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Introduction

The Introduction to ILA module will give an overview of the role of an actuary in a Life and Annuity context. The module will give a strong foundation of understanding of life insurance and annuity product features, markets and distribution. Candidates will also learn the fundamentals of product development, pricing, reinsurance, valuation, financial reporting and administration. This module lays the groundwork for the Fellowship exams in the Individual Life and Annuities track.

Module Learning Objectives

• Understand the role of actuaries in an insurance company context.
• Understand life insurance and annuity product types, benefits and product features; insurance market, consumer needs and distribution channels; and types of companies in the insurance space.
• Assess the financial reporting environment including key stakeholders.
• Understand the basic product designs, design process and actuarial cycle.
• Understand the theory of reserving.
• Understand the basic insurance administration, underwriting of insurance risks and payments of claims.

The Introduction to ILA module consists of six sections:

1. Module Introduction and Role of the Actuary
2. Products, Markets, and Company Type
3. Insurance Company Financial Reporting Environment
4. Product Development Process
5. Basic Principles of Reserving
6. Insurance Administration, Underwriting, and Claims

Module Introduction and Role of the Actuary

The goal of this section is to provide you with an understanding of:

• The roles and responsibilities of actuaries in life insurance companies, such as in the areas of valuation, pricing, policy illustration, and enterprise risk management.
• The key functional areas of a life insurance company.
• Valuation methods applied in the Canadian and US life insurance industry.
• How actuaries perform experience studies and use study results to set assumptions.
• How actuaries develop actuarial models, such as pricing, valuation and capital models.

The Roles and Responsibilities of Actuaries

Roles of a Life Actuary

• Assess the probability of an event and its financial consequences
• Manage Risk: reduce the likelihood or decrease the impact of undesirable events
• Model the financial impact

Skill Sets

• Specialized math knowledge
• Analytical, project management, and problem-solving skills
• Business sense
• Communication skills
• Computer skills

Traditional Roles for a Life Actuary

• Product Development and Pricing:
  • Design and develop the product that meets the policyholders’ needs.
  • Identify, assess and price the risks exposed to the company due to the product issuance.
• Valuation:
  • Calculate actuarial reserves in accordance with relevant standards of practice and the insurer’s internal policies/guidelines, thereby ensuring that the reserves are adequately quantified to meet all the insurer’s policy obligations.
• Asset and Liability Management (ALM):
  • Manage financial risks exposed to the company, by formulating, implementing, monitoring, and revising strategies related to assets and liabilities in an attempt to achieve financial objectives for a given set of risk tolerances and constraints.
  • Provide regular direction to investment management and to the design of products (including product or pricing features) in relation to the supporting assets.
• Experience Study:
  • Analyze historical data.
  • Develop assumptions for various purposes, such as pricing, valuation, and other financial analyses.
• Capital Management / Risk Management:
  • Project company’s future capital needs and solvency position.
  • Identify possible threats to the financial condition of the company and appropriate risk management or corrective actions to address those threats.
  • Inform the company’s management about the significant risks exposed.
• Actuarial Modeling:
  • Develop/modify/validate actuarial models used for various purposes such as pricing, valuation, capital projection, etc.
• Reinsurance Management:
  • Develop the purpose of reinsurance (such as transferring risk, enhancing capital position).
  • Negotiate reinsurance treaties to meet profitability target.
  • Perform reinsurance analysis and identify benefits and costs of reinsurance.

Key Functional Areas of Life Insurer

Appointed Actuary – United States

• Qualifications
  • Notify the Regulator for the state of domicile for the company
  • Must be a Member of the American Academy of Actuaries (MAAA)
  • Must follow the MAAA Code of Professional Conduct
• Responsibilities
  • Value the actuarial and other liabilities for each year’s financial reporting period
  • Ensure the assumptions and methods for the valuation of policy liabilities are in accordance with:
    • Actuarial Standards of Practice (ASOP) established by the Actuarial Standards Board (ASB) of the American Academy of Actuaries
    • Applicable regulations
  • Provide an opinion compliant with the Actuarial Opinion and Memorandum Regulation (AOMR) on:
    • The appropriateness of the policy liabilities as of the valuation date based on their asset adequacy analysis of the sufficiency of the assets to support the policy liabilities.
    • The Valuation Manual Section 30 (VM-30) outlines the requirements of the AOMR. The documentation of the reserve assumptions, methodology, calculations, and review that the actuary must follow is described in VM-30.
• Influential Factors to AA’s Work
  • ASOPs
  • Legal and Regulatory Requirements
  • Professional Requirements Promulgated by Employers or Actuarial Organizations
  • Evolving Actuarial Practice
  • Own Professional Judgment

Appointed Actuary – Canada

• Qualifications
  • Notify the Superintendent
  • Must be a Fellow of the Canadian Institute of Actuaries (FCIA)
• Responsibilities
  • Value the actuarial and other liabilities as at the end of a financial reporting period
  • Ensure the assumptions and methods for the valuation of policy liabilities are in accordance with:
    • Accepted actuarial practice in Canada
    • Applicable legislation
    • Associated regulations and directives
  • Provide an opinion on the appropriateness of the policy liabilities at the calculation date to meet all policy obligations of the Company. The work to form that opinion includes:
    • Examination of the sufficiency and reliability of policy data
    • Analysis of the ability of the assets to support the policy liabilities
  • File with its annual return, the Appointed Actuary’s Report (AAR) on the policy liabilities
    • Instructed by OSFI’s annual Memorandum
  • Meet with and report to the directors or the chief agent on the company’s financial position in each financial year
  • Prepare Dynamic Capital Adequacy Testing (DCAT) report on the company’s expected future financial condition annually
  • If the company mains a participating account, AA needs to report to the directors in writing on:
    • The fairness to participating policyholders of a proposed dividend, bonus or other benefit
    • Whether it is in accordance with the dividend or bonus policy
    • Whether the method selected for allocating investment income or losses and expenses to the participating account is fair and equitable to the participating policyholders
    • Whether a payment/transfer to shareholders from the participating account would materially affect the company’s ability to comply with its dividend or bonus policy or to maintain the level of dividends paid to participating policyholders
  • Provide a memorandum [ref]OSFI expects the AA provide a memorandum covering the areas where the calculation required discretion or where significant technical calculations, methodologies and judgments were applied.[/ref] to confirm the LICAT and LIMAT calculations have followed OSFI’s LICAT Guideline

Illustration Actuary

• Applicable to 
  • US companies that sell individual life insurance products
• Qualifications
  • Must be a member of the American Academy of Actuaries (MAAA)
  • Must follow the MAAA Code of Professional Conduct
  • Must follow the Life Insurance illustrations Model Regulation (LIIMR)
• Responsibilities
  • Notify the regulator for the state of domicile for the company
  • Follow the Life Insurance illustrations Model Regulation (LIIMR) to certify that life insurance illustrations of future projected policy values are compliant with this regulation and “self-supporting” [ref]The primary requirement of the regulation is that the illustration of future values must be “self-supporting.”[/ref]
    • Self-Supporting: illustrated policy values do not exceed accumulated values based on realistic assumptions for all points in time beyond 15 year

Insurance Contract Valuation Methods

Canada

• Actuarial liabilities are calculated by the Canadian Asset Liability Method (CALM)
  • For each scenario and after reinsurance, the amount of actuarial liabilities = the amount of supporting assets, requiring sufficient but not excessive provision for the insurer’s obligations.

US

• Calculation or review of policy reserves is subject to the Valuation Manual (VM)
  • Principle-based reserves (PBR) and Actuarial Guidelines (AG) [ref] The AGs provide product and reserve technique specific reserve requirements thereby supplementing the requirements of the VM. [/ref] are defined by VM.
  • Details of Reserve Calculation are described in VM-31
  • Reading:
    1. Valuation Manual Section 30, 31
    2. ASOP No. 22 Statements of Opinion Based on Asset Adequacy Analysis by Actuaries for Life or Health Insurers
    3. ASOP No. 52 Principle-based Reserves for Life Products

Experience Studies for Assumption Setting

Traditional Experience Study Process

1. Determine appropriate experience period
2. Gather data and validate data
3. Perform exposure calculations (exposure could be based on face amount, policy count, or other metrics)
4. Calculate actual figures
5. Calculate expected figures
6. Calculate the actual-to-expected ratios
7. Group/split results
8. Analyze study output
9. Validate results and produce report

Types of Experience Studies

• Economic Assumptions: credit defaults, credit spreads, equity returns, equity return volatility, correlations, investment expenses
• Non-Economic Assumptions: mortality, mortality improvement, morbidity, expense, lapse, other policyholder behavior assumptions such as product conversion, partial withdrawal, etc.

Considerations

• Key Considerations: The credibility and homogeneity of data
• Adjust the raw data: Exclude subset of data, modify data for temporary, correct data
• Validate internal experience study by comparing with the results from the external study

The Use of Predictive Analytics

• Allow a company to gain new insights into various factors affecting the emerging experience
• Allows a company to leverage much more data and allows the examination of the relationships between the variables that are being examined on an all-else-equal basis

Setting Assumptions

• Basis: Experience study results
• IF Products:
  • Validate the existing assumptions
  • Confirm the continuous appropriateness of the current assumptions used.
  • Where the experience study result suggests a significant or permanent shift in the emerging experience from the originally assumed basis, consider developing new assumptions and establishing new basis
• NB Products: set assumptions based on similar studies of experience conducted for other products, or relevant industry experience, or mix of insurers’ and industry experience

Developing Actuarial Models

Stochastic Models vs. Deterministic Models

Deterministic Models

• • Assumptions are predetermined.
  • Output is fully determined by the parameter values and the initial conditions.
  • Loss distribution is expected to be symmetric and stable over time, with most of the dispersion close to the mean or median result.
  • Risks are diversifiable risks where there are a large number of independent heterogeneous risks.

Stochastic Models

• • Assumptions combine random variables and probabilities.
  • Output is a distribution of likely results.
  • Generate possible future paths for the underlying state variables, thereby obtaining a probability distribution of values for the risks

The Actuary’s Roles in Model Use

Key Areas of actuary’s roles in model use are:

• • Selection, design, development, modification of a model. : 
  • Choice of assumptions appropriate for use in the application of the modeling process.

Model Selection

1. 1. Specify purpose of the model (e.g. pricing, valuation, ALM)
   2. Identify sources of input for the model (This includes understanding data and confirming assumptions)
   3. Select the actuarial platform and develop the model

Analysis

To determine the appropriateness of the set of assumptions employed, the actuary performs sensitivity testing to know what extent results projected by the model will change with changes in the assumptions employed.

Model Validation

Compare the model output against emerging experience over time to confirm or adjust the model design.

