Study Notes and Published References - Note SN 8I-103-01

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
    - rarely used
- 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))
  - net of reinsurance
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
      - not used by many cos
- 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

Copyright © 2004 Steve Welander.
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