8I-U
Marketing
Book:Life and Health Marketing (LOMA) - Chapter 3 - REGULATION OF LIFE AND HEALTH INSURANCE MARKETING
Book:Life and Health Marketing (LOMA) - Chapter 5 - PLANNING MARKETING GOALS AND STRATEGIES
Book:Life and Health Marketing (LOMA) - Chapter 6 - ORGANIZING, IMPLEMENTING AND CONTROLLING MARKETING ACTIVITIES
Book:Life and Health Marketing (LOMA) - Chapter 7 - MARKET SEGMENTATION AND TARGET MARKETING
Book:Life and Health Marketing (LOMA) - Chapter 15 - DISTRIBUTION CHANNELS
Book:Marketing for Actuaries (LIMRA) - Chapter I - INTRODUCTION
Book:Marketing for Actuaries (LIMRA) - Chapter II - MARKETING MANAGEMENT OBJECTIVES AND STRATEGIES
Book:Marketing for Actuaries (LIMRA) - Chapter III - MARKET RESEARCH
Book:Marketing for Actuaries (LIMRA) - Chapter IV - TRADITIONAL DISTRIBUTION SYSTEMS
Book:Marketing for Actuaries (LIMRA) - Chapter V - NONTRADITIONAL AND EMERGING DISTRIBUTION SYSTEMS
Book:Marketing for Actuaries (LIMRA) - Chapter VI - MARKETING AND PRICING
Book:Marketing for Actuaries (LIMRA) - Chapter VII - ILLUSTRATION AND DISCLOSURE
Book:Marketing for Actuaries (LIMRA) - Chapter VII - APPENDIX I - MATHEMATICS OF COST COMPARISON APPROACHES
Book:Marketing for Actuaries (LIMRA) - Chapter VII - APPENDIX II - NAIC LIFE INS ILLUSTRATINOS MODEL REGULATION
Book:Study Notes and Published References - Note CIA Education Note - INSURANCE AND ANNUITY ILLUSTRATIONS
Pricing
Book:Life Insurance Products and Financing (Atkinson/Dallas) - Chapter 11 - PROFIT MEASUREMENT AND ANALYSIS
Book:Life Insurance Products and Financing (Atkinson/Dallas) - Chapter 14 - FINANCIAL MODELING
Book:Life Insurance Products and Financing (Atkinson/Dallas) - Chapter 15 - STOCHASTIC MODELING
Book:Life Insurance Products and Financing (Atkinson/Dallas) - Chapter 16 - FINANCIAL MANAGEMENT
Book:Life and Health Marketing (LOMA) - Chapter 12 - PRICING: A MARKETING PERSPECTIVE
Book:Study Notes and Published Refences - Note TSA XXXIX - PRICING IN A RETURN-ON-EQUITY ENVIRONMENT
Book:Study Notes and Published Refences - Note SN8I-200-00 - EXPERIENCE ASSUMPTIONS FOR INDIVIDUAL LIFE INS AND ANNUITIES
Book:Study Notes and Published Refences - Note SN 8I-201-00 - GROSS PREMIUMS FOR DISABILITY WAIVER BENEFITS
Book:Study Notes and Published Refences - Note SN 8I-202-00 - VARIABLE ANNUITY MINIMUM DEATH BENEFITS - A MONTE CARLO PRICING APPROACH
Book:Study Notes and Published Refences - Note SN 8I-204-01 - REPORT OF THE SOA TASKFORCE ON PREFERRED U/W
Valuation and Financial Statements
Book:Valuation of Life Insurance Liabilities - Chapter 1 - TYPES OF VALUATIONS AND BASIC REQUIREMENTS
Book:Valuation of Life Insurance Liabilities - Chapter 2 - RESERVE METHODOLOGIES AND BASES
Book:Valuation of Life Insurance Liabilities - Chapter 3 - TYPES OF RESERVE FACTORS
Book:Valuation of Life Insurance Liabilities - Chapter 4 - VALUATION OF INTEREST SENSITIVE LIFE PRODUCTS
Book:Valuation of Life Insurance Liabilities - Chapter 5 - VALUATION OF ANNUITIES
Book:Valuation of Life Insurance Liabilities - Chapter 6 - VALUATION OF VARIABLE PRODUCTS
Book:Valuation of Life Insurance Liabilities - Chapter 7 - MISCELLANEOUS RESERVES
Book:Valuation of Life Insurance Liabilities - Chapter 8 - CASH FLOW TESTING
Book:U.S. GAAP - Chapter 3 - EXPENSES AND CAPITALIZATION
Book:U.S. GAAP - Chapter 4 - TRADITIONAL LIFE INSURANCE (SFAS 60 AND SFAS 97)
Book:U.S. GAAP - Chapter 5 - TRAD LIFE (SFAS 120)
Book:U.S. GAAP - Chapter 6 - UNIVERSAL LIFE INSURANCE
Book:U.S. GAAP - Chapter 7 - DEFERRED ANNUITIES
Book:U.S. GAAP - Chapter 8 - VARIABLE AND EQUITY-BASED PRODUCTS
Book:U.S. GAAP - Chapter 9 - ANNUITIES IN PAYMENT STATUS
Book:Study Notes and Published Refences - Note SN 8I-309-01 - MANAGEMENT REPORTS AND REPORTS TO REGULATORY BODIES
Book:Study Notes and Published Refences - Note TSA XXXVIII - STRATEGIC MANAGEMENT OF LIFE INS CO SURPLUS
Book:Study Notes and Published Refences - Note SN 81-303 - ACTUARIAL REVIEW OF RESERVES AND OTHER A.S. LIABILITIES
Book:Study Notes and Published Refences - Note SN 8I-304-00 - VALUE BASED FINANCIAL MEASUREMENT
Book:Study Notes and Published Refences - Note 8I-306-00 - CASH FLOW ANALYSIS TECHNIQUES
Book:Study Notes and Published Refences - Note SN 8I-308-00 - REGULATORS' PERSPECTIVE ON ACTUARIAL OPINIONS AND VALUATIONS
Book:Study Notes and Published Refences - Note SN 8IU-310-04 - VALN OF LIVING AND DEATH BENEFIT GUARANTEES FOR VARIABLE ANNUITIES
Product Development
Book:Life and Health Marketing (LOMA) - Chapter 11 - PRODUCT DEVELOPMENT
Book:Reinsurance - Tiller and Tiller - Chapter 4 - TRADITIONAL REINSURANCE
Book:Reinsurance - Tiller and Tiller - Chapter 5 - FINANCIAL REINSURANCE
Book:Study Notes and Published References - Note ASP 1 - REDETERMINATION OF NON-GUARANTEED CHARGES AND/OR BENEFITS FOR LIFE INS AND ANNUITY CONSIDERATIONS
Book:Study Notes and Published References - Note CIA Recommendations - DIVIDEND DETERMINATION AND ILLUSTRATION
Book:Study Notes and Published References - Note SN 8I-100-00 - PRODUCT DEVELOPMENT TRENDS
Book:Study Notes and Published References - Note SN 81-101-00 - LIFE INSURANCE AND ANNUITY NONFORFEITURE PRACTICES
Book:Study Notes and Published References - Note SN 81-102-00 - LIFE AND ANNUITY PRODUCTS AND FEATURES
Book:Study Notes and Published References - Note SN 8I-103-01 - POLICYHOLDER DIVIDENDS
Book:Study Notes and Published References - Note SN 81-104-03 - NAIC STANDARD NONFORFEITURE LAW FOR LIFE INSURANCE
Book:Study Notes and Published References - Note SN 8I-105-03 - NAIC UNIVERSAL LIFE INSURANCE MODEL REGULATION
Book:Study Notes and Published References - Note SN 8I-106-03 - NAIC STANDARD NONFORFIETURE LAW FOR INDIVIDUAL DEF ANNUITIES
Book:Study Notes and Published References - Note SN 8IU-107-04 - EQUITY INDEXED ANNUITIES: PRODUCT DESIGN AND PRICING CONSIDERATIONS
Book:Study Notes and Published References - Note PRODUCT MATTERS - REGULATORS RESPOND TO INDUSTRY INNOVATION THROUGH GUIDELINE AXXX
Book:Study Notes and Published References - Note PDNEWS - SEAC SECONDARY GUARANTEES DEBATE
GNU Free Documentation License
Marketing
Life and Health Marketing (LOMA) - Chapter 3 - REGULATION OF LIFE AND HEALTH INSURANCE MARKETING
Overview
- special position of public trust - financial well-being & business conduct of insurers is of such importance to so many people
- PO can lose $ if insurers don't adhere to standards
- policies are complex documetns not easily understoon
- PO wants to be treated fairly and ethiclly w/ accurate info
US State Regulation
- Background
- McCarran-Ferguson Act (1945) - state regulates insurance
- insurance dept - admin agency w/in each state
- insurance commissioner - head of ins dept
- NAIC - Promostes coinsistency w/in each state's ins dept
- insurance laws in two basic categories
- solvency laws - esnure insurers financially able to meet obligations
- Mkt Conduct Laws - ensure insurers and distributors operate fairly adn ethically
- Regulation of Products
- protect customers by requiring certain provisions or not allowing certain provisions
- require simplified language
- Regulation of pricing
- reasonbale rate - cover's insurers expenses & provides a fair profit
- competition usually keeps rates reasonable
- loss ratios - total claims incurred / total prems rec'd
- adequate rate - high enough to provide insurer w/ enough $ to pay operating expenses and benefits when they come due
- life ins rate adequacy indirecly regulated via min reserve reqs
- equitable rate - prem rate that varies from policy to policy based only on factors affecting the product's costs - not allowed to vary based on race or religion etc
- Regulation of Distribution
- Licensig of Ins Producters - to get license, must prove: are of good character/meet residency req/pass an exam
- license for each state/line they sell
- reciprocity - two states agree that if ok in one state, ok in the other
- Prohibited Sales Practices
- Misrepresentation - false or misleading statements
- Replacement - replacing one contract with another. In itself, not illegal
- Twisting - misrepresent features of a product to induce replacement
- Churning - replacing one policy after another to earn series of 1st year commissions
- Rebating - offer inducement to purchase (not banned in all states)
- Missappropriation - illegal use of PO funds
- Commingling of Funds - combining monies belonging to PO(s) w/ producer's own funds
- Suitability requirement - need reasonable grounds for recommending a specific product as suitable for customer's needs
- Regulation of Promotion
- Advertising and sales Promotion Materials
- Advertisement - any material designed to create public interest in life ins/annuities, insurer, producer OR induce public to purchase, increase, modify, restate, borrow on , surrender, replace, retain a policy
- Insurer ultimately responsible, even if producer creates ad
- Disclosure
- NAIC Disclosure Model Reg
- aid customers in puchasing suitable & reasonably priced ins
- provide accurate adn reliaebl info to ensure competitive mkt
- discourage undesirable mkt behavior
- must give prospect a Buyer's Guide and Policy Summary
- Buyer's Guide
- describes various types of ins and points out +/- of each type
- explains cost comparison indexes
- Policy Summary
- disclosure info on specific policy being considered by prospect
- Market Conduct Examinations
- peridodic exams of insurance co to ensure they comply w/ state laws
- areas of focus in mkt conduct exam
- cert of authority adn licensing of agents/brokers nonf options on life ins pols
- policy form/endorsment approvals sales/advertising materials
- u/w and rating of policies apps rejected/declined
- pols cancelled/not renewed replacements
- claims practices customer complaints
US Federal Regulation
- Antitrust Regulation
- state antitrust regs, but subject to certain provisions of Fed antitrust laws
- Boycott - competing cos agree to refrain from doing business w/ another co
- Coersion and Intimidation - methods of force used by a business to make another business act or refrain from acting in a certain manner
- Price fixing - competing businesses act together to affect the price of a product
- Consumer Protection Regulation - affect mktg of life and health ins
- FTC Act - regulates unfair competition, deceptive business practices adn prohibits false or deceptive advertising that crosses state lines
- Fair Credit Reporting Act (FCRA) - must comply when insurer obtains credit reports for u/w or claims investigation
- GLB Act Privacy Provision - protect non-public personal info from indescriminate dessemination.
- disclosure of practices @ beg of relationship and annually thereafter
- allow opt-out of sharing
- maintain policies to protect security and confidentiality of non-public info
- refrain from sharing acct #s w/ non-afiiliated 3rd parties for mktg purposes
- HIPAA 1996 - privacy protections for group adn health mkt
- Regulation of Variable Ins Products
- subject to regulation by SEC
- 4 fed Laws affect mktg of variable products
- Securities Act of 1933
- Securities Exchange Act of 1934
- Investment Co Act of 1940
- Investment Advisors Act of 1940
- Securities Act of 1933 - Truth in Securities Act
- general fraud provision - prohibits misrep
- registration provision - must provide essential info
- prospectus - most of the info in the registration statement
- any communication (written or oral) that offers security for sale
- Securities Exchange Act of 1934 - gave SEC broad authority to regulate securities
- primary focus - registration of brokers and dealers who sell securities
- securities broker - indiv, corp or other legal entity engaged in business of buying/selling securities for the account of others
- securities dealer - engaged in business of buying/selling securities for own account
- firms that sell must a) register as B-D w/ SEC and b) become member of NASD
- NASD - non-profit self regulating org responsible for making sure everyone follows rules
- SEC registration of B-D - most often an insurer will create and register a subsidiary ot be a registered B-D
- NASD Registration of Respresntatives and Principals
- Registered Rep
- business assoc of NASD member
- engages in securities business on behalf of member
- passed a specified NASD exam
- Principal
- officer/manager or an NASD member
- involved in day-to-day operations of securities business
- qualified as a registered rep
- passed additional exams
- NASD regulatory Oversight Activities
- B-D must supervise reg reps & principals to ensure compliance
- reg reps and principals must serve customers properly and deal fairly w/ public
- reg reps mush have reasonable grounds for believing recommendation is suitable
- NASD approval of ads and sales lit
- Name of B-D
- no promises of results exaggerations or opinions w/ no reasonable basis
- don't imply state or fed endorsement/approval of product
- no rediction/project o finvestmetn results
- SEC "Good" Internal Controls
- strong/capable compliance/legal staff
- create regular exceptino reports and review
- regular communication w/ customer - disclose fees/risks
- periodic reviews of customer holding by branch office
- written procedures fro branch audits w/ written reports as results
- clear compliance guidance to producers
- regular provider trainig - compliance/security laws/self reg rules
- immediate discipline
- review producers to ensure continued licensing/education req
- optical scanning instead of manual paper-based processing
- written procedure to minimize error/delays
- quality control unit to monitor trx processing
- procedures to separate adn secure incoming premium payments
- Investment Company Act of 1940 - regulates conduct of investment cos
- Sep Acct considered an investment company by act
- Investment Advisors Act of 1940 - conduct of investment advisors
- investment advisors - compensated for providing advince to investors about value of securities or advisability of buying/selling securities
- if producer sells VA/VUL and only gets commissions, not req'd to register as investment advisor, jsut reg rep or principal
- Federal Regulation of Bank Insurance
- Licensing and Locatoin
- agency/B-D must be clearly identified adn separate from teller area
- employee must be properly licensed/registered
- must fully and accurately disclose identity of business providing the service
- Prohibited Sales Practices
- Tying Arrangement - conditions the sale of one item on the sale of another
- Advertising adn Dsiclosure Requirements
- Fed Banking laws require additional disclosures
- product is insurance/annuity and not bank-guar product
- amounts payable are premiums and not deposits
- product is not insured by FDIC or other gov't agency or bank
Canadian Legal Environment
- Background
- Dual regulation - both federal and provincial govt regulate
- Federal - OSFI
- Provincial Regulation of Market Conduct
- Insurance Act of each procince regulates conduct and creates Office of Superintendent of Ins
- Canadian Council of Ins Regulators (CCIR) - similar to NAIC
- because of CCIR - fairly uniform regs across provinces
- CLHIA (Canadian Life and Health Ins Association)
- voluntary associate that promotes self-regulation to avoid over-regulation
- CLHIA guidelines
- Products
- CCIR Uniform Life Ins Act & Uniform Acc and Sickness Ins Act - adopted by all provinces by Quebec
- CLHIA Indiv Var ins Contracts (IVIC) Guidelines
- Compliance Report - questions exploring compliance
- Information Folder - collection of 21 items to prove financial soundess of a product
- Policy Form filing required if
- condition to obtaining license to conduct business w/in province
- before mktg an individual variable life contract
- no new filings for trad products after licensed
- Pricing
- indirectly since ins must charge adequate rates to fund sufficient assets
- prohibit unfair discrimination (race/sex/religion/etc)
- can't discriminate between two people who present same risk
- Distribution
- Producer Licensing - no special license to sell variable products but must be accredited by provincial securities commission
- Prohibited Sales Practices - similar to US
- in addition, license revoked if
- violates ins act and/or related regs
- material misrep on license app
- guilty of fraudulent practice
- demonstrates incompetence or untrustworthiness in trx of life ins
- Promotion - prohibits specified ad/sales promotion practices adn mandates cost/benefit disclosures
- Advertising and Sales Promotion - prohibits
- false/misleading ads or statement re: policy features
- conduct that results in unreasonable delay/resistance to fair settlement of claims
- Add'l guidance by CLHIA prohibits
- false/misleading statement/presentations/testimonials
- disparaging statements about other insurers or their products
- statements w/ tech/industry language beyond general public understanding
- guarantees unless conditions/limitations fully explained
- Coupon Advertisements
- must be truthful and not misleading
- must define terms & disclose exceptions/exclusions/limitations
- Cost adn Benfit Disclosure
- CLHIA-developed buyer's guide
- policy summary
- if guarnateed values of reatures mentions, must be display inillustrations
- if non-guar elements displayed, illustration must have at least two summaries
- variable products - must give copy of Info folder onfile w/ office of super
- describes guar/non-guar benefits
- method of determing benefits
- surr/loan/nonf provisions
- charges imposed if surrendered
- Federal Regulation to Maintain Competition
- Ins Co Act - Admin by OSFI - regulates
- fed incorp ins cos
- insurers incorp outside of Canada but do business in Canada
- provincially incorp insurers that choose to register w/ fed gov't
- regulates incorporation, corp governance, solvency
- Competition Act (1986)
- Prohibits
- mergers/monopolies that may operate to detriment of public interest
- price fixing agreements that unduly lessen competition
- other anti-competitive or deceptive mktg or unfair trade practices
- Feds - Privacy
- Provinces - Customer Protection
Life and Health Marketing (LOMA) - Chapter 5 - PLANNING MARKETING GOALS AND STRATEGIES
Marketing Management - process of planning, organizing, implementing and controlling a company's marketing activities in order to create effective and efficient exchanges
Marketing Management Process
- Planning
- - Set Marketing objectives
- - establish guidelines for implementation and control of mktg activities
- Organizing
- - establish a framework for carrying out mktg plans
- Implementation
- Control
- - analyze results
- - evaluate performance
- - make necessary changes
Types of Planning
- +Corporate Planning
- primarily strategic
- consists of establishing company's overall business plan
- top-down. begins by deining the company's mission - defines scope of org's business activities and business direction
- Establishs Corp objectives - long term results co hopes to achieve
- Outlines Coprorate Strategies - long term methods used to achieve objectives
- must regularly evaluate plans to make sure still appropriate
- +Marketing Planning
- bottom up portion of planning process
Stategic Marketing Planning
- 1-5 years into the future. review and update as necessary. as oftern as every 6 months. focus on long term
- - establishes marketplace objectives
- - defines the target market
- - develops mktplace stategies
- - defines resource needs
Tactical Marketing Planning
- 1-2 years into the future - focus on the day-to-day
- - develops action-oreineted product, price, distribution and promotion tactics
- - describes when activities will take place, how they will be performed and who will perform them
The Planning Process
- 3 primary activities: analyze situation, establish objectives, develop course of action
- Conducting a Situation Analysis
- 3 primary parts: environmental analysis, environmental forcast, internal assessment
- Environmental Analysis - ongoing exam of outside events/relationships that can influence strategic decion making
- Key environmental areas for Financial Services Corp (fig 5-3 p 105)
- - current target markets
- - competition
- - economy
- - society
- - technology
- - regulation
- - labor
- - distributors
- - international conditions
- Environmental Forcast - prediction of major environmental trends that will affect a companies business activities
- several types of forcasts available from businesses, universities, governments and industry associations
- commercial forcasts are a good starting point
- Internal Assessment - exam of co's current activities, strenghts, weekenesses and ability to respond to potential threats & opportunities in environment
- internal factors that have greatest effect on co's mktg planning:
- - mission
- - fin, tech, human resources
- - current distribution systems
- - product lines
- - operational efficiency
- Tools of Analysis
- SWOT Analysis
- Strengths, Weaknesses, Opportunities and Threats
- Mktg Opportunity arises when right combo of circumstances allows co to use its strenghts to take advantage
- Strategic Window - time period where optimum fit between co's distinct capabilities and key requirements of mktg opportunity
- Business Portfolio Analysis
- allows co to evaluate business units according ot their potential contribution to co
- determines units potential for:
- - generating financial resources
- - requiring financial resources
- SBU - strategic business unit
- - operated as a separate profit center
- - own seperate set/share of customers adn competitors
- - own mgmt (generally)
- - owm mktg strategy
- Marketshare/Mkt Growth matrix - Boston Consulting Group
- - Star - high mkt share, high growth mkt - becomes a cash cow when mkt growth slows
- - Cash Cow - high mkt share, low growth mkt
- primary role - provide income to cover corp overhead, pay divs, finance R&D
- - Question Mark (aka Problem Child) - low mkt share, hight growth mkt
- requires more cash than they generate
- - Dog - low mkt share, low growth mkt
- generate enough revenue to cover their own expenses
- unlikely to become stars or cash cows
- many SBUs have the following life cycle
- Question Mark -> Star -> Cash Cow -> Dog -> sold/discontinued
- Market Attractiveness/Business Strength Matrix - GE and McKinsey & Co
- created to address problems w/ mktshare/mkt growth matrix
- 9 matrix cells
- business strength - strong/average/weak (x-axis)
- mkt attractiveness - high/medium/low (y-axis)
- "A" - good investment/growth opportunity
- "B" - average opportunities
- "C" - little growth/investment potential
- mkt attractivness - composite index - uncontrollable env factors
- - market size - market growth rate
- - gov't regulation - mkt stability
- - competitive intensity - tech reqmnts
- business strength - composite index - controllable factors
- - price competitivness - product quality
- - customer loyalty - mktg skills
- - sales growth rate - relative cost advantages
- - tech and fin resources
Establishing Objectives
- objectives s/b
- - clearly stated
- - specific and measurable
- - realistic
- - actionable
- objective shoudl specify (in quantifiable terms) what is to be accomplished and time period to accomplish it
- Corp Objectives - normally 1-5 years
- Marketing Objectives
- primary - describe overall mkt response they hope to achieve in target mkt
- secondary - cover mktg functionnnnnnns needed to carry out plan
Developing Stategies and Tactical/Action Programs
- Corporate Strategies
- - intensive growth strategy - usually requires significant financial resource
- + Market Penetration - increasing sales of current products to current mkts
- + Mkt Development - increasing sales of current products to new mkts
- + Product Development - increasing sales of new/modified products to current mkts
- - diversified growth strategy - venture beyond normal business domains
- + Horizontal Diversification - intro diff products to co's current mkt
- + Concentric Diversification - new mkts, new products similar to current products or current mktg methods
- + Conglomerate Diversification - new mkts, new products that bear no relationship to curernt products
- same product related new product unrelated new product
- new mkt mkt development concentric diversification conglomerate diversification
- same mkt mkt penetration product development horizontal diversification
- - Integrated Growth Strategy - taking over another level of industry or dist channel
- + Forward Integration - control of distribution channel
- + Backward Integration - upstream (manufacturer or supplier)
- + Horizontal - competitor
- Marketing Strategies
- focus w/r to SBU's mkt share
- + Build Strategy - increase mkt share. usually S/T loss (capital outlay) for L/T gain
- most appropriate w/ relatively low mktshare in relatively high growth rate mkts
- Question Marks or "A"s
- + Hold Strategy - maintain mkt share
- Cash Cows or "B"s
- appropriate for high mkt shares in low growth mkts
- + Harvest Strategy - maximize S/T earnings and cash flow
- appropriate for weak growth potential
- weak Cash Cows, Qeustion Marks, Dogs adn "C"s
- + Withdrawal Strategy - selling/discontinuing a SBU
- appropriate for weakest growth and inv potential
- Tactical/Action Programs
- - what activites are to be performed
- - how/when/where they are to be performed
- - who is responsible for performing each activity
- - how much each activity will cost
- - type and magnitude of results expected from each activity
- - main elements of uncertainty involved
- - how results will be monitored and evaluated
- Benchmarking - identify best practices adn outcomes
- - emulate best practices to equal/surpass best outcomes
- avoids reinventing the wheel
- programs must be coordinated and integrated to be successful
- formed for each marketing area and combined to form annual mktg plan
- Setting Budgets
- tell Sr Mgmt how much and when - bottom up
- sometimes top down and funds need to be allocated. Proposed programs scaled up/down as necessary
- budgets provide feasibility info
The Marketing Plan
- written document that specifies marketing goals for a product/product line and describes strategies and implementation and control efforts co intend to use to achieve those goals
- focuses on target markets and elements of marketing mix
- Benefits
- - facilitates communications among all levels of org and among function units
- - allows mgmt to monitor consistency of actions across units
- - focuses EE on right issues
- - keeps poeple focused on overall goals
- - provides basis of performance comparison
- Elements
- - executive summary
- - situation analysis
- - mktg objectives
- - mktg strategies
- - tactical/action programs
- - budgets
- - control mechanisms
Life and Health Marketing (LOMA) - Chapter 6 - ORGANIZING, IMPLEMENTING AND CONTROLLING MARKETING ACTIVITIES
Organizing Marketing Operations
- Essential Mktg Functions
- - Information Management
- - Marketing research
- - product development and pricing
- - sales and distribution
- - advertising, sales promotion and publicity (aka Mktg Communications)
- - customer relations
- - mktg personnel development
- - mktg mgmt and admin
- Four common mktg structures: function/product/geog region/customer type
- Organization by Function
- most common
- different areas of responsibility depending on work performed
- ex. Chief Mktg Officer/Mkt Research Mgr/Sales Mgr/etc
- Advantages
- - simplicity
- - focuses on developemnt of managerial and tech skills
- works best w/ small cos or cos w/ homogenous customers
- Organization by Product
- each SBU responsible for its mktg (most of)
- may be some shared services
- Organization by Geographic Region
- usually mktg manager for each region
- usually some shared services
- Organization by Customer Type
- mktg manager for each division
- ex: households/small business/big business
- Combination Structures
- flexible - meets both co's strategic implementation needs and customer needs
- Matrix Organizational Structure
- project manager directs individuals from different function areas
- two bosses during project
Implementing Marketing Strategies
- Mktg Implementation - process of translating mktg plans and strategies into action
- accomplished through day-to-day tactical and operational activities
Controlling Marketing Activities
- marketing control - process of examing results of mktg plans and company to plan and taking actoin to keep it on track
Performance Evaluation
- performance std - internal vs external std
- - usually incorporated into mktg plan
- management by exception - mgmt only gets involved if performance outside acceptable range
- - saves time and allows attention to be focused on problems/opportunities
- if a problem, read to identify toe cause and take actions to correct
- - change tactical/action programs
- - establish new implementation method
- - new strategies
- - modify how performance data collected/analyzed
- - re-evaluate performance standards
- control tools
- sales analysis vs
- - forcasted sales - prior years sales
- - expenses to generate sales - competitors' sales
- - estimated mkt potential - current industry sales
- measured - # products, 1st yr comm, face ,avg prem, etc
- expense analysis
- natuaral accounts - ledger accounts
- functional accounts - based on purpose
- expense ratios - ex. mktg expenses/$1m face sold
- profitability analysis
- compares sales to expense incurred to generate sales
- use several years data since for line ins, 1st yr expenses > 1st yr revenues
- valuable source of info since combines sales and expense info
- mktg audit
- systematic examination and appraisal of mktg environment, objectives, startegies, tactical/action prgms, organiztional structure and personnel
- key areas of mktg audit (chart p 135)
- mktg environment
- macro environment
- task environment
- mkts adn customers
- other factors in mktg system
- mktg strategy
- business mission and mktg objectives
- mktg strategy
- budgets
- mktg organization
- formal structure
- functional efficiency
- cross-functional efficiency
- mktg systems audit
- mktg info system
- mktg planning system
- mktg control system
- new product developemnt
- mktg productivity audit
- profitability analysis
- cost-effeciveness analysis
- mktg function audit
- products
- price
- distribution
- promotion
- Reporting Sytems
- - provide managers w/ detailed summary info as needed
- - provide accurate adn timely info
- - be flexible to adjust to co's changing info needs
- - be cost effective
- - easily understood by
- + those who evaluate performance
- + those whose performance is being measured
- detail s/b appropriate for level
- lower level needs more detail
- higher level mgmt needs just summary
-
Life and Health Marketing (LOMA) - Chapter 7 - MARKET SEGMENTATION AND TARGET MARKETING
Market Segmentation
- dividing large markets into smaller markets w/ similar product/mktg mix needs
- single variable segmentation - only 1 variable to segment market
- multiVariable segmentation - uses combo of variables
- Requirements for Effective Segmentation
- - customers should have similar product needs/buying habits
- - needs/behaviours s/b distinguishable from other segments
- - potential sales/costs/profits s/b lare enough to be measured and compared to other segments
- - profit potential enough to warrant segment attention
- - customers accessible thorugh currently available means
- - size/composition s/b relatively stable over planning period
- Bases for Segmenting Consumer Markets
- Geographic Segmentation
- country/region/state/county/zip/legal boundaries/rural-suburuban/urban
- Demographic Segmentation
- age/sex.marital.household composition/income/education/occupation/family life cycle/nationality/race/etchic group/social class
- GeoDemographic Segmentation - combo of geographic adn demographic
- economic means/cultural background/perspective/neighborhood
- Psychographic Segmentation
- lifestyle/activities/interests/opinions
- Behavioristic Segmentation
- benefits sought/usage rate/buyer readiness/pref method of purchase/risk tolerance/buyer loyalty
- Demographic - commoonly used in consumer markets
- traditional life ins demographics - hi/middle/low-income households and families/boomers/seniors
- Bases for Segmenting Organizational Markets
- Organizational Mkts - group benefits and continuation of business operations
- therefore two markets, group and business
- Georgraphic Segmentation - simialr to consumar markets
- Demographic Charachteristics
- business activity/type of group-organizatoin/size of group-organization
- SIC - Std Industrial Classification - 1930
- NAICS - N. American Industry Classificatino System - by-product of NAFTA
- small groups <=100 - 80% of contracts, 25% or prem
- medium groups 101-499 - 10% of contracts, 25% of premiums
- large groups 500+ - 10% of contract, 50% of prem
- Behavioristic Segmentation
- similar to consumer markets - usage is a key
Target Marketing
- process to identify, select and focus mktg efforts
- Evaluating Potential Target Markets
- Mkt Size and Growth Potential
- majority fallacy - blind pursuit of largest, most easily identified or most accessible mkt segment
- competition makes big mkts less profitable
- should offer combo size/growth/profitability that best meets co's needs
- Mkt Attractiveness
- depends on level of compettition and buying power of consumers
- Company Goals and Resources
- only puruse targets if it has (can easily get) fin/tech/hr necessary to compete sucessfully
- Target Mktg Strategies
- Undifferentiate Mktg - mass mktg - singel mktg mix for entire mkt
- + cheaper since only one mkt strategy
- - might miss differences w/in segment
- - disadvantage to specialty marketers
- Concentrated Mktg
- for a product - focus all mktg efforts on a single segment of total mkt
- Niche Mktg - form of concentrated mktg w/ narrowly defined mkt
- - all eggs in one basket
- + can be profitable
- Differntiated Mktg
- offer differing product/mktg mixes to appeal to diff segments
- - most expensive
- + better served customers = incr customer satisfaction = incr sales
- Factors to consider when picking mktg strategy
- company resources - if limited, concentrated probably best strategy
- product variability - homogenous products - undifferentiated mktg
- Mkt Variability - if buyers have similar usage/purchase patterns - undifferentiated
- product's life cycle stage - new products - concentrated/undiffernetiated
- Consumer and Organizational Target Markets for Ins Products
- Affluent Consumers
- mass affluent - 100k -$1mil liquid assets - 99.9% of affluent mkt, 54% of total mkt assets
- high-net-worth - $1-25 mil liquid assets - 0.1% of mkt, 31.3% of assets
- ultra-high-net-worth - 0.001%, 15.1% of total mkt assets
- Single-Parent Families - need large amt ins to protect single wage earner
- Non-family Households - low need for life ins, high need for health/retirement products
- Working Women - strong potential for wide range of products
- Employer Groups - ex. negotiate trusteeship/voluntary trade assoc/MEWA
- Small Businesses - rapidly growing segment - approx 99% of businesses are small businesses
- significant market for products that
- - protect against loss due to death/dis of owner
- - preserve value/prevent liquidation due to owner/partner death
- - preserve sharelohlder equity/mgmt control due to majority shareholder death
- - protect against death tax on inherited business
- - enhance credit/fin stability by assuring business continuation
- - source of emergency funds
- - non-qual def comp to attract/retain key employees
- - EE health/life/dis ins and qual ret plans
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Life and Health Marketing (LOMA) - Chapter 15 - DISTRIBUTION CHANNELS
Overview
- Distribution Channel - network of cos and people that performall mktg activities req'd to deliver products to customers
- 3 types: personal selling/financial institutions/direct response
Personal Selling Distribution Systems
- Agnecy-Building Distribution Systems
- Ordinary agency distirbution system - full or part-time agents to sell/service ins pols
- field force - agents in the system
- career agent - full-time commissioned salesperson w/ agency contract
- agency contract - agreement that defines roles/responsibilities/compensation/power of agency
- power of agency - agents right to act for the insurer
- Career Agents - independent agents, not employees
- exclusive agent - tied/captive - not permitted to sell other insurers products
- agent-broker - broker - places business w/ cos other than primary co
- marketing territory - geographic area insurer distributes products
- field offices - sales offices in marketing territory
- considered a branch office or agency office
- Branch Office System
- Branch manager responsible for increaing sales/recruiting and developing career agents/managing expenses for the co
- Branch manager and office staff are ins co employees
- Agent in branch office under contract to ins co, not branch manager
- General Agency System
- Agency offices established, maintained and funded by general agents
- General Agent - Independent agent under contract to insurer
- primary funtion of GA is to build and manage an agency of career agents focused on distributing products of single insurer w/in defined territory
- GA is agent of insured, not EE
- office staff EE of GA, not insurer
- Comparison of Branch Office adn General Agency Systems
- expensive to build field force from scratch so use GA system
- GA bears some/all of agency startup costs incl office expenses/salaries
- Insurer commission costs ~ sales
- Branch office - high costs @ beginning even though sales low
- Well established insurers prefer branch office
- - greater control & flexibiltiy
- - can transfer personnel between territory
- - can transfer someone w/ experience vs training from scratch
- - rewards good producers w/ better territories
- under GA, need consent of GA to transfer people
- distinction between GA and Branch office getting fuzzier
- Multiple-Line Agency (MLA) Distribution System
- uses career agents to distribute life/health/p/c ins for group of commonly managed or financially related ins cos
- MLAs establish own office w/ little/no help from insurer
- benefits of MLA system
- - efficiency in serving certain markets - one agent for all needs
- - opportunities to cross-sell products
- - persistency - more business and more satisfied = better persistency
- - economies of scale for insurer
- Home Service Distribution system
- exlusive agaents (home service agents/debit agents)
- defined products/defined territory
- autohorized ot collect renewals @ PO's home
- employees of home service co
- req'd to keep certain hours and may be transferred
- MDO policy (monthly debit ordinary) - prems collected monthly at PO's home
- 1k-25k face amts typically
- PNO policy (premium notice ordinary)
- $10k/$15k min face
- prems paid via mail/payroll ded/mbd/eft but may be collected at PO's home
- usually a district office w/ district manager
- districts split into territorys - 1 agent/territory
- Worksite Mktg Distribution System
- individual/grp ins distributed at place of work on voluntary, paryroll deduction basis
- advantages
- - effective way to reach and meet the needs of mill/lower income mkts
- - more cost effective than distribution of indiv plans of ins
- - builds name recognition
- - possible gateway to sell grp benefit products to employer
- - payroll ded less likely to lapse that direct billed for EE who remain w/ company
- disadvantages
- - two sales to make - one to employer, one to EE
- - small face amounts and prems
- - persistency problems in high turnover workplaces
- Location-Selling Distribution System
- consumer initiated sales at kiosk/desk in other store
- may be agency building or direct response dpeending on staffing levels
- pre-need funeral is a specialized type of location-selling
- Salaried Sales Distribution System
- relys on salaried sales reps to sell/service products
- employees of insurer and paid salary
- Group Representative - handle group sales - specially trained for groups
- Call and Contact Centers
- call center - phonebank for support
- contact center - like phone center but email/mail/phone/web chat
- possible source of cross sells
- Non-Agency-Building Distribution Systems
- Pros
- - don't have to train/finance or provde office support
- - less expensive to establish
- - expenses linked directly to sales
- Cons
- - agents not exclusive
- - less control
- Brokerage Distribution System
- uses agent-brokers and licensed brokers
- licensed broker
- - independent life broker
- - licensed to sell but not under an agency contract w/ any insurer
- - responsible for own office space and other expenses
- producer group
- - independent producers organized
- - negotiates compensation/product/service arrangements w/ ins co
- - normally focus on specific segment of mkt
- soliciting brokerage business
- Brokerage Rep
- appointed to solicit brokerage business and appoint brokers on behalf of co
- may be full-time salaried employee or soliciting agents
- Brokerage General Agency
- agency operated by Brokerage General Agent (BGA)
- BGA - independent agent under contract w/ numerous insurers
- BGAs have minimum production reqmts
- primary function - encourage agents/brokers to sell products of cos BGA represents
- Wholesaler - broker rep that solicits business for an insu co primarily from broker-dealers adn banks
- Personal-Producing General Agency (PPGA) System
- PPGA - commissioned salesperson, not housed in insurer's field office, engaged primarily in personal production
- most co's that licensse PPGAs have min prod reqs
- soliciting PPGA business
- Regional Officer - independt contractor or EE who recruits and manages PPGAs for only one insurer
- Managing General Agent (MGA) - indepentd contractor typically recruits and manages PPGAs for # diff cos
- primary advantange of PPGA system - tendency to hold down costs
- Professional Advisors Distribution System
- Financial planners/CPAs/Attorney distributing life ins
- sometimes fee based, sometime commissioned
- laws and ethics codes are strict for these folks - lots of extra disclosures
Financial Institutions Distribution Systems
- Broker-Dealer (B-D) Distribution System
- variable products can only be distributed through B-D
- if insurer want to distribute variable products
- register ins co as B-D
- establish sub that registers as a B-D
- mkt prducts through affiliate that is a registerd B-D
- Bank Insurance
- distribution of ins to bank customers through bank-affiliated insurer or ins agency
- authorized by Gramm-Leach-Bliley Act (GLB Act)
- Insurance Companies
- nonproprietary products - products manufactured by another insurer
- common products - DI/Indiv Health/small group health
- done to keep agents/customers happy
- home-office-to-home-office arrangement
- HO distributes specific product lines mfg by another insurer
- career agents allowed to broker on their own for products not carried
- in-house brokerage agency - solicits dist agreements w/ other cos for prodcuts not offered
- keeps exclusive agents from dealing with other cos
Direct Response Distribution Systems
- overview
- normally noface-to-face contact occurs - sometimes phone sales reps or agents
- Direct Response Mkts - using one or more media to elicit an immediate and measurable response from a customer
- Two types of direct response materials
- Invitation to inquire - communications designed to generate interest in product/service and provide prospects w/ means to request and receive add'l info
- Invitation to Contract - communicaton desited to solicit and close a sale
- fullfillment kit - package of materials designed to address customer's request
- Products Distributed Through Direct Response Marketing
- generally simple to apply and pay for, u/w, administer
- typically non-med or guar iss basis
- non-med basis - sold w/o exam by doc/paramed - may have health questions on app
- guar-iss basis - no indiv u/w takes place - if an eligible member of group, apply and meets specified contitions, automatically issued a policy
- Media used in Direct Response Marketing
- Direct Mail - generally print form via mail service - contains mail kit
- mail kit
- intro letter response device (application/form)
- brochures business reply envelope
- Telemarketing - use telephone to produce sale
- Outbound Telemarketing - co calls you
- Inbound Telemarketing - cust call your - usually as a response for other ads
- Internet
- Aggregator - site where users can comparison shop many co's for rates
- Type of Mailing Lists
- House List - compiled from people who have shown interst in co or been referred by current customers - most productive list
- Response List - people who have brough from another co through direct response - their house list - second most productive list
- Compiled List - derived from direcories/newspapers/tradeshow registrations/ etc
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Marketing for Actuaries (LIMRA) - Chapter I - INTRODUCTION
Overview
- Actuary responsible for product designs and pricing is as much a part of mktg as those more directly involved
- product design adn pricing should not be done in actuarial vacuum, but integral part of total mkt strategy
- must be familiar w/ mkt segment targeted & dist-system used in order to properly price products
Marketing for Actuaries (LIMRA) - Chapter II - MARKETING MANAGEMENT OBJECTIVES AND STRATEGIES
Overview
- Critical Ins Co functions
- establishing mkt objectives
- determing how to grow in mktplace
- implementing strategies to implent these goals
- mktg objectives s/b designed to maintain existing business and generate NB w/in existing mkts adn from existing dist channels
- growth objectives s/b designed to generate NB from new mkts, new products and new dist channels
- mkt adn growth objectives s/b based on
- historical results - where co has been, is today, and why
- strengths - s/b viewed as opportunities and capitalized as either competitive edge or way to enhance profitability
- weaknesses - eliminated or minimized as much as possible
- external environment - assesment includes
- competition
- consumer needs/desires
- demographics
- economic conditions
- int rates
- inflation
- reg climate
- consumer attitudes
- gov't intentions (regarding public/private fin security issues)
- internal assumptions
- assume sufficient CF & reserves to support sales goals and forays into new mkts, products, dist channels
- strategic assumptions about how it will utilize capital and other resources
- mktg strategies
- specific interrelated & complementary activities a co will perform to achieve its goals
- markets, product, distribution
Markets
- specific mkts co wants to operate in
- must be indentified and defined as precisely as possible
- definition includes
- demographic characteristics
- geographic location
- lifestyles
- motivation
- needs
- product use
- social mobility
- each mkt mustbe measurable (size and purchasing power)
- must be large enough to be profitable and reachable by distribution
- once mkts identified, can plan how to best penetrate these mkts
- req'd resources, who will implement, time frame
Products
- products offered must be suitable to targeted mkts and dist systems
- must be designed to support mktg adn pricing objectives
- objectives for quality, services and growth s/b met w/in budget adn w/in expense loadign for each product line
Distribution
- Cos must tailor each dist system to mkt it will serve and products it will sell
- pay attention to what is needed to enhance capability of field & HO to deal w/ new products and to penetrate targeted mkts
- pay attention to how internal programs might impact dist system
Role fo the Actuary
- offer assistance to mktg officer in formulation of mktg mgmt objectives and strategies
- gauge potential effects of mgmt decisions
- project expectd results
- take active role in design of product and compensation
- measure progress toward attainment fo mktg objectives
- advise on impact of strategies on fin rating
- advise on appropriateness of sales illustration
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Marketing for Actuaries (LIMRA) - Chapter III - MARKET RESEARCH
Overview
- conducting surveys to analyse
- sales and persistency trends
- census demographics and econ stats to sales data to id mkt-potential
- developing conservation programs
- studying profiles of buyers and products purchases
- examining trends in buying and paying behavior
- exploring motivations invovled in various purchases
- conducted both at company and industry level
- study both internal ins environment and external environment
- external environ - demographic,economic, regulatory, cultural, technical trends that may affect ins mkts
- sources: fed govt agencies, private industry, trade orgs, professional assoc & vendors
- conducted at industry leve by various ins fin services trade orgs and prof ins orgs
- helps senior management in
- setting company objectives
- monitoring goals established by such objectives
Market Surveys
- montior sales activites and their persistency
- tracked by several measures including product lines and dist systems
- results are used
- strategic planning process
- establish mkt share goals adn monitor such goals
- as performance criteria
- competitive intelligence process
- diagnose strengths adn weknesses
- mkt segmentation purposes
- motivational purposes
- measure of the mktg effectiveness of the ins industry
- problem identification
Sales Surveys (LIMRA primarily)
- Individual Life
- qtrly and ytd indiv life sales performance trends by dist channel
- annualized new premium, face amt, # pols, avg size pol, prems/pol, prem/$1m
- allows cos to compare results w/ others
- WL/Term/UL/VUL
- Individual Annuities
- qtrly sales trends by product type
- deposits for variabel adn fixes annuites, qual/nonqual, single prem/periodic prem
- Individual Health
- DI - qtrly indiv DI sales by annlzd prem and # pols
- LTC - new issues and trends in inforce
- Indiv Health - annlzd prem & pols - medicare supplement, acc, hospitalization, major med, comprehensive
- Buyer Study
- Indiv life sales observed for trends in variety of product and buyer characteristics
- provides overall picture of industry
- hleps w/ design of new products
Other Market Data
- helpful to have info on competition w/ mkt share
- analyse using primary (internal company) data along w/ secondary data
- used to estimate expected growth rates
- sources fo seconday data:
- US Census Bureau - population and household counts, estimates and projections by area
- Bureau of Economic Analysis - aggregate personal and per capita income for areas & income proj
- Bureau of labor Stats - unemployment stats adn workforce size
- Nat'l Assoc Realtors - housing starts and sales and home values
- Persistency Studies
- periodic studies for indiv def ann, indiv life, indiv DI
- Consumer adn Field Force Surveys
- mostly mktg info from
- analysis of internal operating stats
- policyholder records
- trade assoc figures compiled across groups of cos
- more and more info from own records
- move from policy records to client records (householding)
- focus groups can help w/ consumer info
- industry studies needed for avg ins holding and similar data
- Public in General
- ACLI surveys American Public
- Sub-Population of the General Public
- survey of widows/people who recently bought through a bank/etc
- survey ow policyowners
- cross section or subgroup such as recently serviced or recently terminated
- Field Force
- evaluating compensation systems, portfolio, policyowner service, field-HO communication, quality of agent training
- wants & needs of public - at least agents perception
- field survey vs field advisory council
- field survey represents all agents, not just most vocal/top producers
- field morale improved if ask all
- Caveats
- surveys can mislead - using info for purpose other than intended
- surveys are an "art" and trick to get set up adn utilized properly
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Marketing for Actuaries (LIMRA) - Chapter IV - TRADITIONAL DISTRIBUTION SYSTEMS
Overview
- two distinct dist systems in US: Agency and Direct Response
Agency-Building Systems
- Career Agents - co recruits, finances, trains & sometimes houses agents to represent them
- field offices - general agencies (headed by GA) and/or branch offices (agency manager)
- GAs appointed by HO and considered independent contractors
- usually receive expense allowance to cover office-type expenses
- responsible for fin mgmt of agency
- Branch Office - agency mgr gets assignment from HO and directly supervised by HO in fin mgmt of agency
- difference between GA and agency manager has blurred
- Multiple Line (MLEA) and Home Service Agents
- usually exclusive relationship w/ HO
- MLEA also sell P/C products
- MLEA has much higher agent retentino rate than career agents
- Home service Agents - generally work in a debit (defined geog area)
- works in lower-middle income mkts
- all business is assigned to a servicing agent (eliminates "orphan" problem)
- commissions generally NOT vested to writing agent
Independent or Non-Agency Building Systems
- Brokerage
- mktg attempt to maintain relationships w/ producers whose primary affiliations are directed elsewhere
- usually do not finance, train, or house agents who represent them
- broker-insurer relationship - independent contractor
- many variations on brokerage - specialized products, substd business, etc
- brokerage supervisor - HO employee who contracts w/ brokers
- PPGA
- contracted similar to how brokers are
- co-employed regional directors (RD), MGAs (Managing General Agents) & direct contact via press
- RDs and MGAs authorized to appoint PPGAs
- PPGAs supply own office facilities
- receive tech assistance in form of computers and adv sales support
- usually have contracts w/ several cos
- cu usually has min prod req to continue to receive tech support
- Marketing Organization - co contracts w/ independent org to mkt its products
- Wholesaling - co produces basic product and producer adds fees or commissions
- Producer Groups - groups of high-producing agents agree to place min amts of business w/ a co in return for a share of profits
- usually through reins or stock options
Elements of Agent Compensation
- Overview
- major components: FY/RY comm, asset-based comm, bonuses, exp allowances, security benefits
- First Year Commissions
- expressed as combination of %FY prem, amt/polcy, amt/$1m, %CV
- usually just % FY prem
- often annualized & fully vested w/ chargebacks for early lapse
- Renewal Commissions
- rate of compensation (usually % of prem), pattern of comp, conditions fro payment can be fully, partially, or non-vested
- reasons for disparate nature of renewal comm scales
- competitive concerns
- regulatory constraints (ex. NY Section 4228G)
- desire to improve persistency
- direct agent's efforts in manner conducive to co philosophy
- conditions for payment of renewal comm
- renewal comm can be viewed as
- deferred 1st year comp
- reward for loyalty to co
- payment (reward) for persistent business
- payment for service to PO
- start toward a retirement plan
- Asset-Based Commissions
- aka trails
- % of acct value/cash value
- concept from stock/mutual fund world
- more common on annuities
- when on life, usually on UL/VUL products
- not a significant source of income for newer agents
- Bonuses and other Compensation
- bonuses focus agents attention on product profitability
- various bonus measures
- FY prem or commissions
- net FY comm
- total prems or comm
- persistency (s/t and l/t)
- # new clients or policies sold
- combination
- Expense Allowances
- usually a % of some mesure of slaes
- sometimes based on renewals/persistency
- used (in some cases) when agents pay some/all costs of office adn business expenses
- Security Benefits
- a necessary and important part of overall compensation for career agents
- includes live ins, health ins, dis, ret benefits, profti sharing, thrift or savings adn 401(k)
- sometiems includes deferred comp options
- covered under federal and state laws - OASDI, unemployment, workers comp
- benefits ~ 16% of agent earnings
- ERISA - probably biggest impacy adn most important - 1974
- other acts include:
- age discrimination - 1978
- TEFRA 1982
- DEFRA 1984
- REA 1984
- COBRA 1985
- TRA 1986
- OBRA 1987
- FAS106 - 1990 req'd co's to carry retiree benefit costs as liab on fin statements
- Salary Compensation
- usually restricted to new agents
- Differences Between Brokerage Contracts and Career Contracts
- career agent usually considered a stat employee adn receives a W-2
- broker compensation on 1099
- brokerage contracts - normally no provision for fringe benefits
- brokers commission schedules generally fully vested and pay rates generally below typical career agent
- Compensation for Internal Replacements
- common methods for determing first year comm on internal replacemnt
- % of full 1t yr comm where % increases based on dur of old pol, usually 100% after 10 yrs
- full comm on increased prem, reduced comm on rest
- difference between full FY and nwe and old
- full FY if new prem > 2x old prem, otherwise %
- full FY regardless
Levelized Commissions
- high front-end commission structures palce persistency risk w/ cos
- level com shifts much of that risk to agents
- aligning agents' interestes w/ co may be what is needed ot arrest churning of business
- problem w/ transistions to level comm structures
- increase in new agent fin cost since much lower early year comm
- transitioning existing agents from high FY to levelized
- Possible solutions:
- option to commute later year renewals to earlier years
- adding add'l comp to existing business during transition
- Two major challenges
- what will it cost to make this conversion
- will change produce overall favorable results to co
Estimating the cost of Agent Compenstation
- PC(n) - % of companies FY prem producted by agents in nth year of service
- O(n,t) - prob FY prem written by agents in nth YOS is from agents who will leave before policy enters year t
- O(t) - prob FY prem from agents who leave before business enters year t
- P(t) = prob prem fro year t will be paid
- P(t)O(t) - prob that in policy year t, prem paid and agent no longer w/ co
- r(t) - nonvested renewal comm as % of prem
- cost of nonvested newnew comm = sum(r(t)*v^(t-1)*P(t)*[1-O(t)]
- To calc O([n],t)
- l(n) = # agents entering nth yos
- w(n) = # agents w/d from service in yer n
- wq(n) = w(n)/l(n) = prob agent entering nth yos will w/d that year
- PRD(n,s) = FY prem produced by one agent during their nth yos who will leave in their n+s-1th yos
- O(n,1) = 0
- O(n,t) = sum(PRD(n,s)*w(n+s-1)) / sum(PRD(n,s)*w(n+s-1)) where first term is summed from s=1 to t-1 and second term is from s=1 to infinity
Financing the New Agent
- Overview
- fundamental purpose of financing - make up difference between income needed (on a fair and resonable basis) and income initially earned under co's std basis of compensation
- Degree of Financing
- depends on individual curcumstances
- Aptitude
- Preliminary Training adn Supervision
- Company and Agency
- Type of Commission Scale
- Annualization of Commissions
- Personal Circumstances
- Types of Financing Plans
- Advances - loans made against future comm earnings
- security against advances
- comm on all business produced during financing period only
- comm on all business, past and future, produced by agent
- all fo agent's assets, incl commission earnings
- rarely used
- Subsidy - aka Training Allowance Plan (TAP)
- payments, on a formula basis, in addition to comm
- Salary
- payments made in lieu of part (or all) of earned comm
- Validation Requirements
- Validation Schedule - contains production requirements necessary to continue agent financing adn/or avoid contract termination
- 3 basic factors to a validation schedule
- expected growth rate in agent production
- avg comm scale expected for financed agents
- avg persistency and modal mix of business sold by financed agents (usually on premium basis)
- need to know what to include/exclude from validation req
- intercompany mktg agreements
- subsidiaries
- non-insurance products
- efforts to reflect indiv performances
- salary plan that pay comm on sales > validation reqs
- shift from salary to subsidy plans
- subsidy plans that pay variable TAP based on performance instead of initial salary level
- some co's set up drawing accts to smooth out income fluctuations
- Variable TAP
- Advantages
- production driven
- agent experiences effect of production on income
- less costly
- Disadvantages
- income can fluctuate more than for experienced agents
- Fixed TAP
- Advantages
- income stable as production increases
- strong incentive to produce b/c comm paid
- Disadvantages
- high producers not rewarded proportionately
- production does not have to be smooth
- income can fall below income needs
- Line-of-Credit Plans
- Advantages
- income stable as long as acct cr/dr constant
- large fluctuations in prod may still yield relatively stable income
- fairly flexible by incorp adv from other types of plans
- Disadvantages
- agent could have decr in income after fin period b/c comm withheld
- production doesn't have to be smooth
- more costly due to development and admin
- Salary Plan
- Advantages
- Level income regardless of production
- additional payments if production > certain limits
- attractive to prospective agents
- easier for mgmt to recruit
- Disadvantages
- high producers not always rewarded proportionately - may cause retention problems
- costly if agents do not produce @ expected levels but continue on plan
- income may change considerably when agent goes from salary to comm
- requires close supervision adn strict adherence to validation scheds
- Estimating Financing Cost
- avg financing level
- validation schedule
- agent retention rates
- first year prems - estimates should include FY prems by agents who terminate w/in fin period
- persistency rates and modal dist (freq of prem payments)
- comm payments and subsidy payments
- "unvested" recoveries - agents who terminate normally forfeit normally vested commissions on business written during fin period
- "recoveries" normally subtracted from subsidy payments to determine fin costs
- example p.IV-22
- Field Management Cost-Sharing
- provisions for sharing cost and risk of fin new agent usually in GA's contract and now branch managers as well
- Basic approaches
- field mgmts share of the cost is highest in early part of fin period
- discourages hast recruitment and careless selection
- may carry marginal/failing agents until managers share becomes lower
- field mgmt's share increases during financing period
- mgr will continually evaluate prospects for sucess
- field mgmt assums full cost responsibility from point when agent's production falls below some minimum validation level instead of requiring termination
- Home Office Supervision
- agencies usually req'd to submitprogress reports on financed agents
- Evaluation of Financing Plans
- criteria for evaluating effectiveness of plan
- cost - ultimate excess of total payments over total comm
- investment - amt outstanding at any time
- simplicity of operation
- understandability
- degree of control
- correlatoin between benefits and agents performance
- dist of cost between co and GA or branch manager
- likelihood of co's new agents meeting validation schedule
- relationship of validation schedules to co's training porgrams
- financing plan is ont substitute for training, supervision and sales assistance
Elements of Field Mgmt Compensation
- GO or agency manager - vital position in co's mktg org
- many responsibilities incl
- recruiting/selection of agents
- agent training/development
- sales assistance and support
- 2nd line mgmt development
- business mgmt
- agency planning and admin
- agency mgmt pay partly income for doing job and partly reward for taking risk
- five major categories of risk
- development risk - associate w/ weighting various sources of business and productivity of source
- persistency riks - assoc w/ payment/nonpayment of renewal prems and conservation of assets
- expense risk - running the agency w/in certain standard for "controllable" expenses
- product mix risk - multiple products w/ smaller exp loading and profit margins
- time risk - delay between "virtuous activities" adn "result" that system rewards
- may also be stabilization factors adn deferrals which futher separate reward from behavior
- General Ageny vs Agency Manager Systems
- Theoretical Differences
- GA is indep dist adn therfore assumes greater business risk in return fro greater l/t reward
- 3 distinct types of GA contracts
- general agency contract calls for specific overrideg comm to the GA and provides separately for the soliciting agent's comm
- company pays comm to GA and PG pays to comm to agents - seldom used today in agency-building situations
- PPGA contract primarily a producer contract
- Personal Production
- regualar comm on personally produced business often not a substantial element of agency head's income
- agency managers historically viewed as sales managers w/ principal responsibility to increase sales of co's products
- expected to recruit/select/develop career agents whose perforamcne will help co achieve corp growth adn profit objectives
- Compensation Overview
- Salary - exclusive to managerial systems since inconsisten w/ indep dist philosophy of GA approach
- First-Year Overrides - motivate new sales
- most sytems place significant rewards on this component
- Renewal Overrides - usually paid in a GA system, less freq in a managerial system
- provides CF stability to a GA and incentive for persistent business
- Vesting - usually subject to vesting provisions that give GAs ownership of future override streams if they leave co
- originally intended to continue the return of invested capital after GA returned
- Service Fees - common in GA systems
- orig established to cover prem collection and certain service functions
- usually not vested
- Bonuses - do not usually vest
- aka leverage elements
- ex agency productivity, new agent organization, agency persistency, growth
- Expense Allowance/Business Management Factor
- GA pays all expenses (in theory)
- managerial approach - co provides agency office and support
- GA expenses generally lower since he makes decisions based on actual CF
- Sharing of new Agent Financing Cost
- loss-sharing assures better supervision and encourages more economical use of co resources
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Marketing for Actuaries (LIMRA) - Chapter V - NONTRADITIONAL AND EMERGING DISTRIBUTION SYSTEMS
Overview
- "nontraditional" for life ins is mainstream in France adn Spain
- high cost of fact-to-face selling by trad ins agents forced most co's to upscale mkt
- middle mkt co's either abandoned mkt or chosen diff dist channel
- nontrad dist channels by mkt
- Middle Mkt
- worksite
- banks
- direct mktg
- internet mktg
- Upscale Mkt
- fin planners
- mutual fund salespeople
- stockbrokers
- accountants (CPAs)
Nontraditional Dist Channels in the Upscale Markets
- many reps used to be full-time agents in traditional system
- Financial Planners
- negative perception of life ins agent - many got ChFC or CFA and advertise as fin planners/advisors/consultants
- objective: to become trusted advisor providing full range of fin advice
- growing number compensated on fee basis (vs commission)
- fees: unpront to develop a written plan or asset-based
- some states allow both fees & comm, some states say either/or
- few ins cos make fee-based fin planning a primary strategy
- potential liabilities, admin costs, potential conflict between independent advice and sale of proprietary products
- Stockbrokers adn Mutual Fund Salespeople
- VAs a natural extension b/c of tax advantages vs stocks/bonds/mutual funds/etc
- stockbrokers most significant source of VA sales
- not as sucesful selling life ins
- grid-based compensation systems - consistent w/ evolving needs of distributors & producers
- grid approach - gross dealer concession - gross dist margin
- Accountants (CPAs)
- enjoy high degree of respect and integrity in eyes of ins buying public
- clients good opportunities for 2nd-to-die life, annuities, and mutual funds
- traditionally good source of referrals
- if not selling themselves, expecting agents to split comm w/ them
- very influential in fin affairs of high net worth clients
Nontraditional Dist Channels in the Middle Mkt
- Worksite Marketing
- aka voluntary benfits
- mktg personal ins products to EE at their place of work
- products endorsed by employer that EE decides whether to purchase
- ER cooperation needed to initiate sales process and implemet payroll ded plan for EE prem payment
- insurers view as way to reach underserved potential clients in a cost-effective manner
- agents view as either primary or secondary mktg focus. For both
- provides daytime selling opportunities
- large prospecting list
- fresh "door opener" conversations w/ decision makers
- EE view
- discounted rates
- convenient, non-intrusive slaes process
- policy portability
- usually low min prems and guar iss/simplified u/w
- 3 ways to present and enroll
- agent (or salaried enroller) meets w/ EE 1-on-1 at work
- group settings
- payroll stuffers/direct mail
- account admin is most critical factor to determining effectivness and success of program
- depends on ability of payroll deduction
- systems must be able to accomodate w/o add'l ER expense
- pricing requires special knowledge and u/w assumptions that allow for attractive profit margins
- requires close monitoring of actual experience
- Banks
- increasingly important for annuities
- 3 main strategies for bank annuities
- licensed platform staff - specially trained bank employees
- in-branch (bank) agents - usually work for Bank's ins agency subsidiary
- third-party agents
- some mkt annuities through b/d or securities units
- some use direct mktg methods
- life ins sales not as sucessful as annuities < 1% total life sales
- reason for poor life sales
- regulatory constraints (eased by passage of GLB)
- u/w process an annoyance banks not used to dealing with (collecting blood, etc)
- planning for a negative life event vs savings for home or college
- banks used to transaction sales adn life ins not a transaction sale
- Compensation
- most bank producers paid base salary w/ some form of incentive
- banks hesitant to have sales force paid solely on incentive basis b/c of fear of agressive sales tactics
- since prospecting not an issue, don't need to compensate for that
- banks usually compensated by LIC via commission
- other methods
- expense reimb & allowance
- override
- lease paymenets for use of bank office space
- incentive for non-licensed bank personnel for lead generation
- Bancassurance in Europe
- very succesful in Spain (50%) and France (60%)
- Direct Mktg (aka Direct Response)
- uses one or more media to elicit an immediate and measurable response
- records, tracks and analyses that action
- stores info about action in database for future retrieval and use
- methods
- direct mail - tech allows to be highly targeted adn personalized
- print media
- broadcast media - select shows/times to hit target mkts
- telemktg - outbound and inbound (primarily to support other direct response media by processing responses)
- fax mktg
- retail centers and kiosks
- internet dist methods - own site or aggregators
- traditionally used for consumers not served by personal selling dist systems
- need only limited or supplemental ins
- live in geog remote areas
- need products not widely avail from most co's, agents, brokers
- need products whose comm potential is too small in relation to an agent's personal selling efforts
- Tarket mkts also includes indiv who can be easily reached b/c belong to special into or consumer groups
- company's own customers
- consumers who have prev inquired about a co's products
- consumers who have prev inq about another co's direct mktg offer
- members/vets of armed forces
- hold dept store or bank credit cards
- Credit Card holders and SR Citizens frequently targeted
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Marketing for Actuaries (LIMRA) - Chapter VI - MARKETING AND PRICING
Life Insurance
- Persistency
- Short-term Persistency
- generally measured using lapse rates based on face/# pols/prem
- # pols = # decisions to lapse
- prem - better measure on fin impact
- most common def of s/t lapse - policy that fails to pay 1st prem of 2nd policy yr (aka 13th mo) for reasons ofther than lapse/conversion
- early lapse rate stressed b/c
- fin impact on eraly terminations greater than later terminations
- early lapse primary indication of if business being sold efficiently
- early lapses most susceptilbe to chagne by direct co effort
- Long-term Persistency
- loss of older business significantly affects profits, div scales and current pricing
- Establishing Persistency Objectives
- consider effect of req'd effort on dist channels and on co fin results
- agents must allot their time between pursuing NB adn servicing old business
- keeping in mind potential monetary payback
- if measures to imporve persistency reduce expenses, but production inhibited to point where cost/unit actually increases, no fin gain has resulted
- Factors Affecting Persistency
- Income and mode of prem payment are major factors related to persistency
- MDB close to same as annual b/c of automatic nature
- buyer-related: higher than average persistency among
- older
- professional adn executives
- already own ins w/ same co
- insuring lives of juveniles/students
- initiating sale themselves
- Product Related: higher than average persistency
- perm vs term
- higher prem and/or acct value (cv plans)
- w/o policy loans
- u/w on med basis
- sold w/ insurability option
- larger PRD policies
- business vs personal policy
- issued as applied for
- sold w/ wvr in home service mkt
- Producer Related
- persistency incr as agent's YOS incr
- new agent terminators sell business w/ poor persistency
- positively related to agent's product knowledge
- persistency obnuses have intended effect
- orphans - good business lost b/c lack of contact
- poor agents selling poor business
- Sales Process Related - higher lapses when
- partial or no cash w/ app
- needs selling not employed
- agent stresses savings and thrift
- policies not deliverd personally to insured
- post-sale service not employed
- Related to Outside Environment
- persistency poorer during high unemployment and high int rates
- persistency improves when personal savings adn eff buying incomes high
- growing competition from competitive inv media incr replacements
- better persistency in mid-Atlantic and Norther part of US
- Replacements
- reasons why PO may consider replacing existing coverage
- reduced prems
- volume discount
- flexibility
- interest rates
- insurer's financial health
- factors to consider when determining if replacement in PO best interest
- FY acq expenses
- Increased prems
- Values in existing pols
- suicide adn contestable provisoins
- new-money plans vs Trad plans
- tax consequences
Annuities
- most same info as life
- Persistency
- measured using surrender rates based on contracts or CV
- SC relatively effective @ preventing surrender activity when in effect
- surr rates increase when charges expire (aka shock lapses) & tend to remain higher
- dist channel has major impact on annuity persistency
- SPDA shock lapse rates lowest->highest career agents/banks/ind agents/stock brokers
- Replacements
- reasons to replace annuity contract
- change of investment risk tolerance
- cost
- product perforamnce
- product features
Managing Persistency
- loyalty perspective - whole copmany perspective
- potential for quantum leap gains in persistency
- tweaking - relatively small improvements can have large financial gains
- financial incentives - sales reps and/or customer a persistency bonus
- compensation for persistency - reducing FY and increase RY comm
- continuous educatoin - educate PO about purchased products
- reduces risk of "escalator effect" - switch products to participate in recent performance of stocks/bonds w/o consideration to their risk tolerance or LT goals
Managing Replacements
- strategies to combat replacements
- aggresive pro-active measures by formal conservation unit
- computerized detection system to indentify internal replacements
- inform sales reps when policy about to lapse
- guidelines to sales reps to id potential replacement situations
- educational materials and sample letters for sales reps to use
- provide service to former sales reps who service policies
- compensate sales reps for high retention thru persistency bonuses, incentives, recognition programs
- do nothing - may be OK for some blocks, but may send wrong signal to field
- increase face for existing policy. costs s/b offset by improved profits
- decrease premium for existing policies. costs s/b offset by improved profits
- set up loan repayment program or exchange program for special cases
- keep product protfolio attractive and flexible
- selling good product reduces chance of replacement
- provide quality customer service
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Marketing for Actuaries (LIMRA) - Chapter VII - ILLUSTRATION AND DISCLOSURE
Competition
- consumer level - competing against otehr cos w/ similar products
- distribution level - compete for agents or other sales sources
- inter-industry competition - consumer savings and retirement dollars
- mainly focused on price comptetition adn disclosure regs
- price comparison - measures relative attractiveness of pols avail from diff cos
- policy benefit disclosure - informing prospects of structure of policy offered
- prems, CVs divs, options and supp benfits
- life ins is usually "sold" instead of "bought" - different from most consumer products
Cost Index for Price Comparison
- old std basis - net cost = sum prems for 20 years - 20 yr CV - illustrated divs
- 70s - suggesting int adj cost index
- slow acceptance b/c
- controversy over choice of new cost comparison system
- apprehension that emphasizing comparative costs might hampter selling and discourage prospects from buying
- failure to sufficiently recognize risks of buying needed coverage
- failure to sufficiently recognize the risks of delay
- feds started looking @ alternate indexes and spurred cos to react
- ind adj finally adopted by NAIC in 76
- myth: cost alone is basic comparison factor among ins products - int adj method perpetuates this
- doesn't help buyers assess appropriateness of product to their needs
- consumerists often forget that one of the benfeits for buyer is education and services of a professional agent
- efforts to improve quality and availability of comparative info ineffectove for several reasons
- failure by industry leaders (and actuaries) to recognize delay may lead to widespread buyer rejection of ins
- problems in comparing dissimilar policies - policy types adn company philosophies (new money vs portfolio)
- agent's ability to vary illustrations - esp int racditing rates