Back-Testing

Under the back testing, the actuary applies the model to project experience for a past period to identify how closely the model results are compared to reality.

The Actuary’s Roles in Model Governance

• Setting out the model governance framework, which includes a formal policy/guideline with defined responsibilities and oversight in managing model risks;
• Performing model validation and user tests; validation should include verification of inputs, calculations and outputs;
• Model documentation and the documentation of model validation;
• Ongoing monitoring of model performance, and model change management.

Products, Markets, and Company Type

Upon successful completion of this section, you will be able to:

• Define life insurance.
• Compare life insurance product types, benefits, and product features.
• Describe annuity product types, benefits, and product features.
• Discuss other individual insurance product types, benefits, and product features.
• Explain insurance market segments including size and trends in life insurance.
• Explain distribution channels and trends in life insurance.
• Describe types of insurance companies including mutuals, stock companies, and companies with nontraditional structures and business models.

Definition of Life Insurance

Contract Law

A life insurance contract is a document representing the agreement between an insurance company and the insured.

Elements to valid a life insurance product:

• Offer and Acceptance
  In many cases, the offer of an insurance contract is made by the applicant when the application is submitted with the initial premium. The insurance company accepts the offer when it issues the policy.

• Consideration
  In a life insurance contract, the insured person makes a premium payment (consideration). In return, the insurance company promises to pay in accordance with the terms of the contract.

• Competent Parties
  The insurer is considered competent if it has been licensed or authorized by the state(s) in which it conducts business. The applicant, unless proven otherwise, is presumed to be competent with three possible exceptions: he or she is a minor, mentally infirm, or under the influence of alcohol or drugs.

• Legal Purpose
  The object of the contract and the reason the parties enter into the agreement must be legal.

A life insurance contract is:

• Unilateral: A life insurance contract is unilateral, under which only the insurer makes a legally enforceable promise to pay covered claims. If the insured pays the required premium, the insurer has to pay a qualifying death benefit.
• Aleatory: The parties involved do not have to perform a particular action until a specific event occurs.

State Requirements

For life insurance, the contract must contain certain provisions.

• Entire Contract Clause: A provision in an insurance contract stating that:
  • The entire agreement between the insured and the insurer is contained in the contract.
  • A description of the benefits is provided
  • A description of the premiums
  • Several other requirements depending on the product design.

Reading: Section 1: ADDITIONAL SUBMISSION REQUIREMENTS of IIPRC-L-04-I: Individual Term Life Insurance Product Standards

Insurable Interest

A person is said to have an insurable interest in themselves or if the life of the insured would cause financial hardship upon death. Examples are:

• A person taking out insurance on themselves.
• An immediate family member taking insurance on another member of the family.
• A business partner with shared ownership and division of labor to manage the business.
• A valued employee that would require expenditures to find a suitable replacement. 

Internal Revenue Code §101 And §7702

In order for the benefits associated with the form to have preferential tax treatment as life insurance the form must also adhere to federal requirements provided by the Internal Revenue Code.

• Internal Revenue Code §101 Certain Death Benefit:
  • Provides exemption from taxation of certain life insurance proceeds payable upon death.
  • Defines flexible premium life insurance contracts.
• Internal Revenue Code §7702 Definition of Life Insurance:
  • Defines life insurance using one of two tests.
    The first test is the cash values accumulation test, which compares the guaranteed cash surrender value of the policy to the actuarial defined net single premiums.
  • The second test is a two-prong test that evaluates the accumulated premiums paid to the greater of the guideline single premium or the accumulated guideline level premium. The second part of the test is a minimum ratio between the cash surrender value and the policies death benefit.

Tax Advantage

The accumulation of value within a life insurance contract, as defined by state and federal regulations, benefits from two tax exemptions in most cases:

• As values build within the contract, the gain is not taxed as income until it is taken out of the contract.
• The death benefit paid to beneficiaries is tax exempt.

Internal Revenue Code §7702A

Modified Endowment Contract (MEC)

A modified endowment contract (MEC) is a tax qualification of a life insurance policy whose cumulative premiums exceed federal tax law limits.

• • Tax Exemption: Death benefits for a MEC
  • If a contract is classified as a MEC, disbursements from the policy occur on a gains first basis or Last-in-First-out basis (LIFO).

Non-Modified Endowment Contract (Non-MEC)

The considerations are withdrawn before gains. The First-in-First-out (FIFO) approach delays the taxation of proceeds until all considerations are withdrawn from the policy.

Canada’s Definition of Life Insurance

Exemption Test

Reading: Overview of Canadian Taxation of Life Insurance Policies

Uses of Life Insurance

• Debt Cancellation
  This may be formalized with credit life insurance, mortgage insurance, or the proceeds of life insurance to pay off debt.

• Replacement of Lost Income
  Cover the income that would be lost by the untimely death of the insured.

• Wealth Transfer
  Above a certain level of income and asset transference, life insurance proceeds are the only way to transfer wealth from one person to another without incurring taxation.

• Supplemental Retirement Income
  Periodic disbursements from a life insurance contract either through partial withdrawals or policy loans can be used to supplement retirement income.

• Emergency Fund
  Cash value life insurance can serve as a source for emergency fund in case of need. Cash value policies usually have a provision to take loans using the life insurance policy as collateral.

• Long-Term Care Proceeds
  The use of life insurance as a means to pay all or part of the cost of long-term care expense is relatively new. These combination products combine a life policy with a long-term care rider. There are many different ways this might be developed.

Premium Types

Almost all life insurance requires some premium to be paid. The only exception to this is a policy created under a continuation provision where the primary insured dies and other insureds included in the policy are allowed to continue as a paid up contract.

Premiums types are:

• Fixed or Guaranteed
  Premiums that are set upon issuance of the contract and guaranteed never to change.
• Indeterminate Premiums
  Policies with a current premium scale and a guaranteed maximum premium scale. The current premiums charged to a policyowner may be increase to reflect adverse experience. The current premium scale cannot exceed the guaranteed maximum premium scale.
• Flexible
  Premiums paid by the insured may vary from year-to-year. Limitations exist on the amount of premium that can be contributed and failing to pay sufficient premium may cause the policy to terminate prematurely.

Premium Structure

Premium Structure	Advantages	Disadvantages
Single Pay or Limited Pay	Premium is only required for a specified period. Once paid-up, no more premium is required. Usually have cash value.	The larger premium may trigger a MEC status.
Level	Peace of mind knowing that premiums don’t increase. The cost of the death benefit may not be covered in later years.	Overpay for the death benefit protection in the early years.
Increasing at specified duration or attained age	The initial premium is often the lowest possible rate for life insurance. The premium is more appropriate for the mortality risk.	The premium at older attained ages may become unaffordable. When the premium increases, there may be a spike in lapsation and future mortality may be higher than expected.

Product Designs

Traditional Products

• • Level Death benefits
  • Decreasing Death benefits. Some life insurance products will mimic the amortization pattern of a mortgage.
  • Increasing Death benefits. Typically, this is associated with participating life insurance

Non-Traditional Products

• • Option 1 or A: The death benefit is intended to be level
  • Option 2 or B: The death benefit includes the face amount of the policy plus the account value at the time of death
  • Option 3 or C: The death benefit includes the face amount of the policy plus the accumulated value of all or part of the premiums paid.

Comparison of Life Insurance Products

Categories

Life insurance products generally fall into one of two broad categories. The categorization is based on how the product is designed and the amount of information disclosed to the policyholder:

• Bundled: Life insurance is described as bundled when there is very little disclosed about the mechanics of how the product was developed.
• Unbundled: In an unbundled design, the policyholder may have an understanding of charges associated with various aspects. Some of the types of charges that may be imposed are below:
  • Percent of Premium: This charge is assessed based on the amount of premium paid into the contract.
  • Per Policy: Typically, a fee is associated with the acquisition or annual maintenance of the policy.
  • Per Unit of Death Benefit: An expense is associated with the amount of death benefit protection.
  • Percent of Account Value: An expense is associated with the amount of value within a contract.
  • Investment Management Fees: If a policy has a separate account, the management of the separate account could have a fee based on the value of the account.
  • Cost of insurance: This is usually associated with the mortality charge associated with the insured life.

Participation Status

Life insurance can be filed as either participating or non-participating.

• Non-Participating: life does not share divisible surplus.
• Participating: provides the opportunity for the policyholder to receive dividends based on the insurance companies experience.
  • Divisible Surplus: Components to determine divisible surplus are: mortality, investment yield, expenses
  • Dividend Payment: could be paid in cash, premium payment, purchase of paid-up life insurance and purchase of paid-up one-year term insurance.

Illustrations

A life insurance product filed as illustrated has an advantage over a non-illustrated product when the product has non-guaranteed elements [ref]When a product has non-guaranteed elements, the projected future value can be shown to the consumer on a current basis and a non-guaranteed basis in an illustration. Often, the non-guaranteed projection is much more favorable to the policy holder.[/ref].

• Regulation: Involves certification upon initially filing the product and annual re-certification that the product continues to pass or is exempt from testing requirements.

Term Life

The idea behind term life insurance is that the need for death benefit protection is fleeting or temporary.

Benefits

• • Death Benefits: May be level, decreasing, or even increasing.
    • A common form of decreasing term life is associated with mortgage protection. The amount of death benefit decreases as the loan balance decreases. Insurance associated with mortgage protection can be classified as either individual life insurance or credit life insurance.

Product Features

• • Premium:
    • Can vary from limited pay, level, or increasing.
    • Can be guaranteed or indeterminate.
  • Re-Entry Term: A type of life insurance contract that offers low rates for a fixed period and will remain low if the policyholder passes periodic medical examinations.
  • Cash Value: Term life often qualifies for exemption from paying cash value. The longer the level premium period the greater the likelihood that cash values could develop where the policy does not qualify for exemption.

Advantages

• • Possibly the least expensive consumer option.
  • High death benefit when there are no cash values.
  • Highly competitive market allows consumers to shop for the best rates.
  • Offers multiple risk classes and placement into a class is determined by underwriting.
  • Could have conversion options to permanent life insurance without the need for underwriting.
  • Can be developed to meet a number of different temporary needs.
  • Riders can offer supplemental coverage for a variety of needs.

Disadvantages

• • If the contract does not have a return of premium feature, there is a “use it or lose it” aspect.
  • Increasing premium structures may result in the policy becoming unaffordable.
  • Death benefits cannot be increased without additional underwriting after the policy has been issued.
  • From the writing company’s perspective, the initial strain associated with acquisition is high compared to the premium collected. Principle-based reserving (PBR) helps to reduce initial strain and there are other risk mitigation aspects, too.

