SP2 – Life Insurance Notes

Revision booklet 2 – With Profits & General business environment

1. Asset shares are most typically used for with profits contracts but can also be determined for without profits
contract.

2. AS = Premiums * (1+i) – Expenses – Commission – Cost of benefits – Taxes – Transfers to SH – cost of capital –
any contri to free assets

3. If other than asset share is paid out on average of surrender, then the calculation could also include addition of
surrender profits (or losses) from with profits business

4. The probability of remaining solvent increases by deferring the bonuses. Gives investment freedom results from
delayed distribution and may result in higher bonuses however, not usually supported by PH.

5. Special reversionary bonuses – Usually occur as the result of restructuring a with-profits fund.

6. Terminal bonus can be defined in 2 forms – 1. Percentage of total attached bonuses 2. Percentage on
total claim bef terminal bonus.

7. Non-unitized AWP are similar to conventional with-profits contract

8. Unitized AWP are similar to unit linked contract

9. Under AWP, bonus allocation is done by following method –

1. Price of unit remains same – Company allocates additional units as bonus

2. Price of unit changes – Company changes the price of the unit instead of allocating new units

10. Guarantees under AWP are floored to zero.

11. Surrender value for unit linked contract – bid price of the allocated units less any surrender penalty (no
discretion)

Surrender value for unitized AWP – Same as above but company may allow for MVR (market value reductions)
and this deduction is determined at the discretion of the company.

12. Death benefit can be SA, ROP or return of the fund value

13. Charging structure similar to unit linked

14. Principles to allocate bonuses –

- PRE

- Equitable between different categories

- Not threaten the future business plans

- No impact on Investment strategy

- No risk of insolvency
15. Choice of bonus method is dependent on following:

- Margins for future adverse exp (to remain competitive)

- Business objectives (to max profits distribution)

- PRE (based on documentation, historical data, industry practice) [Failure to meet this will impact NB]

16. Reserves for undistributed profit is lower than had the profit been distributed.

17. NB are cyclical which increases the cost to insurer. In downturn in NB, resources are made redundant but re-
employing a similar staff may prove difficult when NB improves again.

18. Economic env - Volatile economic environment will tend to be more expensive with less take up rates. Insurer
will have higher solvency and regulatory requirements. Higher risk means higher returns.

18. Regulatory restrictions -

- type of contract that can be offered

- premium rates/charges

- rating factors used for prem calc

- terms and conditions of contract (eg, paid up & SV calc)

- sales channel

- underwriting extent (eg restriction on genetic testing)

- reserves requirement (defines the business that can be written)

- solvency requirement

- investment regulations (type of assets, amount of investment, extent of mismatching)

19. Set up investment mismatching reserve to increase the mismatching extent. Higher reserves if investing in
highly risky assets. Increases liability & reduces free assets.

20. Insurers have monopoly in providing pure protection benefits but not of savings benefit

21. Climate change related regulations-

- consider climate risks for existing business & investment management

- disclose & report on climate related risks

- consistent & reliable means of assessing, pricing & managing climate risks

22. Market consistent reserves –

- Assets held at market values

- Liab are discounted on risk free assets

- Investment returns are assumed on risk free assets

*Risk free rates are determined based on government bond yields or swap rates. May allow for deduction for
credit risk.
23. This risk margin would reflect the compensation required by the ‘market’ in return for taking on those
uncertain aspects of the liability cashflows.

24. COC rates - This rate can be considered to represent the cost of raising incremental capital in excess of the risk-
free rate, or alternatively it represents the frictional cost to the company of locking in this capital to earn a risk-free
rate rather than being able to invest it freely for higher reward.

25. solvency capital can be either calculated based on cost of capital % or % of reserves. If reserves calc is
complicated based on stochastic then insurer can use relatively simpler approach of taking % of a driver (reserves
or sum at risk, whichever is linearly closest to capital).

26. These projected capital amounts are then multiplied by a cost of capital rate. This rate can be considered to
represent the cost of raising incremental capital in excess of the risk-free rate, or alternatively it represents the
frictional cost to the company of locking in this capital to earn a risk-free rate rather than being able to invest it
freely for higher reward or vis-à-vis.

27. Solvency capital can be calculated using either VAR approach (99.5% confidence interval) or run-off method
(amount of capital needed at outset to cover all future liabilities until last policy has gone off books).

