La mexicanidad entendida desde el arte contemporáneo

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(t P t Rg A t P t P t Rg

P = − + + α − − − − −γ −

decomposes the participating contracts and explains the bonus distributions mechanism. In the formula, we can see that the interest rate guarantee is a protection which provides minimum return when no bonus is distributed in the former year.

Further more it also explicates why and how can we consider the bonus mechanism as option element in the contract. Since American type options can be exercised at any time before the maturity, those participating policies which give policyholders rights to sell back have a surrender options.

6.3 Interest rate’s influence on the life insurance companies

6.3.1 Effects of the increase of interest rates

When the interest rates in financial markets go up, the items in a balance sheet of a life insurance company can sensitively show the effects. Most debts on the liability side are policy reserves saved for policyholders’ future claim. Policy reserves are deposits accumulating when life insurance companies sell a policy and get a premium, which will not be paid back until a legal affair happens. Generally most life insurance contracts have a longer maturity, more than 10 year, than assets do. Compared to liabilities, assets of a life insurance company are much more sensitive to the changes/increases of interest rate. When interest rates go up, though fair values of both assets and liabilities will go down, the gap between the interest-rate-sensitive

assets and the interest-rate-sensitive liabilities are narrowed because the decrease of liabilities is bigger than that of assets. On the other hand, newly added investments, such as sales from policies, interests from investment combinations, returns form other bonds and financial assets, will get high return at the increased interest rate.

Standing at this point, life insurance companies may benefit theoretically from the increase of interest rates.

In the above paragraph, we have seen that the increase of interest rates may benefit certain items of the balance sheet. But the increase is a sword which means it harms at the same time. Assume that the interest rates go up and the policy reserves accumulate at the initial interest rate, the rate given when a policy was sold, the changes harm the benefits of the policyholders because they can invest money in other financial products at a higher rate. The increase of interest rates may cause policyholders’

claim before maturity. Contract holders may stop the contracts and ask the life insurance companies pay the principles back to them if the interest rates increase high enough. Most Chinese Long-term Life Insurance Contracts give the policyholders rights to stop a contract and ask principles back after 4 or 5 year. Besides, policyholder may ask policy guaranteed loans from life insurance companies, which means that the policy holders get money at a rate lower than market rate and lend at a higher rate. Both above situations will cause large and unexpected amount of cash out flows from life insurance companies. If the increase is pretty high and last for a long period, life insurance companies will have severe problems on working capitals.

The increase of interest rates will also have negative effects on life insurance companies’ profitability. When situation of increase happens, life insurance companies are forced to enhance contract rates so as to keep market share and attract new customers. Most of the life insurance companies’ profits come from the gap between yields/rates of assets and those of liabilities. Simply say, life insurance companies sell policies at lower rates, and invest their money at higher rates. But if we assume that the policy rates go up sharply, but the yields of assets keep stable or

change slightly, the profits will lessen. Especially in practice, it is unrealistic to enhance yields of certain investment projects. The upwards changes need time and other resources. The observation explains why life insurance companies’ profits go down when the interest rates go up in financial markets.

6.3.2 Effects of the decrease of interest rate

Then decrease of interest rates causes an opposite effect, compared to 1.1, on the traditional life insurance contracts. As mentioned above, assets usually have shorter maturity than liabilities in life insurance companies. When interest rates go down in financial markets, both the market values of assets and liabilities go up. But the changes of liabilities are bigger than these of assets. The decrease of interest rates causes negative changes in a life insurance company’s balance sheet.

On the other hand, when interest rates in financial markets become lower, debtors usually pay back loans before maturity in that they can borrow money at new and low rates. When the situation happens, life insurance companies are forced to re-invest the paid-back money in other projects at lower rates. The newly established projects or investments produce lower yields than the old ones done before the decrease of interest rates. It means the returns on long-term investments of life insurance companies go down.

At the same time, old policyholders will choose keep on holding their policies because the rates on policies are higher than the current rates in financial markets. In the process, life insurance companies may experience a period of better profitability as insurance companies can lower policy rates right after the decrease of interest rates in the financial markets. On the contrary we have mentioned that the changes of yields of asset investments usually go (down) slower.

But when the interest rates in financial markets goes sharply and suddenly down to a

level lower than the policy guaranteed rates, life insurance companies will face losses from interest gaps. The shocks are especially obvious on the latest issued policies, because the correspondent premium reserves are under construction or just finished.

The losses on old contracts will float onto the water gradually because the decreases of yields on investment needs some time. Chinese life insurance companies have had such a lesson in the 1990s.

We have separately discussed about effects on life insurance companies caused by both increase and decrease of interest rates. Another noteworthy issue is that interest rates have different effects on different policies, namely, some policies are exposed more to risks than others. Among these policies, the traditional policy is the one with high risks. The premium reserves for traditional policies are the main debt in Chinese life insurance companies. During the fast growing period of Chinese life insurance companies in the 1990s, traditional policies were the main products in the market.

Until now the ratio of traditional policy reserves still take around 80-85% of all.