Whole Life Insurance

Whole life insurance provides death benefit protection for the life of the insured. The cash value in the end equals the death benefit and is paid to the owner.

Benefits

• • Death Benefit: Initial death benefit is much less than a term policy with the same annual premium.
  • Maturity Benefit: Unlike the death benefit, a maturity benefit payment may be taxable if there is a gain in the policy at the time of the payment.

Product Features

• • Premium: Products classified as whole life often have guaranteed premiums, which are level for the life of the policy or until it is deemed to be fully paid-up. Thus, whole life insurance often has cash value and the cash values accumulate to equal the death benefit when the policy reaches the maturity age.
  • Divisible Surplus: If the policy participates in divisible surplus, the death benefit and cash surrender value can grow significantly over time if the dividends are used to purchase paid up additions.
  • More Expensive than Term Life: because of:
    • The guarantees associated with the premium and the development of cash value. 
    • Has cash outflow that is usually not available to non-cash value term insurance.
  • Challenges:
    • Long projection periods of future death benefits and premiums.
    • Often the greatest risk associated with whole life products is investment yield rather than mortality as is the case for term insurance.
    • The net amount at risk is a decreasing function whereas the interest accumulation tends to gain in value over time.
    • The cash value also adds
      • additional administrative complexity for providers since the cash value may warrant paid-up nonforfeiture options and policy loan provisions that may not be used on non-cash value products.
      • complexity because of taxable gains and other tax reporting situations.

Advantages

• • Have guaranteed premiums which are level for the entire premium payment period.
  • Has Guaranteed development of cash value.
  • Has maturity benefit which is equal to death benefit.
  • Has cash surrender value.

Disadvantages

• • Is more expensive than term insurance.
  • Has increased exposure to investment yield risk.
  • Less death benefit protection per $1,000 of premium when compared to term insurance.
  • Increased administrative cost compared to term insurance.

Graded Benefit Life

Graded Benefit Life is often sold as a final or burial expense product. This type of a product may be either a term or a whole life design. Graded benefit life is not pre-need.

Product Features

• • The initial benefit is reduced in the first few policy years:
    • to a specified percentage of the ultimate death benefit or a percentage of premiums paid.
    • This helps to offset anti-selection and keep the premiums lower.

Unbundled Products

Some of the basic expense components in an unbundled product include:

• Cost of Insurance: This can be comparable to the pure cost of the insurance death benefit.
• Percent of Premium: Expenses associated with premium, such as premium tax or premium based commissions.
• Per Unit of Death Benefit: Expenses that can be attributed to the amount of life insurance.
• Per Policy Expenses: The expense associated with issuing or administering a single policy.
• Investment Expenses: The creation of a deposit account within the policy requires that a fund be set up to manage the pooled assets. The assets require management, and this can result in investment expense or management fee depending on the structure.

Universal Life (UL)

Product Features

• • Death Benefit: The amount paid upon death could be one of three options:
    • Option 1 or A: Face amount only
    • Option 2 or B: Face amount plus the account surrender value
    • Option 3 or C: Face amount plus a return of premiums paid
  • Investment Saving: Universal life insurance is permanent life insurance with an investment savings element and low premiums like term life insurance.
  • Credit Rate: Earnings on the account are credited and usually with minimum guaranteed credit rate.
  • Charges: The policy’s account value may decrease due to the charges withdrawn from the account.
  • Premium: Universal life insurance is an unbundled life insurance where the premiums can be either fixed or flexible. The premiums paid are deposited into a policy account and charges are taken from the account periodically.
  • Managing Account Value: Under the original approach, the company offering the product invested the assets and credited interest based on the earnings minus spreads for profitability, expense charges, and default risks.

Advantages

• • The design creates a lot of flexibility to meet different needs.
  • Has the potential to mirror investment market returns through interest crediting.
  • Different designs have led to newer products

Disadvantages

• • Complexity leads to confusion for all parties.
  • Greater care is needed in the administration because of state and federal requirements.
  • Misleading and inaccurate disclosures in the past have led to class action lawsuits (e.g. Vanishing Premium).
  • The return on the policy has the potential to be less than market returns because of the charges subtracted from the account.
  • If the policy’s account is depleted, the policy may terminate.

Variable Universal Life (VUL)

Product Features

• • Separate Accounts: The policyowner could elect separate accounts in which the account value of the life policy is invested, based on their risk tolerance and desired return expectations.
  • Shifted Risks: Almost all of the investment risk is shifted to the policyowner.
  • Regulation Control: Some of the regulatory controls are shifted to the Securities and Exchange Commission (SEC).
    • Has increased regulatory control and disclosure throughout the sales process, which includes broker dealer licensing of agents selling the products and annual requirements such as prospectus mailings.

Advantages

• • Investment gain can exceed those of portfolio assets of a life insurance company.
  • The investment orientation requires that suitability analysis be conducted by a Principal to ensure the risk is appropriate for the policyowner.
  • The separate accounts were often sold with rebalancing and dollar cost averaging strategies to help individuals manage their risk tolerance and return expectations.

Disadvantages

• • Downturns in the market can result in the account value being insufficient for expected charges.
  • Agent requirements for NASD licensing are expensive to obtain and maintain.
  • Administratively complex to manage one or many separate accounts for a single policy.
  • SEC regulatory requirements added additional expenses to develop and maintain such policies.

Universal Life with Secondary Guarantees

Product Features

• • Longer Guarantees: Offer longer guarantees than level period term and a lower premium than whole life.
  • Prevent inadvertent termination due to insufficient account value to cover the contract charges.
  • Expense of Protection: The cost of the added protection has a cost that may be either passed on in the form of additional charges or require minimum premium payments during the protection period.
  • Additional Reserve Requirements: Should consider the length of secondary guarantee period. The longer the protection period, higher the additional reserve associated with the secondary guarantee.

Advantages

• • Prevent inadvertent termination due to insufficient account value.
  • The length of the no lapse guarantee [ref]A no-lapse guarantee provides an agreement by the insurance company to keep a permanent life insurance policy in force – even if the cash value in the policy drops to zero, or less than zero, provided that a specified minimum continuation premium is made at the required time.[/ref] can be structured with minimal premium requirements allowing the product to be used as a death benefit focused design.
  • From the consumer’s perspective, they assume less risk and the company assumes more risk.

Disadvantages

• • Increases statutory reserve requirements.
  • Use of shadow accounts may complicate administration and valuation processes.
  • Minimum premium levels may be required for the no lapse guarantee to be effective.

Indexed Universal Life (IUL)

Product Features

Similar to a standard Universal Life (UL), with one exception: The floor on the guaranteed minimum rate of return

• • For UL, credit rate is determined from the return on invested assets supporting the policy minus the spread, investment expense, and default risk charges.
  • For IUL, the return on invested assets is used as the budget to purchase options, which produce an index straddle through the purchase of calls and puts. The return from the options establish a credited to the return known as the cap.

Advantages

• • Increased account value stability over traditional and variable universal life.
  • Minimum guaranteed crediting interest.

Disadvantages

• • Illustrated rate can be higher than the actual historical credited rate leading to misleading projections.
  • Complicated index formulas (e.g., annual point-to-point, monthly point-to-point).

Pre-Need Life

Product Features

Pre-need life insurance is an insurance policy whose benefits cover the cost of the predetermined expenses of a funeral, cremation or burial.

• • The primary differences of this product compared to final expense include who sells the policy and who receives the death benefit proceeds. Usually, pre-need life insurance is sold through funeral homes and the benefit is paid to the funeral home to cover burial expenses.
  • This product can be underwritten, but is more often on a simplified issue or even a guaranteed issue basis. As a result, the early duration mortality tends to be exceptionally high. Therefore, statutory reserve requirements continue to use the 1980 Commissioners Standard Ordinary mortality tables.

First-to-Die and Second-to-Die Life Insurance

Product Features

• • Joint life insurance policies cover two or more lives where a benefit is paid upon the first death or the second death.
  • The most common application for joint life insurance is for married couples or business partners.
  • Multiple life contracts can take on the structure of various contract types.

Supplemental Benefits and Riders

Types of Riders

Riders will often incur additional charges or require additional premium. However, there are some that require no additional premium:

• • Term Life Riders: Term life insurance that provides additional death benefit on the primary insured, spouse or another individual.
  • Accidental Benefits: Unintentional accidentally injury or death provides benefits. Death as a result of an unintended injury could result in benefit that could be as much as the primary benefit.
  • Long -Term Care Riders: These riders make available benefits intended to offset some of the costs associated with nursing and rehabilitation services.
  • Return of Premium: For term insurance, the insured may receive all or part of the premium paid for the policy should they reach a specified duration. Prior to that point, a vesting schedule may limit the return of all premiums.
  • Waiver of Specified Premium or Changes Only: Upon qualifying either by becoming disabled or unemployment, the contractual premiums or charges may be waived for a specified period of time or under satisfying conditions of the rider, for the remaining premium payment period of the contract.
  • Index Crediting: Whether annual or monthly point-to-point, the mechanics of a crediting mechanism in an indexed product offers greater flexibility when attached using riders.
  • Child Term Insurance: This form of term insurance may cover the life of one or more children until they reach a specified age. Upon reaching the expiry age, children often have the opportunity to convert to a separate policy without evidence of insurability.
  • Guaranteed Insurability: Additional insurance may be purchased at specified future points or at the occurrence of different life events without the need to provide evidence for insurability.
  • Cash Value Enhancement Riders: Enhance the cash value of the underlying base policy.
  • Acceleration of Death Benefit Riders: The most common acceleration riders include terminal illness, chronic illness, and critical illness. Upon qualifying conditions being met, all or part of the death benefit can be accelerated.

Annuity Products

Definition of Annuity Product

• Is a long term investment.
• to help protect annuitant from the risk of outliving income.

Benefits of Annuities

• Retirement Savings
• Tax Deferral: All money contributed to annuities, regardless of the tax status of the annuity (that is, regardless of whether the premiums paid are qualified or non-qualified funds), grows tax-deferred until it is withdrawn from the annuity
• No Contribution Limits
• Lifetime Income
• May Avoid Probate: Annuities are exempt from probate nationwide

Considerations When Purchasing an Annuity

• Long-term contract: Surrender charges generally apply if funds are withdrawn early (surrender charges often apply for the first 7 – 10 years.
• Illiquid
• Complexity: Some types of annuities, such as fixed index annuities and variable annuities, may offer additional benefits and have additional charges or fees. In such cases, the contract can be more complex than the basic annuity described above.
• No Capital Gains

Categories of Annuities

Immediate vs. Deferred

• • Immediate Annuity: Annuity is paid after the annuity is purchased.
  • Deferred Annuity: Annuity payments begin after a deferral period that is longer than the interval of an annuity payment.

