rate stabilization reserve,
if any, is lower)
- Cost of conversion charge, if any
- Risk and expense charge
- Allocated claims including incurred but unpaid claims
- Change in IBNR reserve
= Year-end gain/loss,
If we subtract the Change in reserve including rate stabilization reserve would
give total year-end gain. If this figure is positive then a percentage of this year
end gain shall be year-end gain to the client.
Prospective Experience Rating
The main reason to offer prospective experience rating is to quote a more

accurate insurance premium for the group. Failure to carry out prospective
experience rating will be to the disadvantage of the insurer for the following
reasons:
 If a particular insurer fails to incorporate a group’s positive past experience,
to the extent it is credible, then the group in question will likely choose
another insurer that will reflect this good experience. Thus, the losing
insurer may find that its portfolio of groups consists of worse risks than can
be supported by its premium rates.
 If a particular insurer fails to incorporate a group’s negative past

experience, to the extent it is credible, then the group in question will
likely choose this insurer over other insurers that will reflect the negative
experience. Thus, the insurer may be accepting a disproportionate number
of poorer-risk groups than can be supported by its premium rates. It is
therefore imperative that the insurer correctly assesses the extent to which
a group’s past experience should be reflected in the premium. This
assessment will be based on various considerations.
 It is commonly assumed that claims in a group are independent of one

another and also over time. This may be an erroneous assumption if the lives
covered by a group face common hazards specific to the group e.g. the
safety of employees at workplace is poor or strenuous job leading to higher
mortality. In general the independence of claims’ assumption would less
valid for health covers than for life insurance. The main reason may be lack
of morbidity (sickness) experience.
 Nevertheless, group insurance mortality will be less independent than the

mortality of an individual life portfolio. The Actuary keeps this in mind when
quoting for groups. The mortality trends are also kept in mind along with
any established breakthrough in treatment of particular disease and that
outbreak of pandemic in a particular year may not repeat next year. The
paid claims be distributed to respective years and be compared with the
exposure for particular year. Incurred but not reported reserves should be
taken into account if it is believed that the most recent year of experience
may have outstanding claims. To calculate exposures, care to be taken
relating to timings e.g. figures provided at year-start, mid-year, or end-of
year? If a group is growing rapidly in terms of employees, then one may land
into underestimating the claims rates by if he/she uses the year-end number
of employees.
 It is also particularly important to establish the validity of past claims

experience. The deaths may be underreported either at Company level or
sales intermediary level as there is a financial incentive in underreporting
deaths. However, for very large organizations the available experience be
given weightage especially if such experience would lead to higher rates
than indicated by the manual rate.

Credibility
The actuary computes the credibility of the group's own experience. And with
this exercise the file and use rate for similar groups is adjusted. The credibility
factor is denoted by Z. Which lies between 0 and 1. The formula for expected
claim cost is given by;
Expected Claim Cost = Z × Experienced Claim Cost + (1 - Z) × similar group’s

Claim Cost
Premiums
The premiums are paid in advance by the group client over the year and thus
there may be some interest credit on net premium basis.
Group Business Renewal
Group renewals pose specific challenges to an Insurer. The primary objective for
insurer is to retain the group on mutually acceptable terms. It is preferable to
pre-empt the scheme sponsor from seeking an open market quote by being
proactive, but of course this cannot always be avoided. The group market has
been very competitive in India and remains same. Sometime prior to the
renewal date, a representative of the insurer contacts the employer to discuss
the renewal process. It is important to obtain the employer’s views as to the
quality of the insurer’s service and to discuss/propose any modifications to the
group scheme. In fact, the group renewal process build upon the usual
procedures for quoting for a new group. The group department personnel
reviews the group policy. He or she gets a thorough knowledge of the scheme.
In this process one need to know the answer to many questions e.g. correctness
of initial information correct, usefulness of the past information, new available
information. The employer would have informed the insurer about all details
that have changed within the previous year and the insurer should ensure that it
has been notified relating to exit members from the scheme, changes in cover
for the existing scheme members, lists of new members with all relevant
information, individual employees’ health declaration where necessary or
detailed information for all claims that occurred during the previous year; etc.
The insurer need to be aware of the demographics of the scheme in addition to
occupational class, age, and gender, final participation rates; distribution of
benefit levels. It also need to take into account whether group membership has
been steady, increasing, or declining and thus ascertain how have the
demographics of the group changed? And thus the aim of insurer lastly would be
to ascertain any change in the group in previous year.
It need to analyse the exposure and claims experience of the group and the size
of the group determines the level of the depth and degree of analysis. The
larger the group, the more analysis is required to fine-tune the renewal rate. As
indicated earlier the analysis of claims experience would be inclusive of
reported but unpaid claims and IBNR claims’ reserves. The claims and exposures

may be analyzed by age, sex, class/occupation, location and other factors e.g
taking into account the group’s internal record keeping mechanism, mortality
experience confidence intervals and credibility to the experience. The A/E ratio
(i.e. the actual mortality experience be compared with the group expected
mortality experience). The analysis at time of renewal is not different than for
a new group quote for which experience is available. This is of paramount
importance if experience refunds are to be calculated or if there is a need for
premium reductions or increases. As in any study the extremes be not allowed
for fully e.g. catastrophic losses in the early years, or if there is evidence of
anti-selection. The loss-making position groups be considered whether to try to
recover past losses by including an additional load to the premium. The result
may be that doing so may force the group to lapse and so need to clarify to the
group. The small groups adverse experience may be as the result of statistical
fluctuations and so may not warrant a change in rates if the pooled experience
of similar groups is credible and favourable. The claims’ analysis would lead to a
good estimate of the renewal premium rate. One potential problem also relate
to the timing of reporting of claim. The claims are reported late however
experience is that delay in reported claims in group business is not so grave as
in individual business. However it need to be accounted for based on general
experience. It is also difficult to estimate reserve requirements in light of
incomplete claims data and estimating IBNR reserves.
The employer may anticipate upward premium revision by the insurer but not
too high in case adverse mortality experience of the group. Hence group
personnel to ponder upon whether to allow past adverse experience in a single
year or spread over a number of years in future years. The group personnel
should be very careful when quoting first time since it becomes very difficult to
convince the group sponsor that the original underwriting was based on overly
optimistic claims assumptions or marginal administrative costs. In case the
group scheme sponsor wishes to discuss changes in the design of the scheme,
e.g. profit-participation or additional benefits or changes in benefits, the
representatives of the insurers should be prepared to discuss these options and
offer their terms. In absence of this insurer might lose the scheme. The insurer
should also consider if employer has budget constraints and thus there may be
a need to introduce a voluntary plan or, if the plan is already voluntary, to
increase employee cost sharing. However this need to be kept in mind that
existing regulations allow such changes. Similarly, in existing schemes there is
demand for higher FCLs or additional rider coverage. The insurer is expected to
handle these requests. On gaining experience the insurer on their own modify
group underwriting guidelines or introduce riders. Such changes might be
brought to the knowledge of group scheme sponsor.
The renewal of scheme permits insurer to review its internal processes, e.g.
employees were properly distributed in various classes, undue prudence in
selecting the rate table, underwriting guidelines not properly applied and that
administrative procedures are efficient.

Test Yourself 3
While determining the extent to which the premium rate could be reduced or
increased to reflect the new claim experience of the concerned group, which of
the following combination of factors are considered by actuaries?
1. Size of the group

2. Age of the group members
3. Occupation of the group members
4. Number of policy years
The options are:
I. Options 1 and 4
II. Options 1 and 2
III. Options 2 and 4
IV. Options 3 and 4

Summary
a) A group is generally thought of as a group of individuals, a group of

employees, a group of companies, trade unions, associations, clubs etc.
There is a leader for every group.
b) A group insurance contract is a long term contract with guaranteed

renewable terms every year, with new members joining during the policy
year or at the end of the year, as the case may be and the existing members
(at the beginning of the policy year) leaving the group during the policy year
on grounds of death, resignation, retirement, or cessation of membership
with the group.
c) The following are group insurance contracts offered by insurers:
 Group Term Insurance Contract

 Group Health Insurance Contract
 Group Gratuity Contract
 Group Superannuation (Pension) Contract
 Group Savings Linked Insurance Contract
d) The main attraction of group insurance is the ability to cover large number
of individuals in a cost efficient manner.
e) FCL helps in reduction in significant cost and is time saving feature.
f) Group life insurance rates on an annual renewable basis are not usually
guaranteed for more than a single year.
g) Retrospective experience rating refers to allowing the group to participate
in the good or adverse claims’ experience it will have at the end of the
insurance term. Retrospective experience rating is carried out at the end of
the period of coverage and is often referred to as profit sharing.
h) Profit sharing is an incentive offered to group policyholders in which there
would be refund of premium in cash to group policyholder.
i) The main reason to offer prospective experience rating is to quote a more
accurate insurance premium for the group.
j) Group renewals pose specific challenges to an Insurer. The primary
objective for insurer is to retain the group on mutually acceptable terms. It
is preferable to pre-empt the scheme sponsor from seeking an open market
quote by being proactive, but of course this cannot always be avoided.

Answer 1
The correct answer is II.
A trade union of taxi drivers in a city and members of a professional group can
be treated as groups for the purpose of insurance contract
Answer 2
Group benefit contract is not a type of group insurance contract offered by

insurers.
Answer 3
Factors 2 and 3 are not relevant for the purpose of determining the increase /
decrease in premium rate.

Question 1
In which of the following type of group contracts will the additional benefit i.e.
the accumulated amount of contributions be payable?
I. Group Superannuation (Pension) Contract

II. Group Term Insurance Contract
III. Group Savings Linked Insurance Contract
IV. Group Benefit Contract
Question 2
Which of the following is not a type of insurance contract under which a death
benefit is paid?
I. Gratuity scheme
II. Superannuation scheme
III. Group insurance contract
IV. Savings linked investment schemes
Answer 1
This is one of the features of the Group Savings Linked Insurance Contracts.
Answer 2
The correct answer is IV.
Savings linked insurance schemes involve payment of death benefits, not savings
linked investment schemes.

–
CHAPTER 7
PREMIUM BASES – INTEREST RATE

Life insurers invest a certain portion of the premiums collected in Government

bonds (fixed income securities) and other securities. When bond returns fall,
the amount available to pay the benefits declines. Sometimes insurers may have
to increase premiums to compensate for this fall in income provided it is
allowed. In India currently the increase in premiums are not allowed.
Life insurance premiums are calculated based mainly on many factors or

assumptions, such as interest rates, mortality or morbidity, persistency and
expenses and commission.
Mortality covers health and age and has the biggest effect on premiums for
protection type of plans. While interest rates have a significant impact on how
much new policyholders pay as premium in case of saving type of products.
Persistency impact will depend upon how surrender terms are defined in the
product. Expenses usually impact premiums equally for most type of contracts.
The cost of insurance rises as people age (i.e. as they get older), but payments
are the same (level) from year to year. So, technically, you’re paying more for
insurance when you’re healthier and less as you age.
As it’s unlikely that your policy will be paid out when you’re young, those
premiums are invested mostly in fixed income products such as bonds and
mortgages.
Insurance companies invest one’s money so they’ll have enough money to pay
out when one dies, and also to make profits for their shareholders.
Learning Outcomes
A. Assumptions setting process

B. Importance of interest rates in calculation of premiums
C. Concept of interest rates
D. Determination of interest rates
E. A simple example
F. Interest rate risk

An insurance premium is the amount of money charged by a company for active

coverage. The sum a person pays as premiums, also referred to as the rate, is
determined by several factors, including age, health, the area a person lives in
etc. People pay these rates annually or in smaller payments (monthly /
quarterly / half yearly) over the course of the year.
The starting point for an insurance premium is largely based on statistics,

though people's habits and history can cause the rate to be higher or lower.
The cost of a premium for the same service can vary widely among providers,
which is why experts strongly recommend that consumers get several price
quotes before committing to a policy.
Insurance premiums are thus calculated considering the following assumptions:
 Interest Rates
 Mortality Rates
 Persistency rates
 Commission Rates
 Other Expenses
Additionally on all of these assumptions except commission margins will be

applied. Margins are extra cushions applied on the assumption to ensure that
premium is not underpriced. We will understand each of these assumptions in
detail in the coming chapters. In this chapter, we have taken up ‘interest
rates’.
The word assumption means the values which are assigned to parameters used
for pricing or valuing an insurance contract. Basis refers to a set of assumptions
used for pricing or valuing an insurance contract.

[
A. Assumptions setting process
This process usually requires the actuary to make fairly long-term assumptions
for each parameter in the assumption set. In this and following few chapters we
explain how the actuary can decide on what is a suitable assumption for each
parameter. The key part of the process is the determination of what future
experience is expected. A second aspect is what other factors may need
consideration: for instance, the extent to which margins against adverse future
experience are required. What these other factors are will depend greatly on
the application, or purpose, of the basis. Here we deal with pricing aspect of
assumption setting. Since, reserving is also a part of pricing process we will
touch upon that also briefly in later chapters
General process for setting assumptions
Deriving assumptions for future experience has the following steps:

1. Investigate the historical experience using the appropriate and relevant past
data. Care must be taken to choose the period to use. It should be relevant
for the purpose. For example for setting withdrawal rate assumptions it is
usually appropriate to consider latest experience since more historic
experience might be too old to be of any use. While for mortality generally
a longer period is considered to include any trends which might be missed if
only say a year's data is used. In case the data of company is not available
industry data or reinsurance data can be used if relevant.
2. Make best estimates of the parameters from above experience. These
estimates will be appropriate in the context of the historical conditions and
circumstances that applied at the time of that experience, including the
condition of the commercial and economic environment.
3. Consider what the conditions (including the commercial and economic
environment) will be like in the future period for which you are making your
assumptions.
4. Determine what the best estimates of your assumptions will be, given the
expected future conditions. The historical parameter estimates will be used
as a starting point, (when possible or appropriate), but the effect of the
different circumstances of the future, compared with those of the past,
must be allowed for. In other words, how will the parameter values change
given the changed conditions?
5. The extent to which you would rely on the experience data, and the extent
to which you allow for other factors, including judgement, depends on the
credibility and relevance of the data, and how predictable the parameter is.
6. The best estimates may need to be adjusted in order to include a margin for
prudence. The size of any margin incorporated into an assumption will
depend on the purpose for which the model is required, and the degree of
risk associated with the parameter.
The process as explained above is a general process which is modified for the
purpose for which assumptions are set.
For example, for a new company where historical data would not be available,
consultants or reinsurers can help in deriving assumptions which should be used
for pricing.

B. Importance of interest rates in calculation of premiums
In pricing a product, an interest rate is used as an investment return to earn on

assets invested to meet the liabilities and also to discount future premium,
investment income, benefits and expenses. This is based on the principle of
time value of money. If we do not use this, we would be charging a premium
rate which is very high.
Conventional method of pricing always had single rate for investment as well as
discounting. Since, there were less computational power and hence formula
method was used. With the ever increasing speed of computational power cash
flow method of pricing has gained remarkable popularity. Now complex models
and tools are available which can project all the cash flows of the product for
all future years. As a results formula method is not used now and where it is
used it is used just as an indicator of premium to start with. Then the resultant
premium is profit tested using cashflow model and using the discount rate as
risk discount rate as discussed earlier in pricing chapters. Hence, interest rate
earned on investment will be different from risk discount rate used to discount
the cashflows to ensure a profit criterion is met. We will disuses more about risk
discount rate in the margin chapter.
Here also we will discuss about the interest rate as investment return rather
than as a discount rate.
Let us understand the characteristics of interest rates:
a) An interest rate is used to estimate and project the investment income

which would be earned on the assets invested to meet liabilities.
b) Shareholders of insurance companies expect a return on their investment,

and this should be considered. If we do not transfer a portion of
investment income or other insurance income towards profits, no
shareholders would continue the business of insurance and they would
rather prefer to keep their money in a bank to earn interest, as they
expect a return. This is their prime objective.
c) Premium rates have to be competitive in the market, and performance of

investments plays a crucial role. Therefore, interest rates are important.
d) More so for saving contracts this assumption plays a crucial role in deciding
the premium since, for those contracts investment income is a major
portion of overall income earned in the product. Other income such as
mortality profit is insignificant portion of saving contract.
We can express this in a mathematical equation for a single premium contract:

Single premium = Present Value of Benefits that would be payable in future +
Present value of Expenses to run the business in future - Present value of
investment income expected to earn on investments.
Present value is determined using a risk discount rate suitable to the entity
(insurer).
Test Yourself 1
If interest rates fall, what would be the impact on the premium rates assuming
all other same?
I. Premium rates would also fall

II. Premium rates would rise
III. Premium rates would not be affected

C. Concept of interest rates
Interest rate is the rate that would be earned on investments in future and also
the rate that would be earned on re-investments.
Rate of interest offered by government paper is the risk free rate of interest.
Return earned on equities is usually higher than the risk free rate of interest.
(Perhaps, the difference is on account of risk which arises in equities, where
dividend flow could be zero and shares might not be sold at the desired price.)
Suppose Government paper offers a return of 7% p.a. We should expect a return

of at least 10% p.a. on equities. Since it is difficult to know what would be the
rate of interest in future, a best estimate is determined using actuarial
principles. Suppose the current rate of return on Government paper is 7% p.a.,
it is not unusual to have a best estimate of 6% p.a. in future for the next 20
years, and 5% p.a. thereafter, in the premium bases. Rates are reduced since
insurance is a long term contract and premiums would need to be reinvested in
future at unknown interest rates.
The factors that would be considered in choosing an interest rate are:
a) Interest rate risk

b) Nature and term of liabilities in respect of benefits and expenses, this
will depend upon type of product
c) Available matching investments, which could be Government paper,
corporate paper, equities (quoted and unquoted), property, etc.
d) Past experiences of rates of interest in the economy for each investment
type
e) Investment expenses that would be incurred
f) Taxation on investment income
g) Government monetary policy as this has an effect on interest rates
h) Trends of inflation, as this could affect interest rates too
i) Defaults that could arise in investments in respect of receipt of income
and sale proceeds.
j) Impact of interest rates on the profitability of the contract
k) Reinvestment risk
l) Intended investment mix, current return and future expected returns.
Test Yourself 2
Which factors would be considered while estimating interest rates?
I. Past experiences of rates of interest in the economy

II. Investment charges that would be incurred
III. Trends of inflation

D. Determination of interest rates
Best estimates of investment return are required to be made. Pessimistic and

optimistic estimates are also made to choose a prudent rate. Since the aim is to
meet the shareholders’ objective, it is not unusual to be a little more
conservative in choosing a rate of interest. If things fail and do not work out
properly, it would be the shareholders who have to bear the burden of meeting
expenses and claims.
a) What is the risk free rate of interest prevalent in the market (where the
insurer would earn without any problems and he is sure of earning it)?
b) What is the rate of inflation prevalent in the economy, so as to estimate

the rate of return on equities?
c) What would be the rate of return required by shareholders on their

investments (to finance the new business, initially)?
d) What is the past experience and whether this could be used as a guide to
the future?
An actuary needs to answers all the questions in the determination of rate of

interest.
Rate of interest varies with the type of product, as mentioned below:
1. Single premium products
Under which a lump sum one-time payment of premium is made by the

policyholder at the outset and he would not pay any further premiums to the
insurer. Hence, major investment is required at the outset.
2. Regular premium products
Under which premiums are payable at required intervals of time, such as

annually, half-yearly, quarterly, monthly etc. in future. Amounts that would be
received in future have to be invested at a rate that would earn more than what
has been assumed in the premium bases.
3. Limited premium payment products
This is similar to (b) above.
4. Without profit contracts
Investments should provide known amounts in future, such as government paper

where the redemption amount is known, so that it would be possible to match
the claim payments with the investment proceeds.
5. With profit contracts
Investment should provide higher returns to meet the expectations of

policyholders, such as equity and property, where capital appreciation is
possible.
Factors explained
The value assigned to interest rate parameter will be affected by the extent to
which the cash flows of the product are impacted by interest rate risk. The
level and impact of interest rate risk and hence the value assigned to this
parameter will be dependent on all the factors above. They are discussed in
details below:
● Nature and term of liabilities in respect of benefits and expenses, this will
depend upon type of product:
Longer the term of the liabilities, higher will be the risk and vice versa. Nature
refers to the type of liabilities. If it is guaranteed then there is a risk of fall in
returns and hence more cautions will be required. For liabilities which are not
guaranteed assets which yield higher can be chosen. This factor will impact
directly the type of assets which will be used for investment and hence will
impact interest rate assumption.
● Available matching investments, which could be Government paper, corporate

paper, equities (quoted and unquoted), property, etc.
This will depend upon country to country. In a country where equity market is
not liquid and developed, it will be too risky to invest in equities. Also, for
matching perspective suitable bonds of longer duration might not be available.
This will impact the asset chosen, level of mismatching and therefore interest
rates.
● Past experiences of rates of interest in the economy for each investment type
This past experience will affect the future yields to be earned in future and
hence interest rate assumptions.
● Investment expenses that would be incurred
These should be expressed as percentage and deducted from the best estimate
rates. Alternatively it can be ignored here and can be taken in projection as a
separate cashflow. Nevertheless the investment expense of different asset
classes will impact the type of assets to be purchased and therefore interest
rate assumption.

● Taxation on investment income:
Taxation on different investment income will impact the net of tax return
earned on investment and will therefore impact the type of assets to be
invested and interest rate to be assumed. Tax is usually considered as a
separate cashflow rather than netting off from best estimate interest rate.
● Government monetary policy as this has an effect on interest rates:
Tight or loose monetary policy will impact current and future interest rate
scenario. Any known changes in the monetary policy in future should also be
considered.
● Trends of inflation, as this could affect interest rates too:
High inflation will increase inflation risk premium of interest rates and will
therefore lead to higher interest rates. High inflation will also lead to tight
monetary policy because of its impact on economy again leading to high interest
rates. Opposite will be true for lower interest rates. This will also impact the
type of assets to be used.
● Defaults that could arise in investments in respect of receipt of income and

sale proceeds.
This is essentially credit risk. This is a major factor to look at risk adjusted
return. This will impact the type of asset and therefore the interest rates to be
assumed.
● The significance of the assumption for the profitability of the contract, which
will depend on the level of reserves built up and the investment guarantees
given.
Level of reserve build up will depend upon the benefits provided by the
product. A protection product say term insurance, with no maturity benefit will
have much lesser reserve than a saving product say endowment with significant
maturity benefit. Reserve for term insurance with no maturity benefit will
increase and then will fall as maturity nears while for endowment product
reserve is usually maximum near maturity. This is the case because for an
endowment product maximum funds are required at the end to pay the maturity
benefit while for term insurance very less funds are required near maturity
since maturity benefit is nil.
Investment guarantees also carries cost. Hence it is critical to choose

appropriate investment return to ensure proper pricing of investment
guarantee. For example, if a very high investment return is chosen, investment
guarantee could easily be met in that scenario and then there is a possibility of
under charging or pricing of investment guarantee. Similarly, if very low
investment return is chosen, the desired investment guarantee would also be hit

and will cost money and then there is a possibility of over charging or pricing for
investment guarantee.
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 more onerous the guarantee, the more cautious the life company should be
in its asset selection. This caution should then be reflected in the investment
return assumption (because the expected return will differ according to the
assets selected).
This point is also important when it comes to considering the size of the margins
required for the investment assumption. However, the first step in considering
what the investment assumption should be is to establish how important the
assumption is for the results of the modelling we are performing. If, for
example, there is very little sensitivity to the investment assumption, then the
actual value chosen for the parameter would not be critical.
Hence, the two key factors which lead to sensitivity to the investment
assumption are the size of the reserves built up (relative to the cashflow, for
example), and the investment guarantees given. The larger the reserves, the
greater the proportion of total cashflow (and profit) that arises from investment
income, and hence the greater will be the sensitivity to changes in the
investment return. The higher the investment guarantee the greater the care
needed over setting the level of the assumption.
● 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.
Reinvestment risk refers to the uncertainty of the return which can be obtained
from investment in the future. The best estimate of the return available from
future investment may well differ from the best estimate of the return
available from investment now, and may also differ according to how far into
the future the investment is made. The overall best estimate investment
assumption will reflect the expected balance between the expected future and
current investment yields
If the real cashflow is positive over a future period, then the company will need
to buy assets. The more that such future investment is expected to occur, the
more the investment assumption should reflect the expected future investment
returns. For example in a regular premium product where the annual premiums
are received over a 30 year period it is expected that real cash flow will be
positive in the future. In that case there would be a need to buy assets at many
point in future. Those assets would yield more or less depending upon the
investment conditions at that point of time.