- actuaries who confuse illustrations w/ projections and reject any form of comparative analysis
- regulators and regulations that have not kept pace w/ products
Illustrations as Method of Comparison
- historically used to show effects of dividends
- b/c of external copetition, began using illustrations to show inner workings as comparison to external products
- tech alloed agents to produce illustrations on the fly
- if done on a consistent basis, illustrations provide valid comparison
- abuse of illustrations have caused may problems
Illustration Model Reg and ASOP 24
- NAIC working group indentified # of computer illustration problems
- inappropriate use of illustrations to estimate future performance and compare policies
- lack of accountability of any of the parties to the sale
- lack of standardized format fo rlife ins illustrations
- lask of std and consistent definitions, lang, assumptions adn methodology
- inadequate description of the policy
- consumers not notified of changes in current assumptions
- insufficient penalty provisions exist for disclosure violations
- current regulatory approaches out-of-date considering desings of poliices being sold today
- NAIC Life Ins Illustration Model Reg - app 1995
- provided for protection of consumers
- fostered consumer education by making illustrations understanbable
- provided illustration formats
- prescribed standards
- req'd disclosure in connection w/ illustrations
- created illustration actuary
- Illustration Actuary - certifies illustratoin based on ASB standards
- ASOP 24 provides guidance
- "Illustrated Scale" must be supportable (disciplined current scale)
- to appease regulators concerns over "bait and switch" scales (non-guar elements)
SelfSupport Test
- policy form should not be supported by another policy form or another source
- accumulated value of policy CF using disciplined current scale and underlying assumptions s/b >= illustrated PO valued for 15th anniv and every illustrated point beyond
Lapse-Supported Test
- req prohibits illustration of non-guar elements in poliicies deemed lapse supported
- req degined lapse-support test - used disciplined scale assumptions except years 6+ assume 100% persistency
- intended to insure that any persistency bonuses included in test
Illustration Assumptions
- disciplined current scale assumptions s/b based on actual experience to extent experience is current, determinable, and credible
- otherwise use actual exp/trens of similar blocks from
- same co
- other co
- other sources
- in above order
- major experience factors
- interest mortality taxes
- direct sales costs all other expenses persistency
- aggregation reinsurance changes in methodology
- model req defines min expenses w/ 3 option approaches
- approach must be used for all policy forms during certification year
- Fully Allocated Unit expenses
- Marginally Accocated Unit Expenses
- similar to fully but excluded corp overhead adn general adv
- GRET
- marginal only to used if > GRET
- GRET can only be used if > marginal (in aggregate)
- can always use fully allocated as minimum
- cannot project favorable trends into future
- Illustration Actuary needs to certify scale
- scale has not changed since last certification and experience doesn't warrant changes OR
- scale has changed since issue only to extent chagnes are reasonably consistent w/ changes in exp assumptions underlying current disciplined scale OR
- currently payable scale has been made less favorable to PO since last certification and change is more than current experience would necessitate
- Illustration Actuary should certify annually
- and for newly introduced forms before new policy form is illustrated
- certification should contain
- for business issued in last 5 years, if currently payable scale as been reduced since last cert for reasons unrelated to exp changes
- statement as to whether inconsistency between illustrated non-guar elements for new policies adn similar inforce policies
- statemetn whether illustrated non-guar elements for new and inforce pols consistent w/ non-guar element amts actually credited or charged to smae or similar forms
- statement as to choice of expense assumptions
-
Marketing for Actuaries (LIMRA) - Chapter VII - APPENDIX I - MATHEMATICS OF COST COMPARISON APPROACHES
Int-Adj Cost Index
- 1/s(n|)*[sum([t]P(x)*(1+i)^(n-t+1)) - sum([t]D(x)(1+i)^(n-t)) - [n]CV(x)]
- P - prem, D - Div
- originally 4% in US, 5% in Canada, now 5% in both
- if i=0, Net Cost Index is result
- NAIC model REg Int Adj Payment index - same formula in book, but use 0 for yield
Actuaries Index (Canada)
Linton Yield Approach
- solves for a level effective int rate or yield
- compares a level prem policy to a term adn invest such that investement @ solved for rate = nth yer cash value
Internal Rate of Return
- commonly used w/ "leveraged" COLI policies
- only appropriate for sophisticated buyers
Basic Differences Among Cost-Comparison Methods
- Actuaries' Index is a "group-average" type adn other methods are "event-specific"
- "group average" - average cost to a group of PO
- main objection to "group avg" - employs probabilitys that represetn avg and therefore not applicable to many of the buyers who rely on the result
- main objection to "event specific" - likelihood of chosen event occurring is rather small
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Marketing for Actuaries (LIMRA) - Chapter VII - APPENDIX II - NAIC LIFE INS ILLUSTRATINOS MODEL REGULATION
Overview
- N/a to
- variable life
- ind and gruop annuities
- credit life
- life policies w/ no illustrated DB > 10k
- disciplined current scale - reasonably based on actuarl recent hist exp
- does not allow projected improvements
- does not allow assumed expenses < minimums
- illustrated scale - lesser of
- disciplined current scale
- currently payable scale
- lapse-supported illustration - disciplined current scale ecxept 100% persistency years 6+
- min assumed expenses
- fully allocated expenses
- marginal expenses (only OK if > GRET)
- GRET
- if no approved GRET, must use fully allocated
- self supporting illustration - accum CF >= PO value (CV adn other available amts) for 15th policy yer & all illustrated points beyond
Policies to Be Illustrated
- can't use an illustration prior to 1st anniv if policy form marketed w/o illustration
- if mktd w/ illustration, illustration must follow reg
- quotations for non-term group life: show sample age values <> illustration for purposes of reg
- but illustrated values must be consistent w/ illustrated scale
- basic illustration must be available to any non-term gruop life enrollee who requests it
- General Rules and Prohibitions
- labeled "Life Ins Illustration" adn contain basic info
- name of insurer name adn address of sales rep
- name/age/gender of prospect u/w/rating class illustrations base upon
- generic & company prodict name and form #
- initial DB dividend option election or application or non-guar elements
- shall NOT
- represent pol as anything other than life ins pol
- use or describe non-guar elements in a misleadaing manner
- state or imply that non-guar elements are guar
- use a non-compliant illustration
- use an illustration more favorable than reality
- provide an incomplete illustration
- represent that prem payments not req'd to maintain illustrated DB unless that is true
- use "vanish"
- use "lapse-supported" illustratino, unless prodcut has no non-f benefits
- use a non-self-supporting illustration
- int rate can't be greater than disciplined scale rate
Standards for Basic Illustration
- Format
- boat load of caveats adn supplemental explanations for anything not guaranteed
- have date prepared and page # of ##
- Narrative Summary
- brief descriptoin of policy
- breif desc of prem outlay
- brief desc of policy features/riders/options
- identification adn brief def of column headings and key terms
- not-guaranteed caveat
- Numeric Summary
- Pol years 5,10,20,AA70
- Policy guarantees
- insurer's illustrated scale
- "mid-point" scale
- divs @ 50%
- credited rates @ avg guar & illustrated
- non-guar charges @ avg guar & illustrated
- Statements
- one signed by applicant/PO
- one signed by sales rep
- Tabular Detail
- basic illustrations
- every year 1-10 adn 5th year thereafter
- any year premium outlay changes
- prem outlay and mode of payment
- guar db
- guar csv
- non-guar elements may be shown if described in contract
- must show at same durations
- must show 0 in guar column
Standards for Supplemental Illustrations
- must be associated w/ basic illustration
- can't show values more favorable than basic illustration
- non-guar caveat
- must include notice to look @ basic illustration
Delivery of Illustration and Record Retention
- copy if signed illustration attached to app
- revised illustration need to be signed if policy issued other than applied for
- agent must sign if no illustration used and illustration provided w/ policy
- signed illustration must be kept in file for 3 years after policy no longer in force
Annual Report; Notice to PO
- Illustrated policies must provide annual status reports
- UL
- beg adn end odate of report period
- pol value @ end of last and current period
- total amts credited/debited - by type
- current Db
- CSV
- loan balance
- lapse notice - if applicable
- Other Pols
- current DB
- ann prem
- current CSV
- current DIV
- applicatoin of current div
- outstanding loan
- if pol has no nonf values, only need to supply annual report when change made to non-guar elements
Annual Certifications
- Illustration Actuary - appointed by board of directors
- Ill Act will certify that illustrations in compliance
- Illustratio Actuary is
- MAAA
- familiar w/ illustration ASOP
- not been bad - from an illustration actuary perpsective
- disclose material changes in scales/assumptions
- disclose expense assumptoin
- certify policy forms annually adn before first use
- another responsible officer certified
- illustrations in use are ones Ill Act certified
- co gave agents info about expenses
- company will promptly inform when and why illustration actuary changes
Study Notes and Published References - Note CIA Education Note - INSURANCE AND ANNUITY ILLUSTRATIONS
Considerations
- professional responsibility of member to public - don't mislead
- familiarity w/ users and uses of sales illustrations - who are users and what is purpose
- determination of range of primary scenarios - ensure ranges are reasonable
- based on policies, practices adn expereince adn economic environment
- demonstrate reasonable sensitivity - pick an alternate scenario to demostrate sensitivity of policy to changes in experience
- documentation
Guidance
- historical results s/b adjusted for current factors
- ex Investment Income Tax, current tax law, current expense levels adn margins for profitability, compensation, etc
- historical results s/b adjsuted for unique/one-side factor
- impact of declining canadian $ on international inv yields
- temporary dividend enhancements
- co's intended management of product
- caveat that primary scenario is NOT prediction of results
- scenarios shoudl encompass all exp factory which might materially impact results
- caveat that alternate scenario is NOT worst case scenario
- info on variability of results
- also consider
- policy provisions
- company practice
- potential impact of illustration on PRE
- ease of implementation of new scenarios
- whether product is lapse-supported
- consistency between assumptions used in scenario
- consider product special features
- for par dividend scales, consider
- trends in inv returns
- compositoin of portfolio of assets
- investment adn div policies of co
- recent co experience on factors impacting div scale
- for UL consider
- guar credited rates
- LT avg of inv returns by major inv options
- availability and use of hedging fo rindex-linked inv options
- guar mort andtoehr charges
- int credited copared to cgross inv returns
- recent co experience which might impact spread
- for toher products
- recent adn anticipated experience in factors affecting results
Sources of Info
- co's valn report
- co's long range plan
- economic forcasts
- spot yield curves
- CIA economic statistics
- historical results as reported by organiztions such as S&P, Morgan Stanley, etc
-
Pricing
Life Insurance Products and Financing (Atkinson/Dallas) - Chapter 11 - PROFIT MEASUREMENT AND ANALYSIS
Distributable Earnings
- Calc in 3 steps
- pre-tax solvency earnings
- deduct taxes to detmine after-tax solvency earnings
- adjuste after-tax solvency earnings for incr req captial and add after-tax inv income on assets backing req'd capital
- Pre-Tax Solvency Earnings
- product cash flow - ProdCashFlow(t) = Prem(t) - Ben(t) - Exp(t)
- adjust for reins if necessary
- increase in solvency reserves - SolvResIncr(t) = SolvRes(t) - SolvRes(t-1)
- investment income - InvIncome(t) = PolLoanInt(t) + InvInc(t) + CashFlowInt(t)
- PreTaxSolvEarn(t) = ProdCashFlow(t) + IncIncome(t) - SolvResIncr(t)
- After-Tax Solvency Earnings
- AfterTaxSolvEarn(t) = PreTaxSolvEarn(t) - Tax(t)
- Adjustment for Req'd Capital
- ReqCapIncr(t) = ReqCap(t) - ReqCap(t-1) -> increase in req'd capital
- ATInvIncRC(t) = InvIncRC(t) - TaxInvIncRC(t) -> after tax inv income on assets backing req'd cap
- DistEarn(t) = AfterTaxSolvEarn(t) - ReqCapIncr(t) + ATInvIncRC(t)
- often not practical to price over lifetime of product, instead use 10/20/30 years
- if n is pricing horizon, need to account for all profits beyond n
- release req'd capidal @ end of n (ReqCap(n) = 0)
- either explicitly or set lapse for n to 100%
- present value of all future events need to flow through year n calc
Stockholder Earnings
- solvency reserves distort profit w/ significant NB strain, earnings reserves have smoother pattern, often no loss in first year
- Pre-Tax Stockholder Earnings
- similar to pre-tax solvency earnings
- product cf are identical
- main diff: change in earning reserves (net of DAC) vs change in solvency reserves
- assume invested assets = solvency reserves + req'd capital
- PreTaxStockEarn(t) = ProdCashFlow(t) - BenResIncr(t) - DACAmort(t) + InvIncome(t) + InvIncRC(t)
- DACAmort(t) = DAC(t-1) - DAC(t) where DAC(0) = 0
- From Solvency Reserves
- PreTaxStockEarn(t) = PreTaxSolvEarn(t) + SolvResIncr(t) - BenResIncr(t) - DACAmort(t) + InvIncRC(t)
After-Tax Stockholder Earnings
- need to deduct 3 components of tax
- Tax(t) - PreTaxSolveEarn tax
- TaxInvIncRC(t) - Tax on Inv Inc earned on assets backing req cap
- DefTaxProv(t) - Tax on diff between shareholder and solvency earnings excluding II on req'd capital (aka Provision for Def Taxes)
- AfterTaxStockEarn = PreTaxStockEarn(t) - Tax(t) - TaxInvIncRC(t) - DefTaxProv(t)
- Positive Distributable earnings - max amount that can be paid to stockholders
- Negative Distributable earnings - capital contributions stockholders must pay into co
- After-Tax stockholder earnings - earnings reported to stockholders
- often exeeds distributable earnings for a growing co
Return on Equity (ROE)
- After-Tax stockholder earnings / stockholder equity base
- stockholder equity base
- stockholder equity @ BOY OR
- avg of BOY and EOY stockholder equity
- stockholder equity = Assets - Liab
- Assets = DAC + inv assets backing solvency reserve + req'd capital
- Liab = benefit reserves + def'd tax liab
- StockAssets(t) = SolvRes(t) + ReqCap(t) + DAC(t)
- StockLiab(t) = BenRes(t) + DefTaxLiab(t)
- StockEquity(t) = StockAssets(t) - StockLiab(t)
- EquityBase(t) = StockEquity(t-1) or 0.5*(StockEquity(t-1) + StockEquity(t))
- ROE(t) = AfterTaxStockEarn(t) / EquityBase(t)
- ROE varys by year therefore tough to determine if co's ROE goal is met over product lifetime
Selection of Profit Goals
- basic questions
- which acctg basis to calc profits
- how to reflect products degree of risk
- what rate to discount future values or as targeted rate of return
- should impact of req'd capital be reflected (authors assume yes)
- Choice of Acctg Basis
- solvency earnings
- important to regulators and rating agencys
- solvency reserve and cap req drive shareholders investments
- stockholder earnings
- if co places heavy emphasis on stockholder earnings
- added difficulty so not as popular
- Reflecing Risk in Profit Goals
- profit goals related to risk (more risky, higher profit margin)
- possible ways to reflect risk
- formula that might reflect lapse/mort/exp/inv risks
- profit margin set to estimated degree of risk
- sensitivity analysis to estimate degree of risk and set profit margins
- examine product design adn origin of assumptinos used to id risks that req special treatment and possibley make design chagnes to minimize risk
- Choice of Discount Rates adn Rates of Return
- factors to consider when choosing discount rate
- company's cost of capital - weighted avg and marginal
- "opportunity cost" of capital - what could they earn if that money was elsewhere
- current capital position adn expected capital position over next few years - might be receptive to lower yield s/t opportunities
- how will discounting be used
- generally based on cost of capital or opportunity cost
- if discounting to give more weight to early years, pretax or after-tax yields on inv assets may be appropriate
- rate-of-return rate that discounts the stream of profits to zero
- it taxes are level % of pre-tax profits, pre-tax and after-tax rates of return are same
Present Value
- PVPrem = sum(Prem(t)*DiscFactor(t-1)) => t-1 b/c prems paid at BOY
- PV(var,n) = sum(var(t)*DiscFactor(t)) over n years
- if some PVFP < 0 [ i(t) - normal disc rate j(t) - discount rate when profits are neg - typically after-tax int rate earned on invested assets]
- PVFP(n) = Profit(n)
- for t = n to 1 step -1
- If PVFP(t) > 0 then
- PVFP(t-1) = PVFP(t)/(1+i(t)) + Profit(t-1)
- else
- PVFP(t-1) = PVFP(t)/(1+j(t)) + Profit(t-1)
- endif
- next
- PVFP(n) = PVFP(0)
- if n = 1, Profit(0) = 0
Profit Measures
- Overview
- Embedded Value Return on Investment (ROI) Weighted-avg return on equity (ROE)
- Profit as % of Prem/Assets/revenues/risk charges
- Accum Porift at % of reserves breakeven year new business strain
- most co use ROI or ROE along w/ profit as % of prem
- publicly traded stock cos tesnd to use embeddev value, ROI/ROE as one of their profit goals - each involves a targeted rate of return
- Embedded Value (aka value added)
- simplest measure - only one decision - hurdle rate
- hurdle rate - rate of return owners expect
- s/b in line w/ weighted avg cost of capital for stock co
- s/b consistent w/ return avail on investments of comparable risk
- normally base profits on after-tax solvency earnings or distr earnings
- distr earnings better reflect owners' expected cash flows
- EmbeddedValue(n) = PV(Profit,n)
- Return on Investmetn (ROI)
- solved for discount rate that causes PV Profits = 0
- normally base profits onafter-tax solvency earnings or dist earnings
- Dist earn preferrable - better reflects owners' expeced cash flows
- ROI can be primary or seconday profit goal
- ROI fails if all policy years are profitable
- posses in later years can olso produce meaningless ROI
- Simple ROI
- 0 = sum(Profit(t)/(1+i)^t and solving for i
- Multiple ROIs
- # positive roots of polynomial = # sign changes of Profit(t)
- Generalized ROI
- if muliple sign changes, use an int rate for borrowed money (j(t)) adn use iterative process to solve for i
- PVFP(t-1) = PVFP(t)/(1+[i(t) or j(t)]) + Profit(t-1)
- Weighted-Avg Return on Equity
- calculate a weighter avg return = (after-tax stockholder earnings) / weighted avg equity base
- can weight by discounting using ROI goal or hurdle rate
- can link to targeted growth rate
- WtdAvgROE(n) = PV(AfterTaxStockEarn,n) / PV(EquityBase,n)
- hopefully each policy year ROE approx = WtdAvgROE
- Profit as Percentage of Premium
- one of most common profit measures
- advantage: fairly concrete and easy to explain
- common to use pre-tax or after-tax int rate eaerned on assets for discounting
- using ROI or Hurdle rate, PVProfits approx = 0 therefore meaningless
- this logic applies to all measures that compare PVprofit to another measure
- Proft%Prem(n) = PVProfit(n) / PVPrem(n)
- Profits as Percentage of Revenue
- generalization of Profit%Prem
- useful mainly as way to compare relative profitablilty of similar product types
- NOT useful at comparing two diverse products
- not all products use premium as important soure of revenue (ex. UL -> inv income and charges)
- Profits as Percentage of Assets (aka Return on Assets or ROA)
- many product priced w/ targeted spread between rate earned and rate credited
- useful to know how much of spread (on avg) retained as profits
- numerator and denominator need ot be in sync
- after-tax solvency earnings <-> solvency reserves
- dist earn <-> solv reserves & req'd cap
- after tax stock earnings <-> solv resv & req'd cap & DAC
- ROA(n) = PVProfit(n) / PV(Assets,n)
- Profits as Percentage of Risk Charges
- Risk charges -attempt to quantify degree of risk inherent in product
- may consist of mortality, lapse and inv components
- simpler: risk charge as % or req'd capital (assuming req'd capital is accurate measurement of risk)
- no std approaches
- PVProfits(n) / PV(risk charges,n)
- attraction: compares profit to risk
- detraction: may be illusion since risk charges somewhat arbitrary
- difficult to explain concept to management
- Risk-Free Rates and Risk Charges
- investors want higher reterns for higher risks
- minimum rate of return for risk free investment
- goal to developing meaningful risk charges - profits net of risk charges earn risk-free rate
- w/ PV based on risk-free rate, PV(Profits) = PV(Risk Charges)
- use industry avg rates of return to establish appropriate level of risk charges
- ensures pricing roughtly in line w/ rest of mkt
- Accumulated Profit as Percentage of Reserves
- one of earliest profit goals - primarily mutuals
- goal - one generation of PO provides capital to fund next generation
- rarely used (currently) for new products
- sometimes used for setting div scales
- usually after tax solvency earnings and usually after-tax int rates
- AccumProfit(n) = sum(Profit(t)*AccumFactor(t))
- AccumProfitPct(n) = AccumProfit(n) / Res(n) where Res(n) is appropriate reserve
- Breakeven Year
- Policy year when accum profits first turn positive adn remain positive
- more of an indicator or danger signal than profit measure
- Modified Breakeven Year - assume all policies lapse at end of given year, releasing req'd capital and excess reserves inro profit calc
- first yer w/ accum profits (including releases) is modified BE year
- late BE year may be acceptable for mutual
- req'd as part of US Illustration Reg supportability test
- New Business Strain
- Not truly a profit measure
- often evaluated as part of pricing process
- often converted to % 1st yr prem
- coupled w/ prem projections, can easily estimate capital necessary to finance NB
- NBStrain = DistEarn(1) / Prem(1)
Sample Problems - text p
Life Insurance Products and Financing (Atkinson/Dallas) - Chapter 14 - FINANCIAL MODELING
Modeling of Liabilities
- Overview
- create financial model by combing results of numerous ages and risk classes
- multiply per-unit-issued results by wieghts for dist of business by age adn risk class and summarize the weighted results
- General Steps
- calc results on per-unit issued basis for a number of cells
- multiply each cell's per-unit-issued results by appropriate # units -> gross results/cell
- sum up gross results to calc total model results
- Uses of Liability Models
- heavily for product decisions - including feature design and price structure
- combined from several products -> entire product line
- decide to introduce new product/discontinue existing one
- assess value of block of business to be acquired/sold
- essential tools to decide to continue/sell/close down LOB or Co
- Types of Liab Models - purpose of model will determine scope/size/complexity
- Pricing Models
- prelim models typically few representative IA/sex/risk/pol size cells w/ highest expected sales
- final models include complete range of representative ages
- often use refined models for bulk of pricing and simplified methods to handle rest
- usually necessary to develop rates for all rep IA for both genders for at least some subset of cells
- allows you to cross-subsidize results between pricing cells
- higher profits from most cells may support lower profits at one or two key cells
- New Business Models
- for planning and budgeting purposes
- project amt and fin impact of NB
- more useful - model that reflects effect of exp NB from all major products
- usually sufficient to model results of co's best sellers and gross up
- InForce Models
- uses
- combined with NB models for planning/budgeting
- calc value of block to be sold/acquired
- determine adequacy of reserves
- test reasonableness/equity of revised div scale/COI rates/int crediting strategy
- project future liab CF to maatch asset CF
- similar products usually grouped together
- law of diminishing returns - additional accuracy gained not worth time it takes to model the next product
- maybe vary issue ages modeled - fewer for smaller products
- Building Data for Liab Model
- type type of data input: aggregate and cell data
- aggregate data
- few assumptions, assumption multipliers and other parameters
- easily changable
- cell data
- mainly product parameters and assumptions
- assumptions in cell data include mort rates/lapse rates/expense rates/avg size/# units
- many assumptions from pricing assumptions or recent experience studies
- avg size/# units usually from inforce data
- many cos use purchased modeling software
- extract used to input to liab model - normally cnotains plancode/issuedate/IA (or DOB)/sex/risk class/units/SAPVx/TaxVx/AcctVal(ul)/Amt Reins
- Liability Model Calculations
- want model to reasonably approximate fin statement results, therefore cal yr results
- may need quarterly projects for plan/budget
- book assumes 1/1 issue date to ease calendar year reporting
- can group data so 1/1 is avg issue date
- Model Variables
- calyr = issyr + t - 1 where t is policy year
- issyr = calyr - t + 1
- t = calyr - issyr + 1
- Number of Units
- reflects distribution of business among cells
- NumUnits(c) - # units for cell c (# issued)
- NumUnitsIF(c) - # units inforce @ start of model for cell c
- NumUnits(c) = NumUnitsIF(c) / SurvFactor(c,begyr-1)
- if SurvFactor(c,begyr-1) = 1, above adjustment not necessary
- Total Results
- variable_tot(calyr) = sum(variable(c,calyr)*NumUnits(c))
- Cell and Total Calculations
- cash flows, reserves, reins calced @ cell level
- ii, taxes, req'd cap, profit measure could be calced @ cell or total level
- calcing @ cell level
- probably slower
- makes summarization simpler adn more flexible
- calcing @ total level
- more contol over final results
- Quickly adjust total only parameters adn recalc results
- Validating a Liability Model
- essential to validate prior to use
- NB or Pricing - compare ratios/patterns over time
- Inforce Model - reproduce starting inforce #s
- static validation - reproducing actual values @ given point in time
- ways to improve model
- changing representative issue ages
- adjusting avg issue date
- splitting into more issue periods
- after initial inforce validated - reasonability of model going forward
- test model using inforce from year-1 and compare to actual results
- validating over a period of time - dynamic validation
- instead of tuning assumptions, sometimes just make adjustments @ total level
- Liability Model Output
- commonly rows for each result and coulms for time periods
- s/b organized into familiar and useful formats, such as I/S or B/s
- other common outputs include
- product cash flows - useful for planning inv strategies
- inventory reports - ins inforce, # pols inforce
- AmtInfIF(c,calyr) = DB_pu(c,calyr)*NumUnits(c)*SurvFactor(c,calyr) (_pu is per unit)
- NumPol(c) = NumUnits(c) / AvgSize(c) where AvgSize(c) = avg # units / policy issued
- NumPolIF(c) = NumPol(c)*SurvFactor(c,calyr)
- AmtInsLapsed(c,calyr) = DB_pu(c,calyr)*Lapses(c,calyr)
- Annualqw(calyr) = AmtInsLapsed_tot(calyr) / AmtInsIF_tot(calyr - 1) -> annualized lapse rate
- Total Profit Measures
- w/inforce data included, can onlyl calc meaningful results for ROI, ROE, adn EV
- EV can be calced sep for inforce and each future issue year
- Aggregate Models
- over short-term - relatively simple aggregate models commonly outperform elaborate cell-based models
- focus on growth rates adn trends of ratios
- ex. Income Stmt items as % of prem - probably see stable relationships and clear trends
- some kinds of business better predicted as % of assests or some other base
- no std approaches to aggregate models
- aaggregate models are poor predictor if co makes significant changes
- best models combine s/t fit of simple aggregate models w/ long term predictive capability of cell-based models
- once it is understood how to adjust s/t results to better match aggregate results, same techniques can be used to adjust l/t results
Asset/Liab Modeling
- Purpose of A/L Modeling
- design investmetn strategy that fits product/liab portfolio
- more accurately predict inv income
- determine potential effect of diff int rate scenarios
- test strategies used to set credited rates
- asset modeling is driven by inv strategy, but informed inv strategy can only be develped once cash flows have been estimated
- Designing an Investment Strategy
- most non term products depend heavily on investment returns
- Predicting Investment Income more Accurately
- calc investment income from an asset model tied to liab cash flows
- already know a lot about own portfolio - use this knowledge to predict future ii
- ii from asset model has two parts
- income from existing assets
- income from future assets
- Testing the Effect of Interest Rate Scenarios
- can predict how cash flows change to various int rate scenarios
- modeling assets allows testing of investmetn strategies
- rise in int rates can cause losses for a company
- if co subsidized the credited rate to stay competitive, reduces profit but keeps business
- if rate not competitive, PO surrender, minimal SC, large outflow when L/T assets have depress mkt value
- testing of int rate scenarios can have several positive effects
- makes co more aware of significant risks it is taking
- may change inv strategies to reduce exposure to certain risks
- may change the products offered to reduce exposre ot certain risks
- may limit total amt of certain kinds of business it will accept to limit aggregate risk
- may increase certain kinds of business to better balance and diversify its risks
- some type and levels of risk acceptable
- Developing Int Crediting Strategies
- mostly some capability to test int rate scenarios needed to develop and test int crediting strategies
- need to estimate how competitor's credited rates, our credited rates and prodcut CF will vary w/ diff int rate scenarios
- Introduction to Asset Modeling
- asset model used to project CF, mkt values, book values and otherh items for portfolio of assets
- assuming that asset portfolio being modeled is tied to specific liab portfolio
- assumptions
- bonds can be purchased at time in reality
- all bonds purchased at end of quarter, immediately after coupon payment made
- all coupon and maturity payments at end of quarter
- BookValue(b,cyq) = Price(b) - when bond purchased @ cyq (calyr qtr)
- BookValue(b,cyq) = BookValue(b,cyq - 1)*(1+Qtryield(b)) - GrossCashFlow(b,cyq)
- Gross Cash Flow includes coupons and par @ maturity
- Book Values can also be calced as PV(future gross cash flows) @ yield rate
- from book value, can calc net cash flows (CumCashFlow)
- CumCashFlow(b,cyq) = GrossCashFlow(b,cyq)-[DefaultRate(b) + InvExpRate(b)]*BookValue(b,cyq-1)/4 (/4 since quarterly cf)
- InvIncome = NetCF + delta BookValue
- InvIncome(b,cyq) = CumCashFlow(b,cyq) + BookValue(b,cyq) - BookValue(b,cyq-1)
- Assembling Data for an Asset Model
- Items needed (in addition to liability items)
- prelim asset strategy
- inventory of assets available for purchase
- inventory of assets currently backing liab (for inforce block)
- assumptions that describe future int rate patterns
- strategy for dealing w/ negative CF
- Preliminary Inv Strategy
- need to narrow the universe of assets to consider for model
- attributes of assets to consider (acceptable classes, quality, dur, maturity)
- used to guide model to types and mix of assets to purchase from future positive CF
- s/b joint effort between co's inv mgr and those responsible for liab
- characteristics will depend on
- co's general inv philosophy
- A/L already on books
- regulatory restrictions
- Assets Available for Purchase
- inventory of assets avail for purchase is needed
- s/b consistent w/ prelim inv strategy
- select a relatively small # of representative assets
- "model assets" that reflect mix of quality ratings and assoc yields
- do NOT mix assets w/ diff maturities - mat date greatly affects CF pattern
- Assets Currently backing Liabs
- Inventory of existing assests hould include all infor needed to project future asset CF, book values and mkt values
- Future Int Rate Patterns
- Assuming future int rates modeled one set at a time
- Handling Netative Cash Flows
- Two common strategies
- borrow money
- typically from other porduct lines w/in same co
- need assumption as to int rate charged when borrowing is necessary
- rate for external borrowing should reflect co's credit quality
- borrowed funds to be repaoid at earliest opportunity from pos CF
- S/T rates appropriate
- selling assets
- model must calc MV adn needs rules for which to sell first, such as
- assets w/ largest cap gains first
- assets w/ shortest time to mat first
- assets held for at least 1 year first
- Asset Adequacy or Free Cash Flows
- Asset Adequacy
- performed on block of inforce to test adequacy of assets allocated to block
- projection of both a/l under various int rate scenarios
- total assets > total liab, assets adequate for scenario
- if insufficient under many scenarios, actuary can require more assets allocated to back block
- can be performed w/ beginning assets < or > beg reserves
- Free Cash Flow
- assets rebalances @ end of each period to match solvency reserves + req'd capital
- free cash flow - fee to be uses as co chooses OR
- req'd to be contributied to support business
- Asset Modeling Process under Free Cash Flow Methodology
- focus on meling assets of policy year basis
- for model, assum CF only at BOY, middle, EOY and rebalancing only @EOY
- at BOY and Mid-year
- cum CF is determined
- if cum CF > (<) 0, int rec (paid) next CF date = 1/2 years int on this cum CF
- Beginning of Year
- AssetsReq(t-1) = SolvRes(t-1) + ReqCap(t-1)
- CumCashFlowBeg(t) = AssetCashFlowBeg(t) + LiabCashFlowBeg(t)
- if CumCashFlowBeg(t) < 0
- IntReceivedMid(t) = 0
- IntPaidMid(t) = CumCashFlowBeg(t)*IntPaidRate(t)
- if CumCashFlowBeg(t) > 0
- IntReceivedMid(t) = CumCashFlowBeg(t)*IntReceivedRate(t)
- IntPaidMid(t) = 0
- Middle of Year
- CumCashFlowMid(t) = CumCashFlowBeg(t) + AssetCashFlowMid(t) + LiabCashFlowMid(t) + IntReceivedMid(t) - IntPaidMid(t)
- IntPaid[Rec'd]End(t) = CumCashFlowMid(t)*IntPaid[Rec'd]Rate(t) (and other is 0)
- End of Year
- CumCashFlowEnd(t) = CumCashFlowMid(t) + AssetCashFlowEnd(t) + LiabCashFlowEnd(t) + IntReceivedEnd(t) - IntPaidEnd(t)
- AssetsEnd(t) = AssetsReq(t-1) + InvIncome(t) - AssetCashFlow(t)
- Free Cash Flow
- AssetsReq(t) = SolvRes(t) + ReqCap(t)
- AssetsEnd(t) + CumCashFlowEnd(t) - FreeCashFlow(t) = AssetsReq(t)
- FreeCashFlow(t) = SolvRest(t-1) + ReqCap(t-1) - [SolvRes(t) + ReqCap(t)] + CumCashFlowEnd(t) + InvIncome(t) - AssetCashFlow(t)
- = CumCashFlow(t) + InvIncome(t) - AssetCashFlow(t) - SolvResIncr(t) - ReqCapIncr(t)
- Free Cash Flow and Dist Earnings
- FreeCashFlow(t) = LiabCashFlow(t) + InvIncome(t) + IntReceived(t) - IntPaid(t) - SolvResIncr(t) - ReqCapIncr(t)
- new formula for dist earnings
- Validation of Asset Model
- compare avg int rates for each period w/ assumed yield on ne and existing assets
- compare asset purcahses w/ resulting asset net CF taht follow
- amts not expected to match exactly, s/b saem range
- par value, book value and avg yield @ beg of model should match inforce portfolio
- Asset Model Output
- liab cash flows
- assets purchased
- asset cash flows
- loans to fund cash shortfalls & repayment of prin and int
- inv income
- book value of assets
- mkt value of assets
- avg yeild on new assets purchased
- avg yield on entire asset portfolio
- avg dur of new assets purchased
- avg dur of entire asset portfolio
Asset/Liability Matching
- Overview
- immunization - matching of assets and liabs
- reduced financial effect of changes inint rates
- assuming liab CF not affected by int rate changes
- Exact Matching
- begin by matching final liab CF and working backwards to curretn time
- cant to exact matching for very L/T (> 30 yr) liabs
- Practical Problems w/ exact matching
- future pos cash flows need ot purchase assets. Cant purchase future assets until then
- need to factor future asset purchases into matching plans
- if significant disintermediation risk, migh need to match shortest dur first
- asset defaults or calls, matching is out of balance. more assets need to be purchased
- if liab CF deviates significant from expectd, portfolio needs rebalancing
- Exact matching case study - pp 756-759
- Duration Matching
- exact matching is not usually practical
- duration matching mor common
- secondary use: excellent predictor of effect of small int rate changes
- if both A/L durations matche, small change in int rates should have equal effect on A & L
- company will have to rebalcnae occassionally to maintain matching of A/L
- Macauly Duration
- duration - a measure of average time of a series of CF
- Macauly dur - weighted avg w/ PV(CF) used as weights
- MacDuration(i) = sum(t*v^t*CashFlow(t)) / sum(v^t*CashFlow(t))
- MacDur of a single cash flow is that cash flow's time
- MacCur of multiple CF is wtg avg time of the CF
- when matching A/L dur, both need to use same int rate stream - usually current rate
- Modified Duration
- used to estimate the effect of a small change in int rates on PV of CF
- useful for predicting changes in PV due to int rate changes
- mod dur is what most people mean when they say "duration"
- PVCashFlow(i) = sum(v^t*CashFlow(t))
- ModDuration(i) = d(PVCashFlow(i))/di / PVCashFLow(i)
- = sum(t*v^(t+1)*CashFlow(t)) / sum(v^t*cashFlow(t))
- = v*MacDuration(i)
- %change in PVCashFlow(i) = -ModDuration(i)*delta(i)
- w/ duration matching - not exact matching of CFs
- dur matching implicitly assumes mismatches can be offest by investing/borrowing @ int rate used for dur calc
- possible to match dur and have terrible mismatch of CF
- Convexity
- 2nd order deriviative of PVCashFLow(i) (modDur is 1st order)
- Convexity(i) = sum(t*(t+1)*v^(t+2)*CashFlow(t)) / sum(v^t*CashFlow(t))
- Mod Dur and convexity combined - more accurately calc effect of change in i on PVCashFLow(i)
- % change in PVCashFlow(i) = -ModDuration(i)*delta(i) + 1/2*Convexity(i)*delta(i)^2
- cannot expect 2 term formula to reproduce complexity of n cash flows
- when matching using convexity
- calc dur and convexity for liab CF
- create 2 asset portfolios w/ same dur
- blend to get convexity to match liab convexity
- Horizon Matching
- exact matching used first few years (5-10) adn remaing CF matched using dur matching
- as time progressed, rebalcned w/ migration of some CF to exact matching group
- Summary of A/L Matching
- requires collaboration between actuaries (liab experts) adn investmetn dept (asset experts)
- year-by-year CF can be significantly mismatched
- if disintermediation is most significant risk - asset dur s/b < laib dur
- if reinvestment risk is most significant risk - asset dur s/b > liab dur
-
- discussions ingored fact that most liab CF ARE affected by int rate changes
- policyowner optionality - PO elecing options that affect CF
- partial w/d, pol loans, surrenders
Exercises - beginning p 772
Life Insurance Products and Financing (Atkinson/Dallas) - Chapter 15 - STOCHASTIC MODELING
Introduction
- chapter focus on practical applications of mathematical and statistical techniques
- best estimate assumptions can usually be established w/ fair degree of confidence
- int rate is hard to predict w/ confidence
- strategies to reduce effect of int rate unpredictability
- conservative assumptions for i
- offer products that adjust benefits when int rates change
- match asset & liab cash flows
- stochastic modeling produces distribution of likely results
- allows answers to questions such as "what is prob of ROI < 7%" or "avg roi for worst 10% of scenarios"
Overview of Stochastic Modeling
- Uses of Stochastic modeling
- single product, portfolio of products, or entire company
- increasingly used for both pricing and ongoing mgmt of A/L
- can be applied to any variable/assumption - most commonly int rate/inv returns
- Steps Involved in Stochastic Modeling
- select a distribution function
- choose a random number generator
- stochastically generate sets of variables
- calc results for each set of rates
- liab or prodcut related results
- asset-related results
- Select a Distribution Function
- should generate values that best fit the range/freq/deviation of possible outcomes
- shoudl reproduce expected mean and variance
- mortality - typically a binomial dist function
- int - often normal or lognormal dist to reflect the change in int rate
- should test to see how well it fits w/ experience over a number of years
- parameters adjusted to improve fit
- Choose a Random Number Generator
- used in conjunction w/ dist function to generate random values
- Stochastically Generate Sets of Variables
- random number generator applied to dist function to create many sets of variable being modeled
- one set of rates is however many rates are needed to run the model once
- ex. mortality, sep rates for each cell in each period of the model
- ex. int rates - sep yield rates for each type of asset avail for purch in each future time period (in practice - only key assets & rest are determined via reference to key rates
- Calcualte Results for Eaach Set of Int Rates
- A/L Calcs perfomred as of deterministic model (w/ currently generated sets of rates)
- make sure affected variables adjusted
- ex. int rate assumptions can/will affect
- credit rate and acct values for dynamic products
- divs for par products
- lapse rates
- sales levels
- premium levels
- asset mkt values
- asset calls and prepayments
- some models will adjust for these automatically
Random Variables
- developed by combine dist function w/ random number generator
- general steps
- develop cdf F(x) that reflects distribution
- calc random number S ~ U(0,1)
- calc x for each S F(x) = S (if continuous) F(x-1) < S <= F(x) (if discrete)
- Binomial Distribution
- X(n) -> sum of n trials where P(x=1) = p
- mean (mu) = np variance (sigma squared) = npq std dev (sd or sigma) = (npq)^0.5
- Normal Distribution
- for sufficiently large values of n (book suggests minimum value of n = 30)
- Z(n) = (X(n) - 0.5n) / 0.5*(n)^0.5 ~ N(0,1)
- ex. generate 30 random values to calc X(30)
- so if you need 2000 values, need 2000 * 30 = 60000 random numbers
- then determine dist function f(x) (prob X(n) = x) ^ CDF F(x) (prob X >= x)
- otherwise can be used to generate values of Z
Stochastic Mortality
- mortality fluctuations can be quite significant
- stochastic mort models can help to understand likely variability of mort results and design products or programs (such as reins) to stabilize results
- models presume all lives independent
- not quite true, but good enough
- multiple policies on same insured
- disaster can simultaneously kill many insureds that work/travel together
- common accidents on family members
- lonely heart syndrome
- Seriatim Stochastic Modeling
- simplest approach is model 1 policy at a time
- perform for each policy each period
- qd and qw for that policy that period
- S ~ U(0,1)
- is S <= qd policy is marked as dead (set qd = 1)
- if not dead, S ~ U(0,1)
- if S <= qw policy is lapsed (set qw = 1)
- once policy terminated, s/b removed from inforce for future periods
- essentially, each policy is its own cell
- Alternate to Stochastic Modeling
- volatility of largest policies modeled using seriatim apporach
- volatility of remaing policies modeled as follows
- deterministic model to determine expected deaths each period
- calc avg expected mort rate (q(t) for each period
- total variance for each period approx = (#pols)*(q(t)*(1 - q(t))*(avgDB)^2
- assumes identical policies
- better estimate - calc variance for each cell and sum variance
- best estimate - calc variance for each cell and sum results
- law of large numbers - mean and variance above and normal dist allown prediction of distribution of DC
- Binomial Stochastic Modeling
- best fits a group of independend lives w/ same mort & DV
- often the case for a single cell
- useful wehn seriatim approach not feasible
- Applying the Binomial Distribution
- allows use of 1 random number to determine outcome for n policies at once
- how-to for 1 cell in 1 period:
- determine assumed qd and qw and # policies in force (no) (# pols will decrease from period to period)
- using Bin Dist, create CDF F(x) for # deaths (x) in peroid based on n pols in force
- S ~ U(0,1)
- if F(x-1) < s <= F(x) then x is # deaths and qd = x/n
- using Bin Dist, create CDF F(x) for # lapses (y) in period based on n - x pols in force
- S ~ U(0,1)
- if F(y-1) < s <= F(y) then y is # lapses and qw = y / (n-x)
- # pol inforce beg next period is n-x-y
- Calculating teh Binomial Dist Function
- apply bin dist to cell n w/ prob death = q
- f(x) = nCx*q^x*(1-q)^(n-x) where nCx = n! / ((n-x)!*x!)
- nCx can be gotten from Pascal's triangle
- fratio(x) = f(x) / f(x-1)
- fratio(x)
- f(x) can be calculated directly (see above) but more efficient to calc iteratively
- f(x) = f(x-1) * fratio(x) where f(0) = (1-q)^n
- fratio(x) = q/(1-q) * (n-x+1)/x
- Cumulative Dist Function F(x)
- F(s) = sum(f(x)) from 0 to s
Stochastic Interst Rates
- Overview
- more scenarios created, more credibel the results
- # scenarios limited by speed of software/hardware
- time for additional scenarios vs value of additional information
- stochastic modeling of int rates best performed in aggregate
- complexities include
- must product yield rates for all possible future asset purchases, not just one rate for each future period
- int rates driven by world events which can have long term effects on rates
- can randomly generated rates adequately reflect this?
- int rates also driven by supply/demand
- to handle great variety of yields available on different investments, yields assumed to be some of two pieces
- gov't yield rate from same maturity of an asset
- spread over that yield rate (in BPS)
- int'l standard for comparing s/t rates - LIBOR
- In US, spread usually vs Treasuries
- Assuming spread is fixed and unchanging for each type of asset
- Yield Curves
- shows yield rates on one axis and time to maturity on other axis
- normally slope upwards w/ increasing time to maturity (normal yield curve)
- inverted yield curve - yield curves that slope downward w/ increasing time to maturity
- in practice, yield curves defined by one S/T and one L/T rate (90 day and 10 yr) and other rates determined from these
- interpolated rate = (1-Factor)*[90 day rate] + factor*[10 year rate]
- sample factors
- 90 180 1yr 2yr 3yr 5yr 7yr 10yr 20yr 30yr
- 0 .1694 .3600 .5671 .6706 .7647 .9059 1.0000 1.0784 1.1176
- Interest Rate Scenarios
- int rate scenario consists of one yield curve for each future period in model
- int rates from one period to the next are highly correlated so we can't jut generate two random int rates
- 90 day adn 10yr rate are correlated - often fall and rise in unison or partial unison
- three approaches to handling (among many)
- arbitrary method
- probablistic method
- successive ratios method
- Arbitrary Method
- not a stochastic model
- involves manually creating a set of int rate scenarios in an arbitrary fashion
- different scenarios may test effect of gradual or sudden incr/dec in int rate
- of limited value - rarely sufficient # to be credible
- arbitrary input -> arbitrary output
- ex. NY 7
- Probablistic Approach
- assume every curve defined by level (10 yr rate) and slope (90 day/10yr)
- using historic info, develop prob of each level changing to any other level during next period
- probabilities arranged into grid
- in example grid
- sum(prob) = 1.0 for each row
- min i = 2% and max i = 15%
- rates equally likely to move up or down near middle of grid
- near edges, more likely to move away from edge
- similar grid showing probability of each slope changing to any other slope
- randomly determine change in level and slope, still end up w/ 10yr and 90day rates that are related
- develop CDF F(x) for each level and slope
- can combine F(x) for current level and rand number to stochastically generate teh level for the next period's yield curve
- can combine F(x) for current slope and another rand numberto generate slope for next period's yield curve
- Jetton - single grid w/ yield curves and probabilities of moving from one curve to the next - only need 1 rand #
- Successive Ratios Approach
- assume ln of rato of successive int rates is normally distributed
- don't want to apply to both 10yr adn 90 day since would end up w/ 2 ind rates
- use one RV w/ successive ratios approacht to generate next 10 yr rate
- combo of RV_10 adn RV_90 to generate 90 day
- RV_10*weight_10 + RV_90*weight_90 = 90 day rate
- weights reflect degree of correlation between 10 and 90 day
- alternate approach uses volatility factor (VolFactor)
- Z1,Z2 - 2 sep RV ~ N(0,1)
- Correlation - degree of correlation between changes in i90day(t) and i10yr(t)
- Z10yr - RV used to generate changes in i10yr(t) (reflects some correlation w/ i90day(t))
- i90day(t+1) = i90day(t)e^(Z1-VolFactor)
- Z10year = Z1*Correlation + Z2*(1-Correlation^2)^0.5
- i10yr(t+1) = i10yr(t)*e^(Z10yr-VolFactor)
- Advantages (compared to probablistic method)
- not limited to predetermined # of int rates or yield curves
- not necessary to research adn create large tables of probabilities
- only need volatility factor and correlation factor
- Disadvantages (can be corrected w/ adjustments)
- no min/max int rate
- no corridor...if you feel int rates will gravitate toward certain level
- tends to product more inverted yield curves than you'd normally expect
- Might need to bias formula towards normal curves
- differnece between 90day and 10yr can grow to unrealistic extremes
Effect on Liabilities
- overview
- Int Scenarios ->Int Rates->Product Cash Flows->Asset Cash Flows
- four rates determined beginning of each period
- avg rate earned on exiting assets - prior period inv income / prior period avg assets
- int rates avail on new investments - scenario yield curve
- int rates avail on competing products - aka Mkt Rates
- int rates creditd to company's products being modeled - credited rate
- Modeling Interest rates
- mkt rate - rate avail from financial alternatives
- if co is crediting rates in line w/ mkt rates
- surrenders, w/d s/b normal
- if co is crediting > mkt rates - improved persistency
- if co is crediting < mkt rates - worse persistency
- if big difference, could see large cash outflows
- partial w/d adn loans also affected by mkt rates (vs credited rates)
- term generally immune to int
- however prolonged inflation can erode value leading to lapses
- possibly reflect non-ins product int rates
- money mkt fund, 5yr bank CDs 10 yr govt bonds
- new money vs portfolio rate
- relevant mkt rate might be max(new money, portfolio)
- probably approximated fairly well as constant spread from gov't yeild rate
- Modeling Credit Int Rates
- function of 4 int rates
- portfolio rate (avg net int rate earned on products backing portfolio)
- new money rate (avg net int rate on new investments)
- guaranteed int rate (for product)
- mkt rate
- int guarantees & mkt rate act as constraints on what co can credit
- if segmentation method
- new deposits get new money rate
- existing deposits - net int earned on assets backing segment
- if portfolio method - earned rate => portfolio rate (w/ some adjustment for new funds @ new money rate)
- a product can have one or more guarantees
- long-term guaranteed rate
- short term current int rate guarantee
- bailout rate
- credited rate can't be less that LT or ST guarantees
- can be < bailout rate if willing to waive SC
- most co's have targeted spread they wish to earn
- credited rate = earned rate - targeted spread
- some cos have strategy of largest spread mkt will allow, subject to a max spread while maintaining a credited rate subject ot a min spread
- most cos - credited rate w/in certain range of mkt rates
- sample formula
- Max Possible Spread (MPS) = earned rate - 90% mkt rate
- credited rate = 90% mkt
- if MPS > 2%, credited rate = earned rate - 2%
- if credit rate > 110% of mkt rate, credited rate = 110% mkt rate
- if mps < 1%, credited rate = earned rate - 1%
- credited rate formula could reflect SC
- existence of SC allows co to credit slightly lower rate than if no SC
- Modeling the Effect on Lapses
- Life Ins products sole as investement vehicles generally have lapses quite sensitive to diff between mkt adn credit rates
- especailly sensitive if product has explicit credited rate
- study industry and company experience to develop formulas to help predict changes in lapse based on diff between mkt and credited rates
- formula should produce no additional lapses when spread is small
- change large and positive - lapse rates should increase
- change large and negative - lapse rates should improve
- sample lapse formulas
- qw(t) = qwBasic(t)(1+0.5*(100-difference)^2) - SC% min(0.01), max(0.50)
- qw(t) = qwbasic + 1.25*difference*3.25^|100*difference| - SC%, min(0.01), max(0.60)
- in general, a formula should cause lapses to fall below the base rate if credited rate exceeds mkt rate
- lapses should increase/decrease exponentially as the spread widens
- existence of SC should lower the lapse rate
- Modeling other Product Cash Flows
- credited rates affect dynamic CV and reserves
- div int rate affects amt divs paid and amt applied to div options
- partial w/d and prem persistency affected by spread for flex prem products
- pol loan utilization increases as mkt rates increase (esp if fixed LIR)
- expenses might inflate faster than expected
- could model inflation = mkt rate - constant
- anti-selection as unhealthy lives persist while healthy one lapse for more competitive products
Effects on Assets
- Steps applied to assets each period
- asset cash flows are determined, reflecting effect of current yield curve
- net CF determined = asset CF + product CF - dist earnings
- if net CF > 0, new assets purchased based on inv strategy
- if net CF < 0, model rules dictate sell assets or borrow cash
- book and mkt values determined for all assets @ EOP
- inv income, cap g/l determined for period
- Major Asset Classes
- questions for each asset adn how it relates to an ins company
- what are typical cash flows
- what are unusual cash flows and when can you expect them (what triggers them)
- does borrower have any rights to alter CF (by delaying or accelerating payments)
- does co have any rights to alter cash flow (puts)
- what expenses will co incur for mgmt/accting of each asset
- what % of investmetn will be lost to defaults/devaluation
- how liquid is the asset
- Gov't Securities
- diff between purchase price adn par is discount/premium
- if purchased @ discount, bond's yield > coupon rate
- if purchased @ premium, bond's yield < coupon rate
- amount of discont/premium amortized to 0 over life of bond in a fashion that results in a constant yield to maturity
- gov't bonds generally not callable
- assumed default rate often 0%
- usually lowest yielding asset
- expenses s/b consisten w/ corp bonds
- very liquid (most) - active mkt allows efficient trading
- Corp Bonds
- can have call adn put options
- call - borrow can repay early
- put - co can ask for early redemption
- usually issue non-callable when rates low
- call premium
- penalty on borrow for early repayment
- diff between call price and mat value
- helps reimburse bondholder for lost int
- call price that decreases over time ex 104%, 103, 102, 101, 100
- private bonds have more substantial call premium
- typically PV of all remaing int & prin payments calced using spread over yield rate on govt securities
- model needs to make assumption as to when bond will be called
- futher away from original yield, greater prob. @ 1%-2% change, most bonds usually called
- puts less common
- allows borrow to repay @ less than full maturity value
- put option valuable for matching A/L
- ins co can liquidate assest @ favorable prices when rates high and reinvest @ higher rates or fund outflows
- most bonds in public mktplace
- u/w and sale managed by one or more investment banking groups
- privates negotiate and issued directly between borrower and lender
- Inc Co's like privates b/c investment banker fees saved
- privates shoudl have slightly higher yield b/c no inv banker fees
- privates often have sinking fund provision
- sinking fund provision clearly affects CFT timing
- cost to borrower for call option, therefore then to have higher rate
- put options tend to have lower rate
- public bonds more liquid that privates (day vs week w/ higher trading costs on private)
- diff in liquidity another reason why privates should have higher rate
- bond have different levels of seniority. Higher seniority, less default risk, lower rate
- BBB or higher - inv grade - majority of what ins cos purchase
- public less expensive to manage in portfolio b/c info more readily available
- High Yield Bonds (Junk)
- rated lower than BBB
- higher probability of default (5-10%) therefore higher yields to compensate for higher risk
- historically higher yield has more than compensated for higher defaults
- call option on high yield should have lower chance of being exercised
- like mortality anti-selection
- Commercial Mortgage
- large loans on commercial real estate (retail/office buildings)
- normally prin & int over 20 years, due @ 10 (10 year ballon)
- borrow usually pays origination fees
- usually contain prepayment provision
- prepayment penalties usually modest
- default risk usually highly correlated by geographic area
- not as risky as junk, but don't want too high a concentration
- fairly illiquid w/ no active mkt
- can usually sell a group of comm mort in about a month
- high asset monitoring costs
- Residential Mortgages
- loans on residential real estate - typically 50-80% of mkt value of real estate
- monthly payments of int and prin
- most 15 adn 30 year
- fixed of variable int rates
- mortgage may be purchased at either premium or discount
- amortized over life of mortgage, altering yield somewhat
- can be prepaid, usually w/o penalty
- if penalty exists, only first couple years
- level of prepayments based on multiple factors
- as int rates drop, more refinancing
- default risk
- usually related to unemployment, dis, death
- increases during recession (like junk and comm mortgages)
- fairly illiquid w/ no active market
- Collateralized Mortgage Obligations (CMOs)
- mortgage specialists assemble pools of thousands of indiv mortgages, then sell slices to investors
- securitization - creation of a new financial security that is backed by underlying cash flows
- by purchasing a slice of thousands of geographicly diverserve mortgages, buy can diversify risk
- tranche - slice of CMO
- payment and interest of each tranche varys depending on underlying cash flow
- each int paymetn dependent on underlying morgage prin outstanding
- each tranche receives its principle (subject to default) but amt of int rec'd depends on prepayment speed
- shorter tranches generally receive most of principle repayments first
- modeling is difficult b/c sensitivity of prepayments to change in i
- PAC (planned amortization class) - specialty tranche developed to address stability issues for investors
- PAC investure assured of getting fixed, pre-scheduled payments over speciifed period over a wide range of prepayment scenarios
- more volatile tranches created to absorb flucuations
- PAC has lower yield therefore other tranches can have higher yield for higher uncertainty
- many CMOs backed by gov't securities therefore no defaults and AAA rating
- CMOs actively traded and liquid (some volatile tranches may be difficult to sell)
- considered investment grade
- Asset-Backed Securities (ABS)
- consumer/corp debt - ex. credit card balances, auto loans, home equity loans, bank loans, commercial mortgages
- similar to CMOs
- some unique regulatory/acctg issues make these not as popular w/ ins cos
- CBO - collateralized bond obligation - corp bonds
- Real Estate
- most produce rental income - modest and uncertain compared to bonds and mortgages
- cash outflows req'd to maintain property
- largest cash flow is from sale of property
- sizable portion of return from apprectiate in property value
- perhaps most illiquid asset
- poor match for most ins liab (modest/variable CF)
- makes sense when matched against very long-term liab or portion of co's capital
- Common Stock
- trend toward smaller divs (as % of stock price)
- rarely purchased for ongoing cash flows
- appreciation in price is main attraction
- prices highly variable
- very liquid - related to # shares outstanding (more shares, more liquid)
- historically 9-11% total return over 20-year periods
- poor match for most liab (low CF, volatility in price, acctg treatment)
- makes sense when matched against very long-term liab or portion of co's capital
- liquidity could be welcome addition
- Preferred Stock
- similar to bond w/ no maturity date
- junior to all bonds
- some have options to convert to common stock
- potentially valuable is stock price increases
- tax treatment of Pref Stock divs different from bond int
- fairly liquid, but ont as liquid as CS or bonds
- prices behave much like prices for 30+ year bonds
- if yield/quality acceptable, non-callable PS could make excellent match for longest LT liab, esp > longest bond mat avail
- Policy Loans
- if fixed int rate, utilization increases when PO can earn higher rate elsewhere
- some co's reduce credited rate on portion of value loaned
- par products make adjustments for loaned policies as well
- if variable rate, utilization will be more stable
- an increase in int rates can cause
- increase in surrenders (which repays policy loans)
- increase in policy loan activity
- Summary of Asset Cash Flows
- Positive Asset cash flows
- sales of any asset type
- bonds
- coupon payments
- calls (mat val + call prem)
- puts (mat val - put discount)
- sinkng fund payments
- maturity payments
- mort/cmo/abs
- regular payments of prin & int
- prepayments of prin and any prepayment penalties
- maturity payments
- real estate rental income
- CS & PS dividends
- policy loans
- int payments
- prin repayments
- Negative Asset cash flows
- investment expenses for all types, incl real estate maint
- improvements to real estate
- nwe/add'l policy loans
- asset defaults
- Stochastic Modeling of Asset Cash Flows
- overview
- extrememly difficult undertaking
- basic groupings
- sales of assets
- prescheduled CF
- premature CF
- asset defaults
- prescheduled can be easily reflected once others addressed
- Sales of Assets
- many models assume assets held until they mature/prematurely repaind
- often @ odds w/ actual mgmt sime portfolios often actively managed
- best to reflect reality
- if activley managed portfolio, strategy s/b discussed & reflected in model
- Premature CF
- bond calls driven almost entirely by int rates
- to model bond calls, build grid of bond call rates that vary by change in i and bond quality rating
- bond puts
- controlled by insurer
- establish some parameters for exercising puts
- ex. if put price >10% above mkt value or neg CF & put price > mkt value
- extra sinking fund payments - modeled similarly to calls
- mortgage prepayments - similar to calls
- residential mortgages - add'l level of prepayments unrelated to delta i (relocations, bigger homes, etc)
- CMO/ABS prepayments - brute force approach - model all tranches to figure out what your trache will do
- recommended alt - table of prepayment rates that vary w/ delta i
- Default Assumptions
- CF interrupted on first default
- many times, assets in default are rehabbed and missed payments made up
- other times, asset sold @ reduced price
- reduction in price & missed payments is true cost of default
- simplest approach is treat defaults as perm loss of % of asset
- ex. if 0.4% annual default, carried in book @ 99.6%, 99.2%, etc
- economic downturn will incr default rates for many asset types
- if possible, vary default rates w/ economic activity
- Purchasing New Assets
- inventory of possible new assets part of input into model
- need to purchase from this inventory, if positive net cash flows
- ways to apply co's inv strategy
- input data may specify % of new assets to be invested in various classes of various quality and maturity
- input data may specify dist of new assets by asset class & quality and let model determine maturity to better match A/L CF
- might have different strategies for different LOB
- Covering Cash Shortfalls
- what to do when net CF is negative - borrow $ or sell assets
- sell assets closest to mat date - MV least affected by delta i
- if investors don't care about unrealized g/l, sell assets w/ offsetting cap g/l
- sell assets that help co better match A/L
- ex. if assets longer than liab, sell LT assets
- modify strategy to min net cap g/l
- Calculation of Investment Results
- Book Values
- for many assets - price originally paid
- bonds, mort, cmo, abs - starts equal to price paid
- bonds: book = mat val + unamortized prem/discount
- mort/cmo/abs: book = loan priinciple + unamortized delta(price paid/principle)
- Capital G/L
- delta price sold and book value @ time of sale
- defaults recorded as capital losses
- Investment Income
- includes capital g/l
- InvIncome = Net Asset CF + increase in book value during period
- if new assets included in net asset CF as negative, will be included in delta book as positive
- no effect if purchased @ EOY
- 6 mo growth if mid-year purchase
Summarizing Stochastic Results
- # of scenarios depends on variablity of results
- depends on speed of modeling software and complexity of model being tested
- once all scenarios tested, results arranged sequentially, summarized by percentile adn sometimes gruoped to see range of possible results
Exercises
Life Insurance Products and Financing (Atkinson/Dallas) - Chapter 16 - FINANCIAL MANAGEMENT
introduction
- fin goals vary widely from co to co in ins industry
- focus on ROE, embedded value, consistent growth in earnings & revenues, total return to stockholders, total return to PO
- factors influencing choice
- type of co
- co tradition
- company strengths and weaknesses
- past co results
- competition
- regulation
- fin mkts
- personalities and beliefs of senior mgmt
- need to activley monitor and manage finances in 3 braod areas
- risk management
- earnings management
- capital management
- in most cases - risk mgmt motivated by desire to stabilize earnings
- protects company's solvency
Tools of Financial Management
- overview
- Informational Tools - Financial analyasis and modeling
- Risk transfer options - reinsurance adn acq of business
- Finanacial Analysis
- worthwhile analysis provides info that leasd to decisions
- I/S & B/S results (broke down by LOB or finer)
- mortality and lapse studies
- inv results, including net int rates and default costs, inv expenses, cap g/l by asset class and segment
- distribution fo sales by product, risk class, gender, etc
- relevant unit costs for vaious levels fo decisions
- by reviewing past, learn from mistakes, see where doing good and adjust accordingly
- Modeling
- ability to project future financial results
- results need to be at least as detailed as various summaries avail from fin analysis
- useful for testing effect of various decisions on future earnings and other results
- can be used to produce PV of future results
- Embedded Value(begyr) = sum(DistEarn_tot(calyr)*1+i)^(begyr-calyr))
- allows determination of which products/pkts/other factors contributing/detracting from goals
- can be used to roughly estimate costs and potential value of adding new markets, new dist systems, new products
- Combined Financial Analysis and Modeling
- connect teh past and future - giving more complete view
- combined results can help w/ questions such as
- to stop offering certain products
- exit certain markets
- sell or close down LOB
- keep co independent or seek affiliation via merger/aquisition/being acquired
- can calc LT performacne measures such as ROI or wtg avg ROE
- solve 0=sum(DistEarn_tot(calyr)(1+ROI)^(-calyr)) across all years for ROI
- remember: simple ROI can be misleading, esp if multiple sign changes
- Reinsurance
- possibly most flexible tool for managing financial position
- in addition to transferring risk, it can shift earnings, capital, revenue, benefits, expenses, assets adn liab from one co to another
- Effect on Stability of Earnings
- can be used to stabilize earnings - more than any other tool
- can be used ot offest virtually every kind of risk
- usually used to stabilize mortality risk
- Effect on Pattern of Earnings
- pattern of YRT prem rates often doesn't match pattern of exp mort
- difference in patterns can affect incidence of earnings by yera
- varying term adn features allow possibility of many diff fin objectives
- when risk is transferred, req'd capital also transferred
- pattern of earnings can be shifted or left alone
- can be designed to have benef effect on taxes,esp when unused tax losses about to expire
- usually affects timing of solvency earnings adn taxable earnings (including current period earnings)
- effect of reins on expected stockholder earnings usually spread over dur of agreement
- sometimes designed specifically to ahve desired effect on solvency or taxable earnings
- Reinsurance as Capital
- can be used to obtain financing more quickly, often cheaper, compared to debt/equity
- since risk transferred, also financies strain of new business and lowers ceding co's capital req
- allows co to write higher levels of NB if sales take off
- can assume reins to put excess capital/dis earnings to work
- may be possible to generate tax losses
- every reins trx has same effect on capital of both cos
- possible to construct reins to accomplish several targets, such as
- transfer of targeted risks
- transfer of a targeted amt of cash (including none)
- targeted increase/decrease in
- solvency earnings
- solvency capital
- assets
- liab
- req'd capital
- not only increase co's capital, but decreases need for capital by reducing risk and req'd capital
- some countries limite reins severely
- reins as capital can behave more like equity or deby
- if amoutn of reief is large in relation to future earnings, like equity, small, more like debt
- Reinsurance Leverage
- can be used to leverage a co's returns
Acquisition or Sale of Business
- Overview
- most complex & difficult way to affect co's fin results
- sometimes sell blocks of business to raise capital
- usually dispose because does not have econ of scale, not a stategic fit, low rate of return
- buy blocks to build econ of scale, add value by cutting expenses, put idle capital to work, grow co for benefit of owners
- excess capital amoung life ins often leads to fierce price competition for acquisitions
- Assumption Reinsurance and Indemnity Reins
- acq or sale of blick of business usually accomplished by special form of reins
- reins not needed for sale of entire co
- Assumption Reinsurance - company that issued policies is removed from liab after block of business sold
- some jurisdictions require PO approval for assumption reins
- in those cases, use indemnity reins w/ transfer of admin
- no right to recapture for any reason
- Indemnity Reins - company that issued policies is NOT removed from liab stream
- seller relys on reinsurer to reimburse for all benefits paid
- admin typically transferred to buyer
- buyer handles all transactions
- seller still has to reflect business on books (w/ 100% offset)
- accomplishes most of toals of assumption
- seller receives fair value and no longer has to admin pols
- however, since still on books, ultimately liable if something happens to reinsurer
- this risk is usually better than deling w/ requirements that might be imposed in assumption situation
- seller has no right to recapture, except for breach
- Prerequisites for an Acquisition
- number of conditions
- buyer must have access to capital necessary to complete acq
- must be likely to improve buyer's earnings
- "buyers curse" - historically, results of most acq significantly worse than orig expectations
- buyer must have resources to complete acq
- need staff capable of handling integration from start to finish
- differences in business practice can force complex choices
- most difficult aspect -> people
- if acq driven by expense saving from combining operations -> downsizing
- better integration strategy is very few changes immediately after acq
- gradually institure changes that buidl on strengths and bring orgs closer together
- Prerequisites for a Sale
- seller must have use for capital raised by sale
- sale must be likely to improve seller's earnings
- seller s/b aware of pirce currently avail for business (might not be right time to sell)
- what effect will sale have on remaining staff if only part of co sold
- Determining the Purchase Value of an Inforce Block
- when block of inforce purchased, need to agree on two things
- what amount of liab will buyer assume? Typically solvency reserve of block
- what amount of assets will seller transfer to buyer in order for buyer to assume liab
- Typically assets transferred < liab transferred
- Purchase Value = liab transferred less assets transferred
- = SolvRes(0) - Assets(0) wehre time 0 is purchase date
- Assets(0) most difficult part of negotiations
- typically begin w/ EV(0) using buyer's desired rate of return
- = SolvRes(0) + ReqCap(0) - EV(0)
- Purchase value typically tax deductible, but still may be tax impact @ time 0
- Tax(0) = (SolvRes(0) - TaxRes(0) - PurchaseValue - TransCosts)*EarnTaxRate
- other items might affect Tax(0) and need to be taken into account
- Assets(0) = SolvRes(0) + ReqCap(0) + Tax(0) + TransCosts - EV(0)
- PurchaseValue = EV(0) - Tax(0) - TransCosts - ReqCap(0)
- EV(0) = PurchaseValue + Tax(0) + TransCosts + ReqCap(0) (rearranging prev formula)
- New Business and Goodwill
- closed block = no new business
- if block sold still has NB coming on (and sale assumes will continue), results in intangible asset on B/S
- often reflected only in stockholder acctg
- Goodwill
- value of future new business
- a risky asset for stockholder accounting
- value of intellectual capital, reputation, brand name, and other intangible assets
- for stockholder acctg, balancing item to force assets = liab @ purchase
- Amortization of goodwill reduces earnings
- straightline over X years (10-40 typically)
- some countries allow goodwill to be expensed immediately
- can have major effect on acq, depending on how quickly amortized adn tax deductibility
- no simple formula for determing purchase value for an ongoing business
- usually only include 3-5 year NB in purchase value b/c of risk and uncertainty
- Purchase Price and Purchase Value
- no consistent def of purchase price
- press release version is typically some function of public acctg stds used by cos involved
- purchase value defined b/c of lack of definition
- other considerations - stock co
- effect of acq on stockholder EPS & ROE
- if dilutive for more than S/T, might not be attractive
- wtd avg ROE < target b/c of acq might not be attractive
- Earnings Mgmt
- Act or sales of business can help manage earnings
- can sell loss-producing business. Loss now, but avoids future losses
- can buy business - usually moves it earnings up a notch (or more depending on size)
- strategy of growth primarily through acquisition
- need confidence and backing of fin mkts to raise capital necessary
- or convince sellers to accept buyer's stock
Risk Management
- Overview
- understanding, balancing, and controlling the risks inherent in a LIC
- Market Risk
- Int Rate Risk Asset Valn Risk SubOptimal asset allocation
- Mkt Fluctuation Risk Spread widening risk currency fluctuation risk
- Interest Rate Risk
- discussed previously
- fin derivatives can be purchased as int rate hedges
- even matched A/L can have risks b/c of acctg quirks
- some assets marked to mkt and liab not
- ways to control risk
- encourage saels of products w/ MVA, incl variable products
- limit sales of products w/o MVA
- hold extra capital to be able to withstand int rate fluctuations
- work w/ regulators & acctg bodies to bring acctg fo rliab in line w/ acctg for assets
- Market Fluctuation Risk
- MV of volative assets (CS & Real Estate) subject to considerable fluctuations over time
- 3 main strategies for managing risk of loss do to a fall in mkt values
- use volatile assets mainly to back products w/ MVA (incl variable products)
- otherwise limit volatile assets to small percentage of overall assets
- hold extra capital to be able to withstand mkt fluctuations
- Asset Valuation Risk
- risk of overly agreesive valuation of assets
- difficult to determine MV is not an active mkt for a particular type of asset
- sometimes person who purchased asset is same person who asked to provide MV
- if significant portoin of co's capital in affiliated co, need to take extra precautions to ensure unbiased estimate
- undervaluing assets can also be a problem
- step to reduce asset valuation risk
- majority of funds in assets w/ readily available & verifiable MV (such as publicly traded stocks and bonds)
- ensure controls exist so that those determining MV of assets do so independently
- independent audits should reinforce these controls
- for large inv in an affiliate, consider IPO to sell parot of the affiliate to public and establish an independent mkt value for it
- Spread Widening Risk
- an asset class can fall out of favor, resulting in spread widening
- spread widening is a function of supply and demand
- strategies to control spread widening risk
- invest mainly in assets w/ small risk of spread widening - high quality, heavily traded, widely held securities
- use assets w/ large spread-widening risk mainly w/ products that have MVA (including variable products)
- otherwise limit to small % of total assets
- hold extra capital to be able to withstand effect of spread widening
- SubOptimal Asset Allocation
- level of asset risk s/b tied to capital position
- extra capital -> take on more risk
- is enough risk being taken given the co's capital position?