Fixed vs. Indexed vs. Variable (payout can also be fixed vs. variable)

• • Fixed Annuity: A fixed annuity guarantees at least a minimum rate of interest. Additionally, fixed annuities must provide a guaranteed minimum value that satisfies the standard nonforfeiture requirements applicable to fixed annuities
  • Variable Annuity: A variable annuity does not guarantee a minimum level of interest, nor is a variable annuity required to comply with standard nonforfeiture provisions that provide a guarantee minimum value
  • Indexed Annuity: An indexed annuity (also called a fixed index annuity or FIA) is a type of fixed annuity that determines the interest credited by reference a market index. A minimum level of interest of 0% is guaranteed and it must satisfy the minimum value requirements of standard nonforfeiture laws.

Single Premium vs. Flexible Premium

• • Single Premium: An annuity can be funded via a lump sum called a single premium.
  • Flexible Premium: An annuity that allows for multiple premium is called a flexible premium annuity. Flexible premiums might be a made via a regular salary reduction or via multiple transfers from other products (e.g., other annuities or IRAs) into the annuity.

Deferred Annuities

Common Features

Accumulation Period

• • Definition: The accumulation period is the period of time from the purchase of the deferred annuity until the date when income payments will begin.
  • Cash Value: During the accumulation period, the annuity accumulates a cash value equal to premiums paid, plus interest earned, less withdrawals taken, and less any fees or charges assessed.
  • Minimum Cash Values: are generally required and are defined by state laws or other applicable regulations.
  • Death Benefit: Death benefit if the owner dies during the accumulation period. The death benefit, payable to a beneficiary, is equal to the all or a portion of the annuity’s cash value as of the date of death.

Payout Period

• • Income Period: The income period is the period of time during which income payments are made by the insurance company to the annuitant.
  • Annuity Payments: might be made “period certain”, life-contingent or life contingent with period certain.
  • Fees and Charges: surrender charge.

Liquidity Provisions

• • Partial Withdrawal
  • Surrender
  • Annuitization: Annuitization is the provision by which a deferred annuity is converted into a stream of annuity payments. This occurs through election of a payout option, such as a period certain payout or a life contingent payout. The payments are calculated based on the surrender value of the annuity and the payout option elected.

Other Features

• • Premium Bonus: A bonus amount, calculated as a percentage of the initial premium or as a percentage of each premium received during a specified period, is added to the accumulation value of the annuity at the time the premium is received. A vesting schedule or premium bonus recapture provision may apply to a premium bonus.
  • Interest Bonus: An additional interest rate that applies for a state period of time.
  • Persistency Bonus: A bonus, which may be calculated as a percentage of net premium or as a percentage of accumulation value, only applies if the contract meets certain conditions
  • Annuitization Bonus: A bonus, often a percentage of the accumulation value of the contract, applicable upon annuitization under specified conditions, such as annuitizing after at the end of the surrender charge period or after a specified number of contract years.
  • Return of Premium (ROP): An ROP provides guarantees that the surrender value will be no less than a return of net premiums.
  • Bailout Provisions: A bailout provision provides for full surrender of the contract, with any surrender charges or other penalties, if certain conditions are met.
  • Market Value Adjustment (MVA): An MVA feature helps to mitigate disintermediation risk by sharing interest rate risk between the company and the policy holder.

Fixed Index Annuities

FIA Interest Crediting Methods

The crediting method is to determine the performance of the market index, for purposes of calculating the interest to be credited to the FIA.

• • Annual Point-to-Point Method
    \(\dfrac{MIV(t)-MIV(t-1)}{MIV(t-1)}\), where:
    • \(MIV(t)\): Market Index Value at the end of the current annuity contract year.
    • \(MIV(t-1)\): Market Index Value in the beginning of the current annuity contract year.
  • Additional Factor
    • Common factors include participation rate, annual cap rates, or annual spreads.
    • Participation Rate: Interest Credited = Participation Rate x Index Gain
    • Annual Cap Rate: Interest Credited = Min(Index Gain, Index Cap Rate)
    • Annual Spread: Interest Credited = Index Gain – Annual Spread
      • An annual spread is a specified amount that is subtracted from any index gain before determining the final interest credited to the annuity.
  • Other FIA Crediting Methods
    • Multiple-Year Point-to-Point
    • Monthly Point-to-Point
    • Monthly Averaging
    • Daily Averaging
    • Multi-Year Averaging
    • High Water Mark
    • Multi-Index Strategies

FIA Guarantees

• • Guaranteed Minimum Interest Rate of 0%
  • Guaranteed Minimum Surrender Value: State regulations generally also require that an FIA provide a guaranteed minimum surrender value. This value is defined by the Standard Nonforfeiture Law for Individual Deferred Annuities (SNFLIDA). While each state adopts its own version of the SNFLIDA, many states adopt a law that is substantially similar to the NAIC Model Regulation,
    • Surrender Value > 87.5% of all premiums – withdrawals, accumulated at a minimum interest rate. The minimum interest rate is calculated according to terms set forth in the SNFLIDA.

Developments in the FIA Industry

Guaranteed Lifetime Withdrawal Benefit (GLWB) (Rider)

• • • Definition: A GLWB guarantees a specified withdrawal amount each year during the life of an annuitant)
    • Fees and Charges: A specified percentage (e.g., 0.75%) of either the accumulation value or the GLWB value. The fee is usually deducted from the accumulation value of the annuity on an annual basis.
    • GLWB Value:
      • Often, the GLWB value is equal to the premium paid for annuity, possibly with a bonus percent added, accumulated at a specified rate for a specified period of time, and reduced for any withdrawals taken.
      • Roll-Up Rate: The rate at which the GLWB value accumulates. The roll-up rate could be guaranteed, or it could depend on interest credited to the accumulation value of the underlying annuity, or both.
    • Benefits: Guaranteed Lifetime Income
      • GLWBs provide lifetime income by guaranteeing that a specified amount will be available every year. However, this lifetime income amount is only guaranteed if no withdrawals in excess of this specified lifetime income amount are taken. If an excess withdrawal is taken, the lifetime income amount available in future years is reduced.
      • Amount is determined by multiplying the GLWB value at the point in time when lifetime income is to begin by a factor called a lifetime withdrawal percentage.
    • Distinguish from Income Annuity: Having access to the surrender value and death benefit of the deferred annuity, even while taking lifetime income withdrawals from the GLWB.
    • Other GLWB Features: Multiplier Feature (increases the income amount for a specified number of years when certain conditions)

Volatility Control Indexes

• • • Definition: As an option within the index annuity, volatility control indexes, sometimes called managed volatility indexes, apply a methodology that is intended to manage volatility to a target level.

• • • Benefits: Managing to a target volatility reduces option costs, which can provide the potential for higher indexed-linked interest credits to the FIA in times of low interest rates.
    • Mechanism: Allocating between a higher-volatility component (e.g., equities) and a low volatility component (e.g., cash or bonds).
      • When market volatility is high, allocation is shifted from the higher volatility component to the low volatility component.
      • When market volatility is low, allocation in shifted from the low volatility component to the higher volatility component.

Variable Annuities (VA)

Features

• • Key Difference: Differs from a fixed annuity in that the variable annuity does not guarantee a minimum level of interest.
  • Not required to comply with standard nonforfeiture provisions that provide a guarantee minimum value.
  • No Interest Rate Risk: Interest rate risk is borne by the policy owner.
  • Regulated by the SEC: Considered as a high risk / high return investment and regulated by the SEC.
  • Separate Account: Underlying assets are generally held in a separate account and there are few investment restrictions, whereas fixed annuities are held in the general account and may have restrictions requiring higher-quality assets.
  • generally guarantee that any amount of premium can be paid and can be surrendered at any time.

Benefits – Guaranteed Income

• • Guaranteed Minimum Income Benefit (GMIB): provides a minimum level of income if the owner chooses to annuitize the underlying contract.
    • Owner must annuitize the contract to access the guaranteed income amount.
    • Owner does not get surrender value from the contract once the annuity has been annuitized.
  • Guaranteed Lifetime Withdrawal Benefit (GLWB): provides guaranteed minimum income for life.
    • Owner hoes not have to annuitize the underlying contract to access the guaranteed income amount.
    • Owner has the option to surrender the entire contract for the remaining surrender value before the end of guaranteed withdrawal period.
  • Guaranteed Minimum Withdrawal Benefit (GMWB): provides guaranteed minimum income available over a specified, non-lifetime, period.
    • Owner hoes not have to annuitize the underlying contract to access the guaranteed income amount.
    • Owner has the option to surrender the entire contract for the remaining surrender value before the end of guaranteed withdrawal period.

Benefits – Others

• • Guaranteed Minimum Death Benefit (GMDB)
  • Guaranteed Minimum Accumulation Benefit (GMAB): provides a guaranteed minimum account value at a specified future point in time.

Contingent Deferred Annuity (CDA)

Product Features

• • Provides protection against longevity risk (the risk of outliving assets in retirement).
  • Provides a benefit layered on top of the investment account。
  • Provides guaranteed lifetime income payments if an investment account is exhausted during the life of the annuitant through:
    • Allowable lifetime withdrawals, and/or
    • Poor investment performance.
  • The investment account contains the “covered assets”— typically mutual funds or managed accounts.
    • The covered assets are not owned by the insurance company and remain under the control of the policyholder.
  • The covered assets will drop below zero if the market performance has depleted the value of the assets or if the policyholder’s withdrawals have depleted the assets due to the number and/or amount of the withdrawals over the policyholder’s lifetime.

Structured Settlement

Product Features

• • provides tax-free, periodic payments over a period of time, specifically designed to meet an injured party’s needs.

Product Design

• • Structured settlements are often issued as part of a personal injury settlement, and as such may reflect substandard mortality.

Supplementary Contracts

Supplementary Contracts is an agreement between a life insurance company and a policyholder or beneficiary by which the company retains the cash sum payable under an insurance policy and makes payments in accordance with the settlement option chosen.

Other Individual Insurance Products

Credit Insurance

Product Feature

• • Whether the benefit is payable upon becoming disabled or death, the type of insurance is often priced quite differently
  • In many cases, traditional medical underwriting is not performed. Instead, the financial analysis performs to underwrite the loan often provides sufficient evidence to be insurable.
  • Credit insurance is different from traditional life or disability insurance because benefits until the outstanding balance are paid to the financial institution. Any excess benefits are paid to the policy owner or the insured’s beneficiaries.
  • Individual life insurance could be handled in a similar manner if the beneficiary is collaterally assigned to the financial institution.