Revision booklet 3 – Design & Monitoring

1. Product design factors –

- Profitability (To cover expenses & provide profit margin)

- Marketability (Innovative design, offer options & guarantees, competitive premiums)

- Competitiveness (Remain competitive, premiums similar to competitors)

- Financing requirement (Minimize req, more flexibility with unit linked products to adjust the design)

- Risks (Depends on risk appetite, absorb internally or reins or hedge)

- Onerousness of guar (level of guar SV under non linked prod)

- Dist channel (sophistication of target client)

- Sensitivity of profit (Sensitivity test)

- Extent of cross subsidies (Conflict with desire to avoid cross subsidies under single prem)

- Admin system

- Consistency with other prods

- Regulatory requirements (Any capped charges, treat customers fairly)

- Sustainable investment options (Focus on ESG)

2. Mortality assumptions setting –

- Use company’s historic data or similar product’s data [The company should aim to set assumptions that
reflect the expected future experience of the lives concerned]
 - Decide appropriate years of data (not too less or not too much to include many trends)

- Divide data in homogeneous groups [sufficient volume and quality of data in each group e.g.,
occupations or location for annuity]

- If inappropriate data, use industry wide or standard tables

- Further adjust data according to target market, distribution channel or basis of underwriting

- Project mortality improvements in case of annuities [Expectation, extrapolation & explanation]

- Use correlations, stochastic modeling (lee carter or p-spline), multi factor predictive modeling to
estimate improvement rates.

3. Risks can be reflected through rdr, stochastic approach or assess risk margins for cashflow model. Under formula
model, it cannot use first 2 methods and use judgement for these margins.

4. Use CAPM to calculate risk premium rates i.e., riskiness of underlying investment. This might be based on
judgement.

5. Features that make product design riskier –

- Lack of historical data

- High guarantees & options

- Complexity

- overheads

- untested market

6. Use best estimate assumptions when need to show better picture of the company (at time of sale or reward to
staff for growth). Negative reserves are allowed. Probably use cashflow method.

7. Expense experience analysis –

- Split as direct or overheads

- Define based on number of contracts or business in force or size of benefit?

- sub divide into cells (regular or single prem), cell size shouldn’t be too small

- allocate expense based on product level or department wise?

8. Reasons to analyze profits –

- Compare expected vs actual

- financial effect on NB

- check on valuation data & process

- identify non-recurring occurrence of profits

- to improve profitability

- give info to management on trends

 - meet regulatory requirement

9. Key assumptions set during pricing –

- Investment return

- Expenses (Overheads and others)

- Commissions

- Mortality

- New business volume

- Expense Inflation

- Profit margin

- Reserving

- Solvency

- Persistency

- Underwriting

- Taxation

Revision booklet 4 – Surrenders & Alteration

1. Principles to alteration –
a. The term after alteration should be supportable by the earned asset share at the date of
alteration to avoid company making a loss
b. The profit expected from contract after the alteration should be same as before
c. If benefits are to be increased, the terms should be consistent with the premium which would be
charged for a new policy with a sum assured equal to the proposed increase
d. Alteration terms should be stable, ie small changes in benefits should result in small changes in
premium
e. Should avoid lapse and re-entry
f. Costs of alteration should be recovered
g. Easy to calculate, explain and understand
h. Any increase in benefit should be made subject to additional health evidence
i. The profit expected from the contract after alteration should be the same as the expected
amount had the policy been written originally on its altered terms.
j. Conversion to paid-up status can be viewed as the limiting case of a reduction in sum assured

Revision booklet 5 – Reinsurance

1. Risk premium reinsurance –
- Risk premium reinsurance gives the insurance company greater freedom to change its premium rates
independently of the reinsurance rate.
 This could be particularly valuable for the term assurance product if the market is competitive, as it
would allow premium changes in response to competitors changing their rates
2. Quota share – Reduce parameter risk
3. Individual surplus – Reduce claim fluctuations

4. Retention level factors in case of NEW PRODUCT reinsurance –

- Average benefit level
- Expected distribution of the benefit level
- Risk appetite for mortality and counterparty risk
- Free assets and ability to absorb loss
- Reinsurance cost
- Effect of retention on company’s retention limit
- Retention on other products within the company
- Try modeling net retained profit under different assumptions using different retention
- Level of underwriting (depend on prior experience)
- Experience it has in a product
- Extent of financial reinsurance required
- The expected impact of NB strain
- Any minimum retention imposed by reinsurer
- Any profit sharing in reinsurance treaty
- Typical retention limit in industry
- Impact from company’s credit ratings

Other Points:
1. ‘Selective withdrawal’ refers to the fact that those who withdraw from a contract might be
expected to exhibit different mortality experience from those who remain to the detriment of the
insurer.

2. The base rate of mortality should allow for the expected movement in mortality between the
time of the last experience investigation and the point in time at which the new contract will be
sold.