- Currency Risk Fluctuation
- balance sheet risk and i/s risk
- B/S risk - a/l significantly out of balance by currency
- currency change could reduce co's capital
- managed by balancing a/l by currency
- I/S risk - income, benefits & expenses significantly out of balnace by currency
- currency change could reduce co's net income
- buy currency hedges, but not common
- normal fluctuations in earnings often > fluctuations due to currency changes
- might not make sense to stabilize relatively small currency risk
- Credit Risk
- overview
- several categories (first 3 asset related)
- asset default risk
- concentration risk
- risk of inadequate spreads
- counterparty risk
- Asset Default Risk
- excessive asset defaults that may result from prolonged poor economic conditions or poor asset selection
- managed by
- share risk of default w/ PO via MVA and variable products
- invest in mainly inv grade assets
- limit investments that are below inv grade to a small % of assets
- hold extra capital to withstand effect of excessive asset defaults
- Concentration Risk
- risk associate w/ large protion of co's investments concentrated in a particular issuer/sector/industry/part of country/part of world
- can be controlled by adopting (and following) a strick policy of diversification of risk
- Risk of Inadedquate Spreads
- credit-realted spreads may not adequately compensate investor for credit risk assumed
- risk is smaller where reliable info is available over a long period
- controlled by limiting % of assets invested in newer/less familiar issuers/sectors/countries/classes of assets
- Counterparty Risk
- risk that outerh parties not able to fulfil their obligations
- controlled by only dealing w/ high-quality business partners or diversify by spreading risk w/ multiple business partners
- for reinsurance, YRT and Coins Term largely "paygo" so minimal risk
- larger risks can be reduced by placing assets in trust or securing letters of credit
- Liquidity Risk
- overview
- risk of not being able to meet the cash flow obligations on time
- types of liquidity risk
- "run on the bank"
- holding co
- risk of excessive liquidity
- "Run on the Bank" Risk
- risk that ratings dwongrade or other adverse publicity could cause many of co's PO to simultaneously demand cash from the co
- strategies for dealing w/ run-on-the-bank risk
- give co an option to delay payments when designing ins contracts
- avoid "hot money" products - products sold to those who quickly move their money when conditions change
- maintain some % of co's portfolio in highly liquid asses/gov't securities/st investments/cs)
- establish credit facilities that allow co to raise cash immediately in a time of need
- Holding Company Liquidity Risk
- applies to LIC owned by holding co
- LIC may have adequate liquidity, but holding parent may not
- holding co needs $ to pay divs, int on debt, cover expenses, etc
- holding co only regular source for additional cash if divs from subs
- if subs growing and need add'l capital - could be problematic
- regs often limit amt of divs that can be paid by LIC (to protect solvency)
- other source for holding co $ is capital mkts
- holding co liquidity risk best managed by planning well ahead
- Risk of Excessive Liquidity
- could maintain too much liquid assets and not get enough yield
- determine optimal level of liquidity
- credit may provide liquidity protection cheaper (compared to loss of yield w/ liquid securities)
- Pricing Risk
- Mortality/Morbidity/Longevity/Pricing Assumption/Liability option
- Mortality Risk
- RBC factors for mort risk based on 1918-1919 flu epidemic
- advances in medical science, but partially offset by potential to spread quickly (air travel and increased mobility)
- natural disasters
- man-made disasters
- selective lapsation - genetic testing
- should take measures to protect against - w/in reason
- hold extra capital
- reinsurance - regular and cat
- Morbidity Risk
- primary cause of unexpectly hig morbidity cost - ability of insured to outwit ins co
- us economy of 80/90s let to situation where more attractive to be disabled than working
- liberal u/w & loopholes in definition of dis allowed relatively healthy insureds to make legitimate claims against policy
- controlled through
- careful u/w
- diligent handling of claims
- clear and verifiable benefit provisions
- designing benefits that encourage beneficial behaviour (partial dis benefit)
- Longevity Risk
- annuitiants living longer than expected (reverse mortality risk)
- little can be done to cotrol risk
- allow fo rgreater mort improvement when pricing
- attractive priced reins hard to find - reinsurers have similar concerns
- Pricing Assumption Risk
- danger pricing assumptions wrong
- new mkts/new products/new u/w stds/new dist systems
- inadequate experience to base assumptions
- unlikely to happen when pricing assumptions based on credible experience
- sometimes price below cost in anticipation of being able to reduce cost
- good ways to reduce pricing risk
- reinsure business that has worrisome levels of pricing risk
- work w/ pricing experts (consultants/reinsurers) to develpo assumptions that reflect latest information/techniques available
- Liability Option Risk
- improperly priced options given to PO
- perhaps greatest shortcoming in life ins pricing
- cost of most options is never quantified and never explicitly reflected in pricing
- to manage risk
- greater level of awareness and cost of such options
- use of reinsurance
- consciously avoid too large a concentration of option risk
- manage concetration of risk similar to how done for assets
Earnings Management
- overview
- decisions and actions a co can take to influence FUTURE earnings (usually too late to affect current period earnings)
- two common goals
- grow earnings over time - usually @ targeted growth rate
- minimize unexpected fluctuations in earnings
- Product Management
- managine inforce products and design adn intro of new products to help co better meet fin goal
- essential for good earnings mgmt
- limited ability to adjust inforce products to achieve fin goal and manage earnings
- divs/non-guar prem/credited int rates/COI rates all changeable
- considerations when making these adjustments
- delivery on promises
- equity among policyowners
- effect on persistency
- regulatory restrictions
- pricing of new prducts - most imprtant tool to drive future earnings
- increase profit margins on new products
- introduce productw w/ features that reduce risk, increase earnings, improve competitiveness and sales levels OR reduce capital needs
- Asset Management
- Inv strategies can be shifted
- Avg yields and earnings increase by shifting to riskier (or less liquid) investments
- if in position to easily handle greater risk, wise to improve yields
- could focus on reducing volatility of earnings
- usually not possible to both increase yield and decrease volatility
- A/L matching strongly encouraged
- reasons why mismatching occurs
- liab CF too unpredictable to match, except over short horizon
- A/L purposely mismatched to improve avg yields adn expected earnings
- best handled by co that is over-capitalized and consciously using excess capital to support mismatching
- LT yields can be improved by increasing proportion of assets in stocks/realestate
- need strong capital position to absorb up/downs of mkt
- disadvantage: treatment of cap gains by stock mkts essentially ignored by stock mkts b/c can use to artificially inflate earning in a given year
- if co & stock mkts focused primarily on operating income (excl g/l)
- some volatility acceptable if confined to capital g/l
- Expense Management
- lower expenses generally means higher profits
- quality and friendliness sometimes matter more than price or efficiency
- crucial to understand what matters to customers and dist system
- look @ not only cost, but what it buys you in customer satisfaction of agent loyalty
- some worthless activities can be ingrained into organization adn therefore hard to recognize and eliminate
- Major Expense Reductions
- common techniques
- across-the-board cut - not always a good thing since some areas need to expand, not shrink
- "surgical incissions" - intelligently reduce expenses in areas that most need reductions
- corp raider perspective - look at company from view of corp raider - "slash & burn" areas to shave expenses and boost profits
- ask what a corp raider would do, then do it yourself
- start-up perspective - look @ co from POV of new, start-up co
- Minor Expense Reductions
- analyze jobs throughout co & derive value that each job adds to co
- might also identify structural problems such as too many layers of mgmt & not enough workers
- pursue outsourcing - allows a co to focus on what it does best
- if someone else can do it cheaper, let them
- reengineer processes - involves redesigning or automating processes to improve service or reduce costs
- restructure or reorganize all/part o fthe company so various units wrok together more effectively
- identify ways that company culture can be shifted to improve collaboration, communication, decision making, initiative, creativity, retention of staff, etc
- Allocation of Corp Expenses
- expenses that directly or indirecty relate to a product line s/b allocated accordingly
- expenses not related to anything but total co (corp expenses) should not be allocated
- create a "corp" LOB
- possible def of corp expenses - those that would be eliminated or replaced if company merged into larger organization
- allocating corp exp to LOB may disguise true contibution of each LOB
- Legacy Systems
- outdated, patched-together systems used for u/w, issue, billing, etc
- conversion is hugely difficult, maint is increasingly complex and expensive
- solving this problem has huge savings potential
- possible solution
- modern system for all NB
- bridge over existing as needed
- eventually only the most difficult products left on legacy system
- "incentive" replacement to PO to get policies off books or put forth the effort to get the final policies moved
Capital Management
- overview
- maintaining the proper amounts and types of capital needed to efficiently and safely run the company
- Determining the Proper Amount of Capital
- several perspectives
- insurance regulations
- specify min amt capital req'd to remain solvent and operate independently
- co's strive to maintain capital well in excess of min reg to handle fluctuations
- rating agencies
- rate financial strength/claims paying ability of inc cos
- use req'd capital formulas similar to regulators
- more likely to adjust req'd capital to reflect greater familiarity w/ bus of each co
- company
- internal point of view as to how much is proper
- in line w/ primary competitors
- formulas based on historical events and designed to provide enough capital to survive all but most unusual/extreme events
- Determining the Proper Capital Structure
- debt/equity/reinsurance - options more limited for mutuals
- Corporate Structure
- most common - stand-alone life insurer w/ no parent and no subs
- can issue stock to raise equity capital
- cannot make effective use of deb (ins regs - debt is not capital for solvency purposes, but liability)
- many ins cos have parent holding co - to make effective use of debt
- parent co issues debt and uses proceeds to make captial contribution to ins sub (debt from parent becomes equity to ins co)
- single ins co w/ all ins operations creates some capital efficiencies
- same capital can be used to support mult ins businesses, often w/ complementary risks
- common for large corp to have many holding cos and many ins cos
- add'l holding cos oftern useful for capital and tax reasons
- corp structure partially driven by careful planning and partially by historical events, such as past acq
- Equity
- usually largest component of capital
- owner's capital contributions & retained earnings of co
- capital w/ highest risk, therefore investors demand the highest return on equity capital
- PS & CS do not have to be repaid
- no scheduled maturity date adn no repayment of prin
- normally pay divs
- CS divs must be discontinued before PS divs are cut
- cutting of divs viewed by mkts as sign of poor performance/weakness/distress
- Debt
- mainly used by stock cos
- holding co needed to make debt useful to ins co
- viewed as low-risk capital (for co's w/ good fin ratings)
- often, int paid on debt is tax deductible to the borrower
- since relatively safe, investors settle for much lower rate of return on debt capital
- cost of debt (usually) only slightly higher than yield avail on new investments of similar quality and maturity
- most appropriate for supporting low-risk capital needs
- should structure maturity of various debt offerings to match release of excess reserves adn capital
- s/b structured in conjunction w/ A/L management since debt is another form of liab
- bond debt most commoon
- bank debt - usually S/T @ s/t floating int rate
- if co fails to make int or prin payments on time, faces bankruptcy
- cost of borrowing increases as % of capital in form of debt increases
- rating agencies will lower ratings if it adds too much debt
- investors will criticize if co doesn't make sufficient use of debt to leverage returns
- WACC - weighted avg cost of capital
- = % of capital in equity * desired return on equity + % of capital in debt * after-tax cost of debt
- if co has long range target ratio of debt adn equity, WACC can serve as basis for hurdle rate
- Combinations of Debt and Equity
- aka mezzanine financing
- convertible bonds and surplus notes - types of mazzanine fin used by ins cos
- convertible bond - features of both debt and equity
- similar to regular bond except
- much lower rate of int
- convertible to CS @ price that s/b attractive in a few years
- rating agencies might view as more equity than debt depending on how attractive conversion option is
- surplus notes - function like bonds, except coupon and mat payments
- subject to ongoing approval by ins regulators
- if regulators prevent payment, co is NOT in default and lenders can take no action
- treated as equity for solvency purposes
- rating agencies view as more debt than equity since likely to be repaid
- Reinsurance
- favorable attributes of using reins as capital
- transfer of risk as well as capital
- reduction in need for outside capital
- access to capital as needed, vs prematurely raising idle capital in the form of equity or debt
- Methods of Raising Capital
- Sources of Capital for Mutual Cos
- if formed by original group of PO, these PO would provide capital needed to start co
- if formed by mutualization of stock co, capital remaining after stockholder buyout is starting capital
- once capitalized, no ability to raise add'l equity except retained earnings
- two levers to keep actual capital in line w/ req'd capital
- carefully manage growth so capital needs do not outstrip growth in capital
- manage divs to PO so existing PO provide add'l cap needed to finance new PO
- Sources of Capital for all Cos
- reinsurance (in most jurisdictions)
- amounts and timing of provided captial can be dovetailed to closely match the business needs
- surplus notes (where regs permit)
- sell all or part of one of its businesses to raise capital
- moving a successful business to a sub and selling a piece of it to the public particularly effective way to raise capital
- when a co sells all or part of one of its businesses, may move from too little capital to too much and not know what to do with it
- need to consider where/how to deploy raised capital
- if too much, may be other ways to structure sale
- Sources of Capital for Stock Cos
- in addition to prev choices, fin mkts to raise debt and equity capital
- debt
- easier to raise
- greater a co's fin strength, lower the int rate
- lareg amt of debt usually financed by selling bonds to public
- moderate amts - sometimes sold privately
- s/t adn smaller amounts - usually provided by bank debt
- bank debt - couple days to arrange
- public bonds - a couple months for req'd documentation and approvals
- private - quicker
- equity
- can be problematic
- existing stockholders & new investors have opposite points of view
- existing stockholders - dilutes their ownership
- unless capital rec'd from add'l shares can be immediately deployed to earn same rate as existing capital, offering will be dilutive to EPS
- if permanently dilutive - offering was a stupid idea
- new investors - need to be drawn to offering
- must regard co and/or stock price as attractive
- IPO - takes approx 6 mos
- subsequent offerings - much faster b/c most of req'd info already publicly reported
- Methods of Deploying Excess Capital
- most obvious and most ignored option - distribute to owners
- Distributing Excess Capital to Owners
- special dividend if stock co or increase div rate to pay out over longer period
- buy back shares of stock (if publicly traded)
- tends to raise price of shares since remaining shares own greater portion of co
- more tax-efficient than dividends depending on tax laws
- enhance PO benefits (if Mutual) - increase divs, enhance crediting rates, lower COI
- Deploying Excess Capital into Current Operations
- examine current operations to see where extra capital could do some good while providing adequate return on that capital
- if capital has been main pricing constraint, more capital-intensive be developed or existing products repriced
- expand distribution capabilities
- significant projects to improve productivity or service capabilities
- when raised through debt/equity offering, often more capital than it can immediately use
- makes sense to deploy excess capital through a few large/ST transactions
- Deploying Excess Capital into New Operations
- opportunity to start up new LOB, enter new mkt, build new dist system or pursue acquisition
- must ultimately change or face obsolescence
- Internal Capital Management
- overview
- Company must allocate capital to each business to properly measure performance
- assets backing liab & capital of each business must be allocated
- allows inv income to be calced for each business
- two common methods for allocating capital: historical and req'd capital methods
- Historical Method
- tracks results for a business from inception, accumulating actual cash flows and ignoring capital reqs
- pro:
- tracks inception-to-date contribution of each business
- current results can be viewed in context of historical capital contributions
- con:
- ignores reality by ignoring req'd capital, since buiness must maintain some req'd capital
- understates earnings when accum earnings < req'd capital
- overstates earnings when accum earnings > req'd capital
- ROE grossly misstated (both earnings and equity distorted)
- requires co to keep accurate records of capital contributions to and distributions from each buinsess
- can lead to significant misunderstandings and mistakes
- Req'd Capital Method
- allocates amt of capital req'd to support a business, ignoring past results
- actual earnigs calced consistent w/ dist earnings
- results for young and old business NOT distorted by historical results
- can be allocated by region, etc
- Authors believe req'd capital is THE RIGHT METHOD for measurinng current performance
- however, many co still use historical method
- if no clearly defined std for req'd capital, may be hard to apply
- Value At Risk
- two components of req'd capital (RC)
- portion truly at risk
- portion req'd to satisfy redundant req'd reserves/excess cap req
- value at risk - method of allocating capital that reflects both components
- two-tier approach for each business
- high-risk req'd capital - amt of capital necessary to withstand adverse experience (amt to withstand 99% of 1 yr fluctuations)
- low-risk req'd capital - amt needed to maintain fin ratings or attain desired level of fin strength
- third-tier - not allocated - overall excess (or shortage) of capital
- ideally Tier 1 s/b backed by equity adn Tier 2 by debt
- in reality, debt req'd for Tier 2 would not be acceptable
- if Tier 3 < 0, capital s/b raised
- Using VAR to Allocate Cost of Capital
- calc WACC
- allocate asses backing reserves & Tier 1 req'd capital to LOB
- retain assets backing Tier 2 in unallocated corp segement
- allocate a charge for Tier 2 req'd capital to LOB
- retain assets backing tier 3 in sep unallocated segment
- allocate NO charge since excess corp capital
- ROE = [after-tax LOB income - charge for Tier 2 RC] / Tier 1 RC
- calc charge for Tier2 RC as % of Tier 2 RC
- This percentage is set so co achieves targeted ROE if all LBO achieve target ROE
- company's LOBS will have different proportions of high/low risk capital needs
- measures return on each LOBs high-risk capital while taking into account extra cost of add'l capital
- more common in banking industry, but applicable to ins world as well
- Allocation of Excess or Shortage of Capital
- authors recommend
- if viewed as temporary, allocate to corp segment
- if viewed as perm, calc of req'd calc s/b revised to reflect this
- alternate approach
- allocate all capital in proportion to req'd capital for each LOB
- results can be distorted by reins
- if reins trx designed to help overall company, not just single line, may be appropriate to share costs and benefits across all lines
- Rationing of Capital
- particularly important when shortage of capital
- difficult choices when capital is short
- who should get it?
- some LOB may bet it even w/ inferior returns if of strategic importance
Achieving Financial Goals
- Basic Requirements
- simple story that explains why company will succeed
- told to employees, rating agencies, investors, customers (sometimes)
- explains how co will apply competitive adv to serve mkts that provide opportunities for desirable profits and growth
- embodied in co's vision, mission, strategy
- to achieve goals, many areas need to work together
- products developed
- assets managed
- reins/acq/divestitures coordinated w/ mgmt of risk, earnings, capital
- find right balance between growth, profitability & risk to match availability of capital
- Financial Management Techniques
- simple techinqes/behaviors that can help a co serve owners better
- better to underpromise and overdeliver
- make modestly conservative acctg adn reserving choices -> reduces chance of negative surprises
- increase vigilance when times are good - tend to get overconfident and careless when times are good
- timing is important w/ capital mkts
- raise capital in advance of when you need it...when it is cheap
- have bias toward opportunities w/ more upside than downside potential
- options historically a major source of added earnings & unexpected losses
- strive to include options that benefit co and minimize options that could hurt
- build speed into org
- many opportunities more attractive to those who react first
- Achieving Fin Goals for Mutual Policyowners
- they want fin security adn max value from their pols
- they don't care how fast/slow a co grows, just max value
- when acq costs high and returns low, PPO may be better served by closing down NB & running off inforce and returning all capital to PO
- Demutualization
- since mutuals return much value through PO divs, ROI/ROE often far below that for stock co
- when demutualized, starts as stock co w/ very low ROE
- effective way to unlock mutual PO's value in co w/o dismantling coin process
- most use demutualization and opportunity of IPO to raise add'l capital
- Achieving Stockholder Financial Goals
- want to maximize return through stock price appreciation & stockholder divs
- stock price driven by 2 main factors
- outlook for co and industry
- recent history of co under current management team
- largely a function of P/E ratios (stock price to EPS)
- P/E ratios largely function of expected growth rate for co, tempered by current attractiveness of life ins industry
- ins cos tend to have lower P/E ratios than stock mkt avg
- if privately held, still a fair amt of importance to stockholder divs
- public - not as important. Price appreciation now main focus
- investors focus on stockholder reporting, not regulatory reporting
- co can show negative solvency earnigns and investors will hardly notice
- (rating agencies adn regulators WILL notice)
- fast growing co typically has soaring stockholder earnings and plummeting solvency earnings
- b/c of extreme conservatism in most solv reserves
- slow growing co may experience opposite - solvency > stockholder reserves
- as conservative solvency reserves released on old business
- Embedded Value (EV)
- gaining acceptance in capital mkts as important fin measure
- EV - PV of co's distributable earnings, including any current exess capital
- future NB not included
- EV represents run-off value for co, discounted @ given rate
- why EV may become key driver of Life Ins Stock prices
- used extensively in Europe
- actuarial valuation tool
- used by buyers to substantiate take-over prices
- value of target in 3 pieces: EV, goodwill, multiple fo potential annual cost savings
- allows investors to see how much of a co's current value is represetned by inforce business and how much is based on expected future growth
- good test of recoverability of life ins intangibles (DAC)
- should provide a minimum value for a LIC
- Does have limitations
- time and staff consuming to implement and maintain
- sensitive adn can change significantly w/ assumption change
- difficult to explain to mgmt and outside analysts from one perios to the next
Exercises
Life and Health Marketing (LOMA)
Chapter 5 - PLANNING MARKETING GOALS AND STRATEGIES
Marketing Management - process of planning, organizing, implementing and controlling a company's marketing activities in order to create effective and efficient exchanges
Marketing Management Process
- Planning
- - Set Marketing objectives
- - establish guidelines for implementation and control of mktg activities
- Organizing
- - establish a framework for carrying out mktg plans
- Implementation
- Control
- - analyze results
- - evaluate performance
- - make necessary changes
Types of Planning
- +Corporate Planning
- primarily strategic
- consists of establishing company's overall business plan
- top-down. begins by deining the company's mission - defines scope of org's business activities and business direction
- Establishs Corp objectives - long term results co hopes to achieve
- Outlines Coprorate Strategies - long term methods used to achieve objectives
- must regularly evaluate plans to make sure still appropriate
- +Marketing Planning
- bottom up portion of planning process
Stategic Marketing Planning
- 1-5 years into the future. review and update as necessary. as oftern as every 6 months. focus on long term
- - establishes marketplace objectives
- - defines the target market
- - develops mktplace stategies
- - defines resource needs
Tactical Marketing Planning
- 1-2 years into the future - focus on the day-to-day
- - develops action-oreineted product, price, distribution and promotion tactics
- - describes when activities will take place, how they will be performed and who will perform them
The Planning Process
- 3 primary activities: analyze situation, establish objectives, develop course of action
- Conducting a Situation Analysis
- 3 primary parts: environmental analysis, environmental forcast, internal assessment
- Environmental Analysis - ongoing exam of outside events/relationships that can influence strategic decion making
- Key environmental areas for Financial Services Corp (fig 5-3 p 105)
- - current target markets
- - competition
- - economy
- - society
- - technology
- - regulation
- - labor
- - distributors
- - international conditions
- Environmental Forcast - prediction of major environmental trends that will affect a companies business activities
- several types of forcasts available from businesses, universities, governments and industry associations
- commercial forcasts are a good starting point
- Internal Assessment - exam of co's current activities, strenghts, weekenesses and ability to respond to potential threats & opportunities in environment
- internal factors that have greatest effect on co's mktg planning:
- - mission
- - fin, tech, human resources
- - current distribution systems
- - product lines
- - operational efficiency
- Tools of Analysis
- SWOT Analysis
- Strengths, Weaknesses, Opportunities and Threats
- Mktg Opportunity arises when right combo of circumstances allows co to use its strenghts to take advantage
- Strategic Window - time period where optimum fit between co's distinct capabilities and key requirements of mktg opportunity
- Business Portfolio Analysis
- allows co to evaluate business units according ot their potential contribution to co
- determines units potential for:
- - generating financial resources
- - requiring financial resources
- SBU - strategic business unit
- - operated as a separate profit center
- - own seperate set/share of customers adn competitors
- - own mgmt (generally)
- - owm mktg strategy
- Marketshare/Mkt Growth matrix - Boston Consulting Group
- - Star - high mkt share, high growth mkt - becomes a cash cow when mkt growth slows
- - Cash Cow - high mkt share, low growth mkt
- primary role - provide income to cover corp overhead, pay divs, finance R&D
- - Question Mark (aka Problem Child) - low mkt share, hight growth mkt
- requires more cash than they generate
- - Dog - low mkt share, low growth mkt
- generate enough revenue to cover their own expenses
- unlikely to become stars or cash cows
- many SBUs have the following life cycle
- Question Mark -> Star -> Cash Cow -> Dog -> sold/discontinued
- Market Attractiveness/Business Strength Matrix - GE and McKinsey & Co
- created to address problems w/ mktshare/mkt growth matrix
- 9 matrix cells
- business strength - strong/average/weak (x-axis)
- mkt attractiveness - high/medium/low (y-axis)
- "A" - good investment/growth opportunity
- "B" - average opportunities
- "C" - little growth/investment potential
- mkt attractivness - composite index - uncontrollable env factors
- - market size - market growth rate
- - gov't regulation - mkt stability
- - competitive intensity - tech reqmnts
- business strength - composite index - controllable factors
- - price competitivness - product quality
- - customer loyalty - mktg skills
- - sales growth rate - relative cost advantages
- - tech and fin resources
Establishing Objectives
- objectives s/b
- - clearly stated
- - specific and measurable
- - realistic
- - actionable
- objective shoudl specify (in quantifiable terms) what is to be accomplished and time period to accomplish it
- Corp Objectives - normally 1-5 years
- Marketing Objectives
- primary - describe overall mkt response they hope to achieve in target mkt
- secondary - cover mktg functionnnnnnns needed to carry out plan
Developing Stategies and Tactical/Action Programs
- Corporate Strategies
- - intensive growth strategy - usually requires significant financial resource
- + Market Penetration - increasing sales of current products to current mkts
- + Mkt Development - increasing sales of current products to new mkts
- + Product Development - increasing sales of new/modified products to current mkts
- - diversified growth strategy - venture beyond normal business domains
- + Horizontal Diversification - intro diff products to co's current mkt
- + Concentric Diversification - new mkts, new products similar to current products or current mktg methods
- + Conglomerate Diversification - new mkts, new products that bear no relationship to curernt products
- same product related new product unrelated new product
- new mkt mkt development concentric diversification conglomerate diversification
- same mkt mkt penetration product development horizontal diversification
- - Integrated Growth Strategy - taking over another level of industry or dist channel
- + Forward Integration - control of distribution channel
- + Backward Integration - upstream (manufacturer or supplier)
- + Horizontal - competitor
- Marketing Strategies
- focus w/r to SBU's mkt share
- + Build Strategy - increase mkt share. usually S/T loss (capital outlay) for L/T gain
- most appropriate w/ relatively low mktshare in relatively high growth rate mkts
- Question Marks or "A"s
- + Hold Strategy - maintain mkt share
- Cash Cows or "B"s
- appropriate for high mkt shares in low growth mkts
- + Harvest Strategy - maximize S/T earnings and cash flow
- appropriate for weak growth potential
- weak Cash Cows, Qeustion Marks, Dogs adn "C"s
- + Withdrawal Strategy - selling/discontinuing a SBU
- appropriate for weakest growth and inv potential
- Tactical/Action Programs
- - what activites are to be performed
- - how/when/where they are to be performed
- - who is responsible for performing each activity
- - how much each activity will cost
- - type and magnitude of results expected from each activity
- - main elements of uncertainty involved
- - how results will be monitored and evaluated
- Benchmarking - identify best practices adn outcomes
- - emulate best practices to equal/surpass best outcomes
- avoids reinventing the wheel
- programs must be coordinated and integrated to be successful
- formed for each marketing area and combined to form annual mktg plan
- Setting Budgets
- tell Sr Mgmt how much and when - bottom up
- sometimes top down and funds need to be allocated. Proposed programs scaled up/down as necessary
- budgets provide feasibility info
The Marketing Plan
- written document that specifies marketing goals for a product/product line and describes strategies and implementation and control efforts co intend to use to achieve those goals
- focuses on target markets and elements of marketing mix
- Benefits
- - facilitates communications among all levels of org and among function units
- - allows mgmt to monitor consistency of actions across units
- - focuses EE on right issues
- - keeps poeple focused on overall goals
- - provides basis of performance comparison
- Elements
- - executive summary
- - situation analysis
- - mktg objectives
- - mktg strategies
- - tactical/action programs
- - budgets
- - control mechanisms
Life and Health Marketing (LOMA)
Chapter 6 - ORGANIZING, IMPLEMENTING AND CONTROLLING MARKETING ACTIVITIES
Organizing Marketing Operations
- Essential Mktg Functions
- - Information Management
- - Marketing research
- - product development and pricing
- - sales and distribution
- - advertising, sales promotion and publicity (aka Mktg Communications)
- - customer relations
- - mktg personnel development
- - mktg mgmt and admin
- Four common mktg structures: function/product/geog region/customer type
- Organization by Function
- most common
- different areas of responsibility depending on work performed
- ex. Chief Mktg Officer/Mkt Research Mgr/Sales Mgr/etc
- Advantages
- - simplicity
- - focuses on developemnt of managerial and tech skills
- works best w/ small cos or cos w/ homogenous customers
- Organization by Product
- each SBU responsible for its mktg (most of)
- may be some shared services
- Organization by Geographic Region
- usually mktg manager for each region
- usually some shared services
- Organization by Customer Type
- mktg manager for each division
- ex: households/small business/big business
- Combination Structures
- flexible - meets both co's strategic implementation needs and customer needs
- Matrix Organizational Structure
- project manager directs individuals from different function areas
- two bosses during project
Implementing Marketing Strategies
- Mktg Implementation - process of translating mktg plans and strategies into action
- accomplished through day-to-day tactical and operational activities
Controlling Marketing Activities
- marketing control - process of examing results of mktg plans and company to plan and taking actoin to keep it on track
Performance Evaluation
- performance std - internal vs external std
- - usually incorporated into mktg plan
- management by exception - mgmt only gets involved if performance outside acceptable range
- - saves time and allows attention to be focused on problems/opportunities
- if a problem, read to identify toe cause and take actions to correct
- - change tactical/action programs
- - establish new implementation method
- - new strategies
- - modify how performance data collected/analyzed
- - re-evaluate performance standards
- control tools
- sales analysis vs
- - forcasted sales - prior years sales
- - expenses to generate sales - competitors' sales
- - estimated mkt potential - current industry sales
- measured - # products, 1st yr comm, face ,avg prem, etc
- expense analysis
- natuaral accounts - ledger accounts
- functional accounts - based on purpose
- expense ratios - ex. mktg expenses/$1m face sold
- profitability analysis
- compares sales to expense incurred to generate sales
- use several years data since for line ins, 1st yr expenses > 1st yr revenues
- valuable source of info since combines sales and expense info
- mktg audit
- systematic examination and appraisal of mktg environment, objectives, startegies, tactical/action prgms, organiztional structure and personnel
- key areas of mktg audit (chart p 135)
- mktg environment
- macro environment
- task environment
- mkts adn customers
- other factors in mktg system
- mktg strategy
- business mission and mktg objectives
- mktg strategy
- budgets
- mktg organization
- formal structure
- functional efficiency
- cross-functional efficiency
- mktg systems audit
- mktg info system
- mktg planning system
- mktg control system
- new product developemnt
- mktg productivity audit
- profitability analysis
- cost-effeciveness analysis
- mktg function audit
- products
- price
- distribution
- promotion
- Reporting Sytems
- - provide managers w/ detailed summary info as needed
- - provide accurate adn timely info
- - be flexible to adjust to co's changing info needs
- - be cost effective
- - easily understood by
- + those who evaluate performance
- + those whose performance is being measured
- detail s/b appropriate for level
- lower level needs more detail
- higher level mgmt needs just summary
-
Life and Health Marketing (LOMA)
Chapter 7 - MARKET SEGMENTATION AND TARGET MARKETING
Market Segmentation
- dividing large markets into smaller markets w/ similar product/mktg mix needs
- single variable segmentation - only 1 variable to segment market
- multiVariable segmentation - uses combo of variables
- Requirements for Effective Segmentation
- - customers should have similar product needs/buying habits
- - needs/behaviours s/b distinguishable from other segments
- - potential sales/costs/profits s/b lare enough to be measured and compared to other segments
- - profit potential enough to warrant segment attention
- - customers accessible thorugh currently available means
- - size/composition s/b relatively stable over planning period
- Bases for Segmenting Consumer Markets
- Geographic Segmentation
- country/region/state/county/zip/legal boundaries/rural-suburuban/urban
- Demographic Segmentation
- age/sex.marital.household composition/income/education/occupation/family life cycle/nationality/race/etchic group/social class
- GeoDemographic Segmentation - combo of geographic adn demographic
- economic means/cultural background/perspective/neighborhood
- Psychographic Segmentation
- lifestyle/activities/interests/opinions
- Behavioristic Segmentation
- benefits sought/usage rate/buyer readiness/pref method of purchase/risk tolerance/buyer loyalty
- Demographic - commoonly used in consumer markets
- traditional life ins demographics - hi/middle/low-income households and families/boomers/seniors
- Bases for Segmenting Organizational Markets
- Organizational Mkts - group benefits and continuation of business operations
- therefore two markets, group and business
- Georgraphic Segmentation - simialr to consumar markets
- Demographic Charachteristics
- business activity/type of group-organizatoin/size of group-organization
- SIC - Std Industrial Classification - 1930
- NAICS - N. American Industry Classificatino System - by-product of NAFTA
- small groups <=100 - 80% of contracts, 25% or prem
- medium groups 101-499 - 10% of contracts, 25% of premiums
- large groups 500+ - 10% of contract, 50% of prem
- Behavioristic Segmentation
- similar to consumer markets - usage is a key
Target Marketing
- process to identify, select and focus mktg efforts
- Evaluating Potential Target Markets
- Mkt Size and Growth Potential
- majority fallacy - blind pursuit of largest, most easily identified or most accessible mkt segment
- competition makes big mkts less profitable
- should offer combo size/growth/profitability that best meets co's needs
- Mkt Attractiveness
- depends on level of compettition and buying power of consumers
- Company Goals and Resources
- only puruse targets if it has (can easily get) fin/tech/hr necessary to compete sucessfully
- Target Mktg Strategies
- Undifferentiate Mktg - mass mktg - singel mktg mix for entire mkt
- + cheaper since only one mkt strategy
- - might miss differences w/in segment
- - disadvantage to specialty marketers
- Concentrated Mktg
- for a product - focus all mktg efforts on a single segment of total mkt
- Niche Mktg - form of concentrated mktg w/ narrowly defined mkt
- - all eggs in one basket
- + can be profitable
- Differntiated Mktg
- offer differing product/mktg mixes to appeal to diff segments
- - most expensive
- + better served customers = incr customer satisfaction = incr sales
- Factors to consider when picking mktg strategy
- company resources - if limited, concentrated probably best strategy
- product variability - homogenous products - undifferentiated mktg
- Mkt Variability - if buyers have similar usage/purchase patterns - undifferentiated
- product's life cycle stage - new products - concentrated/undiffernetiated
- Consumer and Organizational Target Markets for Ins Products
- Affluent Consumers
- mass affluent - 100k -$1mil liquid assets - 99.9% of affluent mkt, 54% of total mkt assets
- high-net-worth - $1-25 mil liquid assets - 0.1% of mkt, 31.3% of assets
- ultra-high-net-worth - 0.001%, 15.1% of total mkt assets
- Single-Parent Families - need large amt ins to protect single wage earner
- Non-family Households - low need for life ins, high need for health/retirement products
- Working Women - strong potential for wide range of products
- Employer Groups - ex. negotiate trusteeship/voluntary trade assoc/MEWA
- Small Businesses - rapidly growing segment - approx 99% of businesses are small businesses
- significant market for products that
- - protect against loss due to death/dis of owner
- - preserve value/prevent liquidation due to owner/partner death
- - preserve sharelohlder equity/mgmt control due to majority shareholder death
- - protect against death tax on inherited business
- - enhance credit/fin stability by assuring business continuation
- - source of emergency funds
- - non-qual def comp to attract/retain key employees
- - EE health/life/dis ins and qual ret plans
-
Life and Health Marketing (LOMA)
Chapter 11 - PRODUCT DEVELOPMENT
Product Innovations
- Major Innovations - new prduct that meets needs not addressed before by other products
- Start-up Businesses - new product for a mkt served by a similar product
- New Prroducts for Currently Served mkts - new product for co, but product avail from other cos
- Prodcut Line Extensions - new product forms adn items to existing product line to give customers wider choice
- Product Modifications - characteristic changed ot allow competitive advantage over similar prod
- Style Changes - alter appearances or tangible aspects (ie logo change)
Product Development Process
- 5 basic steps - after first 3 steps (each one) decide continue/abandon/refine
- Product Planning/Business Analysis/Tech Design/Implementation/Monitor & Review
- Product Planning
- Idea generation
- Screening
- two potential screening errors
- - potential of a good idea underestimated and idea rejected
- - poor idea looks deceptively attractive and pursuded, wasting resources
- may use a screening critera checklist to help objectively screen
- - compatible w/ corp goals and strategic inititiatives
- - will prodcut enhance copr image
- - does a need exist in target market
- - can current prodcut be modified to meet this need
- - will product generate new sales or shift sales
- - mkt potential large enough to generate enough business to make product profitable
- - can product be mkted through existing methods
- - support a level of commissions that will motivate slaes force
- - can current systems handle the product
- - will target mkts understand the product
- - would it be more attractive if offerred thorugh a sub
- Concept Testing - measures acceptability w/o actually producing items
- - helps determine how customers would compare product ot existing products
- - what sets of benefits/attributes customers like most
- - which ideas are unacceptable in the mktplace
- - which target mkt to taimfor
- Field Advisory Council - group of agents to test new ideas on for feedback
- Comprehensive Business Analysis
- Mkt Analysis - study of environmental factors that might affect sales
- - potential value of product ot customers
- - nature adn size of target mkt
- - potential value of product to company
- - nature of products competition inthe mkt
- - customer appeal of product
- - appeal of product to distributors
- - products relationship to other products offered by co
- - potential legal/regulatory problems w/ product
- - special tax considerations
- - economic considerations
- - product/company fit
- Product Design Objectives - products basic characteristics/features/benefits/issue lmits/u/w classes/etc
- Feasibility Study - operational & technical viability of producing/offering/admin of product
- Mktg Plan - outlined in C 5
- Prelim Sales & Fin Forcasts
- If analysis indicates good potential, product proposal prepared for mgmt
- Product proposal typically details
- - product objectives - product description
- - mktg strategy - mktg fit
- - fin fit - inv fit
- - systems fit - scope of product implementation
- - legal/regulatory
- Techical Design
- writing contract/actuarial assumptions/rate structure/benefit levels/issue u/w standards
- usually several revisions utnil compromise reached
- prod dev process flow/timeline/budget assembled
- all put together and presented to management
- areas involved
- Mkts/Distributors/IS/Actuarial/Investments/Admin/Acctg/Legal-Compliance
- Implementation
- establishing admin structure adn processes necessary to take product to market
- 3 concurrent activities
- - obtain necessary legal approvals
- - design promo & training materials
- - develop IS systems/procedure to mkt & admin product
- Policy filing - dynamic process b/c state variations
- Design of Promotion and Training Materials - product naem, sales lit
- need to get approval from legal on most materials
- some might need state approvals
- Systems Activities
- IS might need to buy/develop new systems to support product
- usually takes greatest amount of time in process
- Product Introduction
- offering new product for sale and having mktg and product support in place
- Intro sales kit
- - outline of product features and how they work
- - desc adn sample of policy and fin statement insured will get each year
- - table of issue and u/w limits
- - commission scales
- - table of premium rates
- - list of possible mkts
- - sample illustrations
- - saels presentations
- - suggested sales solutions for diff mkt situations
- - samples of local and national advertising to intor product to public
- - sample pre-approach letter adn/or postcards
- - booklet about product for producer
- - brocure about product to give to prospects
- - prospectus (if req'd)
- - sample app
- - details on promo campaign
- - privace disclosures
- - instructions on how to access website for more info
- Training classes
- Incentive prizes/awards
- Sales Monitoring and Review
- review PD cycle to see if time/budget met
- review sales to see if matching forecast - if not, attempt to determin why
- check fin results to see if goals met
- Product Modification
- - s/b systematic as development for new products
- - changes might occurr because of actual sales/profit experience
- Product Withdrawal
- sometimes necessary b/c of legal regs
- sometimes end of lifecycle or unprofitable
- may meet resistance from agents
- good to have an acceptable replacement product
- review portfolio periodically to see if anything should go
Life and Health Marketing (LOMA) - Chapter 12 - PRICING: A MARKETING PERSPECTIVE
Pricing - the process of determining the amt to charge a customer for a product
Primary Factors Affecting Pricing Decisions
- Pricing Objectives - goal co wants to achieve when pricing profit
- ideally stated in writing so they can be verified against actual results
- Profit-Oriented Pricing objectives
- Profits (or contributions to surplus)
- Target return objective - specific level of profit as an objective
- often used to evaluate performance
- Sales-Oriented Pricing Objective
- Mkt share
- Types of competition-oriented pricing objectives
- - discouraging the competition
- - beating the competition
- - meeting the competition
- nonprice competition - product features, quality customer service, etc
- Cost - a big unknown since costs not known until blocksize = 0
- projected costs a big estimate
- some costs hare to split by product
- Direct Cost - directly attibutable to the product (u/w cost/comm/etc)
- Indirect Cost - not directly attributable (rent/shared services/etc)
- Fixed Cost - constant regardless of volume sold (rent/utils/prod dev/etc)
- Variable Cost - varys w/ volume (pol issue/prem tax/comm/etc)
- Demand - determines upper limit of products' price
- Price Elasticity - % change in qty demanded / % change in price
- Elastic Demand - change in price results in greater than proportional change in qty demanded
- Inelastic Demand - change in price results in less than proportional change in qty demanded
- Price elasticity depends on
- - number of substitute products available
- - need associated w/ product
- - level of expenditure req'd to purchase a product
- Customer Influences
- Purchasing Power (aka buying power) - measure ability of customer to buy goods and services
- affected by economic conditions - inflation/taxes/unemployment
- Price Consciousness - importance that customers attach to price
- Price Flexibility Desired - guaranteed price stability vs risk of higher price for chance at savings
- Competition
- - number of competitors and competing products
- - cost factors assoc w/ product and level of costs facing each competitor
- - level of fin resources avail to each competitor
- - level or resources each competitor has already commited to product
- - historic pricing behavior of each competitor
- - expected reaction of each competitor to price changes
- - each competitors overall strengths and weaknesses
- Regulatory Requirements
- need apporval for healt ins rates. Normally not for life ins
- solvency requirements
- XXX
- Other Mktg Mix Variables
- Type of promo efforst, form of distribution and product (features, benefits, levels of service, etc) aslo affect overall price
Pricing Strategies
- Cost-Driven Pricing Strategies
- establish price that will cover all costs and profit objectives
- most effective if a market leader
- might also work if
- - exclusive agent force
- - little competition
- - exclusive access to customer base (worksite)
- - fraternal
- can be problematic in competitive mkt situations
- Competition-Driven Pricing Strategies
- base price on competitors price and place in market hierarchy
- adjust conversion/renewability options, commissions to arrive at price (ie. products modified to fit price)
- Penetration Pricing - low price to build mkt share
- Flexible Pricing - negotiable price w/ each customer
- competitive bidding
- negotiated contract
- Customer-Driven Pricing Strategies
- usually focuses on compensation element of pricing
- focus on "product value"
- Psychological pricing - certain types of prices more appealing to customers
- 99.95 vs 100 or monthly vs annual
- Price Skimming - charging highest possible price that customers who most desire product will pay
- more true for tech than for fin services
- Promotional Pricing - lower (than normal) prices on certain items to stimulate all sales
- Price Leaders - low cost products to attract customers to all products at regular prices
- Loss Leaders - price leaders priced below cost
Rate Structures
- Preferred Risk Discounts - better rates for those with characteristics of loewr mortality
- Quantity Discounts - rates graded by size of policy
- banding
- policy fee system
- Gender Based Pricing - like PRD - know difference in M/F mortality
- Market-by-market pricing - different rates by jurisdiction/geor area/target market/prem taxes/mandated product features/reserve requirements
- Contingency Pricing - adjustable premiums/experience refunds
- High & Early cash value pricing - used on UL for early buildup of Cd
- intial prem rates higher to pay for this
- High and Late CV pricing - lower early prems
- discourages early surrenders w/ SC
- Indeterminate premium pricing - dual prem structure - curr and guar
Pricing Methods
- specific procedure co uses to set final price (or price structure) for a product
- cost-based/competition-based/customer-based
- Asset Share Calculation
- Asset Share - amount of assets a block will have accum at any given time
- Asset Share Calc - mathematical simulation of A/L/Surp interaction over years on a block
- Basic steps
- - establish gross prem based on estimate costs/demand and competition - starting point
- - choose conservative mort talbe and int rate to calc products reserves
- - choose more liberal mort and higher in to estimate NP req'd to pay benefits
- - choose a div assumptoin, expense rate, lapse rate nad profit margin objective for all years
- Validation period - breakeven period - time req'd for product to become profitable or begin adding to surplus
- Validation point - end of validation period
- if validation period is too long, co will abandon product or adjust assumptions
- increase GP or lower benefits/expenses
Price Evaluation
- assess
- - price's impact on co's fin performance
- - impact on performance of producers & other distributors
- - reactions of both competitors and customers
- factors to monitor
- - investment margin
- - u/w margin
- - expense margin
- - lapses (diff between actual and expected)
- - taxes (actual vs expected)
Product Line and Portfolio Pricing Considerations
- Pricing a Product Line
- rank each item from lowest to highest price and determine price of each item
- need price set to cover all product line costs
- if one item is priced low to meet competition, other need higher prices to make up diff
- Pricing a Product Portfolio
- need ot ensure all products cover all costs
- model office - whole co model - can help verify pricing is correct for entire portfolio
-
Study Notes and Published Refences - Note TSA XXXIX - PRICING IN A RETURN-ON-EQUITY ENVIRONMENT
Overview
- ROE = GAAP Income / Prior YE GAAP equity
- corp profitability measure common in ins industry
- relationship between pricing objective ROI and corp profit measure ROE
- examing relationship between ROE and after-tax ROE
- StatSurplus(t) = StatSurlus(t-1) + StatIncome(t) - Dividend(t)
- GAAPEquity(t) = GAAPEquity(t-1) + GAAPIncome - Dividend(t)
- StatIncome(t) = BookProfit(t) + i*(StatSurplus(t-1))
- DAC(t) = DAC(t-1) - (DAC(0)*g*v^(w-t+1))/(1-v^w)
- v = 1/(1+g) where g = i from DAC amort sched and w is amort period
- GAAPIncome(t) = StatIncome(t) - DAC(t-1) + DAC(t)
- ROE = GAAP Income / GAAP Equity
- example shows what happens if DAC < ROI adn i < ROI
- since i < ROI, stat income invested @ lower rate, brings down ROE below ROI
- DAC amortizes more at lower rate than ROI rate which brings down ROE in early years
- trend reverses in later years
- can fix i < ROI problem by releasing Stat Income via divs to other LOB or to stockholders
- ignoring taxes, 2 main reasons why ROI = ROE objective is prevented
- stat surplus not used to acq NB will hurt performance if surplus not earning an annual return equal to RO objective
- GAAP requires degree of conservatism.
- Eliminates use of annual ROI pricing objective as inv earnings rate in development of DAC amort sched and benefit reserve
- therefore earnings deferred to later years and result is non-leve (incr) emergence of ROE
Effect of FIT
- ROI is minimally affected by FIT
- intro of FIT dramatically changes relationship of ROI to ROE
- 1st yr ROE reduced by factor of (1-T) - since initial equity not affected by after-tax ROE
- for ROE=ROI, GAAPEquity(t) = (1-T)DAC(t) w/ DAC amortized @ ROI
- and stat surplus = 0 or reinvested @ ROI/(1-t)
- a company holding surplus, invested at rate < ROI/(1-T), en excess of that necessary to producce new business &/or producing new business cannot produce a compnay-wide after-tax ROE = ROI pricing objective
- unless it owns a block w/ an after-tax ROE > company-wide after-tax ROE objective
- This could occur
- past business priced to produce ROI > current objective and pricng assumptions met
- experience emerged more favorably than was anticipated in pricing
- past accts practices were conservative and deferred earnings
- Potential soln - price new products using ROI objective > corp after-tax ROE objective
- advantages
- if corp after-tax ROE < ROI, will meet ROE goal quicker
- in later years, renewal business ROE would = ROI which is > corp ROE goal which will offset negative effect that production of NB has on corp ROE
- if goal was to meet ROE goal in 1st year, ROI pricing objective = ROE/(1-T)
- and renew ROE > corp ROE (approaches ROI) if suplus dividended out
- GAAP won't allow ROI as amort schedule rate
- marketplace may not allow success of ins product w/ ROI that high
- non-ins industries produce returns by leveraging equity w/ debt
- stat acctg principle eliminate this option for LIC
- equity (not just current assets) needed to acq new life ins business
- need to leverage new business w/ old
- growth in ne production dictated by
- past and current acct practices
- reinvestment adn stockholder div practices
- age of existing blocks
- relative size of existing blocks vs NB
- reinvestment and stock div practices must consider degree of risk assoc w/ existing block
- stat surplus in excess of what is needed to produce NB must be maintained and amt ret depends on risk elements assoc w/ block
- therefore, get effect on after-tax ROE of maintainnig this surplus must be considered when detererming how much NB can be writeene w/in ROE constraints
- Soln: calc ROI on new products on basis of stat "reserve" = reserve + add'l amt needed as risk surplus to ensure solvency of LOB (benchmark surplus)
- ROE = ROI shoudl emerge even though sufficient assets avail to ensure solvency
Generalized Case
- conclusions drawn from examples not dependent upon specific emergence of SAP profits assumed
- by def, Sum(PVProfit_SAP) = 0 @ ROI rate
- therefore sum(PVProfit_GAAP) = 0 @ ROI rate
- if inv earning rate for GAAP = ROI and all other assumptions = pricing
- GAAP book profit each year (leveled as % prem) must = 0
- ROE = ROI regardless of emergence of SAP profits if SAP-GAAP adjustments assume inv earning rate = ROI
Special Considerations
- DEFRA mess w/ GAAP income and ROE b/c of "fresh start"
- need to be taken into consideration during corp planning process
Conclusions
- Relationship between ROI and ROE dependent on # items
- past and current Acctg practices
- past and future reinsvestment and stockholder div practices
- risk assoc w/ existing block and stat suplus req'd to insure co's future solvency
- age of existing block of business
- relative size of existing block when compared to NB to be produced.
-
Study Notes and Published Refences - Note SN8I-200-00 - EXPERIENCE ASSUMPTIONS FOR INDIVIDUAL LIFE INS AND ANNUITIES
Experience Assumption Process
- Introduction
- examples of models taht use expereince assumptions
- pricing adn repricing studies
- product design studies
- determination of reserve adequacy
- financial reporting (DAC)
- financial projections or forecasts
- actuarial appraisals
- categories of experience assumptions
- cash flow view
- 3 broad categories
- obligation or liability assumptions - mort, lapse, admin exp, taxes, div and int crediting strategies
- asset assumptions - earnings rates, default, inv expenses, inv strategy
- scenario assumptions - scenario(s) being analyzed
- degree of conservatism
- best estimate or include PAD - depends on how used
- acctg rules may require w/ or w/o PADs
- acctg/regulatory rules may prescribe assumption (may or may not be conservative)
- best estimate assumptions represents actuary's judgement as to most likely outcome
- if in doubt - pick more conservative choice
- in fin reporting context - conservative assumption means w/ higher liability or smaller asset
- in pricing context - lower benfit or higher charge to customer
- PAD should consider degree assumption is at risk in total and by duration
- adjusting a PAD shoudl make result more conservative
- prescribed assumptions usually contain implied PAD
- if doesn't seem conservative, test w/ realistic assumptions
- Establishing Experience Assumptions
- steps necessary to develop assumptions
- identify assumptions req'd
- determine structure of each assumption
- analyze experience and trends in experience for each assumption
- review and adjut set of all assumptions for reasonableness, consistency, and appropriateness
- document assumptoins
- monitor experience and update assumptions
- Identify Assumptions Req'd
- depends on model - different simplifying assumptions based on model purpose
- common assumptions
- obligation (liab) assumptions
- mort/morb rates tax rates
- lapse rates incidence and level of prem payments
- expense rates reins results
- Asset Assumptions
- inv earnings rate default rates
- capital gains rates inv expenses
- Scenario Assumptions
- specified set of deterministic int rate scenarios
- stochastically generated int rate scenario
- set of possible economic scenarios
- set of sensitivity tests
- Determining Structure of Each Assumption
- can be very simple or very complex depending on model and purpose and materiality
- assumptions determined for particular experience class
- purpose of grouping - establish homogenous groups for analysis expected to generate similar experience
- experience class consists of all contracts that
- similar type (UL/Term/WL/etc)
- same structure of charges/benefits
- issued over continuous time period
- similar mktg objects
- different assumptoins might have different classifications
- experience class used for pricing shoudl remain in tact - OK to merge w/ another class, but not split
- key principles to decide on complexity of assumption structure
- differences in exp assumptions shoudl reflect differences in experience
- ok to vary mort by IA/sex/smoker/dur
- ok to vary lapse by mode of payment
- if no differences in an assumption, don't split
- definition of class s/b objective and easily understood
- # class s/b practical and cost effective
- balance between precision and expense
- Analyze Experience adn Trends in Expereince for Each Assumption
- evaluate credibility of data
- homogenity of data - ex. split out substd from std for mort
- reasonability of methods and results
- Evaluate quality of data
- understand the data and how it will be used
- possible alternate sources of data - balanced w/ practicality
- can it be obtained in a reasonable time at a reasonable cost
- appropriateness of data - recent? limitations? biases?
- reasonableness and comprehensiveness of data - internally and externally consistent
- Use Actual or similar experience
- s/b that of class of business assumption applies to, provided experience is determinalbe, available, and credible
- if actual experience not determinable, available, or credible, base assumptions on
- "similar expereince" from same company
- similar business other cos
- other sources
- in this order
- Reflect Trends in Exp as Appropriate
- evaluate trends and make judgemenet whether trends will continue
- ok to ingore trends if doing so is conservative or not permitted in regs
- Reflect Company and external Factors
- review company business practices and reflect in assumptions
- esp true if company practices changed recently or will shortly or if relying on other co data w/ diff business practices
- mort rates shoudl reflect selection criteria for each rating class
- freq of u/w exceptions, reinstatement reqs, etc
- inv assumptions shoudl be consistent w/ limits on asset type, quality, duration, convexity
- different assumptions for each segment if appropriate
- Sensitivity Test Assumptions
- test to show impact of probable deviations that could have material financial effects
- standard stat tests or historical exp for likely range
- Review & Adjust Set of all assumptions for Reasonableness, Comsistency, & Appropriateness
- generally not a single assumption but a range fo assumptions that are consistent w/ underlying data
- set of assumptoins s/b comprehensive and internally consistent
- consistency checks
- inflation assumptions for expenses consistent w/ inv earning assumptions
- mort anti-selection assumptions consistent w/ lapse assumptions
- u/w exense and mort rates consistent w/ u/w practices
- inv expenses and returns consistent w/ inv policy
- model validation chekcs
- does model produce aggregate reserves consistent w/ most recent valuation
- does model produce cahnge in reserve in future years consistent w/ past trends in actual reserves
- Document Assumptions
- Documentation of experience assumptions should cover
- what the assumption is
- data underlying the assumption
- how assumption was developed
- how to use the assumption
- Monitor Experience and Update Assumptions
- need ot be reviewed and updated on a regular basis
- just because you reviewed doesn't mean you have to change it
Mortality Assumption
- normally of form of table of rates varying by IA and duration since issue
- q(x,t) = q(y,s) if x+t = y+s adn t>n and s > n (ultimates s/b in sync)
- q(x,t) <= q(y,s) if x+t = y+s and t<s and t<= n (same AA, qx for one closer to issue)
- ANB <=> ALB - normally just average rates @ adjacent ages
- q_ALB(x) = 1/2*(q_ANB(x) + q_ANB(x+1))
- q_ANB(x) = 1/2*(q_ALB(x-1) + q_ALB(x))
- M/F smoker/nonsmoker have signficantly different mort rates and relationship si NOT a simple multiple
- other distinctions usually just expressed as a multiple or other simple mod
- credibility of data plays role in whether experssed as multiple or completely different table
- common variations in mort class
- risk selection class
- selection process - simplified/guar iss blood/no blood
- size of policy - usually lower mort for higher face
- misc - mktg method, plan type, policy provisions, other
- Analyzing Experience
- Credibility
- confidence intervals - convenient way to judge credibility of co's experience
- 95% conf interval (of expected claims) E+/-1.96(VAR^.5)
- E = expected = nq
- Var = npq (for claims)
- 95% conf interval of mort rate [E+/-1.96(VAR^.5)]/n
- Risks Covered
- normally studies done on "std" issues and exclude
- policies not subject to normal u/w stds (GIO/group conv/term conv/simpl/guar iss)
- substd policies
- policies inforce under ETI/RPU
- multple life policies
- sep studies for excluded policies
- then use a multiple or other mod to std table
- multiple life mort generally derived from single life mort assumptions
- Mortality Studies
- anniv to anniv studies and calendar year studies
- ways into study - A-inforce @ BOP and N - new entract (age x+ r)
- ways out - B - inforce EOP W - w/d (age x+s) D- death
- use Balducci assumption for dist of deaths
- q(x) = D / [A + (1-r)N - (1-s)W]
- exposure for a cell - seriatim or aggregate
- if aggregate, use mid-year assumption for entry/w/d
- 6 ways to get through study and their exposure
- (A,W) s
- (A,B) 1
- (A,D) 1 <- no deduction for deaths)
- (N,W) s-r
- (N,D) 1-r
- (N,B) 1-r
- sum up indiv exposure to get total exposure
- aggregate - exposure = 1/2[P(x,z) + P(x,z+1) + D(x,z)]
- using calendar year-end inforce data and deaths
- Other Aspects of Mortality Studies
- need to look at several years for credibility concerns
- too long a study might not be representative of recent experience
- usually 5 years of data
- usually policy count or amt (or both ) study basis
- count basis
- distorted by multiple policies by same insured
- if overall # pols in large, s/b not an issue
- amount basis
- shows financial impact
- generally preferred
- credibility not as high as count (b/c of variation in amts of ins)
- Enhancing Credibility
- grouping IA & durations together can enhance credibility
- similar to adding years to study
- grouped results smoothed
- A/E analysis can also help credibility
- Credibility of A/E Ratios
- Var(expected # claims) = sum(pq)
- 95% conf interval of claims (CIC)
- E[# claims] +/-1.96*sqrt(var(# claims))
- 95% Conf Interval of mort ratio = CIC / E[# claims]
- Var(amt claims) = sum(A(i)^2*q(i)*p(i)) where A is Amt of ins
- E[amt claims] = sum(A(i)q(i)
- conf interval - amt of claims E[amt claims]+/-1.96*sqrt(var(amt claims))
- variation in policy size can increase size of confidence interval
- Adjusting Mortality Tables for Special Situations
- some mort assumptions derived from mort tables, not developed by study
- multiple life/substd
- Term conversions
- expected mortality is higher than regular u/w polices and needs to be accounted for in pricing and other models
- include term conv in regular mortality study and have all permanent policies share extra mort cost
- include charge in term pricing for PV of cost of extra anticipated mort on perm policy
- (q_c([x]+t+s) - q_s([x+t]+s)*NAR(s) <- cost of extra mort in year s after conv
- can do sep study on converted policy mortality if enough data
- extra mort can be estimated by making assumption about degree of anti-selection
- Anti-Selection
- several situations when PO can be expected to antiselect
- when ART rate @ renewal is higher than newly u/w policy
- if healthy enough to qualify for new policy, they can be expected to do so & those that cna't will keep policies
- conservation of deaths
- A - portion of policies that lapse @ dur r to buy new policy @ x+r
- A*q(x+r,t-r) + (1-A)q_AS(x,t) = q(x,t)
- A(s) - portion of policies that lapse @ s to buy new @ x_s
- q_AS(x,t) = [q(x,t) - sum(A(s)q(x+s,t-s))] / [1 - sum(A(s))] where sum are s=1 to t
- Blending Tables
- sometimes necessary to combine two tables to get a single blended table (ie Unisex)
- usually better to blend survival table (lx) instead of mort tables (qx)
- Adjusting Similar Experience
- factors to consider if using similar experience b/c actual not credible
- quality fo co u/w relative to experience underlying other experience
- distribution channels - more antiselection in brokerage than career
- anti-selectin from excessive lapses
- u/w reqs for preferred or substd risk classes
- reins quotes on the business
- if need a table in a country where no study of insured lifes mortality exists
- also consider
- starting w/ general population mortality studies
- quality of data
- cause of death info
- abiltiy to do medical u/w
- ability to contest claims
- liklihood of wars, epidemics, or natural disasters
Lapse Assumptions
- Stucture
- generally by duration since policy issue
- may also vary by
- IA
- freq of prem payment
- policy size
- plan type (term/WL/UL/annuity)
- mktg method
- market
- for perm, 1st year usually higher than renewal
- term and annuity - often shock lapse tied to product design
- annuity - when SC expires
- term - when level prem period ends
- lapse rates often vary by scenario for CFT or option pricing b/c of different interest rates
- expressed as a formula that adjusts base rate to reflect
- delta mkt and credited rate
- size of SC
- Lapses assumed to occur on prem due dates
- "lapse skew" might be appropriate depending on distribution of business
- Analyzing Experience
- Credibility
- generally less of an issue for lapses than for mort
- generally less refined assumptions than for mort (helps w/ credibility of data)
- lapse rates generally higher (helps w/ credibility of data)
- confidence intervals - calced same as mort
- Lapse Studies
- mechanics same as mort - except lapses & deaths switch spots in calcing claims and exposures
- Factors Affecting Lapse Rates
- product design
- policy size
- dist channel - brokerage higher lapses than career due to shoping
- effectivness of company conservation programs
- if lapse rates expressed as formula that varies by int rate scenarios
- significant judgement involved in setting parameters
- sensitivity of lapse to int rate usually varys by
- product type - DAs more sensitive than trad life
- dist channel - stock broker business more sensitive than agent sold
- Types of Lapses
- usually include
- termination w/o value b/c failure to pay prems
- cash surrenders
- transfers to ETI/RPU
- others that depend on study or purpose of assumptions
- term conversions
- if term conv charges attributable to term policy, need a sep study
- if cost absorbed by new policy, count as lapse
- partial w/d - usually included in lapse rate unless product design has provision for free partial w/d
- premium persistency - actual to target/billed from flex
- termination w/o value b/c policy loan > CV
Interest Assumptions
- Structure
- deterministic models generally use one of two appraoches
- portfolio avg
- Inv generation method (IYM)
- for IYM
- fixed prem policies grouped by issue year
- flex prem polices group prems by mo rec'd
- nv income assumptions generally net (after expenses & defaults)
- Policy loans can be asset CF or liab CF
- for deterministic models - generally aggregated w/ other investments
- therefore also need assumptions for
- policy loan int rate
- policy loan expenses
- policy loan utilization rate
- if model has multiple int rate scenarios, policy loans generally modeled as liab CF w/ utilization rate that varys by scenario
- how many?