Even if the real cashflow is predicted to be negative in the future, mismatching
of assets and liabilities by term may still mean that assets have to be sold and
bought in the future, so that the future reinvestment yields will still be
important. For example consider a single premium product; it is usually the case
that very long term assets are not available to exactly match the benefit
payout. In that case also there would be a need to sell the assets and purchase
again in future time periods at then available yields. Even if assets are available
for longer term there would be mismatching because of uncertain times when
the benefit would be payable because of say withdrawal or death. However, the
greater the degree of matching, the less influence future investment rates
should have on the investment return assumption.
Of course, when you are pricing a new contract then all investment is to be
made in the future. Nevertheless you will have a much better idea of what
investment returns are likely to be at the point of sale of the contracts you are
pricing (which will take place in the near future) as compared to much later in
the terms of those contracts. The expected time between changes to the
company’s pricing basis for a contract will therefore also be important in
establishing the best estimate investment assumption to use.
● The intended investment mix for the contract, as affected by the above, the
current return on the investments within that mix and, where appropriate, the
likely future return.
This is, of course, a very important point: consider the likely mix of assets
which will back the contract in the future, investigate the returns that such
assets are yielding now (and in the past), and attempt to predict the returns
that will be obtained from the future asset mix bearing in mind the impact of
future changes to the economic environment, in particular.
The intended investment mix for the contract will not be derived from looking
at the contract in isolation, as it will be affected by the level of free assets or
capital available to the company to support writing the business. Capital is
required in writing new business because insurance contract usually have new
business strain. New business strain is excess of outflow as compared to inflows
as soon as a contract is sold. Requirement to hold reserve is also an outflow for
the policy since investment would be required for that amount. Hence, usually
because of requirement to hold higher prudent reserves there is a new business
strain.
Also, the extent of matching necessary to control the investment risk will be
less when there are more free assets, hence affecting the mix of assets used.
More the free assets more will be cushion against the bad experience and more
risky investment strategy can be supported. Where the free assets are less
matching is required to ensure that free assets are not wiped out by less than
required returns.

Use of interest rate models:
The estimation of likely future return requires the use of interest rate models
and equity pricing models. Complex stochastic models are also used to ensure
precise estimation for interest sensitive products. A very simple approach which
can be taken as a starting point is explained in the next section using a simple
example.
This estimation is the starting point in putting a value on a parameter. We

would then consider what margins might be appropriate in the later chapters
Test Yourself 3
Which of the following statements is true?
I. Single premium = Present Value of Benefits that would be payable in future

+ Present value of Expenses to run business in future - Present value of
investment income earned in future
II. Single premium = Future value of Benefits that would be payable in future +
Present value of Expenses to run business at present - Present value of
III. Single premium = Present value of Benefits that would be payable in future
+ Future value of Expenses to run business at present - Present value of
IV. Single premium = Future value of Benefits that would be payable in future +
Future value of Expenses to run business at present

E. A Simple example
ABC is an insurance company in India working for last 10 years. It has number of
products ranging from traditional non participating, traditional participating and
unit linked plans. Based on the recent regulatory changes and stock market
performance a need is felt to launch a product with higher guarantees on
maturity and death in the traditional non participating plat form. Product
committee has asked the actuarial department to work on the required product.
It is decided that product will have a design where guarantees would keep on
adding year after year starting from 6th policy anniversary. To keep the risk
lower this product would be offered in a limited premium payment term. The
product should have higher guarantees to have an edge over the guaranteed
products as available in the market.
Since, this is a guaranteed product most important assumption would be

investment return assumptions. The price of the product would be most
sensitive to interest rate assumption.
For deciding on this assumption, company has contacted investment department

who has provided the following information.
Asset class Return earned or current interest rates

Government bonds Current interest rate 7%
Corporate bonds Current interest rate 9%
Equities Earned a return of 12% over last 5
years
Recurring deposits Current interest rate 4%
Investment department is of the view that these asset classes would earn the
following returns on a 7-10 year time horizon. This time horizon is consistent
with the premium payment term.
Asset class Expected return

Government bonds 6%
Corporate bonds 8%
Equities 12%
Recurring deposits 4%
Since, the product will have significant guarantees it has been decided to invest
major potion in bonds with small exposure to equities to provide higher returns.
Also to have some liquidity for withdrawing or claim policies a small portion
would be invested in recurring deposits. Investment mix expected for the
product as decided in discussion with investment team is given below:

Asset class Investment mix
Government bonds 50%
Corporate bonds 30%
Equities 15%
Recurring deposits 5%
Best estimate investment return is simply the weighted average of expected

return where the weights are investment mix:
Asset class Expected return (A) Investment mix(B) AxB

Government bonds 6% 50% 3%
Corporate bonds 8% 30% 2.4%
Equities 12% 15% 1.8%
Recurring deposits 4% 5% 0.2%
Best estimate rate 7.4%
Best estimate rate in this case is 7.4%. This would be further reduced by
margins to ensure extra cushion for the company. Margins are discussed later in
the course.
The method use above is a very simple method. In practice much complex
methods are applied. The decision on both estimation of expected returns of
asset classes and investment mix are done after brain storming various
sensitivities generated through complex projection models. There are factors
such as competitiveness of the premiums which might force company to change
this assumption.

F. Interest rate risk
This refers to earning less or more return then expected while pricing the
product. This could lead to huge losses if product is interest rate sensitive.
This risk could arise because of misestimating of parameter value which is

referred to as parameter risk or may be because of choice of wrong model used
to estimate future investment return refer to as model risk.
Interest rate risk is an important concern for life insurance firms. Insurers issue
products for which the amount and timings of benefits payment are unknown at
time of policy issuance because of future uncertainty and invest the premiums
to maximize the return. The asset cash flow is composed of investment income
and principal repayments while the liability cash flow in any future time is
defined as the sum of the policy claims, policy surrenders and expenses minus
the premium income expected to occur in that time period.
Impact of changes in interest rates:
When interest rates fall as the net cash flows are positive, the net flows will
have to be reinvested at rates lower than the initial rates. The reinvestment
risk emerges. On the other hand, negative net cash flows mean shortages of
cash needed to meet liability obligations. A cash shortage requires the
liquidation of assets or borrowing. If interest rates rise when the net cash flows
are negative, capital losses can occur as a result of liquidation of bonds and
other fixed-income securities whose values have fallen. And the price risk
occurs.
In developed economies where interest rate is too low, Insurers realize that
high fixed interest products are too costly to issue but low fixed-interest rate
products won’t be attractive to potential buyers. With the sale pressure,
insurance companies start to issue unit-linked products as well as interest
sensitive products to attract buyers.
Insurance companies, through their new business issuance activities, normally

provide some guaranteed rate of interest. As interest rates can come down,
insurance companies must properly lock in a positive differential between what
they earn on their investments (equities and bonds) and what they pay out on
these contracts. Otherwise, there will be a mismatch between what is earned
and what is paid. If yields are low, companies essentially starve for yield. This
creates investment tension as carriers push as far out on the risk/return
spectrum as possible, while respecting the need to balance their willingness to
increase their risk for yield when there may be no perception that the risk is
any lower.
This and need for liquidity results in premiums, deposits, reinvestment of

interest income and returns of principle on maturing fixed-income securities
being placed into lower-yielding investments (short to intermediate treasuries),
which will push net investment income down over time. In a prolonged low
interest rate environment – in which rates remain consistently below those that
insurers assumed when they priced these products – the shortfall in investment
income will lower earnings and probably negatively impact credit ratings.
Disintermediation Risk
This is the risk that a policy owner will withdraw funds that are locked in at a
low rate to instead invest at a higher new money rate. In developed economies,
during the high interest rate days of the late ’70s and early ’80s, many clients
with old whole life policies and guaranteed low loan rates borrowed the
maximum loans and invested the monies in higher yielding money market
accounts.
In general, if an investor has monies in a low yield investment, like a fixed

account, he or she might divert monies from accounts with low fixed interest
rates to direct investment in high-yielding instruments.
Such a scenario in insurance markets (surrender) could accelerate the pace of

asset sales when such sales would likely produce financial losses.
Academic research has shown that insurer insolvency is significantly related to

interest rate volatility.
The importance of interest rate risk to life insurance firms can be summarized
as
1) the investment portfolio of the typical highly leveraged insurer is

concentrated in long-term fixed-income securities
2) life insurer performance is negatively related to changes in interest rates
3) for insurers whose duration of assets exceeds that of their liabilities, rising
interest rates erode the value of surplus, leading to increased leverage and
a greater probability of ruin;
4) for insurers whose duration of assets is less than that of their liabilities,
falling interest rates erode the value of surplus, leading to increased
leverage and a greater probability of ruin;
5) higher leverage increases the insurer’s cost of capital ; and
6) interest rate risk leads insurers to take steps to match asset-liability

durations with futures and options (hedge) in order to hedge to protect their
value
Duration and convexity, has long been developed to manage traditional life
products such as fixed interest rate whole life or term life products. Further

with immunization techniques, insurers aim to minimize variations in cash
inflows and outflows on the assumptions that interest rates experience small
deterministic changes and all cash flows are fixed and not dependent on
interest rates. These are assumptions on which immunization model works.
Immunization is a process of matching duration and convexity of assets and

liabilities to ensure that they move in tandem with change in interest rate.
Duration is the weighted average duration of any asset or liability where the
weights are present value of cash flows of those assets and liabilities. Duration
represents the rate of change of value of asset or liability with the change in
interest rate. Convexity is the rate of change of duration with the change in
interest rate.
With more innovative products onto the market, traditional immunization

methodology won’t be proper to measure interest risk because timing or
amount of the cash flows of such products depends on interest rate
fluctuations. Hence need is felt for applying stochastic interest rate approach
for hedging purposes

Summary
a) Life insurance premiums are calculated based mainly on five factors, namely
mortality, persistency, interest rates, expenses and commission.
b) Generally, assumption setting process consists of 6 steps namely, historical

experience, best estimate, future conditions, adjust best estimates, extent
of reliance and adjust best estimates for margins.
c) Interest rate assumption is very important for product with more saving
element or more guarantees.
d) Interest rate is the rate that would be earned on investments in future.
e) Rate of interest determination varies with the type of product selected.
f) There are various factors to be considered for deciding this assumption,

majorly interest rate risk, liability profile, reinvestment risk and sensitivity
of interest rate for profit.
g) Interest rate models are used to derive interest rate assumptions.
h) Interest rate risk is dependent on duration and convexity of assets and

liabilities.

Answer 1
Life insurers invest premiums in the bond market and when interest rates fall,
the amount available to pay benefits declines - premiums rise to compensate.
Answer 2
All of the above
Factors that would be considered while estimating interest rates include past
experiences of rates of interest in the economy for each type of investment,
investment charges that would be incurred, trends of inflation
Answer 3
Single premium = Present Value of Benefits that would be payable in future +

Present value of Expenses to run business in future - Present value of

Question 1
Life insurance premiums are calculated based on _________
I. Mortality rate
II. Interest rates
III. Corporate expenses
Question 2
In which of the following products would the policyholders expect the highest
returns?
I. With profit contracts
II. Without profit contracts
III. Both of the above
Answer 1
All of the above
Life insurance premiums are calculated based on mortality rates, interest rates,
corporate expenses etc.
Answer 2
In with profit contracts, the investment should provide higher returns to meet
the expectations of policyholders, such as in the case of equity or property,
where capital appreciation is possible.

CHAPTER 8
PREMIUM BASES – MORTALITY AND MORBIDITY RATES

Mortality rate is a measure of the number of deaths (in general, or due to a

specific cause) in a population, scaled to the size of that population, per unit of
time.
Mortality rate is typically expressed in units of deaths per 1000 individuals per
year - thus, a mortality rate of 9.5 (out of 1000) in a population of 1,000 would
mean 9.5 deaths per year in that entire population.
Mortality rate is distinct from morbidity rate, which refers to the number of
individuals in poor health during a given time period (the prevalence rate) or
the number of newly appearing cases of a disease per unit of time (incidence
rate).
Learning Outcomes
A. Reasons for use of parameters

B. Mortality and morbidity rates
C. Determining mortality and morbidity rates
D. Experience analysis
E. Mortality or morbidity experience studies
F. A Simple example
G. Mortality or morbidity risk

Mr. Sam asks his insurance agent how the insurance company decides on the
amount of premium to be charged.
The agent tells him that one of the important factors used to decide premium is
mortality or morbidity rates. Now Mr. Sam is confused as to what these rates
are and how they are calculated.
This chapter will help you understand these concepts.
A. Reasons for use of parameters
An insurer is in the business of protection by offering insurance cover. It cannot

afford to ignore the mortality rate (e.g. there are two claims by death out of
1000 policies issued). He should know what would be the expected number of
claims and amounts of claims. Only based on this information, insurer would be
able to calculate its expected benefit payout and therefore premium.
Example
An insurance company sells 1000 policies and expects 2 claims. The amount of 2
claims is Rs. 100,000/-. The company has to use this amount for deciding the
premium rates. It is obvious from this that if the period of cover is one year, the
insurer should have Rs. 100,000/- from 1000 policies to meet these claims, so
that the total income is equal to total outgo. Suppose the insurer thinks there
would be 10 claims, then the premium the company has to charge from
policyholders would be high.
So the higher the expected claim experience, the higher is the premium. This is
similar in the case of morbidity.
However, in some of the products benefit is only payable if there is any health
problem not leading to death, such as some stand alone critical illness products.
In these types of products there is a survival period after the onset of critical
illness, which has to pass to become eligible for claim. In these types of policies
higher mortality rate would mean lower benefit and therefore lower premium.
For annuity plans also since benefit is payable on survival, higher mortality
means lower benefit and therefore lower premium.

Test Yourself 1
An insurance company sells 1000 policies and it expects 5 claims. The total
amount of claims is Rs. 2,50,000/-. If the period of cover is one year and if the
company wants its total income to be equal to the total outgo, what premium
should the company charge from each of those 1000 policyholders?
I. Rs.250/-
II. Rs.500/-
III. Rs.100/-
IV. Rs.2500/-

B. Mortality and morbidity rates
Mortality and morbidity rate is used to find the expected number of events of
claims. This is related to the rate that would be expected in the number of
claims in future. That would also be based on past experience and
improvements that would have taken place at present.
Definition
Morbidity rate refers to the number of individuals in poor health during a given
time period (the prevalence rate) or the number of newly appearing cases of a
disease per unit of time (incidence rate).
Definition
Mortality rate is a measure of the number of deaths (in general, or due to a

specific cause) in a population, scaled to the size of that population, per unit of
time.
Rate of mortality used by insurers would also depend upon the selection of lives
to be insured by the insurer. A strict medical underwriting process would ensure
better mortality experience. Rate of mortality used would also depend upon
what classes of lives are going to be targeted by insurers:
 Workers in various occupations

 Children
 Affluent people
 Females
 People with no steady income, etc.
Life table below shows the death rates and also the number of survivors at each
age. Such tables are constructed to estimate the premium rates.

Table 8.1
Number Number Number
Age- Number of Death Age- Death
of deaths of lives – of deaths
x lives - lx rate x rate
- dx lx - dx
15 100000.000 0.015 1500.000 58 20595.146 0.058 1194.518
16 98500.000 0.016 1576.000 59 19400.627 0.059 1144.637
17 96924.000 0.017 1647.708 60 18255.990 0.090 1643.039
18 95276.292 0.018 1714.973 61 16612.951 0.092 1520.085
19 93561.319 0.019 1777.665 62 15092.866 0.093 1403.637
20 91783.654 0.020 1835.673 63 13689.230 0.095 1293.632
21 89947.981 0.021 1888.908 64 12395.598 0.096 1189.977
22 88059.073 0.022 1937.300 65 11205.620 0.098 1092.548
23 86121.773 0.023 1980.801 66 10113.072 0.099 1001.194
24 84140.973 0.024 2019.383 67 9111.878 0.101 915.744
25 82121.589 0.025 2053.040 68 8196.134 0.102 836.006
26 80068.550 0.026 2081.782 69 7360.129 0.104 761.773
27 77986.767 0.027 2105.643 70 6598.355 0.140 923.770
28 75881.125 0.028 2124.671 71 5674.586 0.142 805.791
29 73756.453 0.029 2138.937 72 4868.794 0.144 701.106
30 71617.516 0.030 2148.525 73 4167.688 0.146 608.482
31 69468.990 0.031 2153.539 74 3559.206 0.148 526.762
32 67315.452 0.032 2154.094 75 3032.443 0.150 454.866
33 65161.357 0.033 2150.325 76 2577.577 0.152 391.792
34 63011.032 0.034 2142.375 77 2185.785 0.154 336.611
35 60868.657 0.035 2130.403 78 1849.174 0.156 288.471
36 58738.254 0.036 2114.577 79 1560.703 0.158 246.591
37 56623.677 0.037 2095.076 80 1314.112 0.240 315.387
38 54528.601 0.038 2072.087 81 998.725 0.243 242.690
39 52456.514 0.039 2045.804 82 756.035 0.246 185.985
40 50410.710 0.040 2016.428 83 570.050 0.249 141.943
41 48394.282 0.041 1984.166 84 428.108 0.252 107.883
42 46410.116 0.042 1949.225 85 320.225 0.255 81.657
43 44460.891 0.043 1911.818 86 238.567 0.258 61.550
44 42549.073 0.044 1872.159 87 177.017 0.261 46.201
45 40676.914 0.045 1830.461 88 130.816 0.264 34.535
46 38846.453 0.046 1786.937 89 96.280 0.267 25.707
47 37059.516 0.047 1741.797 90 70.573 0.270 19.055
48 35317.719 0.048 1695.250 91 51.519 0.273 14.065
49 33622.468 0.049 1647.501 92 37.454 0.276 10.337
50 31974.967 0.050 1598.748 93 27.117 0.279 7.566
51 30376.219 0.051 1549.187 94 19.551 0.282 5.513
52 28827.032 0.052 1499.006 95 14.038 0.285 4.001
53 27328.026 0.053 1448.385 96 10.037 0.288 2.891
54 25879.641 0.054 1397.501 97 7.146 0.291 2.080

55 24482.140 0.055 1346.518 98 5.067 0.294 1.490
56 23135.622 0.056 1295.595 99 3.577 1.000 3.577
57 21840.028 0.057 1244.882 100 0.000
Factors that would be considered in choosing a rate are:
a) Mortality or morbidity risk
b) the target market for the contract
c) the underwriting controls applied (or not applied) and associated costs
d) Expected change in experience overtime
e) Nature and term of liabilities in respect of benefit
f) Available mortality experience within the company/industry; and also

reinsurer’s rates, if any;
g) Past experience of rates of mortality in the economy—census and

industry;
h) Insurer’s geographic operation: for instance, overseas operations;
i) Operational risks: Frauds that could arise in acceptance of claims – proof

of death, verification and suppression of material information.
Test Yourself 2
Which of the following is not a factor to determine the rate of premium?
I. Life table
II. Underwriting expenses
III. Classes of individuals
IV. Color of skin

C. Determining mortality and morbidity rates
Best estimates or mortality or morbidity rates are required to be made;

pessimistic and optimistic estimates are also made to choose a prudent rate.
Since the aim is to meet the shareholders’ objective, it is not unusual to be a
little more conservative in choosing a rate of mortality i.e. for assured lives,
higher mortality rates and for annuitants, lower mortality rates.
If things fail and do not work out properly, it would be the shareholders who
have to bear the burden of meeting expenses and claims.
1. What is the best estimate rate of mortality (morbidity) prevalent in the

market where the insurer would incur a number of claims (lower than or
equal to the expected number) without any problems?
2. What is the rate of improvements (adverse trends) prevalent in the

economy, so as to estimate the rate of mortality on assured lives?
3. What is the past experience and could this be used as a guide to the future?
An actuary needs to answers all these questions to determine the rate.
Factors Explained:
The values assigned to mortality or morbidity rates should reflect the expected
future experience of the lives who will take out the contract being priced. The
importance placed to this parameter would be dependent on the extent of
mortality or morbidity risk of the product.
The general assumption setting process as was discussed earlier would be

applicable here also. Assumption setting would require the analysis of historical
experience and estimation of future conditions and its impact on mortality or
morbidity. In case company or product is new with no historical experience,
industry data, experience of similar product, reinsurance data, consultants
estimates etc can be used.
The expected future experience of the policyholders will depend crucially on

the factors as listed above. Details as explained below:
 The target market for the contract: – for example, is it rural or urban
population? The target market would be dependent on the distribution
channel involved or vice versa. For instance, if distribution channel is
bank then it is expected that people targeted would be financially
affluent people with aces to medical facilities. In that case better
mortality experience is expected. While if distribution channel is a
broker in rural area, mortality experience is expected to be bad because
of rural target population having less access to medical facilities.

 The underwriting controls applied (or not applied) and associated costs:
underwriting is a process to evaluate a life for deciding the best terms
which can be offered to him or her depending upon his or her health.
Terms can be higher premium or lower sum assured for same premium or
exclusion clause for a high risk etc ,depending upon the risk involved.
Underwriting controls are also dependent upon the type of product. Unit
linked product with death benefit of maximum of sum assured and fund
value will have low and reducing sum at risk with time, thus requiring
lower underwriting controls. At the same time a term insurance contract
with benefit payable only on death would need very strict underwriting
because of high sum assured per rupee of premium.
There is always a choice between the extent of underwriting controls

applied and encourage prospective policyholders to purchase the policy
without much hassle. Medical underwriting involves health checkups and
medical test which can be a big hassle for some prospective
policyholders. It also cost money which in turn is chargeable to
customers and is reflected in higher premiums. Strict underwriting is also
act as a deterrent to customers and discourage them to purchase a
policy.
However, underwriting has lot of advantages such as it gives fair

treatment to all lives depending upon the risk involved, anti selection
and fraud risk is greatly reduced and bad risk are identified are given
proper terms. These all is then reflected in the better mortality
experience for the insured population. This expected better experience
is then passed to customers in terms of reduced premium. Moreover,
with strict underwriting controls, reinsurance terms are favorable. That
is, reinsurance is available at cheaper prices. This further reduces the
premium to be charged.
Similarly underwriting expenses that would be incurred should also be

considered. If every life that would be insured is going to be medically
examined, it would be good, but this would incur cost and consideration
should be on to what extent the insurer would bear the cost.
Hence, to decide on the mortality rates to be used, first decision is how

much underwriting would be required? This would be dependent on
relative pros and cons of all the factors above. After this decision, it can
be estimated whether the expected experience would be good or bad as
per the underwriting policy.
 The expected change in the experience overtime: that is since the time
of the last historical investigation to the point in time at which the
assumption will on average apply (typically you would be looking about
ten to fifteen years into the future).

Historical investigations are not always done frequently, since it takes
time for trends to emerge. Hence, it is important to see the time gap
between now and the last historical investigation. There may have been
improvements in medical science leading to better experience now.
Further, since insurance is a long term contract, these mortality rates
assumptions would apply for many years into the future. There can be
medical advances as well as catastrophes impacting mortality
experience. Mortality rate estimation should take into consideration
both these aspects.
 Nature and term of liabilities in respect of benefit: This will be

dependent on product design. As discussed above also, this will decide
the extent of mortality or morbidity risk for the contract. A pure term
insurance would have much higher risk when compared to with profit
endowment contract. Similar, more we look into the future more will be
the risk because of the difficulty of predicting future. Hence, long term
policies would be more risky than short term policies.
 Available mortality experience within the company/industry; and also

reinsurer’s rates, if any: This is important since it is expected that trend
will follow until unless there is significant change in underwriting, target
market etc. Reinsurer’s rate also provide good information of the
expected trends since, they have data of different companies as well as
different countries.
 Past experience of rates of mortality in the economy—census and

industry; this factor is similar to the above factors, but along with the
experience of company or industry, experience should also be seen for
the economy or census as a whole vis a vis industry. This can provide
useful information the trends of medical development within the
country.
 Insurer’s geographic operation: for instance, overseas operations; This

will bring even more uncertainty and would require even more data of
those locations to estimate the rates. Mortality o morbidity rates would
be dependent on the experience of those locations.
 Operational risks: Frauds that could arise in acceptance of claims – proof

of death, verification and suppression of material information. This
poses an additional risk, but it is very much controllable by putting strict
operational controls. In India particularly this problem is majorly
translated into “dead man” insurance, where a person who is already
dead is insured, by using forged signature and other documents, to gain
quick money at the expense of insurance company.