Disability Insurance

Product Design

• • The insured becomes disabled and is then entitled to receive a periodic payment usually equal to a percentage of their regular take home pay as long as the percentage is less than 100 percent.
  • Anti-Selection Risk: the percentage is less than 100 percent is due to anti-selection risk that would encourage the insured to not get better.

Long-Term Care

Product Design

• • Stand-alone Long-Term Care Insurance covers the cost of home health care or institutional care received upon being unable to perform as few as two of Activities of Daily Living (ADLs).

Encountered Problem

• • Due to several factors ranging from cost, interest rate environment, and even mismanagement, stand-alone long-term care products are not as available as they once were.
  • At one time, combination life/LTC or annuity /LTC plans were thought to help close this perceived gap.
  • Another avenue to potentially close part of the gap is the accelerated death benefit rider on life policies or withdrawal riders for annuities.

Corporate and Bank-Owned Life Insurance (COLI/BOLI)

Product Design

• • are usually designed as permanent insurance plans priced specifically for the market and purpose.
  • Under COLI, a business purchases life insurance to cover the life of a key employee:
    • to provide a return on the life on the insured
    • the policy could be part of a sophisticated sale where the accumulation of cash value is used to supplement retirement benefits thought partial withdrawals or policy loans.
  • Under BOLI, a bank is the beneficiary and usually the owner of the policy. Such insurance is used as a tax shelter for the financial institutions, which leverage its tax-free savings provisions as funding mechanisms for employee benefits.
  • Managing Corporate Tax: Employer has an insurance interest in its executives thereby complying with insurable interest requirements of both tax and insurance law.

Hospital Indemnity Riders

Product Design

• • Pays a per diem benefit upon qualifying stays in a medical facility.
  • The per diem amount usually become available after meeting a short elimination period and the trigger that requires confinement may be limited to unintentional injury or all causes.

Insurance Market Segments

Defined by Customer Need

Insurance Market Segment	Detail
Protection	Death / Accidental Death Disability / Accidental Disability Critical Illness Medical Expenses
Accumulation of Wealth	For retirement For education For expenses – planned or unplanned
Maintenance of Wealth	Real growth in capital Availability of money/ liquidity
Release of Wealth	After retirement After disability To dependents Via partial withdrawals

Identify New Market Opportunities

• • Needs of insureds and brokers
  • World market: Identifying demographic and geographic trends that might have insurance implications.
  • Regulatory & legislative
  • Responding to catastrophe

Effects of External Environment

• • Social Factors
    • An example of social factors is the evolution of family structures from a single, male breadwinner covered by a traditional life insurance policy to dual-income families that need joint life plans that cover both working spouses.
  • Economic Factors
    • Variable life insurance is developed to respond the concern that level premiums calculated years ago are not sufficient to cover current expenses that have increased due to inflation.
  • Legal Factors
    • Government can always regulate life insurance to impact market opportunities and product designs.
    • Regulations may restrict product designs and tax regulations.
    • The risk is that the government can always change regulations.
  • Competitive Factors

Trends in Insurance Market

• • Microinsurance: provides insurance products that have been specifically designed to meet the needs of low income markets.

Worksite Marketing

• • Worksite marketing involves the sale of various types of insurance products to employees via their employers.
  • The goal of worksite marketing is to maximize participation. However, persistency can be one of the greatest challenges facing this market. It can also be a challenge to retain policyholders after they leave their employer.
  • Premiums are collected via payroll deduction.
  • Can benefit employees by providing convenience and potentially better rates.

Life Settlements/Viatical Settlements

• The secondary market consists of individuals and companies whose business it is to purchase existing insurance policies at a discount to face value and eventually realize a profit when the insured dies and they can collect the death benefit of the policy.
• Provides an opportunity for a policyowner to forfeit their ownership rights and the benefits of a policy in exchange for a cash payment (cash settlement is often greater than the cash surrender value of the policy or the perceived value of the death benefit from the original policyowner’s perspective).

Pre-Need Insurance

• Funeral homes often sale small life insurance policies to cover the cost of burial expenses. The pre-need life insurance market, which was introduced earlier, is different than the individual life insurance for two primary reasons:
  • Pre-need policies are distributed through funeral homes by individuals not fully licensed to sell life insurance.
  • Death Benefit: Paid to the funeral home. Any amount in excess of the cost of the burial expenses may be paid to the insured’s beneficiaries.

Distribution Channels and Trends

The Role of Distribution

• Provides consumers with access to a product;
• Provide education or technical assistance about the product;
• Provide purchase confirmation to help consumers gain confidence in their purchasing decision or that a product meets their needs.

Factors to Distribution Management

• Product type;
• Market characteristics;
• Availability of distributors;
• Characteristics of available distributors;
• Distribution resources available.

Challenge: Identify the most effective and efficient match between product, market, and distribution.

Characteristics of Life Insurance Distribution Channels

• Product:

• • Intangible
  • Difficult to understand

• Purchase:

• • Infrequent purchase
  • While necessary, not a pleasant purchase to contemplate
  • Emotional purchase

• End User (Beneficiary): is typically not the purchaser.

Direct-to-Consumer (D2C)

• Become more common across many industries.
• Growth of direct-to-consumer distribution of life insurance can be attributed to several factors, including:

• • the growth of direct-to-consumer distribution of products from other industries;
  • creating a consumer expectation that such purchasing options will exist for life insurance products as well;
  • life insurance companies’ search for cost-effective means to reach markets (e.g., the middle market) that have not been successfully reached via more traditional distribution methods.

Life Insurance Distribution Channels

• Direct Mail
• Internet Direct
• Call Center
• Home Service
• Worksite
• Financial Advisors
• Independent Agent
• Career Agent
• Multiple-Line Exclusive Agent
• IMOs

Key Steps in Distribution of Life Insurance

• Prospecting
• Needs Analysis
• Present and Close
• Manage Client Relationship

Management of Distribution

• CEO
• Head of Distribution
• Regional Directors
• Agency Heads
• Sales Managers
• Agents

Distribution Compensation

• Commissions
• Financing (of new agents via advances, subsidies, or salaries)
• Commission Advances (advance a portion of commissions expected on in-force business)
• Vesting
• Bonuses
• Expense Reimbursement Allowance
• Benefits
• Recognition
• Overrides paid to agency heads
• Gross Dealer Concession (GDC) paid to brokerage firm that then pays a portion to the representative who sold the policy

Economics of Life Insurance Distribution

Cost of Selling Life Insurance

• • Major and Biggest: Distribution Compensation
  • Revenue generated by the distribution channel
  • Cost of selling life insurance through the distribution channel

Distribution Channel Conflict

Determine which distribution channel to use:

• • align markets, products, and distribution
  • offer products that meet the needs of that market
  • through a distribution channel that the company can compensate adequately and fairly, while still meeting its profit objectives

Types of Insurers

Captives

• Definition: A wholly owned subsidiary of another company, which is to provide insurance to a non-insurance parent company. Captives are essentially a type of self-insurance in which the insurer is wholly owned by the insured.
• Various Types of Captives: 
  • Owned by a single-parent
  • Owned by an association, such as a trade or industry group.
  • Captive reinsurance subsidiaries formed by life insurers.
• Goal:
  • Mitigate the parent’s exposure to a variety of risks, including general liability risk, professional liability risk, and product liability risk.
  • Underwrite specialized coverage for the parent; one such example is oil companies insuring the risk of environmental claims.
  • Traditionally used as a solution when commercial insurance was unavailable, expensive, or difficult to obtain.
  • Nowadays are largely used for risk management and risk financing.
  • While there are tax advantages to captives, such advantages can’t be the primary reason for creating a captive; there must be a legitimate business need.

Reinsurance Companies

• With reinsurance, the ceding company is insuring some or all of the risks associated with a block of insurance policies it issues.
• Transfer of insurance risk is as part of the reinsurance transaction.
• Without the transfer of risk, the transaction is a financing arrangement not a reinsurance arrangement.

Fraternal Insurance

• Definition: Insurance issued by or available to members of a fraternal organization.
• Fraternal Organization: In North American, a fraternal organization is a not-for-profit membership organization whose members share a common social, charitable, educational, religious, or other cause.
  By virtue of membership in such associations, members have access to certain financial benefits, such as life or other types of insurance.
  Many financial institutions today, including some insurance companies, trace their origins back to fraternal organizations.

Mutual Insurance Companies

• Definition: is owned entirely by its policyholders. This differs from a stock company, which is publicly owned by investors who purchase shares of the company. 
• Compared with Stock Company:
  • Distribution of Profit:
    • Any profits generated by a mutual company are retained by the company or distributed to policyholders – who are the owners of the company – via dividends.
    • Any profits generated by a stock company are generally distributed to the investors who own the company, such that profits do not necessarily benefit policyholders.
  • Raising Capital:
    • A mutual company raises capital from its members to provide services to them. Generating sufficient capital is one of the biggest challenges faced by mutual companies.
    • A stock company raises capital from its investors, providing a larger base for raising capital.
• Demutualization: Many of the insurance companies that started as mutuals have evolved into either stock entities or mutual holding companies.  Some mutual have even become employee owned stock entities.

Insurance Company Financial Reporting Environment

After successfully completing this section, you will be able to:

• Describe accounting and valuation requirements for life insurance companies.
• Describe key financial statements for life insurance companies.
• Explain the financial reporting process including key stakeholders.
• Explain the general components of life insurance solvency frameworks, including key regulatory topics and considerations.
• Describe primary considerations for establishing financial reporting control environments.
• Explain the components and considerations for audits on actuarial calculations and describe the audit process.

Accounting and Valuation Requirements

Accounting and Valuation Requirements vary depending on:

• The audience intended
• Jurisdiction of the Insurance company
• The type of product

Accounting Principles

Accounting Principles	Primary Users	Emphasis
Statutory Accounting Principle (SAP)	Regulators	Balance Sheet: Level of Statutory Capital and Surplus (Solvency)
Generally Accepted Accounting Principles (GAAP)	Shareholders, Bondholders, Banks, Rating Agencies	Income Statement: Matching of Current Revenue with Current Costs
International Accounting Standards (IAS)	Regulators	Consistency in financial statements around the world: Avoid preparing multiple sets of financial statements for multi-national companies
Tax Basis Accounting	Internal Revenue Agency	Application of Internal Revenue Code (IRC) to policy reserves and DAC to determine taxable income for Life Insurance companies
Fair Value Accounting	Various	Consistent measurement of assets and liabilities

Valuation Types

The methodology and assumptions underlying the determination of policy reserves, which are a component of both the balance sheet, depend upon the accounting principles of the financial statements.