- specified by client/regulation?
- generated by stochastic model
- # scenarios depends on relative importance of asset risk and practical concerns (such as model runtime)
- for each scenario, int rates can vary by
- time
- asset class
- asset quality
- credit risk
- Inv returns can be measured on a book ro mkt value basis
- also need assumptions for
- mix of existing assets by asset class and maturity
- reinvestment and disinvestment strategy
- Analyzing Experience
- int rate determined as inv income from block / avg assets in block
- for "new money" rate - usually some benchmark rate + spread
- total returns on a mkt value basis - needs to realized and unrealized g/l
- r = (B-A-C)/(A+C/2) - C is net cash flows, A&B - mkt values
- mutual funds often calc daily and if assume that all CF @ end of day
- if evaluating rates of return over time
- time-weighted return - geometric mean of rates of return
- dollar-weighted return - level rate of return earned taking into acct timing of CF
Expense Assumptions
- Structure
- generally split between direct (aka marginal) expenses and indirect expenses
- certain expenses can be direct or indirect depending on model and purpose of model
- also split between acq, maint and overhead
- Analyzing Experience
- Units
- unit expense assumption = expenses / # untis
- experience study looks @ expenses by calendar year
- pricing
- policy year expenses
- usually charge expenses @ either BOY, EOY or midYear
- need appropriate unit count based on when expense is charged
- expenses charged BOY -> count = (A+B+N)/2
- Expense ALlocation
- important to understanc how co allocates expenses to LOB
- some expenses clearly associated w/ particular product or LOB
- other not so clearly - several methods to allocate
- first need to split total expenses into major components
- once categorized, allocate
- transaction or item counts
- transfer costs
- employee time allocations
- indexed based allocations (allocated by policy count or prems)
- Projecting Expenses
- future unit expenses depend on estimating of total level of expenses an dcount on which unit expenses based
- projection shoudl reflect
- historic trends
- expected future volumes of business
- expected inflation rates
- how expenses vary w/ changes in business volume (fixed/varaible/step rate)
- impact of any planned business changes
Study Notes and Published Refences - Note SN 8I-201-00 - GROSS PREMIUMS FOR DISABILITY WAIVER BENEFITS
Introduction
- insurers limit coverage at older ages
- dis rates increase dramatically at older ages
- hard to tell between dis and normal ret at older ages
- Calc of PV of benefits is a 2-step process
- benefit provided at point of where dis occurs must be calced
- benefit is a disabled life annuity = PV waived prems using int and rates of termination of dis
- PV @ issue of each benefit is calces using int, active life mort and rates of dis
- calced at each point dis can occur and summed
- calc of actual gross prem can be simplified by loading published valn net prem
- loading determined by fitting adjusted experience prems to valn net prems
Assumptions for Experience Premiums
- Prems Waived
- prems used in benefit calc s/b net cost to insurer of prems actually waived
- consider
- commissions paid on waived prems
- prem taxes not paid on waived prems
- if offered, sex-distinct prems s/b used
- if prems vary by size of policy, either
- avg size s/b used or
- sep prems calced for each band
- YRT - S&U - simplified by calcing single AA table based on ultimates
- Term Conversions - should use permanent plan's premium in calc
- if prems vary by s/ns - blended rates or sep prems
- Interest
- significant impact b/c long dur benefit
- conservative LT rate s/b used
- Expenses
- cost of initial and ongoing claims investigation
- acctg for waived prems
- reserving for coverage
- command prem tax on premium for benefit
- some cos charge share of overhead
- Active Life Mortality
- used to determine survivorship for non-disabled lives for
- PV (@ issue) of benefits
- annuities used to calc net ann prem
- use same experience assumption used for pricing base coverage
- table of commutation functions D([x]+k) = v^(x+k)*l([x]+k)
- Lapse Rates
- conservative to assume no lapses
- use base contract rates if using any
- Morbidity
- Rates of Disablement - measure chance of life aged (x) becoming disabled at age (x+k) (and remaining alive and disabled to end of waiting period)
- probability of disablement - r(x+k)
- absolute annual rate of disablement - r'(x+k)
- Rates of Termination of Disability
- needed to calc dis life annuity values
- measure probability of leaving the group of disabled lives (from recovery or death)
- highly select by duration since disablement
- usually monthly for first 2 years
- very few people beyond retirement age recover from disabled status
- Termination rates used to construct table for dis lives
- l_i([x+k]+m/12+s)
- k+1 - year disablement occurs
- m - months in waiting period
- s - duratoin since end of waiting period
- D_i([x+k]+m/12+s) = v^(x+k+m/12+s)*l_i([x+k]+m/12+s)
Experience Premium Formulas
- Assume
- disabilities occur mid policy year
- prem and benefit payments payable continuously throughout policy year
- waiting period is 6 months
- B(k+1) - benefit provided if dis occurs in year k+1
- P(k) - prem/14m payable during k+1
- u = age wvr benefits end
- h - prem paying period of base plan
- n - cvoerage period for waiver provisoin = min(h,u-x)
- h' - prem paying period for waiver provision
- B(k+1) = sum(P(k+s+1)*(D_bar_i([x+k+1/2]+1/2+s) / D([x+k+1/2]+1/2))) from s=0 to n-k-2
- if P is level = P*abar_i([x+k+1/2]+1/2:n-k-1|)
- if coverage retroactive, B(k+1) increased by half prem payable in k+1 (0.5*P(k))
- PVB = B(k+1)*v^(x+k+1)*l([x]+k+1/2*r'(x+k) / D([x])
- = B(k+1)*v^(1/2)*r'(x+k)*D([x]+k+1/2) / D([x])
- NWSP = sum(PVB) from k = 0 to n-1 -> net waiver single premium
- NAWP = NWSP / active life annuity
- = sum(B(k+1)*v^(1/2)*r'(x+k)*D([x]+k+1/2)) / sum(D_bar([x]+k)) for (numerator) k = 0 to n-1 and (den) k=0 to h'-1
- To load for expenses
- E_wp(pi) - exp prem, loaded for expenses
- B'(k+1) - expense loaded benefit if dis in k+1
- c(k) = active life % prem expense in k+1
- e(i) - active life per pol expense in k+1
- c_i(s+1) - dis life % benefit expenses paying in dis year s+1
- e_i(s+1) - dis life per pol expense in s+1
- assuming per pol expenses paid @ BOY and % expenses paid continuously
- B'(k+1) = .5*P(k) + sum{[P(k+s+1)*(1+c_i(s+1)) + e_i(s+1)]*[D_bar_i([x+k+1/2]+1/2+s)/D_bar_i([x+k+1/2])]} for s = 0 to n-k-2
- E_wp(pi) = sum{[e(k)*D([x]+k) + B'(k+1)*v^(1/2)*r'(x+k)*D([x]+k+1/2)]} / sum{(1-c(k))*D_bar([x]+k)} for (num) k=0 to n-1 and (den) k=0 to h'-1
Special Considerations
- substandard risks
- waiver usually restricted to least substd risks
- waiver prems usually multiples of std business wvr prems
- Payor Benefit
- waives premiums if payor of juvenile policy is death/dis until juv attaines 21/25
- prems depend on age of applicant, plan of ins, age of insured
- gross prems usually published at table of factors
- Riders on Insured Spouse or Children
- waives rider prems
- based on base insured, not spouse or children
- Non-traditional Products
- indeterminate prem products
- using guar prems in calc is conservative
- use judgement re: most likely scale of prems to be charged and use in calcs
- UL
- waiver of coi
- specified amt - use specified amt in formulas and is aount req'd to keep contract in force if all guarantees realized
- does not have any relationship to prms actually paid into contract
- either case, use same formulas, just different P(k) stream
-
Study Notes and Published Refences - Note SN 8I-202-00 - VARIABLE ANNUITY MINIMUM DEATH BENEFITS - A MONTE CARLO PRICING APPROACH
Overview
- generous min DB designs, harder to understand risks in providing MGDB
- benefit costs little (if anything) usually
- could be very costly in certain events
- Monte Carlo approach
- large # scenarios b/c > 1/2 trials result in 0 or minimal cost
- but very long tail (sd > mean typically)
- results similar (but slightly higher) than B-S approach
- first tests using 3.75% base return assumption
- historical returns consistenly above that.
- author uses 8% remainder of note
- cost of MGDB drops drastically as assumed yield increases
- base return assumption is a CRITICAL ASSUMPTION
- distribution has large kurtosis
- large number of outliers
- sd > mean demonstrated volatility of results
Pricing
- approach pricing through an asset charge
- problem - charge collected over longer time frame than claims
- creates reserving problem and insurer exposed to lapse risk
- one approach - study point in each scenario where insurer is in worst position
- if distribution of results is unsatisfactory, try again w/ higher/lower asset charge
Enhanced DB Definitions
- enhanced DB provisions included in many contracts
- "Ratchet 5 to 70" increases (never decreases) min DB on every 5th anniv to then current policy value (if it is higher than prior min db)
- no increases after age 70
- "Increase 5% to 200%" - prems accumulated at 5% subject to 200% max, no age limit
- "combined to age 70" - combines ratcheted formula w/ int formulat - greatere DB under either formula, but no increases after 70
- enhanced formulas add signficantly to cost
Ratcheting Frequency
- resets are most important cost factor
- frequency of reset also significant cost factor
Summary - Volatile Results
- actual costs highly sensitive to
- base underlying yield assumption
- issue age
- mkt volatility
- lapse rate
- benfit provisions
Evaluation of Methodology
- B-S easily produces sensible, quick calcs of values for min DB for simpler cases
- complex for ratcheted formulas
- Monte Carlo - requires many trials, but easy enough w/ current spreadsheets
-
Study Notes and Published Refences - Note SN 8I-204-01 - REPORT OF THE SOA TASKFORCE ON PREFERRED U/W
Overview
- based on 10 year term (level prem)
- generally experienced more insureds qualifying for pref non-smoker risk class than expected
- less qualifying for pref smoker than expected
- not takes generally lowest for most restrictive pref ns and highest for least restrictive std smoker
- most freq used risk criteria
- personal history
- diabetes
- heart disease
- cancer
- elevated cholesterol
- Lifestyle criteria
- alcohol and other substance abuse
- some allow exceptoins to pref risk criteria
- blood pressure and build
- family history
- slight variations in one criteria
- cholesterol level
- majority of respondents use captive or independent agents to sell pref risk products
Background
- pref risk class - risk class w/ better expected mortality from gruop of non-substd applicants
- std class - residual non-substd applicants
- pref risk class if very varied, even w/in same co
- varys between products and even generations of same product
- established by splitting an aggregate risk class into two or more risk classes
- common formulas
- q_pref = (1-discount)*q_agg
- q_std = [q_agg - q_pref*%qualifying]/[1 - %qualifying]
- two critical assumptions - based on pref u/w criteria chosen
- what discount to give to pref u/w class
- consider
- agg mort used
- screening tools used
- strictness and level of criteria used to qualify for pref risk class
- co's practices on u/w exceptions
- % of applicants desired to qualify for pref risk class
- stricter u/w -> better discount
- usually 10-20% range
- % expected to qualify
- normally cos determine this and adjust u/w criteria to make it happen
- the lower the assumption, the more aggessive the discount can be
- more applicant & producer dissatisfaction w/ lower assumption
- additional pressure on U/W to make exceptions
- possibly higher than expected not-taken rate
- important for actuarial/u/w/mktg to be involved and understand
- # applicant for pref class (initially) may be higher than expected b/c producers tent to bring better risks forward
- % placed in pref class initially exceeds expectations as well for same reason and higher not-takens
- other reasons for getting disproportionate share of pref or std risk class
- producer's client base
- specific criterion much different from what other cos use
- u/w concessions
- unreasonable initial expectations
- Why have new risk classed developed
- legitimate descrimination
- equity considerations
- mktg tool <- main reason
- most often developed for competitive reasons and/or defensive purposes
Results
- Risk Classes
- trend toward using more pref risk classes
- Percentage Expected to Qualify adn Percentage Actually Issued by Risk Class
- on avg, more policies issued in most restricive NS class than originally expected to qualify
- slightly less policies in most restrictive smoker class than originally expected to qualify
- if actual results appreciably different from expected, maybe investigate reasons
- possible explanations:
- agent selection
- improper initial assumptions
- u/w exceptions which allow more issues in pref risk class
- not takens in std risk class (which distorts the % placed in pref risk class)
- Not Taken Rates
- most restrictive NS (5%) < agg smokers < most ristrictive smoker < least restrictive NS < least restrictive smoker (24%)
- applicants dissatisfied w/ risk class may look elsewhere for better rating
- Expected Mortality
- in general, pref risks had decreased expected from prev study
- possible reasons
- tighter pref u/w
- shift from NS to NT
- better than expected early dur experience
- competitive mkt pressures
- Ratio of Std To Pref Mort
- Max IA and Min Face Amt Limits
- usually around 70/75 for pref class
- min face usually 100,000 for pref class
- Age and Face Amt for U/W req
- features that influence what reqs used
- company's mkt
- distribution system
- specific criteria that must be met to qualify on a pref risk class basis
- mortality expectations
- competitive environment
- u/w philosophy and expertise
- other fin objectives
- Common Reqs
- Blood Profile $100k+ sometimes lower over 20 tests
- DBS infrequent
- Oral Fluid (OFT) infrequent can test for HIV, continine and cocaine
- Urine $100k+ usually in combo w/ blood - tests fro continine, cocaine, diabetes, kidney probs
- Cotinine $100k+ as part of urine or OFT
- Cocaine $100k+ as part of urine of OFT
- Illegal drugs infrequent
- NonMed <$100k limits increasing w/ PHI, MVR adn agent collected fluids
- ParaMed $100k+ & older ages
- Medical $500k+ & older ages
- APS older ages adn $500k
- MVR about half $100k+
- ECG older ages
- PSA about half older ages
- HIV $100k and about half < 100k
- Collection of Fluids
- considerations when using other than paramed or med to collect
- legal liability
- chain of custody considerations
- confidence in quality of test results
- producer/consumer reaction
- must weigh cost savings against these issues
- Indicators Being Used as Preferred Risk Criteria
- Three broad categories of application info
- personal history
- family history
- lifestyle considerations
- some important info is verified independently from app
- sometimes favorable info could offset unfavorable
- personal history considered more important than family history
- personal history and lifestyle most freq used criteria
- Personal History
- except for cholesterol, at least half cos preclude applicant from qualifying for pref risk class for bad info on personal history
- diabetes/heart disease/high cholesterol/non-skin cancer/stroke/hypertension/melanoma/treatment for hypertension/mental-nervous/non-melanoma skin cancer/treatment for cholesterol/prescription drugs
- Family History
- heart disease/cancer/stroke/diabetes/hypertension/non-accidental early death
- heart disease is only family history that is an automatic preclude - approx 1/2 cos
- most base family history on occurence of death, not diag
- other factors
- whether natural parents or natural parents & siblings included
- # incidences of death or diagnosis allowed
- age limit for incident of death or diag
- offsetting family history w/ good applicant health or neg stress test in last year
- using gender specific cancers only
- Lifestyle
- MVR and body fluids verify lifestyle items
- if declined, will reconsider after they discontinue adverse activity for period of time
- alcohol abuse/illegal drugs/driving/DUI/aviatoin/avocation/hazardous sports/other tobacco/cigarettes/occupation/foreign residence/foreign travel/felony conviction/regular excercise
- all but exercise used regularly
- drug and alcohol abuse were automatic out
- Driving Record and DUI
- normally no more than 2 or 3 moving violations in 3 year peroid
- no DUI w/in last 3-5 years
- Cigarette and other tobacco use
- usually no usage in last 12-36 mo
- Differences in Criteria by Smoking Status
- rarely - blood pressure, build & cholesterol
- Diff in criteria by gender
- Other criteria use to Determine Pref
- Ranges of Criteria in Use (to qualify for Pref)
- total cholesterol - usually around 250 (220/240/250)
- Total Cholesterol/HDL-C ratio - 5.0/5.5/6.0
- GGT (tests for liver damage) - 65 units/liter
- SGOT (myocardial infarction/hepatitis) - 40/41 units/ml
- SGPT (liver enzyme - hepatitis) - 45 units/ml
- PSA (prostate) - 4.0 ng/ml
- Preclusion from Pref Risk Class due to lab test result
- approx 2/3 based on Tot-C/HDL-C
- < 1/2 on other criteria
- Blood Pressure
- considered a coronary risk factor - 140/90 as max untreated BP
- about 1/3 preclude individuals w/ treated hypertension
- remaining allow treated BP in range
- Height and Weight
- approx 1/2 do not automatically exclude if out of range
- Debits
- ome co's don't allow credits for pref u/w, some do
- max debits usually <= 25 (after credits)
- most <= 50 before credits
- U/W guidelines for Exceptions
- approx 1/4 ahve written guidelines for exceptions
- virtually all cos allow u/w judgement to pref qualification
- Exceptoins to Pref Criteria
- most allow exception if overall risk profile would still qualify for pref risk class
- Additional Comments
- one co has agent "IOUs" baed on production
- can be redeemed to reduce prem rating by up to 2 tables
- Dist Channels
- must used indepenant agents and captive agents
- about half use multiple dist channels
- Effect of Introduction of Pref Risk Class
- approx 2/3 saw increased production
- caveat - toher factors couls also affect sales
- Illustration Restrictions on Pref Risk Classes
- virtually all allow best class to be illustrated
- some discourage illustrating initially
- other allow, but must also illustrate on std class at same time
- some require field u/w assessment before allowing pref illustration
- Application for Pref Risk Class
- approx 10% require applicant to apply for best class to receive it
- Pref Risk Classes on OTher Products
- most cos w/ pref class have it on products in addition to 10yr Term
- Review of Pref Risk Criteria
- how often to review
- approx 1/2 review at least annually
- Future Changes in Pref Criteria
- approx 15% had plans to change pref criteria
- > 1/2 no plans
- rest didn't know
-
Valuation and Financial Statements
Valuation of Life Insurance Liabilities - Chapter 1 - TYPES OF VALUATIONS AND BASIC REQUIREMENTS
Overview
- principle liablilities of a LIC are due to contingent benfits granted on its long term policies and contracts
- small cahnge if value can have significant impact on co's earnings
- reserves - liablilities for amts inc co is boligate to pay in accordance w/ policy
- amts usually uncertain or contingent as to exact amt and/or time of payment
- some reserves for incurred but unknown to ins co - claim (or loss) reserves
- some reserves for event not yet happened but ins co obligated to pay - policy reserves
- actuarial reserves = policy reserves (as far as text is concerned)
- actuarial valuation - process of determining actuarial reserves
- theory behind reserves (law of large numbers) only true for blocks of policies, not at the indiv policy level
Types of Valuations
- Statutory Valuations
- used to help regulators assess financial health of the company
- conservative assumptions since emphasis on solvency
- in US - assumptions and methodology very explicit in the law
- US rules based on old practical decisons made in pre-computer era
- trend toward more than just "cookbook" - need to ensure liabilities good and sufficient
- GAAP Valuations
- required if stock is publicly traded or owned by a apublicly traded co
- objective: accurate allocation of income to period earned
- assumptions required to be reasonable and conservative, not as conservative as stat
- Canada - GAAP = Stat (using PPM)
- incorporates explicit lapse/surrender assumptions
- Gross Premium Valuations
- used to produce "best estimate" value of co's liabilities
- less conservative than GAAP
- may be appropriate to determin co value for acquisition/merger
- incorporates explicit lapse assumption
- PV future gross prems - PV future benefits
- PPM is a gross prem valn
- value-added financial measurement - offshoot of GP Valn
- uses stat reserves, but future values of stat profits recognized in valn
- Tax Reserve Valuations
- used to calc reserves for determing taxable income
- Canada - 1.5 yr FPT w/ csv floor
- may be > or < statement Vx
- US - 1958-1984 based on stat Vx w/ adjustments
- 1984+ - FPTR (Fed Prescribed Tax Reserves)
Effects of Stat Reserve Requirements
- Gross Premium Levels
- indirectly affect since guar prems typically set at level to avoid def reserves
- take into account cost of capital required
- Product Design
- guar rates to avoid def reserves
- avoid product features too difficult to reerve
- int guarantees on annuities affected by CARVM
- FIT
- FPTR make it fairly insensitive to Stat
- if unspecified in tax code - follow stat practices
- Tax Vx <= Stat Vx
- Divs to PO
- if div formula uses Stat Vx, significant impact
- if doesn't use Stat Vx, still probably uses some stat info to allocate surplus
- Stat Earnings
- obvious - stat Vx affects Stat earnings
- US: divs to stockholders limited to accum stat earnings of Co
- Important Indicators
- several industry measures are based on Stat Financial Measures (like rating agencies)
- Other Considerations
- pricing profit objectives might be accum surplus / stat Vx > y% at year z
- reserving methods do not directly affect total profitability of a product, only emergence of profit by year (pre-tax)
Valuation Requirements
- 3 major components - math calc, verification of results, actuarial opinion
- Mathematical Calculations
- PV of excess of future benefits over future premiums
- based on assumptions for lapses, mortality, interest, etc
- Verification of Results
- demonstration that assumptions are reasonable
- interest given more scrutiny o flate
- structure of assets need to be viewed together w/ structure of liab
- Actuarial Opinion
- qualified actuary signs opinion re: appropriatness of Vx
Valuation Requirements in the US
- SVL
- Opinion shoudl list items and amounts for which expressing an opinion
- OK to have sep opinions for separate blocks
- indicated reliance on others
- requires an actuarial analysis of reserve and assets supporting reserves
- Opinion as to Non-Guaranteed Elements
- includes contracts such as (if they contain non-guar elements)
- single and periodic premium DAs
- UL contracts w/ fixed and/or flex prems
- indeterminate premium life contracts
- single and periodic premium ilfe contracts
- ren and conv term ins contract which do not guar the prems payable on renewal or which provide fo rrenewal on teh then current basis
- if contract ahs charges or benefits which vary at co discretion (excl divs and sep acct based contracts) then A.S. aslo needs
- statement containing determination procedure for non-guar elements
- 8 interrogatories dealing w/ determination of non-guar elements, supportibility and relationship of current non-guar elements to those used in sales illustrations
- actuarial opinion related to non-guar elements signed by a MAAA
- RBC Requirements
- Four components
- Asset quality and payment default risk
- Insurance Risk (pricing)
- Interest Rate risk (disintermediation, reinvestment)
- Business risk
- represents "minimum" capital and surplus level for a particular co
Valuation Requirements in Canada
- big gap here since 8I-U and not 8I-C
-
Valuation of Life Insurance Liabilities - Chapter 2 - RESERVE METHODOLOGIES AND BASES
Valuation Standards in the US
- determined as of policy issue date by state valn laws then in effect
- most state laws based on SVL
- min Vx defined in terms of net prem valn
- defines minimum standards of mortality and interest
- 1980 amendments - dynamic valn int rate - allows automatic adjustments to int rate changes
Valuation Bases in the US
- Valn Mortality
- Pre-80 SVL Amendments
- AA mortality tables w/ setbacks for females
- 80 SVL Amendments
- adopted 80 CSO table
- had to choose from
- 80 CSO M/F
- smoker/ns versions of both 80 CSO M/F
- Unisex 80CSO
- Unisex S/NS 80 CSO
- ANB/ALB
- 10/15 year select factors
- all states allow unisex for nonf
- some states require M/F for valn
- Int Rates
- 1947-1974 most states used 3.5% for all classes
- max was a problem as investment rates increased
- rates were increased
- 80 amendments - changed to dynamic max valn rate - linked to Moody's Corp
- resulted in rates that ary by duration of contract guarantees
Reserve Methods in teh US
- NLP Reserve Method
- designed to cover benefits only
- no explicit recognition of any expenses is made
- for a plan/issue age, net prem = constant % of gross prem
- sum(k*GP(t)v^(t-1)*l(x+t-1)/l(x)) = sum(DB(t)v^t*d(x+t-)/l(x))
- NP(t) = k*GP(t)
- if WL then NP = P(x) = A(x)/adue(x)
- typically produces highest Vx
- typically requires significant V(1) therefore avoided by surplus conscious cos
- Expense Allowances
- used to reflect large first year expenses intended to be recovered from future margins
- Modified Reserves - basically NL reserves less an unamortized expense allowance
- note:DAC is essentially an expense allowance
- EA = beta_mod(x) - alpha_mod(x)
- beta_mod(x) = renewal net premium for modified Vx method
- alpha_mod(x) - 1st year net premium
- V_mod = V_nl - EA*adue(x+t)/adue(x)
- FPT Reserves - 1st year net prem = 1 year term net prem & renewal net prem = NLP for remaining coverage @ IA + 1
- for WL, EA = A(x+1)/adue(x+1) - c(x) (c(x) = A'(x:1|) results is V(1) = 0
- for stat valuations, expense allowance is limited to a max
- expense allowance is formula based and not limited by actual first year expenses incurred
- CRVM
- FPT reserves if FPT adj NP < 20 pay life adj FPT prems
- if DB non-level, then DB = AvgDB(2-10) per AG17
- valn NP for years 2+ are constant % (k) of gross prems
- sum(k*GP(t)v^(t-1)l(x+t-1)/l(x)) = sum[t=1](DB(t)v^td(x+t-1)/l(x)) + 19P(x+1) - DB(1)c(x) (P_FPT > 19P(x+1))
- sum(k*GP(t)v^(t-1)l(x+t-1)/l(x)) = sum[t=2](DB(t)v^td(x+t-1)/l(x)) (P_FPT <= 19P(x+1))
- AG21 - if beta - alpha < 0, excess to be taken as 0
- AG25 - COLA policies to be reserved w/ increases = i_valn - contanst based on type of guarantee
- CRMV produces 0 V(1) from most policies which helps surplus strain on NB
- Other Methods
- Grade from CRVM to NL after x years (typically 20 years)
- reason: to offer products w/ higher (than min) 20yr CV by < Vx
- (P_G - P_NL)*adue(x+1:19|) = EA_CRVM*adue(x+1)/adue(x)
- in general, NL reserve method defined by magnitude of EA and period over which it is amortized
- Other Alternatives
- Arguments for a change to SVL
- based on artificial, predetermined i, fixed for life of contract
- embedded conservatism deliberately adds a solvency margin ~ volume business transacted
- this is in addition to RBC
- several insolvencies illustrate weaknesses in current system
Valuatino Standards in Canada (mostly skipping b/c Canada)
- < 1978 - similar to US
- 1978-1991 - Valn Actuary - modified NP
- PPM - expenses treated explicitly therefore gross prem valn
Valuation of Life Insurance Liabilities - Chapter 3 - TYPES OF RESERVE FACTORS
Mean and Mid-Terminal Reserves and Their Relationshiop to Deferred and Unearned Premiums
- Mean Reserves
- Interpolated Mean Reserve - (1-h)([t-1]V(x) + [t]P(x)) + h*[t]V(x)
- Mean Reserve h = 1/2 -> [t]MV(x) = 0.5*([t-1]V(x) + P(x) + [t]V(x))
- Deferred Premiums
- modal premiums due after valn date & befroe next policy anniv
- an Asset in US (neg liab in Canada)
- b/c mean reserves based on annual net prem payment @ boy overstate reserves on policies w/ more freq modes of payment
- use net prems since reserves based on net prem
- usually calced using an inventory
- can use avg def premium (m-)/2m * P(x)
- using avg def prem, net liab = 0.5*([t-1]V(x) + [t]V(x)) + 1/2m*P(x) (mean reserve - net def prem)
- Mid-Terminal Reseres and Unearned Premiums
- interpolated terminal reserve (1-h)[t-1]V(x) + h*[t]V(x)
- mid-terminal reserve 0.5([t-1]V(x) + [t]V(x))
- used by some companies instead of mean reserves
- understates reserves unles sprems paid very frequently
- Unearned Premium Liablility - used as an adjustmetn
- usual practice - 1/2 modal prm for each policy
- can also calc exact for each policy
- or estimate as 1/2m * P(x)
- net liability is saem as formula shown under def prems
Graphic Representatin of Reserves
- show start-step of modal premium reserves
Other Reserve Adjustments and Alternative Types of Factors
- Curtate and SemiContinuous Factors
- reserve formulas assume prems payable at BOY and claims paid at EOY
- reality: prems paid modally and claims paid at death
- Immediate Payment of CLaims Reserve (IPC)
- AG32 - need to establish IPC reserve if basic reserves calculated using curtate functin
- IPC reserve = i/2*death portion of basic reserve (term portion if an endowment) if policy credits interest from DOD to date of payment
- i/3 if payment made immediately upon receipt of due proof of death
- 0 if payments made @ EOY or Vx calculated using continuous or semi-cont or disc cont
- Semi-Continuous Reserves - prems payable @ BOY, claims paid at moment of death
- P(Abar(x)) = Abar(x)/adue(x) [t]V(Abar(x)) = Abar(x+t) - P(Abar(x))*adue(x+t)
- Fully Continuous and Discounted Continuous Factors
- Fully Continuous - continuous prems adn IPC
- Discounted Continuous - prems paid BOY, IPC and refund of unearned portion of Px @ death
- two net prems - one for terminal reserves and one for mean reserves
- discounted continuous is what most cos using "continuous" actually use
- difference between fully continuous and dicounted continuous
- fully cont based on NP payable continuously throughout the year
- reserve factors are mid-terminals adn unearned prem reserve must be set up for prems paid beyond valn date
- disc cont terminal reserves = full continuous terminals
- mean reserves calculated using annual NP = continuous NP discounted w/ int only
- def prem reserve calculated if mode <> annual
- Relationship of the Expense Allowance to type of Reserve Factor
- NP under semi-cont and cont methods > curtate
- SOA published tables using abar(1|)*Pbar(Abar(x)) + (P(x+1) - c(x))/adue(x) <- cont renewal prem for WL
- theoretically correct s/b abar(1|)*Pbar(Abar(x+1)) <- s/b used per AG18
- Nondeduction Reserve
- under curate or semi-cont - assumes full annual premium collected each year
- not true since std practice is to not collect modals due after death
- reserve for this -> term insurance for avg # remaining def prems @ date of death
- for endowment, this woudl be[t]V'(x:n|)*((m-1)/2m * P_modal(x:n|))
- Refund Reserve
- many cos refund pro-rata share of prems for periods beyond DOD
- reserve for both this and non-ded reserve -> 0.5*P_modal(x:n|)*[t]V'(x:n|)
- where P_modal(x:n|) approx = P(x:n|) / (1 = (m-1)/2m*d - 0.5P(x:n|))
- co's often omit (m-1)*d/2m term so 1 factor applies regardless of mode
- these reserves not necessary for fully and discounted coint reserves - already built in
-
- nice grid goes here showing various reserve components for curtate, fully, disc and semi cont
-
Valuation of Life Insurance Liabilities - Chapter 4 - VALUATION OF INTEREST SENSITIVE LIFE PRODUCTS
overview
- policies develop CSV based on retrospective accum of (flex) prems less mort and expense charges at a declared or indexed rate
- this makes them not compatible w/ trad valn procedures
Flexible Premium UL
- premiums less expense charges credited to fund
- int credits credited to fund
- mort and expense charges deducted from fund
- CSV = fund value - SC
- Minimum Reserves
- 1983 - NAIC rules - to make UL work w/ trad valn formulas
- GMP - guaranteed maturity premium - level gross premium that provides for an endowment at the latest possible maturity date
- calculated at issue using policy guarantees for expesne and mortality charges adn int credits
- GMF - guaranteed maturity fund - calced as of issued date assuming GMPs are paid
- r = min(actual fund value / GMF, 1)
- policy fund projected forward using max(GMF, Actual Fund Value) assuming GMPs paid
- this produces guaranteed DBs and Guar Maturity benefit for valn purposes
- PV of these benefits calced on the valn basis
- NL reserve = r*(PV projected DB - PV projected GMPs) (assuming GMPs paid from issue (not valn))
- CRVM reserve = NL Reserve - r*unamort CRVM allowance for plan of ins generated at issue on guar basis assuming GMPs paid
- Simplified: Model Reg assumes all UL plans are permanent plans @ issue
- "r" factor to measure if policy is "on track" as permanent plan
- if CV > Vx, excess held elsewhere on statement (was 8G)
- Alternative Minimum Reserves (AMR)
- may be req'd if GMP < valn net premiums
- if req'd - max(a,b)
- a - reserve calculated using reserve method, mort basis and valn i actually used for policy
- b - reserve calced usnig reserve method actually used, but using min stds of mort and i allowable for V_def(x) & replacing valn net prem w/ GMP
- valn net prem (VNP) not explicity defined in model reg
- most cos interpret VNP = P_NL + EA/adue
- Features that lead to AMR
- no load products if guar COI and i similar to valn basis
- Guar COIs < valn mort (esp if i_guar = i_valn adn low/no fe loads)
- i_guar > i_valn
- any product features that lower GMPs
- Examples
- [t]V_NL = r*(PVFB(t) - P_NL*adue(x+t)
- PVFB(t) - PV based on project of policy funds using policy guarantees where initial value is max(actual fund, GMF)
- for CRVM - [t]V_NL reduced by r*EA_CRVM*adue(x+t)/adue(x)
- for monthly pay policies, DB incr monthly, for PV, use avg annual DB and continuous commutatoin functions
Fixed Prem UL
- key difference for fixed vs flexible premium
- GMP = gross prem
- EA adn rate of amort determined by plan of ins guaranteeed at issue
- r = 1
- to calc CRVM
- project future benefits on guar basis - take secondary guar into acct
- value benefits using valn mort and int
- subtract PV cuture CRVM net prems for plan of ins guar at issue
Secondary Guarantees
- provides teh PO a guar set of CVs, DB and/or mat benefits regardless of fund performance
- 1995 valn model reg - if secondary guarantee keeps policy in force 5+ years, reserves = form implied by secondary guar
Off Anniversary Reserves
- UL Model Reg defined terminal , but not off-anniv
- issues
- r - should it be as of valn date, prior or next anniv
- how to calc GMF on valn date if r is calced on valn date
- use first priciples or mean/mid-terminal/interpolated reserve
- generally considered appropriate to calc r as of valn date
- use annual GMPs or GMPs consistent w/ planned prem mode? - be consistent w/ reserve method used
- advantage if using first principles - avoid net def and unearned prems
Possible Changes and California UL Regulation
- some resistance to change since UL tax reserves defined in terms of existnig UL Model Reg (UL-CRVM)
- if change, might need to calc using 2 different methods into the future
- Guaranteed Maturity Premium Method (GMP Method)
- Calc GMP, GMF, r
- [t]V_GMP = r*[t]V_CRVM where [t]V_CRVM is reserve for traditional CRVM based product (perm ins w/ mat date = latest possible date under UL plan)
- if Fund(t) <= GMF(t) then (above)
- else [t]V_GMP = [t]V_CRVM + Fund(t) - GMF(t) (if Fund(t) > GMF(t))
- if r < 1, this generates save value as model reg
- if r > 1, felt this is a reasonable approx for most products
- California Method (1991 for 1992+ issues)
- simmilar to UL model reg exept valn i <= credited rate guar in contract or alt reserve = mean(CV,fund value)
- NY147 (1994) - allows CA method as elective alt basis for UL reserves
- SVL - reserves >= min aggregate amt req'd by state statement if filed, therefore if filing in CA, need to test for this
- even if use CA reserve, need model reg calc for tax reserves
Minimum vs Adequate Reserves
- using CV as reserve for flex prem UL can effectively defer losses to later years
- CV can become > CRVM reserves once SC wear off
- renewal losses can occurr when CV increases not supportable by the gross prem
- this would fall under unusal CSV provision of Model Reg of Trad, but UL is specifically exempt
-
Valuation of Life Insurance Liabilities - Chapter 5 - VALUATION OF ANNUITIES
Overview
- Commissioners Annuity Reserve Valuation Method (CARVM) - 1976 amendments
- Vx = greatest excess of PV @ valn date of future guar benefits @ end of each contract year over PV future considerations from future gross considerations
- many companies slow to adopt CARVM and held more conservative reserves
- tax law changed to say use CARVM as methodology for FPTR
- cos forced to implement at that point
Basic Application of CARVM to SPDAs
- project fund balcne forward at guar basis in policy, then calc all future benfits guar under policy
- take PV of all these possible benefit streams
- subtract out PV required considerations
- considered a "worst case" valn method
- ususually possible to determine which benefit produces the greatest PV eliminating most paths
- accumulation phase uses policy guarantees
- how to determine which dur will produce largest PV (for SPDA)
- if guar annuity purchase rates less liberal thatn valn basis and CSV used to calc guar annuity payments, future guar annuity payments will never be used in CARVM b/c PV(future annuity pmts) < CV @ annuitization
- if contract has no SC, guar fund accum rate < i_valn, then CV @ valn date is largest CV
- if contract has no SC, guar fund accum rate > i_valn for n years after valn, CV @ last year i_guar > i_valn
- if contract has no SC, guar fund accum rate always > i_valn , CV @ latest mat date
- if SC, combined effect of i_guar & reduction in SC > i_valn for n years, CV @ end of year n
- if this is ignored @ product design, might have to do complete CARVM w/ each valn
- Mid-Policy Year Values and Continuous CARVM
- projecting 1 more day causes cash values to jump b/c of SC changing day after valn
- CARVM specifically state EOY
- NY reg states any point during year aka Continuous CARVM
- other states now following NY example
Common Product Features
- Contingent Benefits (not elected by annuitant)
- Death Benefits in Excess of CSV
- such as SC waived at death or min DB = sum(prems paid)
- AG33 - each benefit be considered in calc of CARVM Vx
- in practice - DB reserve calsed as an add-on as PV excess DB over CSV
- common approx - mort Vx = sum(PV(DB-CSV)) @ valn int and mort
- more exact - only do above calc to policy year w/ largest CARVM reserve
- Nursing Home Waiver
- SC waived if annuitant enters nursing home
- reserved similar to DV but using q_nursinghome instead of q_valn
- Bailout Provisions
- surrender charge waived if i_credited fall more than a specified amt below initial rate
- if bailout provision is in effect, SC s/b ignored for CARVM
- AG13 - 1985 - can't include "significant" contingent SC in CARVM calc
- NY126 - Vx if contract as significant SC = max(a,d) where
- a = fund @ valn w/o SC
- b = CARVM reserve w/o SC
- "signficant" SC - SC% > i_guar
- Market Value Adjustments (MVAs)
- MVAs expressed as formulas
- questions
- should MVAs be include in CV calc @ valn if operable
- possible future MVAs, shoudl they be taken into account
- if assets in general account, ignore MVAs in CARVM calc since GA assets not revalued under SAP
- Modified Guar Annuity Reg - MVA annuity assets s/b in sep account
- min Vx - CSV including MVA effect
- NY127 has specific definitions
- max(a,b) where a = CSV @ valn including MVA and b = PV guar contract benefits
- where PV(b) - i =
- annual mkt yeild S/A assets - inv expenses - 2.5% for junk - 0.25% PADs
- Moody's Corp Bond Yield Avg (month - 1)
- if assets held at book, max(a,b) where
- a = CSV @ valn excluding MVA and b = PV guaranteed benefits assuming "B" type contract
- Free Partial Withdrawals (FPWs)
- PO can w/d % of fund w/o SC
- sometimes limited to x days after anniversary
- need to reflect this free % in actual SC
- for valn, two approaches
- aggregate - adjust SC% (ie 5% SC adjusted to 5.0% - 0.5%free = 4.5%)
- seriatim - test each and every partial w/d that could be made
- some state ins depts have taken issue w/ aggregate approach and require seriatim
- Annuity Purchase Rates
- often purchase rate incentives to encourage annuitization
- purchase rates more favorable than guarantees
- typically use current rates which are more favorable than guarantees
- discontinuities in CARVM reserve
- AG33 - if co guarantees that PO can annuitize @ then current rates, then CARVM Vx >= 93% of contracts fund value @ valn
- waiver of SC
- take into account when valuing
- often limited to 10 yr+ options
- two-tiered interest credits
- one fund for nonf values and DB
- one for for annuitization (and possibly DB)
- second fund typically has higher int rate
- first fund used for CARVM CVs
- second fund for CARVM annuity purchase funds
- if 93% rule in effect, then it is used against second fund
- Interest Index
- if indexed - NAIC Int-indexed Model Reg says
- future int crediting rates = stat int rate for contracts defined in SVL
- if actuarial opinion not filed, a 115% rule is in effect
- reg not adopted by all states
- most cos ignore indexing unless in effect @ valn
- except to extent CFT indicated need for additional reserves
Practical Considerations in Calculation of CARVM Reserves
- Calendar Year Valuations
- same basic principles apply
- even though cal year, fund balances need to be accum to end of policy year
- some co's calc CARVM @ end of next policy year and discount back
- Current Cash Values
- NAIC blank requires max(CV, CARVM Vx)
- even though CARVM doesnt specify off anniv CVs, it is necessary b/c of this
- when comparing CV vx CARVM, CARVM needs to include any DB reserve
- Grouping Methods
- common and accepted to calc Vx on a group basis (vs seriatim)
- assume groups of policies occur mid-year (unless known skewing)
- SVL says OK
- may not be appropriate for two-tiered or toher complicated product designs
- Change-in-fund Valuation Basis
- SVL allows either issue-year or change-in-fund basis for PVFB calc
- issue year basis - i_valn determined based on issue date of policy
- change-in-fund basis - different discount rate depending on when increase in funds occured. Looks like IYM
- AG33 - election of method @ issuance of contract and cant' be changed w/o written approval of ins commissioner
Annual Premium Annuities under CARVM
- same basic principles apply
- difference - PV appropriate future "valuation considerations" is subtracted from PV of each of the future benefits
- "valuation considerations" - portions of teh respective gross considerations applied under the contract
- not as easy to "analytically" determine where CARVM reserve will be, therefore lots of calcs
Flexible Premium Annuities Under CARVM
- since prems flexible, they aren't "req'd by the terms of such contract"
- reserved as SPDAs
- if contract has no SC, guar fund accum rate > i_valn for n years after valn, CV @ last year i_guar > i_valn
- Valn Actuary should still use judgement
Immediate Annuities
- generally no problem under CARVM
- AG9 and AG9B define Immediate Annuity
- 1st payment due not more than 13 mos from issue date
- suceeding payments at least annually for at least 5 years
- pattern of payments due in any contract year not > 115% of those in prior contract year
- can value annuity as settlement option or annuitized DA using immediate annuity rate from original contract issue or current rate
- AG9A and AG9B have special guidelines for structured settlements
Determination of Appropriate Int Rates under SVL
- 80 amendments introduced annuity valn int rate categories
- SPIAs and annuity benefits w/ life cont arising from other annuities w/ cash settlement options and GICS w/ cash settlement options
- Other ANnuities
- whether or not policy offers cash settlement options
- issue year or change-in-fund basis
- whether or not policy contains future int guarantees applicable to future considerations (future > 1 year off)
- w/ cash settlement options - # years int guar in excess of long life rates (guarantee duration)
- and w/o cash settlement option - # years from purchase date to 1st payment date
- plan type
- A) at any time the PO may w/d funds only
- 1) w/ adjustment to reflect i or assets values changes since reciept of funds
- 2) w/o adjustment, but in installments over 5+ years
- 3) immediate life annuity
- 4) no w/d permitted
- B) Before expiriation of int rate guarantee, PO may w/d funds
- 1) same as a1)
- 2) same as a2)
- 3) no w/d permitted
- at end of int rate guar, funds may be w/d w/o such adjustment in single sum or installments < 5 years
- C) before expiration of int rate guarantees, PO may w/d funds in single sum or installments < 5 years
- 1) w/o adjustments to reflect i or asset value changes since reciept of funds
- 2) subject only to fixes surrender charge stipulated in contract as % of fund
- AG33 - different benefits under SPDA may be valued assuming different plan types
- defines guarantee duration as # years from contract issue to date of annuitization
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Valuation of Life Insurance Liabilities - Chapter 6 - VALUATION OF VARIABLE PRODUCTS
Overview
- Variable products - policies whose cash values matched by assets held in sep account of the LIC
- CRVM adn CARVM are prospective methods
- variable products don't have future guarantees
- Variable Life Ins Model Reg - 1983 - w/ actuarial principles that recognize variable nature of benefits proivided and any mortality guarantees
- similar to VA Model Reg
- Reserve methodology dependent upon product type
Flexible Premium and Bybrid Variable Life
- Flexible Premium Variable life aka VUL
- main diff between VUL and UL - accum fund - VUL - bears investment risk since tied to fund
- Hybrid Products - scheduled premium concept is used
- if VUL products fully front-end loaded, CV is generally deemed to be sufficient reserve
- if FY loads > renewal year loads by more than EA_CRVM, CV as reserve is questionable
- if back-end loaded, typically use UL Model Reg type reserve with one of following for i
- if has fixed-acct option, long term guar rate in teh fixed acct
- valuation rate less some (or all) of contractual asset-based charges
- 4% (rate specified in tax law)
- rate credited to policy loans
- SEC adn Model Reg require asses in Sep Acct >= acct value
- Stat Vx on back-end loaded can be < account val to reflect SC
- suplus in sep acct >= sum VUL EA credits taken
- Additional reserve req'd if product has GMDB
Fixed Premium Variable Life
- Typically FEL
- DB adjusted to reflect performance in one of two ways
- NY Life Design
- DB = Orig Face * Actual CV / hypothetical tabular CV
- hypothetical CV calced using AIR (assumed int rate)
- GMDB = orig face
- reserves = trad reserves fro policy if @ current DB, IA, dur
- Equitable Design
- net investemnt earning > AIR used to purchase PUA @ NSP using AIR
- negative buys negative PUAs
- if PUA balance < 0, negatives carried forward againt future PUAs, but DB never drops below initial face
- reserve base as if traditional
- PUAs like normal PUAs
- additional reserves for GMDB risk
Single Premium Variable Life
- Flexible Single Premium
- marketed as single premium, but PO can make additional prem payments
- reserved as if VUL
- Fixed Single Premium
- GMDB w/ gross premiums based on AIR
- can be of Equitable or NY Life method or may use UL-type mechanics to generate CVs
- reserved identical to regular permanent contracts of same type
- Tax law changes in 1988 have virtually eliminated teh market for these
Variable Annuities
- FEL - CV is good and sufficient reserve (in general)
- BEL - subject to debate - same methods as proposed for VUL
- SA surplus s/b >= excess of acct value over reserves
GMDB Reserves: Flexible PRemium Life Products
- Variable Life Model Reg requires reserves if product has GMDB
- GMDB reserve carried on general acct
- different calcs for fixed premium and flexible premium VL contracts
- flexible premium - GMDB only for grace period when funds insufficient to support deductions to maintain coverage infoce
- term cost of GMDB assuming immediate 1/3 drop in current value of SA assets followed by net investment return = i_valn
GMDB Reserves: Fixed Premium Life Products
- GMDB typically DB never less than orig face
- V_GMDB(x) = max(OYT & AA Level reserve)
- OYT Reserve - term cost of GMDB covering 1 full year assuming immediate 1/3 drop inSA assets value followed by investment return = AIR
- AA Level Reserve = "residue" of prior years AA level reserve +/- current "payment"
- can not be < 0
- "residue" = prior year's AA level reserve increase @ i_valn - tabular mort for GMDB / tabular probability of survival
- "payment" = (A_GMDB(x+t) - A_SADB(x+t) - residue)/adue(x+t:n|)
- SADB = sep acct DB calced using actuary chosen i (but <= max valn rate)
- for VUL - GMDB = OYT reserves except measure over GMDB period instead of 1 year
GMDB Reserves: Annuity Products
- Method 1 - OYT cost of the shortfall w/ or w/o 1/3 drop
- Method 2 - allocate an annual contribution (% of acct value, vary by dur) to GMDB Vx
- any DB in excess of basic reserves deducted from GMDB reserve fund
-
Valuation of Life Insurance Liabilities - Chapter 7 - MISCELLANEOUS RESERVES
Overview
- may misc reserves quite small and tedious/difficult to calculate exactly
- in practice - less precise techniques used, such as
- single average age
- single set of factors for range of policy forms
- Valn Actuary must be prepared to show that these approximations do not significantly overstate reserve liabs
Deficiency Reserves
- reserves in attidion to basic reserves w/ gross premiums < certain level
- US
- prior to 1976 - SVL stated V_def(x) req'd if gross prem < valn net prem (if valn net prem used)
- criticisms
- reserve strengthening could cause basic policy reserve to increase. GP could be sufficient at old rate and not under lowered rate
- having conservative reserve basis sometimes caused def reserves and wouldn't be req'd w/ more agressive reserves
- V_def(x) not allowed as a tax reserve
- 76 amendments removed specific references to V_def(x), but basic reserves req'd to be increased in certain instances
- reserve is max(a,b)
- a - Vx calculated according to method, mort table and int rate actually used for policy
- b - Vx calculated by policy method, using min valn standards for mort, int and max(valn net prem, gross prem) each year
- excess of b over a is referred to as V_def(x) everywhere except SVL
- since part of Vx definition, gets tax credit
- Def Reserves don't follow usual pattern of prem paying life reerves
- generally have max value at issue and decrease w/ time
- because of resulting surplus strain - try to design product w/o (or minimal) def Vx
- Practical Considerations of Def Reserves
- GP is total annualized GP for policy, including modal loading and policy fee
- premiums for benefit/riders not included, but deficiencies in base can be offset by sufficiencies in riders
- because of these complications, usually calc these reserves via seriatim method
- many co's continue to calc using the old method. Produces teh exact same reserve in typical case
- Def Reserves for Renewable Term Policies
- old school - series of sep policies for reserve purposes - never V_def(x) for ART until mid-70s
- late 70s - early 80s - lower ART rates, regulators concerned, state regs said to consider it an ongoing policy
- 2 methods for looking at valn prems for ART
- Unitary Method - considers entire stream of future gross prems & develops proportional set of valn net prems
- Term Method - looks at each renewal period separately
- Unitary Method fell into disfavor w/ regulators since ultra high prem @ old ages offset deficiencies at early ages
- AG4 (1984) - term policies w/o CV - req'd add'l reserve if future guar prems < valn net prems as calced using a special basis in AG4
- Valn Model Reg (1995) - Contract Segmentation Method
- G(t) = GP(x+k+t) / GP(x+k+t-1)
- R(t) = q(x+k+t) / q(x+k+t-1)
- GP is guar gross prem w/o policy fee (if pol fee is level) - NY says uses current prem
- q(x+t) = valn mort rate for def reserves
- each time G(t) > R(t) a new segement is created +/-1% on R(t) to avoid new segments b/c of rounding
- basic reserves calced for each segment, EA_CRVM only for first segment
- Valn net prems a constant % of gross
- ex. 10 yr renewable term - CRVM first seg, NL thereafter
- Valn Model Reg - Vx = max(unitary, segmented) for each dur
- n-year renewable term w/ non-deficient guar prems exempt & some AA YRT
- Def reserves calculated as per 76 amendments using gross instead of net
- 5 year safe harbor if 1st segment < 5 years, don't have to use gross, even if deficient
- actuary must opine that reserves are sufficient
- Valn Model Reg allows updated selection factors in calc of basic reserves
- even lower selection factors OK for def reserves
- Canadian Practice for Renewable Term Policies
- Valn Tech Paper #2
- valued to end of benefit period, not renewal
- excess of heaped @ renewal over normal renew comm may be treated as issue expense
- how-to calc valn net prem if gross not level is described
- lapse rates can spike @ renewals if prem increases
- re-entry proportion (% of PO who will requalify for select @ rentry)
- Alternative Min Reserves for UL (AMR)
- these are UL equiv to def reserves and covered in Chapter 4
Accidental Death Benefit
- Usually calced using 1959 ADB tables
- calced using same methodology
- [t]V_ADB(x) = [1000*(M_ADB(x+t)-M_ADB(x+n)) - P_ADB(x)(N(x) - N(x+m)]/D(x+t)
- P_ADB(x) = [1000(M_ADB(x)-M_ADB(x+n)]/(N(x) - N(x+m))
- M_ADB(x) = sum(v*q_adb(x)*D(x))
- many approximations used, often w/ age and plan groupings
Disability Waiver of Prmeium Benefits
- SVL - reserve using Period 2 disablement rates of SOA 1952 disability study
- Active Life Reserves
- what prem to waive - gross or net w/ or w/o wvr prem w/ or w/o other (ADB etc) prems
- usually gross since commissions and what not still paid & ususally other benefits as well
- many approximations used
- reserves shoudl reflect prems (ex increasing if ART)
- UL policies - two types
- waiver of COI
- waiver of planned premium
- Disabled Life Reserves
- consists of 4 types of claims
- approved, in course of settlement (ICOS), resisted, incurred but not reported (IBNR)
- ICOS, resisted, IBNR considered policy claim liabilities
- valuation of approved claims
- disabled life annuities using tables mentioned in SVL and appropriate valn int rate
- these factors applied to amount being waived
- adue([x+0.5]+n-.5:t-.5|) where
- x - insurance anniv prior to dis
- n - policy year of dis
- t - # years benefits run, from pol anniv in year of valn
- normally use a seriatim valuation
- Disability and Death of Payor Benefits
- typically waives prem to child's age 21 or 25
- theoretical reserve complicated since 2 lives involved
- if dis payor, both death and dis must be considered
- essentially decreasing term so small or negative reserves expected
- approximations normally used
- usually ignore child's mortality
- often hold 1/2 gross prem of payor benefit as reserve
- reserve after death of payor is an annuity for remaining premiums
- often mortality is ignored and annuity certain used
Nondeduction of Deferred Fractional Premiums at Death
- term reserve for amt of ins = (m-1)/2m * P_modal <- net prem
- once common approximation
- for each reserve basis, select a few major plans or key ages
- calc S_tot (amt of ins) G_tot (gross AP) P_tot (net AP) and V_tot (base reserve)
- Gbar = G_tot / S_tot Pbar = P_tot / S_tot (avg gross and net prem per $1m)
- pick xbar where Pbar and Gbar are approx the same (find age that has these prems)
- Vbar = V_tot / S_tot using xbar and Vbar, find approx tbar (dur)
- using xbar, tbar calc [tbar]V'(xbar:n|) where n is orig prem pay period of paln (term reserve factor)
- multiply term reserve factor by P_tot
- after doing for each grouping
- avg non-ded reserve factor is b/a
- a = sum(P_tot) and b = sum(P_tot*[tbar]V'(xbar:n|)) across all plans
- this factor applied to total net def prems for all plans w/in reserve basis
- Surrender Values in Excess of Reserves
- excess of SV over Vx needs to be carried in 8G
- based on seriatim, no offsetting overage w/ underages
Canadian Lapse-Supported Policies
- Valn Technique Paper #1 - Valn of Lapse-Supported Products
- established b/c Canadian Actuaries can recognize lapses in valn
- <maybe revisit this if applicable to 8I-U>
Last-To-Die Policies
- Traditional
- pays small db or becomes paid up @ first death
- valued as single life after first death
- Frasier-Type
- no change of status @ first death
- valued independently of wheter a death death has occurred
- Reserves for Traditional Policies
- if paid up @ first death A(x+t:y+t)bar - P*adue(x+t:y+t)
- if pays x% @ first death and 100% at second death A(x+t:y+t)bar + xA(x+t:y+t) - P*adue(x+t:y+t)bar
- after first death A(y_t) if paid up, A(y+t) - P*adue(y+t) otherwise
- Reserves for Frasier-Type Policies
- l([x]+t:[y]+t)bar = l(xy)bar*([t]p(x) + [t]p(y) - [t]p(xy)
- A([x]+t:[y]+t)bar - P*adue([x]+t:[y]+t)bar
- joint equal age (JEA) often used to simplify calculation
- AG20 - acceptable rules for JEA 80CSO for First-to-Die
- many cos use these same rules for Last-to-Die
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Valuation of Life Insurance Liabilities - Chapter 8 - CASH FLOW TESTING
Overview
- Good and Sufficient - used to be OK to just do a GP valuatin
- GP valuation used to cover following situations
- stat Valn was deficient - did not consider w/d or expenses
- experience mortality higher than stat valn standard
- reserve strengtening needed due to investment yields not supporting valn i
- Now relies on Valn Actuary concept
- CFT includes interaction between A/L under differernt int scenarios
- impact of epidemics on co's resources
- impact of mortality deterioration due to selective lapsation
Definition of CFT
- projection of cash flows in which specific timing of asset and liab cash flows is considered
- CFT generally recognizes the following factors
- interrelationship between assumptions
- competitors i & div rates
- investment yields available in marketplace in general
- company assumptions w/r to non-guar elements in different economic environments
Assumptions Needed
- Future Economic Environments
- must choose a set of future economic scenarios to test under
- Handpicked Scenarios (aka Deterministic Approach)
- 1990 SVL adn NY126
- Advantages
- teset is more comfortable w/ reviewing results since he constructed them
- scenarios tend to be easy to describe (up/down, rapidly increaseing, etc)
- Disadvantages
- disagrement over probability of a scenario
- cumbersome to generate a large # of hadnpicked scenarios
- need a lot of scenarios for statistical credibility
- tens to produce more favorable restults than expected statistically
- Log-Normal Model
- basic assumptions
- ln(i(t+1)/i(t)) is Normal RV
- mean (mu) = 0 and std dev (sigma) is measure of volatility to be expected
- used to generate future s/t and l/t in rate
- usually 90 day and 10 yr
- other rates through interpolation or functional relationships
- Transitional Probability Approach
- define universe of yield curves
- probability matrix - probabilities of one yield curve following another
- start w/ current yield curve and run monte carlos to generate future yield curves
- Competitor Rate or Market Rate Assumption
- important since many CFT funtional relationships key off relationship between credited int rates , mkt int rates and lapse rates
- mkt rate assumptions often bases as function of current int rates and a moving avg of an int rate
- Nonguaranteed Elements Practices
- Typical CFT strategies include
- credit earned rate less investment margin
- credit some function of market rate
- hybrid approach
- Lapse Rates
- little experience w/r to interaction between lapse rates and credited rates on life and annuities
- lapse assumption based on common sense argument - as other options become more attractive, more likely to surrender policy
- things to consider
- presence and level of SC
- mktg techniques and loyalty of field force
- prominence of i in mktg and maint of policy
- duration from issue
- type of products sold - SPDAs more int rate lapse sensitive than trad life
- Reinvestment Strategies
- actuary and investemetn officer work together to understand/define how positive cash flows invested in future
- ex. % of pos cash flows into each type of security or a blance of each type w/in total portfolio
- need to define what mkt conditions might change this strategy
- negative cash flows
- sell assets
- negative assets (borrowing between lines)
- borrowing @ s/t rate
Case Study
U.S. GAAP - Chapter 3 - EXPENSES AND CAPITALIZATION
Background
- Statements of Financial Concepts (SFAC)
- SFAC5 - Recognition & Measurement in Financial Statements
- Guidance for expenses and losses in intended to recognize
- consumption of benefit - expenses recognized when economic benefit is consumed
- Loss or Lack of Benefit - losses recognized if it becomes evident taht prev recognized future benefits have been reduced
- SFAC6 - Elements of Financial Statements
- Expenses - outflows incurred in producing or other activities central to ongong operations
- expenses represent actual or expected cash outflows that have or will occur as a result of ongoing central operations
- implications - cost not an expense until it is recongnized in co's fin statement
- example - DAC
- amortization of the cost, not the original cost that becomes the expense
- Statements of Financial Accountnig Standards (SFAS)
- SFAS60 - covers all contract except those reclassified by other standards
- SFAS97 - covers most life and annuity products w/ account values
- UL/VUL/most fixed def annuities and VA in teh accum stage
- SFAS60 w/ prems payable < coverage period
- SFAS91 - investment contracts defined in SFAS97
- in general DAC for GICS, Funding Agreements & DAs w/ minimal SC
- SFAS120 - Par Trad
- Terminology
- DAC - amt of capitalized expenses remaining in balance sheet at any reporting date
- aka Unamortized Aquisition Costs (UAC), Def Pol Acq Cost (DPAC), Unamort Expense Asset (UEA) and expense reserves
Categorization Stipulated by SFAS 60
- P26 - maint expenses s/b part of benefit reserve (suggested)
- some co's segregate main exp and report separate reserve
- P27 - general expenes not related to acq s/b expensed as incurred
- P28 - acq costs ~ acq of new & renewal ins contracts
- 1994 audits P 8.38 - separate deferral for expenses w/ substantial future utility and recoverable from future revenues => future utility expenses
- 6 expense categories - mutually exclusive
- Expense Category Asset or Liab Affected
- 1 Deferrable Acq DAC
- 2 Non Def Acq None
- 3 Direct Maint Benefit Reserve
- 4 Investment Expenses DAC & Benefit Reserve
- 5 Future Utility Expense Unique Asset
- 6 Overhead None
- Deferrable Acq Costs - expenses considered to vary w/ and primarily relate to acq of new business
- NonDeferrable Acq Costs - expenses associated w/ NB funtion that dont relate to or vary w/ securing of new policies.
- ex. new ratebooks, product dev costs (Vx factors, etc)
- costs in period incurred
- Direct Maintenance Costs - costs associated w/ maintaining records relating to ins contracts & processing of premium collections & commissions
- Investment Expenses - expenses properly chargable against inv income
- included transaction costs that cannot be capitalized into cost of asset being purchased
- Future Utility Expenses
- costs of start-up activities, including organization costs s/b expenses as incurred (AICPA SOP 98-5)
- certain computer hardware and software may qualify for capitalization (AICPA SOP 98-1)
- Overhead - aka indirect cost - balancing item
Expense Categorization Under Other Pronouncements
- SFAS91 - Investment Contracts
- tightens rules on loans (compared to SFAS60)
- SFAS97 - same expense categories as SFAS60
- % of premium expenses (commis & prem tax) must be separated between deferrable acq and direct maint
- P23-24 - excludes from deferrable category acq costs that tend to be level or recurring => maint expenses instead
- Practice Bulletin 8 (AICPA)
- P25 identifies contract admin charges to be included in calc of EGPs as those from P23-24 of SFAS97 (ex ult renewal comm adn recurring prem tax)
- SOP 95-1 (AICPA) & SFAS 120
- guidance for mutual co's Par policies
- similar guidance as SFAS97
Line of Business and Category Analysis
- studies must be done to allocate expense to 6 categories
- LOB allocation - first, group expenses by LOB, then to appropriate accounting model
- Category determination - costs assigned to appropriate category
- Then some converted to "unit" basis to make calcs easier
- Categorization
- example in book illustrates allocations
- total expenses should tie to statement
- Percentage of premium expense allocation
- prem taxes usually removed from study since they can be directly assigned @ policy level
- prem tax and commissions usually stated as % prem in reserve formulas
- Allocations of Salary & Other Expenses
- salaries important allocation b/c other expenses (such as EE benefits) can use same allocation
- utilities & rent can be allocated by # EE/ # pol inforce/% prem income
- Distinction between Direct Maintenance and Overhead Expenses
- requires judgment
- non-level direct maint expenses (claims settlement exp & limited pay policies after prem period) affect benefit reserve
- level % of revenue expenses do not affect benefit reserve (prem collection expenses)
- entire direct maint cost s/b included in developing benefits reserves
- SFAS97/120 policies - level maint expenses can affect either benefit reserves or DAC
- General Practice - include entire direct maint costs in generating GAAP A & L
- Investment Expenses
- if investments allocate to products w/in LOB, easy to directly assign expenses
- usually expressed as a reduction of investment income
- Inv Income and Expenses generally expressed as % of underlying assets
- % is what is generally used in formulas for benefit reserve & GAAP
- Selection of Units of Measurements & Unitization of Expenses
- Types of Per Unit Measures - per policy, per current face amt, per unit issued, % prem
- use judgement in determing most appropriate unit of measurement
- p. 43 - table w/ common choices
- investment expenses - % of underlying assets - bps
- investmetn expenses/(avg cash and invested asset balances)
- can use muliple units for an expense ex. $150/policy + $2/unit
- u/w cost on a per app basis (not per policy issued) - needs to be converted to per policy
- DI claims adjustment expenses - per $claims paid
- if converting to GAAP, need to develop expense assumptions for earlier years
- Other Issues
- some deferrable expense occur prior to policy issue (u/w costs) - could be in separate reporting period
- record as prepaid expense, then wehn policy issued, release and capitalize expense
- backdating - soem cos restate prior period, other include in current cohort
- related party service agreements typically transparent
- expense reimbursements tied to production of business usually deferrable
- tied to avg # pols inforce - ????
- w/r to large non-recurring expenses, little guidance, but actuary s/b soncsitent between years
- carve out development expenses from overhead to minimize earning distortions
- this distortions would accelerate earnings
- little experience when starting a new LOB - usually expensed too high and refined as necessary
- re S/A products - expenses associated w/ product should follow the product
Determination of Deferrability of Acquisition Costs
- All expenses capitalized are subject to recoverability testing
- Commissions
- short duration contracts - entire comm is capitalized
- long duration - excess of first year over ultimate level is deferrable
- excess of renewal over ultimate is deferrable in renewal years
- ultimate level - direct maint expense
- question on excess for flex prem F97 products - "facts and circumstances" of each case govern
- beware of commission advancing and chargebacks
- agent financing costs often capitalized
- if loans - accounted as receivables adn not a DAC element
- commission trailers - usually considered maint
- commission vesting schedule - declining over times - creates higher initial DAC
- Expenses Similar to Commissions
- volume bonuses, sales contests, etc - if based on purely new production ,then deferrable
- persistency bonus - grey area, but normally considered deferrable, at least in part
- facts and circumstances should determine
- commission overrides - if % of premium, treated same as commission
- salary-plus-bonus basis - allocation less clear
- agency recruitment and training not deferrable
- sales lead creation and sales illustrations are deferrable
- agency expense allowances & expense reimbursments - if vary w/ production, deferrable
- Home Office Expenses
- some mktg and sales expenses deferrable, some not. Are if closely related to selling
- most u/w expenses are deferrable - includes support staff to a degree
- most policy issue expenses are deferrable
- some HO services in support of policy issue (sales illustrations) usually deferrable
Timing of Deferrability
- actuary should ensure that expense in reserve formula correlate to actual in financial statement
- True-Up
- amount capitalized shoudl equal DAC incurred in financial statement
- SFAS60 P31 - estimated costs can be usded if difference not significant
- Two general techniques
- direct input of actual quantified dollars
- conversion and expression of actual dollar values to units for entry into actuarial reserve formulas
- reserve factors normally used for F60 and limited pay F97
- assumptions locked at issue, basic benefits and guar values don't change w/ time
- F97 & F120 products - easier to use direct input dollars
- SFAS60 P31 i) and II) not significantly different
- i) implied capitalization derived from reserve formulas
- ii) actual def acq costs incurred
- approaches used to demonstarte this equality
- re-enter deferrable cost assumptions preiodically from recently performed studies
- apply modification factors to certain policies based on issue date (pp 50-52 for details)
- Commission Timing
- must be consistent w/ recognition of commissions as a cost in the income statement
- if due premium, commission would have been payable - liab established for cost of collecting unpaid prem and asset for due prem
- if mid-terminal, unearned prem is established. Associated commission is re-established as an asset (aka equity in the unearned prem) and is part of total DAC
- for worksheet approaches, amount is input directly from general ledger
- will include some prior period commissions, but assumed to be nota significant concern
- Anticipation of Future Deferrable Expenses
- future deferrable expenses must be anticipated and estimated in the DAC calc from the issue date forward (ex - heaped renewal commissions)
Recoverability Testing and Loss Recognition
- Authority and Definitions
- SFAS60 P32-37 - establish a liability or decrease DAC to provide for probable future losses in a LOB reducing the chance of a loss emerging in the future
- Recoverability - whether a DACable expense is deferrable from exonomic perspective
- PVGP >= PV (Benefits + Direct Maint Costs + DAC Expenses)
- if not, remove or reduce PADs and retest
- Loss Recognition - testing fro probable loss on entire LOB
- prospective recoverability testing on entire LOB of existing business
- best-estimate assumptions
- Level of Aggregation for Testing
- consistency - once groupings defined, classifications maintained
- recoverability - accounting period cohort
- loss recognition - entire LOB inforce
- guidance for groupings - SFAS60 P32
- manner of acquiring - major sales type (direct vs agency)
- manner of servicing
- manner of measurement of profitability - F60 vs F97
- Gross Premium Valuation Test and teh Order of Adjustments to the Balance Sheet
- compares gross prem valn w/ GAAP net liabilities
- if GAAP net liab < Gross Prem Valn, probable loss - prem def = difference
- Gross Prem Reserve (ASOP22) actuarial value future CF disbursements - future CF receipts
- pre-tax
- if a premium deficiency from recoverability resting, order of adjustments
- F60 - sufficient margins for deviation removed until def eliminated
- no PADs for 97/120 so this step skipped
- reclassify expense from def to non-def until deficiency eliminated
- premium def reserve established such that net gaap liab = gross prem reserve
- if premium def from loss recognition testing, order of adjustments
- eliminate PADs until deficiency eliminated (F60, no PADs for F97/120)
- reduce DAC asset until deficiency eliminated
- prem def reserve established
- once F60 loss recognition occurs, revised assumptions locked in place, unless future loss recognition
- can't adjust for future improvments
- 20-30 years is usual lifetime of policies modeled (as approx to keep spreadsheets managable)
- Exclusion of Interest on Surplus from the Testing
- aka interest on prior profits - should we count it for testing?