Own table vs Standard table?
Pricing assumptions used for mortality rates will be based on an adjustment to

mortality or morbidity rates from a standard table. Standard table is usually
published for the whole population and is usually a single source used by most
of the companies. Company can then adjust standard table rates depending
upon its own experience and its own estimation of future conditions.
Even a company with a very large body of suitable experience would probably
not construct its own tables, but would use the mortality data to adjust a
standard table. This is both to save resources, and to protect against the errors
which might easily arise with an inappropriate smoothing (especially for ages
where there is little data)
Adjustment to mortality or morbidity rates:
If the company has adequate data, the adjustment would be derived by

analyzing 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.
This alternative may provide appropriate data, depending on the similarity

between the contracts concerned. For example, suppose you want to price a
new with-profits whole life contract. With-profits whole life and long-term
with-profits endowment assurances may have similar mortality experience.
However, move a little further (eg to a pure endowment) and different
underwriting procedures and target markets may make experience much more
significantly different. Move even further (eg to a term assurance, where the
customer needs differ greatly) and experience will almost certainly be very
different.
The data would relate to an appropriate period of years, such that the volume
of data is adequate but at the same time a very old data not relevant today
should be avoided.
There is a conflict here between the desire to have a large pool of data, and a
requirement not to look at significantly different generations of lives. A
“generation” in this context could be just five or ten years. If the data include
lives who enjoy different mortality because of different generations then the
mortality implied by the data may be misleading. This will be so if differently
aged lives have seen different mortality improvements from one generation to
the next. So mortality investigations are normally based on three or four years
of data.
The analysis would classify the data into similar groups to maintain the quality
of analysis. For example male and female or smoker and non smoker might be
separated because of different mortality experience.

If the adjusted rates are to apply to a class of lives which is expected to have a
different experience from that to which the analyzed data relate, then further
adjustments may need to be made. This situation could arise due to a change in
target market, distribution channel, or the basis of underwriting and accepting
lives as discussed above.
It can be argued that the class of lives concerned is almost always going to have
a different experience from that underlying the data, just due to the influence
of time.
Other consideration:
Consideration should be paid to the expected changes in rates over time. This is
a particular issue for annuities where increased longevity is a risk.
So in this case if mortality improvement is underestimated the product will

become too risk and could lead to huge losses in future.
Similarly, for contracts that pay significant death benefits such as term
contracts, any expectation of increasing mortality (eg due to AIDS or deadly
viruses) should be included in the basis. If this estimation is not done and
adequate allowance is not made, mortality rates can lead to under pricing.
However, for some contacts future expected mortality changes can be ignored
where mortality risk is insignificant financially, such as unit linked saving
contracts.
In India, usually the premium rates or mortality or morbidity charges are

guaranteed and not reviewable for individual class of products. This mortality
rates assumption would be even more important in those scenarios where there
are no chances of correcting our mistakes later.
Ideal case vs Practice?
For all the above discussion, we assume the “ideal case” of an actuary having
complete freedom to decide on the most appropriate assumption. However, it
will often be the case that the regulatory authorities will constrain, perhaps
severely, this choice in a pricing context. There are competitive considerations
also which can impact the mortality rates used for calculating premium or
mortality charges.
This estimation is the starting point in putting a value on a parameter. We

would then consider what margins might be appropriate in the later chapters

Rate of mortality (morbidity) varies with the following as well:
a) Assurances: Term, Whole Life, Endowment Assurance, Money Back

Products: Under this, lives with medical examination and without
medical examination. Sometimes size of Sum Assured also leads to
variation in premium
b) Annuities: Deferred Annuity and Immediate Annuity Products;
c) Census rates
d) Industry experience and
e) Reinsurers rates
Test Yourself 3
From an underwriter’s point of view, while deciding on pricing of products,

what can be the best scenario that can be assumed with regards to mortality
rates?
I. Where number of claims are higher than expected number of claims

II. Where number of claims are equal to expected number of claims
III. Where number of claims are lower than or equal to expected number of
claims
IV. Where number of claims are higher than or equal to the expected number of
claims

D. Experience analysis
Here we will look at the first step of assumptions setting process of analyzing
the past experience.
The experience can be analyzed directly by looking at “Actual vs Expected

(A/E)” where expected can be a defined benchmark. For example, for mortality
experience studies, expected would the number of deaths as per a standard
table of mortality an actual would be actual number of deaths experienced.
Based on this A/E, a suitable adjustment can be applied on standard table to

derive mortality or morbidity rates.
This experience can also be monitored for already priced and launched product
to see the financial impact of any divergence.
Reasons for analyzing past experience are given below:
 Derive or update assumptions as to future experience for pricing.
 Monitor any trends in experience, which can be used for deriving

assumptions as well as estimate future profitability of existing business.
 Monitor actual compared to expected experience and take corrective

actions as needed. These corrective actions include re pricing the
product to make it more appropriate as per current experience.
 Provide management information to aid business decisions. However,

management of a life insurance company is not just a reactive process
(responding to adverse experience) but also a pro-active one. Hence
while the company may not be suffering particularly adverse experience,
it may still be able to identify ways in which it can make its operation
more profitable. Therefore it will be interested as much in its profitable
activities as it is in its unprofitable ones. This will help identify:
o profitable products
o profitable sales channels or agents
o profitable markets
o efficient sections of the business
o successful investment strategies.
 Make more informed decisions about pricing and about adequacy of

reserves.

Data for experience analysis:
The basic requirement is of a reasonable volume of stable, consistent data,

from which future experience and trends can be derived.
Consistent refers to data of similar form, from similar source, grouped based of
same criteria and same in terms of reliability.
Example of inconsistent data:
- For one analysis age is date last birthday and for another it is age
nearest birth day
- Different smoker definition in terms of number of years
Grouping of data:
Once the appropriate and relevant data is available, it should then be divided
into similar groups based of similar risk characteristics. These groups should be
reasonably homogenous.
However, grouping should not be so much so as to undermine the statistical

significance of the data. More the number of groups, less data will be there in
each group making it less statistical significant.
These groups should remain stable over time. Otherwise, this grouping itself
may result into change in mortality experience within groups (just because of
grouping mix change), leading to wrong conclusion that experience has
changed. For example, if two groups having different source of business is
combined, experience can change because of different population now. It
should not be inferred as actual change in experience.
Period of data:
One of the key decisions in conducting any investigation is the time period to be
analyzed. In order to have reasonably sized data, interval as long as possible is
desired, and normally greater than, say, one year. However, we want to
investigate recent experience, not an average of recent and ancient; so this will
place an upper limit on the time interval. This upper limit will depend on what
we are investigating; for instance an expense investigation would normally be
confined to twelve months, whereas mortality investigations would often be
based on a three or four year span.
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.
We will now discuss about the experience analysis for mortality or morbidity.

E. Mortality or morbidity experience studies
Experience analysis of mortality or morbidity is the first step in deriving the

assumptions.
This involves four steps namely;
1. collection of data,
2. grouping of data,
3. calculation of expected experience and
4. calculation of actual experience.
We will now study these steps one by one:
1. Collection of data:
This involves the consideration of different sources of data within the

company as well as the period of data to consider.
Time period is important for various reasons. We expect mortality to

change over time due to advances in medical science, changes in
cultural attitudes, improvements in standard of living, new diseases,
etc. This would lead us to consider an interval of at most five years.
Period should not be too large or too small. The time interval needs to
be large enough to ensure that there is a sizeable amount of data, and
that seasonal influences do not affect the data. For instance a study of
annuitants’ mortality over a hard winter would give rather misleading
results.
However the period of investigation should not be too great, because we

want to be able to act as quickly as possible on any recent changes in
mortality levels, in particular as regards product pricing. Thus looking at
an investigation based on the last five years of data, for instance, will
imply a reaction time three years slower than if we were to use just two
years of data.
For mortality analysis, it is usually considered appropriate to use last 3-4

years data as a thumb rule.
Best source would be the actual policy data maintained in the policy
administration system. Data should be checked properly with other
sources such as data if kept separately by any other department.

2. Grouping of data:
The data (both actual claims and expected claims) would ideally be
analyzed, where relevant, by
- type of contract
- age
- sex
- Region: rural, urban etc
- duration from entry
- distribution channel
- Occupation
- Level of underwriting
- smoker / non-smoker status
- medical / non-medical status
- Sum assured bands: high vs low
3. Calculation of expected experience:
This involves choice of one benchmark such as standard mortality or

morbidity table against which experience will be compared. Under each
sub grouping the expected number of claims or amount of claims would
be calculated by using age of each contract. This work is normally done
contract wise by taking into account the age of each contract and then
contract wise expected claims are summed to get expected claims for
each subgroup.
This is done for both number of claims and amount of claims separately.
4. Calculation of actual experience.
Actual experience would be available for each subgroup and is used

directly. Using this actual experience then “Actual vs Expected (A/E)” is
calculated which is used further to derive mortality or morbidity
assumptions.
Credibility analysis:
It was discussed earlier that company adjust standard table rates depending
upon its own experience and its own estimation of future conditions. This
adjustment along with the name of standard table is what is referred to as
mortality or morbidity assumption in practice. For example, it is represented as
90% of LIC 2006 – 08 mortality tables.
This adjustment factor is a mix of own experience and its own estimation of
future conditions. Own experience is “Actual vs Expected” as calculated above.
Own estimation will depend upon lot of factors as discussed earlier in this
chapter.

How much weight to give to own experience and how much to estimation, is
essentially decided by credibility analysis. Credibility refers to reliance which
can be placed upon the own experience. If data is small, say for a new
company, statistically that data can contain random fluctuations. Similarly if
data is not fit for the purpose it is not credible for a particular task.
A credibility factor is calculated using statistical analysis and depending upon

the purpose of analysis. This factor ranges from 0% to 100%. 0% means not
credible at all while 100% is fully credible. This is essentially the weight given to
own data to derive adjustment factors.
Lets call own experience as A, estimation as T and credibility factor as Z. Then

the formula for finding the adjustment would be:
Adjustment factors = A x (Z) + T x (1 – Z)
So, with Z at 100% adjustment factor will be equal to actual experience. And
with Z at 0%, adjustment factor will constitute of only estimated experience

F. A Simple example
XYZ is an insurance company in India working for last 10 years. It has number of
products ranging from traditional non participating (including term), traditional
participating and unit linked plans. Board of directors in their meeting has
asked the chief actuary to conduct a review of the pricing assumptions to
ensure that these are appropriate. This will also be helpful for all new products
to be priced in coming year. These results are required quickly so there is no
time for policy by policy calculation. Grouping which can be considered is broad
product types.
Chief actuary has asked policy administration department to provide the

relevant data.
Following data is received:
Type of business Number of Average Actual deaths in

policies Age last one year
Traditional term 3,00,000 35 1050
Traditional endowment 2,00,000 40 700
Traditional participating 2,00,000 35 640
Unit linked 1,00,000 25 240
Based on this data actuary has looked up the mortality rate from as standard
table and calculated expected number of deaths:
Type of business Number Average Standard table Expected deaths

of Age mortality rate in last one year
policies (no. of policies x
rate)
Traditional term 3,00,000 35 0.0034 1020
Traditional 2,00,000 40 0.0039 780
endowment
Traditional 2,00,000 35 0.0034 680
participating
Unit linked 1,00,000 25 0.0031 310
Actual experience is as calculated below, Actual deaths divided by Expected

deaths:
Type of business Actual Expected Actual experience

Traditional term 1050 1020 103%
Traditional 700 780 90%
endowment
Traditional 640 680 94%
participating
Unit linked 240 310 77%

Actuary has also done the credibility analysis and has calculated 60% credibility
for traditional term and endowment and 40% credibility for Unit linked and
participating business.
Apart from this actuary has also calculated estimated experience using factors
such as target market, underwriting industry data etc, which comes out to be
90% of standard table for non term business and 70% of standard table for term
business.
Based on above information the adjustment factors for all product types are
calculated as shown in table below:
Type of business Actual Estimated Credibility Adjustment factors

experience experience factors (Mortality
(A) (T) (Z) assumption as a % of
standard table)
[A(Z)+T(1-Z)]
Traditional term 103% 70% 60% 90%
Traditional 90% 90% 60% 90%
endowment
participating
Unit linked 77% 90% 40% 85%
These rates were found to be consistent with rates used in pricing.
It should be noted here that the example which we have considered is very
simple to explain the basic concept. In practice much more complex method is
applied with calculation done policy by policy using a lot more groups.
Reinsurer’s knowledge is also very useful for this estimation when the company
has less experience in these issues.

G. Mortality or morbidity risk
Mortality risk refers to the risk of actual experience being different from what
was assumed in pricing and the financial significance of that a variance.
It is possible that there is a difference but it is not financially significant for a

particular product say unit linked. This would be treated as less mortality risk
for that particular product.
Mortality assumption setting can have risk of following three types:
- “model” risk that the model, used to estimate future mortality, etc,
may not be appropriate or may contain errors;
- “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.
For example, mix of healthy vs non healthy life used in model may be
incorrect.
- “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 risk here is that mortality or morbidity turns out to be more adverse than
assumed in the models we have used for decision-making. The three types of
risk listed above help us to understand the various ways in which the risk can
arise. This in turn can help us to devise suitable means of controlling the risk. In
other words, if we know the risk then only we can control it.
Parameter risk can arise from incorrect or inadequate data also, if that data is
used to derive the parameters. Hence, data risk gives rise to parameter risk in
that case.
At one extreme we could be dealing with a well-established type of contract,

with reasonably stable and predictable experience, and lots of relevant data on
which to base assumptions. This would be low risk. At the other extreme we
might be dealing with a contract type that is completely new to our market,
and have to rely on a mixture of intelligent guesswork and heavy adaptation of
what little relevant data exist. This would be high risk.
Even if the past data is good, the possibility of new diseases or sudden advances
in medical treatments can never be ruled out. In other words, there will always
be this risk of uncertain future.
The “random fluctuations” risk is most likely to arise if the data is not large
enough for the “law of large numbers” to apply and to be statistically
significant. Smaller the data larger will be fluctuation. For example of there
are just 100 policies, few deaths may look like a worsening experience in
percentage terms, even if it is not likely to be sustainable.
Financial significance of risk:
This will be mainly dependent on the benefit structure and product design. The
larger the death benefit as a percentage total benefit paid; larger will be the
financial impact of this risk. This will also be dependent on the guarantees on
death embedded in a product.
Pure term insurance where the benefit is only payable on death will have
maximum financial impact. This is because the death benefit is the only benefit
payable so will be impacted by this risk.
This will be followed by traditional non participating endowment with

guaranteed death benefits. Then it will be participating plan with lower death
guarantees. Finally impact will be minimum for unit linked plans where
maximum of fund value or sum assured is payable on death.
Having said all that, in an established market there is likely to be good data on
which to base assumptions. Also, population mortality has been reasonably
stable, or at least subject to steady trends, in developed countries. So there
should be low model and parameter risk.
Even so, the possibility of a new disease represents a risk that is difficult to
quantify.
Controlling risk:
Underwriting and reinsurance are the most important ways of controlling this
risk. Other ways are to ensure that appropriate data and model is used and is
completely validated before use.
Underwriting:
Underwriting is the process of consideration of an insurance risk. This includes

assessing whether the risk is acceptable and, if so, setting the appropriate
premium, together with the terms and conditions of cover. It may also include
assessing the risk in the context of the other risks in the portfolio
Underwriting helps a life insurance company to control the quality of lives

accepted for insurance.
Based on the underwriting policy then suitable mortality or morbidity

assumptions can be used in pricing. If the underwriting policy and mortality or
morbidity assumptions are consistent, here is a less chance of actual being
different from assumed.
Underwriting is of two types, medical underwriting and financial underwriting.

Medical underwriting screens the prospective policyholder for any known or
expected health issue which can impact the premium or acceptance of that risk.
Financial underwriting makes sure that person will be able to afford the policy
financially. It also helps in detection of fraud where a person who is aware
about his health goes for life policy much beyond his/her financial capacity.
Reinsurance:
Reinsurance is a process used by insurers to share the mortality or morbidity risk

with some other party. Insurer pays premium to the reinsurer; in turn reinsurer
pays insurer the claim amount if there is any claim. Amount of premium and
claim will depend upon the terms and conditions of reinsurance.
There is usually a credit risk of default or non timely payment associated with
reinsurance, which is considered while deciding the terms and conditions of
reinsurance.
We will study more about reinsurance in a separate chapter.

Summary
a) Premium amounts can be determined using the mortality and morbidity

rates
b) Mortality rate is a measure of the number of deaths (in general, or due to a

specific cause) in a population, scaled to the size of that population, per
unit of time.
c) Morbidity rate refers to the number of individuals in poor health during a

given time period (the prevalence rate) or the number of newly appearing
cases of the disease per unit of time.
d) Most important factors which are important in choosing a rate are mortality
or morbidity risk, target market, underwriting, liability profile and past
experience.
e) The values assigned to mortality or morbidity rates should reflect the

expected future experience of the lives who will take out the contract being
priced.
f) Company adjusts standard table rates depending upon its own experience
and its own estimation of future conditions.
g) Experience analysis involves calculation of “Actual vs Expected” and has

main objective of deriving assumptions apart from others like monitoring
trends and performance.
h) Data used for experience studies should be appropriate and correct and
should be grouped based on relevance.
i) Credibility analysis is done to give weights to own experience and own

estimation of future conditions to derive mortality or morbidity assumption.
j) Mortality risk is controlled majorly by underwriting and reinsurance.

Answer 1
Total amount of claim / No. of policyholders

= Rs. 250000 / 1000
= Rs. 250.
Answer 2
Color of skin does not affect the premium. All other mentioned factors help us
to determine the rates of premium.
Answer 3
Where number of claims is lower than or equal to expected number of claims.

Question 1
Poor health raises the rates for life insurance because ________
I. There is a risk of dying during the policy

II. It decreases number of years one is likely to pay premiums
III. It reduces the time before which the company may have to pay a claim
Question 2
Which of the following is not a factor to determine mortality or morbidity rates?
I. Census rate
II. Past rates of mortality in the economy
III. Birth rate
IV. Reinsurers’ rates
Answer 1
As there is a risk of dying during the policy period due to poor health, the
company is required to pay the claim early, and it also decreases the number of
years one is likely to pay premiums.
Answer 2
Birth rate is not a factor to determine mortality or morbidity rates.

Other given rates are required to calculate the mortality and morbidity rates.

CHAPTER 9
PREMIUM BASES – PERSISTENCY/WITHDRAWAL RATES
Persistency refers to the volume of business that a life insurance company is

able to retain. This rate can be gauged with the help of "persistency ratio". It
implies a "percentage of an insurance company's already written policies
remaining in force without lapsing or being replaced by policies of other
insurers."
Withdrawal rates are opposite of persistency rates. Hence, it is percentage of

insurance company’s already written policies withdrawn by the policyholders. If
the persistency ratio is 80% then withdrawal rate will be 20%.
Withdrawal is a policy option and excludes exits such as death and maturities.
It takes into account voluntary lapse or surrenders, partial withdrawal from the
unit fund, making the policy paid up with reduced benefits etc.
Learning Outcomes
A. Reasons for use of persistency

B. Withdrawal rates
C. Determining withdrawal rate
D. Withdrawal experience analysis
E. A Simple example
F. Withdrawal risk

Mr. Yank asks his insurance agent about the term “persistency” and what its
role in deciding the premium should be.
The agent tells him that one of the important factors used to decide premium is
withdrawal rate which is opposite of persistency. Now Mr. Sam is confused as to
what these rates are and how they are calculated.
This chapter will help you understand these concepts.
A. Reasons for use of persistency
Persistency of a life insurance policy indicates whether the customer is

renewing his or her policy each year or quitting it midway. A high persistency
rate reflects good sales practices because life insurance is a long term product.
Persistency is a very important metric in insurance as life insurance is a long-

term contract. In fact, both the insurer and the policyholder benefit if the
policy is held for the entire tenor of the contract. Agents benefit if the policy is
churned every few years as they collect higher first-year commissions than the
commissions due from year two onwards. In the long term agent also benefits if
he tries to maintain the same policy and bring new policy for higher
commissions.
Withdrawal rates are used for deriving the premium that should be paid for a
particular product.
If pricing is done through formula approach withdrawal rates are unlikely to be

used for deriving premiums. This is one of the limitations of simple formula
approach.
However, even in formula approach the premium needs to be profit tested to

see if it meets the minimum set criteria of profit margin. In that profit testing
withdrawal rates assumption must be considered otherwise the resultant
premiums can be over or under charged. If it is over charged it will be bad from
marketing point of view and if it is under charged it will lead to losses.
In cash flow approach of pricing, withdrawal rate assumption is a very important

assumption for most of the contract types and therefore must be considered. If
withdrawal rates are not considered, the company will not know its impact on
the profitability of the contract.

Impact of withdrawal rates on profits:
Withdrawal rates impact profits and therefore the premium to be charged for the
product.
Actual profits earned on a contract can be impacted by withdrawal rates positively

or negatively. It will depend upon the asset share vs. surrender value at the time
of withdrawal since the future profits is lost for the withdrawing contract.
Asset share of the policy is the amount accumulated for the policy till date.
Amount of profit earned on the contract is excess of asset share over the
surrender value at the time of withdrawal. But this policy will not give any profits in
the future, which it would have been given had it not been withdrawn.
If the actual profit is less than the total profit without withdrawal assumption
(expected profit), then this will lead to negative impact on intended profit margin.
Conversely, if withdrawal terms are such that it recoups all the profit to be earned
in future for the policy and still give some more profit then the withdrawal rates will
increase the profit margin.
This can be explained using three simple scenarios:
Scenarios Asset Surrender Present value of Expected Impact on

Share value future profit lost profit without intended
(at time of withdrawal profits
withdrawal) assumptions
1 12,000 9,000 2,000 5,000 (2,000)
2 12,000 7,000 2,000 5,000 NIL
3 12,000 6,000 2,000 5,000 1,000
In the 1st scenario, profit earned by contract at withdrawal is Rs. 3,000, which is
calculated as asset share minus surrender value. Because of the withdrawal,
company will be losing Rs. 2,000 as future profits from this policy. The expected
profit from this policy, had it continued from inception till end, would have been
Rs. 5000. This profit is calculated by taking withdrawal rates assumption as zero.
Hence, in this case impact of withdrawal on profit is the reduction of Rs. 2,000,
which is expected profit minus actual profits (5000 minus 3000).
In the 2nd scenario, profit earned by contract at withdrawal is Rs. 5,000, which is
calculated as asset share minus surrender value. Future profits lost and expected
profit is same as scenario 1. In this scenario, the surrender terms are such that it
is able to recoup the profit lost in future as well. Hence, in this case impact of
withdrawal on profit is the NIL, which is expected profit minus actual profits (5000
minus 5000).

In the 3rd scenario, profit earned by contract at withdrawal is Rs. 6,000, which is
calculated as asset share minus surrender value. Future profits lost and expected
profit is same as scenario 1. In this scenario, the surrender terms are such that it
is able to recoup the profit lost in future and give some additional profit on
surrender as well. Hence, in this case impact of withdrawal on profit is additional
profit of Rs. 1,000, which is expected profit minus actual profits (5000 minus
5000).
The scenario 3 is usually referred to as lapse supported products. These types of

products encourage lapses since it is profitable for the company. To discourage
these types of products, regulator in India, has provided specific guidelines on the
calculation of surrender values.
The excess of asset share over surrender value will be dependent on the duration
of withdrawal and the actual asset share earned during that time point. Both asset
share and surrender value increase with time.
However, any withdrawal terms have to follow the regulations and regulations in
India provide specific guidelines on how to frame the withdrawal terms. Any terms
which seems unfair to the policyholder will not be approved. Hence, it is most
likely that in Indian scenario withdrawal leads to a negative impact on intended
profit margin.
Test Yourself 1
If actual profits from withdrawal are more than the expected profit without
withdrawals, then this policy will impact profit…..
I. Negatively
II. Positively
III. No impact
IV. Any impact is possible

B. Withdrawal rates
Withdrawal rate is used to find the expected number withdrawals from the
policies inforce at the start of the month or year. This is related to the rate that
would be expected in future. That would also be based on past experience and
change in conditions that would have taken place at present.
Definition
Withdrawal rate refers to the probability that a policyholder not pays the
premium or withdraws from the policy fully or partially willingly before the
maturity date.
An example of duration wise withdrawal rates is given the table below.
Month Withdrawal rates

13th month 20%
25th month 10%
37th month 5%
49th month onwards 2%
We start from 100 annual premium policies that have paid the 1st year premium.
20% policies from 100 policies, that is 20, will not pay 2nd premium due in 13th
month. Out of remaining 80 policies, 10%, that is 8, will not pay next premium
due in 25th month. Then out of remaining, 72 policies, 5% that is 3.6 policies,
will not pay 4th premium due in 37th month and so on.
The policies are in fractions because these work like probabilities and are
applied to each single policy in fractions only.
The example given above is the example of lapse rates where policyholder waits
till the time premium is due and then do not pay the premium.
Same concept applies to surrender rates also, where the policy can be
surrendered at any point of time in between the premium payment terms also.
Usually for few initial years surrender is not allowed, after which policyholder
can come any day and surrender the policy in return for surrender value.
Accordingly, surrender rates are applicable for full year rather than at any
specific month. In this case for modeling purpose it is assumed that a small
portion will surrender every month with effect being given for seasonality for
any higher surrender in a particular month (for example in month when
premium is due).

