SP2 Notes - Life Insurance

1. If a questions asks about the factors affecting capital requirement in any product.
• Design of the contract
• Frequency of payment of the premium
• Relationship between the pricing and supervisory reserving bases
• Additional solvency capital requirements
• Level of the initial expenses (including any initial commission)

2. If a questions asks about the factors to be considered before launching a product.

• Profitability
• Marketability
• Competitiveness
• Financing requirement
• Risk characteristics
• Onerousness of any guarantees
• Distribution channel
• Sensitivity of profit
• Extent of cross-subsidies
• Administration systems
• Consistency with other products
• Meeting regulatory requirements

3. If a questions asks about challenges in Pricing of any product:

• Mortality risk:
o Model risk.
o Parameter risk
o Random fluctuations risk.
o Reinsurance support
o Depends on reliability of data
o Future expected experience difficult to predict.
o Risk of inappropriate underwriting.
• Expense risk:
o Underwriting cost.
o Medical cost.
o Cost of training and educating.
o Option cost per policy

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 • Investment risk
• Underwriting risk
• Competition
• Regulatory risk

4. Relationship between Pricing and Reserving basis:

If the company calculates its supervisory reserves using its premium basis assumptions, and
there is no solvency capital requirement, then there will be no initial capital strain. This follows
from the fact that the premium has been calculated to pay the initial expenses and then be
exactly sufficient, on the premium basis (= reserving basis), to meet ongoing expenses and the
final benefit. However, if the reserving basis is stronger than the pricing basis then the premium
charged will seem insufficient, on the reserving basis, to meet the expenses and the benefit.
Capital will therefore be needed to set up the required reserves at outset. The stronger the
reserving basis compared with the pricing basis, the more capital is needed.

5. What is asset share?

Asset share is the accumulation of premiums less the deductions associated with the contract,
all accumulated at the actual rate of return earned on investments.

6. What are the components of asset share?

Monies In:

• Premium income
• Investment income
• Surrender profit/losses if any
• Profit from without-profit contracts

Monies out:

• Expenses including commission

• Cost of providing death benefits in excess of asset share
• Cost of providing maturity benefits in excess of asset share
• Cost of any other benefits like waiver of premium
• Tax
• Transfer profit to shareholders
• Cost of capital
• Contribution to free assets
• Share of any non-participating business profits

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 7. Risks in offering a new product or new feature/options of an old product:
• Policy data
• Business volume
• Mortality risk
• Competition
• Expenses risk
• Investment risk
• Anti-selection risk
• Distribution channel
• Policy administration system
• Capital requirement
• Underwriting
• Withdrawal risk
• Regulatory/Legal risk
• Counterparty risk
• Reinsurance

8. Determining the mortality basis of a product:

The value assigned to mortality rate should reflect the expected experience of the lives taking
out the insurance. The expected experience depends on below factors:
• Target market
• Distribution channel
• Underwriting controls applied
• Expected change in experience from the last experience investigation to the point in
time at which the assumptions would apply

The final mortality rates will be combination of:

• Base mortality (some percentage or adjustment to standard mortality rates)

• Mortality trend
• Margin applied

The extent of margins used generally depends upon

• The level of confidence in the base mortality assumption

• The financial significance of the mortality assumptions
• The need to be competitive

9. Determine the expenses basis of a new product:

The expense assumptions need to reflect all the expenses to be incurred in term assurance
contracts. The expenses are initial expenses, renewal expenses and terminal expenses.

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 Assumptions should be made for initial expenses which may include stamp duty, commission,
underwriting cost etc. However, commission is usually fixed and hence no assumption needed.

Although the company cannot deny the cover based on underwriting, but they want to classify
the lives into different groups to enable them to charge appropriate terms. Hence, assumptions
need to be made.

Some expenses are incurred at termination or at the time of claim. The investment expenses will
be minimal in term assurance but assumptions may be needed.

The expenses assumption may also include contribution to the company’s overheads. The
assumptions may consider the recent experience of company’s existing products and consider
how they translate for the term product. The overhead costs may not change but underwriting,
claim cost and investment expenses may change.

The assumptions should also reflect the expected budget for sales staff and business volume.

The company may need to use external data or reinsurers’ data.

As these are long term contracts, assumptions may be required to consider future inflation
rates, inflation may be based on expected future wage rate or other source of information.