- GPV (gross prem reserve) = net GAAP liab - PV future GAAP book profits
- formulas do not include Int on Surplus
- Int for GPV traditionally level, but can be graded if that is Actuary's best estimate
- exclusion of int can result in some unexpected GAAP losses in preiods of declining int rates
- due to int related gains on asset sales (not a SAP problem because of IMR)
Relation fo GAAP Expense Assumptions to Pricing Expense Assumptions
- start w/ same baseline expense assumptions
- potential different classifications across line for pricing, GAAP will have more aggregation
- variation in allocation of costs between base/rider/supp benefits
- expense assumptions can vary by dur for non-level prem (and some other) palns
Special Expense Issues
- Internal Replacements
- DAC asset is NOT carried over from old contract to new contract (SFAS97 P26)
- Reinsurance
- SFAS60 P39 - coins allowance apply a negative to DAC to obtain net capitalized position (converse for assuming party)
- timing may differ between direct and reinsured block
- Purchase Acctg
- VOBA (Value of Business Acquired) - asset established at purchase
- might be reduced in anticipation of paying future commissions (1st yr & heaped renewal)
- these commissions s/b reflected in DAC (even though pre-purchase business) & not in VOBA
- Discontinued Operations
- APB30 - segregate infrequent transactoins from typical results
- if difficult to allocate expenses to the segment being disposed, transaction should NOT be classified as a disposal trx
- if a loss recognition, GPV @ measurement date indicates loss for block, provide for future losses
- expense assumptions may change due to segregation of assets assigned to a block
- fully allocate expenses to block, including severance etc
- need a way to deal w/ expenses in fun-off mode when block becomes very small
Worksheet Approaches to DAC Calc
- works best w/ non-commission acq expenses
- if comm included, need to estimate future (heaped renewal) commissions
- Static Worksheets
- initial DAC established
- expected inforce schedule created using mortality and lapse rates
- terminal duration selected and amortized to zero
- example p. 65
- drawbacks
- remaining DAC may be behind/ahead depending on actual persistency
- no convenient byproduct that extablishes recoverability or facilitates loss recognition
- Dynamic Worksheets
- resolve ahead/behind drawback of static worksheets
- takes static results and adjusts by ration of actual/expected cumulative persistency
- F97/120 worksheet (vs F60) would use EGP ro EGM instead of GP as amort basis
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U.S. GAAP - Chapter 4 - TRADITIONAL LIFE INSURANCE (SFAS 60 AND SFAS 97)
Overview
- non-par trax fixed-premium policies
- F60 products need to be classified as short or long duration contracts
- short-dur - fixed period of short duration
- insurer can cancel contract or adjust provisions
- ex. P&C (most) and some term life (like credit life)
- long-dur - generally not subject to unilateral changes in provisions
Product Features
- Normal stuff here WL/Endow/Term
Benefit Reserve Methodology
- short-dur - different chapter
- long-dur
- prems as revenue when due
- net GAAP reserves accrued when prem revenue is recognized
- based on assumptions applicable at issue
- unpaid claims and claim adj expesed accrued when insured event occurs
- loading - diff between gross and net prem - portion of gross prem that emerges as profit
- if no loss recognition or loading, net prem a constant percent of gross prem
Expense Recognition
- Acquisition costs s/b capitalized and charged to expense in proportion to prem revenue recognition
- other expenses charged as incurred
- can only defer expenses to the degree they don't create a loss in later years (recoverability)
- thorough discussion in chapter 3
- DAC - hold as deferred cost on asset side of balance sheet (negative reserve)
- using an inflation assumption on maint costs WOULD generate a maint exp reserve
- for limited-pay policies, establish reserve for maint expenses incurred after prem pay period
Selection of Assumptions
- GAAP Assumption Eras
- era where assumptions are appropriate for new issues
- sometimes known as a "ratebook"
- Provisions for Adverse Deviation (PADs)
- s/b included when setting assumptions
- broad guidance as to level of PADs
- same product @ 2 different cos w/ identical experience
- ultimate profitability same, but emergence will be split between level % of prem and release of PADs
- likely different between two companies
- ASP10 provides some guidance
- two types of assumptions
- best estimate assumptions - s/b reasonable
- PADs - the riskier the assumption, the higher the PAD
- should not raise net prem > gross prem
- 1994 Audit Guide
- PADS will cause profits to emerge from release of risks
- in relation to NAR
- invested funds or investment income
- w/d in relation to excess of (benefit reserve - unamort acq expense) over CV
- expenses less than estimated
- profit in premium
- PADs should apply to interest, mortality, w/d & settlement expenses
- "reasonable and realistic"
- Investment Earnings Rate
- typically assume declining int rate in later policy durations
- F60 - based on estimates of inv yields expected at issue
- shoudl be consistent w/ co portfolio
- Mortality and Morbidity Rates
- PADs typically 5-10% above best estimate
- expected mortality @ issue + PADs
- f60 - include risk of anti-selection
- GAAP actuary need to be aware of projected improvements Pricing Actuary is using
- Lapse Rates
- be careful of lapse supported policies - PADs are backwards from normal
- best-estimate w/o PADS may be good enough
- or PADs added in such a way that % prem profits decrease at all durations (vary PAD by dur)
- Expenses
- Ch 3 for most expense info
- No PADs for commissions since a controllable expense - we know the rates
- Taxes
- Lock-In
- Assumptions locked at issue
- some co's use factors and others use first-principles
- results calced from inforce
- not considered a violation of lock-in concept
- Loss Recognition
- Prem deficiency may result if experience emerges diferent from assumed
- prospective loss on a group of contracts = prem deficiency
- F60 - prem deficiency recognized as charge to income
- reduction of DAC or increase in future policy benefit liab
- future changes in liab based on revised assumptions
- adjust when first becomes apparent
- ASOP10 - use best estimate assumptions when testing for loss (no PADs)
- based on grouping of policies
- F60 amt of prem def = gross prem reserve - GAAP net reserve
- Numerical Examples p. 81
Limited-Payment Contracts
- income from limited pay contracts s/b recognized over period benefits are provided, not period payments collected - F97
- all other aspects same as F60
- F97 Limited Pay - life - ins in force as profit carrier
- annuity - expected future benefit payments
- profits emerge as level % of ins in force vs % of prems (f97 vs f60)
- Deferred Profit Liability (DPL) established (aka Unearned Revenue Liab/Unearned Profit reserve/unreleased profit reserve)
- Limited-Pay numerical example - pp. 95-97
Participating Products
- if NOT using contribution principle - use F60 methodology
- policyholder dividends a component of GAAP benefit reserve
- level and slope of PO divs also affect GAAP benefit NP
- divs an expense when incurred
- UPPEA - Undistributed Par PO Earning Account
- where profits in excess of what can be dividended to stockholder are put
- ASP10 describes distribution of this $
- example p. 99
Indeterminate Premium Products
- F97 - if policy is not essentiall a UL, treat it as F60
- assumptions may be "unlocked" at gross premium change dates - ASP10
- if adjusted, done prospectively, w/o change in liab as of valn date
- Indeterminte Premium Method (aka Prospective Unlocking)
- Res(t) = PVB(t) - PVP(t) t-> reporting date
- Res(t) = PVB'(t) - PVP'(t) = PVB'(t) - GP'(t)*level%'*Ann'(t)
- same applies to maint reserves and DAC
- if level% > 100, loss recognition testing s/b performed
Implications of Reserve Formula Selection
- Benefit Reserves
- Terminal Benefit Reserve
- TBR(t) = [(TBR(t-1)+NP(t))*(1+i) - DB(t)*q_d(x)*(1+i)^(1/2) - CV(t)*(1-q_d)*q_w] / [(1-q_d)*(1-q_w)]
- TBR(0) = 0
- lapses a significant part
- std practice -> policies only lapse on prem due date
- Final Reserve - reserve the moment before terminal (just before lapses assumed)
- FBR(t) = [(TBR(t-1)+NP(t))*(1+i) - DB(t)*q_d(x)*(1+i)^(1/2)] / (1-q_d)
- Mean Benefit Reserve MBR(t) = 1/2*(TBR(t-1) + NP(t) + TBR(t))
- MidTerminal Reserve midBR(t) = 1/2*(TBR(t-1) + TBR(t))
- sometimes use FBR(t) for end of year in above two formulas
- if MRB used, non-annual polices need a deferred prem assest
- if midBR used, unearned prem liability
- Expense Reserves
- same concept as benefit reserves
- Terminal Expense Reserve - TER(0) = 0
- TER(t) = [(TER(t-1)+Pol(t)+GP(t)*(Comm(t)+PT(t))-NP(t))*(1+i)] / [(1-q_d)*(1-q_w)]
- FER(t) - same at TER(t) but w/o (1-q_w) term - analagous to FBR
- MER(t) = 1/2*(TER(t-1) + Pol(t) + GP(t)*(Comm(t)+PT(t))-NP(t) + TER(t)) - Mean Expense Reserve
- similar to def prem asset, cost of collection liability - typically just the comm and PT payable on gross def prems
- midER(t) = 1/2*(TER(t-1)+Pol(t)+TER(t))
- similar to unearned prem loab, EUP asset - generally comm * PT payable on gross unearned premium
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U.S. GAAP - Chapter 5 - TRAD LIFE (SFAS 120)
Overview
- mutual co's par products have similarities to both F60 and F97 UL products
- earnings emerge in a manner similar to UL
- product features are similar to Trad Life
- actively managed dividend scales cause earnings to emerge w/r to margins vs level of premiums
- F60 and by reference F97 specifically exclude mutuals
- SOP95-1 adn F120 address this
- model assumes dividend fund exists to determine divs
- Dividend Fund DF(t) = DF(t-1) + DP(t) + DI(t) - DQ(t) - DE(t)
- DF(0) = 0
- DI(t) - interest credited to DF
- DP(t) - gross prem credited to DF
- DE(t) - expense charges to DF
- DQ(t) - mort costs
- Div(t) - Dividend Paid
- M(t) - Margin to enterprise
- DF'(t) - same formula as DF(t) , but w/ actuals instead of modeled
- Div(t) - (DF'(t) - DF(t)) - M(t)
Scope and Applicability
- SOP95-1 - mutuals exected to pay divs to PO based on contribution principle
- only applicabel to mutuals
- F120 - stock cos can use it on blocks that meet provisions of SOP
- must be long duration, par and expected to pay divs based on "actual experience of ins enterprise"
- SOP model assumes earning emerge relative to earnings net of PO divs
- Par policy considered UL (F97) if any of the following are true
- PO may vary prems w/in contract limits w/o insurer consent
- stated account balance w/ credits and debits wehre amounts of cr/dr not guaranteed
- contract charges expected to be interest/market based rather than experience bases (group/block of pols)
- F120 specifically says to follow F60/F97 guidance if not par
Overview of Acct Model
- where F60 and F120 are the same
- prems recognized when due
- expenses - non-deferrable recognized when incurred
- benefits as incurred
- where F60/F120 are different
- Policyholder benefits - both use NLP to accrue PO benefit liab
- F60 - useing assumptions based on anticipated exp as issue
- F120 - only guar mort and div fund int assumptions
- Annual PO Divs
- F120 - recognized as such amounts are earned by PO
- F60 - either element of PO benefits and accrued based on NP
- or accrual of def div liab when profits to shareholders are limited
- Acq Costs - identification and deferral smae
- F120 - amortized based on constant % of PV of EGM expected to be realized over life of contract
- adjusted to reflect actual adn current estimates of future experience
- Terminal Divs - recognized as level amt w/r to EGM based on amt expected to be paid
- adjusted to reflect actual and current estimates of future experience
Amortization Methods
- EGMs - primary basis for recognizing earnings
- comparable to F97 EGPs
- EGMs shoud include estimates of (SOP95-1)
- + Expected Premiums GP(t)
- + INvestiment INcome on PO balances I(t)
- - Expected paid benefit claims B(t)
- - Contract Admin costs (incl nondef aqui costs) E(t)
- - Expected change NLP Benefit Reserve NLP(t) - NLP(t-1)
- - Expected PO Divs Div(t)
- +/- other expected assessments/credits
- NLP(t) = NLP(t-1) + P(t) + IR(t) - BR(t) where
- P => increase in reserves due to prems
- IR => increase in reserves due to interest
- BR => decrease in reserves due to benefits
- EGB(t) = GP(t) + I(t) - B(t) - E(t) - (NLP(t) - NLP(t-1))
- = (GP(t) - P(t)) + (I(t) - IR(t)) + (BR(t) - B(t)) - E(t) - Div(t)
- DE(t) => deferrable expenses
- PV()(t) => present value @ time t
- [t]EGM(t+1) => gross margins expected in period t+1 as projected # time t
- k(t) = [PV(DE(s>t)(0) = PV(DE'(s<=t)(0)] / [PV([t]EGM(s>t)(0) = PV([t]EGM'(s<=t)(0)]
- Amort(t) = k(t)*[t]EGM(t)
- if significant EGMs in any period, need to select alt amort base
- possible alternatives: PV(EGMs before divs), est gross prems, life inforce
Selection of Assumptions
- two main classes of assumptions:
- those underlying PO benefit liab
- those for estimating future gross margins
- Benefit Reserve Assumptions
- NLP method - requires mortality and interest assumption
- SOP95-1
- use div fund int rate (if determinable)
- mort - rateas guar in contract for calcing CV
- Mortality - contractually specified
- if substd - include extra liab
- Interest - hierarchy - if not avail, drop to next level
- div fund rate at issue
- guar csv rate
- NAIC min nonf rates
- if rates vary by duration, then reflect that in reserve calc
- Method
- NLP
- timing s/b consistent w/ financials
- Estimate Gross Margin Assumptions
- best estimate basis w/o PADs
- Mortality - best estimate mort assumptions
- look at div scale mort/pricing mort/recent co experience
- Interest
- div fund int rate
- inv int rate on PO liabs
- base on yield rate on invested assets
- net of inv expenses
- int rate used to discount future EGMs
- rate used to estimate gross margins in first year of contract is expected inv yield
- discount rate - once chosen, must stick with it
- either use inv yield rate at issue
- OR current yield each year
- Dividend
- Gross margins don't include expected terminal divs
- EGMs must show effect of elected div option (PUA/Accum/1YrTerm/Cash/ReducePrem)
- best estimate assumptions to show how PO expected to use divs
- Lapse Rates
- sensitive to changes in div scale
- if ETI/RPU are par, need to reflect that
- Expenses
- costs expected to be incurred for contract admin (including non-capitalized acq)
- Groupings
- policy-by-pol or group methods can be sued
- need grouping for recoverability testing and loss recognition
- groupings s/b consistent w/ way co acquires/services/etc LOBs etc
- issue year groupings at a minimum
- Example p. 123
True-up and Unlocking
- can be done at LOB level or lower level (consistent w/ groupings)
- EGMs adjusted to reflect actual results
- future EGMs s/b adjusted if necessary as well
- True-up - current period effect on amort of DAC or accrual of term div liabs
- difference between actual and expected Gross Margins for period, w/ k held constant
- Unlocking - current period effect on amort of DAC or accrual of term div liabs of a change in k
- caused by current period true-up or change in estimated EGMs
- DAC(t+1) = DAC(t) + AmountsCapitalized(t) + Interest(t) - Amort(t)
- Interest(t) = DAC(t)*i(t)
- k(t) = [PV(DE(s>t)(0) = PV(DE'(s<=t)(0)] / [PV([t]EGM(s>t)(0) = PV([t]EGM'(s<=t)(0)]
- Amort(t) = k(t)*[t]EGM(t) + [k(t+1)*[t+1]EGM'(t) - k(t)*[t]EGM(t)] <- true up term
- +(1+I){k(t+1)*[v*[t+1]EGM'(t) + PV([t+1]EGM(s>t)(t)] - k(t)*PV([t]EGM(s>t+1)(t)} <- unlocking term
- DAC(t) = k(t)*PV(EGM(s>t)(t) - PV(DE(s>t))(t)
- if we assume no deferrable expenses after year 1
- DAC(t+1) = DAC(t) + i(t)*DAC(t) - Amort(t)
- Unlocking = k(t+1)*PV([t+1]EGM(s>t+1))(t+1) - k(t)*PV([t]EGM(s>t+1))(t+1)
- first term reflects revused future expectaions
- True-Up = k(t)*([t+1]EGM'(t) - [t]EGM(t))
- if both unlocking and true-up, allocation of amort among components is judgemental
Realized Capital Gains
- an element of gross margin
- will affect the amortization charge
- p. 128 for example of impact of realized capital gain
Recoverability and Loss Recognition
- recoverability testing - PV amts to be capitalized vs PV EGMs
- Loss recognition - ongoing evaluation
- k(0) < 100% - amts being capitalized are recoverable
- for terminal div liab accural, k_DAC(0) + k_TermDiv(0) < 100%, then recoverable
- Loss recognition
- evaluating whether existng net liab combined w/ anticipated future revenues is adequate to provide future obligations
- if not adequate, premium deficiency
- SOP95-1 - liab for future policy benefits = sum of
- NLP reserve for death & endow policy benefits
- liability for terminal dividends
- any probable loss (prem def)
- Prem Def must be recognized if defiency exists on an entire LOB (minimum)
- Test for Prem Def
- + PV future benefit pmts & related settlement/maint costs using revised assumptions based on actual and anticipated experience
- - PV future gross premiums - using revised assumptions
- = liab for future policy benefit using revised assumptions
- - (liab for future policy benefits @ valn - unamortized acq costs)
- = premium deficency
- for par products, divs can be reduced to adjust for adverse experience making a prem def unlikely
Policyholder Benefit Liabilities
- SOP95-1 - PO benefit liabs be calced using NLP
- net prem ratio - levelp proportion of each gross premium payment necessary to provide contract benefits
- only considers mortality and interest
- use guaranteed mortality and div fund int rate
DAC and Terminal Div Liabilities
- Acq costs both variable and directly related to acq new and renewa ins/ann contracts are capitalized and amortized into income over life of assoc contract
- amort determined relative to PV EGMs
- terminal div payments and accrual of term div liab excluded from EGM calc
- terminal div payments charged against accrued liablity
Additional Considerations
- Policy Riders
- not specifically addressed in SOP95-1
- if rider viewd as sep contract, may have features that place them w/in scope of F120 and SOP95-1
- if rider intertwined w/ policy
- consider them one and include all acq costs etc from both coverages
- develop benefit Vx sep and add together
- w/ PUA divs to purchase PUAs, EGMs show divs as expense and income
- later durs, EGMs reflect CV surrender from PUA to purchase Term Ins
- if rider not intertwined and not w/in scope, treat it under F60 or whatever is appropriate
- if rider detached from base for acctg purposes, not part of same block
- Reinsurance
- depends on contract adn treaty
- paying ceding commission - use to offset acq costs otherwise capitalized
Examples p. 137+
- Base Case
- Dividend fund different than NLP reserve
- Experience diffent than best-estimate assumptions
- alternate discount rates
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U.S. GAAP - Chapter 6 - UNIVERSAL LIFE INSURANCE
Background
- Account for UL - 198 AAA
- AICPA 1984 Issues Paper
Applicability
- UL-type contracts, investment contracts adn limited pay long dur contracts that would be F60 if not mentioned in F97
- EOY1998 w/ restatements for prior years fin statements
- amended F60 for reporting req for realized g/l
- AICPA Practice Bulletin 8 - 1990 - provided guidance
- only looking at fixed (general acct) UL
Definition
- UL - long dur contract w/ death or annuity benefits w/ terms that are not fixed and guaranteed
- contract assessments made by insurer that are not fixed and guar by terms of contract
- amounts that accrue to benefit of PO that are nto fixed and guar by terms of contract
- prems that may be varied by the PO w/o consent fo the insurer
- sometimes requires judgement
- some normal looking contracts s/b accounted for as UL
- existence of account balance for which amounts assessed or credited is not fixed & guar
- expectation fo insurer that changes in any contract elemetn woudl be based onchanges in mkt conditions or int rate and not group experience
- par contracts w/ ability of PO to vary prems w/o consent fo insurer
Typical Product Designs
- prems treated as deposits
- credited rate - rate used to increase fund balance (account balance) aka account value
- surrender charege - penalty for w/d funds
- cash surr value = fund value - surrender charge
- fund is decreased w/ various charges (mort, maint, risk, etc)
- partial surrenders usually allowed
- prems may be fixed or variable - sometimes has a Target Prem that guarantees a certain level of benefits if paid
- many allow extra "dump-in" prems
- may be FEL, left % load, no load (fees taken from account balances)
- enough mortality benefit is provided to qualify as Life Ins under IRC
- mort benefit can be level (Type A) or level NAR (type B) or other pattern
- COI charge - normally monthly to NAR
- might have persistency bonus
Presentation of Results
- retrospective deposit method must be used to account for UL
- benefit reserve - F60: PVFB - PVFP F97:Account Balance (plus adjustments)
- Balance sheet - similar to F60
- Income statement - significantly different
- prems are not revenue
- payments to PO that are return of PO balances not reported as expenses
- revenue
- amounts assessed against PO (COI charges, SC, pol fees, other charges)
- reported in period rec'd - unless deferrable, then repoarted as URL and amortized into income using same methods/assumptions as DAC
- expenses
- benefit claims in excess of acct balances
- costs of contract admin
- int credited to PO balances
- amortization of DAC
Benefit Reserves
- liab for future benefits must be established on balance sheet
- account balance products - retro deposit method
- account balance is basic benefit reserve liab
- UER balance and refundable assesments must be held as liab
- additional liab if prem def exists
- unearned COI held as liab by some co's (not mentioned in F97)
- other products
- if no explicit acct balance, benefit reserve is implicit acct balance or CV
Capitalization and Amortization of Acquisition Expenses
- Amortization method used EGPs
- Estimated Gross Profits (EGPs)
- made up of margins from mort and contract admin, inv earnings spread, SC and other expected assessments/credits
- Mortality
- mort margin - excess of COI over amt paid as benefit claims (in excess of PO balances)
- can estimate if admin system doesn't split DB between NAR and AV
- if level COI or "reverse S&U", excess over std COI needs to be deferred and amortized as URL
- Costs of Contract Admin
- margin - excess of expected admin assessments over expected admin costs
- contract admin costs
- non-DAC policy related costs (policy admin, settlement and maint costs)
- non-DAC acq costs (prem tax and ult ren commission)
- DO NOT include non-DAC, non-policy costs such as mktg and adv
- Investment Earnings
- spread - amount expected to be earned from PO balances - int credited to PO balances
- expected realized g/l s/b estimated and included
- includes amortization of discount or premium on bonds
- includes estimates of equity growth rates
- Surrender Charges
- total SC expected to be collected each year
- diff between account balance for surrendered pol and CSV paid in each year
- product design taken into account when estimating future SC
- Other Assessments and Credits
- rider charges
- reinsurance - consider excess claim recoveries & ceding allowances voer reins prems in EGPs (historically and prospectively)
- treatment varies in practice
- some treat as F60 offset
- Nondeferred Acq Costs
- expensed in year incurred
- if policy related, they affect gross margins
- Expense Capitalization
- same expenses as F60
- except acq costs that vary in constant relationshiop to prems or ins inforce and recurring in nature shall be charged to expenses in period incurred
- under F60, since prems are amort basis, this isn't an issue
- commissions in excess of ultimate level are capitalized
- Amortization of DAC
- k-factor - ratio of present value of deferrable expenses to EGPs usnig int rate that accres to PO balances - at issue
- after issue - actual gross profits replace EGPs and future projections are reviewed/updated
- realized g/l included in investment earnings
- k-factor is recalculated
- all changes in DAC reported in the period
- unlocking - this cumulative catchup amount
- common to use 30 years instead of life of contract
- Negative Gross profits
- est gross revenues, gross costs, or balance of ins inforce substituted for gross profits
- if significant neg gross profits expected for any period
- example p. 154-161
- Selection of Assumptions and Unlocking
- selectoin of assumptions
- best estimates w/o PADs
- includes mort, persistency, prem persistency (or future prem pattern), expenses,future inv earnings, future crediting strategy
- at issue, pricing assumptions generally used as best estimates
- need to understand what underlies pricing assumptions
- if policy maintained at acct value/face levels similar to term, expect persistency to be similar to term
- FIT is not part of DAC process or benefit reserves
- True-up for Actual Experience/Retrospective Unlocking
- replace projected w/ actual at end of each reporting period
- include realized g/l
- unrealized g/l needed for F115
- w/o changing future assumptions - retrospective unlocking
- assumptions and prospective unlocking
- updating future assumptions - prospective unlocking
- retro/pro unlocking examples p 164-165
Deferral of Unearned Revenue
- unearned revenue liab (URL)
- front end loads (FEL) or excess COIs - deferred as unearned revenue and grought into income during period earned
- done via same logic as DAC
- example p. 166
Treatment of Bonuses and Other Special Benefits
- types of special benfits
- day-one bonuses/persistency bonuses/enhanced int rate bonuses
- initial bonuses most common w/ single prem or rollover products
- persistency bonuses are usually either retro int rate increase or refund of COI
- examples
- calculate two streams to establish a liab for the special benfit
Recoverability and Loss Recognition
- same principles as F60
- discount rate for recoverability testing s/b best estimate of earned rate, not crediting rate
- once recoverability has occurred or loss recognition - appropriate to use earned rate to amortize any remaining DAC
- DAC is reduced until k-factor is 100% using earned rate and gross prem approach appropriate thereafter
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U.S. GAAP - Chapter 7 - DEFERRED ANNUITIES
Overview
- characteristics of current DAs
- premium pattern - SPDA & FPDA
- load structure - FEL, BEL (SC) or combo. BEL most common
- surrender Value - typically prems rec'd + credited int - prior partial w/d - SC
- typically has 10-15% free partial w/d provision
- int guarantee structure - guaranteed for a year or less subject to floor.
- based on co experience and competitive considerations
- sometimes guaranteed longer (SPDA products)
- taxable nature - tax-qual or nontax-qual.
- tax-qual deposits deductible on taxes
- both - int not taxed until w/d
- all w/d taxed to extent not previously taxed
- features
- db = max(fund value, prems paid)
- bailout - SC waived if actual rate credited falls below a set limit
- MVA annuities - normally SPDAs
- if early surr, SC and MVA
- adjustment normally defined in contract
- bonus annuities - either extra $ added to fund value or bonus int rate - typically 1st year only
- two-tiered annuities - one int rate for accum to annuitizaton, one rate for accum to surrender
Accounting Model Classification
- older annuities fall under f60 - issued before F97, prems fixed by contract, int guarantees and benefits bundled (similar to trad life)
- prems considered revenue
- reserves calced vial NLP
- DAC amortized w/r to premium revenue
- most modern DAs dont qualify for F60 for 2 reasons
- product features unbundled - excess int, expense charges & SC explicitly defined by contract
- prems not fixed - can be varied w/o insurer consent (w/in contract limits)
- to classify properly, need to know
- accum and payout phase - single contract or two contracts
- if contract contains significant mort guarantees
- significant sources of revenue other than investment of contractholder funds
- "significant" mort risk - generally disregard the presence of guaranteed purchase options in DA contracts as significant mort risk
- usually defined as an Investment Contract
- AICPA Practice Bulletin 8 reinforces thinking - most DAs either F97 or F91
Benefit Reserves
- F97 for Investment Contracts
- generally use UL guidance for defining reserves and DAC asset
- liab for policy benfit = account value
- + amounts assessed for future services (fees, FELs)(URL)
- + previously assessed amounts refundable at termination [seldom applicable to DAs]
- + any probably loss (prem def)[n/a to inv contracts]
- URL accrues in direct proportoin to gross profits
- accrual s/b made for int bonuses (& accrual s/b part of gross profit calc)
- F91
- DAs w/ little or no SC & no add'l DB other than account value
- policy liab = account value using retrospective deposit method
- if no explict acct value, prospective method using best-estimate assumptions w/o PADs
- DAC and FEL considerations
- Practice Bulletin 8 - DA F97 DAC s/b treated as an asset like UL
- not explicitly stated, but same method used for F91
- Commissions and CREs are primary acq costs, but anything else that qualifies under F60 s/b OK
- FEL in excess of ongoing service loads s/b deferred as Unearned Revenue
- DAC amortizes and URL accrues w/r to EGP for F97, int method for F91
- DAC Amortizatoin under F97
- uses saem revenue defintion as F97 UL
- use gross profits as revenue for amortizing DAC and accruing URL
- Definition of Gross Profits
- F97 P23 includes the following EGP items
- amounts expected to be assessed for mortality less benefit claims in excess of PO balances
- amounts expected to be assessed for contract admin less costs incurred for contract admin
- amounts expected to be earned from investment of PO balances less int credited to PO balances (int margin)
- amounts expected to be assessed against PO balances upon contract termination (SC)
- other expected assessements and credits
- best estimates over life of contract w/o PADs
- for DAs, admin, int and SC are most significant items (particularly int margin)
- mort margin usually trivial unless rider w/ significant mort charges included
- other includes things like contingent bonus accruals
- Excluded items: DAC, deferred excess FEL, FIT
- Included : recurring acq expenses, ultimate level of commissions, PT
- Overhead is excluded
- Int Margin is to include realized g/l
- AICPA Practice Bulletin 8 - Expected G/L s/b included since projected future income should include expected total yield from these investments
- int margins should include impact of policy loans if applicable
- DAC Amortization Process
- F97 DAC - amortized in proportion to EGP revenue each accounting period over the period that such revenue is recognized (often capped at x years)
- many co's use worksheet approach
- some co's use valn systems that calc DAC at contract level
- amort process can be expressed using eithe retrospective or prospective approach
- k(0) = pv(DAC)(0) / PV(EGP)
- assumptions not locked - replace EGP w/ actual each acctg period (true-up)
- update best estimate assumptions if warranted
- k(t) updated each accting period
- recalc is as of original issue date
- adjustments to balance made to current and future balances - don't restate past financials
- if k(0) > 1 at issue, recoverability problem may exist
- k(0) recalced using estimated earned rate (instead of credited rate)
- confirms earnings will be available if needed and maintain consistency w/ loss recognition concepts
- if still > 1, reduce DAC until k(0) = 1
- reduction charged against earnings in current acctg period
- F60 procedures for handling recoverability problmes
- if PV(EGP)(0) < 0, no DAC is established
- no additional reserve req'd to make up deficiency
- possible for GAAP loss in all future years for F97 DAs
- adhere to general guidance in F60
- if significant profits expected in one or more periods
- PV(EGR, Gross Costs, or balance of Ins inforce) s/b substituted as base
- int rate for k(t) is either
- rate in effect at contract inception
- actual prior credited rates and latest revised rate for future periods
- int rate choice must be used consistently for all future years for cohort
- EGP & DAC formulas
- assumptions
- EGP derived from investment and expense margins and SC
- all commission expressed as % of prem
- Definitions
- t - contract or calendar year
- n - # years to end of revenue period
- GP(t) - expected GP collected in year t
- m - # prem payments per year
- C(t) - deferrable commision rate in year t
- i(t) - credited int rate for year t
- I_E(t)/AI_E(t) - expected/actual earned rate
- I_C(t)/AI_C(t) - expected/actual credited rate
- E_A(t)/AE_A(t) - expected/actual admin costs
- E_C(t)/AE_C(t) - expected/actual admin contract charges
- SC_E(t)/SC_A(t) - excpected/actual SC
- EGP(t) - EOY value of EGP(revenue) in year t
- AGP(t) - EOY value of AGP in year t
- DAE(0) - non commission deferrable expenses @ issue
- CAP(t) - BOY cap acq costs
- = DAE(0) + C(1)*GP(1)*(1+i(1))^{-(m-1)/2m} in year 1
- = C(t)*GP(t)*(1+i(t))^{-(m-1)/2m} in renewal years
- DAC(t) - DAC asset at end of policy year t
- DAC_CY(t) - DAC asset at EOY t
- k(t) - amort factor for AGP/EGP in year t
- Formulas
- EGP(t) = (I_E(t) - I_C(t)) + (E_C(t) - E_A(t)) + SC_E(t)
- k(0) = sum(CAP(s)/prod(1+i(p))) / sum(EGP(s)/prod(1+i(r))) for s=1 to n; p=0 to s-1; r=1 to s
- assume CAP(s) - BOY value and EGP(s) - EOY value
- k(t) = sum(CAP(s)/prod(1+i(p))) / [sum(AGP(v)/prod(1+i(v))) + sum(EGP(w)/prod(1+i(w)))] for s=1 to n; p=0 to s-1; v = 1 to t; w=t+1 to n
- Retrospective formula for DAC (end of contact year)
- DAC(t) = (DAC(t-1) + CAP(t))*(1+i(t)) - k(t)*AGP(t)
- Prospective
- DAC(t) = k(t)*PV(future EGP revenues) - PV(future deferrable costs)
- Calendar year apporx
- DAC_CY(t) = 0.5*(DAC(t-1) + DAC(t))
- if amort schedule developed from first principles, validatoin of model data w/actual inforce data s/b done
- validate account value, commissions, policy count, & premium at a minimum
DAC Amortization under SFAS91
- Practice Bulletin 8 - recognize acq and int costs as expenses @ constant rate applied to net policy liab
- interest method
- generally defined as diff between policy liab and notional account value, calced @ solved for BE rate
- BE rate - rate where policy liab @ issue = notialnal account value + PV(est DAC) <- @ assumed credited rate
- after issue, notional acct valued calced using original BE rate and remaining DAC is diff between notional acct value and policy liab @ valn
- Int method generally used when policy liab calced under prospective method
- if contract has explicit account value, retrospective method used in practice & handled more like F97 product, including using EGPs
- F91 Inv Contracts not subject or recoverability analysis or loss recognition testing
- in practice, amt of DAC allowed @ issue is limited if BE rate exceeds co's best estimate of investment rate
- if DAC is eliminated and best est rate is still < BE rate
- NO add'l reserve req'd & losses each year earned rate < BE rate
Accrual of Unearned Revenue Liability (URL)
- FEL in excess of level renewal service loads are deferred
- F97 P20 FEL - amt assessed that represnt compensation to insurance enterprise for services to be provided in future periods
- FEL genearlly associated w/ DAs subject to F97 investment contract acctg model
- recognition of deferrable FEL reseults in establishment of URL
- excess loads deferred each acct period as incurred and realased into earning in proportion to AGP realized each period (similar to DAC capitalization adn amortizatoin)
- release rate factor developed similar to k factor
- k(0) = PV future URL / PV future EGP sicounted as assumed credited rate
Selection of Assumptions
- need to select appropriate assumptions at issue and periodically thereafter as necessary
- best estimates w/o pads
- often pricing assumptions w/ PADs removed
- historic prem patterns s/b reviewd since PO can vary FPDA prem payments
- exonomic trends can alos affect payment history
- assumed earned and credited rates - two of most important assumptoins for DAs
- take into account
- investment strategy
- asset type and quality
- asset duration
- liquidity
- disintermediation risk
- provisions for default cost - by quality rating
- int crediting strategy can change over tiem
- strongly influenced by competition and desired spread
- new LOB probably very competitive
- runoff block probably large spread to maximize profits
- reflect prem taxes
- gross of FIT (no tax assumption)
Loss Recognition Tests
- adverse experinece over a period of time reduces AGP and can cause future assumption changes
- these can lead to doubts as to remaining DAC recoverability
- Practice Bulletin 8 - if portion of DAC balance is probably not recoverable, it should be written off
- necessary to conduct preiodic tests of recoverability
- if k(t) ? 1, may not be adequate future revenues to amortize remaining DAC
- need to reduce DAC balance until k(t) <= 1
- F97 investment contracts never need a def reserve
- cannot reinstate written off DAC if experience improves
Examples pp 186 - 190
Presentation of Results
- income statement considerably different from US Stat and F60
- s/b reported in form similar to F97 UL
- F97 revenue
- investment income
- COIs
- SC
- expense charges
- released URL
- DA expenses
- benefit claims in excess of acct value
- admin expenses
- int credited
- amort of DAC
- accrual of special liab (ex. accrued liab for contingent bonus features)
- primary differences - prems, surr benefits, resv incr, credited int
Acconting for Special Features
- MVA Annuities
- product description
- allows companies to guar a competitive crediting rate in exchange for additinal surrender penalty
- MVA designed to cover g/l when surrenders occur @ times when int rates are higher/lower than when contract was issued
- change in intended discourange disintermediation and to recover the realized g/l on those surrenders that do take place
- accounting issues
- when and how MVA adjustments and realized g/l s/b included in EGP calc
- what discount rate s/b used when int rates change
- at contract issue - most co' do not anticipate future MVA adj or realized g/l
- credited rate set equal to guar rate and earned rate = (for guar period) earned rate on assets underlying assets @ issue
- when int rates change, need to decide if need to adjust rates going forward (recalc EGP)
- which int rate to use to recalc VP EGP in DAC amortization factor calc
- crediting rate in effect @ inception OR
- latest revised rate applied to remaining benefit period
- example pp 194-195
- Bonus Annuities
- Product Description
- two bonus designs
- immediate fund enhancement of % of first yr prem (or single prem)
- additional int enhancement in one or more years early in contract
- both usually accomplished by reducing commissions
- usually increases early persistency
- bonus may or may not be immediately vested
- Accounting Issues
- some argue that bonus is a mktg related cost adn s/b a sales expense like commmission
- some co's designate the benefit as contingent and not guaranteed to occur and accrue liab over a period of years, commonly in relation to EGP
- AICPA had not yet rendered an opinion on this yet
- Example 196-197
- Two-Tiered ANnuities
- Product Description
- two tiers
- one w/ lower rate for surrenders (liquid fund)
- one w/ higher rate for annuitization (income fund)
- usually between 100-300 bps difference between rates
- liquid fund typically FEL (5-10%)
- some use SC (BEL) 5-10 yrs grading to 0
- int usually near guar rate until end of SC period (or approx 10 years if FEL)
- then usually same as income fund
- income fund typically enhanced by 5-10% 1st year prem bonus
- Accounting Issues
- fairly controversial for GAAP methodology
- typically considerred investment contracts (despite annuitization encouragment)
- two basic approaches - based on liquid fund and based on income fund
- some use a blended 3rd approach
- liquid fund reserve - liquid fund + accrual of add'l lib for diff between liquid and income funds
- URL for FEL established and released in proprtion to AGP
- add'l liab generally accrues ~ liquid fund or EGP
- income fund reserve = income fune (including any enhancements)
- DAC amortized in relation to EGP, defined by approach selected
- EGP for income fund approach -
- = excess inv income on assets supporting income fund
- + diff between two funds on surrender
- + expense load margins
- income fund bonuses - some co's capitalize tihs amt liek DAC and mortize w/r EGP
- some calc amt in same manner, but report it as a contra-liability instead of deferred asset
- some believe liquid fund approach yields a more reasonable GAAP earning pattern
- income fund leads toward over-reserving
- liquid fund approach doesn't have capitalized bounus issues
- example p 199-202
-
U.S. GAAP - Chapter 8 - VARIABLE AND EQUITY-BASED PRODUCTS
Introduction
- variable products - products that effectively provide for PO to bear substantially all the inv risk on all or a portion of the assets suporting the savings elemtn of their prem payments
- frequently acct model for variable version of product is same as non-variable version of product
Variable Products
- Product Descriptions
- VUL
- A UL product that allows PO to direct all or a portion of their acct balnce into an investment that effectivley passes risk/reward bask to PO
- Does not guarantee inv performance
- Despite added volatility, acctg for VUL saem as UL
- Extra accounting for extra features (secondary guarantees)
- Variable Deferred Annuities
- classified as investment contract unless significant mort benefits, then UL
- Lots of extra features
- GMDB
- Guar Min Maturity Value
- GMIB
- if any of these features establish significant mortality risk, then may require UL-type acctg
- Variable Payout Annuities
- Income benefit indexed to performance of investments underlying variable account
- Ins company may need to +/- assets backing block depending on emergence of mort experience
- Contract Classification
- Life Insurance
- variable feature prohibits classifying them as trad life
- trad life w/ variable features -> UL-type contract -> F97
- variable UL doesn't change it from being UL -> UL-type contract -> F97
- Deferred Annuities
- typically accounted for as investment contracts
- GMDB may cause it to be classified as UL-type contract
- F97 essentially considers GMIB & Guar Min mat value as pricing risk and not mort risk
- Payout Annuities
- limited pay contract w/ variable features can no longer be classified as limited pay contract & classified as UL-type
- since don't ahve stated account balance or explicit charge for mort benefits, accounting requires judgement
- PO Acct balance = PV expected income stream using pricing basis mortality adn discount rate = rate elected by PO @ annuitization
- mort assessments - expected benefit payments calced using same mort rates used to calc PO balances less amt annuity values incr through survivorship
- mort component of EGP - excess of actual benfits paid over amt of mort assessments, then reduced by amt of req'd additions to assets supportin gcontract due to mort exp different from pricing basis
- contract admin assessment based on purchase rate calc
- g/l relative to mort exp - considered part of mort component or "other expected assessments"
- Assumptions
- Contract Interest Rates
- the rate of int that accrues to PO balances (contract rate)
- this rate is then used
- in estimating the amt of future PO acct balances
- as rate credited to PO balances in investment element of EGP
- as discount rate used in determining PV of EGP
- variety of alternatives in developing int assumptinos
- range from estimating rate for all perods to a single rate for all future periods
- usually incorporate element of recent inv results in establishing assumptions for future periods
- regardless of method, needs to be actuary's best estimate of the future based on underlying investment
- one method uses investment horizons
- need to know lenght of investment horizon and est long term rate
- then need to estimate where we are in inv horizon to determine future yields
- Mortality Rates
- for VUL and Var Life, s/b same conderations as non-variable versions
- for Var DA w/ mort adn variable payout annuities
- since not u/w (generally) mort s/b similar to unselect populations (worse than u/w UL contracts)
- Other Assumptions
- expense assumptions s/b same as non variable forms
- may include expense elements for PO activity (moving funds, etc)
- Methods
- In general, consistent w/ nonvariable forms of contract
- exception: variable payout annuity classified as UL
- A - initial deposit x - contract IA
- t - time from contract initiation (t >= 0) i - premium int rate
- p(x+t) - prob surr x+1 to x+t+1 [t]p(x) - prob survival x to x+t
- v = 1/(1+i) s(x) = sum(v^t*[t]p(x))
- uv(t) = accum inv perforance from issue to time t
- I(t) - inv income rate earned on inv in var acct for period ending @ t
- I(t) = (uv(t) / uv(t-1)) - 1 uv(0) = 1
- P = (A - loading) / a(x) => income units purchased
- IUV - Income unit value IA(t) - ann income payable at t
- IA(0) = P*IUV(0) = P (IUV(0) = 1.00)
- IA(t) = P* IUV(t) IUV(t) = UV(t) / (1+i)^t
- PAB(t) - PO acct balance - principal element of liab for var payout ann
- = IUV(t)*P*a(x+t)
- rollforward of this acct balance generates elements of EGP used to amort DAC
- a(x+t+1) = [a(x+t) - 1]/(v*p(x+t))
- IUV(t+1) = IUV(t)*[UV(t+1)/UV(t)]/(1+i) = IUV(t)*(1+I(t))*v
- PAB(t+1) = IUV(t+1)*P*a(x+t+1)
- = PAB(t) - IUV(t)*(1+I(t+1))*P + I(t+1)*PAB(t) + [1/p(x+t) - 1]*[PAB(t) - IUV(t)*(1+I(t+1))*P + I(t+1)*PAB(t)]
- or
- mort assessent = (IUV(t)*P*PAB(t))/p(x+t) - PAB(t)
- int credited = I(t+1)*[(IUV(t) + P + PAB(t)) / p(x+t)]
- allocated inv performance on benefit payouts to int credited component
- methods may need to be developed for unearned mort assessments for any db features
- added to any variable def ann
- most common is to recognize revenue as assessments are deducted and recognize DB as they are paid
- examples p 215-240
Equity-Indexed Annuities
- Nature of Product
- simplest form - on SPDA chassis
- NAIC SNF - value fo policy @ any point = 90% of prems accum @ 3%
- equity indexing feature rides atop SPDA
- often a cap or participation rate to actual growth rate of index befroe applying to premium
- variations on indexing
- choice of index may be provided
- designated period may be changed
- SC may be applied to indexed value if not annuitized
- DB may or may not include unrealize gains in index @ time of death
- flex prems may be allowed (each prem has own indexing)
- equity indexing may be provided as transfer option w/in VA
- index growth may be averaged across several day/weeks/mo to prevent "all or nothing" scenarios
- the underlying (3%) floor my be reset periodically to the current index value
- may be blendingof indexed and guar values
- other index patterns may be used such as lowest value or highest value during designated period
- assets used to support contract primarily bonds to support the guarnatee
- this is lower than costs of bonds for a normal DA
- extra funds used to puchase call options to hedge index risk
- Acctg for Deriviatives
- SFAS133 (1998) - not only derivative assets, but derivatives embedded in host contracts
- embedded derivative object s/b separated from host contract & acct for as derivative
- once separated, host contract acctd based on non-derivative version
- g/l on derivative used as hedge adn hedged item recognized currently in earnings in same acctg period
- Derivatives Implementation Group (DIG) - formed to offer guidance on F133 Implementation
- intial value of host contract on fund-type cntract = premium paid less valued of embedded derivative
- Establish GAAP Methodology for DAC and Reserves
- F133 - EGPs s/b claced using F97 procedures - w/o consideration of equity benefit
- F115 - unrealized gains from assets available for sale s/b processed thorugh EGP calc to produce shadow DAC
- considerations for reporting EIAs
- host contract treated as F97 DA. Fund value = guar fund value
- when index credit is applied, fund value steps up to reflect
- unrealized g/l on embedded policy derivative and hedging assets become components of EGP
- in GAAP projection, assume exact hedge intent is accomplished
- since value of host contract is balancing item @ issue, unearned FEL normally created by 10% load at issue disappears
- open issues regarding reporting of EIAs under GAAP
- floor of csv or prem paid could emerge as floor for benefit reserve
- choices as to how derivatives enter EGP for amortizing DAC
- cost of underlying asset s/b amort linearly to 0 over life of mat period
- amortize cost using EGM prior to insertion of derivative
- only unrealized gains fo both asset and offsetting liab derivative shoudl only enter shadow DAC calc (consistent w/ many co's F115 practice)
- most F97 calcs can be generated using single set of expected values
- because of importance of value of options, may need to forcast multitude of scenarios and take advantage of results to generate DAC and related items
- Numerical Example 242-247
-
U.S. GAAP - Chapter 9 - ANNUITIES IN PAYMENT STATUS
Background
- Annuity in pay status come from many sources
- SPIA
- settlement options embedded in life/DA contracts
- structured settlement
- fund state lottery prizes
- others
- if payment of benefits contingent on continued survival of annuitant(s) - F97 limited pay contracts
- if investment contract (no significant life-cont payments), s/b accounted using methodologies consistent w/ those used for similar products offered by other fin services institutions
Contract Classification
- Annuity w/ no mort or morb risk - investment contracts
- Life w/ certain - ins contract unless
- prob life portion every being paid is remort
- PV life portion is insignificant
- Option to annuitize on a DA not a mort risk, a pricing risk
- once exercises, a mort risk, but accounted for as a separate policy
- rule of thumb - life contingent payments > 5-10% of PV of all payments -> not nominal mort risk
Investment Contracts
- F97 - little guidance
- amt rec'd as payments NOT reported as revenue, but liab and accounted for in manner consistent w/ acctg for int bearing or other fin instruments
- F91 - some insight via loans
- loan orig fees, purch prem, discounts recognized as an adjustment to yield
- generally by interest method based on contractual terms of loan
- Constant Yield Method (aka Prospective Deposit Method)
- project anticipated cash flows - best estimate assumptions w/o PADs
- solve for int rate where PV flows = net proceeds @ issue
- PV CF @ solved for rate on valn date is GAAP reserve
- net proceeds - consideration rec'd less comm or acq costs
- GAAP liab can be split into asset piece and liab piece for B/S presentation
- calc PV maint exp (maint Vx) adn PO benefit payments (benefit Vx) only
- where i is rate that gives PV @ issue = Prem Paid
- DAC balance = benefit reserve + maint reserve - net GAAP reserve
- Prems booked as deposits (consistent w/ other fin institutions)
- PO benefits not ded to income, merely return of deposit
- Appropriate I/S presentation
- + Inv Income
- - Maint Exp
- - Req'd/Credited Int
- - Incr Maint Exp Reserve
- + Increase in DAC
- = Pre-tax GAAP profit
- if actual main expense = expected, profit emerges as inv income earned on assets supporting net reserve @ BOP - req'd int of benefit and maint exp reserves + change in DAC
- if benefit paid and maint exp emerge as expected, profits emerge as difference between inv income earned and req'd int on net GAAP reserve
- appears that loss recognition is N/A to inv contracts
- AICPA Practice Bulletin 8 - write off DAC, if determined that not recoverable from future profits (written down to recoverable level)
- realized g/l not an issue since not being amortized over EGP
- Also no shadow DAC
- assumptions not locked-in
Limited-Pay Contracts
- once determined that enough mortality risk exists, contract s/b accounted for as F97 limited-pay contract
- premiums as revenue
- liab for policy benefits same basis as for other long dur contracts
- amt of gross prem in excess of net premium s/b deferred and recognized over period that services are provided
- initial prem is revenue
- acq expenses capitalized adn amortized over prem period (instantaneous in most cases)
- benefit and maint exp reserves established using assumptoins reflecting co's expectations, incl PADs
- any excess of gross prem over acq exp and initial benefit reserve and initial maint reserve is capitalized as a deferred profit liab (DPL)
- DPL amortized in proportion to expected annuity payments to be made
- since essentially treated as F60, assumptions locked at issue
- critical assumptions - mortality and inv earnings assumptions
- ok to grade inv earnings rate down over time as a PAD
- to include PAD in mortality, decrease (not increase) future mortality (usually projecting mortality improvement)
- loss recognition: PV pre-tax GAAP profits using pre-tax inv earnings rate
- if < 0, liab s/b increased by amt of deficiency
- DPL set to zero
- benefit adn maint reserves recalced using best-estimate assumptions
Conversion of Policy-Year Factors To Calendar-Year Factors
- reserve factors on dates other than policy-year ends typically done through interpolation
- alt: exact calc of PV of projected payments made on each valn date
- if benefit payments not uniform, exact calc s/b made
Study Notes and Published Refences - Note SN 8I-309-01 - MANAGEMENT REPORTS AND REPORTS TO REGULATORY BODIES
Intro
- mgmt reporting systems designed to satisfy 3 basic purposes
- external reporting to shareholders/policyholders/regulators
- internal reporting to mgmt for control and planning
- internal reporting to mgmt for non-routine decision making
Management Reporting
- comprises teh published reports of financial results for shareholders, PO, or other users of fin reports
- along with those used internally by mgmt for control and decision making
- Reports for External Readers
- frequency and form dependent on # factors
- stock vs mutual
- needs of co mgmt
- subject to SEC
- demands of others (credit rating agencies)
- Annual/Qtrly usually consist of
- balance sheet as of reporting date - usually w/ comparison to prev periods
- income statement since last report - usually w/ comparison to prev periods
- cash flow statement
- statement of changes in shareholder equity (or PO surplus)
- explanatory notes to fin statements (lots of disclosures)
- common to provide a narrative (MDA)
- Reporting for Mgmt Control
- provides mgmt w/ info necessary for planning and controlling current operations, making special decisions and formulating long-range plans
- Basic Objectives of Mgmt Reporting
- must be at a level of detail & freq to enable the user manager to accomplish the control or planning function
- shoudl focus on key controllale tiems on which a manager cna act
- distribution of reports s/b limited to those who can act on the info
- one mgmt reportng linnked to strategic objectives, mgmt comp can be lined (in part) to measurment of these metrics
- Economic Value Analysis - analyze economic value of various untis of co to determine capital allocation strategies & req'd rates of return
- Structure of Report
- system s/b single integrated multi-purpose reporting package taht provides all relevant data via fewest pages of reports
- all report elements s/b generated as a routine by-product of the acctg and info gathering process (ideally)
- data warehouse - allows mining
- top mgmt need less detail fo results of operations and more analysis from lower mgmt
- exception reporting - reports only detail matters that have varied from the plan
- reports sould include explanations for any deviations and propose corrective action (if needed)
- Reporting for Cost Control
- needs good historical data
- best accomplished through techniquies of responsiblity level reporting
- Elements of Responsibility Reporting
- forms basic design of complet mgmt control system
- focuses on individual manger who has primary responsibility for revenues/cost
- recognized cause and effect relationship between decisions made an dactions takes and economic results of such decisions and actions
- procedures shoudl provide for direct and indirect cost indentification and techniques for their allocation to benefiting functinos
- levels of cost containment shoudl take into account
- operational responsibilities of dept fro whom cost accumulated
- other cost centers from which work rec'd
- otehr cost centers benefiting from work performed
- plans of ins or major types of ins served by function
- Report Design for Responsibility Control
- only report results that can be directly controlled
- objective negated if info reported is outside their authority
- managers can only utilize a level of report detail commesurate w/ style of mgmt, authority and info needs
- many orgs re-designing chart of accts & cost centers so they "roll-up" better
- reports generally provide net operating results on
- contribution to income by LOB function or
- contribution to overhead
- reports show results for period, comparison w/ budget and forcasts and variances
- Analytical Reporting
- great deal of add'l info that is financial or statistical in nature
- add'l elements - control of performance
- policy counts and avg volumes
- w/ explanations for deviations (both fair and unfair)
- changes in acq costs - all deviations s/b explained
- trend analysis of Stat and GAAP reserve/$1m
- clerical cost control reports
- % of perforance std achieved for each work element, volume of processing, volume of backlog
- mgmt info systems control
- expansoin or decline of units of work completed for users, improvement or degradation of user value rec'd
- add'l elements - Planning
- historical trend analysis
- persistency
- comparison of ins inforce
- A/E mort and morb analysis
- model of sample block of business
- stratified A&H claims
- recoverability analysis of DAC
- investment yield analysis
- inv yield on new funds
- repayments and maturities of investments
- cash flow projections
Reporting to the SEC
- SEC
- one of their primary functions - examine registration statements and annual and periodic reports filed by publicly held co's to determine if appropriate disclosures made
- Reporting under Securities Act of 1933
- disclosure statute concerned primarily w/ registration and disclosure before public selling
- Securities Registration Statements
- approval of registration statement and prospectus prior to sale of securities
- public document (except for a few confidential sections)
- Form S-1
- principal registratoin statement
- Part I - same stuff as prospectus
- selected fin data - 5 year comparison revenue/income/assets/LT obligations/divs
- supplemental fin info - quarterly
- MDA
- financial statements
- Part II - stuff we don't care about
- Other Registration Forms
- Shelf Registrations
- Reg C allows registering early and waiting to sell
- Regulation S-X
- principle acctg regulation
- supplemented w/ FRRs (replace ASRs) and SABs
- same as GAAP w/ additional footnotes
- Important Parts
- Article 3 of S-X - fin stmt rules for when and what
- Article 4 Rule 4-08 - general notes - lists additional disclosures
- Article 7 - Inc Co Fin Statements - GAAP rules w/ addtional req's
- Application of Regulation S-K
- objective: standardize disclosure reqs for SEC filings
- 9 major sections - 8 relate to insurance
- buisness
- financial info
- securities of the registrant
- mgmt and certain security holdings
- registrant statemnt and prospectus provisions
- exhibits
- misc
- list of industry guides
- Significance of FRRs
- designed to communicate SEC's position on acctg and auditing principles and practices
- SABs - informal rulings and interpretations
- Reporting under Securites Exchange Act of 1934
- registration under 1934 act - certain public cos not on an exchange must register w/SEC if they meet size reqs
- Ins Cos exempt from 1934 act b/c under control of state depts/agencies
- annual reporting under 1934 Act - annually 10=K
- other periodic reporting - 10Q, 8K, proxy statement
- Regulation S-B
- small business
- forms SB-2 10QSB 10KSB 10-SB
- Electronic Filing
- EDGAR
- Reg S-T details reqs and procedures for electronic filing
Reporting to Other Regulatory Agencies
- Reporting to Stock Exchanges
- Form 10 to SEC and Applicatoin for original listing w/ exchange
- reqs for original listing
- varies for each exchange, most stringent for NYSE
- listing application
- original listing or subsequent issuance of additional securities
- periodic reporting reqs
- annual audited and quarterly unaudited w/ exchange and 10K to SEC
- Periodic Reporting to State Ins Depts
- annual and most states quarterly
- some states have reqs for special reports
- Statutory Codificatoin
- report beginning 1/1/2001 in accordance w/ revised NAIC Acctg Practices and Procedures Manual
- designed to provide consistency between cos and states
- 3 objectives: conservatism, consistency, recognition
- provides guidance where Stat had been silent and changes stat in some areas
- IRIS
- NAIC database designed to give early warning re: cos w/ fin difficulties
- Financial TEsts
- Ratio 1 - Net change in cap & surplus - delta cap & surplus / delta cap & surp (-1) >1/2 <-1/10 warning
- Ratio 1a - gross change in capital and surplus
- Ratio 2 - Net gain to Total Income - NGO (incl real g/l) / gross income <=0 warning
- Ratio 3 - Comm adn exp to Prems and Depostis - >60% - supplemental ratio only
- Ratio 4 - Adequacy of Inv Income - NII / Int Req'd <125% >900%
- Ratio 5 - Nonadmitted Assets to Admitted Assets - >= 100%
- Ratio 6 - Real Estate to Cap & Surplus >100% ($5mill or less of cap&surp), >200% rest
- Ratio 7 - Inv in Affiliates to cap and Surp - >100%
- Ratio 8 - Surplus Relief - net reins somm & exp allow / cap & surp - >10%<-10% smaller co >30%<-99% rest
- Stability Tests - exceptions require evaluation of mgmt strength to control dramatic change
- Ratio 9 - chagne in premium - >= 50% < -10%
- Ratio 10 - Change in product mix - >= 5%
- Ratio 11 - Change in Asset Mix - >= 5%
- Ratio 12 - Change in reserving ratio - agg incr indiv life resv / indiv life renewal and single prem - >= +/- 20%
- Co should monitor these ratios since automatically calculated from AS filings
- MDA
- include all material and significant changes and events
- specifically must address
- financial position
- results of operations - unusual or non-recurring events, favorable or unfavorable trends
- cash flow and liquidity - include any planned capital expenditures w/ purpose and funding
- Special Reporting to the IRS
- 1099 - reports int, divs and certain other payments and taxes withheld
- withholding rules - mandatory in some cases
- special rules
-
Study Notes and Published Refences - Note TSA XXXVIII - STRATEGIC MANAGEMENT OF LIFE INS CO SURPLUS
Strategic Planning
- "capital budgeting" process for allocating capital to various activities
- won't tell co if activity is worth doing in first place - strategic planning for that
- textbook approach to capital budgeting can result in random group of project w/ no clear stategic focus
- sometimes necessary to fund projects taht return less tahn the co's cost of captial to support co's strategic direction
- strategic planning - basic tool to evaluate attractiveness of each SBU for inv of copr resources
- "attractive" - both achieve sustained competitive advantage
- earn ROE >= cost of captial
Financial Planning
- Creating a Structure for Financial Planning
- necessary to determine amt of co surplus devoted to each business
- "business" s/b defined in a strategically significant way
- one technique for determining amt - "req'd surplus formulas"
- by applying formulas @ different points in time, possible to see amt fo surplus flowing into or out of each profit center
- residual surplus - unallocated surplus acct
- usually need to convert from Stat Req'd Surplus to GAAP to reflect investment in acq cost and surplus strain
- GAAP req'd surplus = Stat req'd surplus + unamort GAAP DAC + excess of stat benefit reserves over GAAP benefit reserves
- side benefit - meaning ROE can be calced for each profit center
- keep GAAP-ROE limitation in mind
- may or may not correspond to internal rate of return used in pricing
- differences
- some acq costs not deferrable under GAAP
- GAAP amortizatoin @ expected earned rate, pricing uses cost of captial, therefore different patter of profits and req'd surplus
- GAAP includes PADs, causes GAAP profits to be deferred
- these distortions can be prevented/lessened by selecting GAAP assumptions
- another soln - sep accting system for managment acctg
- stock - GAAP close enough w/ minor adjustments
- Mutual - gross prem valn techniques
- either case, new system can be $$ to implement
- Determing the Cost of Capital
- Cost of Capital - best benchmark for evaluating ROE from each profit center
- determined as weighted cost of each source of capital
- cost of equity capital - adding a risk prem to risk-free rate of return
- "risk prem" based on the additional yield req'd by investors to compentate for investing in co's common stock
- cost of debt capital - based on LT int rate could borrow bades on its credit rating
- since int of debt is tax deductible, appropriate to use after-tax rate
- cost of debt & equity capital weighted to determine overall cost of capital
- adjustemnts may be need to extent co incurrs corp expenses
- not allocated to profit centers
- Concept of Economic Value
- financial planning objective - increasing the economic value of co
- economic value - PV free cash flows, discounted using the co's cost of capital
- free cash flow - excess of increase in stat surplus (before shareholder divs) over increase in req'd stat surplus
- ignoring cap g/l, free cash flow can be approximated by excess of GAAP earnings over increase in req'd GAAP surplus
- GAAP def most useful for financial planning
- actuary can determine which product lines generating cash flow by comparing GAAP-ROE w/ GAAP equity growth rate
- GAAP equity growth rate - req'd GAAP Equity (EOY) / req'd GAAP Equity (BOY)
- if GAAP ROE > equity growth rate - generating free cash flow
- if GAAP ROE > cost of captial - growth is desirable
- if ROE < cost of capital - destroying economic value
- explore ways of improving ROE
- if not possible, amt of capital flowing in s/b minimized
- if > equity growth rate < cost of capital sometimes tolerated, esp if strategic
- if ROE < cost of capital and < equity growth rate - most destructive - "cash sinks"
- can have varying ROE for profit centers based on relative risk
- Financial Planning Process
- to manage surplus, process needed to ensure capital allocated to most attractive areas
- financial plan s/b developed annually for each profit center
- s/b more than 1 year plan
- 1st yr financial plan #s = objectives for following year
- often used for incentive compensation
- tend to be conservative
- years 2-3 often best representation of future financial performance
- first version of plan normally unacceptable to mgmt for variety of reasons
- uses more captial than available
- allocate too much to an area deemed unattractive
- insufficient ROE for co as whole
- should allow enough time to generate & discuss 2-4 different versions of plan
- important b/c provides insites to fin performance not possible otherwise
- simplified financial models often work best b/c of tight time frame
Company Organization
- profit centers should correspond to organizatoinal untis (SBUs)
- failure to use SBU, results in accountability issues
- shared business services - bill SBUs for services used
- each SBU should develop fin plans for its business
- this type of org gives many cos best framework to evaluate performance of each SBU and control resource allocation on relative attractiveness of each SBU
Evaluating Financial Performance
- commonly, SBUs not defined in a way that corresponds to co structure
- mgmt needs way to allocate current surplus among SBUs to monitor use of surplus
- if req'd surplus formula defined simply enough, can be done qtrly/monthly
- compare results to fin plan
- ROE determined and variance to plan analyzed
- mgmt can react quickly if things begin to go awry
-
Study Notes and Published Refences - Note SN 81-303 - ACTUARIAL REVIEW OF RESERVES AND OTHER A.S. LIABILITIES
Overview
- audit - "critical review" process of complex org, transaction, operation or inventory
- final objective of an audit - communicate clearly to the auditee an authoritative opinoin on such org (etc) being audited, in the least time, at the least cost, and with least disruption of operations
Applicable Professional Stds Regarding Actuarial Review of Reserves
- AAA yearbook discusses
- standards for "Qualified Actuary"
- Recommendation 7 - Statement of Actuarial Opinion
- Recommendation 9 - Materiality
- materiality is an important principle
- there comes a point wehre a small amt of increased accuracy may not justify the extra assembly or reviewing expense
- "a difficult professional judgement"
- Valuation Actuary - appointed by co board
- determines appropriate reserves
- render a report to mgmt of reserve determination techniques employed
- statement of appropriateness of assets supporting reserves
General Principles of a Satisfactory Audit
- Be certain of Audit Objectives
- communication is necessary to see if objectives consistent w/ estimated cost
- customer should know what audit will/won't include (scope of audit)
- attempt to communicate objective helps customer clarify and thefine the most efficient objective
- Plan Audit in Advance
- prior to beginning detail checks
- gain overall knowledge of components of inventory being audited
- develop plan of review for each component
- Sampling Principles to remember
- test each element fully (insofar as possible)
- pay extra attention to
- new plans, new benfits, operations that have undergone recent changes
- stratificatoin so that all methods and procedures used to obtain results included in sample adn tested
- Prior Audit s/b reviewed
- guide to planning current audit
- point out errors from past and where current review s/b concentrated
- Customer should have one audit coordinator through whom all Q&A funnel
- Have physical copy of document "checking to" for numerical audit
- Leave no links in audit trail untested
- Audit Report
- brief descr of review process used
- detailed decription in auditors own files
- nature of operation being audited (briefly described)
- should resemble previous reports (if periodic)
- comment on material observations and recommendations from last report
- Auditee s/b given draft to review
- State all objects adn recommendations resulting from audit in specific and measuralbe terms
Reserve Assembly Process
- financial provides schedule of tiems needed for completing annual statement
- date needed
- item needed
- person repsonsible for sending data
- distribution list showing recipients fo data
- typical co might have schedule which counts backwards
- main objectives of assembly process
- speed
- contril
- paying attention to official AS instructions
Auditing Life Insurance Reserves and Related Actuarial Items
- Five categories of effective reserve audit techniques
- spot checks
- independent full recomputations
- tests of aggregate progress of reserve from one fiscal period to another
- tests of relationships of reserve items to toher financial itmes and stability when comparing to previous periods
- tests of reserve adequacy
- first four test to see if calced as tehy are supposed to be calced
- fifth "good and sufficient" testing
- tests of approx valn method - could be in first, second or last test
Spot Checks (tests of inventory, test calcs, transactional checks and policy traces)
- sampling - random, systematic, stratified
- systematic - every nth element (after elements ordered)
- generally superior validity to random sample since form of stratification
- stratefied - "forced representativeness" sampling techinque
- closes confidence interval substantially
- when an error of principle is discovered, systematic (or otherwise stratefied) sample can be used to estimate effect of error on entire block of business
- tests that involve sampling
- tests of inventory are made to assure no major errors of ommission or commission
- depending on situation
- compare major reserve assemble worksheets to previous year to assure no categories omitted
- at same time, look for unusual growth/dimunition of amts
- check chain of process used to go from reserve detail to financial statement exhibit
- identify all pol # blocks
- select systematic sample of pols
- trace through orig records
- if inforce, what components and for what amounts
- tests of calculations (spot checks)
- same sample from inventory tests good starting point
- spot checks can include
- retrieval of folder and checking that all listed policy benefits reserved properly
- check of policy or contract language to see if reserveing methods proper and all inclusive
- direct contact w/ insured to verify policy elements
- transactional checks of reserves and due premiums
- if surrendered in current policy year, policy shouldn't be part of reserve inventory
- if life premium past due-date, s/b paid, loaned, or net due prem asset
- direct reserve s/b in sync w/ corresponding reins ceded reserve
- policy trace
- pick a policy and follow it through calendar year
- should be in inventory for
- EOY net def prem
- BOY net due prem
- EOY net due prem
- BOY SV due and unpaid
- EOY SV due and upaid
- BOY reserve
- EOY reserve
- BOY claim liab
- EOY claim liab
Independent Full Recomputations
- only done if it can be done in a cost efficient manner
Tests of Aggregate Progress of Reserve From One Fiscal Period to the Next
- Analysis of Increase in Reserve Checks
- Formula I
- C - tabular cost of mort for the year
- I - req'd int for the year
- (C-I) / ([0]m(x) + 1/2P) historically and check for smoothness of trend
- C / avt amt @ risk = approx qx => find x= avg attained age historically and analyze progress
- Formula II
- annuity type reserves
- separate by type - dis life, supp con, normal annuities
- reserves released by death or recovery (A) used to back into (T) tablular reserves released
- t/([0]m(x) + 1/2(P-Payments)) = approx death/recovery rate
- = approx avg decremental rate from underlying valn table