3. EV assumptions may vary based on requirement:

1. Internal – Best estimate
2. to sell company – Prudent (buyer) or B.E. (seller)

4. In theory, a market-consistent value of a liability is the price that someone would charge for
taking responsibility for (ie ownership of) a liability, in a market in which such liabilities are freely
traded.

5. To equate on realistic prospective basis for alterations:

- Suitable if size & term of policies similar before & after.
- Unsuitable incase of early surrenders, gives unreal values.
- Unsuitable if policy size is increased substantially.
[This means that under realistic basis company would want to keep full expected profits of the
current policy on the altered contract. If policy size is reduced then company will need to charge
higher premiums to keep the same profit which would not be aligned with any new business
 contract being issued and hence contradicts with PRE. Similarly, if policy size is increased then
company will charge lower premiums to keep the same profit which may not be what the
company is expecting if the policy has doubled/tripled.]

6. To equate on original premium basis:

- Suitable if bases haven’t changed much.
- Suitable incase of early surrenders & policy size change
- Unsuitable if conditions have changes (such as premium guarantees)
[This means that under original premium basis, company will extract a proportion of profits
(accrued profit) that increases as duration increases. On the altered contract, it would produce
further profits if basis were still suitable now. This copes well with change in size both increase &
decrease. However, if conditions are changed i.e., basis needs to change then it may give
unsuitable values.]

7. Matching Assets & Liabilities –

- Guaranteed in monetary terms (Without profit) - Fixed interest securities (govt/corporate)
or bonds
- Index linked - Underlying index linked bonds
- Discretionary - Medium return equities (blue chip market) for security or property
- Investment linked - Underlying same assets (for unit) & cash or fixed-interest bonds (for
non-unit)

8. Illiquidity premium can only be added against corporate bonds. This premium component
increases the discount rate and reduces the value of liabilities. Hence, better solvency position.
But if corporate bonds are riskier than expected then not advised to allow for illiquidity
premium.
- Whether an illiquidity premium can be included is likely to be dictated by the regulatory
regime in place which would also specify how and when it can be used.

9. Investment strategy –
To match assets & liability to greater extent

Product Benefit Assets

Term Lump sum (Guaranteed in monetary) Fixed interest bonds (govt, corp) +
assurance cash
Annuities Lump sum (Guaranteed in monetary) Fixed interest bonds (govt, corp) +
Cash (for liquidity)
[Period is unknown, liquidity is
needed]
Index linked (Guaranteed in index Matching index linked bonds (prefer
linked) corporate bonds with high returns n
high risks)
Unit linked Unit Reserves (Guaranteed in Match by PH’s investments
investment)
Non-unit fund Cash
 ** Level of free assets would determine the investment in equities or properties for long term
period (mostly annuities or WL?)

10. Valuing assumptions for mortality options –

As the company recently started selling the product, it will have only limited past experience
data to use in setting assumptions.

So, when considering data to use in setting the extra assumptions the company may consider
their available expertise and data on any other similar products may look for assistance from a
reinsurer.

It may use its pricing assumptions as a reference point for its supervisory reserving assumptions.
The assumptions should comply with the relevant supervisory reserving regulations and,
depending on the regime, a degree of prudence in the assumptions may be required.
Any prudence in the assumptions may be explicit or implicit.

Assumed option take-up rates -

1. will depend on the terms and conditions of taking up the option such as the communications
with policyholder at the 10-year point
2. could be assumed to be worst-case scenario ie that 100% of eligible policyholders exercise the
option.
3. Mortality assumption for those who take up the option: should be heavier the lower the
assumed take-up rate should be heavier than the mortality of those who do not take-up the
option eg by assuming a higher percentage loading of a standard table or by applying an n-year
addition to the policyholder age.

Additional expenses of the option –

need to allow for increased administration associated with processing the option and additional
policyholder communications.

Mortality assumption for those who do not take up the option –

1. could be the same assumption that would apply if the option did not exist, but this would
result in higher average mortality overall than the base assumption
2. a lower level of mortality may be assumed for those who do not take up the option, so that
the average mortality overall is in line with the base assumption.

An assumption is needed about the premium rates to be being charged for the renewed five-
year policy.
These would normally be assumed to be the company’s current standard premium rates given
the policyholder age at the point of exercise of the option.

In setting the extra assumptions required to value the options the company would need to
consider:
- the financial significance of each assumption to the valuation result
- whether to use a stochastic or deterministic approach
- how the additional assumptions can be built into its existing cashflow models.

The starting point for the extra valuation assumptions would be those used in the previous
valuation, if one has been performed.