Also, appropriate margins are needed to be added to reduce the risk of adverse experience, as
this is a new product for the company.

10. Retrospective and prospective reserve and surrender values and the analysis of both methods.
Retrospective method:
The retrospective value will represent the earned asset share at the date of surrender or an
estimate thereof. Therefore, it would represent the maximum that the company could pay
without making a loss.
At early durations it should not look too unreasonable compared with the premiums paid.
However, the retrospective method is likely to produce negative values (and hence zero
surrender values) for regular premium contracts at very short durations, depending on the
relationship between premium, initial expenses and commission.

Disadvantages:
• It does not say anything about the profit the company would have made if the contract
were not surrendered. Hence it is not easy to ensure equity either with continuing
policyholders or with any shareholders.
• Except by chance, the surrender value will not run into the maturity value

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 The most complex component of the method is obtaining the necessary historic information to
build up earned asset shares or to determine suitable parameters if a formula is used.

Prospective method:
If a realistic basis is used with this method, it will produce a surrender value that represents
what the contract is worth to the company. In the context of without-profits contracts, it
enables the company to quantify how much profit to retain and hence maintain equity with
continuing policyholders and any shareholders.

There is no guarantee that the surrender values produced will not consistently exceed the
earned asset share. Moreover, depending on the basis used, the method could produce
surrender values at early durations that look distinctly unreasonable from the (surrendering)
policyholder’s point of view.

For without-profits contracts, the surrender values will run into the maturity value. The
prospective method is more likely than the retrospective method to produce comparable
surrender values to those available at auction and for comparable competitors’ contracts, since
it is the method that is normally used. However, the assumptions used with the method – rather
than the method itself – are likely to be the more important factor in any such comparisons

Unless the company decides to use a complicated basis, it is relatively easy to operate since it
does not require any knowledge of what has happened in the past

11. Principles of investment for a life insurance company

The principle of investment for a life insurance company states the fundamental approach
towards balancing in risk and return.
• The company should invest in assets which match the terms, nature and currency of its
liabilities.
• The company should invest in assets which maximize its return, both investment income
and capital gain.
• The extent to which maximizing return depends on company’s free assets and risk
appetite.

12. Appropriation price:

Appropriation price is the price at which the company creates the units. In other words, it is the
amount of money that the company should put into the fund in respect of each unit it creates to
preserve the interest of existing unit holders.

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 13. Expropriation price:
Expropriation price is the price at which the company cancels the units. In other words, it is the
amount of money that the company should take out of the fund in respect of each unit it
cancels, to preserve the interests of continuing unit-holders.

14. How appropriation price is calculated?

• Market ‘offer price’ value of the assets held by the fund
• Plus the expenses that would be incurred in the purchase and any stamp or other duty
payable in respect of such a purchase
• Plus the value of any current assets, such as cash on deposit or investments sold but not
yet settled
• Less the value of any current liabilities, such as investments purchased but not yet
settled or loans to the fund
• Plus any accrued income, such as interest income from fixed-interest securities and
deposits, net of any outgo, such as fund charges.
• Less any allowance for accrued tax, if applicable.

This gives the net asset value of the fund on an ‘offer basis’. Dividing by the number of units
existing at the valuation date, i.e. before any new units are created, gives the appropriation
price.

15. How expropriation price is calculated?

• Market ‘bid price’ value of the assets held by the fund
• Less the expenses that would be incurred in the sale
• Plus the value of any current assets, such as cash on deposit or investments sold but
not yet settled
• Less the value of any current liabilities, such as investments purchased but not yet
settled or loans to the fund
• Plus any accrued income, such as interest income from fixed-interest securities and
deposits, net of any outgo, such as fund charges.
• Less any allowance for accrued tax, if applicable.

This gives the net asset value of the fund on an ‘bid basis’. Dividing by the number of units
existing at the valuation date, i.e. before any units are cancelled, gives the expropriation
price.

16. Define basic equity principle of unit pricing.

The interests of the unit-holders not involved in a unit transaction should be unaffected by that
transaction.