- review historical treand
- Formula III
- I s/b = approx (avg credited rate) * ([0]m + 1/2(P-Payments))
- "roll forward" approach
- + BOY acct value
- + net prem deposits
- - admin charges/pol fees
- - COI charges
- - benefit prems
- - acct values released by termination
- compare against acct value @ valn
- delta s/b int credited to block
- once roll forward proved
- create historical table of (act value - reserve) / acct value
- roll forward is test of engine that drives machine, not machine
- Check of Increase in Life reserve/$1m over time
- review smoothness of incremental progress
- when comparing current to prior, use current year renewal only (no current NB)
Tests of Relationships of Reserve Items to Other Financial Items (Units of Measurement) And Stability Therein From One Fiscal Period to Another
- examples
- Group Unearned Prem Reserve -> incurred group prems (collected & delta due prems)
- Substd Extra Prem reserve -> total incurred prem
- ADB reserves -> ADB inforce
- Ordinary Dis Reserve -> ann prems to be waived, inforce
- purpose: spot unusual trends
- well suited for
- net due and deferred prems
- ancillary benefit reserves
- reserves for nondeduction of fractional prems
Tests of Reserve Adequacy
- traditional definition of adequate - actuary's best estimates
- reserve plus future prems and int make good and sufficient provision for future benfits adn expenses
- three common tests of adequacy
- loss ratio tests
- gross prem valn methods
- claim runoff tests on dis life reserves, claim reserves, loss reserves
- Loss Ratio tests ("check students guide and see what they say"
- Gross Prem Valn (aka Prospective Asset Share)
- GPV(t) = sum([B(s)+E(s)-P(s)]*v^(s-t-1)*[s-t-1]p(x+t)) from s=?? to infinity
- PVBP(t) - pv book profit - Anderson's Method
- =[t]V - GPV(t) where [t]V = Stat Reserve
- > 0 -> reserve officially heald exceeds best estimate provision (a good thing)
- adjust cells for fractional durations for calendar year calc
- discount 1/2 year, add future gross due and def prems less expenses and expected benefit
- subtract mean reserve and net due & def prems - [t]V*v^(1/2)*[1/2]p(x+t-1/2)
- A&H blocks - adjusted loss ratio approach
- historical look at sum of incurred claims and incr active life reserves
- sufficient margin at EOY t woudl be
- + revised PV future profits
- - reserve according to an up-to-date standard
- + reserve actually held
- Claims Runoff Tests
- loss triangles
- gaining popularity due to high-speed computers -> multiple scenario CF surplus proj
- diff between GP valn and CF surplus proj
- indiv assets tracked as to actual income, redemptions, taxes
- multiple scenarios run, usually w/ different int rate paths
- diff int rate paths & assumed behavior patterns shoudl show consistent relationship
- as review of CF projections, two circumstances
- reviewer of another actuary's CF projections
- both methodology and experience assumptions s/b reviewed
- testing another actuary's reserve adequacy by performing own CF projections
- other "good and sufficient" test
- that an approx vlan method is accomplishing its goals
- approximating well the trad, more detailed method
- making good and sufficient provision for liability it purports to represent
- historical analysis of formula II type reserve (payment annuity) to see if T-A released generally positive
- if so, decrement assumption may render reserve inadequate
Conclusions
- remember certain priorities
- errors of principle more important than clerical errors/typos
- priority to large items vs smaller ones due to time restrictions
- when selelcting samples for spot checking, think diversity
- priority to new plans and products along w/ procedural changes
- once on-site audit finished, final reports s/b given priority over actuary's other work
Healthy Skepticism
- "developed a healthy skepticism concerning data and other info proffered by others"
- "apply a test of reasonableness to all figures you are given"
Appendix A - "Qualified Actuary" Standards
- Education
- pass exams and take CE
- genearl and actuarial math
- life and health policy forms and coverage
- divs, reins, and tax laws
- investment and valn of ins co assets
- valuatin and liabs
- valn and nonf laws for jurisdiction
- Experience
- 3 eyars responsible experience (recent) under qualified supervision
Appendix B - Recommendation 7 - Statement of Actuarial Opinion
- list items and amts on whch the actuary opines
- common stds adn sound actuarial principles - dictated by ASOPs, recommendations, etc
- contract provisions such as fractional prems paid beyond date of death, conversion rights, etc
- check valn reqs in state of domicile
- reserve adequacy - GP valns < reserves held => ok
- comments on changes in actuarial assumptions or methods
- include who you are and who you work for
Appendix C - Recommendation 9 - Materiality
- a difficult professional judgement
- consider decision-making framework of typical user of actuary's work and their probable response
- quantitative and qualitative consideration
Appendix E
- Analysis of degree of improvement in validity by changing from random to stratified
- blah blah blah
Appendix F - Analysis of Increse in Reserves
- Formula I - [0]M + P + I - C - V_D - V_T = [1]M (life)
- Formula II - [0]M + P + I + (T-A) - Pmts = [1]M (life annuities)
- Formula III - [0]M + P + I - Pmts - [1]M (int only reserves)
- Life Insurance
- [0]M,[1]M - 12/31 reserves
- P - tabular net prems collected
- I - req'd int for year
- C - tabular cost of mort for year
- V_D, V_T - reserves release by death/other than death
- (C-I) = ([0]M + P) - ([1]M + V_D + V_T)
- I = i*(1/2)*([0]M +[1]M + V_D + (C-I)) wehre i = reserve rate of int
- C is balancing item = (C-I) + I
- Life Annuities
- T - annuity reserves expected to be released by deaths of annuitants according to valn table
- A - annuity reserves actually released by death during year
- Pmts - actual amts paid to annuitants during year
- (T-A+I) = ([1]M + Pmts) - ([0]M + P)
- I = i*(1/2)*([0]M + [1]M - (T-A+I))
- (T-A) = (T-A+I) - I
- Int Only Reserves
- I = ([1]M + Pmts) - ([0]M + P)
-
Study Notes and Published Refences - Note SN 8I-304-00 - VALUE BASED FINANCIAL MEASUREMENT
Background
- rapidly changing business environment
- external forces
- megers/consolidation in fin services sector
- continues product revolution/evolution
- shrinking profit margins b/c incr competition and unbundling of services
- turbulence in inv mktplace
- significant internal/external replacements
- increased consumer sophistication
- shorter product life cycles
- frequent/major tax code changes
- restructuring of product delivery systems
- internal forces
- inadequate co performance (vs goals/expections)
- replacement of obsolete admin systems
- desire to measure g/l by source
- analysis of appropriate surplus levels
- pressure to lower acq and maint expense
- incr demand for incentive comp
- limited capital resources
- purpose/limitations - use of a value-based fin measurement system for internal/mgmt reporting purposes only
Concepts Underlying Value-Based Financial Measurement
- Key Elements of a Financial Measurement System
- Mgmt needs relevant and timely fin info
- assist making economic decisions
- evaluate fin condition and performance of co
- compare fin results w/ pre-determined goals
- allows appraisal of mgmt performance
- Desirable characteristics of fin system
- should reflect economic fundamentals w/ underly co's business
- results s/b available by profit center
- results s/b readily communicable to and understandable by senior mgmt
- Shortfalls of Stat and GAAP for Internal Reporting
- designed for external uses
- contrained by rules and guidelines
- hampers timely measurement of emerging experience and/or underlying profitabilty of a product
- Stat Reporting
- measured on a liquidation (vs ongoing) basis
- calced using prescribed conservative methods and assumptions
- NB production expenses charged 1st yr w/ limited relief
- non-admitted assets may have real utility/value to co
- causes anomalous situations relatvie to positive actions taken by ins co mgmt
- increase in NB can cause decrease in current year stat earnings b/c
- 1st yr expenses > 1st yr revenue
- modified reserve system only provides partial relief
- decrease in NB production may result in increase in CY stat income
- policy termations via lapse/surrender result in incr in stat earnings in year of termination b/c Vx > CV
- not usually best LT interest of CO since future stat profits won't be realized
- substantial capital expenditures charged in year incurred despite LT benefits of these expenditures
- enhanced IT capabilities or field force expansion
- GAAP Reporting
- F60 codified life ins GAAP acctg
- shortcomings have appeared
- best suited for periods of economic stability
- does not adapt on time basis to flucuations in int rates or lapse rates
- UL type products don't fit into F60 well - F97 developed
- 2 very different acctg methods depending on product types
- GAAP is transactional based - reflects earnings based on transactions central to co's operations
- inconsistent w/ way most cos price products
- several mechanical features of GAAP create distortions in measuring fin performance of co
- non-deferral of certain acq costs
- lock-in assumption @ issue
- PADs
- treatment of deferred taxes
- GAAP acctg often doesn't provide adequate "early warning" signs to mgmt until too late to react properly
Description of Value-Based Measurement
- utilized concepts and techniques consistent w/ Anderson pricing method
- reports earnings as change in economic value of life ins co over a specified period of time
- economic value - PV expected future cash flows discounted @ hurdle rate
- cash flows - defined as stat earnings for this purpose (aka book profits)
- includes delta stat Vx - a non CF item
- stat earnings best represent "free cash flows"
- can be dividended, reinvested, or RE
- economic value at YR = adj stat capital and surplus + value fo business inforce
- adj stat capital and surplus = stat capital and surplus + items which are allocations of surplus (MSVR) or reclassification of certin stat itmes (restoring non-admitted assets)
- value business inforce = PV future stat book profits @ hurdle rate
- delta economic value + shareholder divs = value based earnings for year
- consistent actuarial assumptions at both end points - so change is not due to change in assumptions
- consistent hurdle rate between endpoints
- then new calc showing difference due to change in hurdle rate
- 3 elements to value based earnings
- earnings on adjusted capital and surplus
- earnings on business inforce at BOY
- earnings on NB written during year
- if actual = expected
- earnings on adj cap and surplus = after tax investment earnings of assets supporting it
- earnings of BOY inforce = hurdle rate * value of inforce BOY
- earnings on NB depends on relationship to pricing ROI and hurdle rate
- pricing ROI = hurdle rate - no economic value b/c PV future renewal renewal book profits = 1st yr surplus strain
- pricing ROI < hurdle rate - economic value reduced
- pricing ROI > hurdle rate - economic value increased
- critical that new products priced and measured using realistic assumptions
- since actual rarely expected, variations would be reflected in value based system
- Determination of the Hurdle Rate
- viewed as desired, risk adjusted, rate-of-return on invested capital
- closely linked to co's cost of capital
- can use CAPM
- CAPM breaks expected returns into 3 components
- risk free rate of return
- rate of return on avg equity investments
- business risk factor - identifies variance in risks between different cos and industries
- ROR = (I + R(r)) + B(R(m)-I-R(r))
- I - inflation rate
- R(r) - real rate of return
- B (aka Beta) - business risk adj factor
- R(m) - rate of return on avg equity inv
- I + I(r) - risk free rate of return available to investors
- cost of debt capital - typically after-tax int expense paid on debt
- equty capital tend to be more expensive than debt capital
- may be appropriate to ahve different hurdle rates for different LOBs to reflect underlying risk of each LOB
Numerical Illustrations of Fin Measurement Systems
- Level Return on Equity
- special case of value-based-methodology
- hurdle rate = pricing ROI
- Policy Premium Method
- Gross Premium Reserve - based on best estimate assumptions
- less "limited adn reasonable" PAD
- all future benefits adn expenses accounted for
- can result in profit at issue
- similar to value-based - can have profts/loss at issue
- different - renewal years earnings from release of PADs
- regardless of method used - total earnings equal
- different reserving methods affect the incidence of profits, not amounts in total
- Comparison of Earning Emergence
- Stat - large first year loss followed by increasing profits
- US GAAP - smaller 1st yr loss followed by fairly level stream of profits
- PPM - fairly level streams of profits in all years
- Value-Based - level early, trailing off near end
- spread over life of product in proportion to equity employed
- not front-ended at issue
- Level ROE method - 1st year earnings = 0 by def
- earnings spread over lifetime of product in proportion to equity employed at Pricing ROI
- Comparative Observations
- Stat produces substantially different pattern of earnings that other methods compared
- methods which do not permit full deferral of acq costs generally report loss in year of issue
- even if product is profitable
- neither value-based nor PPM report all earnings at issue
- both methods accelerate reporting of earnings for profitably priced business
- value-based & PPM more responsive in reflecting underlying profitability of product
- reported earnings (except Stat) similar during middle years
- early and later years diverge => rapidly growing/contracting co would report signficantly different earnings depending on method used
Practical Considerations of Implementing a Value-Based System
- Model Office Projectinos
- basic tool req'd for value-based system
- 20-30 yrs of future stat projections needed
- PV s/b determined over period of time sufficient to allow runoff of significant portion of business inforce
- "HowTo Model" is discussed
- actuarial assumptions used s/b best estimates consistent w/ recent experience and pricing assumptions
- appropriate to use pricing over current experience for items when realistic improvement toward pricing assumptions can be made
- static validation - compares total beg reserve and prem inforce for each model plan to actual amounts
- shows how well plans and ages have been modeled
- dynamic validation - performed by projecting backward one year and comparing model to actual prev year results
- Other Lines of Business
- for smaller blocks, less refined modeling techniques can be used
- annuities - if major, cell-based model
- if relatively minor - project using aggregate int rate spread approach
- if most of stat profit in annuity line is from spread, shoudl be sucessfully modeled using aggregate appraisals
- group life and health - if considered 1 year YRT, value of business inforce is zero
- most appraisals develp value by assuming business renews each year adn expected stat profits discounted to appraisal date to determine value
- unless large block, appropriate to assign no value to any expected future profits
- value-based earning = stat earnings
- if projections are made - aggregate expense and loss ratio approach w/ all items expressed as function of premium yields reasonable results
- indiv A&H - if significant, cell-based approach appropriate
- if line is immaterial or primarily coverage w/o active life reserves, aggregate approach similar to group is appropriate
- group pension - aggregate int rate spread, similar to annuities often adequate
- if major line - cell-based approach more appropriate
- misc line - two approaches
- assume no further stat profits => no value exists for business inforce
- project stat profits in aggregate adn spread between earn inv rate and stat int rate
- Pricing Assumptions vs Current Expereince
- if current exp <> pricing, may be appropriate to use pricing if a plan established to restore current experience to pricing over a reasonable timeframe
- typical approach in value-based syste for this situation
- calculate value of business inforce using pricing
- calculate difference between pricing assumptions and current expereince
- determine plan of action to make disappear ove a relatively short timeframe (3-5) years
- if you can't do this, s/b using current and not pricing
- calc PV of difference @ hurdle rate and deduct from prev calced value of business inforce (optional)
- Target or Required Surplus
- used to reflect need to maintain minimal level of surplus (in pricing and profit testing)
- for regulatory reasons and rating agencies
- if co does price incorporating target surplus formula, it should be recognized in value-based fin measurement system
- stat profits increased by inv income earned on target surplus adn decreased by increase target surplus
- further adjustments
- req'd surplus -> transferred from adj net worth component of value to value of business inforce component
- adj net worth becomes "free" surplus
- value of business inforce and value of business written during year calculated using "available profits" instead of stat book profits
- net reserves - state reserves + req'd surplus - PV future avail profits
- introduction of req'd surplus changes pattern of earnings reported in value-based fin measurement system
- comparison reveals lower earnings in first-year followed by higher earnings in renewal years
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Study Notes and Published Refences - Note 8I-306-00 - CASH FLOW ANALYSIS TECHNIQUES
Valuation Concepts
- Forms of Risk
- Interest rate duration risk - C-3
- insurance co can be selected against when int rates move
- if rates increase - disintermediation risk
- if rated decline - reinvestment risk
- Valn Actuary's concern - how to make good and sufficient opinion w/r to reserves when faced w/ C-3 risk
- Credit (or default) Risk - C-1
- real default in asset value or a mkt value change in the common stock
- Pricing Risk - C-2
- ins co can suffer loss due to unforseen changes in experience levels w/r to mortality, morbidity, expenses, etc
- Valuation Actuary's Job
- have skills and tools necessary to measure C1, C2 adn C3 risk
- understand and obey SOP established by profession adn regulations regarding messurement of risk
- recognize that need to rely on key indiv in co (COO, CEO, CIO (inv)) for continuation of stated policy and good business judgement in managing co's affairs
- let them take responsibility for what is theirs
- render an opinion as to adequacy of reserves, taking into account nature of assets supporting the reserves
- NOT the Valn Actuary's job to guarantee solvency
- Statement of Opinion
- two levels to the various opinions
- reasonable reserves
- reasonable reserve + designated surplus to cover plausible deviations
- current opinion
- reasonable - probability of reserves being inadequate < x% where x% > 1
- plausible - probability of reserves & designated surplus being inadequate < 1%
- actually probability of ruin
- Elements of Cash Flow
- insurance (liability) adn asset cash flows projected into future under various int rate scenarios
- some assumptions used in projection are dynamic (vary w/ int)
- main elements of cash flow
- liab side
- income components - premiums, policy loan repayments, policy loan interest
- outflow - benfit payments, surr, divs, comm, expenses, taxes, policy loans
- policy loans on liab side (asset on B/S) b/c investment people can't invest in policy loans
- asset side
- income - bond maturities, mort prin & int pmts, coupons, calls, prepayments, stock divs, real estate, rental income, liquidations adn borrowed money
- outflow - repayment of borrowed money and capital losses
Cash Flow Analysis for Valuation
- actuary must select: scenario set, lapse function, prepayment functions adn reinv function
- information on assets more extensive than traditional valuation methods
- Scenarios
- definitions
- int rate scenario defined as sequence of yield curves
- yield curves - function showing relationship of yield to duratino
- scenario - sequence of yield curves - one for each period-end in teh future
- cash flow analysis requires choosing a scenario set
- can arbitrarily select a set of scenarios that seem to cover possibilities (NY7)
- drawbacks
- # possible scenarios unlimited therefore no singel scenario likely to occur in real life
- no unique way to make probability statement about outcome of testing
- advised (in absense of regulation) to use approach that attempts to capture statistical meaning
- common methods: transitional probability and successive ratios
- Transitional Probability Approach
- begin by defining universe of std yield curves
- one approach, 10yr and 1yr rates w/ intermediate rates set by fitting exponential curve
- define matrix of transitional probabilities
- P(ij) -> prob c(j) follows c(i)
- often set in consultation w/ investment officers
- most of the time, probabilites equal and opposite moves set equal
- set c(0) to std yield curve most like current rates
- monte carlo simulation used to pick future yield curves
- repeat using same c(0) and transition matrix until adequate # scenarios choses
- Successive Ratios Model
- stochastic model of ratios of successive interest rates
- y(1)...y(n)... sequence of historical int rates
- ratio of y(n+1)/y(n) calculated for last 10 years for 1 long and 1 short dur
- dist function determined which models frequency values appear
- correlations between long and short rates studied historically
- bivariate dist w/ proper correlation coefficient constructed
- simulation performed on bivariate dist to get N pairs of rates for each scenario
- Morgan Stanley research shows promise using ln(y(n+1)/y(n))
- distribution not precisely normal
- close enough to justify simplifying assumption
Functional Relationship: The Liab Side
- significance of number 40 - can get 40-50 scenario results on a single sheet of paper
- when testing stochastically generated scenarios, quite a few boring ones and on a few exciting ones
- most extreme scenarios don't necessarily give most extreme results
- function relationships - formerly known as setting assumptions
- ways to choose assumptions
- dart board
- xerox - using someone else's assumptions
- rules of thumb - similar to Delphi technique
- key element sto consider when choosing functional relationships
- relationships
- consistency
- validation
- should validate reasonably to whatever experience is available
- should validate reasonable results (sniff test)
- Market Rate Assumption
- possibly most important functional relationship - between credited rates, mkt rates, and lapse rates
- mkt rate - rate PO can get by lapsing policy and buying comparable new policy
- generally rate competing co offering on similar products
- when defining mkt rate, keep in mind what mkt rate used for
- if intest to set credited rate = mkt rate, mkt rate definition for model should match definition for way intend to credit
- sometimes results very sensitive to mkt rate definition and sometimes not
- relationship between earned rate adn mkt rate may not be rational, but there is a relationship
- when choosing mkt rate assumption, dont give too much weight to current situation
- mkt does not always react as quickly as scenario rates doo
- assumption should make sence for the long term
- s/b consisten w/ historical past
- apply common sense when looking forward
- mkt rate assumption typically based on current int and sometimes a rolling avg int rate (for cos crediting based on portfolio rate)
- common assumption - mkt rate = max(current, rolling avg)
- Credited Rate Strategy
- not an assumption, but a strategy
- decide whether crediting strategy matches what in in CF projection
- strategies key off of one or more of 3 rates
- fixed rate - initial guar rate, bailout rate, min guar rate
- earned rate less spread
- mkt rate
- SC may complicate matters - somewhat safer to have lower credited rate if SC is present
- consider increasing spread for higher int rates
- applying relationship to mkt rate as well could produce some reasonable answers
- for UL, trend is credit current money rate for 3-5 years
- then roll into new money rate at end of period
- special considerations for div scales on par policies
- Lapse Rate Function
- largely based on intuition and judgement
- littel experience available for many types of plans
- considerations
- if product has SC, less sensitive to difference between credited and mkt
- PO/Agent characteristics important (stockbroker sold -> higher lapses)
- bailout
- "hidden" interest (not obvious to PO like Par WL pols)
- aging of business - possibility that excess lapses decrease over time
- core group of PO not sensitive to int rates
- sample SPDA laspe formulas
- 1982-C3 study - min(5%+ (M-C)^1.5,75%)
- VA Handbook ex - 15% + 2*(M-C)^2 - 3*SC
- Case Study - min(5%+2(M-C)^2, 50%)
- excess lapses increase dramatically as spread widens
- exponential term seems to be fairly well accepted
- Policy Loan Utilization
- policy loan environment changed a lot
- direct recognition and tax law changes
- less likely to take loan and more likely to lapse
- sample utilization rate (mkt rate - loan rate)^1.8
- function of % of unloaded values and % total avail CV
- SP policies w/ 0 net cost loans - loan assumption could be key assumption to CF analysis
- Premium Suspension
- very littel experience available
- new money product premium suspensions should nto be greatly interest sensitive
- lapses could be problem if PO looks at overall credited rate
- premium suspenstion can be very sensitive to credited rate of interest
- Expense Inflation
- generally a valuation concern only for effect on maint expenses
- common assumption - inflation = gov't bond int rate - spread
- overhead might not get appropriate weight in high lapse scenarios
- Mortality
- generally accepted - if extra lapses, future mortality will increase
- impaired lives more likely to keep life ins policy since unable to get equiv policy elsewhere
- several models available for calculating excess mortality due to excess lapse
- after assumptoins created, run through scenarios
- look at results and see if reasonable
Functional Relationships: The Asset Side
- Role of the actuary and the Investment Officer: A discussion
- no agreement on what exactly the Actuary's role s/b w/r to setting inv assumptions
- Larger role in determing investment philosophy
- actuary determining for LOB responsible for
- type of assets, type of maturities, type of risks willing to take
- quality of assets and probability of net realizing expected returns
- strong communications w/ investment dept a must
- actuary shoudl decide if CF volatility for a type of asset is acceptable
- Reliance Role
- one of jobs as Valn Actuary is to rely on other key people
- rely - work with them, not tell them what to do
- collaborative effort
- let the investment people select teh assets they deem appropriate given some guidelines w/ explanations of ramifications of choosing certain types of assets, maturity, structures
- investment people understand modeling, but modeling not "real world"
- inv people look at what's happening in mktplace daily and try to take advantage of mkt conditions
- What is an Investment Philosophy?
- used day-to-day basis by inv dept
- need assumptions re: investment philosophy in the future
- may not match what inv people doing today
- future inv philosophy is an actuarial assumption - actuary responsible for it
- ought to know current inv philosophy
- think about possibility that other philosophies will be used in the future
- inv philosophy may be different depending on purpose of projection
- stat solvency - only need a 1 year projection
- Valn Actuary's role is to evaluate effects of an investment philosophy
- Sr Mgmt's role is to choose the inv philosophy
- if not sure what your co is going to do in the future
- run projections w/ different inv philosophies
- one method - bring in Inv officer, show him the int scenarios and ask "How would you invest?"
- inv officer will buy into projection and feel comfortable with results
- Reinvestment Function
- Positive Cash Flows
- 3 methods
- continuatino of current strategy
- follow stated policy (set of rules)
- keep dur matched and x% to type A assets etc
- mkt timing - important to get investment person involved
- if mkt does A, invest in B
- inv officer will "do whatever is best"
- Negative Cash Flows
- borrow funds - reflect cost of borrowing in projections
- liquidate assets - pro-rata across all assets or involve specific assets
- Activeness of Asset Portfolio
- how will assets be managed
- buy and hold
- trading or purposeful disinvestment
- Valn Actuary needs ot deal w/ pos cash flows, neg cash flows and asset mgmt when doing cash flow analysis
Assets
- which assets backing products valuing?
- s/b consistent w/ investment philosophy statement filed w/ state
- if assets not segmented, either set up segmented pool or use pro-rata share of all assets
- obtain listing of current assets from inv dept (hopefully inv database)
- Treasuries
- 100% guar by govt adn non-callable
- perfect asset except don't earn enough interest to support credited rates
- amortization of prem or discount as CF item
- Donna Claire would not use since not real cash
- better to recognize prem/discount @ sale/maturity
- Corp Bonds
- used to be most popular asset for ins co investments
- major problem - generally callable
- range where very few bonds called - generally 1% of original int environment
- fairly simple approx - 2% greater than current coupon rate - it gets called
- another approx: .25*(coupon rate - current coupon rate - .25*call prem) min 0, max 1.0
- also check other provisions, such as sinking fund provisions
- Commercial Mortgages
- characteristics similar to bonds - take coupons and pay back principal at end
- some have sinking fund payments
- prepayment provision - some have very generous provisions
- current prepayment penalties - such that if investor took payment and invested it in T-bills for remaining period, still wind up w/ same amt int
- could be modeled as non-callable bonds since little reinvestment risk
- have a default risk
- depending on rating, C-1 default risk charge s/b subtracted (similar to corps)
- Agricultural Mortgages
- generally short mortgages
- can be variable int - appear to be well suited for I/S products
- problem: many are defaulting - approx 25% industry wide
- C-1 charge s/b enough to cover this type of default (worse than junk)
- charge must be large enough to cover
- int forfeited
- opportunity loss when owning property
- principal loss on sale of asset
- can be as high as 75bps
- Gov't Backed Mortgages
- GNMA, FNMA, FHLMC - some of most popular inv for ins cos
- give fairly high int rate
- major problem is duration risk
- very important to model correctly in terms of effect of int scenarios on GNMAs
- sample prepayment equation: 5% + 3*S + 2*S^2 where S and 5 <= P <= 60
- # factors affecting prepayments
- moving, years left on mort, general economy in area, employment stats
- Junk Bonds
- begun to play important role in portfolio
- subtract approx 2.5% of principal to cover default in models
- check diversification - very important in junk
- Real Estate
- becoming more popular in I/S portfolios b/c asset is inflation adaptive
- problems modeling real estate
- need to check w/ inv dept as to expected cash flows, not just expected avg returns over expected holding period
- when do you assume you sell property
- what will price be when real estate is sold
- good approx is that it appreciates at economic int rate + x% (typically around 3%)
- Case Study Life
- additional reserve req'd to make probably of inadequacies < 1%
- take PV of cashflows from each trian using that trials int rates
- assuming results normally distributed, use std dev and mean to determine point probability that PV < 0 is <= 1%
- generation of scenarios - monte carlo & lognormal method
- monte carlo - randomly generated using starting yield curve, yield curve universe and probability of movement matrix
- lognormal - randomly generated using starting yield curve, volatility factor and lognormal dist function
- differences between two not enough to say which is better
- reserves should cover reasonable deviations
- reserves and surplus should cover reasonable and plausible deviations
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Study Notes and Published Refences - Note SN 8I-308-00 - REGULATORS' PERSPECTIVE ON ACTUARIAL OPINIONS AND VALUATIONS
Valuation Methodology or Mythology - Robert J Callahan
- dynamic valn int rate 3% = 80% of excess of 12 months moody's avg over 3%
- if co mgmt decides to sell high yielding assets and replace them w/ lower yielding assets, valn actuary, in calcing stat formula reserves, shoudl ascertain whether yields of new supporting assets can still justify the valn int rate or whether he should lower the rate
- CF analysis might indicate need for more assets to support liabs
- Reg 126 allows actuary to rely on inv officer to some extent
- notes that either actuary or investment officer make adjustment for junk
- suggests adjusting CF of assets by reduction in annual income of 2.5% of principal of junk bonds
- valn actuaries work may serve as an audit of pricing
- junk bond study - recommended diversification
- Callahan feels MSVR insufficient for junk and s/b liability instead of earmarked surplus
- NY DOI prefers to place specific limits as to portion of total assets which may be invested into junk bonds
- Actuary cannot make any judgement as to adequacy of assets and future prems w/o considering u/w, mktg, contractual provisions and investments
- actuaries need to coordinate w/ other, rely on others, and advise others
- Callahan feels AAA stds need updating and effects of quality of assets cannot be ignored until standards are developed
- He prefers an objective std for reserves
- statement reserves s/b higher of formula reserves and those indicated as necessary by Valn Act
What Regulators Need - John O Montgomery
- The need
- regulators need to be aware of a deteriorating financial condition of an insurer in time to protect its PO from consequences of insolvency
- The Std Valn Law
- controversy has arisen over what is meant by "present value of future benefits"
- some regulators insist its PV future guar benfits, incl nonf benfits, thus requiring the greatest PV of these two to be used in above formulas
- analagous to CARVM for specified annuity and endowment contracts
- what is needed is a SVL which will define basic concepts and distinguish between reasonable and plausible assumptoins as to determinatino of reserves and margins in surplus which s/b held for plausible contingencies
- restated: SVL should define basis for reserve and min req'd suplus (risk assumed buffer)
- revised SVL will probalby include general rules - NLP and deposit fund approach, depending on nature of plan
- woudl require a redefinition of LOBs by valn method as well as by risk structure
- supporting regs woudl define specific requirements for documentation including int rates, mort, morbidity, persistency, and expense limitations
- actuary woudl be permitted to depart from such limitations if supported by actual experience demonstratoins acceptable to the regulator
- The need for specific guidelines or instructions
- less than 1/3 of US companies have one or more company actuaries
- rest rely on consultants
- if a US insurer has operated w/o actuarial advice, it is revealed at time of state ins exam
- Summary - What do Regulators Need
- practical procedures for projecting the development of reseves and teh effect of such developments on teh production of surplus
- practical procedures for probabilistic multivariate analysis of the various factors contributing to development of surplus and verifying the adequacy of reserves
- readily verifiable systems for testing credibility of projections
- if procedures for projecting surplus generation are not practically attainable for political reasons, system of credible surplus benchmark criteria
- financial stm that clearly shows financial progress of an ins cu, but retains sufficient info to validate teh proper accounting of ins transactions adn to verify projections made w/r to adequacy of reserves and suplus margins for plausible deviations
- revision of financial acctg procedures in conflict w/ concepts of analysis developed for the projection of cash flows and surplus generation
- b/c of large volume of cos to review, survellance procedures needed to distinguish those insurers requiring detailed indiv company analysis from those requiring only a perfunctory monitoring
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Study Notes and Published Refences - Note SN 8IU-310-04 - VALN OF LIVING AND DEATH BENEFIT GUARANTEES FOR VARIABLE ANNUITIES
Introduction
- key diff between VAs and mutual funds - guarantees
Types of Guarantees
- GMDB - payment on death of covered live - effective at time of sale
- Living Benefits guarantees
- GMIB - guaranteed minimum payment at annuitization
- usually constrained to a window after a defined waiting period
- GMWB - sum of w/d benefits paid = specified amt (such as prem paid)
- GMAB - guaranteed a minimum acct value after a specified waiting period
Characteristics of Living and Death Benefit Guarantees
- Common Characteristics
- Guarantee Amt - usually a function of premiums, w/d, and/or future acct values
- return of prem
- ratchet "X"
- x% rollup
- Reset "X" (unlike ratchet, can decrease)
- High Anniv value
- ratchet "Xth"
- x% simple
- Reset "Xth"
- NAR is difference between guarantee and actual acct value
- Limits on teh Guar amt
- guar may only adjust up to a certain AA
- guar may be capped by some absolute limit (such as twice starting value)
- guar may be n/a after certain age
- guar may not be offered beyond a certain age
- guar can be adjust on a $/$ basis or proportionally for w/d
- guar can be capped by a facter applied to prems less w/d
- Limits on Investment Options
- may require a specific fund allocation or exclude certain funds
- maximum annuitization age
- rider termination - if guar sold as a rider, PO may terminate benefit after x years
- Co may also place limits on sales and future contributions
- Characteristics Specific to a GMDB
- who is covered: owner, first to die of annuitant and owner, last surviving annuitant
- can spouse continue policy: sometimes spouse is given option of DB or continuing policy w/ same guar
- if accept DB, policy has no more guar and reverts to acct value
- what is effective date for DB calc: DOD or date all paperwork filed
- Characterisitcs Specific to a GMIB
- What is length of period before PO can annuitize and invoke guarantee?
- needs to be long enough for co to recoup acq expenses 7-10 yrs common
- What are assumptions for determining int rate in guar annuity?
- lower guar rate decreases cost of cuar. 3 and 3.5% common
- may be influenced (constrained) by stat minimums
- mkt competition and SNFL may influence
- What are assumptions for determining mort rate in guar annuity?
- lower mort reduces cost
- expected mort improvement between eff date and annuitization and between annuitization and end of payment period
- Does Guar Annuity have certain period
- longer certain periods lessen impact of projected mort improvements
- IRS min dist requirements
- Characteristics Specific to a GMAB and/or a GMWB
- deferral period for GMAB between time of sale and eligibility - 10 yrs common
- limits on amt of w/d in any yer (GMWB) - 7% common
- Can PO reset guar amt to current amt and how often?
- Increase charge on reset
- waiting period also reset
- Can GMAB be renewed @ end of guar period
- GMAB: same guar and guar period apply to subsequent deposits
- GMWB: guar amt may be increased by add'l deposits or limited to deposits in certain contract years (2 to 4)
Theoretical and Practiacl Issues in Valuing Guar Benefits
- Policyholder Behavior
- PO may make decisions that are not in their best interests
- media publicity and broker advice can have large impact
- PO awareness can be increased w/ guaranteed amts shown regularly on statements
- more history needed to determine if "in the money" DBs result in anti-selective lapsation
- VA primarily used as a tax-favored investment to provide a lump sum for estate needs vs monthly income
- Lapse Rate
- very low during SC period (4-6%)
- spike after SC period (20-50%)
- then stabilize (10-15%)
- levels vary depending on dist channel and by company
- factors affecting lapse
- length of SC period and level of SC
- qual vs non-qual
- taxes
- distributor incentives
- cahnges in availability of different contract options and their associated prices
- does each deposit have its own SC schedule
- GMAB, GMIB option, especially if "in-teh-money"
- policy performance - relative to other investments and other VAs
- Annuitization Rate
- tend to be very low (<3%)
- GMIB - annuitizatoins have to be modeled separately - can't include w/ lapses
- final decision to exercise GMIB is complex balance
- sample assumption
- Range Annuitization Rate
- 0.00 <= Adj guar/AV < 1.25 2%
- 1.25 <= Adj guar/AV < 1.40 8%
- 1.40 <= Adj guar/AV < 1.55 16%
- 1.55 <= Adj guar/AV < 1.67 24%
- 1.67 <= Adj guar/AV 30%
- other factors affecting annuitization rates
- age
- other assets
- commissions
- volatile mkts
- taxes
Pre-Annuitization Mortality
- biggest impact on GMDB
- does presence of GMDB result in any anti-selection
Partial W/D and Contributions
- 10-15% w/d money on a regular basis
- usually w/in free w/d range - typically 2-3% of acct value each year
- some cos have systematic partial w/d programs
- gains assumed w/d first for tax purposes
- 3 situations cause w/d and contributions to have material impact on valn
- qualified paln @ age 70.5 - min dist - usually done via partial w/d
- benefit options no longer offered in mkt may incent add'l contributions
- may also be a corresponding drop in partial w/d from these plans
- potential anit-selection in $/$ w/d cases
- GMDB - w/d all but $1 av leaves "free" insurance for "in-the-money" portion
- GMIB - w/d all but excess and get free annuity. Even worse w/ guar roll-up
- taxes may be an issue to minimize this behavior
- simplifying assumption - future partial w/d and contributins will offset
- presence of GMWB may increase partial w/d experience over current levels
Grouped vs Seriatim Data
- higher accuracy w/ seriatim
- processing time/costs may force grouped
- beware grouping that an "in the money" and "out fo money" don't offset
Asset Allocation and Fund Transfers
- could project each fund separately - most models group funds into specific categories
- projected acct value is weighted avg return of diff asset categories
- transferes can be modeled static or dynamic basis
- static - transfers don't depend on how any of funds perform
- dynamic - transfers vary based on returns
- most models don't use dynamic due to extreme complexity
- ways to implement static fund transfer assumptions
- asset allocations entered (PO level) and rebalanced @ end of each period
- asset allocations @ PO level and NOT rebalanced @ EOP
- asset allocations @ group level and rebalanced @ EOP
- asset allocations @ group level and NOT rebalanced @ EOP
Future Economic Scenarios
- value of guaranteed benefits highly dependent on level and pattern of future asset category returns
- desire non-trivial reserve for conservative valuation of guar benefits
- if no specified scenarios - set reserves to at least minimum of accumulated fees collected for benefit
- valn can be based on specified scenarios designed to make guar amt > acct value
- valn done stochastically and reserve based on scenario avg
Statutory Valn
- general approach - define model and assumptions so that resulting reserves cover high proportion of possible outcomes
- AG34 adn the Stat Valn of GMDBs
- SVL defined CARVM for annuity contracts
- AG33 provides guidance for applying CARVM to annuities w/ multiple benefit streams
- handled PO behavior by basing reserves on assumption that PO woudl select teh worst case scenario for the co
- AG34 addressed the variablility of inv returns on reserve for GMDBs
- GMDBs projected assuming an immediate drop in underlying asset w/ subsequent recovery at a net assumed rate until maturity of contract
- Asset Class Immediate Drop Gross Assumed Return
- Equity 14% 14%
- Bonds 6.5 9.5
- Balanced 9 11.5
- Money Mkt 2.5 6.5
- Specialty 9 9.5
- table shows gross return - need to adjust for charges to get net return
- fixed acct - assume 0% drop and net return = guar rate
- GMDB reserve = integrated reserve (includes all benfits) - Sep Acct reserve (ignores GMDB)
- Integrated reserve is combo of 3 benefit streams
- projected NAR paid to those projected to die during calc period (valn mortality)
- projected unreduced AV paid to those expected to die during calc period (valn mortality)
- base benefit streams projected during calc period and discounted for survivorship baed on valn mort table
- does not assume drop adn recovery
- reserve is greatest PV at vlan int rate across all durations of the 3 integrated streams
- projected (reduced) acct value => (assets in class)*(1-immed drop%)*(1+net assumed return)^t using 1994 VA MGDB mortality table
- AG34 effective 12/31/1998
- Valuation of Living Benefit Guarantees
- AG34 not designed for living benfits
- LHATF too approach similar to AG34 and RBC C-3 task group
- looking at stochastic approach insted of formula based approach
- AG39 - interim solution until model-based approach could be developed
- total reserves for contracts w/ living benefits guarantees
- = reserve for VA after comparing to the CV and ingoring charges and claims assoc w/ living benfits
- + living benfit reserve (defined as aggregate charges after adjustment for adequacy analysis)
- impicit charges s/b used in not an explicit charge
- can be based on review of charges w/ and w/o benfit and/or modeling of the benfit
- aggregation is simply sum w/o interest
- AG39 implies seriatim calc of aggregated charges
- asset adequacy analysis done on aggregate basis for all contracs w/ living benefit guar
- AG39 does not require CF testing (according to Guidance and Practice notes) but ASOP 22 implies s/b done
- when selecting assets for analysis - consider asset segmentation scheme used for Actuarial Opinion adn presence of any hedges for the living benefit
- CF from hedges can only be used if hedging instruments part of selected assets
- Future Changes to Stat Valuation
- Equity Return Assumptions
- working groups focusing on stochastic distribution model
- val act s/b able to choose model, subject to a set of calibration points
- instead of ILN dist (Indep LogNormal), leaning towards RSLN2 (2 regime switching lognormal process) b/c ILN doesn't generate more extreme results seen in historical data
- old method - calc reserve for several scenarios and use highest result
- option 1 - use precentail of distribution of reseve based on each of scenarios tested
- option 2 - CTE (conditional tail expectation)
- results rank ordered from best to worst
- CTE at the x% level is avg result of worst (100-x)% of the results
- in general CTE x% > (x + 1/2(100-x)) percentile
- current proposals - CTE90 for total balance sheet adn CTE65 for stat reserving
- diff between CTE90 adn CTE65 => RBC (100% NAIC Co action level)
- Policyholder Behavior & Experience Assumptions
- 3 issues w/ CARVM
- always applying can result in very large reserves
- ignores past experience of PO elective behavior adn fact taht PO do not act w/ 100% efficiency
- ignores disincentives to PO for result dictated by CARVM (such as negative tax consequences)
- discussion re: using incidence rates based on prudent best estimates & using co specific data
US GAAP
- overview
- GAAP and Stat differ in several important aspects
- model assumptions are based on best estimates
- rules do not require 0% or 100% utilization on PO behavior
- certain liabs based on fair value (to reflect similarity to derivatives)
- reserves recalced each year due to unlocking of assumptions
- most rules in F97 w/ expanded direction in SOP 03-01
- US GAAP and GMDBs
- is contract an investment contract w/ nominal DB or insurance contract
- has significant mortality risk if benfit could vary significantly in response to changes in captial mkts
- determination based on comparison of benefit payments over acct value to PV of all amts expected to be assessed against PO
- s/b done at issue considering full range of scenarios based on volatility of assumptions (not best estimate)
- if DB deemed significnat and fees assessed or ins benefits not fixed, SOP requires liability if amts assessed in manor that generates profits inearly years and subsequent losses
- liab base on a/b
- a - PV total expected excess payments
- b - PV total expected assessments (gross)
- use same assumptions as for DAC
- add'l liab = benefit ration * cumulative assessments - cumulative amts pd
- test for unlocking as necessary
- US GAAP and GMIBs
- if GMIB can be not settled at annuitization - F133
- GMIB treated as embedded derivative
- F133 - written options be recorded @ fair value at issue and throughout accumulation phase of contract
- changes in fair value recognized in income
- for other GMIB or two-tiered annuities
- SOP requires add'l liability if PV expected annuitization payments @ annuitization date exceeds acct balance @ expected annuitization date
- reserve method is same as for GMDBs
- only difference is addition of an expected annuitization election rate
- US GAAP and GMAB & GMWB
- FASB Derivative Implementation Issue B8 specifies these are embedded derivatives subject to F133
- written options recorded @ fair value at inception and throughout
- changes in fair value recognized in income
Conclusion
Appendix A
Appendix B
Reinsurance - Tiller and Tiller
Chapter 4 - TRADITIONAL REINSURANCE
YRT (see html)
Coinsurance
- coverage is same form as individual policy
- reinsurer establishes proportionate share of policy reserves
- shares proportionately to excess mortality or morbidity, lapses, surrenders, etc.
- Coinsurance Premiums and Allowances
- premium usually proportionate to gross premium
- for banded policies, can
- - reins premium based on banded gross premium, then common set of allowances for all bands
- most common and easiest to understand
- - vary allowances by band
- complicates admin but allows consistent margins by band
- - reins prem and allowance for all bands is equal
- simplifies admin, increases margin for ceding co on smaller band sales
- ceding co typically retains 100% of policy fee
- coins typically follows u/w (S/NS etc)
- sometimes allowances vary by age and/or sex
- can be experience rating
- sometimes first year allowance > 100%
- Coinsurance Premium and Allowance Calculations
- allocances typically determined unique for each policy (product)
- typically paid on annual basis
- substd more complicated - vary by type of extra and length they apply
- WVR/GIO/Payor usually consured w/ generic allowances 75-85% 1st year, 10-15% renewal
- ADB usually flat rate YRT
- Uses of Coinsurance
- can be used on anything
- for life, common on Term where very little CV buildup, therefore minimal investment risk
- used w/ CV products to pass strain or investment risk to reinsurer
- Policyholder Dividends
- < 1990s, uncommon for reinsurer to share in PO divs
- may be a problem if big block w/ large portion ceded as co doesn't control those assets
- currently reinsurers SOMETIMES participate, but only in illustrated scale, not in up or down changes
- NY Reg 102 says reinsurer must participate in divs, including scale changes if ceding co wants reserve credit
- Other Considerations
- reinsurers rarely participate in policy loans
- reinsurer typically remburses for premium taxes on ceded portion
- RPU - reins is adjusted and no further premiums paid
- ETI - no more prems, but coverage for appropriate duration
- sometime at ETI/RPU, reinsurer will pay CSV to ceded co and terminate reins
- reserve credits if reins is admitted/accredited
- will pass deficiency reserve as well as std reserves
- admin is relatively complex since need to calc prem, pay db, calc expense allowance, reserves and apyments of cash surrenders
- Illustrations - p 89
Modified Coinsurance - ModCo
- diff from coinsurance is stat vx on ceded portion is obligation of and held by ceding co
- reinsurer has to fund reserve increases (less credit for investment income)
- Origins - Unknown
- ModCo Prems and Allowances
- ModCo Prem and Allowance Calculations
- similar to coins
- WVR/GIO/Payor typically coins even if base is ModCo
- ADB typically flat YRT rate
- ModCo Reserve Adjustment
- Ening Policy Reserves - Beginning Policy Reserves - Interest on Beg Pol Vx
- if >0 reinsurer pays ceding co. If < 0, other way
- historically an annual calc
- currently (typically) quarterly
- ModCo Int rate is defined in treaty
- - historically could be defined in terms of ceding co portfolio rate, rate of return on reinsured blocks assets, new money rate of return, or outside index
- - sometimes a fixed rate
- - if ModCo rate = ceding co rate of return, result to ceding co is same as if they used coins
- - if ModCo rate = reins co rate of return, result to reins is same as if they used coins
- cap g/l not shared w/ reinsurer
- - NAIC model reg changes that since ALL significant risk must be transfered
- Uses of ModCo
- primarily for products that develop CV - especially par
- in 80s, used to reduce FIT (transfered investment income to u/w income)
- - tax law changes stopped that
- Other Considerations
- Eliminates some problems w/ coins
- - no Vx credit questions since ceding co maintains policy Vx
- - eliminates problem of policy loan participation as well (same reason)
- - ceded co has more control over investments
- Main drawback
- more difficult to admin because of Reserve Adjustment Calculation
- Illustrations - p 100
-
Chapter 5 - FINANCIAL REINSURANCE
Uses of Financial Reinsurance
- based on diffences in timing for stat of tax earnings and on stat Vx redundancy
- usually structured so only cash that changes hands is for fees or risk charges
- Surplus Relief
- most common
- to improve current stat earnings and surplus position
- creates an increase in stat surplus for ceding co in year relief is given
- repayment of relief tied to future cash flow or stat earnings on reinsured block, therefore not guaranteed
- since risk is less than if trad reinsurance, less risk charge
- Tax Plannings
- not as much as before
- company cedes, creates a taxable gain, used to offset taxable loss
- - useful if company hasexpiring tax loss carryforwards
- translates more commonly permanent than with surplus relief
- gain to ceding co is loss to reinsurer
- company might also assume reins to create a loss to offset a gain
- ceding co can usually terminate reins once inital gain repaid
- comany may ced/assume life/health to change co status to/from life/non-life company
- Strategic Business Planning
- may wish to acquire reinsurance to
- - increase future profits
- - utilize excess admin capacity
- - assist co in entering a new market
- may cede to
- - exit a certain market
- - financing in a LBO
- typically permanent in nature
- recapture typically not a provision
- normally assumption reinsurance
Terminology
- Initial Reinsurance Premium
- typically = policy reserve
- Allowances
- used to adjust effective amount of renewal premium
- initial allowance provides first year gain
- stated as % of initial premium, amt/unit coverage, or flat amt/trx
- renewal allowances may provide for ceding co commission/maint and adjust expected results to agreed upon level
- higher allowances => longer for reinsurer to recover intial strain
- Risk Charge
- portion of reins premium retained (by reinsurer) for providing reins
- normally stated in terms of amt outstanding surplus/gain
- amt depends on
- - nature of risks assumed
- - size of trx
- - reinsurer's profit objective
- - mkt conditions at time of trx
- - ceding co's stability
- - tax considerations
- - company relationships
- - reinsurers expenses for analysis, administration, or intermediaries
- historically between 1 and 5% of outstanding surplus relief each year
- Experience Refund
- mechanism to identify and return a portion of stat earnings on rens business to ceding co
- typically not paid until inital allowance is recovered (for fin reins)
- negative experience refunds are uncommon
- - if part of treaty - usually disqualifies stat Vx credits
- loss deficit carryforwards (or similar provisions) OK as long as reinsurer can't terminate treaty to force ceding co into loss position
- Outstanding Surplus Account
- used to track the defined portion of stat gains on business reinsured
- - portion after risk charge, experience refund, and int accumulated on outstanding amount
- usually can't terminate treaty while this is in a deficit position (treaty says)
- ceding co can usually terminate treaty after deficit eliminated
Comparative Model - see book beginning p 112
Plans of Financial Reinsurance
- YRT
- Vx is relatively small, therefore doesn't provide significant relief unless reinsured product also YRT
- Uses of YRT
- most common: I/S Life product where reinsurer doesn't want to be involved in accum element
- if on YRT, typically create special YRT scale as % of policy prem rates
- if on YRT, little difference from coinsurance
- for surplus relief, most effective if reins prem scale has 0 1st yr prem
- - chargebacks for lapses may be appropriate
- could be used where ceding co wants to minimize asset transfer
- OK for health policies, NOT annuities
- Advantages
- limits reinsurer investment and lapse risk (no Vx or CV build-up)
- possibly lower ongoing cost than coins if risks limited to mort or morbid
- Disadvantages
- low cash limits amout of possible future profits (therefore limits allowance/bonuses reinsurer can offer)
- allowance limits limit financial reins applications
- relatively difficult to admin IN FIN REINS situations (fin reins commonly admin on simplified basis & YRT does not work well w/ this type of admin)
- rarely used in financial reins applications
Coinsurance
- Typical arrangement: inforce block, intial reins prem = Vx, reinsurer pays allowance which provides initial gain
- future years - allowance covers ceding co maint and commission expenses
- Alt Arrangement: initial prem = initial Vx - desired gain
- renewal premiums defined w/o reference to policcy gross prem or specific expense allowance
- same effect as typical arrangement, just stated differently
- Subsequest years - reins prems (net of allowances) used to
- pay claims
- fund Vx increases
- cover admin costs
- PADs
- included a charge to reimburse for year 1 investment
- pricing done same as a product actuary used to develop product
- current mkt highly competitive, therefore little PADs in pricing
- larger allowances preferrable to experience refunds for most companies
- in financial reins mkts, pricing not so precise
- in fin reins - usually has exp refund feature
- in fin reins - uses outstanding surplus account
- Advantages
- simplest to admin on a quota share method
- regulators like because no question of risk transfer
- Disadvantages
- primary - need to transfer assets
- can be significant if large inforce block
- if IS or Par, reinsurer has control over part of the div or int rate determination
- requires reinsurer to manage the assets, subject to additional investment risk
- if reins is terminated, reinsurer must transfer assets back and could generate g/l that could have a negative impact on financials
- loss of Vx credit if reinsurer not admitted
- additional insolvency risk to ceding co (ceding co responsible for claims even if reins is insolvent)
- Coins Illustrations - text p. 122
ModCo
- popular for fin reins since ceding co keeps reserve adn assets supporting reserves
- typical arrangement: inforce block, prem = Vx on portion reinsured, ren prems = portion of gross prems, reinsurer pays allowance
- anticipated gain at end of each accounting period
- Advantages
- applicable to all plans of ins
- avoids need to transfer assets
- ceding co retains control of investment policy
- eliminated Vx credit problem
- reinsurer may deduct entire Vx increase for FIT even if Vx not otherwise qualified as tax deduction
- reinsurer avoids necessity of managing assets
- Disadvantages
- more complicated to admin than coins because of mod-co adjustment
- special transactions for surrenders and death
- transfer of assets back to reinsurer @ treaty termination can create capital g/l for ceding co
- Mod-Co Illustrations - text p 131
Funds Withheld Coins
- looks like trad coins in many ways
- impossible to tell difference when looking at intial stat gain
- only difference in initial tranaction - reins retain allowance and ceding co retains intial prem
- if allowance exceeds initial premium, reinsurer sets up an accounts payable item adn ceding co sets up accounts recievable asset
- if initial premium exceeds allowance, reverse is true
- in subsequent periods, account balance increase/decrease as profit emerges, surplus repaid, & reserves increase/decrease
- no cash will change hands until initial account balance reaches zero
- ceded co maintains assets underlying reserves, reinsurer holds reserves on fin stmt, therefore int adjustment like mod-co adjustment is made
- Advantages
- no cash changes hands initially
- cash flow minimized throughout life of treaty
- lessens ceding co insolvency risk
- if reinsurer is non-admitted, ceding co can still take Vx credit up to amount of funds it is holding
- Disadvantages
- more complicated than regular coins
- receivables and payables must be tracked carefully
- int adjustment for net account receivable (foregone int income)
- may still result in Vx credit problem if reins is non-admitted (but somewhat alleviate by amount of funds held)
- Illustrations - text p 140
Funds Withheld ModCo
- looks like ModCo in initial transaction
- reinsurer retains initial allowance and creates payable item
- ceding co sets up corresponding receivable item
- Advantages
- reins retains initial allowance, therefore no need to liquidate assets to pay allowance
- reinsurer has lessened risk in event of ceding co insolvency
- Disadvantages
- one more layer of complexity to admin of treaty
- mod-co adjustment further complicate b/c ceding co doesn't get cash
- special adjustment b/c interest not earned by ceding co on the allowance
- may be viewed as violation of Model Reg
- Illustration - text p 148
Partially Modified Coins (PartCo)
- Initial Coinsurance Vx = initial reinsurance allowance
- remaining reserve liablities reinsured on mod-co basis
- no cash transfer at treaty inception
- renewal years: proportions of co and mod-co are adjusted
- adjustment may be scheduled of may float w/ increase in coins Vx
- Advantages
- no inital cash transaction
- eliminates need to create paper a/l (necessary in funds withheld)
- Disadvantages
- main: very complicated to comprehend and to admin
- if coins reserves float w/ outstanding surplus, 2 stat gain from operatoins calcs necessary
- 1) premlim stat gain from operations needed to calc surplus repaid
- 2) final to show change in Vx from co->mod-co (or vice versa)
- Illustrations - text p. 157
Regulation and Taxation
- < 1984, very little (effective) legislation on financial reins
- used often to reclassify components of taxable income & significant reductions in taxes
- TRA84 - Sectoin 845 - IRS can change an individual tax return if signifianct tax avoidance found
- reins transactions were used to mask true financial condition of company
- therefore State DOI now looks at treaties for significant risk transfer
- treaty terms that concern
- - schedule gains to reinsurer, regardless of actual experience of block
- - reinsurer never having to pay out benefits, just building up a payment due liability
- - reinsurer has right to terminate or automatic termination if
- + reinsured becomes insolvent
- + reinsured has mgmt change
- + business reinsured proves unprofitable
- some states challenge ALL "cashless" reinsurance
- conditions to include to keep regulators happy
- - reinsurer must pay benfits at certain experience level
- - gains to reinsrer based on actual experience of reinsurance
- - no event (insolvency/mgmt changes) can automatically terminate reins (may be terminated after certain level of earnings attained or warranty voided)
- - inforce reins cannot be unilateraly terminated by reinsurer - except for premium non-pmt
- - int paid/credited s/b reasonable w/r to invemenst mkts/assets involved
- - relevant significant risks s/b transferred to reins - including capital loss, disintermediation, and asset default risks (if relevant)
- - ceding co shoudl not be forced to pay back losses except for voluntary termination
- regulators object to Vx credits or receivable credits wehre risk transferred is disproportionate to reserve credit
Security Considerations
- "cashless" reins transactions under criticism
- led to use of trusts, escrow accounts and letters of credit
- also helps protect assets, preserve Vx credits, minimizes currency fluctuations and protects other party in insolvency
- Trusts and Escrow Accounts
- trusts used to secure amounts owed from co that secureds trust to co that is benef
- equitable title to the assets is in the trustee
- commoonly used to segregate assets related to Vx of an inforce block
- most common as alternative to funds withheld trx
- escrow accounts earmark assets w/o actually transferring ownership
- typically used to support funds withheld trx
- if certain stipulated events happen, assets held in escrow are transferred
- possible events include
- surplus dropping below agreed upon level
- change in mgmt
- financial performance of reins below expected levels
- if used to secure reserve credits, Trusts subject to Model Law on Credit for Reins
- Advantages
- - assets separate and identifiable
- - investment income can be limited to performance of specific assets
- - ceding co can still take Vx credit if reinsurer not admitted
- - if recaptured, assets of trust/escrow can be used to effect payment, reducing dispute over mkt values
- - trust is true transfer of ownership -> less suspect to IRS and state regulators
- - on default, benef has right to w/d assets as a secured creditor
- Disadvantages
- - creates additional expense
- - can result in restriction on investment mgmt
- - transfer of assets to trust may necessitate recognition of cap g/l for tax purposes or current mkt values for stat stmt purposes (agreement should state which party takes the cap g/l)
- - if trust, company giving up assets will see reduction in magnitude of assets it reports
- - if an asset transfer reversal occurs, depreciation in mkt values could create surplus straing
- Letters of Credit
- most states will allow Vx credits from non-admitted reinsurer if reinsurer provides a letter of credit for the amt of the reserves
- requires very little admin
- disadvantage (from Reins view) - ceding co and draw down on a letter of credit w/o warning
Product Development
Life and Health Marketing (LOMA) - Chapter 11 - PRODUCT DEVELOPMENT
Product Innovations
- Major Innovations - new prduct that meets needs not addressed before by other products
- Start-up Businesses - new product for a mkt served by a similar product
- New Prroducts for Currently Served mkts - new product for co, but product avail from other cos
- Prodcut Line Extensions - new product forms adn items to existing product line to give customers wider choice
- Product Modifications - characteristic changed ot allow competitive advantage over similar prod
- Style Changes - alter appearances or tangible aspects (ie logo change)
Product Development Process
- 5 basic steps - after first 3 steps (each one) decide continue/abandon/refine
- Product Planning/Business Analysis/Tech Design/Implementation/Monitor & Review
- Product Planning
- Idea generation
- Screening
- two potential screening errors
- - potential of a good idea underestimated and idea rejected
- - poor idea looks deceptively attractive and pursuded, wasting resources
- may use a screening critera checklist to help objectively screen
- - compatible w/ corp goals and strategic inititiatives
- - will prodcut enhance copr image
- - does a need exist in target market
- - can current prodcut be modified to meet this need
- - will product generate new sales or shift sales
- - mkt potential large enough to generate enough business to make product profitable
- - can product be mkted through existing methods
- - support a level of commissions that will motivate slaes force
- - can current systems handle the product
- - will target mkts understand the product
- - would it be more attractive if offerred thorugh a sub
- Concept Testing - measures acceptability w/o actually producing items
- - helps determine how customers would compare product ot existing products
- - what sets of benefits/attributes customers like most
- - which ideas are unacceptable in the mktplace
- - which target mkt to taimfor
- Field Advisory Council - group of agents to test new ideas on for feedback
- Comprehensive Business Analysis
- Mkt Analysis - study of environmental factors that might affect sales
- - potential value of product ot customers
- - nature adn size of target mkt
- - potential value of product to company
- - nature of products competition inthe mkt
- - customer appeal of product
- - appeal of product to distributors
- - products relationship to other products offered by co
- - potential legal/regulatory problems w/ product
- - special tax considerations
- - economic considerations
- - product/company fit
- Product Design Objectives - products basic characteristics/features/benefits/issue lmits/u/w classes/etc
- Feasibility Study - operational & technical viability of producing/offering/admin of product
- Mktg Plan - outlined in C 5
- Prelim Sales & Fin Forcasts
- If analysis indicates good potential, product proposal prepared for mgmt
- Product proposal typically details
- - product objectives - product description
- - mktg strategy - mktg fit
- - fin fit - inv fit
- - systems fit - scope of product implementation
- - legal/regulatory
- Techical Design
- writing contract/actuarial assumptions/rate structure/benefit levels/issue u/w standards
- usually several revisions utnil compromise reached
- prod dev process flow/timeline/budget assembled
- all put together and presented to management
- areas involved
- Mkts/Distributors/IS/Actuarial/Investments/Admin/Acctg/Legal-Compliance
- Implementation
- establishing admin structure adn processes necessary to take product to market
- 3 concurrent activities
- - obtain necessary legal approvals
- - design promo & training materials
- - develop IS systems/procedure to mkt & admin product
- Policy filing - dynamic process b/c state variations
- Design of Promotion and Training Materials - product naem, sales lit
- need to get approval from legal on most materials
- some might need state approvals
- Systems Activities
- IS might need to buy/develop new systems to support product
- usually takes greatest amount of time in process
- Product Introduction
- offering new product for sale and having mktg and product support in place
- Intro sales kit
- - outline of product features and how they work
- - desc adn sample of policy and fin statement insured will get each year
- - table of issue and u/w limits
- - commission scales
- - table of premium rates
- - list of possible mkts
- - sample illustrations
- - saels presentations
- - suggested sales solutions for diff mkt situations
- - samples of local and national advertising to intor product to public
- - sample pre-approach letter adn/or postcards
- - booklet about product for producer
- - brocure about product to give to prospects
- - prospectus (if req'd)
- - sample app
- - details on promo campaign
- - privace disclosures
- - instructions on how to access website for more info
- Training classes
- Incentive prizes/awards
- Sales Monitoring and Review
- review PD cycle to see if time/budget met
- review sales to see if matching forecast - if not, attempt to determin why
- check fin results to see if goals met
- Product Modification
- - s/b systematic as development for new products
- - changes might occurr because of actual sales/profit experience
- Product Withdrawal
- sometimes necessary b/c of legal regs
- sometimes end of lifecycle or unprofitable
- may meet resistance from agents
- good to have an acceptable replacement product
- review portfolio periodically to see if anything should go
Reinsurance - Tiller and Tiller - Chapter 4 - TRADITIONAL REINSURANCE
Yearly Renewable Term (YRT)
- NAR Calc
- Level Term Policies
- Decreasing Term Policies
- Permanent Policies
- Universal Life
- Retention Determination
- Pro Rata
- Level or Constant Retention
- Formula Retention
- Premium Scales
- Normally Select and Ultimate
- often no first year premium (assists with surplus strain)
- can have negative first year premium to further offset production bonuses and the like
- reins prems often stated as percanetage of basic plan premium (or COI if IS)
- used to be experience rated
- normally policy year (vs calendar year) rate scales
- many UL on MRT basis
- Premium Calculation
- YRT rate per thousand * reinsured NAR + substd + cession fee (rare)
- normally paid on an annual basis
- substandard normally a multiple
- tmep or flat extras normally coinsured
- ancillary benefits (WVR, GIO, Payor) typically coinsurance
- ADB usually YRT (rarely by age/duration) often on a bulk basis
- Uses of YRT
- Trad Whole Life
- IS products (usually with no dur 1 premium and rates as pct of COI)
- custom scales often developed to match slope of term premium scale
- some DI benefits
- Other Considerations
- Used to transfer only Mortality or Morbidity risks
- Typically lower profit objective since limited risk, therefore obtainable at lower cost than co or mod-co
- admin is fairly straightforward fo rfixed benefit products
- YRT does not provide relief from def reserves
- YRT premiums must be paid even if base policy goes under nonforfeiture (but amount may be adjusted)
- See book (p75) for illustration
Coinsurance
- coverage is same form as individual policy
- reinsurer establishes proportionate share of policy reserves
- shares proportionately to excess mortality or morbidity, lapses, surrenders, etc.
