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)
    - some states won't allow
  - 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?
      - If so, only limited time
    - what happens to modal loadings after vanish?
      - switch to annual mode
  - 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
      - guar iss u/w techniques
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
    - smoother cash values
  - 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
    - vs 10-15% for std
  - 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
    - reduces effective SC%
  - 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%
    - some cos use tails
  - 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
    - annually $10-30 common
- 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
  - sep record for each fund
- 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
    - vary by AA and sex
  - 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
    - FEl appropriate
  - 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

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'.