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 17. Different prices in unit-pricing.
• Offer price on offer basis: Appropriation price + initial charges
• Offer price on bid basis: Expropriation price + initial charges
• Bid price on offer basis: Appropriation price
• Bid price on bid basis: Expropriation price

18. Factors to consider while calculating surrender value:

• Take account of policyholder’s reasonable expectations
• Should treat surrendering and continuing policyholders equally
• Should not be too low at early durations, when compared to the premiums paid
• Should be consistent with the maturity value at later durations
• Should not be too complicated to calculate
• Should not exceed earned asset share
• Should take account of surrender values offered by the competitors
• Should not be changed frequently
• Avoid selection against insurer
• Be capable of being documented clearly
• Should not be subject to significant discontinuities by duration

19. List the assumptions the company would require to set the best estimate liability
• Mortality/Longevity assumption
• Mortality improvement factors
• Persistency
• Maintenance expenses
• Investment expenses
• Expense inflation rate
• Investment return
• Discount rate
• Taxation

20. Valuation approaches : Best estimate, Cashflow method, Market-consistent

Best estimate: This method will generally be used when management wishes to have a best
estimate of the company’s financial performance. For example, this might arise in circumstances
where the insurer is to be sold or where directors wish to reward key staff for their specific
contributions to the overall growth of the company.
Here assumptions will be derived based on the actuary’s best estimate of future realistic
experience, without the incorporation of any prudential margins

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 Cashflow method: A cashflow method would estimate, possibly for individual policies or
possibly with some grouping, the amounts that need to be held now to meet future claims
(including options), expense and tax outgo against the expected premium and investment
revenue inflow.

Market-consistent: To determine a market-consistent value of liabilities, future unknown

parameter values and cashflows are set so as to be consistent with market values, where a
corresponding market exists. Market values are also used for assets, if market prices exist.

Future investment returns are based on a risk-free rate of return, irrespective of the type of
asset actually held, and the discount rates are also based on risk-free rates. Risk-free rates may
be based on government bond yields or on swap rates. It may be appropriate to make a
deduction to allow for credit risk.
Under certain conditions, it may be possible to take credit for the illiquidity premium available
on corporate bonds and thereby discount liabilities at a higher yield than the riskfree rate. It
may be difficult to obtain a ‘market-consistent’ assumption for some elements of the basis, such
as mortality, persistency or expenses, for which there is not a sufficiently deep and liquid market
in which to trade or hedge such risks.
It is then likely that a risk margin would be added to the best estimate of the liabilities. This risk
margin would reflect the compensation required by the ‘market’ in return for taking on those
uncertain aspects of the liability cashflows. This could be done by adding a margin to each such
assumption or by using the ‘cost of capital’ approach.

21. Needs of the customers can be met by an endowment product:

• To save money for retirement
• To repay the capital on interest-only loan
• To transfer wealth, say from parents to children
• To provide financial protection to dependents in case of death of the life assured
• To save money for future expenses like buying house, car or to fund child education

22. Why would a policyholder surrender an endowment product:

• The policyholder doesn't need to pay the future premiums and will get a surrender value now
• The surrender benefit is payable now rather than waiting till maturity (the impact of
discounting)
• The policyholder needs money now, eg to repay a loan
• The policyholder has no further need for life cover
• The policyholder can get a better deal elsewhere.

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 23. List the factors by which the persistency experience could be analyzed.
• Distribution channel
• Target market
• Premium payment frequency
• Size of premium
• Age
• Gender
• Type of contract
• Duration in force
• Original term of the contract
• Premium payment method

24. State the options/alterations that could be attached to an assurance contract. And the
principles that alteration value must satisfy.
• Altering the premium payable
• Altering sum assured
• Altering the term of the contract
• Making it paid-up
• Option to renew contract without further underwriting

Principles:

• Affordability
• Stability
• Fairness
• Avoidance of lapse and re-entry
• Ease of calculation and explanation to policyholders
• Consistency with boundary conditions i.e. surrender, paid-up, new policy

25. Risks in different assurance and annuity contracts.

• Whole life: Mortality & Investment risks are significant although varies by age at entry and
duration in force, expense risk, withdrawal risk are also there
• Term assurance: Mortality & Anti-selection risks are significant, expense, investment and
withdrawal risks are also there.
• Endowment assurance: Investment, mortality, expenses and withdrawal risks are there,
depends on the contract design.
• Annuity: Main risk is mortality is lighter than expected, investment, expenses and withdrawal
risks are also there.
• Unit-linked: Investment risk is mostly passed to policyholders, marketing, investment, expenses,
demographic assumptions risks are also there.
• Index-linked contract: The main risk is that the assets held, if they are not an exact match, may
not move in line with the index i.e. investment risk

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26. What are the distribution channels used by life insurance companies and how they operate.
Ans. The four main distribution channels are:

Insurance intermediaries

These are independent of any particular life insurance company. They can advise their clients on the
best contracts for their needs from among all the contracts available.