- Coinsurance Premiums and Allowances
- premium usually proportionate to gross premium
- for banded policies, can
- - reins premium based on banded gross premium, then common set of allowances for all bands
- most common and easiest to understand
- - vary allowances by band
- complicates admin but allows consistent margins by band
- - reins prem and allowance for all bands is equal
- simplifies admin, increases margin for ceding co on smaller band sales
- ceding co typically retains 100% of policy fee
- coins typically follows u/w (S/NS etc)
- sometimes allowances vary by age and/or sex
- can be experience rating
- sometimes first year allowance > 100%
- Coinsurance Premium and Allowance Calculations
- allocances typically determined unique for each policy (product)
- typically paid on annual basis
- substd more complicated - vary by type of extra and length they apply
- WVR/GIO/Payor usually consured w/ generic allowances 75-85% 1st year, 10-15% renewal
- ADB usually flat rate YRT
- Uses of Coinsurance
- can be used on anything
- for life, common on Term where very little CV buildup, therefore minimal investment risk
- used w/ CV products to pass strain or investment risk to reinsurer
- Policyholder Dividends
- < 1990s, uncommon for reinsurer to share in PO divs
- may be a problem if big block w/ large portion ceded as co doesn't control those assets
- currently reinsurers SOMETIMES participate, but only in illustrated scale, not in up or down changes
- NY Reg 102 says reinsurer must participate in divs, including scale changes if ceding co wants reserve credit
- Other Considerations
- reinsurers rarely participate in policy loans
- reinsurer typically remburses for premium taxes on ceded portion
- RPU - reins is adjusted and no further premiums paid
- ETI - no more prems, but coverage for appropriate duration
- sometime at ETI/RPU, reinsurer will pay CSV to ceded co and terminate reins
- reserve credits if reins is admitted/accredited
- will pass deficiency reserve as well as std reserves
- admin is relatively complex since need to calc prem, pay db, calc expense allowance, reserves and apyments of cash surrenders
- Illustrations - p 89
Modified Coinsurance - ModCo
- diff from coinsurance is stat vx on ceded portion is obligation of and held by ceding co
- reinsurer has to fund reserve increases (less credit for investment income)
- Origins - Unknown
- ModCo Prems and Allowances
- ModCo Prem and Allowance Calculations
- similar to coins
- WVR/GIO/Payor typically coins even if base is ModCo
- ADB typically flat YRT rate
- ModCo Reserve Adjustment
- Ening Policy Reserves - Beginning Policy Reserves - Interest on Beg Pol Vx
- if >0 reinsurer pays ceding co. If < 0, other way
- historically an annual calc
- currently (typically) quarterly
- ModCo Int rate is defined in treaty
- - historically could be defined in terms of ceding co portfolio rate, rate of return on reinsured blocks assets, new money rate of return, or outside index
- - sometimes a fixed rate
- - if ModCo rate = ceding co rate of return, result to ceding co is same as if they used coins
- - if ModCo rate = reins co rate of return, result to reins is same as if they used coins
- cap g/l not shared w/ reinsurer
- - NAIC model reg changes that since ALL significant risk must be transfered
- Uses of ModCo
- primarily for products that develop CV - especially par
- in 80s, used to reduce FIT (transfered investment income to u/w income)
- - tax law changes stopped that
- Other Considerations
- Eliminates some problems w/ coins
- - no Vx credit questions since ceding co maintains policy Vx
- - eliminates problem of policy loan participation as well (same reason)
- - ceded co has more control over investments
- Main drawback
- more difficult to admin because of Reserve Adjustment Calculation
- Illustrations - p 100
-
Reinsurance - Tiller and Tiller - Chapter 5 - FINANCIAL REINSURANCE
Uses of Financial Reinsurance
- based on diffences in timing for stat of tax earnings and on stat Vx redundancy
- usually structured so only cash that changes hands is for fees or risk charges
- Surplus Relief
- most common
- to improve current stat earnings and surplus position
- creates an increase in stat surplus for ceding co in year relief is given
- repayment of relief tied to future cash flow or stat earnings on reinsured block, therefore not guaranteed
- since risk is less than if trad reinsurance, less risk charge
- Tax Plannings
- not as much as before
- company cedes, creates a taxable gain, used to offset taxable loss
- - useful if company hasexpiring tax loss carryforwards
- translates more commonly permanent than with surplus relief
- gain to ceding co is loss to reinsurer
- company might also assume reins to create a loss to offset a gain
- ceding co can usually terminate reins once inital gain repaid
- comany may ced/assume life/health to change co status to/from life/non-life company
- Strategic Business Planning
- may wish to acquire reinsurance to
- - increase future profits
- - utilize excess admin capacity
- - assist co in entering a new market
- may cede to
- - exit a certain market
- - financing in a LBO
- typically permanent in nature
- recapture typically not a provision
- normally assumption reinsurance
Terminology
- Initial Reinsurance Premium
- typically = policy reserve
- Allowances
- used to adjust effective amount of renewal premium
- initial allowance provides first year gain
- stated as % of initial premium, amt/unit coverage, or flat amt/trx
- renewal allowances may provide for ceding co commission/maint and adjust expected results to agreed upon level
- higher allowances => longer for reinsurer to recover intial strain
- Risk Charge
- portion of reins premium retained (by reinsurer) for providing reins
- normally stated in terms of amt outstanding surplus/gain
- amt depends on
- - nature of risks assumed
- - size of trx
- - reinsurer's profit objective
- - mkt conditions at time of trx
- - ceding co's stability
- - tax considerations
- - company relationships
- - reinsurers expenses for analysis, administration, or intermediaries
- historically between 1 and 5% of outstanding surplus relief each year
- Experience Refund
- mechanism to identify and return a portion of stat earnings on rens business to ceding co
- typically not paid until inital allowance is recovered (for fin reins)
- negative experience refunds are uncommon
- - if part of treaty - usually disqualifies stat Vx credits
- loss deficit carryforwards (or similar provisions) OK as long as reinsurer can't terminate treaty to force ceding co into loss position
- Outstanding Surplus Account
- used to track the defined portion of stat gains on business reinsured
- - portion after risk charge, experience refund, and int accumulated on outstanding amount
- usually can't terminate treaty while this is in a deficit position (treaty says)
- ceding co can usually terminate treaty after deficit eliminated
Comparative Model - see book beginning p 112
Plans of Financial Reinsurance
- YRT
- Vx is relatively small, therefore doesn't provide significant relief unless reinsured product also YRT
- Uses of YRT
- most common: I/S Life product where reinsurer doesn't want to be involved in accum element
- if on YRT, typically create special YRT scale as % of policy prem rates
- if on YRT, little difference from coinsurance
- for surplus relief, most effective if reins prem scale has 0 1st yr prem
- - chargebacks for lapses may be appropriate
- could be used where ceding co wants to minimize asset transfer
- OK for health policies, NOT annuities
- Advantages
- limits reinsurer investment and lapse risk (no Vx or CV build-up)
- possibly lower ongoing cost than coins if risks limited to mort or morbid
- Disadvantages
- low cash limits amout of possible future profits (therefore limits allowance/bonuses reinsurer can offer)
- allowance limits limit financial reins applications
- relatively difficult to admin IN FIN REINS situations (fin reins commonly admin on simplified basis & YRT does not work well w/ this type of admin)
- rarely used in financial reins applications
Coinsurance
- Typical arrangement: inforce block, intial reins prem = Vx, reinsurer pays allowance which provides initial gain
- future years - allowance covers ceding co maint and commission expenses
- Alt Arrangement: initial prem = initial Vx - desired gain
- renewal premiums defined w/o reference to policcy gross prem or specific expense allowance
- same effect as typical arrangement, just stated differently
- Subsequest years - reins prems (net of allowances) used to
- pay claims
- fund Vx increases
- cover admin costs
- PADs
- included a charge to reimburse for year 1 investment
- pricing done same as a product actuary used to develop product
- current mkt highly competitive, therefore little PADs in pricing
- larger allowances preferrable to experience refunds for most companies
- in financial reins mkts, pricing not so precise
- in fin reins - usually has exp refund feature
- in fin reins - uses outstanding surplus account
- Advantages
- simplest to admin on a quota share method
- regulators like because no question of risk transfer
- Disadvantages
- primary - need to transfer assets
- can be significant if large inforce block
- if IS or Par, reinsurer has control over part of the div or int rate determination
- requires reinsurer to manage the assets, subject to additional investment risk
- if reins is terminated, reinsurer must transfer assets back and could generate g/l that could have a negative impact on financials
- loss of Vx credit if reinsurer not admitted
- additional insolvency risk to ceding co (ceding co responsible for claims even if reins is insolvent)
- Coins Illustrations - text p. 122
ModCo
- popular for fin reins since ceding co keeps reserve adn assets supporting reserves
- typical arrangement: inforce block, prem = Vx on portion reinsured, ren prems = portion of gross prems, reinsurer pays allowance
- anticipated gain at end of each accounting period
- Advantages
- applicable to all plans of ins
- avoids need to transfer assets
- ceding co retains control of investment policy
- eliminated Vx credit problem
- reinsurer may deduct entire Vx increase for FIT even if Vx not otherwise qualified as tax deduction
- reinsurer avoids necessity of managing assets
- Disadvantages
- more complicated to admin than coins because of mod-co adjustment
- special transactions for surrenders and death
- transfer of assets back to reinsurer @ treaty termination can create capital g/l for ceding co
- Mod-Co Illustrations - text p 131
Funds Withheld Coins
- looks like trad coins in many ways
- impossible to tell difference when looking at intial stat gain
- only difference in initial tranaction - reins retain allowance and ceding co retains intial prem
- if allowance exceeds initial premium, reinsurer sets up an accounts payable item adn ceding co sets up accounts recievable asset
- if initial premium exceeds allowance, reverse is true
- in subsequent periods, account balance increase/decrease as profit emerges, surplus repaid, & reserves increase/decrease
- no cash will change hands until initial account balance reaches zero
- ceded co maintains assets underlying reserves, reinsurer holds reserves on fin stmt, therefore int adjustment like mod-co adjustment is made
- Advantages
- no cash changes hands initially
- cash flow minimized throughout life of treaty
- lessens ceding co insolvency risk
- if reinsurer is non-admitted, ceding co can still take Vx credit up to amount of funds it is holding
- Disadvantages
- more complicated than regular coins
- receivables and payables must be tracked carefully
- int adjustment for net account receivable (foregone int income)
- may still result in Vx credit problem if reins is non-admitted (but somewhat alleviate by amount of funds held)
- Illustrations - text p 140
Funds Withheld ModCo
- looks like ModCo in initial transaction
- reinsurer retains initial allowance and creates payable item
- ceding co sets up corresponding receivable item
- Advantages
- reins retains initial allowance, therefore no need to liquidate assets to pay allowance
- reinsurer has lessened risk in event of ceding co insolvency
- Disadvantages
- one more layer of complexity to admin of treaty
- mod-co adjustment further complicate b/c ceding co doesn't get cash
- special adjustment b/c interest not earned by ceding co on the allowance
- may be viewed as violation of Model Reg
- Illustration - text p 148
Partially Modified Coins (PartCo)
- Initial Coinsurance Vx = initial reinsurance allowance
- remaining reserve liablities reinsured on mod-co basis
- no cash transfer at treaty inception
- renewal years: proportions of co and mod-co are adjusted
- adjustment may be scheduled of may float w/ increase in coins Vx
- Advantages
- no inital cash transaction
- eliminates need to create paper a/l (necessary in funds withheld)
- Disadvantages
- main: very complicated to comprehend and to admin
- if coins reserves float w/ outstanding surplus, 2 stat gain from operatoins calcs necessary
- 1) premlim stat gain from operations needed to calc surplus repaid
- 2) final to show change in Vx from co->mod-co (or vice versa)
- Illustrations - text p. 157
Regulation and Taxation
- < 1984, very little (effective) legislation on financial reins
- used often to reclassify components of taxable income & significant reductions in taxes
- TRA84 - Sectoin 845 - IRS can change an individual tax return if signifianct tax avoidance found
- reins transactions were used to mask true financial condition of company
- therefore State DOI now looks at treaties for significant risk transfer
- treaty terms that concern
- - schedule gains to reinsurer, regardless of actual experience of block
- - reinsurer never having to pay out benefits, just building up a payment due liability
- - reinsurer has right to terminate or automatic termination if
- + reinsured becomes insolvent
- + reinsured has mgmt change
- + business reinsured proves unprofitable
- some states challenge ALL "cashless" reinsurance
- conditions to include to keep regulators happy
- - reinsurer must pay benfits at certain experience level
- - gains to reinsrer based on actual experience of reinsurance
- - no event (insolvency/mgmt changes) can automatically terminate reins (may be terminated after certain level of earnings attained or warranty voided)
- - inforce reins cannot be unilateraly terminated by reinsurer - except for premium non-pmt
- - int paid/credited s/b reasonable w/r to invemenst mkts/assets involved
- - relevant significant risks s/b transferred to reins - including capital loss, disintermediation, and asset default risks (if relevant)
- - ceding co shoudl not be forced to pay back losses except for voluntary termination
- regulators object to Vx credits or receivable credits wehre risk transferred is disproportionate to reserve credit
Security Considerations
- "cashless" reins transactions under criticism
- led to use of trusts, escrow accounts and letters of credit
- also helps protect assets, preserve Vx credits, minimizes currency fluctuations and protects other party in insolvency
- Trusts and Escrow Accounts
- trusts used to secure amounts owed from co that secureds trust to co that is benef
- equitable title to the assets is in the trustee
- commoonly used to segregate assets related to Vx of an inforce block
- most common as alternative to funds withheld trx
- escrow accounts earmark assets w/o actually transferring ownership
- typically used to support funds withheld trx
- if certain stipulated events happen, assets held in escrow are transferred
- possible events include
- surplus dropping below agreed upon level
- change in mgmt
- financial performance of reins below expected levels
- if used to secure reserve credits, Trusts subject to Model Law on Credit for Reins
- Advantages
- - assets separate and identifiable
- - investment income can be limited to performance of specific assets
- - ceding co can still take Vx credit if reinsurer not admitted
- - if recaptured, assets of trust/escrow can be used to effect payment, reducing dispute over mkt values
- - trust is true transfer of ownership -> less suspect to IRS and state regulators
- - on default, benef has right to w/d assets as a secured creditor
- Disadvantages
- - creates additional expense
- - can result in restriction on investment mgmt
- - transfer of assets to trust may necessitate recognition of cap g/l for tax purposes or current mkt values for stat stmt purposes (agreement should state which party takes the cap g/l)
- - if trust, company giving up assets will see reduction in magnitude of assets it reports
- - if an asset transfer reversal occurs, depreciation in mkt values could create surplus straing
- Letters of Credit
- most states will allow Vx credits from non-admitted reinsurer if reinsurer provides a letter of credit for the amt of the reserves
- requires very little admin
- disadvantage (from Reins view) - ceding co and draw down on a letter of credit w/o warning
Study Notes and Published References - Note ASP 1 - REDETERMINATION OF NON-GUARANTEED CHARGES AND/OR BENEFITS FOR LIFE INS AND ANNUITY CONSIDERATIONS
Background
- std related to advice actuary gives to client co in connection with (re)determination of non-guar charges and for benefits for life and annuity contracts
- std applies to inforce and NB
- does not apply to PO divs
- use of non-guar elements grown dramatcially, but little standardizatoin in benefit design, pricing structure, mktg practices and inv philosophies
- Emphasis of Std
- set forth areas of inquiry and analysis the actuary should cover in developing advice
- outline areas wehre actuary should describe main elements of advice and reasons therefore
- need a redetermination policy for block fo business
- this polcy (an selection of mktg and financial objectives associated w/ it) is a company mgmt decision that provides framework within which the actuary must operate
- actuarial report should include
- recommended info to enable mgmt to make informed decision
- description of framework advice developed within
- description of co's redetermination policy
- description of facts, methods, procedures, assumptions upon which advice based
- description of ony special operating practices that affect/could affect repricing actions
Current Practices and Alternatives
- An evolving type of business
- for some I/S products, int rate guarantees must be subject to review weekly
- unless co's relevant policy changed, actuary would not be asked to formally advise in redetermination process
- whenever redetermination process is changed, expected that actuarial advise sought adn report made
- buy could be shorter report w/ lots of references to prev report
- Client's Policy - redetermination policy and the selectoin of solvency margins, mktg, and potential profit objectives assoc w/ policy are co mgmt decisions
Standard of Practice
- Analysis of Issues and Recommended Practices
- Company's Policy Taken Into Acct - integral element in developing advice
- if co has incomplete policy, actuary should describe addition assumptions necessary to develop advice
- Accumulated Losses or Gains - the extent to which accum g/l will be allowed to affect teh redetermination
- specific provision for recover of past losses or distribution of past gains is a possible element of co's policy
- recovery of acq expense through annual amortization is not considered recovery of past losses
- be aware of any regulatory restrictions
- Special Operating Practices - description of variations
- ex. special u/w rules and an indication if mort exp for this block s/b analysed separately
- any restriction by type of investment and/or A/L matching standards s/b applied
- if investments supporting this block are
- segmented w/in general acct
- combined w/ other assets but w/ sep ID by year of investment
- comingled on a portfolio basis
- include risks involved w/ deviations from these special factors
- Contract Classes
- a contrac class should remain intact until all contracts matured
- assignment to a class s/not be based on (non)occurrence of a claim on that contract
- class consists of contracts that are
- of a similar type
- same structre of guar/nonguar charges/benefits
- based on same anticipated experience factors
- issued over continuous time period
- similar mktg objectives
- Contract Factors and Anticipated Experience Factors
- Contract Factors - valued defined in teh contract or values emerging from the operation of its terms
- Anticipated Experience Factors - elements in the redetermination of non-guarcharges and benefits that reflect expected future experience
- "expected/anticipated" - as determined by actuary through application of sound professional judgement
- s/b based on recent expereince and expected trends in experience for
- factor clas
- similar classes of business
- same co
- other co
- other sources
- in this order of preference
- Modeling adn Averaging
- possible that signficantly diff levels and incidence of prem payments will emerge w/in class
- there s/b reflected in redetermining charges/benefits - by modeling or appropriate averaging of classification of contracts
- Impact of Life Deviations from Anticipated Experience
- actuary should furnish ifo as to impact of likely deviations in experience from that anticipated
- cover degree of variation that migh reasonably occur
- effect these variation would have on likely attainment of co's several goals
- if any variations could have sizable impact, actuary should include a report any changes in operating practices or product design which might alleviate or obviate these potential effects
- Sensitivity Testing
- on potential impact o flikely deviations in expereince that may have material effect
- Application of Regulations
- take into account jurisdictional regulations when developing advice
- Communications and Disclosures
- Actuarial Report - should include
- Description of Clients Policy
- disclose area in which policy is judged incomplete and describe any additional assumptions made
- Description of Special Operating Practices
- Description of Contract Classes
- if any changes in assignment of contracts to these contract classes, report should indentify how assignment changed and reasons for change
- Identification of Contract Factors
- if approximations or projected measures of contract factors used, describe basis of measures used
- Description of Experience Factors
- all changes in teh values of anticipated experience factors from loast redetermination
- Descriptoin of Processes adn Methods
- significant modeling or averaging used
- manner contract factors and anticipated experience factors used
- Reporting on Specific Charges or Benfits for the Period
- present advised non-guar charges/benefits
- if changed
- identify
- indicate amt of change
- describe reasons
- Stating Degree of Conformity w/ Co's Policy
- and degree which actuary expects them to meed co's solvency, profits, and mktg objectives
- Disclosures on Sensitivity Tests
- descriptoin of any tests
- summary of results
- advice re: changes in operating practices or product design to avoid/minimize impact of any likely variations that have materially adverse consequences
- if no testing, reasons why
- Description of Regulatory Requirements and Interpolations
- any applicable reg requirements
- incl any explicit approvals necessary
- if any significant interpretive questions,
- decribe these adn actuary's interpretation and conclusions
- Deviation From Std
- statement w/r to nature, rationale, and effect of deviating from ASP
-
Study Notes and Published References - Note CIA Recommendations - DIVIDEND DETERMINATION AND ILLUSTRATION
Section 1 - General
- describe baseic responsibilities of actuary in application of sound actuarial principlas adn practices to determination adn illustration of divs under par pols
- Contribution Principle cannot be applied over longer term to stock companies unless
- possible to determine the surplus earnings of par business
- limitation on amount that may be transferred from part business and surplus to the shareholders acct
- Section 83 requires par and non-par blocks be maintained separately
- Section 84 limits distribution of par profits to shareholders
- general practice: maintain sep accts for par, non-par and suplus
- significantly restrict transfers from par surplus to shareholders acct
- report should describe method of determining surplus earning of par block and if stock, limitation on distribution of par profits to stockholders
- Recommendation does not address determination of divisible surplus
- Does Address
- determination of currently payable divs for pols inforce
- determining illustrated future divs for both inforce and NB
- Consider in Report
- an actuarial report is a statement of actuarial findings, conclusion, or recommendations
- any manner of transmittal of an actuarl report which involves teh risk that the underlying facts adn assumptions and limitations resulting from their use are not fully commented to teh client involves a corresponding risk that the conclusions or recommendation may be misinterpreted or misapplied
- the client is the co, its policy-making executives and in some situations its board of directors, whether or not he is an employee fo the ins co
- actuarial report should include such underlying data as are essential to findings or conclusions reported
- Recommendation 1
- Whenever an actuary advises an ins co on divs, either illustrated or current, he should prepare a written report which documents the advise
- "Sound Actuarial Principles" - generally accepted actuarial principles adn practices whiich emerge from utilization and adaptation of concepts described in actuarial literature
Section 2: The Contribution Principle
- Basic principle is to distribute teh aggregate divisible surplus among policies in the same proportion as teh policies are considered to ahve contributed to divisible suplus
- Recommendation 2
- use of Contribution Principle is generally accepted practice in Canada
- Actuary's report shoudl state if priciple followed
- if not followed, state deviations and rationale
Section 3: The Process of Dividend Determination
- application of Contribution Principle requires two basic types of elements
- policy factors - elemetns which reflect assumptions inherent in std against which experience is measured
- expereince factors - elements which reflect actual experience
- Methods of Div determination described in actuarial literature
- source of earnings method (contribution method)
- asset share method
- fund method
- experience prem method
- percentage of prem method
- reversionary bonus method
- other methods, including combos, mods to above, also describe in lit
- Recommendation 3
- Actuary's report shoudl include description of precess used to determine divs as well ans manner in which policy and exerience factors are flected in that process
- also describe the formulations used to calc divs
- Recommendation 4
- if impractical to apply Recommendations directly to all pols/benefits, may continue a div scale or use approximations or similar processes and formulations
- rationale and impact s/b disclosed in report
Section 4: Policy Factors
- elements based on guarnatees or underlying actuarial structure of policy
- Recommendation 5
- use of actual or approx policy factors is generally accepted practice
- describe policy factors and of any changes in practice w/r to determination for period covered by report
Section 5: Experience Factors
- actual experience - experience and trends to extent they are determinable, available, adn statistically credibe.
- if not available, interpret w/ sound professional judgement based on similar classes fo business from same co/other co/other sources
- if a trend is projected for one class, s/b make uniformly for all classes
- Recommendation 6
- report should describe experience factor values used
- if projection used, type and extent of usage s/b stated
- Recommendation 7
- if multiple factor classes, differences in factors between classes need to be based on differences in actual experience between teh two classes
- identify differneces and be prepared to provide a demonstration necessary to support such differences
- Recommendation 8
- report changes in experience factors and changes in practice w/r to determination of exp factor classes or placement of policies w/in them
Section 6: Claims Factors
- Recommendation 9
- if multiple claims factor classes, disctinction can be made on basis of
- risk selectin class
- selection process
- mktg method
- policy provisions
- plan
- prem rate
- geographic location
- size of policy
- date of policy issue
- variations s/b reported along w/ explanation of rationale and effect of basis
Section 7: Investment Income Factors
- includes int earnings reduced by investment expense, capital g/l
- effect of taxation may be reflected as reduction of before tax inv income
- investment income for a group of policies may be directly affected by pol loans
- Recommendation 10
- Generally accepted practice to reflect the effect of policy loans in inv income factors
- inv income, excluding policy loans, directly affected by
- amt and timeing of investable CF generated by ins operations of the group of pols
- inv income rates initally and subsequently applicable to CF due to investments actually made
- rate or follover of those investments, which affect investable CF insubsequent periods
- Recommendation 11
- use of either portfolio average approach or investment generation approach is considered generally acceptable practice
- report should state menthod used
- if method changed, or net method for new group of pols, describe nature, rationale adn effect
Section 8: Termination Factors
- terminations for reasons other than claims
- organized set of internally consisten experience factors corresponding to () will be considered one factor in defining a termination rate factor class
- () - IA,sex, prem mode, plan, size of pol
Section 9: Expense Factors
- mktg, u/w and other acq cost may be allocated to all pols or recognized specifically as non-level costs to be charged to a policy and amortized
- Recommendation 12
- direct costs s/b charged to group generating costs and indirect costs allocated
- amortization s/b based on realistic int and termination rates appropriate for group of pols
- considerable latitude in possible approaches for allocating indirect costs w/in various groups of pols
- amort periods and matters may also vary widely
- Recommendation 13
- minimum test of consistency between two expese factor classes is that any difference in total expense charged to each class s/b justifiable and in accordance w/ sound principles of expense analysis
Section 10: Tax and Other Factors
- tax factors may be incorporated into div determination
- Recommendation 14
- variation in tax factor should reflect corresponding variatino inherent in applicable law/regs imposing that tax
- stock co - charge for stockholder retention
- can be reflected at an aggregate level in determining divisible surplus
- can be separate factor in formula for div scale or implicitly included as part of one or more expense factors
- Recommendation 15
- Describe method used by co for shareholder retention charges
- if div scale contains specific expense factor for such charges, describe and detail and changes
- reasons for adjustments to divs
- reflect unusual g/l on certain supplemental benfit riders
- reflect losses arising from presence of settlement option guarantees
- smooth transition from one div scale to another
- provide consistency in quantity discounts made to varying degrees in GP structure
- serve as balancing item so aggregate divs = aggregate divisible surplus
- distribute gains from extraneous sources, such as non-par benefits or LOBs
- smooth incidence of divs w/in div scale by policy dur
- Recommendation 16
- specifically state any special adjustments made to divs
- be prepared to provide demonstrations which support existency adn magnitude of such adjustments
Section 11: Terminal Dividends
- generally reflect a POs share of surplus which has not been distributed through annual div
- terminal divs program may be part of recurring process or may be one time distribution for a limited period
- Recommendation 17
- state whether terminal divs equitably reflect incidence, size and growth of the policy's share of amts previously accumulated on behalf of policies on which such divs payable
- whether diffs in terminal divs among diff poliices reflect differences in corresponding amts accumulated
- whether terminal divs expected to be recurring and/or for temporary period
- describe proscess used to determine
- source of funds or types of inv gains used to support div
- changes in practice w/r to determination of terminal divs
Section 12: Determination of Participating Earnings Limitations on Amts Transferred Among Accts
- if separation of accounts not used, mvoing an amt from experience of par line to another line or to shareholders acct = transfer
- if contribution principle to be followed, transfers from one par line to antoher as important as transfers to shareholder's acct
- describe any such transfers
- Recommendation 18
- report if separation of accts maintained and if so, on Stat or GAAP basis
- Recommendation 19
- state if current limit exists on amts transferred from par to non-par/shareholder's acct
- Recommendation 20
- report (or incorporate by reference) current earnings and PO surplus of each par acct and amts proposed to be transferred to toher accts and distributed to PO
- state why transfers are reasonable/unreasonable
- whether (in actuary's judgement) transfers migh impair co's ability to maintain current div scale
Section 13: Illustrated Dividends
- methods intended to apply equally to currently payable divs adn illustrated future divs for inforce and NB
- may be desirable to assume a conservative position in determining experience factors applicable to only new or recent issues
- circumstances can arise wehn there is substantial probability that an illustrated div scale will not be maintained in near future
- may be appropriate to illustrate a reduced scale
- Recommendation 21
- actuary should conduct tests of illustrated divs to judge if these illustrated divs could be paid in teh near future
- if substantial probability that illustrated divs not supportable in near future, report should state such
- Recommendation 22
- report should identify time period used to determine portfolio inv generation rate of return for policies to which illustrated divs apply
- Recommendation 23
- primary responsibility w/r to illustrated divs - ensure divs appropriately reflect current financial results of co adn related to paid divs in an equitable, justifiable manner
Study Notes and Published References - Note SN 8I-100-00 - PRODUCT DEVELOPMENT TRENDS
Overview of Product Development Process
- Product Design
- prelim decisions - target mkts, perceived needs/wants of consumers, competitor peer group, perceived needs/wants of destributors
- prelim objectives set for prem rates, nonf values, divs, comm rates, u/w stds
- task force containg freps from most HO funtions, most importantly: Executive, Actuarial adn Mktg
- Actuarial - primarily repsonsible for fin soundness of product
- should have (or develop) experience assumptions
- Mktg - responsible for evaluatigin anc characterizing the mkt place
- Exec Mgmt - direction to initial conceptual decision and the design process
- Planning Process - begins w/ clear def of life co's goals adn strategies
- key part of corp strategy - mktg plan
- to select mkt, co will review
- size and character of targeted mkts
- ability of co to effectivley reach mkt
- nature of perceived copmetition in teh mkts
- dist channel that most effectivley serves mkts
- concepts futher refined after initial planning
- general benefit characteristics defined
- decisions as to premium structure
- range ultimate prem structure must fall w/in
- what funing scenarios included in profit test
- fixed or flex prems
- how to grade if not level
- "high" or "low" prems
- guar or adjustable prems
- mktg costs must be determined (comm, mktg OH, adv, etc)
- risk parameters (mort/morb, inv, legal/regulatory, fni, tax, inflation)
- clarify u/w stds
- int, persistency, and exp assumptions taht reflect product risk characteristics and target mktplace
- other reqs
- reins
- policy and app forms design
- computer and admin systems
- distributor education and training
- staffing needs (additions?)
- investment philosophy
- consumerism adn company solidity
- Product Implementation
- Princing - before pricing you need
- experience assumptions - adjustments may be necessary for target mkt/dist channel/sales scenarios/u/w changes/environ factor/expected/recent changes in environmental circumstances
- profit or surplus standards
- competitive standards
- valuation standards
- mktg costs
- FIT
- Policy Values
- must relate to mktg plan strategy
- adhere to legal requirements (SNL)
- Forms - drafted,printed & filed for approval
- Mktg support - materials developed ads/ratebooks/etc
- Systems
- Reinsurance
- Add'l Benefits
- Product Release
- Process Contraints
- Environmental Constraints
- legal
- economic
- taxation
- competition
- Organizational Constraints
- surplus
- systems
- expertise
- tradition
- Critical Product Success Factors
- competitive prices
- valuable benefits
- flexibility
- harmonious w/ co strategy
- complements other portfolio products
- satisfies teh distributor
- ability to admin and u/w (at reasonable cost)
- profitable
- equitable (classes and generations fo PO)
- managable tax status
- Important part of prod dev process - continuous re-evaluation of product and performance
- Evaluation criteria
- sales success
- actual vs expected
- dist receptiveness
- cost of dist
- admin effectiveness
- Conclusion
- Two distinct levels : Product design and product implementation
- product dev must clearly relect interests of potential consumers, POs, potential distributors, co EEs, shareholders, regulators, general public
Product Trends in the US
- Overview
- 3 components of prod dev paradigm: mkt-driven strategies/consumer-oriented/capital focused
- catalysts for development of products
- consumer needs
- shift in mkt awareness
- regulatory issues
- increased flexibility (benefits and funding)
- exonomicn and/or inv conditions
- changes in taxation
- special pricing considerations
- characteristics of newer products - degree of PO flexibility adn non-guar elements
- therefore imperative to perform profit analysis using several diff scenarios
- sensititive tesing w/r to mort/lapse/expenses/int earned/spread/prem pay pattern/etc
- most require comlicated admin systems
- admin systems may limit # bands, commission structures, # inv avail, # lives, type of joint age calc
- costs of new admin systems - developmental adn ongoing
- Indeterminite Premium Life
- Product design
- dual prem structure - guar adn curr
- guar max is stated in policy form, insured pays lower current prem
- purpose - avoid def reserves
- lower prems typically guar first few years
- Pricing Considerations
- prem structure - during guar peroid, def res may be req'd adn s/b consisdered
- low curr prem and guar period - primary features for competitiveness therefore critical assumptions
- regulatory concerns - many states have limitations on prem adj for indet prem products
- prem changes must be on a class-wide basis, justifiable in light of current and anticipated future exp adn not recover prior losses
- many states req notification adn justification prior to implementing change
- Pricing Methodology
- priced using trad techniques to current premium produces proper profit objectives
- consider
- filing req gor a prem change
- def reserves
- FIT
- add'l admin system expense
- consider guar max prem adn analyze profits under a "worst case" scenario where max prms req'd
- Multiple Life Products - Last Survivor
- Product Design
- mainly sold in estate planning mkt - some applications for business ins
- important product features
- premium flexibity - focus on DB/$
- either low AP or limited pay prems
- CV buildup not as improtant since proceeds usually to pay taxes
- automatic increase in DB - to cover inflation or increased value of estate/business
- consider increases when u/w oringal policy
- consider likelihood of anit-selection
- policy split option - some allow policy split into two parts if certain events occur
- sum of new pols = orig face
- may charge processing fee
- some cos req evidence of insurability
- other cos charge extra (like a GIO benefit) but don't require evidence
- estate preservation - additional coverage for 4 years to cover extra taxes if "gift" to trust brought back into estate
- first-to-die benefit - small benfit to pay for final expenses
- sometimes policy becomes "paid up"
- Pricing Considerations
- Product approach - 2 different comman approaches: dual or single status
- dual status - PVFB incr dramatically after first death
- admin systemn need to track sets of pol values for 3 states, x alive, y alive, both alive
- single status - "Frasierized" method
- single life decrement developed from teh joint lives
- a blend of 1 and 2 alive statuses
- Method of Calculating Multiple Life Status - 3 common methods to combine age/risk classes for pricing multiple whole life products
- admin systems may dictate method used
- exact age - everythign calced from first principles based on each life to be insured
- joint equal age - exact age calcs done, bot only at equal ages
- "equal age rules" used to calc JEA based on actual ages
- equivalent single age - rates and values equated to a single age
- admin as a single life product therefore simplest to admin
- wide fluctuation in mortality from exact age
- Mortality - assume independence of lives in formulas
- consider "lonely-heart syndrome"
- single life experience probably not appropriate for pricing a new joint product since more older individuals
- since pays on second death, if one life is "std", second life can be substd ans still get std coverage
- more u/w concessions since competitive mkt
- Persistency - much higher than for single life policies
- bought for a specific need - to pay estate taxes
- owned by trust
- Claims - be concerned w/ steep claim costs in advanced years (long dur product)
- Expenses
- since face amts usually very large, common to have u/w adn per policy overhead as an amt/policy (vs per $1m)
- u/w costs are to u/w 2 people and higher med reqs b/c of age
- maint costs higher b/c dealig w/ lawyers, acctnts, etc
- "not taken" cost higher b/c of "shopping"
- admin and illustration systems might need upgrade
- Cash Values adn Reserves
- b/c of low lapse assumptions, profit results might be counter-intuitive
- CV not the concern of the insureds. 0 CV term would be optimal plan
- Retention:
- some co's beleive higher retention is appropriate (up to 2x single life)
- argument can be made for lower retention (low prems, high face, low claim prob)
- Reinsurance:
- key to mktg sucess many co'w will have w/ last surv products
- help w/ u/w
- reinsurers have difficulty pricing @ attractive rates for ceding co
- YRT rates sometimes exceed those charged by ceding co
- Pricing Methodology
- profit tested similar to trad/UL products
- modifications
- joint age calc methodology
- inclusino of contagion mort factor
- revised to retention limit
- reins costs
- provisions for auto increase/policy split/estate preservation if applicable
- requires select mort charge structure
- each cell needs to be price separately, paying attention to slope of mort
- contagion factor can be incorp into Frasier calc of underlying last surv mort experience and provision for substd risks
- add'l sensitivity tests on varying expenses, persistency and likelihood at least one life substd
- cells w/ wide variation in age of two insureds s/b tested to ensure consistency and reasonableness of results
- Multiple Life Products - First-To-Die
- Product Design
- insures multiple lives (typically 2) and pays on first death
- primary mkts
- business mkt
- fund buy/sell agreements in event of partner death
- multiple key person needs w/ cost-efficient split dollar programs
- family ins mkt
- provide replacement income on first death in two-income family
- pay final expenses/taxes as part of family estate planning
- Important Features
- survivorship purchase option - allows continuation of coverage for suvivors w/o evidence of insurability
- potential for anti-select on surv purch option
- reduced w/ limitations on age/years option is available
- unequal DB - varying face amt on each insured
- automatic increase in DB (COLA) - may be max allowed increase
- must factor in add'l lcost and likelihood of antiselection
- addition/deletion of insureds - for business
- simultaneous death - w/o this option, no benfit payable on simultaneous death
- prob is relatively small and often provided at no extra charge
- thought enough margin in mort to accomodate this
- policy split option
- sum of new pols cannot exceed existing face
- new pols based on orig IA and u/w class
- subject to anti-selection in new pols not subject to u/w
- Pricing Considerations
- product approach - primary approach to build multiple life products is true joint life approach
- method of calculating Multiple life status - same 3 as last-to-die
- Number of lives - typically 2. 4-6 for business products but up to 10
- Mortality - assume independence
- s/b similar to other single life products
- substd rates easier on a formula-driven UL product, more complicated on fixed prem products
- Persistency - generally same as single life products associated w/ family or business mkt
- potentially lower laspse rate on pols that have prem savings vs sep pols
- Expenses
- overhead s/b same as for a single policy. This is the biggest expense
- economy - 2 lives-> 1 expense
- u/w expenses higher since need to u/w multiple lifes
- increased admin & illus styem expenses possible if not already able to handle
- CV adn Expense Allowance Limitations
- expense allowance defined as an absolute max, regardless of # lives covered
- therefore first-to-die generate higher CV that sum of single life pols
- Reinsurance
- reinsurers often add single life rates to get joint first-to-die rate
- possible product charges (add/drop/split) need to be considered by pricing actuary
- Pricing Methodology
- same techniques as trad/UL products
- Mods to input parm
- joint age calc methodology
- expense allocations
- cash value and expense allowance limitations
- rein costs
- surv purchases/auto increase/change of insured/simultaneous death/policy split benefits if applicable
- add'l sensitivity analysis - varying # lives covered w/in one policy
- Variable UL Products
- Product Design
- DB adn CV vary according to investment experience of investment accts underlying the policy
- common features
- flexible prems payable
- DB not req'd to vary w/ inv performance
- expense and mort loads deducted from acct values
- net prems invested in underlying general acct or sep accts
- mort and expense asset risk charges assessed against acct value
- also deduction for COI and admin charges
- SC (10-15 years)
- most important feature - fund approach - outside funds or own funds
- outside funds - instant fund recognition
- own funds - fund startup costs, no track record and no name recognition
- common investment options
- equity - aggressive growth, growth, small-cap, mid-cap, growth and income, blue chip
- fixed income - med term, long term, high yield, govt
- managed - asset allocation, balanced
- international
- money market
- fixed (general) account
- Pricing Considerations
- Regulatory Restrictions
- under SEC regs
- must be registered w/ SEC
- Prospectus delivered to potential investors
- selling agent must be registered to sell securities w/ SEC
- selling co must be licensed as a B/D
- sales load limits
- max sales load is limited on premiums up to SEC GAP
- max slaes load from prems in excess of SEC GAP limited
- sales load percentages cannot increase
- sales load essentially limited to a % of SEC GAP
- actual loads may exceed, but excess must be refunded if surrendered in 1st 24 mo
- admin loads, prem tax and DAC tax loads must be reasonable
- M&E (Maint and exp) risk charge must alos be reasonable
- Admin System
- usually requires sep admin systems b/c unit values need to be calced daily
- SEC reg controls require
- admin procedures consistent w/ prospectus
- annual prospectus updating and mailing to investors
- mandatory record keeping
- processing transactions @ today's price
- seven days to confirm prems and transfers
- payment of benefits w/in 7 days
- Other admin considerations
- integration w/ other systems
- telephone transfers
- atuomated voice response
- maintaining up-to-date mktg info
- trakcing distribution systems licensing
- portfolio rebalancing
- providing dollar-cost averaging capabilities
- Build vs Buy
- considerable investment of time/people/expenses assoc w/ entract to variable marketplace
- co could market other co's product in return for compensation
- "private label" another co's product
- manufacture product but outsource admin to TPA adn use outside funds
- keep all processes inside
- SEC regs make it hard to develop VUL products w/ real differentiation
- Pricing Methodology
- vastly different from trad and UL pricing
- lack of mgmt discretion in determining credited rates and margins as a source of profit
- high degree of regulation, esp in expense load area
- analyze sources of income and cash outflow
- front end premium loads
- issue and maint charges
- mort charges - can't exceed 80 CSO mort
- current COI < max for competitive reasons
- asset charges - % of avg daily net asset bal
- m&E charge compensate for mort adn expense risks and inv advisory fee
- surrender charges - generally level 1-7 grade to 0 @ 15
- transaction charges - charges assoc w/ partial surr and fund transfers
- from these sources of income, need to
- cover DB payments
- mktg dist compensation (siimilar to UL usually)
- expenses (remember extra licensing costs and maint of several funds)
- profits
- potential loss from early surrenders
- important to study profitability under several diff lapse scenarios
- lapse scenarios ~ assumed inv performance
- Market-Value Adjusted Annuity Products
- Product Design
- SPDA or FPDA w/ int and book value guaranteed @ end of specified period
- early w/d subject to MVA & SC
- for buyers, MVAs offer
- longer guar periods
- higher int guarantees
- opportunity for capital gain
- for ins cos
- lower cost of PO disintermediation since MVA protects co from mkt loss on surrender
- lower surplus strain through higher reserve valn int rates
- potential for better persistency through attracting buyers w/ more of a saver's mentality rather than investor's mentality
- Pricing Considerations
- MVA formulas - usually not applied on death/annuitizations
- formula must recognize both up and down adjustments
- may ignor minor (< 25bps) int rate changes
- degree of downward MVA permitted
- some limit adjustment to excess int only
- some restric MVA to all credited int
- some have no limit
- degree of MVA - tradeoff between int rate risk and SEC reg and distribution access
- Valuation Basis - CARVM
- MVA = type B annuity
- allows co to choose between iss year valn basis and change in fund basis
- MVAs rec more favorable valn treatment than fixed annuities b/c of MVA
- most co's choose change in fund basis b/c practically all funds usually rec'd irst year
- pricing actuary shoudl take into consideration impact of reserving methodology choice when pricing MVA product
- Number of Guar Periods
- compete against CDs and gov't issued obligations
- 2,3,4,7,10 yrs most popular
- @ end of guar period, PO can roll into new guarantee
- sometimes 30 day free w/d at end of guar
- if so, shock lapses will be quite large
- Marketing Dist Compensation
- 1st year commission and trail (either increases or total asset value)
- reduced 1st year if rolled into new guarantee
- Admin System - must handle regular SPDA plus
- multiple guarantee periods adn resseting acct val as prem
- MVA formula
- MVA limitations
- indiv products and/or group trust
- sep accts adn acct procedures
- compliance w/ SEC regs if registered
- Pricing Methodology
- profit tested like SPDA except each guar period presents unique situations for evaluation
- MVA adjustment formula determined first
- valn methodology evaluated as part of pricing process
- test various combinations
- each guar period is a subset of overall MVA rpduct
- primary annuity profit source - spread between earned and credited
- determine appropriate spread reqs for each guar period, taking into account
- SC
- "shock" lapse
- penalty free surrenders
- mktg dist compensation
- renewal resetting
- early annuitization
- intial profit tests using "static" inv environment
- then add'l scenario profit analysis
- persistency ~ credited rate
- dynamic pricing to supplement static analysis, consider
- excess lapse
- varying re-investment strategy
- renewal interest creditig strategy
- Two-Tiered Annuity Products
- Product Design
- diff accum values @ mat depending on if annuitized or surrendered
- AV - Annuitizaton value = accum gross prems @ specified credited rates
- SV - surrender value = accum(gross prems - loads)@ lower specified credited rates - SC
- both AV and SV adj for prior partial w/d/annuitizatoins
- higher AV justified b/c profitability maintained w/ lower int margins b/c annuitization rates incorporate (potentially) two profit sources - int and mortality
- payments based on guar settlement rates or current SPIA rates, whichever gives highest payment
- most co's require payout to be >= 5 years to qualify for AV
- AV usually payable on death
- Pricing Considerations
- Credited int rates
- differences between AV adn SV crediting rates is to provide equitable dist of earnings between those who annuitize and those who surrender
- spread between AV adn SV usually 100-300 bps
- some cos may guar these spreads
- Reserve Determination
- reserve calced under CARVM
- calc both AV and SV
- greater is reserve for valn
- pattern will follow value between SV adn SV-SC @ early durs and approx AV @ later durs
- Persistency
- higher than comparable single tier DA products
- biggest diff @ end of SC when normally a shock lapse
- Admin Systems
- systems need to accomodate two accum values adn dual reserve calcs
- Pricing Methodology
- similar to regular DA, esp the SV
- AV priced sep assuming higher persistency and conversion to produce payments @ annuitization
- combine the accum adn payout phase to determine overall profitablity (optional)
- perform dynamic pricing tests under various int rate scenarios
- Varaible Annuity Products - GMDB
- Product Design
- similar to VUL
- GMDB evolution
- DB = acct value (SC waived)
- DB = ROP (net of loads) - partial w/d
- DB = ratcheted or stepped-up value (resets to current AV @ certain points)
- DB = net prems paid accumulated at annual fixed rate (usually 5-7%) aka rollup
- Pricing Considerations
- formula approach
- inherent cost to provide GMDB increases as benefit become more generous
- keep limits in mid (200% or age 75)
- variable account performance
- cost of GMDB varys widely depending on performance of sep accts
- different mixes of assets will give significnatly different benefit amts
- issue age
- shoudl consider various combinations of IA and acct performance in pricing
- mortality
- projected GMDB costs ~ mort assumption
- actual mortality might deteriorate if
- GMDB provisions become critical mktg factors
- lapse anti-selection occurs
- persistency
- higher levels of persistency will result in larger aggregate amts of benfits
- reinsurance
- due to volatility and unpredictability of underlying factors, many cos cede total GMDB risk
- still need to be aware of GMDB consequencesto evaluate reins cost structure
- Pricing Methodologies
- two methods of estimated cost of GMDB provisions
- GMDB as series of put options exercisable @ death of PO
- valued using B-S option pricing formula
- effect of fund diversification s/b considered
- B-S is limited in its ability to analyze these issues
- Monte-Carlo Simulation
- more generalized approach
- project multiple future paths of returns for each of underlying funds offering a GMDB
- @ each point, (GMDB-SV)*qx, then disocunted and summed to estimate cost of GMDB
- taking diversification into account - consider correlation between inv funds
- imperative for pricing actuary to perform scenario sensitivity profit tests to gauge importance of changes in assumptions and parameters
Product Trends In Canada
- Annuities
- consumer shoing increased sophistication
- demanding more guarantees adn more control over investments - conflicting goals (potentially)
- inc co's in competition w/ banks
- even though profit/policy is shrinking, mkt is expanding
- Deferred Annuities
- series of deposits, @ ret, converted to immediate annuity or RRIF
- mostly registered funds (tax deferred)
- gov't limits amt you can contribute to RRSP
- contribution limit offset by pension adjustment
- non-registered are non-exempt
- range of inv vehicles is increasing
- Var Def Ann guaranteed to be at least 75% of prems paid (less w/d)
- 75% req'd by law
- some cos up to 100%
- advantage since other fin institutions don't have guarantee
- Immediate Annuities
- singel life, joint life, term certain along w/ various guarantees
- if term certian purchased w/ registered funds, certain can't go beyond age 90
- non-reg funds min(40yrs, AA100) for certain
- new risk exposure due to back-to-back market
- life annuity - annuity mort
- term to 100 - life mort
- life mort <> term mort
- life is u/w therefore annuity mort is taking anti-selection risk
- RRIF (reg ret income fund)
- allows more flexibility w/ payout pattern than w/ annuity
- can only be purchased w/ funds from RRSP
- invested in segregated fund or guar fund
- w/d chosen by PO, subject to legislated mins
- no max w/d amt
- payment pattern can be modified annually
- LIF (Life Income Fund)
- allo more flexibilty in payout of locked-in pension funds
- goal - extend RRIF options to locked-in pension funds
- prior - could only receive funds when converted to annuity
- increase flexibility by allowing deferral of annuity purchase to age 80
- prior to annuitization, w/d subject to same mins as RRIF
- RRIF and LIF allowed PO to reduce exposure to int rates
- Interest Senstitive Products
- 1st generation - 5 yr adj products
- db/prem/scv guar 5 years
- redetermination every 5th year
- PO could increase prem if DB decreases
- eventually guarantees introduced as to maximums for mort and expensed, int rates linked to external index
- 2nd generation - removed guar csv adn substituted ETI/RPU amts
- guaranteed for each 5 yr period
- generally lower premiums than 1st gen products
- competition led to aggressive int rate projections and poor (none) disclosures
- led to significant prem increases at redetermination time
- 3rd generation - 5 yr adj face, prems and non-guar CV
- new money int rates used for setting prems/face amts
- @ redetermination, prems recalced based on new money rate and accum cv
- very similar to UL except prems fixed
- 4th generation - UL w/ very explicit charges - true unbundled ins products
- 2nd generation UL - dropped explicit expense charges
- hidden in higher COI charges
- increase SC (amt and/or dur)
- SC based on target prem
- inv options varied (true new money inv accounts), but no equity options or VUL due to tax reasons
- current genration UL - decreased unbundling
- COI from YRT to level to age 100
- substantially lapse supported
- subject ot same risks as Term-to-100
- single inv accts linked to moving avg of some outside index
- rise in popularity of equity or segmented fund inv options
- int earnings subject to annual taxation
- still popular despite adverse tax treatment
- Lapse Supported Products (Term-to-100 aka T-100)
- T-100 - NP WL w/ little to no CV
- provides pure death protection @ affordable cost since no need to fund CV
- prems often guaranteed
- popular in capital gains situations
- used to fund tax liab on inherited property
- used w/ immed annuity for back-ot-backs
- since guar, price is critical
- no adjustment mech to reflect actual exp
- 3 assumptions of chief concern (in increasing order of sensitivity)
- mortality - quite popular at ages 60+
- inv rates - represents very long implicit int rate guarantee
- use of asset strategies will have direct effect on rate used in pricing
- lapses - most critical pricing assumption
- nonf benefits < natural reserve, therefore excessive lapses inprove profitability
- higher assumed lapse rate would result in lower premium
- first valn tech paper suggested rarely appropriate for rate > 3%
- considerations
- mkt sophistication - if PO knows that value enhanced by keeping in force, they will tend to not lapse
- if insurer works in sophisticated mkt, expect better persistency on avg
- absence of CV s/b strong disincentive to lapse
- issue ages and lifestyles
- lapse rates should vary by age due to dinstince differences in lifestyle
- insured annuities (back-to-backs)
- T-100 prems funded by immediate annuity
- persistency is better on quality sales
- levelized commissions
- stronger incentive for agent to maintain coverage
- presence of viatical cos willing to buy policies for cash
- Miscellaneous
- Cross-Selling (back-to-backs)
- may provide some tax relief
- under a prescribed annuity, taxable int income spread evenly over life of annuity
- used w/ estate planning to preserve capital
- Segregated Funds
- don't get favorable tax treatment, but increasingly popular w/ consumers
- Compensation
- more consumer-oriented marketplace
- trend towards more levelized compensation
- pros and cons to levelized comm
- + PO receives better and longer service from agent
- + long term relationshiop -> additional sales as needs mature
- + increased persistency of inforce block
- + less 1st yr surplus strain
- + better persistency leads to smaller unit costs
- - insufficient income for new agents
- - less incentive for an agent w/ big block to pursue NB
Product Trends In Other Countries
- Europe
- was either largely deregulated or highly regulated tariff markets
- EU caused most to move to deregulated system
- UK
- traditionally endowment policies
- popular unti mid 80s
- featured
- smooth investment return to PO
- guar DB
- terminal bonuses payable upon death or maturity
- guar endowment benefit
- annual bonuses dependent on co results
- Unit-linked w/ further guarantees in early 90s
- tied to index fund w/ guarantee that a certain min benfit paid if index isn't to a certain amount over guar period (5 yrs)
- derivatives to provide maturity guarantee
- Dread disease products in 80s - lump sum upon diagnosis of speficied disease
- Latin America
- changes effect teh ability of ins cos to do business
- democratization is taking hold
- market based capitalism on the rise
- state industries are being privatized
- inflation is down and becoming more stable
- Argentina - pirvatizatoin of SS system
- ER & EE contribute a percentage of salary to either state or private pension fund manager (AFJP)
- if in AFJP, contributions accumulate in indiv pension accts
- AFJP - sole objective - manage funds
- contributors free to choose fund managers and can change 2x/year
- funds segregated and strict restrictions and limits to what fund manager can invest in
- At retirement, a monthly benfit from state
- if funds to state, then add'l benefit = % 10yr avg salary
- if funds to AFJP, annuity based on fund balance
- Death/Dis benefits also provided
- outsourced as group ins through public bidding
- Ins Co opportunities
- pension fund manager by participating in AFJP
- opportunity to provide death/dis group ins
- opportunity to provide retirement annuities to those who contribute to AFJP
- Asia
- mkts in different states of maturity
- mature adn competitive mkts - substantial % of population insured
- Hong Kong/Singapore/Japan/Korea
- strong growth mkts - very strong growth last 10-15 years
- rapidly emerging markets - recent new entrants or country changed regulatory environment such that there will be many new entrants
- Philippines/Indonesia/Thailand
- immature mkts - mkt exists, but small % of populatoin insured and few products exist
- mkts to emerge - concept of insurance doesn't exist
- basic product development considerations for co's looking to enter these mkts
- regulation
- waht is regulatory environ an din what direction is it heading
- often not a level playing field w/ discrimination againt foreign companies
- distribution
- agency distribution is waning (used to dominate)
- direct mktg, bank dist, and EE dist products gaining attention
- Admin capabilities
- policy sized may be small, but volume may be huge
- Cultural Environ
- must balance co's internal culture w/ culture of country
- products offered should not challenge basic beliefs of target audience
- products should fit customers values and needs
- mkt research - don't just expect to sell what works elsewhere
-
Study Notes and Published References - Note SN 81-101-00 - LIFE INSURANCE AND ANNUITY NONFORFEITURE PRACTICES
Overview
- w/r nonforfeiture - how to treat terminating PO in relatoin to policy is same cohort who hasn't terminated
- min nonf law is almost all US states
- Canada - no min nonf law
- many forms of health ins (including DI) normally do NOT provide nonf benefits
- what forms to offer on voluntary termination adn which s/b automatic optoin
- nonf values must be determined for a broad range of life and annuity products
- level premium plans -> nonf logic
- "overpays" premium in early years for right to "underpay" in later years
- nonf benefit avail on surrender restores PO equity
- chooing to surrender policy instead of paying prems adn forgo the "right" to "underpay" later yers premiums
- prospective and retrospective values can be quite different on a level prem plan
- questions regarding parity among differnt PO
- satisfied by nonf value that reflects teh past
- or should it consider the future value of the policy
- different methods of determining amounts grow from these answers
Methods of Determing Amounts of Nonf Benefits
- Retrospective Method
- based on fund or account value
- SC may be deducted
- currently used for variable products in US
- fairly easy for PO and sales reps to understand, but limits product design
- "no lapse guarantee" requires taht accum value fo actual prems paid >= amt which specified prems would ahve accumulated to under same set of rates
- or coudl require >= specified prem paid each period
- Prospective Method
- present value of future benefits plus PV of co expenses plus contribution to profit less PV future gross prems
- present values may reflect future rates of mort, morb, int yeilds, premium patterns adn lapse/surrenders
- calc may refledct probabilities at various dates of options avialable
- "natural reserve"
- assumptions may or may not be specified by gov't regulation
- changes in these assumptions after issue change resulting nonf values
- not as easily understood by public
- expected future experience w/in class is likely to be less homogenouus thatn overall experience
- resulting nonf values may not be truely represetnative
- for UL adn other flex prem products, assumptions must be made concerning payment of future premiums
- nonf value avail to terminatoirs reflect FV of ins protection to peristing PO
- parity between terminators and persistors is maintained
- deterioration in co experience can lead to decreases in nonf value that may lead to misunderstandings
- Net Premium Method
- method req'd for Trad Wl adn soem term life in US
- subset of general prospective method
- PV future guar benefits - PV future net prems
- @ issue PV net prems = PV guar benefits + PV "acq expenses"
- acq expenses defined by law/regulation
- based on pattern and PV of DB and other policy specs
- mort talbes prescribed and range of allowed int rates
- for flex prem pols, asumptions must be made concerning paymetn of future prems
- US SNL not set up for non-req'd prems
- depending on circumstances, assume no future prems paid
- actuary may taek a constant % of assume future prems adn adjust in the future if necessary
- alternative calcs may be available for flex prem UL
- payment of prem may affect DB, which needs to be relected in calc
- if policy guarantees w/in range of permissible under US SNL, then CSV is kosher w/ req
- Single Premium Method
- Life ins is paid up policy w/ single prem mostly borrowed from ins co
- like a mortgage where prem payments are mortgage payments
- CV (nonf benefit) = paid up value of policy less "principal" outstanding on "mortgage"
- not used
Nonforfeiture Practices Operative in Selected Countries
- Canada
- no min nonf law
- "group equity" concept used
- value from terminating policies may be used to reduce prems or raise level of benefit for all policyholders
- South Africa
- small policies require reduced paid-up nonf benefits
- co must file plan that states ruls that apply to nonf benefits adn rules must be approved
- Scandinavia
- no min amts req'd
- PO s/b informed about surrender terms adn how calculated if available
- UK
- no mins req'd
- strong disclosure reg
- typical product is variable life and nonf values function of MV of sep accts
- Austrailia
- no mins req'd
- looking into nonf & disclosure rules
- US
- NF Laws adn regs specific and prescriptive
- SOA Unruh Report - 1976
- discussed equity
- PO, Co, agent & regulator and 4 different views of equity
- equity is not an absolute but relative truth
- in the long run, costs of early terminations will be paid by continuing PO
- in short run, if co cannot fully pass on these costs, it will reflect them in reduced profits, PO divs, or agent comp
The Nonf Calculational Plan
- if formula not mandatory, co may wish (or be req'd) to use written nonf calc plan for each block of business
- specify method for determining amts at all policy durations
- specify relevant non-guar elements
- specify methodologies for determing policy experience assumptions to be used to calc nonf benefits
- specify extent to which these amts have been Guaranteed
- use of calculational plan permits flexibility in design adn management of diff blocks of ins policies
- may be based on retrospective or prospective
- calc may assume no future voluntary terminations or it may reflect all available options
- hoped that large portion of US regulatory nonf framework could be replaced by
- regulation of nonf calculational plan
- reliance on professional actuarial statements of opinion
- enhanced regulation of disclosure
Misc Practical Nonf Issues
- if nonf amts calced retrospective - adjustements for mort anti-selection may be inappropriate
- ETI as automatic option can reduce mortality anti-selection (b/c not in force as long)
- can use more liberal reinstatement rules (b/c no reduction in face while under ETI)
- RPU advantage - original form and expiry continued
- very little mort anti-selection s/b expected
- APL - reinstatement not necessary
- however may provide incentive to discontinue payment of prem
- tends to increase co maint expenses
- companies varied in practice re: substd lives
- some increase CV, most don't
Permanent Products w/ Little or no Nonf Values
- T-100 - lapse supported non-par WL w/ no nonf values (or values well below natural reserve)
- positive profit realized when policy surrendered prior to death
- particularly sensitive to LT pricing assumptions for lapses, inv yields and mort rates
-
Study Notes and Published References - Note SN 81-102-00 - LIFE AND ANNUITY PRODUCTS AND FEATURES
Term Insurance
- Characteristics of Term Ins
- coverage periods adn face amt patterns
- level term - 10,20 yrs or to a given age (65/95/100)
- decr term - usually follow a patter such as mort amort
- in theory, s/b monthly decline, but most annual
- often level off at some point
- incr term - scheduled increases of face amt or x% or related to outside index
- prem patterns and prem guarantees
- level term
- level over entire term period (usually)
- modified (1 or 2 increases during cov period)
- increasing every "x" years
- prem schedule - AA, select, S&U
- S&U challenges
- lower renewal discourages re-entry but fear mortality results will deteriorate the further from orig u/w
- decr term - level prem may eventually be very large compared to DB
- partial solutions:
- limited pay
- decr prem scales
- level db @ later years
- ann incr prem (ART rate * DB)
- incr term - usually incr prem
- coverage guarnteed, sometimes prem not guar
- trad non-par term - prems guar
- trad par term - not very popular
- mod prem - low early year, higher later years w/ divs
- ann incr prems w/ divs @ higher durs
- adv of par term
- high GP -> no def resv
- cushion against adverse deviations
- net outlay may decrease in later years -> better persistency
- slope can lower costs by minimizing CV
- Indeterminate Premium Plans
- current and guar prem scale
- if need to adjust prems
- must be done as a class
- must be done prospectively
- cannot be used to recoup past losses or distribute past gains
- allows aggressive approach to term pricing
- Re-entry Term
- co can charge higher rates if insured fails evidence of insurabillity every x years
- u/w reqs and stds not guaranteed
- anti-selection on those that don't lapse, if not requalified
- premium spiral may develop
- Premium Differences by Size of Policy and by Underwriting Class
- bands very common in competitive ART mkt
- based on size of policy at issue
- Term usually has higher mins for face adn prem b/c need to spread fixed expenses
- higher per $1/prem b/c of lower term prems vs WL
- Lapse experience probabily much diff between term & WL
- Higher pol fees b/c of higher lapses adn not as much inv income to offset inflation
- reinsurance consideration more important for high face amt policies
- pref rates for better u/w risks
- Term Riders
- usually same prem rates as term base plans
- only diff is absence of pol fee on rider
- another term rider is divs to purchase 1 yr ART
- this option may reg add'l u/w and maybe reinsurance
- spousal - usually w/ conversion priv and payor
- kid riders - usually coverage to age 21/25 (or insured age 65)
- w/ conv priv - usually 5x face
- Other Types of Term Products
- joint life products - good fro mortgages or two-income families
- hybrid term products
- level prem term to 65 w/ decrease in DB after x years
- projected divs by YRT adn PUA to keep DB level
- @ 65, PUA balance approx 1/2 issue face
- Deposit Term
- extra high 1st yr prem
- part is "deposit" that provides PE @ EOY 10
- early lapse, "deposit" is forfeit
- theory - encourages persistency
- Policyholder Options in Term Products
- Conversion Priv - most common option
- ability to "trade-in" for perm policy w/o evidence of insurability
- entire face on level benefit plans
- on decr term, usually 80% of orig face
- option usually expires 5 years before end of period
- some pols have automatic conversion
- if dis and have waiver, then conversion is automatic
- some co's allow terminal reserves as premium credits on new pol
- some co's allow 1st yr discounts
- generally felt perm more profitable than term
- GIO may also exist - incre decr term to orig face amt
- Pricing Considerations for Term Ins
- Mortality
- usually significant factor for term ins pricing
- NAR usually greater for Term vs Perm for same face
- A/E mort lower for term than perm
- term face amts higher and large face mort better than overall
- poorer persistency of term tend to weight more of its exposure to earlier policy years
- as less healthy lives convert (or other options), remove themselves from NB term exposure
- recent trends
- large face mort better than overall
- female large face worse than overall
- term large amt experience significantly less favorable than perm large face
- experience varied by band
- > $1mill had best ratios (and better u/w)
- slope of expected mort by dur a concern
- renewal mort influenced by
- extent coverage (intended to be s/t) is continued by unhealthy lives
- ability of healthy lives to rewrite coverage at lower rates
- no best solution to choosing appropriate mortality assumptions
- design of product and how marketed will have substantial effect
- Persistency
- higher early lapses can make it very difficult to recover u/w and issue costs
- high lapses in later policy years may erode expected profits
- dangerous to assume overly optimistic lapse rates
- too many incentives to rewrite business
- product design features which encourage lapses s/b taken into account
- term lapses more serious problem in renewal than FY
- FY term lapses slightly lower than perm
- renewal term lapses > FY term and renewal perm
- U/W
- similar to perm U/W
- may U/W for larger face depending on GIo or auto-increase options
- substd not as available adn w/ more restrictions
- Field Compensation
- varies substantially
- rates may be higher than perm, but smaller prems
- competition has driven comm and prems very low, esp 1st yr
- comm rates may recycle (each tiem a 5 yr renewable renews)
- renewals typically around 5% adn may be limited # years
- reduced comm for exercise of policy options
- renewal lapses tend to be higher on business written by agents w/ brokerage agreements w/ serveral cos
- esp ART plans w/ S&U pricing
- Other Expenses and Inflation
- U/W & issue expense large share of term prem
- renewal expenses often greater % prem than perm
- term very sensitive to way overhead is allocated
- inflation can cause serious problems b/c minimal investment income to cover
- Pricing Options
- 3 approaches
- costs borne by those who exercise
- costs borne by equally by all willing to pay to have option available
- costs borne by all
- pricing for coversion credits
- form of terminal dividend
- incorporate a specific charge based on the expected conversions @ each dur
- develop appropriate pricing factors
- difficult to estimate proportion of insureds who will elect
- conservative to assume that options will be elected
- assumptions as to % of coverage opted
- lapses generally low for option issued policies
- mortality generally higher on option elected policies
- since no u/w, issue expenses lower and lower lapse rates -> can be quite profitable
- Profit Objectives
- common methods
- profit margin measures - PV fut profits as % PV future prems
- IRR - int rate where PV profits = 0
- IRR w/ target surplus objectives
- BE analysis - year accum assets cover reserves
- usually combine a couple of these
- impact of options on profitability depends on how priced
- pricing and profitability can be very sensitive to variations in expected mort/lapse/exp experience
- greater the uncertainty about future profits, higher profit measures s/b targeted
- Legal and Regulatory Issues
- special regs in some states
- many state have detailed rules for indeterminate prem term
- affects advertising, disclosure adn mkting practices
- a few states require certifications at policy filing and prem redetermination
- contestability - two years from orig u/w
- re-entry term - handle like age misstatement
- what DB would be if they used old scale prems w/ what they actually paid
Appendix 1-I
- Experience under Term Conversions and GIO
- Conversion at end of a Specific Year
- A(x,m,r) = [r]p(x,m)*e(x,m,r)*k(x,m,r)*v^r - PV of extra mort due to conversion
- k(x,m,r) = sum{[t-1][p((y,m,r)+t-1)-q([y]+r-1)]*NAR([y]+t)*v^t} across t
- Special Case
- Total of Extra Mort Costs for the Special Case
Appendix 1-II
- Term Conversion Experience
- Conversion Rates
- tend to increase by attained age
- Lapse Experience
- tend to show decreasing pattern of lapses by incr age at conversion
- during 15 year select period after conversion
- female lapses higher than male
- lapse rates for paramed higher than non-med, med lowest
- Mortality Experience
- generally more favorable for policies converted prior to end of conversion period vs last chance conversions
- automatic conv and renewable term - favorable
- decr term - significantly higher
- female ratios (by amt) lower than males
- select period rates lowest for paramed, highest for nonmed
- overall higher ratios for conversions from term policies than from term riders
Appendix 1-III
- Option Pricing Mathematics
- one technique for charging each year's cost of option to term policies eligible for the options
- recognizes optoin losses in policy year they are assumed to occur
- determination of cost of options
- CR(x,t) + [option handling expense / avg size of pols in radix] * [Optoins(x,t,i) / radix]
Universal Life (UL)
- Characteristics of UL
- Development of Cash Values
- prem paid, load deducted, net credited to fund
- fund accumlated w/ interest, deductions for COI, rider, expense charges
- min guar int, but usually credit higher
- max guar COI, but usually charges lower
- SC
- Death Benefit
- two options: 1) specified amount 2) specified amt + CV
- minimum corridor - necessary to retain favorable tax status
- specified amt can be increased (subject to eligibility) decreased (mins may apply) or DB option changed
- Prem Flexibility
- usually pay whatever whenever
- may have req'd first yr prem or a min prem for a few years
- Partial W/D
- may involve admin fee
- both CV and DB reduced
- Policy Loans
- credits below policy loan int rate or guar rate
- loan taken from general acct assets if variable products
- Riders
- WVR, ABB, GIO, spouse, kids, payor
- wvr - waiver of COI or waiver of stipulated prem
- Nonf Options
- no traditional options, but acts like ETI
- COIs paid from fund value as long as it lasts
- can resume payments anytime (if still inforce) w/o evidence
- Int Rates
- usually 1 year guarantees but may declare monthly
- some tied to external index
- portfolio vs new money
- Mortality Charges
- guar COi - AA scales = nonf mort basis for product
- sometimes guar rates > nonf mort (simplified issue or smokers)
- current COI may be AA or S&U
- S&U used when sold as alternative to term
- reverse S&U - helps recover acq costs
- Expense and Surr Charges
- SC - to help recover acq costs
- FEL - less common now
- more expenses recovered from int and mort margins
- currently, usually a % prem charge & per policy annual charge
- Persistency Bonuses
- means of enhancing long dur CV on UL and ISWL pols
- guar persistency bonuses have reserve and nonf implications
- some states don't allow persistency bonuses b/c of tontine-like nature
- some cos don't pay non-guar bonuses when due
- soem cos hold voluntary reserves for non-guar persistency bonuses
- Other UL Products
- Fixed Prem UL (FPUL)
- aka ISWL, EIWL, current assumption WL
- typical characteristics
- fixed prem req (may be waived under VP concept)
- accumulation acct (just like UL)
- min guar set of benfits/values regardless of actual performance (secondary guar)
- low prem version has reduction in guar Db at some point in time
- csv = max(min guar cv, accum acct - SC)
- vanishing premium version most populr
- consideration on vanishing premium
- commissions paid on "vanished" prem?