Withdrawal rates will be dependent on many factors, the main factor being the
withdrawal risk, which is the risk of more or less withdrawal then assumed and
its impact on profit.
Factors that would be considered in choosing a rate are:
a) Withdrawal risk
b) Past experience and industry experience
c) Type of product
d) Premium frequency
e) Size of premium
f) General economic situation
g) Distribution channel used for selling the contract
h) The target market for the contract
i) Financial knowledge of the client
j) Rural vs urban:
k) Type of premium payment modes available
l) Competitive situation of the product
m) Term of the contract
Test Yourself 2
Which of the following is a factor to determine the rate of withdrawal?
I. Life table
II. Underwriting expenses
III. Financial knowledge of the client
IV. Color of skin

C. Determining withdrawal rates
Best estimates withdrawal rates are required to be made; pessimistic and

optimistic estimates are also made to choose a prudent rate. Since the aim is to
meet the shareholders’ objective, it is not unusual to be a little more
conservative in choosing a rate of withdrawal.
If things fail and do not work out properly, it would be the shareholders who
have to bear the burden of meeting expenses and claims.
1. What is the best estimate rate of withdrawal prevalent in the market where
the insurer operates?
2. What is the estimated future condition that will impact the withdrawal
rates?
3. What is the past experience and could this be used as a guide to the future?
An actuary needs to answers all these questions to determine the rate.
Factors Explained:
The withdrawal rate assumptions should reflect the expected future experience
in respect of the contracts that will be taken out.
They will be based on an analysis of the company’s recent experience.
Ideally, this should relate to the contract being priced, but if no such
experience exists or the available data are inadequate, then the experience
under any similar contracts would be analyzed.
If the company does not itself have adequate data, there may be industry wide
experience that it could use.
Expected future experience of the withdrawal should also be estimated

depending upon an estimate of future conditions.
If the rates are to apply to a class of lives that is expected to have a different
experience from that to which the analyzed data relates, then adjustments may
ne ed to be made.
This situation could arise due to a change in the benefits being offered or target
market or distribution channel.

The expected future experience of the policyholders will depend crucially on
the factors as listed above. Details as explained below:
 Type of product:
Usually, the term insurance plan is purchased by client who is aware

about the need for insurance hence, is expected to have lower
withdrawal rates when compared to other products. However,
introduction of new lower premium competitive term insurance plan is
expected to increase the withdrawal rate as policyholder try to switch
product.
Unit linked product is expected to have lower withdrawal rates in initial

years as compared to conventional products since it is most likely to be
purchased by financially knowledgeable person. However, in India, after
five years now there is no surrender penalty on unit linked contract,
which can increase the withdrawal rate significantly.
 Past experience and industry experience:
Insurer’s past experience as well as industry experience is the major factor

on which rates will be dependent. It is expected that same trend as past
will continue if there is no major change in the selling policies of the
company overtime. Also, the overall industry experience will reflect
general mood of the policyholders regarding the insurance policies.
 Premium frequency:
Single premium contract is expected to have lower withdrawal rates

when compared to regular premium plans. In monthly premiums there
are more opportunities to withdraw than if premiums are annual.
 Size of premium:
A high premium relative to income will be harder to afford than a

smaller one hence can have higher withdrawal rates.
 General economic situation:
The results of each analysis should be assessed to see if they have been
affected by special factors such as an adverse economic situation in the
country. Withdrawal rates are dependent on the state of economy. Any
deterioration in the economic condition is most likely to increase the
withdrawal rates but it is dependent on the type of contract.
The two things to consider in a scenario of economic deterioration are
● whether people can still afford to keep the policy going, and
● whether they would get any cash from surrendering the policy.
So looking at the three specific cases:
1) Regular premium term insurance:
The premiums are fairly low so there should be very few policyholders
who now find themselves unable to continue paying premiums.
There is almost certainly no surrender value available, so there is no

incentive to surrender.
So you would not expect the economic downturn to affect

discontinuance rates significantly for this contract.
2) Single premium savings
There are no premiums to pay!
On the other hand there will probably be a significant surrender value.
So you would expect some increase in surrender rates.
3) Regular premium endowment assurance
The premiums are probably a major portion of policyholders’ incomes.

Some policyholders will now be unable to pay these premiums.
There will probably be significant surrender values available for all

policies greater than a couple of years old.
So you would expect a big increase in discontinuance rates.
 Distribution channel used to sell the contract:
Withdrawal rates are also impacted by distribution channel involved.
Consider the following cases:
Sales initiation: withdrawal rates are likely to be lower if clients

themselves initiate the sales.
Need based selling vs forced selling: The sales practice may be different:
for example, where clients have been put under more sales pressure to
buy a policy, or to take a larger policy, then withdrawal rates are likely
to be higher than where sales have been more strictly based on need.

Sales of policies made without proper information being gathered about
the client’s needs, can lead to inappropriate policies being sold through
ignorance (though this is again a reflection of poor sales practice).
 Target market
Different target markets may reflect different levels of affluence and

economic prosperity. There may then be differences in withdrawals that
arise through economic hardship.
 Financial knowledge
Different levels of financial knowledge of the client base can lead to

different perceptions of the value of a contract, and could lead to
different withdrawal rates.
 Rural vs urban:
Rural vs urban may reflect different levels of affluence, economic

prosperity and financial knowledge. Hence, withdrawal rate of rural is
expected to be higher than urban.
 Type of premium payment modes available:
ECS system where the amount is automatically deducted from clients

bank account can reduce the withdrawal rates, since it's more easier
than going to branch and paying premium by cheque. Also, premiums
paid in cash are more noticeable than premiums paid directly from a
bank account and so lead to higher withdrawal rates.
 Competitive situation of the product:
Introduction of more attractive products can have an adverse effect on

the withdrawal rate of existing product.
 Term of the contract:
Longer term policies usually have high withdrawal rates when compared
to short term policies because there is more opportunity to withdraw for
the former.
Hence, as far as possible while deriving the withdrawal assumption it is

important to set the assumption in conjunction with other economic and
commercial assumptions. So, for example, withdrawal rates can be split channel
wise to give more clear view on the impact on profitability. Also, different lapse
rates should be considered for different investment return scenarios affected by
economic conditions.

Based on the above factors future withdrawal rates are estimated.
Withdrawal rates assumption to be used is a combination of past experience and

estimated future experience based on above factors. Credibility analysis is used
to give the respective weight.
Withdrawal rates are significantly influenced by economic and commercial

factors, which are very difficult to predict. Future withdrawal rates are
therefore subject to considerable uncertainty and so it is essential to explore
the sensitivity of the company’s profits to variations in the future withdrawal
experience.

D. Withdrawal experience analysis
Experience analysis of withdrawal is the first step in deriving the assumptions.
This involves three steps namely;
1. collection of data,
2. grouping of data, and
3. calculation of persistency and withdrawal rates.
We will now study these steps one by one:
1. Collection of data:
This involves the consideration of different sources of data within the

company as well as the period of data to consider.
Time period is important for various reasons. We expect withdrawal

rates to change over time due to change in company policy of selling,
target market or change in financial knowledge of customers etc. Mostly
the recent data is used for persistency.
Period should not be too large or too small. The time interval needs to
be large enough to ensure that there is a sizeable amount of data, and
that abnormal influences do not affect the data. For example,
withdrawal rates increased significantly during the financial crisis of year
2008.
However the period of investigation should not be too large, because we

want to be able to act as quickly as possible on any recent changes in
withdrawal levels, in particular as regards product pricing. Thus looking
at an investigation based on the last 3 years of data, for instance, will
imply a reaction time two years slower than if we were to use just one
years of data.
For persistency analysis, it is usually considered appropriate to use last

1-2 years data as a thumb rule.
Best source would be the actual policy data maintained in the policy
administration system. Data should be checked properly with other
sources such as data if kept separately by any other department.
2. Grouping of data:
The data (both actual infore and expected inforce ) would ideally be
analyzed, where relevant, by
- type of contract –;
- duration in force – withdrawal rates are generally higher near the
start of a contract;
- sales method used and target market –
- frequency and size of premium –;
- premium payment method –
- original term of contract;
Note that these are the factors by which withdrawal experience could be
analyzed. In practice, often only the first three factors will be
considered, in order not to end up with statistically insignificant data.
3. Calculation of persistency and withdrawal rates:
For each homogeneous group to be analyzed, withdrawal rates can be

determined as described below.
The number of contracts issued in the company’s last financial year is

divided into the corresponding number that survive in-force until the
first policy anniversary to give a first year inforce rate. The first year
withdrawal rate can be determined as one less the inforce rate.
Deaths and maturities should be excluded from the calculation (if

material).
A similar procedure can be adopted to obtain the second year, third

year, etc withdrawal rates, by looking at the number surviving from the
number of contracts, in each group, that have their first, second, etc
policy anniversary in the last financial year.
This is done for both count of policies and amount premium separately.
As the results are examined, it will be clear that for some groups there is
little difference (for instance the difference in withdrawal rates for
policies of duration eight years compared with those of duration nine
years), and intuitively a difference would not be expected. For some
groups the differences emerging might seem to be statistically weird
because of small data. As a result of these considerations, the actuary
would regroup the data and recalculate withdrawal rates for these
broader groups.
After having finished the investigation itself to the greatest possible

degree of valid accuracy (ie regrouping to avoid spuriously small groups),
the presentation of results for management information purposes would
probably require further consolidation depending on the level of
management involved. For instance senior management would probably
want results split by broad product class, not by every product.

The above analysis can be done from the start of the company if recent
data is not credible enough because of size or if trends in withdrawal
rate overtime need to be analyzed.
Credibility analysis considerations are same as were discussed in

mortality chapter.
Along with the past experience, expected future experience also is also
estimated based on the industry data and factors above.
How much weight to give to own experience and how much to

estimation, is essentially decided by credibility analysis just like
mortality.

E. A Simple example
ABC is an insurance company in India working for last 10 years. It has number of
products ranging from traditional non participating (including term), traditional
participating and unit linked plans. Board of directors in their meeting has
asked the chief actuary to conduct a review of the persistency assumptions used
in pricing to ensure that these are appropriate. This will also be helpful for all
new products to be priced in coming year. These results are required quickly so
they are interested only in 13th month persistency. Grouping which can be
considered is broad product types.
Chief actuary has asked policy administration department to provide the

relevant data. Assuming all policies are annual policies.
Following data is received:
Type of business Number of Number of Actual Number of

policies policies deaths in policies
issued during inforce at the inforce at the
the previous the start current end of the
year of this year year having
year before paid the
paying the premium
premium
Traditional term 3,00,000 2,99,000 500 2,00,000
Traditional 2,00,000 1,99,000 400 1,01,000
endowment
Traditional 2,00,000 1,98,000 600 99,000
participating
Unit linked 1,00,000 999,000 200 80,000
The difference between 1st and 2nd column above is because of death as also
lapses and surrender during the previous year after the policies are issued.
Number of policies inforce at the end of the year having paid the premium
excludes any new business or revival during the year. Hence, it is remaining
policies from the policies inforce at the start.
Based on this data actuary needs to calculate exposure and actual for 13th
month persistency.
Exposure will be number of policies inforce at the start of this year excluding
from it the deaths happened during the year before premium payment.
Actual will be actual policies inforce during the year having paid the premium at
13th month out of policies inforce at start.
13th month persistency is Actual divided by exposure.

13th month withdrawal rate is 1 minus 13th month persistency.
Type of business Exposure Actual 13th month 13th month

(Column 2 (Column persistency withdrawal
minus 3 4 above) rate
above)
Traditional term 298,500 200,000 67% 33%
Traditional endowment 198,600 101,000 51% 49%
Traditional participating 197,400 99,000 50% 50%
Unit linked 998,800 8,00,000 80% 20%
Actuary has also done the credibility analysis and has calculated 80% credibility
for traditional term and endowment and 90% credibility for Unit linked and
participating business.
Apart from this actuary has also calculated estimated 13th month withdrawal
rate using factors such as target market, industry data etc, which comes out to
be 30% for non linked business and 10% for the linked business.
Based on above information the withdrawal rate assumption for all product
types are calculated as shown in table below:
Type of business Actual 13th Estimated Credibility 13th month withdrawal

month 13th month factors assumption [A(Z)+T(1-
withdrawal withdrawal (Z) Z)]
rate rate
(A) (T)
Traditional term 33% 30% 80% 32.4%
Traditional 49% 30% 80% 45.2%
endowment
participating
Unit linked 20% 10% 90% 19%
These rates were found to be consistent with rates used in pricing.
It should be noted here that the example which we have considered is very
simple to explain the basic concept. In practice much more complex method is
applied with calculation done policy by policy using a lot more groups.
Consultant’s knowledge is also very useful for this estimation when the company
has less experience in these issues.

F. Withdrawal risk
Withdrawal risk refers to the risk of actual experience being different from
what was assumed in pricing and the financial significance of that a variance.
It is possible that there is a difference but it is not financially significant for a

particular product say term plan. This would be treated as less withdrawal risk
for that particular product. Term product can be designed in a way to have less
withdrawal risk by ensuring nil surrender values.
For estimating withdrawal rates to use, models are used which are linked to
future scenarios of investment return. There is a risk that this model might not
be appropriate and gives inconsistent results. This will be model risk associated
with withdrawal model.
Even if model is correct there is a possibility of misestimating of parameters

used in the model for example by generally underestimating the future
withdrawals. This would be parameter risk.
If the data is not large enough, there can be random fluctuations risk affecting
withdrawals.
Withdrawal impact on mortality and expense assumption:
The mortality parameters last chapter will be based on a model of withdrawals

since, number of policies withdrawn will impact number of policies remaining
inforce which might impact number of deaths as mortality assumptions are
applied on policies inforce. Hence, if withdrawal assumption is wrong, mortality
rate assumption will also be impacted.
Similarly, future per policy expense to be used in the model will be dependent
on the number of policies remaining. Hence, if withdrawal assumption is wrong,
expense per policy will also be wrong. Higher than expected withdrawals mean
that fixed costs have to be spread over fewer policies. This may produce higher
per-policy expenses than the company had allowed for in its pricing.
This will also impact the level of charges that company is expecting to receive
in unit linked contracts since some charges are linked to total number of
policies.
Financial significance of risk:
This will be mainly dependent on the benefit structure and product design. As
discussed earlier also, this will be dependent on the respective values of asset
share and surrender value.

Controlling risk:
Withdrawal risk is mainly controlled by choosing a well defined sales strategy,

designed to ensure need based selling of products.
Various ways of controlling this risk are listed below:
 Need based selling after thorough understanding of the needs of the

prospective policyholders. This will also involve mapping particular
products to the particular target market depending upon their respective
needs.
 Making the compensation paid to agent dependent on the levels of

persistency achieved by them by rewarding the higher persistency agents
and penalizing the lower persistency agents. This can be implemented
across channels.
 Providing various premium payment options to ensure easy payment by

customers. This involves converting the customers to ECS payment type
to ensure regular payments.
 Running campaign educating policyholders about the benefits of

maintaining their policies in the long term.

Summary
a) Persistency of a life insurance policy indicates whether the customer is

renewing his or her policy each year or quitting it midway.
b) Withdrawal rates are opposite of persistency rates and are calculated as 1

minus persistency rates.
c) Withdrawal rates impact profits and therefore the premium to be charged

for the product.
d) Profit will depend upon the asset share vs. surrender value at the time of
withdrawal.
e) Withdrawal rates will be dependent on many factors, such as withdrawal

risk, past experience and industry experience, type of product, premium
frequency, size of premium, general economic situation, distribution
channel used for selling the contract, the target market for the contract,
financial knowledge of the client, rural vs urban, type of premium payment
modes available, competitive situation of the product, term of the contract.
f) The withdrawal rate assumptions should reflect the expected future

experience in respect of the contracts that will be taken out
g) Withdrawal rates assumption to be used is a combination of past experience

and estimated future experience based on above factors. Credibility analysis
is used to give the respective weight.
h) Experience analysis of withdrawal is the first step in deriving the

assumptions. It involves three steps namely: collection of data, grouping of
data, and calculation of persistency and withdrawal rates
i) Withdrawal risk refers to the risk of actual experience being different from
what was assumed in pricing and the financial significance of that a
variance.
j) Withdrawal risk is mainly controlled by choosing a well defined sales

strategy, designed to ensure need based selling of products.

Answer 1
Actual profit more than expected profits will impact profits positively.
Answer 2
Financial knowledge of the client affects the withdrawal rates.
Question 1
Credibility analysis is never used for the calculation of withdrawal rates:
I. True
II. False
Question 2
Which of the following is not dependent on withdrawal rates?
I. Mortality rate
II. Per policy expense
III. Profit of the company
IV. None
Answer 1
Credibility analysis is used to derive mortality assumption. Hence, statement is
false
Answer 2
“None” is the correct answer. All choices are dependent on withdrawal rates.
IC92 Actuarial Aspects of Product Development 233

CHAPTER 10
PREMIUM BASES – COMMISSION RATES

In this chapter, we will understand the role of commission rates in determining

the premium for an insurance product.
Learning Outcomes
A. Importance of commission rates

B. Understanding the concept of commission rates
C. Determining commission rates
234 IC92 Actuarial Aspects of Product Development

An insurance premium is the amount of money charged by a company for active

coverage. The sum a person pays in premiums, also referred to as the rate, is
determined by several factors, including age, health, and the area a person
lives in. People pay these rates annually or in smaller payments over the course
of the year. As per regulations, the amount cannot change over time once fixed
if a policy has to remain inforce with all initial benefits.
The starting point for an insurance premium is largely based on statistics,

though people's habits and history can cause the rate to be higher or lower.
The cost of a premium for the same service can vary widely among providers,
which is why experts strongly recommend that consumers get several price
quotes before committing to a policy.
Insurance premiums are thus calculated considering the following bases:
i. Interest Rate
ii. Mortality Rate
iii. Withdrawal rate
iv. Commission Rate
v. Expenses
A major portion of 1st year premium goes into initial commission. Hence, the
commission rate set for the product impact significantly the premium to be
charged.
Depending upon the channel, there are maximum limit on the commission to be
for the product. These limits are for the protection of customer to ensure
premium charged is reasonable.
In this chapter, we will discuss ‘commission rates’.

A. Importance of commission rates
It is always said that insurance is never bought and is always sold. This is
because of the choices available to customers to invest in other competitive
investments such as mutual funds, banks etc. Insurance is not the preferred way
of saving money.
Also, selling insurance for protection is usually not understood by customers

since they cannot imagine themselves dying and needing insurance.
Further, the insurance products are not simple to understand when compared to
simple products like fixed deposits.
All of the above means that for doing business company needs someone who can
bridge the gap between customer and company. This gap is filled by distribution
channels. Distribution channels can be classified as under:
 Agents: They have the license of the company to sell their products.
They represent company but are not their employees. They receive
commission from the company for the business they do. These are
individuals or corporate. In case of corporate, they are known as
corporate agents.
 Brokers: They can sell more than one insurance products and represents
customers. They are paid by customers as advice fee or charge from
insurance company as well.
 Bancassurance: This is one of the very popular distribution channels

currently in India. In this, banks sell insurance product of the company
to which they are tied. They earn their remuneration from the company
as commission.
 Direct marketing: In this company sells its products directly to

prospective policyholders. Products are sold through own salesforce.
Hence, sellers are employees of the company. They are paid salary by
the company along with performance related incentives. Internet selling
which is becoming popular because of information technology revolution
is also classified under direct marketing.
An insurer is in the business of protection by offering insurance cover and also

saving/investment by offering products specifically like unit linked. It
distributes its manufactured products through agents, brokers, and direct sales
force etc. Company cannot afford to ignore distribution channels; otherwise
expected volumes of sales may not be achieved.
Hence, commission is given to every distributor, agent for instance, for the
distribution he/she does on behalf of the insurer.

Commission could be in kind or in monetary terms, which is also termed
remuneration or compensation for acquiring business. Here, the term ‘payment
in kind’ refers to an offer of incentives such as travel to foreign countries,
costly gifts, prizes, etc.
Insurer should know in advance what would be the amount of

commission/remuneration that would attract distributors in the market in the
solicitation and procurement of business. It is therefore important to know the
number of agents, brokers, and direct sales force that will be needed.
Suppose an insurance company plans to sell 1000 policies in a year, then it

should at least have about 80-100 agents on the assumption that each agent
would sell at least 10 policies (considering the fact that some proposals could
not become policies, proposals not becoming policies on account of change in
decision of prospects etc.).
The amount of commission, therefore, should be considered in the premium

bases to decide the premium rates.
Test Yourself 1
In which of the following ways can an insurance agent receive his commission?
I. Costly gifts
II. Sponsored trips
III. Gift vouchers

B. Understanding the concept of commission rates
Commission rate is the amount of remuneration paid to a distributor for

soliciting and acquiring insurance business on behalf of the insurance
companies. Nobody would sell anything unless he gets some returns from it.
Similarly, a bank also expects remuneration from the insurer for the sales he
makes on behalf of the insurance companies.
The peculiarity of the insurance business is that a customer is not charged by an

agent for the services he renders, unlike in the case of purchase and sale of
stocks by a stock broker. Rate of commission used by insurers would also
depend upon the type of product, mode of premium payment, product design
etc. But indirectly, since higher commission increases the premium to be
charged to the customer, it is being paid by the customer only.
Commission structure once set cannot be changed after the product is

launched. It is therefore very important to have appropriate commission
structure after analyzing all pros and cons in this respect.
An attractive commission structure would persuade agent to sell more but

would make the premium expensive and vice versa. The factors that would be
considered in arriving at a commission rate are as follows:
a) Nature and the terms of payment of premium of various products i.e. the
product design.
b) Commission rates offered by the competitors in industry for similar

products.
c) Impact of commission rates on the premium and sales volume
d) Desired profitability target
e) Past experience in terms of commission rats for existing insurers’

products
f) Regulations that has put ceiling on commissions
g) Claw-back terms
h) Persistency target
Usually, the first year commission would be higher than the rest, approximately
ranging from 30% - 35%. This is known as initial commission. Renewal
commission (2nd year onwards) would generally be lower; for instance, in the
second year 7.5%, in the third policy year @ 5% and so on. Commission is
expressed as a percentage of premiums.