They may be remunerated by commission from the insurance companies whose products they sell or by
fees from their clients.

Tied agents

These are salespeople who offer the products of only one or a limited number of insurance companies.
If the tie is to more than one company then usually the product ranges of the companies are mutually
exclusive.

Typically, tied agents are financial institutions such as banks. Tied agents are remunerated by the
companies to which they are tied. The remuneration could be in the form of commission payments or by
salary plus bonuses.

Own salesforce

These are usually employees of a life insurance company and so only sell the products of that company.
They may be paid by salary or commission or a mixture of the two.

Direct marketing

The main forms of direct marketing are telephone selling, press advertising, mailshots, and the Internet.
Telephone selling might involve ‘cold-calling’ by the company or might be in response to an
advertisement (in which case press advertising and telephone selling are part of the same process).
Press advertising might include an application form or invite requests for further information.

Mailshots will definitely include application forms.

Internet selling may be linked to advertising, and is essentially web-based application processing.

27. What are the types of expenses for a life insurance company?
Ans. Initial, renewal, terminal and overheads.

28. State the issues when constructing an actuarial model.

Ans.

• The model should be adequately documented.

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 • The workings of the model should be easy to appreciate and communicate. The results should
be displayed clearly.
• The model should exhibit sensible joint behaviour of model variables
• The outputs from the model should be capable of independent verification for reasonableness
and should be communicable to those to whom advice will be given.
• The model must not be overly complex so that either the results become difficult to interpret
and communicate or the model becomes too long or expensive to run, unless this is required by
the purpose of the model.
• The model should be capable of development and refinement
• A range of methods of implementation should be available to facilitate testing,
parameterisation and focus of results.
• The more frequently the cashflows are calculated the more reliable the output from the model,
although there is a danger of spurious accuracy.
• The less frequently the cashflows are calculated the faster the model can be run and results
obtained.

29. State the basic features of an actuarial model.

• Projecting all cashflows and profit
• Allowance for supervisory reserves and solvency capital
• Allowance for interactions and correlation between variables
• Allowance for guarantees and options

30. What is stochastic model? What are the advantages and disadvantages of stochastic model as
compared to deterministic model?
Ans. Stochastic modelling is now an alternative, under which the investment returns on asset classes
in any given period are modelled as the outcomes of random variables with specified probability
distributions. Such projections can easily be performed on a computer by allowing random drawings
to be made, from the assumed probability distributions, using the computer’s random number
generator.

Advantages:

• The method allows a probability distribution to be assigned to one or more of the unknown
future parameters.
• A positive liability can be calculated where a deterministic approach might otherwise
produce a zero liability, eg where the cashflow includes a minimum guaranteed benefit.
• The future parameters may be assumed to vary together as a dynamic set, which is
particularly useful for modelling with-profits business.

Disadvantages:

• Time and computing constraints – so stochastic modelling work might be done with a very
simplified version of the model, possibly making it unrealistic

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 • The sensitivity of the results to the (deterministically chosen) assumed values of the
parameter(s) involved.

31. What is an embedded value and how it is calculated? What is an appraisal value?
Ans. Embedded value is the present value of future shareholder profits in respect of the existing
business of a company, including the release of shareholder-owned net assets.

It can be calculated as the sum of:

• The shareholder-owned share of net assets, where net assets are defined as the excess of assets
held over those required to meet liabilities.

These assets may be valued at market value or may be discounted to reflect ‘lockin’, for example if they
are required to be retained within the fund to cover solvency capital requirements.

• The present value of future shareholder profits arising on existing business.

The calculation of the present value of future shareholder profits may differ for different types of
business.

For example:

Conventional without-profits business: the present value of future premiums plus investment income
less claims and expenses, plus the release of supervisory reserves

Unit-linked business: the present value of future charges (including surrender penalties) less expenses
and benefits in excess of the unit fund, plus investment income earned on and the release of any non-
unit reserves

With-profits business: the present value of future shareholder transfers, for example as generated by
bonus declarations.