- what happens to modal loadings after vanish?
- typical low prem plan has drop in DB after 5-10 years (on guar basis)
- methods for overriding drop in DB
- if orig prem still deemed sufficient to produce WL benefits, orig DB extended for another period
- PO given option fo paying higher prem if orig prem not sufficient
- orig db continue if actual csv > min guar csv
- Advantages vs flex prem UL
- contract is more similar to trad than UL
- FPUL pays comm to agent on a high prem/$1m
- fixed nature of prems may enhance persistency in some mkts
- Disadvantages
- no prem flexibility (except vanishing prem)
- additional prems can significantly complicate product and admin reqs
- VP dependent on level of int rates
- Single Premium UL (SPUL)
- flex prem can be sold as single prem
- loads, comm, and other parameters can be tailored for SP inv-oriented sale
- tax advantages elimnated w/ 88 Tax Act (some of them)
- still sold for estate preservation purposes
- popular feature - preferred loans
- Group UL (GUL)
- most active mkt - salary deduction basis at large employers
- advantages over indiv UL
- contracts charge expense loads on a group by group basis (in many states)
- MET files product in 1 state, offer coverage in 30+ states w/o add'l filings
- tendency to include experience rating, mort charges based on historic experience
- Pricing Considerations for UL
- Pricing Different Scenarios
- assume premium pattern will vary
- benfit pattern will vary
- w/d & policy loans from client investment anti-selection
- changing interest margins
- inflation adn other economic factors in indefinite flux
- only more realistec scenarios can be reasonably examined
- important to determine sensitivity of profit studies to deviation in assumptions
- important to monitor actual experience compared to expected results
- Source fo Profit Analysis
- important to balance sources of margin so that most scenarios of prems and persistency result in OK profits
- sources of profit
- interest earned - interest credited
- COI charges - DB paid
- Expense Charges - expenses adn commissions
- surrender charges
- Asset/Liability Analysis
- risk of int rate anit-selection
- if assets held have reduced mkt value, capital losses result if assets ahve to be sold
- UL subject to this mor than other life products b/c mkts focus on credited int rate
- important to test various investment and int crediting strategies under different int rate scenarios
Variable Life Insurance
- Characteristics of Variable Life Ins
- CV matched by assets in sep acct
- PO can (usually) transfer assets among accts w/o imposition of charges
- sep acct assets immunized from liab of rest of ins co
- min cv not guar for variable life products
- unlike most insurance, variable life regulated by SEC (in addition to state regs)
- VUL - "hybrid" product
- similarities to fixed prem variable life
- sep accts
- several inv options
- sales loads may be limited by regs
- other charges may be limited (mort and exp charges, inv advisory fee, policy fee all years (some disagree))
- sales illustrations need to consider approp rate
- margins between policy loan int rate charged and credited
- similarities to UL
- flexible prem payments
- DB types 1 & 2
- changed in DB allowed
- monthly charges
- FY per pol loads
- FY month per $1m loads
- COI (current and max)
- charges for riders deducted from fund
- combination FEL and BEL
- commissions based on multiple factors (sometimes)
- polcy loan int margin ofther larger than fixed prev VLI, often charged "in advance"
- VUL usually designed to look like a UL (where permitted)
- no guar w/r to CV
- GMDB good mktg tool, bot don't offer w/o analysis fo risks involved
- Fixed Prem Variable Life
- similar to trad WL
- prems guar and level by dur and min DB guar fo rlife
- CV varies and guar DB varies by intervals
- 3 basic types fo fixed prem designs
- Dutch Design
- DB and prem constant in # shares, share price is variable
- DB = DB(-1)*inv adj factor
- prem varies by same %
- inv adj factor reflects relationshiop between
- actual net inv eprforamcne of sep acct and
- assumed int rate (AIR) used for calcing NP and reserves
- NY Life Design - 1969 SOA paper
- DB = orig face * actual cv / tabular CV
- more closely resemble fixed-benefit policy
- adjustments to DB conceptually simpler than other designs
- buys prem-paying additions (on orig age basis)
- since GP is fixed, continued favorable performance needed to keep additional Db
- DB more responsive to current inv performance
- cost of GMDB higher than Equitable design
- Equitable Design
- used by virtually all US cos offering fixed prem VLI
- purchase positive or negative PUA from excess net inv performance (>AIR)
- DB can't drop below guar
- Ins co allowed to levy risk charge for GMDB
- adv: DB will increase as long as inv performance > AIR (NY Life design, had to be > than prev period inv performance)
Survivorship Insurance
- pays on second death
- considerably cheaper than two pols for half the face
- attractive in situations where $ needed to pay estate taxes
- can be structured so benefits not subject to estate taxes
- Characteristics of Survivorship Ins
- UL/Trad WL/EIWL very littel term, except as riders w/ trad ins
- PAR WL
- preferred product form - used w/ term riders and divs to PUA to keep DB level
- UL adn I/S products
- potential disadvantage - excess performance to increase CV, not DB
- mkt values DB over CV
- mkt responded w/ variations that work more like Par WL
- UL offers prem flexibility - important to this mkt
- goal lowest possible prem to fund benfits over life of contract @ current assumptions
- Single vs Dual Status
- single status - looks like single life policy - frasier
- dual status - x or y or both alive
- in theory, PVFB increases dramatically at first death
- single/dual decision issues
- perceived marketability of approach
- admin feasibility
- ins regulator attitude
- percieved risk profile
- implications of income in term rider costs for dual status policies
- admin - burden of keeping 3 sets of CV/Vx/div factors for 3 states
- single status approach more popular
- Joint Equal vs Exact Ages
- 3 approaches - exact age, joint equal age, equivalent single age
- Exact Age: determined from first principles based on exact age and risk class of each life
- some cos calc for all permutations and store in file - huge file
- some cos calc factors for each policy as issued and store
- soem cos calc on fly - probably most economical
- Joint Equal Ages: each combo of lives based on roughly equivalent ages
- some jurisdictions need add'l certification, if this method used, that JEA results >= exact age results
- Equivalent Single Age: attempt to equate joint life to single life
- results in serious overcharging in early years and undercharging in later years
- Substd and Uninsurable
- very improtant to survivorship mkt
- increase in cost relatively trivial if only 1 life substd (compared to single life coverages)
- b/c high face - rigorous u/w stds, but often make small concessions b/c highly competitive mkt
- Rating Methods
- Age rateup - if impaired, assigned a high age w/ approx same life expectency
- many insurers don't like age rateups b/c IRS def of life rules
- Extra prem - more difficult w/ substd
- some cos price on a case by case basis using formulas to develop extra prem
- for UL plans, age rateups can determine COI charges or multiples applied to std COI rates
- Uninsurable Lives
- many will still issue if one life uninsurable
- still more attractive than single life policy on healthy life
- important to distinguish between uninsurable and terminal
- other reqs
- uninsurable life must undergo normal u/w and have life expectancy of one or two years
- uninsuralbe must not increase contagion factors due to contagious disease or alcohol misuse w/ adverse MVR
- insurable life u/w as if single life policy
- insurable life must not be highly rated (table D max)
- Mortality Assessment
- critical to understand extremely competitive nature of this mkt
- mkt will react quickly to any pricing mistakes made
- very efficient mkt
- Flexibility adn Competitive Concerns
- product that can respond w/ flexibility are more likely to suceed in this mkt
- funding requirements vary
- some want low levels that fall below gift tax levels
- some want to fund immediately
- Competitive Measures
- rate of return on death at specified duration or life expectancy
- min prem payable over max benefit period req'd to fund benefit on current assumptions
- min prem to vanish in specified # years
- min cash value to vanish
- Riders
- Policy Split Rider
- very few sold, but availability can be deal breaker
- no charge but evidence req'd or
- charge GIO prem and n/c for split (and no evidence)
- only split on specified events (divorce, tax law change, etc)
- Estate Preservation Rider - specifically developed for US tax environment
- First-to-Die Term Rider
- used to
- rollout split dollar policies
- fund policy after 1st death
- pay some estate taxes
- split dollar prem recovery
- riders included in basic prem (no charge) or specified charge
- specified charge preferred
- valuation questions w/ free term ins
- sophisticated mkt knows nothing is free
- if needed, cost realtively small and insureds willing to pay for it
- Pricing Considerations for Survivorship Insurance
- mortality assumptions
- factors to consider
- anticipated level of single life mortality for class of PO being targeted usually considerably different from regular single life business
- degree of u/w concession provided
- contagion - in form of joint accident risk
- "broken heart" syndrome
- additional factors
- impact from almost all being medically u/w
- socio-economic class of lives insured
- impact of very low lapses on long-term mortality
- implications of all issued policies covering "married" individuals
- cos often lack credible basis for estimating female mort at very advanced ages
- Persistency
- initial results very good
- lapse-supported products potentially dangerous
- Expenses
- often expressed as amt/policy for this mkt
- expenses should reflect u/w two lives usually w/ multiple APS
- per pol maint exp assumed higher as well
- Reinsurance
- high face amts -> reins vital role in pricing
- some cos increased retention
- logic - if took out sep policies, but under retention, we'd pay out 2x DB on them
- PO Taxation
- low lapse rates can produce counter-intuitive results w/r to cv scales
Appendix 4-III
- Contagion Risk
- normally assume death of individual is independent event
- to exent not true, exists a risk to insurer (contagion risk)
- heartbreak (or lonely-heart syndrome)
- joint accident risk
- problem compounded by lower lapse rates after first death
Extra Premiums for Substandard Life Ins Risks
- Substd risks -
- varying patterns of level and incidence of extra mortality
- level # deaths (independent of age)
- level % of extra mortality
- increasing %
- decreasing %
- slowly decreasing 5
- theoretically, sep mort table for each impairment
- most impairments, difficult to obtain sufficient data to define precise patterns
- most cos - 2 systems to classify extra mort
- multiple table classes
- flat extra - good for consistent extra # deaths/thousand
- used for s/t impairments and hazardous avocations
- numerical rating - debits (unfavorable) adn credits (favorable)
- final results consistent w/ good judgement
- criticized as too arbitrary
- other methods (rarely used)
- advance in age (age rate-up)
- return of prem - in lieu of DB for first n years
- Lien method - reduced fact amount grading to full DB in a few years
- different prems for each subst class, diff NF values and divs to reflect actual experience
- few cos ahve sufficient experience to justify
- if extra hazard too difficult to classify, exclusion clause may be used
- exclusions limited in some jurisdictions
- most substd business written on a multiple table extra basis
- Substd Rating Classes
- decide on # of substd classes and mort range for each class
- consider broad or narrow classifications
- if smaller amts adn/or simplified u/w, usually higher limit for std class and few broad substd classes
- Gross Extra Prems
- Mortality
- std mort table should not have any margins so margins aren't distorted when table multiples applied
- some co's adjust table so an absolute differnece in mortaltiy beyond a certain point
- multiple s/b aruond midpoint of rating range for each class
- Subdivision into M/F adn S/N
- substd usually around 4-8% of business
- splitting substd into M/F S/N may not be worth effort
- if only using 1 set of extra prems, may use age setback
- some indication that relative diff is less for substd than std
- for nonsmokers, if slightly substd, might issue as std smoker vs substd nonsmoker
- Subdivisions by Plan
- Term w/ IA/Dur substd can generate prems higher than substd perm
- causes higher not-takens and lapses on term
- UL - either extra charge for mortality element
- or amt of coverage w/r to "investment" element decreased
- VLI - for simplicity, often same extra prem as trad plan of same face
- single prem - wider classes to absorb more of substd as std
- reduce amt of coverage
- NAR smaller for single prem plans & potential anti-selection reduced
- can always limit certain plans to only std risks
- Expenses
- consideration for expenses properly chargable to substd pols only
- not spread across all pols
- two extremes
- business of taking risks, so expenses, regardless of source, s/b shared across all business
- substd shoudl stand on its own AND contribute to surplus
- usually reqs more u/w (and more experiended U/W), but often expenses not split
- maint expenses generally same, except for requests for rating reduction/removal
- Not Taken & Lapse Rates
- higher and increase as ratings increase
- not takens > 50% in highest rating classes
- lapse rates higher too which drives up substd costs adn fewer pols to amortize initial expense
- Extra Cost of ETI & RPU for Trad Risks
- usually provide ETI/RPU at std mortality
- ETI not available for higher substd classes
- extra cost is single prem to provide benefit at substd mort - single prem to provide benefit at std mort
- Prem Paying Period
- theoretically correct to charge for whole premium period
- can cause prems to exceed face
- some cos limit WL extra prems to max (AA65, 20yrs)
- common to remove hazardous avocations prems after max(AA65, 10yrs)
- Gross Extra Prem Calc
- expereince gross extra prem = experience substd total gross prem - experience std gross prem
- GP_R = NP_R(1+c) + I_R / adue_R(x:n) + k_R + Z_R*GP_R
- GP = NP(1+c) + I / adue(x:n) + k + Z*GP
- wehre R - Rating Class GP - Gross Prem/amt GEP - gross extra prem/unit
- NP - net AP/unit c - per policy claim cost/avg size pol
- I = acq exp per pol / avg size pol
- k - other constant expense incl maint exp/unit, level ann acq extra cost for substd ETI/RPU
- Z - level ann equiv expenses as % prems
- GEP_R = (NP_R - NP)*(1+c) + (I_R/adur_R(x:n) - I/adue(x:n)) + (k_R - k) + GP*(Z_R - Z)/(1-Z_R)
- another method - use asset shares at key ages to determine extra prem that meets targeted surplus
- Cash Values
- since co's usally use std cash values, may want to reduce scale of gross extra prems
- in theory, substd CV would be higher
- Asset Share Tests
- adequacy of substd experience prems s/b tested by asset shares
- select mortality and lapse rates introduced
- should give effect of using std CV, std divs adn extra cost of nonf benefits
- should serve as a check on level exp prems and give basis for making final adjustments to gross extra level prems
- Temporary or Permanent Flat Extra Premiums
- principles same for temp and perm
- reverse of table extra
- prems set first & class rating set afterwards
- provision for extra expenses likely to be less
- expenses usually less
- commissions usually not payable on flat extras
- addition of substd expenses makes intial prems too high
- take prem/$ (usually 2.50, 5.00,7.50, 10.00)
- subtract out expenses
- remainder is annual # extra deaths/thou covered by flat extra prem
- Supplementary Benefits
- same theries apply to subb ben (wvr, ADB, etc)
- as practical matter, most co's charge a multiple fo basic charge
- if rated too high, not available
- Reduction adn Removal of Ratings
- in theory, pricing should reflect removal of ratings from those who later become eligible (via re-u/w) to have ratings removed
Fixed Deferred Annuities
- SPDA
- sold both qual and non-qual mkts
- min size usually $5,000-10,000 - some qual IRAs $2000
- FEL or periodic fees - may charge explicit FE loads or periodic fees
- SC - % of acct value
- % declines over time
- purpose: recover acq costs
- Int rate and int guar period - min guar rate
- usually initial guar rate > min for x years
- renewal rates - generally blend between supportable rate adn competitor rates
- usually guar for 1 policy year
- FPDA
- FE loads adn periodic fees
- may charge FE load
- many have annual charge for periodic policy maint
- SC - % of total annuity acct value
- % grades off
- sometime big drops (plateus and cliffs)
- sometimes:
- SC associated w/ each prem payment (as % prem)
- level % of sum prems paid over previuos x months
- level % of min(acct value, last x years' premiums)
- Int Rates and Intr guar periods
- generally slightly lower rates than SPDAs
- initial rate typically guar 1 year
- Variations in Design
- CD annuities
- SC period adn int rate guarnatees coterminus
- @ end fo guar, 30-60 day window to surr w/o penalty
- SC designed to mimic CD
- loss 6 mo's excess or total interest
- loss of all excess int credited since beg of guar peroid
- level % of acct value - usually 1/2 current int rate
- at end of guar, can renew for same or diff guar period @ then current rates
- deault is usually same renewal period
- initial comm vary by length of guar
- renewal comm usually paid as full first year w/ each renewal
- MVA annuities
- interim contract values based on both SC adn MVA formula
- MVA formula reflects chagnes in current rates since beg of int rate guar period
- typically longer int rate guar than SPDAs
- no MVA @ end of guar period, but may still be SC
- normally MVA is opposite directoin of mkt int rate movement
- intended to reduce disintermediation risk - enables crediting higher rates
- typical formula [(1+a)/(a+b+c)]^(n-t)
- n - lenght of current int rate guar period
- t - period (dur) since beg of current guar period
- a - current guar
- b - current rate
- c - constant factor (0-50 bps)
- "c" constant factor used ot force at last that amt of mkt change before any impact
- some cos don't use factor
- some say MVA formula only applicable if rates changed more than x bps
- reduction in int rate risk results in more favorable stat reserve adn req capital provisions
- Two-Tiered Annuities
- commonly sold in tax qual mkt
- accumlates two values, one fo rannuitization, one for surrender
- some products cap differences between two balances
- designed to encourange PO to keep money w/ co and maintain equity between terminating and persisting PO
- criticism - customers don't understand difference between tiers and illustrations confusing
- Non-Surrenderable Annuities
- surrenders not allowed, except at specified times - typically end of guar periods
- might be limited penalty free w/d provision
- might have loan provisions
- generally no SC
- insurers hestitant to offer since percieved as less mktable than MVAs due to reduced liquidity
- Other Product Features
- Bailout Provisions - waive SC if declared renewal rate drops below defined bailout rate
- may have window period to exercise bailout
- may be permanent waiver
- may be in effect until renew > bailout declared
- once triggered, if PO doesn't exercise rate
- provisions continue as is
- provisoin continues, but bailout reset
- provisoin is terminated
- Medical Bailouts
- when confined to a nursing home or LTC facility
- if conditions trigger non-subjective, easily administered adn not easily abuse, cost is relatively low (< 10 bps)
- Penalty-Free Partial W/D provisions
- cann surrender a portion of acct value w/o SC
- typically avail on full surrender also
- variation - allow unused portion of penalty free w/d to be carried forward
- subject to min w/d amt adn min remaining acct balance
- Return of Principle Guarantee - SV >= prems paid (adj for prior partial w/d)
- stat reserves need to be higher w/ this secondary guar
- if no comm chargeback, beware of churning
- Death Benefits
- normally = acct value
- some = CSV
- some (if allowed by law) - No DB
- Waiver of SC upon Annuitization - may req additional reserve
- Guaranteed Settlement rates
- generally conservative but may impact reserve calculations
- Acct Value Enhancement (bonus)
- annuitization bonus - most common - encourages funds to remain w/ co
- persistency bonus - encourage LT persistency
- bonuses on large acct values
- first year int bonus - designed to attract new funds
- may be vesting schedule for bonus amt
- Princing Considerations for Def Annuities
- C-3 risk - assets arising from a product will be insufficient to fund products liabs due to chagnes in interest rate environment
- DA PO has option of selecting against co
- Interest Spread
- goal of princing exercise - determination of targeted int spread req'd to meed profit objective
- used periodically to set current int rate on NB and renewal rate on EB
- affected by competitive considerations (both other carriers and other (bank cds))
- targeted spreads generally 125-200 bps
- actually usually less due to competitive pressures
- components of spread (what it has to cover)
- spread req'd for inv, acq, maint and commission expenses
- spread req'd for freatures like bailout
- spread req'd for risk cahrges for assuming asset risks
- spread req'd fro expected profit margin
- Pricing must use
- realistic provisions for costs fo features like bailout
- realistic provisions for cost of the int rate risks assumed
- realistic assumptions for w/d, expense, mortality
- Crediting Strategy
- int spread is principal source of revenue available
- consideration of most effective ongoing crediting strategies for realizing targeted spread over princing horizon
- in general, excess laspes -> profit margin not being met
- if still in SC period, "real" int rate = credited rate and decline in SC
- to understand optimal crediting strategy, product design may be evaluated under various crediting strategies by use of int rate scenario pricing
- potential crediting strategies
- net protfolio yield less targeted spread
- net protfolio yiled less targeted spread, but never above competitors rate + x% adn never more than y% below competitors rate
- z% of (net portfolio yield less targeted spread) + (100-z)% of competitors rate
- w/d rates need to reflrect competitiveness of credited rates and magnitude of SC
- examples: a*(j-i-b)*SV/AV + c
- a*(j-i)^b - c*SC + d
- a,b,c,d constants, i- our rate, j - competitors rate
- Withdrawal
- one of most significant pricing assumptions for DAs
- affected by
- SC - incidence and magniture
- credited int rate - level and competitiveness
- distribution system
- int guarantee periods - length and expiration
- age and economic status of PO
- size of contract
- perceived fin strenght of ins carrier
- Partial W/D Provisions
- need assumptions as to amt of CV w/d under provision
- impact of penalty-free w/d on stat reserves s/b incorporated ito profit test
- Mortality
- genearlly not a significant factor
- an annuity mortality table is not appropriate for DA DBs
- S&U life experience not appropriate sicne annuitants do not undergo u/w selection process
- very little guidance as to what table is appropriate
- important consideration at older issue ages (75-85 when mort rate approx 5-8% decrement to inforce
- either restrict issues beyond those ages or reduce commissions
- more difficult to fully amortize comm and acq expenses
- mort also important if DB is excess of CV paid on both death of annuitant and death of non-annuitant owner
- Commissions and other Mktg Expenses
- SPDAs - 3-8%
- FPDAs - typically 7% 1st yr, 3% ren
- some cos use levelized for FPDAs
- CD annuities typically pay renewal at end of guarantee on those that renew
- Expenses
- acq expenses relatively low
- no u/w
- just mktg adn policy issue
- maint expenses relatively low
- Effect of Competition of Expenses adn Compensation Levels
- significant non-ins competitors for DA $
- money mkt, mutal funds, CDs
- underlying asset portfolio of other mkt entities may be significantly diff from ins co in terms of dur and quality
- to compete sucessully, need to admin business adn compensate field force w/in mkt pressure constraints
- restraint in product design to eliminate aspects which increase admin cost w/o increase in competitive advantage
- Surplus Strain
- potential to deplete surplus if significant volumes written
- sources
- first year comm
- reserve increases
- "avg" strain - 4-5% of premium
- additional surplus needed for both solvency purposes and to maintain adequate ratings
- 3.6% of reserves depending on product design and investment strategy
- since surplus limiting resource, distributable profits is profit measure in pricing
- Bailout Pricing
- possible additional surplus strain assoc w/ product design due to stat reserve reqs
- value of option itself, cost of excess lapses adn lost SC if triggered
- cost of artificially supporting renewal rate to not trigger bailout
- estimated cost of bailout provision - avg lost SC * assumed excess lapser rate * probability of trigger
- actual cost - add'l spread req'd to force media profit test from dynamic scenarios to equial profit objectives vs traditional deterministic profit test
- cost of option iself and cost of additional suplus req'd by option presence (in bps) represents total cost of provision
- s/b able to pass entire cost on to PO, but competition forces gap between actual and charged cost
- Pricing CD annuities
- two specific items to consider
- w/d rates @ end of int guar period (can be very high)
- if renewal comm paid if contract renews
- if so, what level
- comm usually paid since proceeds very liquid adn easily movable by agent w/o penalty
- Int Scenario Pricing
- deterministic profit test typically has more favorable results then median results under int scenario pricing
- allows costs associated w/ assumptions of int rate risk to be quantified
- objective - quantify risk vs return trade-offs adn decide on optimal strategies
- a co that does not understand who inv and crediting strategies they've adopted affect CF patterns is at serious financial risk
- Profit Objectives
- profit margin - PV stat book profits (dist profits if include TS) as % of PV prems - either pre/post tax
- internal rate of return - int rate PV stat book profits = 0
- BE year w/r to reserves
- even if objective is only one of these, monitor all 3 as they provide valuable insight
- most cos use a combo
- BE-year more important w/ annuities than life
- target: BE yb end of SC period (or first window w/ CD annuities)
- Pricing Horizons
- generally much shorter than life ins
- 10-20 yrs
- shorter for SPDAs adn non-qual FPDAs
- longer for tax-qual FPDAs
Variable Deferred Annuities
- Overview
- provides benefits which vary according to inv experienc of supportin gassets
- does not have int guarantees like a fixed annuity
- PO bears inv risk and receives inv return actually earned, less charges assessed by co
- general acct may be restricted (by law) as to type and quality of investments it may hold
- sep acct - few (if any) restrictions
- historical rationale for VA - protection of retirement income from inflation
- protection of retirement income from inflatoin - crucial goal of ret savings program
- VAs eliminate C-3 risk found in fixed DAs
- Characteristics of VAs
- often "combination" contracts - offer both fixed and variable adn may allow PO to have funds in each
- may allow transfers between accts
- allowing transfers out of fixed exposes co to risk of anti-selection in timing
- product differences reflect differences in expense levels for mktg, agent comp or admin
- Product Guarantees
- full acct value @ death w/ no SC
- may have GMDB
- ins co bearing inv risk for contingency of death
- assessed charges guaranteed to remain level or below stated max
- contract stipulates annuity purchase rate used to determine initial annuity payment
- Product Charges
- FEL
- rear-end load or SC
- 3-12% of prems or accum value
- decr often to zero
- % of asset charges
- .5 - 1.75% per year
- extra charges for optional guaratnees
- other fees - may be assessed a periodic fixed fee
- Admin Considerations
- much more complex than for fixed annuities
- calculation of unit values on daily basis
- timely processing essential
- SEC requires all disbursements made w/in certain period after request rec'd
- all trx processed effective as of date paperwork rec'd
- SEC req most trx confirmed to PO w/in certain period
- significant mailing expense
- Pricing Considerations for Variable Deferred Annuities
- b/c guarantees limited, pricing consists of selecting product charge structure which will provide adequate profit after recovering sales, admin, adn inv expenses (w/in competitive constraints)
- Lapse
- key factor impacting profitability of BEL products
- b/c primary souce of income is asset charge, brings in more income in later years since expenses don't grow significantly w/ asset growth
- Premium Persistency
- difficult to anticipate VA premium persistency
- limited historical experience
- dependent upon mkt sold in adn feature and economic conditions
- Avg Size
- single prem if SPDA
- anticipated amt of recurring prem on an FPDA
- admin expenses relatively consistent for each contract
- greater prem flow/contract -> greater profit
- Expenses
- regulatory requirements & UV calcs -> high admin expenses
- agent comm substantially less as % prem vs Life Ins
- Pricing Minimum Death Benefit Reserves for VAs
- need to anticipate
- allocation of assets among funds & fixed acct
- mean and variance of total returns for each class
- age/sex distribution of PO cohort for mortality
- sep models for FPDA adn SPDAs
- dur or inforce policies
- consolidate info into one formula where asset charges (equal to expected claim costs) added each month
- actual claim costs deducted
- int on reserve accrues
- Investment Options
- most VAs offer 2 or more types of inv funds
- prospectus states investment objectives of fund and investment policy used to carry out objective
- investment options available in payout period may be more limited then during accum phase
Appendix 7-I: Variable Product Mechanics
- Units
- variable equivalent to dollars
- each contract has x "units" of participatoin in fund
- Accumulation Phase
- account maintained for each contractholder
- account has balance of x units
- acct value = units * unit value
- Calc of Accumulation Unit Values
- at fund inception, unit is assigned an arbitrary unit value
- Sep acct Alone - assume 1 day valn period
- NIF(t) = 1 + [II(t) + UCG(t) + RCG(t-1) - EXP(t)] / R(t-1) - Daily Asset Charges
- AUV9t) = AUV(t-1) * NIF(t)
- II - Inv Income => divs + accrued int
- R - reserve
- EXp - any Inv Exp & deducted directly from II
- RCG/UCG - realize/unrealize cap gains
- NIF - Net inv factor
- AUV - accum unit value
- Unit Investment Trust
- net asset share for each valn period = mkt value of assets / # fund shares held
- NIF(t) = 1 + a/b
- a - value of fund shares held by SA @ EOP less value fo fund share held by SA @ EOP(-1)
- b - total accumation acct values plus annuity reserves @ EOP(-1)
- Annuity (Payout) Phase
- initial VA payout payment based upon AIR
- subsequent payments incr or decr depending on relationship between AIR adn actual inv performance
- unit values supply mechanical method used to determine payments
- each annuity payment = prev payment * UV(t) / UV(t-1)
- Annuity Unit Value - UV(t) = UV(t-1) + (1+NIF(t))/(1+AIR)^(x/365)
- this is different UV than before
- usually assign a # annuity units to payout annuity
- # annuity units = initial payment / ann.uv
- # annuity units * ann.uv(t) = payment(t)
- AIR methodology - at each pmt date, annuity value reflects actual perforamnce to date, but AIR for remainder of annuity period
Income Annuities
- Overview
- guarantee periodic income for a certain period of time, life of annuitant, or both
- pmts usually begin immediately
- rarely - has deferral period => deferred income annuities
- refund options - introduce a DB reature to income annuity which reduces living benefits
- income escalation options - hedge against inflation
- payment-certain annuities for a special set of products - used to provide guar income for limited period, fund an endowment program or as a gift annuity
- specialty mkts
- structured settlements (most significant)
- state lotteries by bid
- gift annuities through charitable institutions
- reverse mortgages
- Characteristics of Income Annuities
- Life Only
- Life w/ n years certain
- Unit refund
- joint and survivor
- payments for a specified period
- tax-qual plans have maximums for certain periods
- Choice of AIR - variable vs Fixed annuity payout
- higher AIR -> higher initial payment
- but relation to actual, pmts could go down for a higher AIR
- lower AIR could have higher ultimate payments
- Pricing Considerations for Income Annuities
- virtually all are single premium products
- assumptions needed for
- projected benefit flows
- prem taxes
- commissions
- admin expenses
- FIT, cost of cap, etc may be part of formula or part of profitability analysis
- for trad ret annuities, most of CF concentrated in early durations and quickly trail off
- structured settlement annuities - cash flows spread into later years
- often substd mort. If u/w, could have large loss if life was std
- int rate should reflect current rates available, adjusted to produce targeted levels of profit
- traditionally used a LT rate for all durations
- current trend, use spot rates at each dur adn LT rate for durations beyond last spot rate
- Mortality
- selection of appropriate mort assumptions for CF made based on know (or assumed) characteristics of annuitant population
- sex distinct rates used, except when unisex required by regulation
- should reflect realistic death rates w/ margins added for conservatism and future potential improvements in mortality
- future mort improvement for potential medical advances reflected through sue of projection scale factors
- substd mortality reflected where life expectancy projected by u/w/medical director is materially different than std mortality table
- constant multiple mort - determine m% constant cultiple such that resultant qxs generate a life expectancy of n years
- rated age mortality - adjust IA so life expectancy @ adjusted age is n years
- constatn extra deaths mortality - add contant k deaths/M to std qxs to get life expentancy of n years
- rated age is most common
- constant multiple and rated age produce similar actuarail values
- rate age - reserves fall off too quickly
- both maintain extra mortality in all durations
- many impairments - expected mortality improves w/ time
- Premium Taxes, Commissions adn Admin Expenses
- prem taxes usually assessed as charges up front
- comm - 2-4% of gross prem payable at issue
- admin charges included in pricing formula to cover future servicing costs
- asset charges for variables - major source of income
- often same as during accum phase
- policy fee - permits explicit recovery of 1st yr acq costs
- Statutory Surplus Strain
- important to consider as part of pricing & PD process
- solvency based reservs (US Stat) calc using int and mort
- that combines to produce conservative reserves (compared to pricing generally)
- reserve at issue typically exceeds premium charged for annuity benefits
- often > gross (fully loaded) considerations as well
Study Notes and Published References - Note SN 8I-103-01 - POLICYHOLDER DIVIDENDS
Introduction
- Dividend scale need only provide broad based equity between different classes of policies w/in LOB
Backgorund
- NY has set lots of div rules
- most mutuals domiciled in NY
- NY rules have been considered good actuarial practice
Participating Policies
- What is a par policy?
- a policy which is part of a dividend calss that has very high probability that the class will be self supporting over the long run, even if very adverse experience occurs
- What are the legal rights of the PO in a mutual ins co?
- any favorable experience retained as increased surplus or paid as PO divs
- very limited rights as owners
- right to receive fair (equitable) share of surplus from their block of business
- co cannot take larger charge for contributions to retained surplus in mutual co than what is needed to assure co's financial ability to meet its obligations, including reasonable rates of growth
- if mutual co were to cease doing business, non-distributed surplus would be claimed by co's state of domicile
- if co is becoming smaller, Actuary should try to avoid creating a tontine for last few PO
- in mutual, each block of business s/b self sustaining over its lifetime
- block is obligated to repay any surplus strain w/ int at fair rate of return that must be higher than expected LT growth of CO
- inforce div scales protected (or smoothed) against large sudden fluctuations due to unforseen future losses by co's total surplus
- all inforce should contribute towards building up Co's total retained surplus
- these contributions considered a true risk premium
- dividends must include charge for expected LT growth rate of co
- charge established to maintain cos TS and limited to stat after0tax ROI (incl provision for TS)
- regardless of ROI, each generation of PO should contribute a reasonable minimum amt to retained surplus
- if mutual uses capital to finance accelerated growth, any additional costs in excess of internally generated capital s/b charged to NB
- a charge could be made to EB, but only if assumed or rationalized that EB benefits from ths growth
- Participating Lines of a Stock Co
- compnay must not take an unfair charge for profits to be paid to stockholders
- How are Par Policies Different from Non-Par policies?
- Par policies w/ other non-guar elements
- mutual may issue par policy that may adjust for future experience using non-guar elements other than divs
- non-guar elements other than divs must be based on future expected experience and not actual past results
- often classified as "par, but not expected to pay divs" and policy must state the same
- should have prems reviewed periodically to see if ad-hoc div necessary
- Policies described as Par, but where div scale fixed at issue
- fixed divs or coupons - used to avoid def reserves
- technically not guaranteed, cos had no intention of varying and do not stat that they share in any excess earnings
- cannot legally be sold in all states
- since technically labeled as par, actuary needs to disclose that does not follow contributory principle
- if policy states these policies will share in future excess earnings, not varying div creates professional prob for actuary and legal prob for co and board
- if contract states PO will participate, excess gains should increase divs
Dividend Actuary
- Who is the Dividend Actuary?
- MAAA who recommends a scale of PO divs to Board that follows contributory principle and equitable to PO w/in LOB
- Also responsible for AS disclosures
- different actuary could be responsible for each LOB
- few cos have a title "Dividend Actuary"
- CV ind life generates majority of annual divs payable for most mutuals
- Actuary should know how theory applies to other lines and how they interrelate
- critical for actuary to ahve understanding of historical treatment of block, including pricing
- sometimes this info isn't well documented and passed on via discussion
- company history is very important
- What are the Dividend Actuary's responsibilities?
- Ask "who is my client adn to whom and I responsible"
- Ins Co is employer, but responsibilities to PO, Board, possibly others and professional responsibilities
- legal responsibility of Board to set aggregate amt of divs
- Div Actuary w/ Sr Mgmt should advise
- Div Actuary responsible for establishing formula that will distribute aggregate amt in an equitable manner in proportion to major sources of past and current (but not future) earnings
- if Board chooses not to distribute divs in a manner recommend by Div Actuary and action not consistent w/ AAA ASOP, actuary must clearly disclose on annual statement
Sources of Earnings that Drive a Dividend Scale
- annual div scale should vary in proportion to how major sources of earnings vary
- Investment Earnings (Interest)
- largest single source of excess earnings for most CV products
- Div Actuary must bridge diff between Stat accts and how inv income tracked for div purposes
- Cap gains is an inter-generational equity issue
- Div Actuary must also decide whether changes in unrealized cap gains s/b included in distribution
- IMR and AVR capture capital gains before releasing into surplus so Div Actuary hsa to consider whether capital gains s/b paid out faster than the spreading provided by these reserves
- since cap gains need to be smoothed, spreading must be over reasonable period
- cap gains on bonds/mort - IMR does spreading automatically - no futher adjustments needed, except for increasing inv returns by gains released from IMR
- Investment Crediting Methods: Portfolio/IYM
- during periods of high inv returns, cos pressured to consider adopting IYM
- if IYM being used, inequitable to merge an old block w/ new block if new money rates lower than earnings on existing business
- method of allocating inv earnings to a block of EB is not normally changed
- Special Concerns for IYM: Defining new classes
- actuary may need ot decide whether forming a new portfolio rate was appropriate and not harmful to older policies
- Policy Loans: Fixed or Variable Loan Rates & Direct recognition of Loans
- Fixed load rate w/o direct recognition of loans
- historically, policy loan int and balances included in determining portfolio rate for all policies
- if policy loan rate < rate co currently earning on other investments, then an incr in loans can have effect of lowering divs on all pols
- cos worked w/ regulators to allow variable loan int rates and/or direct recognition
- Fixed Loan Rate w/ Direct Recognition of Loans:
- each policy receives a dividend that reflects earnings on loaned and non-loaned portions of CV
- have to track loan rate, amt of loan, fraction of year loan outstanding
- Div Actuary should set loan spread at a level where co makes similar contribution to suprlus, expenses adn taxes from earnings on loanded and non-loaned CV
- some cos have loaned adn non-loaned div scales and interpolate
- Alternate: calc non-loaned div and adjust based on avg loan in policy year * (non-loaned - loaned int rate)
- method is self-adjusting and equitable
- "conditional recognition" limits divs paid on loaned pols to not more than that paid on non-loaned pols
- Variable Loan Rate w/o direct recognition of loans
- divs on loaned pols do not reflect their own loan activity
- div rate reglects int on loans and loan balances of all PO in block
- can produce distortions on illustrations for portfolio based div scales if new money rates drop rapidly
- generally equitable, but borrowing still affects divs for non-loanded pols
- Variable Loan Rate w/ Direct Recognition of Loans
- maintains equity between loaned and non-loaned portions of policy values
- some states have caps on loan int rate
- variation in div adjustments for loans by state may be additional admin problem
- Update Programs
- most companies elected to update business on PO election basis, to the new method used by the co
- What Assets Back the Div Int Rate?
- only actively invested assets shoudl back the dividend scale
- a company can use a segmented method between lines of business
- in can use IYM for some blocks and portfolio for others
- this will influence what assets are chosen to back the div scale
- Mortality Experience
- normally block by block, if experience is credible
- traditional div method
- use ultimate mort in divs scale
- use select mort gains to offset u/w and acq expense
- Expense Experience
- often the catchall and called "loading"
- can include items other than direct expesnes such as taxes not included elsewhere
- expense allocation should not favor NB at cost of older policies
- old business should reflect any increased costs of handling these pols
- inflation can cause rapid increase in unit costs, if co not growing faster than rate of inflation
- differences between actual and pricing s/b resolved
- Persistency
- lapse can be directly or indirectly reflected
- depends on how co sets annual div scale
- initial div scale has lapse assumption based on recent or expected experience
- expense charge includes amount of intial expenses
- assuming policy not lapse supported, expense charges can be lowered if lapse rates decline
- lapses can also affect mortality => high lapse rates can lead to adverse mortality
- Other Issues
- Taxes
- taxes which affect other components s/b reflected in component that generates income to be taxed
- using marginal or actual tax rates by the tax law drivers can be used
- actuary must understand current and prior tax laws
- special tax items - Dac tax, equity based tax adn tax vs stat reserves need to be considered and vary by block
- Mergers
- experience of both cos must be combined over time in such a way as to maintain equity for PO of either co, relative to what they had prior
- merger should lower total expenses
- savings s/b allocated to all blocks
- expenses incurred in merger s/b charged against future expense savings
- important that divs on one block not reduced in order to increase divs to merged block
- in defining equity - must look at past separately, but must merge into future experience
- Reinsurance
- risk reinsurance s/b reflected in proper div componenet as expense of that block
- financial reins (used to manage total surp) generally not reflected ina give block, even if that block is reinsured
- can increase cost of capital
Changing Dividend Scales
- scales will be changed periodically, particularly when changes in experience are material
- consider admin cost of changing div scale
- normally advisable to avoid minor temporary declines in payable divs
- Pegging is a smoothing or transitional method used if current dividend to be paid is lower than prior year's div
- trys to pay div at least as large as they rec'd previous year
- only peg non-loaned div if direct recognition
- if future divs on current scale higher than amt paid last year, part (or all) of current reduction eliminated
- usually only look 2-3 years ahead when pegging
- Substitution - replaces current formula div that would be paid with a previous formula scale
- best used for recent issues only and only for first few divs
- usually only used for annual premium business since little or no early CV exist
- Pegging and Substitution slightly improve persistency which may offest part of extra cost
- modified pegging method - experience premium method
- stopped divs from declining in $ terms, but carried cost into future policy years
Adjusting for Experience Changes: Block vs Average
- credible experience - to avoid random variations
- if block too small, blend experience w/ overall co experience
- avg several years to stabilize as well
- can use co avgs instead of tracking each block if no reason to assume a difference
- mortality and morbidity (in general) all that needs averaging
- cost of rein and reinsured claims can be handled several ways
- eliminate claims paid by reinsurer and reflect cost of rein net of claims
- expenses normally stable
- one time exceptional costs can be spread over several years
- change in persistency can effect initial expense recovery speed
- do not overallocate to old blocks of business
- policy fees s/b refelcted per policy
- direct expenses => block incurred
Illustrations vs Payable Scales
- illustrated scale should not exceed actual factors underlying payable scale (NB)
- illustrated scale should not contain pegged or substitued divs (NB)
- inforce illustrations can reflect pegging that is expected to accur assuming practice will continue
- illustration shoul not exceed payable scale, but can be lower if justified
- exceptional one-teim div payments should not be illustrated
- illustrate current div assumptions only if based on actual recent past experience
- IYM divs s/b illustrated using currently available new money rates, rather than overall inv earnings of co
Public Statements of the Dividend Actuary
- statements s/b checked for completeness to assure that they provide comprehensive, important information adn are not misleading
Forming New Classes for New Business
- Mortality Classes
- if new block of business formed, but u/w stds not changed, a new class need not be formed
- for material change in u/w rules or policy rating classification, a new mort class s/b established when material difference in experience are expected or actually emerge
- IYM
- form a new class whenever new money rates have changed by a material amt (1/2%) over a reasonable period of time (6-12 mo)
Retained Surplus
- What is a Reasonable Retained Surplus?
- very complex and needs to be looked at from both co-wide and block basis
- more than amt needed to meet current guarantees - also need to consider suplus needs of future co growth
- Terminal Divs
- paid at death or surr
- some cos believe par block should return most of surplus block produced before last policy terminates
- other cos pay as release of risk - in that needed surplus of co is reduced if pol not inforce
- Stat only allows terminal divs expected to be paid in the next year
- most terminal divs set at issue and rarely changed
- Entity (permanently retained) Surplus
- larger initial strain or smaller the margins, larger expected permanent annual contribution to surplus to reflect risk
- what is a reasonable amt for annual permanent contribution to surplus?
- the amt req'd that will
- allow co to grow at targeted rate
- avoid increasing unit expense costs
- maintain total surplus over long periods at leaste at a minimum level related to future risk
- annual contribution should not be varied by rate of growth of new sales or changes in NB strain
- Week's Axioms - "if a company experiences each year uniform rates of intial expense, renewal expense, mortality and interest, then the divs ought not to change merely b/c of changes in either the volume or NB or in its distribution by plan or age"
- special considerations if co fails to grow and surplus is accumulating
- excess accumulation of entity surplus s/b used to restart growth of co
- Limitations on Aggregate Retained Surplus
- most states do not limit amt of retained stat surplus for a mutual
- NY does limit - max(10% stat reserves and liabs,sqrt(7% stat policy reserves^2 + 35% health prems^2))
- Expense Allocation by Block
- complex since individual judgement as to allocation of overhead
- NY Reg 33 and Holding Co Act give guidance in allocations by line
- once split by line, Actuary as to allocate by Block w/in line
- normally consistent w/ how expenses allocated in Co's acctg systems
- important that co keep growing to prevent overhead cost/unit from increasing too rapidly
- cost of exceptional expansion should not be allocated to inforce, unless inforce will also benefit from earnings or renewal expense reductions from expanding the co
- single reasonableness test
- if allocation needs only minor adjustments when applying to different years, probably OK
Effect of Tax Law or Other One Time Changes
- effect of FIT in co earning has real impact on distributable profits
- div changes can be favorable and/or unfavorable
- Handling FIT Law Changes
- taxes need to be viewd on both a co-wide and per policy basis
- handling transition between laws can be complex
- Div Actuary needs to know corp tax plan and how/if these actions should affect divs
- Past Law Changes
- 1959 Act - used a long time and worked well w/ low int rates
- "arithmetic Menge" formula resulted in increasing marginal tax rate on inv income
- > 100% on investment income
- excess int paid to stock co PO were 100% deductible as int payments
- some cos reduced taxes by raising guar int rate of policy
- mutuals used ModCo 820 to reduce taxes by converting highly taxed inv income to u/w gains which not taxed (or taxed at much lower rate)
- TEFRA 1982 (aka StopGap)
- continued to allow deduction of expenses and NL reserves
- varied deductibility of divs between stock (77.5%) and mutual (85%)
- divs for qual pension plans 100% deductible
- most favorable to mutuals
- DEFRA 1984
- 100% deductiblity of divs
- eliminated immediate deductions for acq expenses by moving from NL to CRVM
- increased divs that could be credited
- increased after-tax expense strain for NB
- law contained fresh start reserve calculation
- divs changed from incurred to cash basis for tax purposes
- in year of change, 50% of divs deducted twice
- ModCo 820 benefit gone, but grandfathered
- stocks and mutuals taxed the same and additional tax for mutuals
- tax reserves redefined
- w/ double deduction for 83 policies, question: should 83 pols get better divs
- conclusion: tax law affects all policies adn transitional g/l s/b considered company-wide
- equity tax - based on difference in earning rates of stock and mutals * tax equity
- tax equity includes AVR/MSVR, adjusted tax reserves adn 50% of div liablilty
- TRA 1986
- changed primary rate from 36.8% to 34%
- forgave ModCo 820 elections
- changed int rate to AFIR (reduced tax reserves and increased taxes where V_t(x)<>CV(x)
- higher taxes reduced early divs for pols w/ CV
- mutuals suggested DAC tax and elimination of Equity Tax
- got DAC tax w/o elim of equity tax
- Div Actuary has to be able to adjust divs to reflect changes as they occur
- How Does Actuary Reflect Equity Tax
- unique tax not related to earnings
- some methods
- charging tax as it is incurred
- may result in large variations in annual div scale
- averaging may be needed
- can produce odd result -> higher surplus = smaller divs
- best estimate of difference averaged over a period of time
- increasing the annual contribution to surplus
- problem: deciding how much is s/b increased
- use target surplus formula and considering any left over tax as belonging to equity surplus
- use TS formula for each block, rather than actual surplus, and charge avg equity tax rate on this amt of surplus to that block
- any extra tax charged to retained surplus
- charge the equity tax on teh actual surplus of a given block of business
- What about Allocation of this Tax under the 1984 Act
- equity tax must be viewed on a company wide basis w/ all policies paying a fair share
- cannot be based on current amt of tax or surplus that currently exists
- How does teh Actuary Reflect teh DAC Tax
- effectively an interest-free loan to the gov't
- stat effect is an additional large up-front strain
- affects both old and new business and cuold be assessed in a couple ways
- as it is incurred for each block of business
- would result in large immediate reduction in divs following credits in the following years
- if used for NB, divs in early years would be 0 for many years
- as flat % of premium charge
- viewed as premium tax or as PV of a positive expense followed by a credit
- DAC tax reduced profits on certain classes of in-force business that could not adjust
- particularly a problem for indiv health ins
- Actuary must consider how to handle limited pay policies, RPU and older issues
- not a problem if using flat % method
Riders to Policies
- CV riders should have own separate div formula
- low prem riders pirced not to pay divs can have excess gains allocated to total block of business
Subsidiaries, other Lines of Business and New Ventures
- most cos have multiple LOBs
- not acceptable to take excess profits from Par lines to finance other co activities, if such actions will not benefit current PO before most of them terminate
- mutual co may look at non-par lines (which do not present unreasonable risks) as a possible good investment of surplus or as an asset backing a par block
- Sr Mgmt of mutual may be constrained w/r to what LOBs it may enter to avoid risk/profit margin not commesurate w/ risk of loss
- Par PO should not have divs reduced to fund growth of new LOB, if expected return too far into future to benefit current PO
- One of main reasons mutuals would like to enter capital mkts
Non-Life Product Lines: Annuities, Health, Disability
- earnings from these lines do not contribute much to annual PO divs (in general)
- main concerns in setting these divs is taking a reasonable profit charge
- health may be regulated by loss ratio
- div on one form may go to zero, have to pay on another form and by LOB, not making adequate profit
- possible b/c of min loss ratio tests, may need to distribute more divs than you or Board would prefer to distribute
- most DAs pay excess int instead of divs
- excess int can also be paid as part of a div
- Par Immediate Annuities (rare) - cash dividend would decline by duration
Non-Par Lines of Business
- most mutuals only sell par policies
- main adv of non-par line to a mutual
- generate add'l income beneficial to whole co
- non-par lines that generate pos stat earnings
- good means for mutual to grow faster than supported by ROI of par lines
- avoid costs of finding sources of outside funds
- if mutual add non-par line - must decide how g/l from these lines affect div paying par policies
- many mutuals place non-par lines in subs and view subs as an investment of the par POs
- if sub used co may not be able to pay stockholder divs to parent on regular basis
- this is why many cos treat these subs as owned by entity surplus
- therefore excluded from calc of investment returns for div purposes
Demutualization
- allowed by most states
- critical that best interests of PAR PO be maintained
- should not receive less that what they would receive if co remained a mutual
- ensure that any existing surplus that remains w/ par blocks is distributed quickly enough to avoid producing a tontine
Schedule NP: Stock Co Earnings
- some states require certain pages of AS to be filed separately for par and other lines
- Schedule NP - req'd in NY - designed to apply to stock cos w/ par business
- separates lines into Par, Non-Par w/o non-guar elements, non-par w/ non-guar elements other than divs
- distributed earnings from a par sector to stockholder is only a stockholder concept
- annual transfer from par sectors for a stock co limited in some states
- stock co's not req's to annually remove surplus from Par lines
- co can not transfer amounts over the limit b/c tehy transferred less in previous years
- mutual can transfer non-par earnings and surplus to a par line at any time
- if transferred, must decide how/if they are to be distributed to Par PO
-
Study Notes and Published References - Note SN 81-104-03 - NAIC STANDARD NONFORFEITURE LAW FOR LIFE INSURANCE
Section 2 - Nonforfeiture Benefits
- within 60 days of due date, nonf benefit kicks in
- table and rate used must be specified in policy
- statement that values >= min req'd values must be in policy
- company can reserve right to defer payment up to 6 months
Section 3 - Computation of CSV
- PVFB - PV Adj Prems - indebtedness + CV PUA
- excludes rider/supp benefit prems when calcing
Section 4 - Computation of Paid-Up Nonf benefits
- PV nonf benefits = CSV @ lapse
Section 5c - Calculations of Ajd Prems by nonf NLP method
- 80 CSO/CET or 1961 Std Industrial Mort Table
- Jan 1, 1989
- PV adj prem = PVFB = 1% ELA + min(1.25*nonf NLP, 0.04 ELA)
- ELA = ten year BOY avg DB
- nonf NLP = PVFB / adue(x) where adue is for prem period of policy
- for non-guar pols - calc assuming no changes
- if changes - recalc adj prems
- PV future adj prems = PVFB (as of reval date) + add'l expense allowance - CSV
- Add'l expense allowance at time of change
- .01*max(0,ELA_new - ELA_old) + 1.25*max(adj prem_new - adjprem_old)
- recalced nonf NLP (NFF)
- NFF_old*adue(x+t) + PVFB_new - PVFB_old) / adue(x+t)
- 80 COS w/ or w/o select factor
- nonf int rate = 125% of cal year SVL rate rounded to nearest quarter of 1%
Section 6 - Nonf Benefits for Indeterminate Prem Plans
- if min vals cannot be determined by other outlined methods
- commissioner must be satisfied that benefits provided are at least as good as min benefits otherwise req'd
- not misleading to PO
- any policy must be approved by commissioner before it can be used
Section 7 - Proration of Values; Net Value of Paid Up Additions
- pro-rata between anniversary
- can ignore:
- ADB
- wvr
- reversionary or deferred reversionary annuity
- term riders (if rider would not qualify if stand alone)
- CTR
- other non-DB/Endow benefits
Section 8 - Consistency of Progression of Cash Surrender Values w/ increasing Policy Duration
- CSV shan't vary by more than 0.2%*ELA from max(0,basic cv) + PUACV - loan
- basic CV = PVFB min(PV NFF, PV future adj prems)
Section 9 - Exceptions
- Does not apply to:
- Reinsurance
- Group INs
- PE
- Annuity or Reversionary Annuity
- 20 YR (or less) LT w/ expiry prior to age 71
- 20 YR (or less) DT w/ expiry prior to age 71
- Policies where no CVs exceed 2.5% of BOY Ins amt
Study Notes and Published References - Note SN 8I-105-03 - NAIC UNIVERSAL LIFE INSURANCE MODEL REGULATION
Section 2 - Purpose
- supplement existing regs to accomodate UL
Section 3 - Definitions
Section 6 - Nonforfeiture
- Minimum CSV for Flex Prem UL
- accumulations of
- + prems paid
- - benefit charges
- - avged admin expense charges for first policy year and any ins increase years
- - actual admin expense charges for other years
- - initial and add'l expense charges (subject to limits)
- - deduction for partial w/d
- - service charges actually made
- - unamortized unused initial and additional expense allowance
- admin expense charges include charges per prem payment, per $ prem paid, periodic charges per $1m insurance, periodic per policy charges and other contractual charges
- averaged admin expense charges - charge rates based on avg or rates policy states will be imposed in years 2-20
- initial acq expense - excess of non service expense charges actually made in first policy year over adg'd admin expense charges for year
- add'l acq expense charge similar to initial acq expense but made in ins increase year
- ins increase year - PO initiated increase
- initial expense allowance - same as SNFL for fixed face/prem endowment of same intial DB
- unamortized unused initial expense allowance = unused intial expense allowance * adue(x+t) / adue(x)
- Min CSV for Fixed Prem UL
- min CSV = A - B - C - D
- A = PVFB
- B = PV future adj prems - calced from SNFL
- C - PV NFF from post-issue guarantees
- D - sum of (B) like items from post-issue structural changes
- future guaranteed benefits determined by
- projecting policy value taking into account future prems and using guarantees of int, mot, expense dedcutinos, etc
- taking into account any guaranteed benefits which do not depend on policy value
- Minimum Paid Up Nonf Benefits
-
Study Notes and Published References - Note SN 8I-106-03 - NAIC STANDARD NONFORFIETURE LAW FOR INDIVIDUAL DEF ANNUITIES
Section 2 - Applicability
- N/A to
- reinsurance
- group annuity purchased under ret plan
- qualified deferred comp (except IRAs)
- prem deposit fund
- VA
- investment annuity
- immediate annuity
- DA after payments commence
- reversionary annuity
Section 3 - Nonf Requirements
- paid up annuity or lump sum payment upon payment stoppage
- lists mortality table and int rate for calcing annuity benefits
- if PV < $20 @ laps, can cash out instead of setting up pd up annuity
Section 4 - Minimum Values
- Min Nonf amt =
- + accumulation of net considerations
- - prior w/d
- - annual $50 contact charge, accumulated at int
- - prem tax paid by co, accum at int
- - loan
- net considerations = 87.5% gross considerations
- int rate = min(3%, a)
- a = 5 yr Constant Maturity Treasury Rate rounded to nearest 1/20th of 1% - 125 bps
- can be redetermined - redetermination period must be stated in contract
- 125 bps reduction can be increased by up to 100bps if equity indexed
- commissioner must be satisfied that extra bps don't harm SV
Section 5 - Computation of Present Value
- computed using mortality table (if any) and int rates specified in contract for determining minimum paid-up annuity benefits given in contract
Section 6 - Calculation of CSV
- CSV >= nonf amt
- int rate can be up to 1% hgiher for CSV than for accum
Section 7 - Calculation of Paid-Up Annuity Benefits
- CV of paid up annuity needs to be at least as great as nonf value
Section 8 - Maturity Date
- assume latest possible maturity date when calcing CSV or PaidUp Benefits
Section 9 - Disclosure of Limited DB
- must disclose if DB not >= min nonf amt
Section 10 - Inclusion of Lapse of Time Consideratoins
Sectoin 11 - Proration of Values; Add'l Benefits
Study Notes and Published References - Note SN 8IU-107-04 - EQUITY INDEXED ANNUITIES: PRODUCT DESIGN AND PRICING CONSIDERATIONS
Introduction
- EIA - fixed annuity w non-traditional method of interest crediting
- int credited a function of some well-known index (generally)
- have a guarantee designed to meet DA SNFL to avoid being categorized as a security
EIA Product Design
- GMAV - guar min acct val - designed to satisfy SNFL
- GMAV(t) = 90%*single prem *(1.03^t) (essentially old DA SNFL min CV)
- Index Acct Value (IAV)
- IAV(t<=index period) = 100%*singleprm*prod(1+indexbasedInterest(i)) from i = 1 to t
- IAV(T') = max(GMAV(T),IAV(T)) where T' is one moment after time T and T is lenght of index period
- Components involved in calc of Index-Based Interest
- index
- index period
- index growth%
- participantion rate
- margin
- cap/Floor
- Index - equity proxy used to calc level of interest credited to IAV
- S&P 500 most common
- DJIA also used
- Index Period - similar to SC period
- usually 7-10 years
- some desings do not continue Index-based int crediting after index period
- some have rolling index periods w/ new SC periods
- Index Growth % - two main categories
- point-to-point growth % - uses only 2 close levels
- IndexGrowth% = (FinalClosingLevel / InitialClosingLevel) - 1
- average Index Growth % - based on average closing level over a peroid of time - typically 1 year
- IndexGrowth% = ([sum(daily closing levels) / # trading days] / initial closing level) - 1
- daily averaging has tendency to keep indiv volatility minimized
- typically will produce 55-60% of unaveraged calc
- can also do monthly averaging - more volatile than daily, less than annual
- still provides 55-60% of unaveraged
- can also have ratcheting - means returns locked and connot be countered by poor future indexes
- Participation Rate - percentage factor applied to raw index growth %
- early plans had up to 125% participation
- if doing daily averaging, still < 100% of point-to-point growth
- Floor Return - usually 0%, can be higher
- floors on index-based int calc guar IAV never lower than SP and IAV will never decrease
- Margin - similar to participation rate < 100%, decreases index-based int relative to index growth %
- can be applied before or after participation rate
- cannot reduce int < 0%
- Cap - can be applied before or after margin
- Margin and Cap - ways to "stunt" growth measurement and allow purchase of less expensive options
- high equity volatility can be a problem for insurers funding multi-year guar EIA products
- index-based int in EIA funded by call optoin on the index
- longer period until maturity, more higher volatility affects option prices
- another strain on EIA funding when rates are low
- GMAV generally funded w/ fixed income bonds w/ remainder of prem income (after expenses) use to fund index-based int
- w/ lower int rates, not much $ left over after funding GMAV
- when int rates low and equity volatility high, if yverything has been adjusted as much as possible (w/in mktg constraints), then participation rate needs to be adjusted
Other EIA Design Features
- need to design products that have less restrictive SNFL min requirements
- Annual Reset EIAs - resettable components still have min guar attached to them with ability to change index-based int components as often as annually, EIA writers have a way to manage high index volatilities
- Flexible Premium EIAs - allows writers to reduce GMAV from 90% of prem @3% to as low as 65% @3%
- common => 75% of initial prem and 87.5% of additional prem
- lowers cost of funding guar, leaving more to spend on int-based index
- Lower GMAV Int Rates
- SNFL being updated to allow 1.5% as min int
- Index Growth Measurement
- averaging - smooths volatility and dampens return
- daily averaging not very common in EIA design
- monthly avg and point-to-point prevalent
- innovative return methods
- binary returns - if index increases, credit x%, 0% otherwise
- or might have tiers 0%, 3%, 6% if [0,5%) -> 3% [5%,infinite) ->6%
- highwater mark - instead of using two end points, use starting point and highest point during period
- Customer Choice
- index choice - client chooses index to participate in
- index growth measurement - client chooses avg or point-to-point
- fixed int - client chooses fixed rate rather than indexed rate
- fund transfer - client can have several options elected adn move money between them
- Inducements to Purchase
- premium bonuses, sometimes spread over index period
- GMAV alternatives
- instead of 90% @ 3%, 100% @ 2% w/ SC
- designed w/ mktg in mind
- example w/ SC = 10%-0 over 10 yrs, 100%@2% w/SC >= 90% @ 3% so SNFL not a problem
Pricing and Design Considerations
- EIA Funding
- 1st - how will product be funded
- traditional annuity - credited rate = inv earning rate - margins for expenses and profits
- EIA funding - premium = GMAV costs + PV expenses/profits + index-based Int budget
- credited rate - two elements - GMAV adn Index-based int component
- for s/t guarantees, GMAV funding can be rolled into pricing spread
- rather than managing option program w/ budget determined up-front, application of traditional spread pricing to EIAs is more realistic
- Net Earned Rate - Pricing spread = hedging budget
- actual option purchase = notional * option cost
- notional for 1st year is prem, for future years, IAV
- several factors can affect ability of hedge budget to fund significant index-based int levels for future years
- reinvestment rates cound incr/decr teh net earned rate which would change the hedge budget
- actual Index-based Int credited affects future levels of IAV
- high int means budget has to cover higher amounts
- high future equity volatility causes higher option costs
- high future risk-free rates cause higher option costs
- high option costs in any year during an index period can strain option budget
- Funding Index-Based Interest
- early EIA writers used OTC equity options to exactly match index-based int they were giving to customers
- designs evolved and OTC deals no longer absolutely necessary
- two major forms of hedging - static and dynamic
- static hedging - synonymous w/ buy and hold and ofter involves OTC options
- most common static hedge today: purchase of a call spread option on teh index
- actually 2 trx - puchase plain vanilla call option adn sale of call option w/ strike = cap rate of liability being hedged
- B/S call option pricing formula: call option price = S(0) - N(d(1))-k*e^(-r(f)*t)*N(d(2))
- d(1) = (ln(S(0)/k) + (R(f)+ (sd^2)/2)*T) / (sd*sqrt(T))
- d(2) = d(1) - sd*sqrt(T)
- S(0) - Initial Security Price
- k - strike price
- r(f) - risk free rate
- sd - volatility
- N() cumm PDF for std Normal dist
- decide on funding ratio
- usually < 100% b/c lapses (assuming not vested @ surr)
- assume too low a lapse rate, stuck w/ extra options
- too high - not enough
- economies of volume necessary on OTC b/c high fixed cost
- Dynamic (delta) hedging
- involves monitoring the delta of the liab portfolio and holding a changing position in index via futures or other instruments
- disadvantages:
- higher trx costs b/c of frequent position changes
- no downside protection
- Other EIA pricing Considerations
- customer choice - might not have enough in each option to offer economies of scale in hedging program
- index return method complexities
- no guarantees that any dealers willing to price deals w/ complex return designs
- policy guarantees - multi-year guarantees currently not attractive
- might be attractive if future int rates increase and volatility decreases and option dealers willing to sell l/t options
- GMAV funding
- necessary to fund GMAV w/ fixed int rate bond fund
- evaluate risks of default and int rate risk
- int rate risk important to consider w/r to lapses
Regulatory Considerations
Study Notes and Published References - Note PRODUCT MATTERS - REGULATORS RESPOND TO INDUSTRY INNOVATION THROUGH GUIDELINE AXXX
Section 1 - Increase tied to an external trigger
- b/c insurer does not have unrestricted right to increase prems
- AXXX requires cos reserve these plans as if prems guar for full level prem period
Section 2 - Refund of Prem - Partially Guaranteed
- right to increase prem not unrestricted since need to provide additional benefits
- must reserve over entire level prem or secondary guarantee preriod
Section 3 - Affiliated Co Guarantee
- prem increased protected by second co via reinsurance, second policy, or agreement
- AXXX requires that the reserves of these combined coverages/benefits = what direct writer would hold w/o this agreement
- reserve credits only allowed if agreement meets reinsurance requirements
Section 4 - Refund of Prem - Fully Guaranteed
- high guar GP w/ CV, div or prem refund after period of time
- creates low net prem
- AXXX requires net prem used in calc
- coinsurance allowances for legit reinsurance does not fall into this category
Section 5 - Re-entry Plans
- AXXX requires initial re-entry period and prems treated as continuation of initial guarantees
Section 6 - Level Net Reins Prems
- additional "expense allowance" has no relationship to actual expenses
- initial segment = full level prem period and valn prems s/b level over that period
UL and AXXX
- Accum of Prem and Shadow Acct Secondary Guaranteed both fall under AXXX
- Accum of Prem already addressed under XXX
- No Lapse Guar is Shadow Acct > 0 (even if regular acct < 0)
- Shadow Acct grows just like regular acct, but w/ more favorable changes/credits than guar in underlying policy
- Catch-Up provisions allow PO to dump money in to reinstate secondary guar
Section 7 - Premium "Catch-Up" Provisions
- AXXX provides relief
- can reduce basic and def reserve by any "catch-up" amounts (reserve can't drop below 0)
Section 8 - Secondary Guar Requirements
- prepaid shadow acct deposits need to be added to reserve
- argument against: actual prem payment history is modification to XXX and UL Model Reg
- Model Reg call for prems at issue and prepayments not known at issue.
Sections 1-7 retroactive to XXX effective date
Section 8 effective 1/1/2003
Study Notes and Published References - Note PDNEWS - SEAC SECONDARY GUARANTEES DEBATE
Are Secondary Guarantees Good for the Public?
- Affirmative:
- Give consumer valuable option w/ no explicit charge
- cost covered by conservatism inherent in contractual guaranteed values
- Negative:
- nonforfeiture law
- can lose entire no=lapse protection with a single late payment
- current legislation unable to address complex reserving issues
- Affirmative Rebuttal:
- Valn Actuary law assures reserves are adequate
- Secondary Guars are voluntary, not forced
- Negative Rebuttal:
- Valn Actuary law won't catch everything or we wouldn't need XXX
- One more confusing option for consumers to deal with
Are Nonf Benefits related to Secondary Guars req'd by law?
- Negative:
- yes, both letter and spirit
- Letter - TX and sorta CA
- Affirmative:
- SNFL does not require segmentation of policy
- UL Model Reg does not require anything add'l for secondary guars
- UL nonf benefits based on retrospective accumulation
- if req'd, stopping payments creates a nonf cliff
- Rebuttal Negative:
- nonf cliff no diff from losing an int bonus by surrending 1 month early
- Rebuttal Affirmative:
- nonf cliffs would not be understood by general public and create new round of litigation nightmare
What Types of Reserves req'd for seconday guars under SAP adn GAAP acctg?
- Affirmative:
- Theoretical reserve - PV of expected utilization of benefit
- GAAP - can be incorporated into F97 projections
- Stat - covered under Valn Actuary Law
- Negative:
- doesn't care about GAAP
- if commish deems nonf values req'd, must be refelcted in benefit reserve
- Rebuttal Affirmative:
- Actuaries need to promote ability to assess risks and establish adequate reserves
- Should not have to have situation clouded by piecemeal regulations
- Sensitivity testing is important part, including mortality if that is the primary risk factor
- Rebuttal Negative:
- secondary guaranteed are valuable benefits that create significant liablity
Can we ever ignore letter of law? Can we ever ignore spirit of law?
- Negative:
- Affirmative:
- NO, but issue is when commissioners have discretion to "interpret" laws
- Ins laws relating to valn and nonf are out-of-date
- not designed for modern products
- ins laws applied inconsistently between states (and w/in states sometimes)
- these grey areas will cause letter of law to to pushed to limits
- for spirit of law, take macro view
Copyright © 2004 Steve Welander.
Permission is granted to copy, distribute and/or modify this document
under the terms of the GNU Free Documentation License, Version 1.2
or any later version published by the Free Software Foundation;
with no Invariant Sections, no Front-Cover Texts, and no Back-Cover Texts.
A copy of the license is included in the section entitled
'GNU Free Documentation License'.