The primary products sold by life insurers discussed here are individual life insurance, disability insurance, and annuities. Insurers often manage their business split in this way. For descriptions of various types of life and disability insurance products as well as annuity products, see LOMA (1999).
Life insurance
Life insurance provides a benefit on death occurring during the term of the policy (ex-cept for exclusions such as a limit on payments if suicide occurs in the early years of a contract) and may include a savings element. The policy with the lowest initial cost provides only a death benefit but no savings element. This type of policy, sometimes known as term insurance, has no cash or surrender value.
For policies with premiums that increase annually over the term of the contract, each premium is set to cover the cost of claims arising over the period covered by the premium plus expenses and a profit margin. The buildup of technical provisions is small for such policies, since the premiums cover claim events only in that policy year. In ad-dition, for the block of policies, an incurred but not reported (IBNR) provision is es-tablished to cover the expected amount of incurred claims that have not been reported by the valuation date. The key variable affecting the adequacy of technical provisions is mortality. If the mortality assumptions used do not mirror the claims rate, the differ-ence between actual and expected claims will affect earnings. Such policies generally provide coverage up to a certain age, after which coverage ceases, since coverage at older ages can be very expensive and the need for coverage may have ended. Premiums may also be level for a period—often 5 or 10 years—with increases defined in the policy.
When policy premiums include a savings element, the contract is usually of longer duration, and the technical provisions will build up over time. Because of the longer duration, discounting is an important element in the calculation. In addition to mortal-ity and the discount rate of interest, assumptions about investment returns, lapse rates, and expense levels over time are also key variables affecting the level of technical provi-sions held.
Several classes of insurance policies have an investment component. Whole life nonparticipating policies provide coverage that does not cease at a defined age but that continues as long as premium payments are up-to-date. Technical provisions accumu-late over time, at very old ages approaching the amount of the death benefit, so that the amount at risk to the insurer (the difference between the sum assured and the technical provision held) decreases over time. However, the premium is normally a level guar-anteed amount payable for life or to a defined age, and the insurer, in determining the premium, makes an assumption about the amount of investment income that will ac-crue. If interest rates decline, the technical provision will have to be increased to cover
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the present value of the expected future shortfall in investment earnings and this will reduce profitability. If the people insured live longer than expected, the insurer will achieve higher than expected profits, while higher than expected mortality rates will decrease profits.
Participating whole life policies share in the profitability of the block of business.
The premiums are higher than those charged for nonparticipating policies with the same sum assured. The additional premium may be considered an investment component, with the insurer spreading the investment risk over a broad range of investments. The policyholders may also benefit from other gains, such as those from improving mor-tality rates. With this type of policy, the insurer should take into account policyholder expectations of future payouts when determining technical provisions. Policyholders often expect a reasonably smooth trend in payouts and a minimum payout level. As a result, insurers tend to take a conservative, long-term view of profitability in the partici-pating fund. The terms of the insurer’s dividend policy are often complex. The technical provisions are likely to be calculated using a best estimate of future dividend payments or using very conservative assumptions that implicitly provide for future dividends in those margins.
Disability insurance
There are two categories of people with disability coverage. One is people who are not disabled but who have insurance providing coverage in the event of disability. The other group is people who are disabled and who receive payments in accordance with their disability coverage.
When calculating technical provisions for people who are not disabled, key as-sumptions are:
a. The chance of becoming disabled b. The chance of recovery once disabled
c. The period during which disability payments will be made if the insured re-mains disabled.
The first assumption depends on, among other things, the insured’s age, the defini-tion of disability in the policy, and the insured’s occupadefini-tion. Recovery is more likely the closer the insured is to the date of the event that resulted in disability. Therefore, the second assumption is represented by a stream of decreasing probabilities, with the val-ues affected by the nature of the disability and the age of the disabled person. The third assumption is based on mortality rates related to disabled lives. Experience studies for the factors in these assumptions are less reliable than mortality studies, since the pool of individuals covered by the experience study is smaller and there are more factors that influence the assumptions. For example, experience has shown that during poor
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economic times the chance that an insured will submit a disability claim increases and the probability of recovery decreases. As a result, the approach to calculating techni-cal provisions is more conservative, and margins for adverse deviation are likely to be larger than those used for mortality.
Annuities
There are two main classes of annuities: deferred (or accumulation) annuities and pay-out annuities. Deferred annuities are often purchased with single premiums that are paid to an insurer, which may guarantee a fixed rate of interest on the funds over a de-fined period. An annuity option is sometimes offered, which may include a guarantee of the annuity payments that could be elected at the maturity of the contract or may sim-ply allow purchase of an annuity at the then existing purchase rates. The accumulated value of the funds is paid out on the death of the insured.