32. What is an appraisal value?

The appraisal value is the sum of the embedded value and the goodwill (ie the estimated profits from
future business). The appraisal value may be used when an insurance company is to be sold.

33. Differentiate active and passive valuation approach.

➢ A passive valuation approach is a valuation approach which is relatively insensitive to the
changes in market conditions and a valuation basis which is updated relatively infrequently.

Example: Net premium valuation approach for liabilities. Historic cost or ‘book value’ possibly with
amortization over time.

➢ An active valuation approach is a valuation approach which is based on more closely to the
market conditions and assumptions are updated frequently.

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Example: Market consistent valuation approach for assets and liabilities, Risk-based capital approach for
the solvency capital requirement.

Advantages of Passive valuation approach:

• More straightforward to implement.

• Less subjectivity is involved.
• Stable profit emergence when used for accounting purposes.

Disadvantages of Passive valuation approach:

• Risk of becoming out of date.

• May miss the important trends.
• May provide false sense of security.
• Assumptions are updated less frequently.
• Not sensitive to market changes.
• Management may fail to take appropriate decisions in response to emerging problems until.

Advantages of Active valuation approach:

• More informative, practical and up to date method of valuation.

• Assumptions are updated more frequently.
• It is sensitive to changes in market condition.
• Help management to take appropriate actions on time in case of emerging problems.
• Enable to assess the ability of the company to meet its obligations.
• Particularly in relation to financial guarantees and options.

Disadvantages of Active valuation approach:

• May result in volatility of profits.

• It can be time consuming and costly method.
• More subjectivity is involved.
• May result in systematic risk, as other companies may also be facing the similar market
conditions.
• May indicate need for higher capital requirement.

34. Types of reinsurance contracts.

• Original terms (coinsurance) approach:
Original premiums and benefits are proportionately shared. Reinsurance commission is
significant and determines the price of the reinsurance.
• Level risk premium approach

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 The reinsurer sets a level premium rate. The insurer can price the contract taking this into
account
• Variable risk premium (recurring single premium) approach
The reinsurer sets the reinsurance premium rates. Risk premiums change from year to year,
and the rates may or may not be guaranteed for the policy duration. Reinsurance benefits
are based on a share of the full sum assured or sum at risk.

All the above types may be quota share or individual surplus. Quota share is a constant fixed
proportion reinsured; individual surplus has a maximum retention per life.

• Excess of loss – non-proportional reinsurance types

Catastrophe reinsurance – shares in the total claims above a threshold from multiple claims
from a single event. Renewable annually. Covers non-independent risks, eg group life
insurance. There may be multiple lines for group business. Stop loss reinsurance – covers
the excess of all aggregate claims in a year over a threshold, up to a maximum.
• Financial reinsurance
Financial reinsurance can help the cedant to relieve part of its new business financing
requirement. It can be structured like a loan, receiving either a lump sum or reinsurance
commissions with repayments incorporated into the reinsurance premium or paid out of
future profits.
• Facultative and obligatory
Reinsurance is usually codified by treaty. Facultative implies freedom of action, obligatory
means removal of this freedom.

35. Why an insurance company would take out reinsurance contracts?

• Limiting claim payouts (single or total)
• Reducing parameter and claim payout fluctuations risks
• Financing new business strain – use financial reinsurance and/or quota share
• Obtaining technical assistance
• Benefiting from regulatory or tax arbitrage opportunities
• Reducing costs
• Separating out different risks from a product
• Allowing aggregation of risks that could not otherwise be written

36. What factors the company should consider before taking a reinsurance contracts?
• Cost of reinsurance
• Counterparty risk
• Legal risk
• Type of reinsurance
• Amount of reinsurance

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37. Factors to be considered when setting retention limit.
• Average benefit level for the product and the expected distribution of the benefit
• Company’s insurance risk appetite
• Level of the company’s free assets and the importance attached to stability of its free asset
ratio
• Terms on which reinsurance can be obtained and the dependence of such terms on the
retention limit
• Level of familiarity of the company with underwriting the type of business involved
• Effect on the company’s regulatory capital requirements of increasing or reducing the
retention limit
• Existence of a profit-sharing arrangement in the reinsurance treaty
• Company’s retention on its other products
• Nature of any future increases in sums assured

38. How underwriting can be used to manage risk?

Underwriting is the process of consideration of an insurance risk. This includes assessing whether the
risk is acceptable and, if so, setting the appropriate premium, together with the terms and conditions of
cover.