Although the commission is paid to a distributor as a reward for procurement of
business, the following arguments are often made in respect of payment of
commission:
a) A distributor has to make several visits to the prospective customer for

realisation of insurance contract/policy, for which various expenses are
incurred by him/her.
b) A distributor has to explain and advise the prospective customer about

the various products offered for sale by insurer. This requires great deal
of skills and knowledge regarding the insurer’s products, and also
knowledge about the prospect’s insurance needs and tax status etc. e.g.
the composition of family and likely amount that would be needed in the
event of the death of the life assured.
c) A distributor also has to render after-sales service to the policyholder for

payment of premiums, surrender of policy, settlement of claims, change
of address, change of nomination, assignment, policy loan, etc.
Distributor has to thus incur expenses for providing the above services; and
since the policyholder does not pay directly, the insurer has to pay way of
commission.
Test Yourself 2
Which of the following is not a factor that is used to arrive at the commission
rate?
I. Financial status of the customer
II. Regulations
III. Commission rates of competitors
IV. Product design

C. Determining commission rates
It is imperative for the insurance companies to make the best possible estimates
of commission rates.
Since the objective of the management of the insurance companies is wealth

maximization of the shareholders, it is not unusual that they adopt a
conservative approach in fixing the commission rates.
Thus, an actuary has to take into account numerous factors and then arrive at
the scales of commission rates payable to the insurance distributors.
The pros and cons of each and every factor as discussed above would be looked
at by the actuary to decide the scale of commission. The factors are detailed
below:
a) Nature and the terms of payment of premium of various products i.e. the
product design
By the rule of thumb, insurers determine the commission to be paid based

on the complexity of the terms and conditions of the product. For
instance, an insurance product with clear terms and conditions, which are
easily understandable by a layman, would carry a lower rate of
commission. However, products with complex terms and conditions,
requiring an agent to utilize his skills and knowledge to make the
prospective customers understand the product, would definitely carry a
higher commission rate.
Rates are also dependent upon if the contract is a long term contract or a
short term contract. Usually higher commissions are paid if the contract
is a long term contract.
Single premium product commission rates are different from regular

premium products commission rates. For a single premium contract, since
premiums are large, commission as a percentage of premium is less.
b) Commission rates offered by the competitors in industry for similar

products.
Insurance companies are expected to rationally calculate the commission

rates, otherwise the distribution of their products would be weak and
retaining the agent force would also become difficult.
For example, if the competitors are giving higher commissions and

company decided to give lower one, agents would shift to other
companies with their clients. However, if the lower commission results
into significantly lower premium rates then competitors, it could lead to
higher sales. Hence, if agents are able to earn higher commission in
absolute amount, then they may decide to stick with the company and
sell the products.
c) Impact of commission rates on the premium and sales volume
Higher the commission rate higher will be the level of premium. Higher
level of premium will not be liked by prospective policyholders who will
shift to other companies. However, higher commission will be liked by
distributors who can bring more business. Overall impact will depend
upon the financial knowledge of the customers and the ability of
distributors to sell even the expensive product.
Actuary has to strike a balance between keeping the distributors happy

on the one hand and giving the policyholders their value for money on the
other hand.
In the long term, lower commission, lower premium and higher sales is
usually beneficial for all the stakeholders.
d) Desired profitability target
Distributors are very demanding as far as their remuneration is

concerned. Commission cannot be very high without increasing the
premium. If it is not possible to increase premium further because of
competitive pressures, then any increase in commissions will lead to fall
in profitability of the company. There will be a point when company will
not be able to increase the commissions keeping its target profitability in
mind.
Hence, desired profitability target is an important factor for deciding the

commission rates.
e) Past experience in terms of commission rates for existing insurers’

products
Company wants to bring new customers but not at the expense of losing
current policyholders. If the existing policyholders has paid inbuilt higher
commission and higher premium rates and a new product is launched with
significantly lower inbuilt commission and premium rates, then existing
policyholders can lapse their policy and shift to other insurers. Hence,
commission should be consistent with existing product commissions.
f) Regulations that has put ceiling on commissions
As was discussed in pricing chapter, there is a ceiling on payment of

commission to the distribution channels as per regulation.

Commission rates to be used in pricing should be in accordance with this
ceiling.
g) Claw-back terms
Claw-back of commission is not very uncommon in the insurance industry.

It involves imposing a financial penalty on the agent for an insurance
policy procured by him, which does not remain in the books of the insurer
for long i.e. the policy holders withdraw their amounts and cancel the
contract. Such events disturb and distort the fund flow calculations of the
insurer. Hence, initial commission can be high if there are claw-back
terms.
h) Persistency target
In was mentioned in the persistency chapter that one of the ways of

controlling withdrawal risk is to structure the remuneration of the
distribution channels in a way to link it with persistency targets. Hence,
initial commission can be lowered and renewal increased to ensure that
agent is remunerated only if premiums come. This will be subject to
regulatory constraints.
Remuneration can also be structured in a band wise structure to make

higher payments for high persistency and lower for low persistency.
Clawback terms as discussed above are also related to persistency target.
Test Yourself 3
Insurance companies follow the _________ approach while fixing the

commission rate.
I. Political approach
II. Conservative approach
III. Liberal approach
IV. Open end approach

Summary
a) Products are distributed via various channels such as agents including

corporate agents, brokers, banks and directly by the insurer.
b) Commission or remuneration is given to distributor for distribution of

insurance policies on behalf of the insurer.
c) Commission could be in kind or in monetary terms.
d) Commission rate is the amount of remuneration paid to a distributor (agent)

for soliciting and acquiring insurance business on behalf of the insurance
companies.
e) Commission depends on various factors like product design, competitors’

rate, impact on premium and sales volume, desired profitability target,
existing products, regulations, clawback terms and persistency targets .
f) Actuary has to strike a balance between keeping the distributors happy on

the one hand and giving the policyholders their value for money on the other
hand.
g) Since the objective of the management of the insurance companies is

wealth maximisation of the shareholders, it is not unusual that they adopt a
conservative approach in fixing up the commission rates.

Answer 1
Commission could be in kind or in monetary terms.
Answer 2
Financial status of the customer is not a factor that is used to arrive at the
commission rate. Other factors are taken into consideration to arrive at
commission rates.
Answer 3
Since the objective of the management of the insurance companies is wealth

maximisation of the shareholders, it is not unusual that they adopt a
conservative approach in fixing the commission rates.

Question 1
When is the claw-back of commission imposed?
I. When the agent is not able to sell the insurance policy

II. When the agent demands more commission
III. When the policy which the agent has sold, is withdrawn and the contract is
cancelled
IV. Whenever the insurer wishes to do so, even without any reason
Question 2
In which of the following cases will the commission rate be lower?
I. First year commission

II. Products with complex terms and conditions
III. Renewal commission
IV. If competitors’ commission rates are high
Answer 1
The claw-back commission is imposed, which involves imposing financial penalty

on agent. This is done when the policy which the agent has sold, is withdrawn
and the contract is cancelled.
Answer 2
In all other cases, commission rate will be higher.

CHAPTER 10B
PREMIUM BASES – MARGINS
In this chapter, we will understand the role of margins in determining the

premium or charges for an insurance policy. Also, we will touch upon risk
discount rate used in pricing. A brief note on reserving is also included in this
chapter.
Learning Outcomes
A. Margins
B. Risk discount rate
C. Reserving

Mr. X is working has just joined insurance company in the underwriting

department. While going through some of the training in Induction, he heard
about the word “Margins” used in pricing of new products or while reserving
calculations.
He is confused and wants to understand more about this. He decides to visit the
actuarial department of the company to learn more about margins.
A. Margins
Margins can be defined as extra cushion used by the company in pricing and
reserving exercise to minimize the impact of risk from adverse future
experience.
As a simple example, if we expect to earn a return of 8% on the investment,

while pricing we should assume say 6%. This extra 2% will be the margin.
It was discussed in the previous chapter that estimated assumptions are loaded
with margins to ensure the risk from adverse future experience is allowed for.
There are various ways for allowing for margins. Especially when cash flow
approach is used for pricing.
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 using the
three approaches:
● Using margins in the expected values.
● Using a stochastic approach.
● Using the risk element of the risk discount rate.
If a formula model is being used for pricing, only the first method can be used
because of its limitation. Hence, the risk of adverse future experience would be
allowed for by taking margins in the assumptions. However, such a model does
not help the actuary to quantify what these margins might be and hence he or
she must use judgment based on past experience.
The important point from the above is that, by including a margin or margins
somewhere in the basis, the risk from adverse future experience is reduced.
The basis actually chosen for pricing, inclusive of margins, will fix the level of
risk the company will be subject to once the product is issued at that price.

Approaches explained:
Approach 1: Using margins in the expected value:
Under the first approach, all margins could be incorporated in the assumptions
for each individual parameter; and the risk discount rate would then (in theory)
be the risk-free rate.
Investment returns assumption:
Pricing assumption for the future investment return might be written as:
Pricing investment return (Ip) = best estimate investment return (Ib) minus
margin (Im)
Once the product is in issue, the company risks making less profit than it
anticipated if i (the actual rate of return achieved) is lower than Ip. So, the
larger the value of the margin Im, the lower the probability that Ip < i and the
lower the risk of making a particular loss.
For example, if Ib is 8.5% and margin required is 1.5%, Ip will be 7%. Company
needs to ensure that investment strategy is such that it earns at least 7%
returns, while targeting higher returns for higher profits.
Lower the Ip higher will be the premium. Hence a balance needs to be struck
between the desire of having competitive premium and degree of risk taken.
Similarly for other assumptions also margins are taken to reduce the risk of
adverse future experience.
Mortality assumption:
For products with significant death benefits, margin is taken in mortality

assumption by assuming higher deaths than expected based on best estimate
mortality.
Mortality assumption is expressed as a percentage of standard mortality tables.

For including margin, simple a higher percentage than best estimate is used. For
example, particularly in term products, mortality assumption is very important.
For term or endowment product or unit linked products with high death benefit:
Pricing mortality assumption (Mp) = best estimate mortality assumption (Mb)

multiply (1 + margins (Mm))
Hence, if Mb is 80% of standard table, margin required is 10% than Mp will be

88%.

Company will make loss if actual number of deaths is more than 88% of standard
table.
Margin works in opposite direction for annuity or some health type of products
where the lower mortality is a risk, since payment only needs to be made if
person is alive.
In those cases, the above formula for calculation of pricing mortality

assumption is modified as below:
For annuity or pure health related products:
Pricing mortality assumption (Mp) = best estimate mortality assumption (Mb)

multiply (1 - margins (Mm))
Hence, if Mb is 80% of standard table, margin required is 10% than Mp will be

72%.
Company will make a loss if actual number of deaths is less than 72% of
standard table.
Expense assumption:
This assumption impact all type of products in same direction. Higher expense
than best estimate would be required to reduce the risk of adverse future
experience.
Pricing expense assumption (Ep) = best estimate expense assumption (Eb)

multiply (1 + margins (Me))
Hence, if Ep is Rs.500 per policy and 20% per premium and margin required is
10% then Ep will be Rs. 550 per policy and 22% per premium based.
Company will make a loss if actual expenses are more than Rs. 550 per policy or
more than 22% of premium.
Similar approach is used for expense inflation which is increased by the margin.
Persistency assumption:
Margins to use in persistency assumption are dependent on product design and

the surrender benefit offered at various durations. For some duration and some
product designs high withdrawal rate is beneficial for the company, particularly
when surrender benefit offered is very low as compared to premiums collected,
for example term products with no surrender value. While for products where
surrender benefit is significant opposite is true.

Hence for deciding about the direction of margin to apply, sensitivity of
premium at different withdrawal rates should be seen. If more withdrawal rate
increases the premium then margin should be on positive side and vice versa.
Pricing withdrawal assumption (Wp) = best estimate withdrawal assumption

(Wb) multiply (1 +/- margins (Mw))
So for example where high withdrawal rate is a risk and Wb is 30% for initial
duration and margin required is 20% then Wp will be 36%.
Company will make a loss if actual withdrawals are more than 36%.
Approach 2: Using a stochastic approach:
Under the second approach, we would assume best estimates for the
parameters and a risk-free discount rate. At least one of these parameters
would take a range of values from a probability distribution, rather than a
constant value, and so the pricing process would give a range of possible
charges or premiums. The company could choose which price from this range of
possibilities it would actually charge (eg the 70th percentile). The risk to the
company will be that the actual experience is in line with one of the more
extreme outcomes of the distribution.
This approach can only be applied where there are probability distributions for
the parameters concerned. For example, mortality, investment return and
expense inflation can be modeled using the stochastic approach using
appropriate probability distribution, while expense and withdrawal may not
have any appropriate probability distribution and hence has to be taken at best
estimate or using the first approach.
Approach 3: Using the risk element of the risk discount rate:
Under the third approach pricing is done assuming best estimates for the
individual parameters, and including margins for risk by assuming a higher risk
discount rate. The company will now make less profit than it requires if actual
investment return, i, is sufficiently low that the return on capital is less than
the required rate of return.
Hence, instead of allowing for risk separately under each parameter risk is
allowed by choosing appropriate risk discount rate. Ideally, different risk
discount rate should be used for different products depending upon the risk
involved. For example, in a high guarantee non participating product, a higher
risk discount rate can be used then say for a unit linked product with Low
guarantees.
We will discuss about risk discount rate further in next section.

Other issues:
These alternatives can lead to the same result (in effect, the same premium),
but they are just different ways of expressing the margin and the resulting risk.
In each case the risk of loss occurs once the margin is “used up”, whether that
be the margin in the individual parameter assumption, the percentile chosen, or
the risk premium in the risk discount rate.
Although the primary worry is that of adverse experience compared with

assumptions, risks are really “two-sided” as discussed in interest rate
assumption as well.
For instance, looking at the issue of risk in the context of the mortality rate for
pricing a term assurance contract:
 if the mortality is under-estimated the company is at risk of a substantial

loss;
 if the mortality is over-estimated the company is at risk of not selling
the product because of high premiums.
However, here it is worse to under-estimate mortality than to over-estimate it.

If there is a risk, company should sell very profitable business rather than sell
loss-making business. If it is selling badly rated business it may accumulate a lot
of it before realizing it is badly rated and hence loss making, whereas if rates
were too high it could quickly adjust them. Here the actuary will need margins
to guard against the risk that the mortality is under-estimated (ie assume
mortality rates which are higher than best estimates).
The extent of the margins depends heavily on the purpose of the basis
concerned. Here we are concerned with pricing, so the margins will also be
influenced by the need to have competitive premiums. Nevertheless, the
margins must reflect the risks involved, and hence the size of the margins must
crucially depend on:
 the degree of risk associated with each parameter used.

 the financial significance of the risk from each parameter.
All the things we have discussed in earlier chapters about risk should therefore
be brought to a consideration of the margins required for pricing (or, in general,
for other purposes for which a basis is required, such as reserving).
Remember that the same principles will apply whether we are allowing for the
margins through the risk premium in the risk discount rate (which would be the
normal approach when pricing), or through adjustment to the individual
parameter assumptions (which would be the approach when reserving and
pricing as well).

Practical scenario:
The approaches as discussed above are used in a blended way in the practical
world. For pricing purpose, first the parameters are adjusted for risks and then
risk discount rate is used to discount cash flows. Hence, a blend of first and last
approach as discussed above.
Second approach is also being used for risks where the probability distribution is
well defined. The use of this approach has increased particularly because of
advance in technology making it possible to run many scenarios in minutes.
Test Yourself 1
The approach not used for allowing for margins in cashflow approach is__
I. Using margins in the expected values
II. Using a stochastic approach
III. Using absolute amount addition of margin in each policy
IV. Using the risk element of the risk discount rate

B. Risk discount rate
In this section derivation of a suitable risk discount rate to use in our pricing
models is discussed.
A key aspect of the risk discount rate will be the return required by the
shareholders on the capital they invest in the insurance company.
It is reasonable to assume that the owners of a life insurance company decide

where to invest by comparing the returns offered by different companies,
relative to the risks which are run, and are able to move their capital from one
company to another if they wish.
An investor will demand a higher expected rate of return from a risky

investment than from a safe investment to compensate the investor for the risks
of default, commercial failure and so on. This is often expressed by saying that
the investor requires a “risk premium” over and above the expected returns on
safer investments.
It is useful to borrow from economic theory the concept of the “risk-free”

asset, namely an asset which offers a certain return, absolutely free from all
risk of default.
Investing in a life insurance company is certainly not the same as investing in

the risk-free asset.
Investors will demand an expected rate of return equal to the risk-free rate plus
a risk premium.
Such a rate of return is called a “risk discount rate”.
Hence, risk discount rate can be defined as the rate of return required by the
investor to take on the risk in question.
Now, the question is what risk premium is appropriate to compensate for the
risks of investing in a life insurance company? This can be answered by looking
at the almost universal model of valuing risk in the asset, capital asset pricing
model (CAPM).
The capital asset pricing model (CAPM):
The Capital Asset Pricing Model has been widely used by stock market investors
to answer exactly this sort of question. The idea behind CAPM is that a well-
diversified portfolio of shares cancels out the risks of investing in individual
shares and leaves only the unavoidable risks of investing in the stock exchange.
This means, only the systematic or non specific risks are considered not taking
into account the risks which are specific and can be diversified away.

A suitable proxy can be chosen to represent risk-free assets, such as bonds
issued by a stable government, and estimate the average risk premium which
the diversified portfolio of shares has yielded over the risk-free rate, over a
period of time.
The bonds here are just one example of an asset which is almost risk free.
Alternatives are government deposits, or long-dated inflation-proof government
bonds. It will be impossible to find any assets that are perfectly risk free.
Thus, the risk is measured as the difference in return comparing “equities” in a

general sense with some risk-free asset. Take a well diversified portfolio of
shares (eg a suitable index) to represent general equities, and say a 10 year
government bond to represent the risk-free asset. Compare the returns from
these two over a period of time to iron out any random fluctuations.
The question can then be asked as to how risky a particular company’s shares
are compared with the diversified portfolio. The result of the CAPM is that the
proper risk premium for any particular share is in proportion to its Beta.
If the market and the investors satisfy certain conditions, such as a perfect
market with perfect information, the CAPM will explain, amongst other things,
the relationship between risk and return. It is possible to derive the following
formula which expresses the expected return on any asset in terms of the
market return.
This is given by:
Ei =rf + (Em -rf) x bi
where:
Ei is the expected return on asset I (eg our company’s shares)
rf is the return on a risk-free asset
Em is the expected market return(eg the stock market)
bi is the “beta factor” of asset i (defined as the covariance of ri and rm divided

by the variance of rm).
So this equation specifies the relationship between the risk premium for an
asset (the risk premium is {Ei – rf}) as proportional to the market risk premium
{Em – rf}. The factor of proportionality is bi .
The beta factor bi can be thought of as a measure of the riskiness of the asset
relative to that of the market. A value greater than 1 implies, when the market
is rising, that the asset’s value will increase more than the market average; and

conversely, when the market is falling, that it will decrease in value more than
the market average.
This beta factor can be estimated by analyzing the historic returns on the asset
in question in conjunction with market returns. However, the beta that is
correct “now” or in the future will not necessarily be equal to that of some
recent period.
This process identifies the systematic risk, or market risk, of the asset. It takes
no account of the specific risk – eg in the case of equities, the risk specific to
the issuing company which can be eliminated by sufficient diversification.
It might seem almost counter-intuitive that we are taking account of just the
systematic risk, not the specific risk. Why is the (significant) risk of investing in
a specific company not allowed for? The reason is that the life company’s shares
are assumed to be just a small fraction of the investor’s portfolio and hence will
get diversification benefit – the CAPM does not reward specific risk. So the
CAPM will quantify just the systematic risk.
Note that the shareholders’ required return on capital is also a function of the
availability of capital.
The harder it is for the company to raise capital, the greater will be the returns
the company will have to offer in order to raise the amount required, and the
greater the returns will have to be to keep the shareholders happy.
This is similar to a loan to be raised by an individual. An individual with a

security to offer as collateral for loan will get a loan at low attractive price as
compared for an individual with no security to offer who will have to pay high
interest rate to get the loan.
The CAPM is just one example of how the market might assess the shares of a
company. The point to note is that it is not up to the actuary alone to decide
what an appropriate rate of return is for shareholders. The actuary will need to
make some assumptions, but the market is the final judge.
Deciding upon a risk discount rate
So what does an actuary actually do in order to determine the risk discount rate
to use in a particular pricing model for a particular product?
So far it is the CAPM, which can give the value of Ei : the rate of return that
shareholders expect from investing in company to compensate for the risk
involved. However we cannot simply use this overall rate as the risk discount
rate in our pricing models. Why not?
The reason is that not all projects are equally risky. The life company should
view itself as an investor like any other when it considers the riskiness of a new

product, as in the long run the profits emerging from the whole company are
the profits emerging from the products that it sells.
A change in the mix of business, for example away from old and safe contracts
towards new and innovative contracts, would change the market’s evaluation of
the company’s riskiness.
So if we propose to launch a new product with innovative design features, this

will change the overall market risk premium demanded by the company’s
shareholders, and the only way to satisfy this demand is for this product to
generate a higher return on capital.
In other words, the risk discount rate used needs to be higher, and basically the
higher the risk, the higher the risk discount rate we should use.
The following are among the features that can make a product design riskier,
viewed as an investment:
 lack of historical data
More historical data helps company to identify the areas of improvement

and trends that will be seen in the future. Lack of historical data on the
other hand makes future more uncertain and hence more riskier.
 high guarantees
High guarantees increases the risk of loss because of adverse future

circumstances making the product more risky.
 policyholder options
Options if not priced properly can be very dangerous as far as the profits
of the company are concerned. If option goes in the money and everyone
exercise the option it can convert probable profits into huge losses.
 overhead costs
High overhead cost carry the uncertainty of not recouping them because
of lower sales or low persistency, making the product riskier.
 complexity of design
Complex design increases the risk of product not being understood and
not being sold enough again making it risky.

 untested market
Behavior of untested market is very difficult to predict and thus makes

the product risky if targeted to untested market.
For an insurance company perspective, risk discount rate should be different for
different products taking into account the risk inherent in each product. So one
way to derive the risk discount rate would simply be to take the “risk-free” rate
(which we can assess by looking at the yields on short-term government bonds)
plus an allowance for the riskiness of the product being sold. It is not easy to
assess these risks, and it is even harder to say what effect they should have on
the risk discount rate.
Practically, risk discount rate is assumed same for all the products taking
allowance for risk separately while arriving at assumptions to use for pricing. It
is argued that risk of investing in a company as a whole is same taking into
account the risk faced by company, allowing any difference in product risk
through specific assumptions.
In reality, the assessment of the risk, and the conversion of that into a risk
discount rate, is a very inexact science. The most important points to remember
are that:
 The risk discount rate must be higher than the risk-free rate, hence
changes in market rates of interest should cause risk discount rates to
change.
 The margin between the risk-free rate and the risk discount rate should
attempt to reflect all sources of risk in the product.
 The risk discount rates used for pricing different products should reflect
the relative risk of those products.
 The overall return earned on the whole capital of the company,

generated from its entire business activities, needs to meet the required
rate of return (cost of capital).
 The risk discount rate is simply a number that is used as a criterion in

profit testing. It is set to ensure that the rate of return from the product
is satisfactory, given the inherent variability of the return and the
required return on capital.
Profit criteria
It is necessary to decide on the profit criteria that need to be met by the price
charged for a product, given all of the preceding assumptions. These have
already been discussed earlier, but it should be noted that the chosen profit
criterion is one of the assumptions that defines a particular pricing basis.
Test Yourself 2
In the CAPM formula, what is deducted from Em on the RHS?
I. Ei
II. rf
III. bi
IV. Si

C. Reserving
Reserving is an important part of pricing since; we need to consider cost of

reserving while pricing the product. This cost is quite significant in the products
where reserving requirement is very high as a proportion of premium such as
high guarantee products.
This section is included to briefly discuss about the method and assumptions
used for reserving.
Method:
In India, gross premium valuation method is used to calculate the reserve of life
insurance liabilities. This method is specified by regulations.
In this method reserve is calculated by taking present values of net cash outflow
which is calculated as cash outflow minus cash inflow.
Cash outflow includes benefit payments, expenses and commissions. Cash inflow
includes premiums.
Cash flows are projected forward till the end of the policy term and is then
discounted using valuation interest rate.
Only future cashflows are considered for reserving. For example, if a policy is 4
years old, total term of the policy is 10 year and reserve is required at the end
of 4th year, cashflows only from year 5 to year 10 will be considered.
The above method is used for the non-linked liabilities and non-unit liabilities of
unit linked policies. For fund related liabilities, full unit fund is kept as reserve
and is known as unit reserve.
Reserve is calculated policy by policy as per regulation.
Negative reserves are not allowed as per the regulations, hence any negative
reserve has to be zeroised.
The reserve should take into account all the reasonable cashflows specifically
guaranteed outflows.
Assumptions used for the calculation of reserves should be prudent to guard

against the risk of adverse future experience.