• Tax Reserve Valuations: Used to calculate the policy reserve for purposes of determining taxable income.
• Statutory Valuations: Helps insurance regulators assess the ability of the life insurance company to pay future benefits and service costs.
  • More conservative methodology and assumptions.
• Embedded Value: Measures the performance of a life insurance company over a specified time period.
  • Sum of: Value of in-force business, and adjusted net worth.
• Gross Premium Valuations: Performed when it is desirable to produce a “best estimate” value of the liabilities of the company.
  • May be appropriate when determining the value of a company, in the case of a merger or acquisition or when a company is being examined to determine solvency.
• GAAP Valuations: Less prescriptive than Statutory and assumptions are generally based on company experience with more modest provisions for adverse deviations. Incorporates explicit recognition of all actuarial assumptions that are considered material.

Canadian Requirements

Specific requirements for performing statutory valuations:

• Insurance Company’s Act
• Standards of Practice for the Appointed Actuary
• Canadian Asset Liabilities Method (CALM)
• Life Insurance Capital Adequacy Test (LICAT)
• Dynamic Capital Adequacy Testing (DCAT)
• Joint Policy Statement

Insurance Company’s Act

requires that a company’s board of directors appoint an actuary (“appointed actuary”)

Standards of Practice for the Appointed Actuary

The Consolidated Standards of Practice (CSoP) designed by the Canadian Institute of Actuaries (CIA) to guide the AA’s decisions. Publication includes:

• • Research Papers and Educational and Guidance notes applicable to the valuation of individual insurance products.
  • The Committee on Life Insurance Financial Reporting (CLIFR) annually prepares a letter to actuaries on “Guidance for the Current Year’s Valuation of Policy Liabilities of Life Insurers”
  • The Office of the Superintendent of Financial Institutions (OSFI) distributes an annual “Memorandum to the Appointed Actuary on the Report of the Valuation of Insurance Policy Liabilities.”

These two documents provide current advice, guidance, and requirements with respect to preparing and reporting on valuations for the current year end.

Canadian Asset Liabilities Method (CALM)

The fundamental method for calculating insurance contract liabilities is the Canadian Asset Liabilities Method (CALM). It follows these principles:

• • Liabilities should equal the amount of supporting assets for a scenario.
  • Calculate policy liabilities under multiple scenarios.
  • Assumptions that are scenario-tested don’t need Provisions for Adverse Deviations (PfAD), i.e., the amount of liability over and above the best estimate amount, determined using MfADs).
  • Assumptions that aren’t scenario-tested do need a PfAD.

Interest rate scenarios should be comprised of:

• • Base scenario;
  • Prescribed scenarios (there are currently);
  • Stochastic scenarios consistent with prescribed scenarios;
  • Other scenarios relevant to the company.

Life Insurance Capital Adequacy Testing (LICAT)

The LICAT measures the capital adequacy of an insurer and is one of several indicators used by OSFI to assess an insurer’s financial condition.

The Total Ratio focuses on policyholder and creditor protection.

Total Ratio = (Available Capital + Surplus Allowance + Eligible Deposits) / Base Solvency Buffer

The Core Ratio focuses on financial strength.

Core Ratio = (Tier 1 Capital + 70% of Surplus Allowance + 70% of Eligible Deposits) / Base Solvency Buffer

Dynamic Capital Adequacy Testing (DCAT)

According to the CSoP, the appointed actuary must make an investigation at least once a year of the current and future financial position and condition of the company, under a set of scenarios.

Objectives of DCAT

• • • Analyzes and projects the company’s capital position.
    • Goal is to help prevent insolvency.
    • Will identify threats to solvency and mitigate those threats.
    • It is defensive—not an exploration of opportunity.

Overview of Process

• • • Review recent and current financial position of insurer.
    • Understand minimum required capital requirements.
    • Run a base scenario and several adverse scenarios to understand projected capital position.
    • Reporting of results, including details on at least three adverse scenarios.

Approach

• • • Review operations and financial position for most recent three years.
    • Model base scenario for forecast period, often consistent with business plan.
    • Assess risk categories and identify those relevant to insurer—sensitivity testing used to determine relevant risk categories.
    • Selection of plausible adverse scenarios requiring further analysis.*
    • Selection of at least three scenarios for DCAT report.
    • Identify possible management actions and impact of these on financial condition.
    • Identify possible regulatory actions for each scenario that causes the insurer to fall below the minimum required capital level.

Joint Policy Statement

The Canadian Institute of Actuaries and the Canadian Institute of Chartered Accountants agreed that each would incorporate the Joint Policy Statement in its standards of practice.

Purpose

• • • Communications between actuaries involved in the preparation of financial statements, and auditors, regarding their respective responsibilities;
    • How those actuaries and auditors would interact in carrying out their respective responsibilities; and 
    • How their respective responsibilities may be disclosed to readers of financial statements.

Application

• • • An auditor is engaged to carry out an audit of financial statements in accordance with generally accepted auditing standards where the financial statements prepared by management include amounts determined by or with the assistance of an actuary.
    • An actuary considers the work of an auditor in connection with conducting the actuarial valuation to determine amounts to be included in the financial statements prepared by management.
    • Does not apply to communications with an auditor’s actuary or an external review actuary.

U.S. Requirements

The Accounting Practices and Procedures Manual produced  by the NAIC contains Statements of Statutory Accounting Principles (SSAPs) to provide principles to apply when calculating statutory reserves for individual life and annuity contracts. Sections for statutory valuations:

• SSAP No. 50, “Classifications and Definitions of Insurance or Managed Care Contracts In Force.”
• SSAP No. 51, “Life Contracts.”
• Appendix A-820, “Minimum Life and Annuity Reserve Standards.”
• Appendix A-822, “Asset Adequacy Analysis Requirements.”

SSAP No. 50

Provides a general framework for classifying insurance contracts into four categories (based on premium pattern and insurance coverage):

• • Life contracts;
  • Accident and Health contracts;
  • Property and Casualty contracts;
  • Deposit-type contracts.

SSAP No. 51

“Life Contracts“, establishes statutory accounting principles for income recognition and policy reserves for all contracts classified as life contracts in accordance with SSAP No. 50:

• • Premiums shall be recognized on a gross basis (amount charged the policyholder) when due from policyholder under the terms of the insurance contract.
  • Statutory policy reserve shall be established for all unmatured contractual obligations of the reporting entity arising out of the provisions of the insurance contract.
  • The reserving methodologies and assumptions used in the calculation of policy reserves shall meet the provisions of Appendices A-820 and A-822 and the actuarial guidelines found in Appendix C of the manual.

Appendix A-820

“Minimum Life and Annuity Reserve Standards”, contains excerpts of the NAIC model Standard Valuation Law (SVL). This is one of two very important model regulations governing statutory valuation. SVL states:

• • Company shall annually submit the opinion of a qualified actuary as to whether the reserves and related actuarial items held in support of the policies and contracts are computed appropriately.

Appendix A-822

“Asset Adequacy Analysis Requirements”, contains excerpts of the model Actuarial Opinion and Memorandum Regulation. This regulation requires the appointed actuary issue a statement of actuarial opinion. Within this opinion, the AA must attest to:

• • Being familiar with valuation requirements applicable to life and health insurance companies.
  • Reserves are at least as great as the minimum aggregate amounts required by the state in which this statement is filed.

Need for IFRS 17

• • Insurers currently use a wide range of insurance accounting practices for reporting on a key aspect of their business.
  • Differences in accounting treatment across jurisdictions and products make it difficult for investors and analysts to understand and compare insurers’ results.
  • Insurance contracts often cover difficult to measure long term and complex risks. Insurance contracts are not typically traded in markets and may include a significant deposit component, posing further measurement challenges. Some existing insurance accounting practices fail to reflect adequately the true underlying financial positions or performance arising from these insurance contracts.

IFRS 17 is expected to addresses these issues. IFRS 17 is expected to make:

• • insurers’ financial reports more useful and transparent.
  • insurance accounting practices consistent across jurisdictions.

IFRS 17 Requirements

IFRS 17 requires a company that issues insurance contracts to report them on the balance sheet as the total of:

• • the fulfillment cash flows—the current estimates of amounts that the company expects to collect from premiums and pay out for claims, benefits and expenses, including an adjustment for the timing and risk of those amounts.
  • the contractual service margin—the expected profit for providing insurance coverage.

IFRS 17 requires a company to group contract:

• • distinguish between groups of contracts expected to be profit making and groups of contracts expected to be loss making.
  • Any expected losses arising from loss-making, or onerous, contracts are accounted for in profit or loss as soon as the company determines that losses are expected.

The company:

• • accounts for changes to estimates of future cash flows from one reporting date to another either as an amount in profit or loss or as an adjustment to the expected profit for providing insurance coverage, depending on the type of change and the reason for it.
  • chooses where to present the effects of some changes in discount rates—either in profit or loss or in other comprehensive income.

Key Financial Statements

Source of Earnings View

• Expected Profit on In-Force: Release of margins in reserves, net management fees received.
• New Business Gain/Strain: How much does the company make/lose as a result of writing new business.
• Experience Gains/Losses: Impact of differences between actual experience and best estimate assumptions (i.e. ,from mortality, lapse, expenses).
• Income on Surplus: Income, net of expenses, on company’s surplus fund.
• Taxes: Gain or loss from taxes if the company performs their analysis on a post-tax basis (and thereby would have an assumption for tax rate)

METHODOLOGY

Expected Income: Expected income from operations for the period consists of the release of Provisions for Adverse Deviations (PfAD) on business inforce at the beginning of the period, expected income on fee-based businesses, expected income on deposits, and possibly the expected income from new business written in the period.

Components of Calculation

Expected Profit

• • • • The release of Provisions for Adverse Deviations (PfADs)
      • Net management fees (i.e., net margin on mutual fund and/or segregated fund, ASO contract, etc.)
      • Expected income on deposits.
      • Expected profit after renewals on inforce business would also be included in the expected profit category.
      • Scheduled amortization of balance sheet allowances for acquisition expenses and other capitalized expenses.

Impact of New Business – Point of Sale

• • • • The difference between the premium received and the sum of the liability established at the point of sale and expenses incurred and allocated constitutes a gain or, if negative, a loss (or strain) at issue.
      • The relationship between the valuation margin and the profit margin inherent in the pricing.
      • The difference between valuation best estimate assumptions and pricing best estimate assumptions, including:
        • The difference between the actual initial expenses charged and the current best estimate acquisition expenses.

Experience after the point of sale would be considered as experience gains and losses rather than as related to new business.