The key assumption relates to the discount rate of interest, which can be prescribed by the regulator or based on the projected earnings of the invested premiums. Another element that must be considered is the need to be able to pay the funds on maturity if the contract is not rolled over for another term. The assets backing this product may be short term and liquid, but if interest rates have increased since the asset was purchased, the capital realized on the early sale of the assets would be below the book value. If the cash flows from the assets precisely matched the cash flows of the maturing contracts, no mismatch risk would exist; however, insurers may choose to mismatch the cash flows. For example, if the insurer believes that interest rates will rise, it may invest short, hoping to benefit from subsequent higher interest rates. If interest rate actually decline, there may be a deficit in interest earnings in relation to the interest rates guaranteed on the deferred annuities.
Asset liability management is therefore a particularly important tool for managing risk in this product (as well as life insurance products that provide interest rate guaran-tees). One approach used calculates an additional technical provision to cover the risks due to mismatch of cash flows. Alternatively, additional capital may be required.
The annuity option guarantee can also pose risks that should be accounted for in the technical provisions. If, for example, the interest assumption used in pricing the payout guarantee is higher than interest rates available at the maturity date and if the insured exercised the option, the insurer would be providing the annuity at a loss. This is another example of an embedded option.
The other form of annuity is the payout annuity, where a single premium is paid to the insurer. In return, the insurer agrees to make regular payments to the annuitant, usually beginning immediately and for as long as he or she is alive, sometimes with continuing payments at the same or a lower rate to a designated survivor. Payments are also often guaranteed to be paid for a defined period, such as 10 years, whether or not the annuitant is alive.
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In deciding what level of payments should be offered, the insurer has to estimate the long-term interest rate on the investment of the single premium. The investment is also complicated by the fact that the payouts will exceed the income earned on the investment, so that the amount of the investment declines with each payment made to the annuitant. Again, asset liability management is an important risk management tool, and its effectiveness affects the level of technical provisions required. Besides the invest-ment assumptions made, the other key variable is mortality. The longer the annuitant survives, the more annuity payments will be paid by the insurer. Mortality rates have generally been decreasing. Conservative mortality assumptions in the valuation may, therefore, incorporate an improvement over time in the mortality rates of annuitants.
Actuarial valuation methods
Various actuarial methods of valuation have been developed over time, including the net premium, gross premium, accumulation, stochastic, and cash flow methods. Actu-arial methods of valuation vary by jurisdiction and by product.
The technical provisions account for possible cash inflows from future premiums paid. The pricing area of an insurer determines the actual premiums. Although the pricing assumptions used for the same type of product (such as whole life) may change over time (for example, as mortality and expenses change) the policies may be grouped together for valuation. The valuation assumptions (mortality, expenses, and the like) are made independently of the pricing assumptions. Thus the premiums paid provide a cash flow, but from a valuation perspective the assumptions on which the premiums paid were based are just useful input when setting future valuation assumptions: most important are the expected cash flows, as estimated at the valuation date.
The insurer has to pay the initial expenses when the policy is sold. These expenses include the cost of underwriting the policy, setting up the records in the administration system, and paying the initial commission. These expense costs are paid out of income in the year in which they arise and therefore have an impact on earnings for the year.
These expenses also often exceed the amount of the first annual premium paid. Regard-less, only a portion of the first year’s premium is really available to cover the initial expenses, since some of the premium must cover the cost of claims arising in the year.
If the policy provides for the payment of premiums in future years, the excess initial expenses may be recovered over time from those premiums. For the actuarial method to reflect this reality, it often, in conjunction with the accounting process, accounts for the skewed nature of expense costs.
A common valuation approach determines the technical provision as follows:
A. Calculate the present value of future benefits and future expenses
B. Calculate the present value of future premiums and future investment income C. The technical provision is the amount by which A exceeds B.
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When the net premium valuation method is used, at the date the policy is issued the technical provision is zero (that is, A = B), because initial expenses are recognized in the equation. Thereafter, regardless of valuation method, initial expenses will not be recognized in the equation. Since the future premiums contain a component for recov-ery of the initial expense costs, the present value of future premiums should be more than sufficient to cover the cost of future benefits and expenses. Thus, for a period of time a policy’s technical provision may be negative. As a result, any negative technical provisions generated by new business will reduce the overall technical provisions for a block of business. The significance of negative technical provisions depends on what proportion of the business is new. If a policy that generates a negative technical provi-sion lapses, overall technical proviprovi-sions have to be increased. Various jurisdictions have developed different approaches to address the impact of negative technical provisions;
for example, some jurisdictions do not permit insurers to recognize negative technical provisions in calculating the total liabilities in their balance sheet.