Assumptions:
Basic concept of assumptions used for reserving exercise is same as for pricing
exercise. Only difference is the margins used. For reserving the margins used
are much more prudent as compared to pricing. The high prudence is required
to ensure that the liabilities are honored with high degree of confidence even in
adverse future conditions.
Most important assumption in reserving is the “valuation interest rate” used to

discount the cashflows. High interest rate will produce low reserve and low
interest rate will produce high reserves.
As per the regulations the margins used for reserving is known as “Margin for
adverse deviation” (MAD).
Use of MAD for the assumptions is mandatory as per regulation issued by IRDAI
and actuarial practice standards (APS) issued by Institute of Actuaries of India.
Major regulations and APS regulating reserving are mentioned below:
 Asset, liability and solvency margin regulation, 2000, defining method

and assumptions.
 APS – 1: APPOINTED ACTUARY AND LIFE INSURANCE BUSINESS
 APS – 2: Additional Guidance for Appointed Actuaries and other Actuaries

involved in Life Insurance
Both these APS provides guidance on method, parameters and MAD used
for reserving.
 APS – 7: Appointed Actuary (AA) and Principles for determining Margins

for Adverse Deviation (MAD) in Life Insurance liabilities.
This APS defines the minimum quantum of MAD to be used in reserving

assumptions.
Actuary should keep in mind all the above APS, regulation and company practice
for setting up the reserving assumptions used to calculate reserving cost in
pricing models.

Summary
a) Margins can be defined as extra cushion used by the company in pricing and
reserving exercise to minimize the impact of risk from adverse future
experience.
b) 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
using the three approaches:
● Using margins in the expected values.

● Using a stochastic approach.
● Using the risk element of the risk discount rate.
c) A key aspect of the risk discount rate will be the return required by the
shareholders on the capital they invest in the insurance company.
d) It is necessary to decide on the profit criteria that need to be met by the

price charged for a product, given all assumptions.
e) Reserving is an important part of pricing since; we need to consider cost of

reserving while pricing the product.
f) For reserving the margins used are much more prudent as compared to
pricing.
g) The high prudence is required to ensure that the liabilities are honored with
high degree of confidence even in adverse future conditions.

Answer 1
Using absolute amount addition of margin in each policy is not used, other three
are used.
Answer 2
rf (risk free rate) is deducted from Em.

Question 1
Application of margin will result into ___ investment return assumption than
best estimate?
I. Higher
II. Lower
III. Both
IV. None
Question 2
Which of the following APS defines the minimum MAD to be used for reserving?
I. APS - 1
I. APS - 2
II. APS - 7
III. APS - 6
Answer 1
Application of margin will result into lower investment return assumption than
best estimate.
Answer 2
APS – 7 defines the minimum quantum of MAD.

CHAPTER 11
PREMIUM BASES – EXPENSE RATES

In this chapter, we will understand the role of expense rates in determining the
premium for an insurance policy.
Learning Outcomes
A. Importance of expense rates in calculation of premiums

B. The concept of expense rates
C. Determination of the expense rates
D. Expense Inflation
E. Expense analysis
F. A Simple example
G. Expense Risk
Newly set-up, ABC Life Insurance Company has just begun insurance operations.
As an insurer, the company will be incurring various expenses related to its
insurance business, like acquisition of land, office premises, furniture, fixtures,
IT system, employing insurance agents, their commissions Etc.
The company will recover these expenses from the customers, by determining
the expense rate as well as determining which expenses can be passed on to the
customers.
This chapter will help ABC Life Insurance Company to tackle these expense
related queries.

A. Importance of expense rates in calculation of premiums
Insurance companies are in the business of providing protection by offering

insurance cover, for which they need adequate infrastructure. It is very
important for an insurance company to regularly monitor its expenses to
maintain profitability.
Premiums which are charged for a product should cover both the policy benefits
as well as the expenses to be incurred on the policy. After taking out both these
profit is earned.
Hence, if the estimation of expense to be charged in premium is incorrect and is

underestimated, it can eat up the profit margin and can even cause losses.
Even if the expenses are over estimated, there is a risk of high premiums not
being competitive. This can cause lower sales than expected. Each policy’s
share of expense is dependent on expected total expense to be incurred and
expected total policies to be sold. Lower than expected sales will cause another
issue of not covering the total expected expenses, hence leading to losses.
Expenses can be primarily classified into fixed, variable and semi-variable.
An insurer should know what would be the fixed expenses and what would be
the variable expenses that he has to incur at the outset, and also subsequently.
Similarly the company should also know all possible semi variable expenses. A
semi-variable expense is an expense which contains both a fixed-cost
component and a variable-cost component. The fixed cost element shall be a
part of the cost that needs to be paid irrespective of the level of activity
achieved by the entity. On the other hand the variable component of the cost is
payable proportionate to the level of activity.
Expenses need to be incurred right from solicitation and procurement of

business to final settlement of claims (policy liability). In solicitation and
procurement— it has to be determined how many agents, how many brokers,
and how much direct sales force, how many branches, how many administration
offices and staff are needed, and what other infrastructure (furniture and
fixtures, telephones, computers, IT systems, etc.) are needed.
Of course, all the expenses have to be passed on to the policyholders, but the
initial expenses for the company setup have to be borne by the insurer’s
promoters (shareholders) at the outset. Unless a proper estimate is made for
use in the premium base, the insurer as well as the policyholders would suffer
financially. This is the most difficult exercise as some expenses cannot be
estimated with ease—such as tax rates, inflation, stamp duties, etc.
Company set up expenses is huge and if passed on in entirety to the

policyholders, it can make the premiums very high making the product difficult
to sell. Hence, initially it is borne by shareholders but is subsequently passed on
to the policyholders in next 7-10 years.
While pricing the product the fixed expenses is also referred to those expenses
which are incurred irrespective of premium size of the policy. For example,
same policy printing cost is incurred even if policy is Rs 1 policy or Rs. 1 lakh
policy. But when the policy is not sold, this amount is nil. Hence, fixed cost
covers both marginal (additional) and non marginal costs.
Marginal cost is that cost which is incurred only when there is a new policy sold.
While non marginal cost has already been incurred, hence is independent of any
new policy sold. Example of non marginal cost is initial set up cost of the
company.
This non marginal cost is also referred to as the fixed overheads. Hence, to be
profitable, the fixed expenses to be charged in premium must cover the
marginal cost and should also cover some of the non marginal cost o contribute
to the fixed overhead of the company. Hence, in this way the initial set up is
recovered from the policyholders in future years as mentioned above.
Sometimes, distinction between marginal and fixed overheads is subjective. For

instance the property costs of the “new business admin” department could be
considered as part of the marginal initial administration expenses, or as part of
overall fixed expenses
Variable expenses are normally the marginal (additional) expenses which are
incurred as the additional policy is sold. Without the policy this expense is nil.
The expenses are also split between initial expenses, renewal expenses,
investment expenses and terminal expenses depending upon the life of the
policy.
Initial expenses are the expenses which are incurred at the outset or at the
point of sales. Initial expenses are also referred to as acquisition expenses.
Renewal expenses are incurred throughout the term of the policy. These
expenses are also referred to as maintenance expenses.
Investment expenses are incurred initially as well as during the term of the
contract.
Termination expenses are incurred when the policy is matured or surrendered.
The example of each of these is provided in the next section.

Test Yourself 1
Insurance expenses can be primarily classified as __________
I. Direct expenses and indirect expenses

II. Fixed expenses and variable expenses
III. Capital expenses and revenue expenses
IV. Standard expenses and non-standard expenses

B. The concept of expense rates
Expense rate is the amount of money to be spent in transacting insurance

business and it is usually measured as per policy, proportion of premium,
proportion of sum assured or proportion of fund for a certain unit of time.
Expense assumptions:
Type of expense assumption to be used in pricing is dependent on the type of

expense and its drivers. Driver is a primary factor on which expense is based.
For example, Stamp duty is calculated as a percentage of sum assured, hence
driver of stamp duty expense is sum assured.
Expense assumption usually comprise of following type of expenses:
Type of expense Example Driver Represented in

premium as
Initial fixed Policy printing cost, initial Number of As amount per
expenses set up cost, Salary of new policy
support staff incurred policies
because of acquisition.
Initial variable Incentive of sales staff New As percentage of
expenses premium premium
Initial sum Stamp duty, Medical Sum As percentage of
assured based underwriting assured sum assured
expenses
Renewal fixed Payment reminder, Number of As amount per
expenses statements, salary of inforce policy
support staff assisting policies
maintenance.
Renewal variable Salary of sales staff Inforce As percentage of
expenses assisting renewal premium premium premium
collection, incentive based
on persistency
Investment Brokerage, custodian Investment
As percentage of
expenses charges Fund total investment
fund
Termination fixed Salary of claim Number of As amount per
expenses department terminated policy
policies
Termination sum Claim underwriting Sum As percentage of
assured based assured sum assured
expenses
Termination refers to death, maturity etc. Usually there would be no specific

expense allowance for the administration of withdrawals or policies becoming
paid-up; instead, the cost would be allowed for in setting the appropriate
discontinuance terms.
The factors that would be considered in choosing expense assumption are:
 Extent of expense risk

 Nature and type of products
 Volumes of sales through various distribution channels
 Persistency assumption for future business
 Company’s recent experience
 Infrastructure—offices, staff, and other material to operate
 Insurance Legislation that would put ceiling on expenditure
 Support from consultants
 Support from reinsurers
 Competitors rates and
 Industry’s practices and data
At the outset, promoters of the insurer would bring in capital to carry on the
insurance business. Capital is meant for creating initial assets (offices,
infrastructure, and employing human resources—skilled and semi-skilled
manpower). It is used to bring in insurance business which should in turn bring
in good returns for the promoters/shareholders.
It is the scale of operation that matters most for use of capital which could be
on account of:
 Number of offices
 Number of agents
 Number of employees
 Number of products and expected size of premium income and
 Infrastructure to meet the above
The insurer usually conducts a market survey to estimate the insurance

potential in the country in which he wishes to operate:
a) How many people would be fit to be insured, knowing the details of their
incomes, habits and culture, and attitudes towards insurance
b) The level of the banking network in the country for collection and
receipt of premiums, and payment of benefits
c) The level of availability of documentary evidence such as ‘income

proof’, ‘medical evidence—availability of medical examiners and labs’;
‘proof of death—whether documents could be relied upon
d) The level of capital markets—how easy it is to invest policy monies in

government paper and corporate debt, and also in equities
e) The level of IT systems—telephones, internet, communication systems,

etc; and various other infrastructure items and

f) Availability of various professionals—actuaries, accountants,
underwriters, claim settlers, etc. and the insurance regulatory practices
The size of the market determines capital requirement. If there is huge

insurance potential, promoters would be willing to pump in more money to do
business.
Test Yourself 2
Expense rate is usually measured as a proportion of: _____
I. Expenses for a certain amount of premium

II. Expenses for a certain unit of time
III. Premium for a certain unit of time
IV. Premium for a certain amount of expenses

C. Determination of the expense rates
Best estimates are required to be made to determine the expense rate.

Pessimistic and optimistic estimates are also made to choose a prudent rate.
Since the aim is to meet the shareholders’ objective, it is not unusual to be a
little careful in choosing a set of expense rates.
What is the best estimate prevalent in the market? The actuary needs to
consider all the above factors regarding the determination of rates specifically
the type of product such as:
a) Assurances: Term, Whole life, Endowment assurance, Money back

products, and other products.
b) Annuities: Deferred annuity and Immediate annuity products
The parameter values for expenses should reflect the expected expenses to be
incurred in processing and subsequently maintaining the business to be written
under the product being priced.
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.
More commonly, the expected expenses would be derived from the construction
of a suitable expense model. This will simply be a projection of the staff
structure and associated overheads, such as buildings, systems etc. The output
from that will be taken in conjunction with expected new business volumes and
expected inforce policies after persistency assumptions to give suitable per-
policy or per-premium costs. Hence, as was discussed in earlier chapter as well,
if persistency assumption is wrong, it can in validate expense assumption
because of this dependence.
Some of the factors such as type of product to offer, infrastructure required,

volume of business and regulatory restrictions will also be analysed at this
stage. These results would then be tested for reasonableness by comparison
with industry averages.
These estimates are then adjusted based on other remaining factors such as
competition, industry practice etc. The exercise is usually subjective and is
dependent on the circumstances of each company.
Variations of this technique will be used for studying (in order of complexity):
 new product launches,
 new distribution channels (or major extensions to existing channels, or
major new sales campaigns), and
 new life insurance companies.
One of the major factors in the expense assumption is the extent of expense
risk. This refers to the risk of incurring more expense than expected and its
impact of profit. The impact of this risk is dependent on the product design,
which can be designed in a way to have minor impact of this risk. For example,
in a product design where the expense loading is insignificant portion of overall
premium, some divergence from expected expenses will have minor impact on
the profit. Expense risk will be discussed separately in specific section.
The other factors on which expense assumption is dependent are described

below in details:
 Nature and type of products
Amount of expenses is dependent on the type of product for instance

term product would have much larger medical underwriting cost because
of higher sum assured, as compared to, say, a unit linked product.
 Volumes of sales through various distribution channels and persistency

assumption
Per policy expense assumption is dependent on the number of new

business sold and number of remaining inforce policies in the future. For
this estimate, company should be able to estimate volume of sales
through different distribution channel and their respective persistency
assumption.
Volume of sales is also dependent on the estimation of number of agents

and their respective productivity, or it can be translated into wider
branch productivity.
 Company’s recent experience
The parameter values will be determined after analysing the company’s

recent experience for the type of business concerned. It will give clear
distension of different type of expenses incurred under each product
type.
 Infrastructure—offices, staff, and other material to operate
This will be useful in estimating the total expenses that will be incurred
in future. This will be one of the major inputs to the expense model as
described above.

 Insurance Legislation that would put ceiling on expenditure
Insurance regulations and legislation has put a ceiling on the total

expense which can be incurred by an insurer. It is not allowed to incur
expenses more than what is prescribed. These ceilings should be
considered while estimating overall expenses.
 Support from consultants
Consultants support is helpful when the company is new and has less
experience in building of expense model and thus expense assumption.
Consultants have a view of overall industry and thus can help greatly in
expense projections.
 Support from reinsurers
If the recent experience is not available or is not relevant or not

sufficient, data from reinsurer can provide lot of insight into the expense
assumption to use.
 Competitors rates
Whatever expense assumptions are derived, it should be consistent with

the competition. If expenses assumed are more than competitors,
premium is also expected to be higher. This can cause lower sales
volumes then expected leading to losses or lower profits than expected.
 Industry’s practices and data
If the recent experience is not available or is not relevant or not

sufficient, data from industry can be used. Whatever, assumptions are
derived, it should confirm to the industry wide practice.
In the context of expense assumptions, the words fixed and flat are used rather
loosely. They refer to expenses that do not vary by premium size but they are
not necessarily fixed or flat in the full sense of the word. For example, future
administration expenses should increase with inflation. Hence, expense inflation
is one of the major aspects of expense assumption. This is significant enough to
deserve a category of a separate assumption altogether rather than being
merged in expense assumption. Accordingly it will be described separately in a
specific section.

Test Yourself 3
Expense rates do not vary with which of the following factors?
I. Overall Industry experience

II. Competitor’s range of products
III. Insurance Regulator’s terms and conditions for distributors

D. Expense Inflation
Expense inflation refers to the rate of increase in the expenses in future. It is

expressed as a percentage of current expense. For example, it can be say, 5%
per annum applied to the expense at end of last year.
An inflation assumption will be necessary to apply to expense assumption in

respect of renewal maintenance, investment and policy termination expenses.
Inflation will be affected primarily by earnings inflation rather than price

inflation, because the majority of an insurance company’s costs are staff costs.
However, rent cost or property maintenance cost, which are also usually
significant, will be dependent on price inflation.
Initial expenses are incurred at the outset and hence the expenses are more
certain. But when pricing a contract we have to consider two distinct aspects
of expense inflation:
 The inflation of expenses during the term of a future new policy, from
the issue date to its termination date
 The inflation of all expenses between “now” (the date at which you are
setting premium rates to be used in future) and the dates at which the
future new policies are actually issued.
As an example of the second point, you might set your per-policy initial expense
assumption at Rs. 1500, but for a policy issued in one year’s time it perhaps
ought to be Rs. 1600, for one issued in two years’ time it should be Rs. 2000,
and so on.
So we need to make the overall future expense assumptions appropriate to the

future period over which we would expect the pricing basis to be used.
In the case above, for example, if we expected our basis to apply for the next
four years, say, we might fix our initial expense assumption at Rs. 2500, for all
policies to be issued over the four-year period.
Hence, it is also important to estimate the time period for which this new
product will be sold in the market.
Here, the inflation impact is given in the expense assumption itself for the
initial expenses. In case of renewal expenses, expense inflation is explicitly
assumed as a percentage per annum.

The following may be considered when setting the value of the inflation
parameter:
 Investment income assumption: The inflation assumption must be

consistent with the future investment income assumption, since both
should be derived using consistent economic scenario.
 Current rates of inflation, both for prices and earnings: This information
will be available freely.
 Expected future rates of inflation: This needs to be estimated using

appropriate methods. One approximate way is to look at the differential
between the return on government fixed-interest securities and on
government index-linked securities, where such exist.
 Recent actual experience of the company or industry: This will require

past analysis of inflation of company’s or industry expenses.
Based on the above factors, inflation to be applied will be estimated and

expressed as percentage per annum to be used along with expense assumptions.

E. Expense Analysis
Expense analysis refers to the process of analyzing the past expenses of the
company to fit the desired purpose.
Expense analysis is usually done for different purposes such as pricing, asset
share, estimating overall profits etc. Here we will discuss about the expense
analysis done for pricing purpose.
An important consideration for an expense investigation is the time period

involved. In practice, companies would normally be seeking to perform an
expense investigation on an annual basis, in which case a logical time period to
use would be one year (and, of course, we are talking about the most recent
year’s experience here).
If a shorter period were to be used, then any seasonally influenced expenses

will not be correctly represented (they will be either under- or over-
represented in the totals). New business figures are often sensitive to the time
of year, in which case expenses associated with selling or processing new
business would be particularly distorted by only looking at part of a year.
On the other hand, the company would not just look at its most recent year’s
expenses in isolation. It would also need to look at, say, the most recent 3-5
years of expense experience, to identify and if necessary allow for unusual or
“random” influences, and to identify trends that could be occurring over time.
When looking over several years it would be necessary to adjust the figures for
inflation, so that each years’ costs could be compared in current money terms,
for example.
Total expenses of the past are split between each expense item such as
underwriting, electricity etc. This will usually be based on an analysis of the
expenses by department or function. Each of the expense items is then further
subdivided into following categories:
 Initial expenses, which arise at the start of the policy term

 Renewal expenses, which arise regularly during the policy term
 Termination expenses, which arise when the policy terminates
 Investment expenses, which relate to the management of the company’s
assets.
Initial expenses, renewal expenses and termination expenses are further split
according to whether the expense is driven by and proportional to:
 The number of new business or inforce policies

 The amount of new business or inforce premium
 The amount of new business or inforce sum assured.

Investment expenses are normally expressed as a percentage of funds under
management so that they can be treated as a deduction from the earned
investment return.
This analysis can be done for:
 the whole business of the life insurance company

 the whole business of a particular accounting fund, or
 each main product line of the company
 Regular premium or single premium
The subdivision will vary across companies depending upon the types and
volumes of business written and what are the requirements of the analysis. The
subdivision chosen should not be so small that the analysis becomes unreliable.
One of the possible approaches which can be used is given below. Here we are
assuming that analysis is done for three main fund types of traditional, unit
linked and group business. The main items of expenses and their analysis are
provided below.
 Salaries expenses
Staff can be split into three groups:
(i) staff whose work comes entirely within a single subgroup of the
analysis: For example, some staff only working on selling of group
business. This can be directly allocated to the appropriate
subgroup.
(ii) staff whose work comes within more than one subgroup: For
example, staff working in selling of traditional and unit linked
individual business. For this group staff timesheets can be used to
split their salaries etc between the appropriate subgroups.
(iii) other staff: For example salary of support staff like valuation
actuary or finance department. The work of this group staff will
straddle both all funds and will also be both new business and
renewal. The split between the two is likely to be made
pragmatically. Time sheet of this group will be used to decide the
split.
 Property costs (rent, property taxes, heating, lighting and cleaning)
If the company owns, as an asset of its policyholder or shareholder fund,

any of the buildings that it occupies, a notional rent needs to be charged
to the relevant departments.

This is because, as an asset of the policyholder or shareholder fund, the
property ought to be earning a return (rental income) from its tenant.
However, owner occupation means that no such rental is forthcoming, so

that occupation has the effect of costing the company to the tune of the
annual rental that it could have earned if the property were let. This is
the “notional rent”: it is an expense to the company, we need the policy
expense loadings to cover it, and it must therefore be included in the
expense analysis.
Of course, if the company actually rents its office buildings, it would

have a real rental cost for each year: the treatment of actual or notional
rent in the analysis would be the same.
This rent, plus property taxes, heating costs etc, can be split, for
example, by floor space occupied, between departments and then
allocated in accordance to salaries.
 Computer costs
The cost of purchasing a new computer could be amortized over its

useful lifetime and then added to the ongoing computer costs. These can
then be allocated according to computer usage. If it is not significant, it
can be allocated based on number of employees.
 Investments costs (investment department, stamp duty, commission,

etc).
These would be directly allocated to investment expenses and hence

allowed for in assessing the investment return to use for pricing etc. It is
easily allocable based on total amount each fund.
Exceptional items, which are not likely to recur, would be excluded completely
from the analysis.
It would be normal to compare results with those of the previous expense

investigation(s), both to look for trends which may indicate the need for action,
and as an immediate check. Such comparisons should take account of expense
inflation.
It could also be interesting to compare results with industry statistics, again

both as a check and to indicate possible problem areas.

F. A Simple Example
Expense analysis for the whole company has the following results:
Table 1: Total expenses

(in INR)
Initial Renewal Termination
Per Policy 100,000 150,000 200,000
Per premium 600,000 100,000 -
Per Sum assured 200,000 - 25,000
Table 2: Drivers of these expenses are:

Per Policy New policies = 100
Inforce policies = Terminated
300 policies =
250
Per premium Total new business Total Inforce -
premium = 2,000,000 premium =
10,000,000
Per Sum Total new business - Total terminated
assured Sum assured sum assured =
20,000,000 10,000,000
Table 3: Final expense assumptions to be used are derived by Total expenses

divided by driver:

Per Policy 1000 500 800
Per premium 30% 1% -
Per Sum assured 1% - 0.25%
These assumptions would be suitably adjusted for expected future changes to

the experience as per the other factors impacting expenses.

G. Expense Risk
Expense risk refers to the risk of incurring more expense than expected and its
impact of profit.
Expense model is used to estimate expenses, which takes various parameters as

inputs such as agent productivity. Hence, there is a parameter risk that the
value of parameter is incorrect. There is also a risk of model being
inappropriate and incorrect leading to significant model risk.
Expense will allow, implicitly or explicitly, either on a deterministic or

stochastic basis, for inflation.
There is therefore a “parameter” risk that the parameter values used in model
is incorrect. In addition, there will be a “model” risk if stochastic model is
being used in estimating inflation.
When a stochastic approach to investment returns is used it is normal to model

inflation stochastically. In fact, the model may be “driven” by a stochastically
generated inflation rate, with investment returns linked in some way to the
projected inflation.
The company will include, either explicitly or implicitly, in the premiums it

charges its policyholders, amounts designed to cover its expenses. These
charges may be augmented by others made, again either explicitly or implicitly,
against the funds built up by contracts.
On non-linked contracts the charges for expenses may be invisible to the

policyholder, as they are loaded within the quoted premium rate. Sometimes, a
fixed policy fee to cover some part of the expenses will be quoted explicitly.
On unit-linked contracts, as we saw earlier in the course, charges are explicit.
They may be deducted from premiums (eg by allocating less than 100% of the
premiums to units) or from the fund (eg a regular policy fee paid for by unit
cancellation).
It is not likely to be possible to design the charges (implicit or explicit) so that

they correspond exactly to the expenses of administering the product, and
change in line with any changes in expenses. This is because in India, most
products have guaranteed charges.
There is, therefore, a risk that the charges accruing to the company in a year
will not cover the actual expenses of the company in that year.
A particularly important example of this is when heavy up-front expenses are

recouped gradually by charges made over the term of the policy. The insurance
company may then be vulnerable, for example, to the policy withdrawing.
Another problem exists on policies of long duration, where higher-than-
expected inflation may mean that the original expense loadings prove to be
inadequate.
Controlling Expense Risk:
Some of the ways of controlling this risk are mentioned below:
1. Regular monitoring and action:
This will involve performing expense analysis on frequent periodic basis

and comparing it with expectation. This can then be used in re pricing
the products in case of major divergence.
2. Checking and controlling the model used and parameters used in the
model to ensure that these are appropriate to minimize model and
parameter risk
3. Outsourcing of some of the activities to third parties administrators with

long term contract to be more certain of expense to be incurred. This is
essentially transferring of expense risk to third parties.