Underwriting can manage risks in following ways:

• It protects the insurer against anti-selection

• Identify the lives with substandard health risk
• Identify the special terms to offer to the substandard risks
• Help ensure that all risks are rated fairly
• Help ensure that mortality experience is consistent with the pricing basis
• Reduce the risk from over-insurance (through financial underwriting)
• It is particularly important for contracts that have a high sum at risk.

39. Describe the forms of underwriting can be used for a term assurance product.
• The company could use underwriting at the policy application stage.
• It could use medical underwriting to identify policyholders who were a higher than normal risk,
to assess what special terms or conditions should apply in such cases, to make sure a fair
premium is charged for each risk, or to determine whether the life should be declined. It is used
to ensure that the company is not selected against. The underwriting may use questions on the
proposal form completed by the applicant, reports from medical doctors that the applicant has
consulted, a medical examination carried out on the applicant and specialist medical tests on
the applicant. It may also be required to comply with conditions of reinsurance arrangements.
• In addition the company may use financial underwriting to ensure the benefits sought are
reasonable given the applicant’s current earnings. The underwriting may use questions on the
proposal form to identify high risk individuals for example through questions on health,

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 occupation, hobbies, place of residence, and to identify applicants with current symptoms or
conditions which may influence the insurance risk. These may be supplemented by further
questions or medical reports or tests in order to clarify the extent on any conditions and how
they should be reflected in terms given.
• In addition the company may use underwriting at the claim stage to ensure claims are valid. In
practice this is likely to be straightforward involving receipt of a death certificate but may be
enhanced if the product offers any rider benefits relating to ill health. In addition, at the claim
stage it may investigate non disclosure of preexisting conditions or whether an exclusion clause
has been triggered.

40. Describe the methods of distributing bonuses.

• Addition to benefits method:
Bonuses can be either reversionary or terminal. Reversionary bonuses are declared (added) to
the benefit during the term of the policy, and once added become guaranteed (cannot be
removed).
Regular reversionary, special and terminal bonus

Regular reversionary
A regular reversionary bonus is a reversionary bonus that is declared on a regular basis, usually
each year, throughout the lifetime of a contract. Once declared it becomes attached to the basic
benefits and is guaranteed and cannot be taken away. The amount of bonus declared can be
calculated in one of the below mentioned ways
o Simple – the bonus is expressed as a percentage of the basic benefit under the contract
o Compound – the bonus is expressed as a percentage of the basic benefit plus any
already attaching bonus
o Super compound – the bonus is expressed in terms of two percentages; one applied to
the basic benefit and a second applied to any already attaching bonuses.

Special reversionary
A company may declare part or all of a reversionary bonus as a one of special in addition to any
regular reversionary bonus that it is giving. This may be given on say re-structuring of the with
profits fund or on some special occasions such as a golden jubilee celebration of a life insurance
company. Once given, these bonuses are guaranteed and cannot be taken away.

Terminal
Terminal bonus is generally payable on a claim event. For example, death and surrenders (after
X no of years), maturity etc. In theory this implies a potentially constantly changing bonus. In
practice this does not happen, but even so a company will not guarantee to maintain the bonus
at any particular level.

The terminal bonus to give to a particular contract may be specified in a number of different
ways

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 o A percentage of total attaching reversionary bonus including any special reversionary
bonus. This percentage may vary depending upon the duration in force and original
terms of the contract
o A percentage of total claim amount before addition of terminal bonus. The percentage
generally varies according to the duration in force and size of the basic sum assured.

• Revalorisation method:
Bonuses under the revalorisation approach are granted by increasing the reserves, benefits and
premiums of with-profits contracts by a percentage, r% say.

In determining this percentage, it is common to divide surplus into a ‘savings’ profit (ie
investment surplus) and an ‘insurance’ profit (ie surplus from other sources).
A (high) proportion of the savings profit is usually given to policyholders, with the rest retained
for shareholders. Depending on the market, all the insurance profit may go to shareholders, or it
may be divided between shareholders and policyholders.