Experience Gains and Losses – Current Period

• • • • Only the differences in experience that are not in the Control of the Company be included in this component.
      • If the company decides to increase its profit margin on fee income business, the impact would be shown in the Management Action component rather than in the experience gains and losses component.
      • If the profit on fee income business were higher than anticipated because there were more funds under management resulting from a lower lapse or a higher natural increase, the difference from the anticipated profit would be included in the experience gains and losses component.
      • Differences between current period actual experience and accounting estimates (accruals) made in previous reporting periods would be included as experience gains and losses.
      • The impact of currency changes during the reporting period would be shown as experience gains and losses. That is, the beginning of period exchange rate would be used in the determination of expected profit.

Changes in Assumptions and Other Changes

• • • • Best Estimate Assumptions and Margins
      • Changes in Methodology
      • Correction of Errors
      • Management Actions

Income on Surplus

• • • • Debt servicing costs (other than those already reflected in liabilities) would be netted against other surplus income.
      • If corporate expenses are charged against net surplus investment income for reporting purposes, then they would be charged against surplus income for Sources of Earnings purposes as well.

Taxes

A company choosing to analyze results on a post-tax basis would determine the impact of tax on a line-by-line basis in the analysis, and would then include an experience gain for tax as well as for other experience factors (that is, the difference between expected and actual taxes).

Financial Reporting Process

• Definition: The financial reporting process is a process that valuation actuaries are deeply involved in that starts with a “closing-date” (valuation date or “as-of date”) when a snapshot of the policies, data and assumptions are locked down, through a number of steps where in the end, financial reports are generated and reported to the various authorities.

Data Gathering and Assumption Setting

• Policy extract data:

• • Purpose: Data gathering
  • Includes policy extract, fund value related, transaction file (premium, credited interest, COI charges, expense charges, etc.)
  • Can be grouped (model point) or ungrouped (seriatim)

• Plan Description Data:

• • Purpose: Assumption setting
  • Includes plan design, valuation method, valuation assumptions

Calculation Module

The gathered data and assumptions are fed into the Calculation Module to get the reserves calculated.

• Input: Data and assumptions
• Core Calculation Engine:  A model that projects the insurance amounts and cash flows from issue date, combined with using the appropriate valuation method and assumptions to perform the reserve calculation for each model point/policy as of the valuation date.
• Output: policy reserves and various reports.

Testing and Analysis

Frequently used analyses are:

• Trend analysis
• Explanation of change in reserve
• Key rates analysis
• Key policy statistics analysis

Key Stakeholders and Financial Reports

• Management and Internal Stakeholders: To make business and strategic decisions
• Regulators: Statutory reports, focus on solvency
• Shareholders, Analysts: US GAAP, focus on earnings and cash flows
• Rating Agencies: Both solvency and cash flows

Automating and Optimizing the Financial Reporting Process

Automation can significantly increase productivity and release resources for other, more critical initiatives. It can also minimize human error and even improve team morale.

• Obstacles: “Nothing is broken” mentality, key man syndrome, etc.

Solvency Frameworks

U.S. Solvency Regulatory Core Principles

• Core Principle #1: Regulatory Reporting, Disclosure and Transparency
• Core Principle #2: Off-site Monitoring and Analysis
• Core Principle #3: On-site Risk-Focused Examinations
• Core Principle #4: Reserves, Capital Adequacy and Solvency
  • Accounting standards, risk-based capital requirements, minimum statutory reserves, and state-specific minimum capital requirements form the backbone of the reserve and capital adequacy requirements.
• Core Principle #5: Regulatory Control of Significant, Broad-based Risk-related Transactions/Activities
  • Certain significant, broad-based transactions/activities affecting policyholders’ interest must receive regulatory approval. These transactions/activities encompass licensing requirements; change of control; the amount of dividends paid; transactions with affiliates; and reinsurance.
• Core Principle #6: Preventive and Corrective Measures, Including Enforcement
  • These measures range from requiring the insurer to provide an updated business plan in order to continue to transact business in the state to seeking a court order to place the company under conservation, rehabilitation, or liquidation.
• Core Principle #7: Exiting the Market and Receivership
  • The legal and regulatory framework defines a range of options for the orderly exit of insurers from the marketplace. It defines solvency and establishes a receivership scheme to ensure the payment of policyholder obligations of insolvent insurers subject to appropriate restrictions and limitations.

United States Solvency Regulatory Mission

• Purpose: To protect the interests of the policyholder and those who rely on the insurance coverage provided to the policyholder first and foremost, while also facilitating the financial stability and reliability of insurance institutions for an effective and efficient marketplace for insurance products.
• Mission statement: Policyholder is the focal point of the mission. It is felt that “facilitating the financial stability and reliability of insurance institutions for an effective and efficient marketplace for insurance products” is in the best interest of policyholders. So this second part is not considered to be a separate and distinct or secondary mission, but is considered to support a focus on the policyholder.

Risk-Based Capital

Definition

• • Risk Based Capital (RBC): is a method of measuring the minimum amount of capital appropriate for a reporting entity to support its overall business operations in consideration of its size and risk profile. 
  • Required Capital: The level of surplus (difference between assets and liabilities) an insurer must hold according to the local regulator. It must be greater than or equal to a certain target or minimum level.
  • RBC Models: was developed as an additional tool to assist regulators in the financial analysis of insurance companies. Separate RBC models have been developed for each of the primary insurance types: Life, Property/Casualty, Health and Fraternal. The risk factors for the NAIC’s RBC formulas focus on:
    • Asset Risk
    • Underwriting Risk
    • Other Risk
  • RBC Ratio:

RBC Ratio = Adjusted Surplus / Authorized Control Level RBC

• • Authorized Control Level RBC:

Authorized Control Level RBC = 0.5 x Total RBC Requirement

• • Total RBC Requirement:

Total RBC Requirement = \(R_0+\sqrt{(R_1^2+R2^2+{(0.5R_3)}^2 +{ (0.5R_3+R_4)}^2+R_5^2}\), where:

• • • \(R_0\): Off Balance Sheet
    • \(R_1\): Fixed Income Securities
    • \(R_2\): Equity Securities
    • \(R_3\): Credit
    • \(R_4\): Loss and LAE Reserves
    • \(R_5\): Net Written Premium
  • RBC Levels: There are four levels of action that a company can trigger under the formula:
    • No Action (RBC Ratio > 200%)
    • Company Action Level (RBC ratio 150-200%): Insurer files financial and business plan
      • An insurer that breaches the Company Action Level must produce a plan to restore its RBC levels. This could include adding capital, purchasing reinsurance, reducing the amount of insurance it writes, or pursuing a merger or acquisition.
    • Regulatory Action Level (RBC ratio 100-150%): Above plus, regulator must examine and require corrective action
    • Authorized Control Level (RBC ratio 70-100%): Above plus, regulator may take control of insurer
    • Mandatory Control Level (RPB ratio < 70%): Regulator required to take control unless corrected within 90 days
  • Tripwire System: The NAIC RBC system operates as a tripwire system that gives regulators clear legal authority to intervene in the business affairs of an insurer that triggers one of the action levels specified in the RBC law. As a tripwire system, RBC alerts regulators to undercapitalized companies while there is still time for the regulators to react quickly and effectively to minimize the overall costs associated with insolvency. In addition, the RBC results may be used to intervene when a company is found to be in hazardous condition in the course of an examination.
  • NAIC Capital Adequacy (E) Task Force: The RBC calculations are maintained by the NAIC Capital Adequacy (E) Task Force and its working groups and subgroups. The formulas are reviewed annually in recognition of the evolving risk landscape.

•  

• RBC takes into account the company’s size and risk profile.
• The calculation of RBC is not completely factor-based because for C-3 there is Cash Flow Testing based RBC calculation.
• RBC is required related to the separate accounts of life insurance policies depending on whether the separate account carries any guarantees..
• If 200% <= RBC ratio < 250%, then company must perform a trend test.

Categories of Risks

• • General Business Risk
  • Pricing Risk
  • Policyholder Behavior Risk
  • Asset Risk

Required capital can be thought of as the aggregation of all of the risk components, divided by (1-Asset Default Factor), which is required to have the required capital grossed up for the risk of defaults on assets backing them. In a formula:

RC(t) = [Asset Default Risk(t) + Mortality Risk(t) + Morbidity Risk(t) + Interest Rate Risk(t) + Interest Spread Risk(t) + Other Risk(t) ] / ( 1 – Asset Default Factor)

• Asset Default Risk = Weighted Average of Asset Default Risk Factors * (Solvency Reserve – Policy Loans)
• Mortality Risk(t) = Mortality Factor(t) * (DB_pu(t) – Solvency Reserve pu(t)) * Survival Factor(t)
• Morbidity Risk(t) = Morbidity Factor(t) * Premium (t)
• Interest Rate Risk(t) = Interest Rate Factor(t) * (Solvency Reserve(t) – Policy Loan(t))
• Interest Spread Risk(t) = Interest Spread Factor(t) * (Solvency Reserve(t) – Policy Loan(t))
• Other Risk(t) = Other Factor(t) * Premium(t)

Considerations of Factor-Based Approach

• Although the factor-based approach makes every company’s products comparable, this approach does not recognize the complexity of different products.
• The formula does not adequately reflect all of the assumptions on which a liability should be established. It also does not reflect the volatility of some of the assumptions.
• Does not reflect risk mitigation such as reinsurance, hedging and diversification.
• It should reflect all risks, such as operational and concentration risks.

Impact of Required Capital on Distributable Earnings

Investment income is earned on the assets backing required capital.

Investment Income on Required Capital(t) = Required Capital(t-1) * Required Capital Investment Return Rate(t)

Tax Investment Income RC(t) = Investment Income on Required Capital(t) * Tax Rate(t)

Life Insurance Capital Adequacy Testing (LICAT)

Life Insurance Capital Adequacy Testing, or LICAT, is the current capital regime in Canada. The LICAT measures the capital adequacy of an insurer and is one of several indicators used by OSFI to assess an insurer’s financial condition.

The Total Ratio focuses on policyholder and creditor protection.

Total Ratio = (Available Capital + Surplus Allowance + Eligible Deposits) / Base Solvency Buffer

The Core Ratio focuses on financial strength.

Core Ratio = (Tier 1 Capital + 70% of Surplus Allowance + 70% of Eligible Deposits) / Base Solvency Buffer

Financial Reporting Control Environment

To minimize the occurrences of errors/misstatement and re-statement of their financial statements, a set of effective well-defined and well-executed internal control policies and procedures must be in place.

• A set of effective internal control policies and procedures will mitigate the risks and minimize the occurrences of error corrections, as well as financial impact.
• Frequent occurrences of error corrections decrease the confidence of the regulators, rating agencies, and investors about the company.

Internal Controls

Overview of Section 404 of the Sarbanes-Oxley Act (SOX)

Purpose: Various regulations have required public companies to implement effective policies and procedures that reasonably ensure the accuracy and reliability of the companies’ financial statements. One key regulation is Section 404 of the Sarbanes-Oxley Act of 2002 (SOX).