Summary
a) It is very important for the insurance company to regularly monitor its

expenses in order to have a competitive product and improve profitability.
b) Expenses can be primarily classified into fixed and variable expenses.
c) The expenses are also split between initial expenses, renewal expenses,
investment expenses and terminal expenses depending upon the life of the
policy.
d) Expense rate is the amount of money to be spent in transacting insurance

business and it is usually measured as a proportion of premium for a certain
unit of time or may be fixed.
e) Type of expense assumption to be used in pricing is dependent on the type

of expense and its drivers
f) The factors that would be considered in choosing expense assumption are:

Extent of expense risk, Nature and type of products, Volumes of sales
through various distribution channels, Persistency assumption for future
business, Company’s recent experience, Infrastructure—offices, staff, and
other material to operate, Insurance Legislation that would put ceiling on
expenditure, Support from consultants, Support from reinsurers,
Competitors rates and Industry’s practices and data.
g) The parameter values for expenses should reflect the expected expenses to
be incurred in processing and subsequently maintaining the business to be
written under the product being priced.
h) An inflation assumption will be necessary to apply to expense assumption in

respect of renewal maintenance, investment and policy termination
expenses.
i) Expense analysis refers to the process of analyzing the past expenses of the
company to fit the desired purpose
j) Expense risk refers to the risk of incurring more expense than expected and
its impact of profit.

Answer 1
Insurance expenses can be primarily classified into fixed and variable expenses.
Answer 2
Expense rate is usually measured as a proportion of premium for a certain unit

of time.
Answer 3
Competitor’s rates affect the expense rates and not the competitor’s range of
products.

Question 1
Which of the following expenses is the most difficult to ascertain while

calculating the expense rate?
I. Nature of product
II. Volume of sales
III. Inflation rate
IV. Competitor’s rate
Question 2
Which of the following expense will be borne by the insurer himself initially?
I. Acquisition of office premises

II. Commission of agents
III. Policy servicing
IV. Policy liability
Answer 1
Some expenses could not be estimated with ease—such as inflation
Answer 2
Initial expenses are required to be borne by insurers.

CHAPTER 12
REINSURANCE SUPPORT
Why does an insurer need reinsurance at all? The insurer could simply decide to
insure only those risks that it is able to accept, within the insurer’s own defined
limits. However, if this happens, then the following issues could arise:
a) Very large losses resulting from a massive explosion or terrorist attack

may not be insurable by one single insurer.
b) Losses resulting from different insured risks may all be connected in

some way e.g. damage caused to several properties at once due to
floods.
Although theoretically, an individual risk could be reinsured entirely, at times,

it would make no business sense. Therefore, insurers reinsure only part of a risk
that they hold. This chapter discusses some of the aspects of reinsurance and
how it works.
Learning Outcomes
A. Meaning and need for reinsurance

B. Types of reinsurance arrangement
C. Regulation on reinsurance
Natural catastrophes such as Hurricane Katrina in the US in 2005 or terrorist

attacks such as the attack on the World Trade Center on September 11, 2001
resulted in large claims for insurance companies. According to a research
report, Hurricane Katrina had a significant impact on the US non-life insurers.
According to a research agency, around 12% of all direct insurers in the US
received payments from reinsurers that exceeded 100% of their shareholders
equity in that year.
This goes to show how reinsurance can save insurers from grave consequences
as a result of significant depletion of capital caused due to unexpectedly high
catastrophe claims.

A. Meaning and need for reinsurance
1. Meaning of reinsurance
Definition
Reinsurance is an arrangement whereby one party (the reinsurer), in

consideration for a premium, agrees to indemnify another party (the insurer)
against part or all of the liability assumed by the insurer under one or more
insurance policies, or under one or more reinsurance contracts.
Example
An insurer, X grants cover of Rs. 1 Cr. under an insurance policy. X can pass on a
substantial portion of the risk (not necessarily the whole risk) to a re-insurer Y’.
This means that Y has to bear the risk to the extent of the amount of cover
agreed with X.
There would be an agreement between X and Y, which is called ‘treaty’ [more

precisely, ‘reinsurance treaty’] which sets terms and conditions of the
reinsurance. As per terms of the treaty, in case of a claim, where X has to
settle, Y would pay the agreed amount to X.
2. Terms and conditions of reinsurance treaty
There is a need to determine the amounts of cover (payable on death) that

would be agreeable to the re-insurer. In determining the amount of re-
insurance, the direct insurer would retain a fixed amount of cover per life and
the rest would be passed on to the re-insurer.
Here, certain terms need to be understood. The amount retained by the direct
insurer is called ‘retention amount (X)’,
The excess of the total amount of cover (T) over the retention amount (X)
would be passed on to the re-insurer.
If the total amount of cover (T) exceeds the amount of Facultative Limit (F),
then the re-insurer would examine and underwrite before the insurer is allowed
to grant cover to the policyholder.
If the insurance cover per life is below F, the re-insurer would automatically
accept without any question. However, the re-insurer would retain the right to
examine and inspect offices of the insurer in this regard to assess the
underwriting practices within the company.
For every life that is reinsured, the excess of T over X is referred to as cession
amount/cover. The re-insurer might also specify a condition of minimum
cession amount stating that such amount should be of a specified minimum
amount, say Y. If T-X happens to be less than Y, the re-insurer may not agree to
reinsure. The details with regard to amount of cover would be discussed in
detail in treaty.
Reinsurance Premiums would be discussed. Re-insurer may have the right to

review the rates at a predetermined period (say 3 years or 5 years). Generally
the reinsurance premium rates would be lower than those charged by the
insurer. The reason is different scale and assumptions on which reinsurer works.
In certain cases of reinsurance portfolio, reinsurance premium rates could be
higher.
There would be also terms when the reinsurance treaty is terminated (there
could be some penalty for early closure).
The terms would mention adjudication where and when disputes could be
resolved. These could arise with regard to settlement of claim, where insurer
fails to provide the requisite information called for by the re-insurer.
3. Need for reinsurance
Reinsurance is needed to reduce the risk and maximise the return on

shareholders’ funds. The advantages of reinsurance are as follows:
a) Efficient utilization of capital: This arises as the risks are passed on to

the re-insurer thereby resulting in reduction of solvency requirements on
account of reinsurance. Also, reinsurers may have lower capital
requirements due to risk diversification or regulatory position. This can
result in overall lower capital requirements for the industry and lower
reinsurance prices.
b) Minimization of losses: Such losses could have arisen had claim

experience been unfavorable to the insurer.
c) Higher risk acceptance: Reinsurance allows aggregation of risks the

insurer cannot manage on its own e.g. if the insurer had a large
concentration of risk in a certain geographical location then the insurer
could reinsure this and still be able to write the business.
d) Underwriting guidance and training (technical assistance): Reinsurance

companies may have a considerable degree of expertise on matters such
as underwriting, product design, pricing and systems design. e.g. Insurer
intends to write a new line of business. It will find that it can receive
technical assistance from its reinsurer until such time as it has built up
its own expertise. This is valuable particular when new diseases emerge
in the country;

e) Re-insurer also could help in the design and pricing of new products
(particularly when insurer is new and does not have any past data to
determine premium rates). As was discussed in assumption chapters that
reinsurer can provide significant assistance in derivation of assumptions
to be used in pricing.
f) It backs the strength and stability of insurer and the insurance industry
as a whole.
g) Volatility of claim experience could be under check (particularly when

insurer underwrites large sum assured cases on few individuals);
For an insurer, one of the main ways in which reinsurance can help
reduce risk is by reducing the variance of the insurer’s claim costs.
The variance relative to the mean can be high because:

a) There are a small number of contracts for very high levels of cover
b) The lives insured are not independent risks.
For reason (a), the methods of reinsurance that could be used would be
either the original terms (coinsurance) method or the risk premium
method, usually on an individual surplus basis. We will discuss these
types later in the chapter.
h) Reinsurance helps in minimising new business strain (particularly when

the re-insurer extends financial support). This is done by ensuring a high
initial commission paid by reinsurer to insurer to minimize initial strain
on capital by writing new product.
Example
To illustrate how this might work, imagine a young company selling a
twenty-year endowment assurance policy. Suppose that initial expenses
are 120% of the first year’s premium, renewal expenses are 5% of
subsequent premiums, and that statutory reserves amount to 85% of all
premiums paid (ignore interest).
The cash flow on writing a Rs.1,000 premium policy is:
Premium – expenses – increase in reserves
Year 1 – Rs.1,050
Years 2+ Rs.100
The capital strain from this is too great for a young company to be able
to write significant amounts of new business without a huge amount of
capital to finance the new business strain.
A reinsurer offers treaty, offering the following commission:

Year 1 Initial commission = 150% of reinsurance premium
Years 2+ Renewal commission = 10% of reinsurance premium
If the company were to cede 50% of business on this basis, the net cash
flow would become:
Gross Monies to Change in Net
cash flow reinsurer reserves cashflow
Year 1 – Rs.1,050 – Rs.250 – Rs.425 – Rs.375

Years 2+ Rs.100 Rs.450 – Rs.425 Rs.75
where for instance in year 1 the company cedes Rs.500 of premium, and
so “passes” Rs.500 – 150% × Rs.500 = – Rs.250 to the reinsurer and the
company now has to establish reserves equal to only 85% × Rs.500 =
Rs.425.
It should be clear from this example that, with this arrangement, the
new business strain is greatly reduced, although at the expense of future
profits.
i) Reinsurance helps in reducing insurance parameter risk e.g. there is a

risk that the level of claims may be different from expected. This may
be due to a number of factors including incorrect pricing, underwriting
failures, fraudulent activities, etc. The use of reinsurance would be used
to share the parameter risk with the reinsurer.
j) Reinsurance increases profits, return or risk-adjusted return on capital

(by reducing risk cost or increasing volumes)
k) Cost reduction: Due to various reasons (including different capital

requirements, diversification benefits, different taxation and different
assessment of risks) a reinsurer may be able to price the risk at a lower
cost than the insurer.
Considerations before reinsuring
Here we will discuss the considerations that should be kept in mind before
reinsuring:
1. Cost of reinsurance
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
insurer.
However, the risk reduction caused by reinsurance may leverage up the return
or risk-adjusted return on capital.

2. Retention limits
General factors to take into account when setting the retention limit include:
 The average benefit level for the product and the expected distribution
of the benefit
 The company’s insurance risk appetite
 The level of the company’s free assets and the importance attached to
stability of its free asset ratio
 The terms on which reinsurance can be obtained and the dependence of
such terms on the retention limit
 The level of familiarity of the company with underwriting the type of
business involved
 The effect on the company’s regulatory capital requirements of
increasing or reducing the retention limit
 The existence of a profit-sharing arrangement in the reinsurance treaty
 The company’s retention on its other products
 The nature of any future increases in sums assured.
There are a number of different possible approaches that an insurer can use to
determine the level at which the insurer should set its retention limit. The key
decision is to set the limit at a level where the expected profit is highest after
taking into account all the risk.
3. Counterparty risk
The insurer retains liability to the policyholder for the benefits even if the
reinsurer becomes insolvent and can’t meet claim payments as they become
due. This is an example of what is known as a counterparty risk. The amount of
exposure to the reinsurer is known as credit risk.
The exposure of some companies to a reinsurer can be large. Exposure could be

measured as statutory or realistic reserves ceded or costs borne to replace the
cover.
Various forms of collateral, or defined actions given certain events, can
mitigate the risk itself.
For example, management could have in place a process to reduce (possibly to

zero) the amount of reinsurance ceded to any reinsurer whose credit rating falls
below a specified level.
4. Legal risk
Reinsurance is usually governed by a treaty between the insurance company and

the reinsurer. The treaty is a legal contract and governed by contract law. As
reinsurance has been around for a considerable period of time, there is a large
body of case law forming precedents, some of which can be quite archaic.

Treaties govern what will be paid by whom and under what circumstances.
There are usually many clauses to be negotiated to cover numerous
contingencies and risks, each one potentially impacting the price of the
reinsurance. In order to achieve contract certainty it is important to ensure the
reinsurance treaties are agreed, and signed, before enacting a treaty and to try
to write into the treaty the responsibilities of the parties involved in as many
scenarios as possible.
Due to the risks involved and impact of disputes where contracts have not been
finalized, regulators around the world are increasingly focused on ensuring
reinsurance treaties are complete and signed.
5. Systems and data risk
Reinsurance involves a number of additional administrative operations and

reinsurers may rely on the insurer performing their side of the contract in a
timely and accurate manner.
For example, there are risks that reinsurance premiums will be calculated
incorrectly or that recoverable claims will not be identified correctly.
If one side fails on its administration then remedies may be specified in the
treaty or may have to be negotiated between the parties.
Reinsurance can also mean the creation of additional data records for reinsured
lives, and it is important that all records are managed consistently.
6. Type of reinsurance
The type of reinsurance (eg original terms/risk premium/excess of loss/financial

reinsurance), and the way in which the amount reinsured is specified (eg
individual surplus/quota share), will depend on factors such as:
 The reason the ceding company is using reinsurance

 The reinsurance costs
 The type of business
 The legal conditions applying
 The forms of reinsurance coverage actually on offer in the market
Test Yourself 1
In a reinsurance contract, the excess of the total amount of cover (T) over the
retention amount (X) would be ________.
I. Passed on to the insurer

II. Passed on to the re-insurer
III. Borne by the insurer and re-insurer in agreed proportion
IV. Retained by the insured
B. Types of reinsurance arrangement
1. Types of reinsurance arrangement
There are different types of reinsurance. These are:
a) Original terms (coinsurance) reinsurance
This method involves a sharing of all aspects of the original contract.
The insurer will provide the reinsurance company with the premium
rates (known as retail rates) it is using for the particular class of
business it wishes to reinsure.
The reinsurance company will determine the rates of reinsurance

commission it is prepared to pay to the insurer for the business.
b) Level risk premium reinsurance
In this method the reinsurer supplies the insurer with a set of premium
rates upon which the insurer can load its costs and profit test against the
intended retail rates.
In effect, the reinsurer will decide upon a level premium rate for the
risk, which it will use to charge the insurer for reinsurance. The insurer
will then price its product in the knowledge of the reinsurance terms it
will be able to obtain. Reinsurance commission is likely to be much less
significant with this variation, as the reinsurance premium will probably
have smaller margins than the retail rates.
c) Risk premium reinsurance
The insurer reinsures part of the sum assured or the sum at risk, ie the
excess of the benefit payable over the reserve, on the reinsurer’s risk
premium basis, which can be annually renewable or guaranteed
The reinsurance company determines its risk premium rates by assessing

the likely experience of the business it is to reinsure and then adding
expense and profit margins. It may or may not guarantee these rates for
the term of the policy.
d) Excess of loss reinsurance
Excess of loss reinsurance can be enacted on a risk basis where the

reinsurer pays any loss on an individual risk in excess of a predetermined
retention.

However, excess of loss 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 may be organized into different levels, or lines.

The insurer may retain the first X of losses. The first Y over the X will
have one price. The next Z over (X+Y) will have a different price, and so
on. Different reinsurers may then take different proportions of each line.
The main types of excess of loss reinsurance used in life assurance are
catastrophe and stop loss reinsurance.
Catastrophe reinsurance
The reinsuring company will agree to pay out if a “catastrophe”, as

defined in the reinsurance contract, occurs. Catastrophe event occurs
with minimum number of deaths, say five, deaths from a single incident
with the deaths occurring within a specified time, say 48 hours of that
incident.
Stop loss reinsurance
Stop loss reinsurance means the reinsurer pays the aggregate net loss
over the predetermined retention for a portfolio over a given time
period, usually a year. In this way the portfolio’s loss to the insurer in
any period is capped.
e) Financial reinsurance
Value in force (VIF): Life insurance companies have to hold statutory or

regulatory reserves (ie supervisory reserves) well in excess of the
realistic reserves (reserves calculated on realistic set of assumption).
This excess reserve over the realistic reserve plus the profit margin in a
portfolio will be released over time.
VIF is an economic asset, but it may not be recognized in a life insurance

company’s regulatory balance sheet, though some accounting regimes do
allow it to be recognized in the company’s report and accounts.
Financial reinsurance allows the insurer to trade VIF, turning the

economic asset into a cash equivalent asset that can be used elsewhere
in the business. Details are beyond the syllabus.
Depending upon the obligation of various parties, there are two types of
reinsurance namely Facultative and obligatory reinsurance.

Facultative and obligatory reinsurance
The term “facultative” applied to the insurer’s part of the agreement

means that it is free to place the reinsurance with any reinsurer.
Similarly, so far as the reinsurer is concerned, facultative means that it
may accept or reject the reinsurance offered. The term “obligatory”
indicates the removal of this freedom of action.
The agreement between insurance company and reinsurer may be:
 facultative/facultative
 facultative/obligatory
 obligatory/obligatory
There are two ways in which the amount to be reinsured can be specified
a) Quota share arrangement
In this arrangement, a specified percentage of each policy is reinsured.
Example
An insurer issues a contract of sum assured of Rs. 100,000. If the re-insurer

shares 50% of this, then in case of claim by death, the re-insurer pays
Rs.50,000.
The reinsurance premium can be charged on the basis of the original premium
(charged by insurer) or different from the original premium (reinsurance
premium can be higher or lower).
b) Surplus arrangement
In this arrangement, the re-insurer shares only the sum at risk which is
calculated by the re-insurer. Under this method, the sum at risk decreases
every year. The sum at risk is the sum assured minus reserve (where reserve is
calculated by a specified method).
The reinsurance premium shall be the sum at risk multiplied by mortality charge
per 1000. The mortality charge is determined by the re-insurer according to a
pre-determined method.
For an insurer, the reinsurance premium outflow would be lower in case of

surplus method when compared with that under quota share method. Insurers
generally choose surplus method, as this is more propitious.
In addition to the above two types of reinsurance arrangements, it is not

unusual to have ‘declined lives’ treaty.

Definition
A declined life is defined as a life declined by insurer but accepted by re-insurer

with some extra premium.
Due to certain reasons, the insurer would bear very low retention (may be 5% or
a specified amount whichever is lower).
Test Yourself 2
The excess loss method of reinsurance is more predominant in which of the

following types of insurance?
I. General insurance business

II. Life insurance business
III. Mutual insurance business

C. Regulation on reinsurance
IRDAI has issued regulation on reinsurance in year 2000 and now has updated it
again in 2013. Some of the important points of regulations which can impact
pricing (because it can impact overall reinsurance cost and benefit) are
highlighted below:
 Reinsurance with Indian Reinsurers
a) Every insurer shall reinsure with Indian reinsurers such percentage of the
sum assured on each policy as may be specified by the Authority by
notification.
b) Provided that no percentage so specified shall exceed thirty percent of
the sum assured on such policy.
c) Different percentages may be specified for different classes of insurance
d) Specify the proportions in which the said percentage shall be allocated
among Indian reinsurers.
 The insurer shall ensure that the reinsurance arrangements in respect of

catastrophe risks using various realistic disaster scenarios testing are
adequate and approved by the Board of Directors before filing the same
with the Authority along-with the reinsurance programme.
 Retention Policy
a) Every insurer shall build the retention capacity within the company and
formulate suitable retention policy for each type of product/risk on an
ongoing basis and justify on an ongoing basis such retention policy in
accordance with the emerging claims experience, financial standing,
underwriting capacity etc. in the annual reinsurance programme
submitted to the Authority.
b) Insurers may be allowed to reinsure on quota share:

i. In the initial two years of starting operations for health insurance
business and group term insurance business and
ii. In the initial two years of introducing a new risks/product for
health insurance business and group term insurance business
Insurance companies has to change retention from time to time depends on

duration since they start operation. Minimum retention limit is given in the
table below.

Minimum Retention Limits
Age of the Retention

insurer or year limit on
Sr. in which the risk the sum at
No. is introduced** Type of the products or riders risk. Rs.
Pure protection products like term

insurance, personal accident products etc 5 lakhs
All kinds of savings products like
endowment, ULIPS etc 10 lakhs
0 to 3 years
1 both inclusive All kinds of group protection products 5 lakhs
All kinds of health insurance products,

except personal accident products. 1 lakh

4 to 7 years


8 to 11 years


12 to 15 years

Above 15 The Authority may prescribe from time to time the
5 years limits for all the four types of products

** If the insurer is introducing the risk for the first time, in such cases the limits
in # 1 would apply irrespective of the age of the insurer.
 Placement of Reinsurance Business
a) Insurers shall place their reinsurance business outside India with only
those reinsurers who have over a period of the past five years counting
from the year preceding for which the business has to be placed,
enjoyed a credit rating of at least BBB (with Standard & Poor) or
equivalent rating of any other international rating agency.
b) Provided that placement of business by the insurer with any other
reinsurer shall be with the prior approval of the Authority.
c) Provided further that no programme of reinsurance shall be on original
premium basis.
d) Provided further that no life insurer shall have reinsurance treaty
arrangement with its promoter company or its associate/group company,
except on terms which are commercially competitive in the market and
with the prior approval of the Authority, which shall be final and
binding.
e) The life insurers shall, before placing the business with the reinsurers,
consider past claims performance of the reinsurers, as available, while
accepting their participation in the reinsurance programme.
IRDAI (Registration and Operations of Branch Offices of Foreign Reinsurers

other than Lloyd’s) (First Amendment) Regulations, 2016
In exercise of the powers conferred by section 3, 6 read with 114A(a) of the

Insurance Act, 1938, and sections 14 read with 26 of the Insurance Regulatory
and Development Authority of India Act, 1999, the Authority, in consultation
with the Insurance Advisory Committee hereby makes the following regulations,
namely:
1. Short title and commencement.—
(1) These regulations may be called the Insurance Regulatory and Development
Authority of India (Registration and Operations of Branch Offices of Foreign
Reinsurers other than Lloyd’s) (First Amendment) Regulations, 2016.
(2) They shall come into force on the date of their notification in the Official
Gazette.
2. Regulation 4 shall be substituted with the following:
“Regulation 4 - Requisition for registration application
An applicant shall make a requisition for registration application under

regulation 3 for reinsurance business in any one of the following:

a) Category I – wherein the branch office of a foreign reinsurer shall maintain a
minimum retention of 50% of the Indian reinsurance business;
b) Category II – wherein the branch office of a foreign reinsurer shall maintain a

minimum retention of 30% of the Indian reinsurance business.”
3. In Regulations 12, 13, 15 and 16 wherever the words “Chairperson of the” are
appearing, they shall be omitted.
4. In Regulation 16(g) the words “to the extent possible” after the words “in its
operations” shall be omitted.
5. Regulation 28(9) shall be substituted with the following:
“Every Indian Insurer shall obtain best terms for their facultative and treaty
surpluses from Indian reinsurer(s) having a minimum credit rating which is
having atleast good financial security characteristics from any of the
internationally renowned credit rating agencies for the previous three years and
also from atleast three entities which have been granted certificate of
registration under Regulation 4(a) of these regulations. The Indian insurer shall
then offer the best terms for participation in the following order of preference;
(a) To the Indian re-insurer(s) having a minimum credit rating as given above
and thereafter to those granted certificate of registration under regulation 4 (a)
of these Regulations.
(b) To other Indian re-insurer(s) or to those granted certificate of registration as

per regulation 4 (b) of these regulations.
(c) To the branch offices of foreign reinsurers set up in Special Economic Zone,
only after having offered to all entities in (a) and (b) above
(d) The balance, if any, may thereafter be offered to Indian Insurers and
overseas reinsurers Explanation - The Authority will undertake a review of the
working of these regulations and in particular operation of Regulation 28(9) –
order of preference for cessions by Indian insurers after a period of one year
based on the reporting’s made to it.

Summary
a) Reinsurance is an arrangement to minimise the insurer’s risks. Insurer’s risks

are passed on to another insurer who is called re-insurer.
b) In determining the amount of re-insurance, the direct insurer would retain a

fixed amount of cover per life (called retention amount) and the rest would
be passed on to the re-insurer.
c) Reinsurance is advantageous as it results in efficient utilization of capital,
underwriting guidance, minimizing new business strain, Minimization of
losses, higher risk acceptance, help in the design and pricing of new
products, check volatility of claim experience, helps in reducing insurance
parameter risk, increases profits and helps in cost reduction.
d) Consideration before reinsurance are: cost of reinsurance, retention limits,

counter party risk, legal risk, system and data risk and type of reinsurance.
e) There are different types of reinsurance namely, original term, level risk
premium, risk premium excess of loss and financial reinsurance.
f) Depending upon the obligation of various parties, there are two types of
reinsurance namely Facultative and obligatory reinsurance.
g) Insurer’s actuary would determine the best retention limits after considering
various factors.
h) Reinsurance regulations impact the impact the insurance companies

specifically regulation on minimum retention limits.