Netpremium valuatioN
The net premium valuation approach has been used since the 19th century. The net premium is a theoretical construct, with no explicit relationship to the gross premium.
The net premium assumed for valuation purposes is the cost of providing the contrac-tual sum assured. If the policy provides a payment on death, the net premium is based on the probability of the insured dying, using a mortality table based on the results of a suitable mortality experience study. Consider, for example, a whole life product where a level annual premium is paid as long as the insured is alive. In this situation the net premium would be such that at the date of issue the present value of the net premiums payable would equal the present value of the sum assured, resulting in a zero technical provision at the outset.
As noted, an insurer often incurs considerable costs at the time of issue of a life insurance contract. After paying these costs, the funds remaining from the actual pre-mium may be less than the valuation net prepre-mium. Using the net prepre-mium approach, a technical provision would be required at the first valuation that exceeded the funds available from the first year’s premium after the initial expenses had been paid. This creates what is known as a new business strain. To avoid new business strain, the net premium may be adjusted (the Zillmer adjustment) in the first year to provide a tech-nical provision of zero at the first valuation. Net premiums used thereafter would be increased slightly to make up the shortfall in the initial net premium used.
Under the net premium valuation method, technical provisions may be calculated by looking either backward or forward. Looking backward, the technical provisions would be the accumulated value of net premiums less the accumulated value of benefits already paid. Looking forward, the technical provisions would be the present value of future benefits less the present value of future net premiums.
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The net premium method is an implicit approach to valuation, since only one vari-able (mortality) is specifically based on the result of experience studies. The difference between the gross and net premiums is assumed to provide for the costs related to the other variables. An interest rate is assumed in accumulating or discounting the values, and it is usually conservatively chosen (and may be prescribed by the regulator). Any margin between the actual earned rate and the assumed rate also helps cover shortfalls between the actual experience related to other variables (for example, expenses) and the assumptions used in calculating the gross premium.
When conditions are stable, the net premium method produces reliable results for less complex insurance products. When products have more complex terms and condi-tions that must be accounted for in the valuation, it is more difficult to assess and cover some of the risks using a net premium approach. Variables not recognized in the net premium method that can affect the level of technical provisions include the rate at which options are exercised and the effects of cash flow mismatches (especially when interest rates are volatile).
Gros s premium valuatioN
The gross premium valuation method uses a valuation premium that includes an amount to cover the expenses related to the policy, in addition to other expected costs, such as paying the sum assured in the event of death, and benefits on surrender of the policy. The valuation gross premium would normally be the actual premium.
Looking forward, the technical provisions would be the present value of future benefits and expenses less the present value of future gross premiums and investment income.
The gross premium method should be able to take into account most variables explicitly but may not be able to handle embedded options adequately. The interest rate assumed in accumulating or discounting the values may be conservatively chosen (and could be prescribed by the regulator). Any margin between the actual earned rate and the assumed rate would help cover shortfalls between the actual experience and the as-sumptions used in calculating the gross premium.
Comments on the reliability of the results using the gross premium method are similar to those made for the net premium method already discussed.
accumulatioNmethod
For products that are investment vehicles with an insurance component, the liability for the insurance component may be small compared with the value of the invested pre-miums. In this situation technical provisions should generally at least cover the value of the fund held on behalf of the policyholder. The accumulation method would be a suitable valuation approach for this type of product. Consider a deferred annuity, where
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a single premium is paid to the insurer, which guarantees the rate of interest that will be earned on the premium. At maturity the premium and accumulated interest are re-turned to the policyholder, or the policyholder can apply the total amount to purchase a payout annuity. The accumulation method would add interest at the guaranteed rate to the premium from the time the premium was paid to the date of the valuation. This accumulated amount would be held as the technical provision.
In this example, the insurance component is the return of premiums plus interest in the event of death and would be covered by the technical provision held. If the an-nuity option offered with the contract is based on assumptions that could not be satis-fied at the time of maturity (such as an interest rate above current levels), an additional technical provision would be required to cover such a risk. When a product offers a similar investment component combined with life insurance, the total technical provi-sion is the sum of two calculations. One uses the accumulation method to value the investment component, while the other uses another valuation method to determine the technical provision for the insurance component.
stochas ticmethods
A stochastic method is forward looking. It assesses the impact of a range of future pos-sibilities on the level of technical provisions required. Each scenario in the range is randomly generated, and the technical provision required to cover that scenario is cal-culated. Hundreds—or even thousands—of these scenarios are used. The distribution
A stochastic method is forward looking. It assesses the impact of a range of future pos-sibilities on the level of technical provisions required. Each scenario in the range is randomly generated, and the technical provision required to cover that scenario is cal-culated. Hundreds—or even thousands—of these scenarios are used. The distribution