• Contribution method
The contribution principle is that each policy receives a share of distributable surplus in
proportion to its contribution to surplus. However, for this purpose policies are classified into
reasonably homogeneous groups.
Various methods exist for determining each policy’s contribution to surplus. One approach uses
a formula to identify the investment, mortality and expense profit from sample policies.

Dividends may be paid as a cash sum, converted to an addition to the benefits, or used to
reduce future premiums.

A terminal dividend may be given when the policy becomes a claim.

41. List the charging structure of unit-linked contracts.

• Policy charge or fee (taken from either the premium or the fund)
• Percentage allocation during an initial period
• A different percentage allocation after the initial period
• Bid-offer spread
• Charge for risk benefits
• Annual management charge

42. Discuss the risks to the company from the unit-linked business compared to other products and
indicate how these risks may be mitigated.

Investment risk

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 • Compared to other products, most of the investment risk from the unit-linked contracts is borne
by the policyholders.
• The life insurance company will have indirect exposure if there are charges based on fund value.
• However, the investment risk for the insurance company would significantly increase if any
guarantees are offered under the product, whether on maturity, surrender of death; but the risk
would still be less than a non-linked contract.
• Guarantees would have to be charged which would reduce the return.
• The return to be generated would have to be significantly higher than the guarantee provided,
to allow the company to deduct administrative charges and death benefit charges (if any) and
still meet the guarantee.
• The insurance company may be able to manage this risk by minimizing the guarantees, although
this will make the product less marketable.
• The guarantee is more likely to bite if the policyholder chooses a high return, high risk fund
because such funds are inherently volatile.
• Thus different levels of guarantee may be offered for investment in different funds. Although
administration will be very difficult in such a case, particularly if fund switching is allowed.
• If there is no investment choice offered the unit linked fund can be invested very cautiously.
• However, the returns from such assets may be lower than that expected by the policyholder
leading to policyholder dissatisfaction, reputational risk, high lapses and low future sales
volumes.
• The company could also consider use of derivatives, if allowed by regulations.

Regulatory changes

• Any specific regulatory restrictions on increases to charges would clearly also increase the risk.
• This type of risk will be difficult for the company to control or manage.

Expenses

• Significant risk relates to the expenses of the company being higher than the charges recovered
under the unit linked contracts.
• If the unit growth is lower than expected any recovery from fund related charges towards
meeting expenses may not be enough.
• Risk that the expense inflation is higher than expected may be managed by having some charges
linked to an index of inflation, provided this is acceptable by the policyholders
• The charges could be structured as reviewable to reduce these expense risks, but the Company
may find it difficult to review charges to fully cover expenses, especially if the unit growth has
been less than expected or compared to competitor products.

Surrenders

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 • Surrenders occurring during the initial policy years, when the non-unit fund is negative or too
small, is a significant risk under unit-linked contracts, especially when there are large initial
expenses exceeding the initial charges. The same risk applies to non-linked products.
• The selective withdrawal risk is likely to be higher, due to the more open charging structures of
the contracts, than under the comparable non-linked contract.
• A surrender penalty may then be imposed in order to reduce the withdrawal risk, but the
surrender penalty amount may be limited by competitor designs and/or regulations

43. Explain why a company may need to hold both a unit reserve and a non-unit reserve under a unit-
linked policy and how it can determine non-unit reserve?

Why hold unit and non-unit reserves:

• Under a unit-linked policy, the liability is denominated partly in terms of units and partly in
monetary terms
• The unit reserve represents its liability in terms of units under the contracts
• The non-unit reserve is the amount required to ensure that company is able to pay claims that
exceed the unit reserve, and meet its continuing expenses without recourse to further finance

Non-unit reserves:

• Non-unit reserves can be determined using discounted cashflow method

• The company should project forwards its non-unit cashflows (eg charges, expenses, benefits in
excess of the unit fund) on the reserving basis.
• This may need to be performed on a policy-by-policy basis.
• The calculation process starts with the last projection period in which the net cashflow becomes
negative
• An amount is set up at the start of that period which is sufficient, allowing for earned
investment return over the period, to “zeroise” the negative cashflow
• This amount is then deducted from the net cashflow at the end of the previous time period
• The process continues to work backwards towards the valuation date, with each negative being
“zeroised” in this way.
• When the process has been completed, if the adjusted cashflow at the valuation date is negative
then a non-unit reserve is set up equal to the absolute value of that negative amount.

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