Answer 1
The retention amount is the amount of cover retained by the direct insurer. The
excess of the total amount of cover (T) over the retention amount (X) would be
passed on to the re-insurer.
Answer 2
The excess loss method of reinsurance is more predominant in general insurance

business. In the case of reinsurance in life business, it is unusual to have excess
loss method. Options III and IV are also incorrect.
Question 1
While choosing retention limits, an insurer’s actuary would consider which of

the following?
I. Time period for which insurer has been in insurance business

II. Solvency requirements with regard to reinsurance
III. All of the above
Question 2
Retention limits would be lower for high risk plans and higher for low risk plans.
High risks would be on account of which of the following?
I. Standard lives
II. Sub-standard lives
III. Savings plans

Answer 1
Both the factors: (a) time period for which insurer has been in insurance
business and (b) solvency requirements with regard to reinsurance would be
considered by the insurer while choosing retention limits.
Answer 2
High risks would be on account of sub-standard lives. The other options are
incorrect.

CHAPTER 12
FINANCIAL VIABILITY – PROFIT MARGIN AND

SOLVENCY MARGIN
Financial stability and strength of the insurer are major considerations taken
into account by a customer when purchasing an insurance plan. The reason for
this is that the insurer will be insolvent if its assets are not adequate or cannot
be disposed of in time to pay the claims of the policyholders.
Solvency margins enable insurers to avert crisis by keeping extra capital that
can take care of problems that are usually not anticipated. This chapter aims at
creating an understanding about the different types of financial viability for
insurers.
Different types to profit margins are also discussed.
Learning Outcome
A. Solvency margin
B. Profit margin
Till 1970s, there was only one requirement to be satisfied by a life insurance
company. The requirement was that, the value of the insurer’s assets should
not be less than the value of liabilities (after distribution of surplus, if any).
In 1970, ‘Solvency Margin’ norms were introduced. These norms stipulated that
the value of assets of an insurer should exceed the value of liabilities by a
specified margin. This margin was known as the Solvency Margin.

A. Solvency margin
1. Solvency margin
In order to understand solvency margin, the following definitions need to be

understood.
Definitions
The Required Solvency Margin (RSM) is the additional amount of capital required
to be kept by the insurance as buffer over and above the reserves of the
policies.
The calculation of this is prescribed by the regulator.

The Available Solvency Margin (ASM) is the capital actually available over and
above liabilities. This is excess of assets over liabilities.
ASM should be greater than or equal to RSM. If this is so, the insurer is said to
have maintained the RSM.
In India, there is a requirement to keep ASM higher than RSM by 1.5 times.
2. Calculation of RSM:
There are mainly two approaches to calculate RSM.
 Factor based approach: This approach uses mainly two factors as a

percentage of reserve and sum at risk to calculate the solvency margin.
Factor based on reserve is usually higher than factor based on sum at
risk.
This is a simplistic approach and is followed in India as well. These

factors are known first factor and second factor respectively for reserves
and sum at risk.
First factor is further multiplied by K1 which is 0.85 or (reserve after
reinsurance / reserve before reinsurance) whichever is higher.
Second factor is further multiplied by K2 which is 0.5 or (sum at risk

after reinsurance / sum at risk after reinsurance) whichever is higher.
RSM is calculated as:
(First factor x K1 x Reserves) + (Sum at risk x K2 x Sum at risk)
Sum at risk is calculated as death benefit minus reserves.

First factor is higher than second factor for example, in non linked life
insurance pure term business first factor is 3% and second factor is 0.1%.
For non linked life other business first factor is 3% and second factor is
0.3%.
For linked life business, with guarantees products first factor is 1.8% and
second factor is 0.2%, without guarantees products first factor is 0.8%
and second factor is 0.2%.
There is a requirement to hold at least Rs. 50 Cr. as required capital if

the above formula gives lower value.
Example
If the formulae produce a figure of Rs. 20 Cr, the RSM should be taken as
Rs. 50 Cr. Suppose the formulae produce a figure of Rs. 80 Cr., then the
RSM is Rs. 80 Cr.
Computation of RSM would address the risks inherent in the business of

insurance. These are:
a) Interest risk (insurer may not earn what has been assumed in the
pricing) and
b) Mortality risk (insurer may incur more claims than what has been
assumed)
Factors based approach has a limitation of producing more required

capital for the company which has higher reserves than company which
has lower reserves for the same type of business. The reserve might be
different because of each company’s view on prudence to be built.
Hence, a company which is already strained with higher reserves is
further strained by the requirement to keep higher capital.
To get around this issue and to have better risk measurement risk based
capital approach is now becoming popular.
 Risk based approach: This is a new development and is quickly gaining

ground in different countries.
Since RSM does not take into account, operational risks such as frauds in
the business which could be fraudulent claims, defaults on investments,
escalation of expenses, etc, this is gradually abandoned.
Instead, Risk Based Capital (RBC) is gradually coming in its place. It is

understood that RBC tests whether an insurer has enough capital
resources to meet various risks he assumes in his business.

Rather than using factors, each risk is measured separately and capital
required to support that risk is determined. This is a more scientific way
of calculating the required capital. Company with good risk management
systems gets the benefit of that and is required to keep lower capital.
Similarly, a company holding higher reserves is required to keep lower
required capital.
Though technically an insurer is solvent, he might be physically

(actually) insolvent and may not have money to pay claims.
Nevertheless, it is better to have some method in place. Insurance
regulators would like to use RBC as a tool to take care of interests of the
policyholders.
3. Calculation of ASM:
ASM is defined as value of assets minus value of liabilities. The valuation of

assets and liabilities in this regard is prescribed by regulators.
In India, liabilities are prudently valued and most assets are values at amortized
book value. Equities are valued at market value. For ASM calculations, some of
the assets are assumed to have zero value:
a) Agent’s balances and outstanding premiums in India, to the extent they

are not realised within a period of thirty days;
b) Agents’ balances and outstanding premiums outside India, to the extent
they are not realisable ;
c) Sundry debts, to the extent they are not realisable;
d) Advances of an unrealisable character;
e) Furniture, fixtures, dead stock and stationery;
f) Deferred expenses;
g) Profit and loss appropriation account balance and any fictitious assets
other than pre-paid expenses;
h) Reinsurer’s balances outstanding for more than three months;
i) Preliminary expenses in the formation of the company;
The value of computer equipment including software shall be computed as

under:--
i. Seventy five per cent. of its cost in the year of purchase;
ii. Fifty per cent. of its cost in the second year;
iii. Twenty-five per cent. of its cost in the third year; and
iv. Zero per cent thereafter.
4. Solvency ratio
This can be calculated as ASM divided by RSM. Regulators want insurers to

maintain a solvency ratio of 150%. This ratio acts as a trigger point to take
action against insurers. It is also an indicator of early warning signal about
insurer’s solvency.

Insurers internally maintain higher solvency ratio so as to be confident and
appear financially stable in the eyes of the public.
Test Yourself 1
Which of the following represents an excess of assets over liabilities?
I. Required solvency margin

II. Actual solvency margin
III. Risk based capital
IV. Available solvency margin

B. Profit margin
Profit margin based on present value of premiums was described in pricing

chapter. One more profit margin known as return on capital can be calculated
to represents the overall return earned on capital employed in the policy.
Definition
Profit margin (return on capital) is the return on insurer’s investment in the

product. It is the ratio of net present value of future net cash flows to the new
business strain (which is borne by the shareholder).
Net cash flow at the end of every policy year is the excess of income over outgo
(can be negative). Assumptions are made in respect of expected income and
outgo. Expected income is the expected receipt of premiums and the
investment income. Expected outgo is the expected expenses that would be
incurred to meet claims, commission, and other management expenses. Along
with this there is strain because of requirement to keep reserves and required
capital. These are also outflows when policy is sold. New business strain is net
negative cashflow because of above when the policy is sold.
Usually a cash flow method is used to determine profit margins and premium
rate. An advantage of this method is that it enables the shareholders to
determine premium rates for a given level of profit margin.
Exact profit is known when the last policyholder goes out of the portfolio. Since
this is not known as it could take place after a number of years, an estimate is
made. This estimate is usually referred to as surplus, which is distributed to
policyholders.
Hence, profit margin can be calculated based on the following in denominator

and net present value of cashflows in numerator:
 Present value of premiums
 New business strain or initial capital – known as return on capital
 Initial commission
 Simply annualized premium – known as value of new business margin

(VoNB margin). This is a widely used term in the industry used to
compare different products.
Profit margins are used as profit criteria to price new or existing products.

Summary
a) The Required Solvency Margin (RSM) is the additional amount of capital

required to be kept by the insurance as buffer over and above the reserves
of the policies.
b) Computation of RSM would address the interest rate risk and mortality risk
inherent in the business of insurance.
c) The Actual Solvency Margin (ASM) is the excess of assets over liabilities.
d) Solvency ratio can be calculated as ASM divided by RSM. This ratio acts as a
trigger point to take action against insurers. It is also an indicator of early
warning signal about insurer’s solvency.
e) Risk Based Capital (RBC) tests whether an insurer has enough capital
resources to meet various risks he assumes in his business.
f) Profit margin can be represented by new business strain, present value of

premium, initial commission and annualized premiums.

Answer 1
Actual solvency margin represents an excess of assets over liabilities.
Question 1
Computation of which of the following would address the interest rate risk and
mortality risk inherent in the business of insurance?
I. Required Solvency Margin (RSM)

II. Actual Solvency Margin (ASM)
III. Solvency margin
IV. Solvency ratio
Question 2
Required Solvency Margin (RSM) does not take into account, which of the
following risks?
I. Defaults on investments
II. Defaults on premium payments
III. Default on solvency margin requirements
Answer 1
Computation of RSM would address the interest rate risk and mortality risk
inherent in the business of insurance.
Answer 2
Default on investment is not taken into account by RSM since it is an operational

risk.

CHAPTER 13
GLOSSARY
This chapter compiles some of the key definitions from various regulations
governing Indian insurance industry as well as general terms knowledge of which
is a key requirement to work in insurance industry.
Learning Outcome
A. Regulations definitions
B. General terms

A. Regulations definitions
1. Death benefit:
Death benefit means the benefit, agreed at the inception of the contract, which
is payable on death as specified in the policy document.
2. Discontinuance:
Discontinuance means the state of a policy that could arise on account of

surrender of the policy or non-payment of the contractual premium due before
the expiry of the notice period as per regulation.
Provided that no policy shall be treated as discontinued on non-payment of the
said premium if, within the grace period, the premium has not been paid due to
the death of the insured or upon the happening of any other contingency
covered under the policy.
3. Discontinued Policy Fund / Discontinued Policy Account Value:
Discontinued Policy Fund / Discontinued Policy Account Value means the

segregated fund/policy account of the insurer that is set aside and is
constituted by the fund value/policy account value, as applicable, of all the
discontinued policies determined in accordance with this Regulation.
4. Grace period:
Grace Period means the time granted by the insurer from the due date for the
payment of premium, without any penalty/late fee, during which time the
policy is considered to be in-force with the risk cover without any interruption
as per the terms of the policy. (this period is normally 15 days for monthly
policy and 30 days for other policies.
5. Limited premium payment products:
Limited premium payment products means the non linked insurance products
where the premium payment period is limited/shorter compared to the policy
term and are paid at regular intervals like yearly, half-yearly etc.
6. Lock-in-period:
Lock-in-period means the period of five consecutive years from the date of
commencement of the policy, during which period the proceeds of the
discontinued policies cannot be paid by the insurer to the policyholder or to the
insured, as the case may be, except in the case of death or upon the happening
of any other contingency covered under the policy. This is applicable to linked
products.

7. Maturity benefit:
Maturity benefit means the benefit, which is payable on maturity i.e. at the end
of the term, as specified in the policy document and is stated at the inception
of the contract.
8. Net Asset Value:
Net Asset Value (NAV) means the price per unit of the Segregated Fund.
9. Partial Withdrawals:
Partial Withdrawals means any part of fund/partial withdrawal that is encashed

/ withdrawn by the policyholder during the period cf contract,
10. Regular Premium Products:
Regular Premium Products means non linked insurance products where the
premium payment is throughout the term of the product and are paid in regular
intervals like yearly, half-yearly etc.
11. Rider benefits:
Rider benefits means an amount of benefit payable on a specified event offered

under the rider, and is allowed as add-on benefit to main benefit.
12. Revival of a policy:
Revival of a policy means restoration of the policy, which was discontinued due
to the non-payment of premium, by the insurer with all the benefits mentioned
in the policy document, with or without rider benefits if any, upon the receipt
of all the premiums due and other charges/late fee if any, as per the terms and
conditions of the policy, upon being satisfied as to the continued insurability of
the insured/policyholder on the basis of the information, documents and reports
furnished by the policyholder, in accordance with their Board approved
Underwriting guidelines.
13. Revival Period:
Revival Period means the period of two consecutive years from the date of
discontinuance of the policy, during which period the policyholder is entitled to
revive the policy which was discontinued due to the non-payment of premium.
14. Single premium products:
Single premium products means non linked insurance products, where the
premium payment is made by a single payment at the inception of the policy.

15. Sum Assured on death:
Sum Assured on death means an absolute amount of benefit which is guaranteed

to become payable on death of the life assured in accordance with the terms
and conditions o f the policy.
16. Sum Assured on maturity:
Sum Assured on maturity means an absolute amount of benefit which is

guaranteed to become payable on maturity of the policy in accordance with the
terms and conditions of the policy.
17. Surrender:
Surrender means complete withdrawal/ termination of the entire policy.
18. Surrender Value:
Surrender Value means an amount, if any, that becomes payable in case of

surrender in accordance with the terms and conditions of the policy.
19. Switches:
Switches means a facility allowing the policyholder to change the investment

pattern by moving from one segregated fund, either wholly or in part, to other
segregated fund(s) amongst the segregated funds offered under the underlying
unit linked product of the insurer.
20. Non-linked or linked Whole Life products:
Non-linked or linked Whole Life products means non linked or linked insurance
products respectively which do not have a definite policy term and the policy
terminates on death of the life assured.
21. Top-up premium:
Top-up premium means an additional amount (s) of premium paid, if any, over
and above the contractual basic premiums stipulated in the terms and
conditions, at irregular intervals during the period of contract.
22. Units:
Units means a specific portion or part of the underlying segregated unit linked
fund which is representative of the policyholder's entitlement in such funds.

B. General Terms
1. Accident
An event or occurrence causing damage/injury to an entity, and is

unforeseen and unintended. Regulatory define extent visible outward
violent.
2. Accident Benefit
Provides for payment of an additional benefit equal to the sum assured or in

instalments on permanent total disability and waiver of subsequent
premiums payable under the policy.
3. Age Limits
Stipulated minimum and maximum ages below and above which the
company will not accept applications or may not renew policies.
4. Agent
An insurance company representative licensed by the state who solicits,

negotiates or effects contracts of insurance, and provides service to the
policyholder for the insurer.
5. Annuity Plans
These plans provide for a "pension" (or a mix of a lumpsum amount and a
pension ) to be paid to the policy holder or his spouse. In the event of death
of both of them during the policy period, a lumpsum amount annuity is
provided for the next of kin.
6. Application Form
Supplied by the insurance company, usually filled in by the agent and

medical examiner (if applicable) on the basis of information received from
the applicant. It is signed by the applicant and is part of the insurance
policy if it is issued.
7. Assignment
Assignment means legal transference. A method by which the policy holder

can pass on his interest to another person. An assignment can be made by an
endorsement on the policy document or as a separate deed.
Assignment can be of two types conditional or absolute.

8. Beneficiary
The person(s) or entity(ies) (e.g. corporation, trust, etc.) named in the

policy as the recipient of insurance proceeds upon the death of the insured.
9. Business Insurance
A policy which primarily provides coverage of benefits to a business as

contrasted to an individual. It is issued to indemnify a business for the loss
of services of a key employee or a partner who becomes disabled.
10. Convertible Whole Life Policy
A mix of "whole life policy" and "endowment policy", it provides for very low
insurance premiums with maximum risk cover while the life assured is just
beginning his working career, and the possibility of converting the policy to
an "endowment" policy after five years of commencement.
11. Coverage
The scope of protection provided under a contract of insurance; any of

several risks covered by a policy.
12. Double/Triple Cover Plans
These offers to the beneficiaries double/triple the sum assured on death of

life assured during the term of the policy. On survival to the date of
maturity, the basic sum assured is paid to the assured. These are low-
premium plans, most useful for situations such as housing.
13. Endowment Policy
An Insurance contract with a savings component involving asset

accumulation and a life insurance protection component. If death occurs
before maturity, the sum assured is paid out. At maturity, the amount built-
up is payable.
Endowment policies can be written in a number of different forms

(participating or non-participating) and are long-term contracts.
14. Exclusions
Specific conditions or circumstances for which the policy will not provide
benefits.

15. Group Life Insurance
Life insurance usually without medical examination, on a group of people

under a master policy. It is typically issued to an employer for the benefit of
employees, or to members of an association, for example a professional
membership group. The individual members of the group hold certificates as
evidence of their insurance.
16. Guaranteed Policies
These are policies where the payment stays fixed.
17. Insurable Interest
A condition in which the person applying for insurance and the person who is
to receive the policy benefit will suffer an emotional or financial loss, if any
specified event occurs. Without insurable interest, an insurance contract is
invalid.
18. Insurability
All conditions pertaining to individuals that affect their health, susceptibility

to injury and life expectancy; an individual's risk profile.
19. Insurance
Social device for minimizing risk of uncertainty regarding loss by spreading

the risk over a large enough number of similar exposures to predict the
individual chance of loss.
20. Insured
The person whose life is covered by a policy of insurance.
21. Keyman Insurance Policy
A life insurance policy taken by a person/company on the life of another key

person who is or was his employee/connected to his business in any manner
whatsoever.
22. Lapsed Policy
A policy which has terminated and is no longer in force due to non-payment

of the due premium.

23. Life Assured
The person whose life is insured by an individual life policy is called life
assured.
24. Maturity
The date upon which the face amount of a life insurance policy, if not
previously invoked due to the contingency covered (death), is paid to the
policyholder.
25. Maturity Claim
The Payment to the policy holder at the end of the stipulated term of the
policy is called maturity claim.
26. Misrepresentation
Act of making, issuing, circulating or causing to be issued or circulated an

estimate, an illustration, a circular or a statement of any kind that does not
represent the correct policy terms, dividends or share of surplus or the
name or title for any policy or class of policies that does not in fact reflect
its true nature.
27. Money Back Policy
Unlike endowment plans, in money back policies, the policy holder gets
periodic "survivance payments" during the term of the policy and a lumpsum
amount on surviving its term. In the event of death during the term of the
policy, the beneficiary gets the full sum assured, without any deductions for
the amounts paid till date, and no further premiums are required to be paid.
These type of policies are very popular, since they can be tailored to get
large amounts at specific periods as per the needs of the policy holder.
28. Moral Hazard
Risk depends on the need for insurance, state of health, personal habits
standard of living and income of insured person. Moral hazard is the risk
factors that affect the decision of the insurance company to accept the risk.
Moral hazard is a situation in which one party gets involved in a risky event
knowing that it is protected against the risk and the other party will incur
the cost.
Example: You have not insured your house from any future damages. It
implies that a loss will be completely borne by you at the time of a
mishappening like fire or burglary. Hence you will show extra care and
attentiveness. You will install high tech burglar alarms and hire watchmen
to avoid any unforeseen event.

But if your house is insured for its full value, then if anything happens you
do not really lose anything. Therefore, you have less incentive to protect
against any mishappening. In this case, the insurance firm bears the losses
and the problem of moral hazard arises. It applies similarly to life and
health insurance.
29. Nomination
An act by which the policy holders authorises another person to receive the
policy money. The person so authorised is called Nominee.
30. Non-cancelable policies
Such policies stay in effect regardless of whatever that might happen and as
long as the premium is paid from time to time
31. Premium
The payment, or one of the regular periodic payments, that a policy holder
makes to an insurer in exchange for the insurer's obligation to pay benefits
upon the occurrence of the contractually-specified contingency (e.g.,
death).
32. Premium Back Term Insurance Plans
These provide for refund of all the premiums paid, in the event of th life
assured surviving to the end of the policy term. The total sum assured is
paid to the beneficiaries in the event death occurs during the policy term.
33. Sub Standard Risk
Person who is considered an under-average or impaired insurance risk

because of physical condition, family or personal history of disease,
occupation, residence in unhealthy climate or dangerous habits.
34. Vesting Age
The age at which the receipt of pension/ starts in an insurance-cum-pension

plan.
35. With-Profit policy
Participating or with profit policy is a life insurance policy where the

policyholder participates in the profits of the company which is paid out as
bonus to the policyholder. These policies hence have a higher premium
compared to non participating policies. In a particular period if the company

does not do well, the vested bonuses to the policyholders get directly
affected.
36. Without-Profit policy
Non-participating or without profit policy is a policy where the policyholder

is not entitled to a share of the company’s profits and surplus. No bonus is
paid to the policyholders. Examples include pure risk policies like term
insurance or health insurance and unit-linked insurance contracts.
Term insurance is a category of non participating life insurance protection
policy with no build-up of a cash value. The insurer only pays out in case of
death within a specific period of time.

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IC-92

Actuarial Aspects of Product Development

This course is prepared with the assistance of:

Revised Edition: 2016

ALL RIGHTS RESERVED

This course is the copyright of the Insurance Institute of India, Mumbai. In no

Published by: P. Venugopal, Secretary-General, Insurance Institute of India, G-

The main topics covered in the course include

2 Importance of Product Design 18

4 Types of Insurance Products – Individual 79

5 Pricing of Products – 2 119

6 Types of Insurance Products – Group 139

7 Premium Bases – Interest Rate 168

Premium Bases – Mortality And Morbidity

10 Premium Bases – Commission Rates 234

10B Premium Bases – Margins 246

11 Premium Bases – Expense Rates 264

12 Reinsurance Support 286

Financial Viability – Profit Margin and

This chapter aims to provide you with an understanding of history of insurance,

IC-92 Actuarial Aspects of Product Development 1

2 IC-92 Actuarial Aspects of Product Development

4 IC-92 Actuarial Aspects of Product Development

1. Concept of an insurance product

An insurance product is a ‘promise’ sold by an insurer to a policyholder either

2. General product categories

The primary attributes of a product are as follows:

a) Shape (physical form) of product

An insurance product is not seen physically, unlike a bar of soap or a TV

IC-92 Actuarial Aspects of Product Development 5

b) Term of the product

An insurance product is useful to the customer because it secures monetary

6 IC-92 Actuarial Aspects of Product Development

Event Financial Problem

Note: Utility expected is referred to as ‘economic value’ - usefulness to the

d) Types of Product Utilities

IC-92 Actuarial Aspects of Product Development 7

ii. Economic utility

The financial power granted by a product refers to its economic utility

iii. Social utility

iv. Philosophical utility

The sensory appeal of a product decides its aesthetic utility e.g. a

e) Legal aspects of a product

Insurance products are legal contracts. A legal contract is a stamped paper

i. Issues related to the policy document

 The policy document is legally negotiable.

8 IC-92 Actuarial Aspects of Product Development

ii. Appellate authorities for insurance disputes

Not all beneficiaries of insurance policies would go to court. Many prefer

Throughout the world, consumer grievances are predominant. Hence it is

iii. Documents related to insurance products

 In most countries, the application for insurance (called the

iv. Commencement of an insurance contract

 An insurance contract is a concluded contract if the first

IC-92 Actuarial Aspects of Product Development 9

A proposer (the applicant or the prospect who wants to buy an

 Is a legal person – i.e. an individual whose age is at least 18 years

Who among the below is not allowed to buy an insurance product?

10 IC-92 Actuarial Aspects of Product Development

1. Parties to a life insurance contract

Relationship between proposer and life assured

 The proposer and life assured are two different persons

A proposer is usually referred to as ‘policyholder’, and ‘policy-owner’ indicating

2. Concept of insurable interest