Requirements:

• • • All publicly-traded companies must establish internal controls and procedures for their financial reporting processes.
    • The managements of publicly-traded companies must document and test/assess the effectiveness of these internal control structures and procedures.
    • The auditors of publicly-traded companies are required to attest to, and report on, managements’ assessment of their internal controls including:
      • Areas in the process where errors may occur;
      • Risks of lack of controls;
      • Purpose of the controls (minimizing errors);
      • Types of controls (preventive, detective);
      • Techniques used for the different types of controls (ex: cross-checks, sum totals, trends, re-calculation, peer review, interview, etc.).

General Ledger Activity

* Policy data, fund balances, transactions, etc.
** Valuation methodologies/formulas, assumptions, etc.
*** Consolidation, Analyses, etc.

Number of Control Points

• The control design generally is tailored to the individual process and is subject to the process owner’s judgment and resources.
• More control points mean tighter controls, but it may be time consuming and inefficient.
• Lesser control points have the reverse effect.
• A balance between the number of control points and efficiency is the key. The process owner needs to feel comfortable with the results that he/she is signing off on.

Sample Control Design

• After the valuation policy data extract is created, there should be some controls to check that all necessary policy data as defined by the Policy Data Extract Requirements have been extracted from the administrative system and included in the valuation policy data extract. Examples of controls include:
  • control totals to confirm the numbers of records extracted from the administration system equals the number of records in the valuation policy data extract;
  • key balances between the administration system and the valuation policy data extract are equal; and
  • flags to check for any invalid data.
• There should be a control to make sure that all the data in the valuation policy data extract have been successfully loaded to the valuation system.
• After all reserves have been calculated, there should be controls to check that the reserves have been calculated for all policies.
• During the reporting process, there should be controls to make sure that the consolidation process does not omit any policies.

Change Management Control

Background

A key component of the internal control process is to manage the changes made to the existing processes, or adding/deleting new/old processes. Companies constantly make changes to their product features, systems, calculations, pricing models, business rules, etc.

Definition

Change management control refers to a formal process for making/implementing changes to a product, a system/model, calculation, and/or a process in a well-controlled environment.

Purpose

To ensure that:

• • No unnecessary / unapproved changes are made.
  • Changes are discussed, reviewed and communicated among all impacted areas.
  • Changes are documented, tested, and approved/signed off by authorized individuals.
  • Changes are implemented timely and efficiently.
  • Services are not unnecessarily disrupted.

Example of Change Management Control Process: Hypothetical Change Request

Company ABC is launching a new product feature, and the valuation team needs to revise the valuation system to incorporate this new feature in the reserve calculation.

Note: In each step, it is important to keep sufficient proper documentation for recordkeeping purpose and for audit purpose.

1. 1. Identify, summarize, and submit the change request.
   2. Assess/Evaluate the financial/operation impacts of the change request.
   3. Submit the assessment results from Step 2 for approvals. Repeat Step 2 & Step 3 as needed.
      If the change request is rejected, the change management control lifecycle ends here.
      If the change request is approved, move to Step 4
   4. Plan for the change request.
   5. Implement the change request (revise the codes/assumptions in the valuation system).
   6. Verify/Test the change request.
      Repeat Step 5 and Step 6 until the valuation system is programmed correctly.

Audit Process

Roles of Auditors / Regulators

• Internal Auditors
  • are employees of the company
  • generally report to the Board of Directors through the Audit Committee.
  • objectively conduct independent audits of the company’s various processes throughout the year, such as financial audits, technology audits and operation audits.
  • help the company in evaluating and improving the effectiveness of risk management, control, and governance processes.
• External Auditors
  • Every company has an external independent auditing firm.
  • examine the company’s financial statements to make sure that the companies’ financial statements comply with the applicable financial accounting standards, and that the numbers shown/reported are completely and reasonably accurate.
• State Examiners
  • may be either the employees of the state insurance department, or actuarial consultants contracted by the state insurance department.
  • conduct own various periodic reviews of the companies domiciled in their states, including the quinquennial review, market conduct and sales practices.
    • Financial statement review falls within the quinquennial reviews.
• Others
  • Periodically, companies may voluntarily hire outside consultants to conduct peer reviews of their works and/or control processes to minimize errors and to benchmark their works/processes against the industry’s best practices.
  • Some companies may have their own internal validation team(s) to do the job first.

Model Audit Process

• Professional judgement and skepticism
  • The auditor may determine the reasonable range of possible values.
  • The uncertainties that affect this judgement need to be disclosed.
  • The auditors may include an emphasis of matter paragraph in their report.
  • Auditing standards also require auditors to maintain professional skepticism—an attitude that includes a questioning mind and a critical assessment of audit evidence.
• Read the “Model Audit Rule” practice note published by the American Academy of Actuaries.

Audit Committee vs. Finance Committee

• The Finance Committee provides guidance about what can be done and monitors the financial transactions.
• The Audit Committee ensures that independent oversight occurs by making sure that tasks are being done according to company policies and with adequate controls.

Read:

• “The Audit Committee: Purpose, Process, Professionalism”
  Provides an overview of the audit committee roles and responsibilities. 
• “Finance-Committee-Fundamentals”
  Provides an overview of the finance committee roles and responsibilities.

Applicable Actuarial Standards of Practices (ASOPs)

Definition

In the United States., the Actuarial Standards Board (ASB) establishes the standards of actuarial practice. These Actuarial Standards of Practice (ASOPs) provides guidance to actuaries on what the actuaries should consider, document, and disclose when performing an actuarial assignment.

ASOP 10: Methods and Assumptions for Use in Life Insurance Company Financial Statements Prepared in Accordance with U.S. GAAP

Provides guidance to the actuaries with respect to setting best-estimate/market-estimate assumptions, provision for adverse deviation, approximations, documentation, communication/disclosures of the financial results. Although ASOP 10 pertains to U.S. GAAP financial statements, the guidance described in this ASOP can also be followed for any financial statements.

ASOP 21: Responding to or Assisting Auditors or Examiners in Connection with Financial Statements for All Practice Areas

Provides guidance to the actuaries with respect to their responsibilities when responding to or assisting auditors or examiners in connection with a financial audit, financial review, or financial examination.

ASOP 23: Data Quality

Provides guidance to the actuaries with respect to selecting the data, reviewing the data, using the data or/and relying on data supplied by others when the actuaries perform various actuarial services. ASOP 23 also covers the element of confidentiality, as well as the documentation and disclosure of the data.

ASOP 41: Actuarial Communications

Provides guidance to actuaries with respect to actuarial communications when issuing actuarial opinions or/and other actuarial findings. ASOP 41 describes the best practices pertaining to the content of the communication (ex: actuarial report), timing of the communication, “must have” disclosures and the identification of and the limitations of the actuary who performed the actuarial services.

Product Development Process

After successfully completing this section, you will be able to:

Describe basic product development strategies.

Summarize the product development process.

Describe and recommend basic product designs that are consistent with market needs, tax and regulatory requirements (including anti-trust).

Explain basic reinsurance arrangements.

Identify the main product risks and explain how they are mitigated through product design and reinsurance/hedging.

Product Development Strategies

Definition

• Before a company can articulate a product strategy, it needs to have a mission and a vision of the future.
• There needs to be alignment between the company’s mission, vision, strategy, culture, core competencies, target markets, and products.

Target Market

For a target market to be a useful tool, it helps if it has these attributes:

• • Precise definition or characterization of the target market
  • Clear method of reaching those in the target market
  • Members of the target market have a number of buying habits, insurance needs, or other useful characteristics in common
  • Sufficiently large to make it worth targeting

Core Competencies

A product should not only fit the target market, but also build on the company’s strengths and core competencies, which might include:

• • Low cost of capital (able to leverage results using debt or reinsurance)
  • Financial strength (high ratings, high capital ratios, strong earnings)
  • Operational efficiency (low acquisition and maintenance costs)
  • Underwriting expertise and discipline (excellent mortality results)
  • High persistency (high customer value, quality sales and service efforts)
  • Investment management (superior returns, low investment expenses)
  • Speed, flexibility, adaptability (ability to pounce on opportunities)
  • Quality of distribution (high-quality sales and service)
  • Control of distribution (ability to shift focus, products, and prices)
  • Low-cost distribution (efficient, no frills, or agents not used)
  • Sophisticated distribution ( able to sell complex products)
  • Sophisticated home office staff ( able to develop and support complex products)

A product to be sold to corporations might require the following competencies:

• • Financial strength, with the highest ratings from outside rating agencies
  • Sophisticated home office support for illustrations and insurance plan design (sometimes referred to as advanced underwriting)
  • Experience and comfort with simplified or guaranteed issue underwriting

A product to be sold through employer sponsorship may require the company to have the following:

• • Trained enrollment teams that can visit employers’ worksites to market and efficiently enroll a large number of people in a short period
  • Administration and billing systems that can electronically communicate with employers’ payroll systems to automatically handle premium payments made through payroll deduction
  • Home office support and easy access for policyowner inquiries.

To compete more effectively and profitably:

• • The company might outsource its administration or investment management to lower costs or improve service and performance. By using outside resources, a company hopes to immediately tap into expertise instead of developing that expertise on its own.
  • The company might reinsure the business to use the reinsurer’s expertise and capital, or to “outsource” the mortality cost to the reinsurer.
  • The company might use consultants to help design and price products, providing expertise or resources that are needed. Consultants may also be used to improve operational efficiency or underwriting discipline.

Risk Profile

The product’s risk profile – the size and type of risks inherent in the product – should fit the company’s goals for stability of financial results.

New Markets

• • Some experimentation outside of the company’s mission, vision, and strategy can create new markets for the future, making the company more apt to be a survivor.
  • On the other hand, too much experimentation can be a major distraction.
  • Some new products may not fit the company’s current strategy.

Product Development Organization

Product development requires input from many different groups within an organization.

Product Development Team

A team might include people with marketing, actuarial, implementation, and legal abilities. In addition, each member of the team should have more than a rudimentary knowledge of the tasks and skill sets of the other team members:

• • The actuary should understand systems constraints and processes.
  • The marketing person should understand pricing and how different pricing assumptions might affect the results.
  • The implementation person on the team should understand the marketing department’s needs.
  • The legal person should understand and be able to communicate any limitations with regards to regulatory constraints on pricing, marketing, and issuing the product.

Senior Management Input

• • Primary Role: give guidance by clarifying how the company’s mission, vision, strategy, and goals relate to the product being developed.
  • The product development team should seek senior management input early in the product development process. Ideally, such input will be used as valuable background information. Senior management should have the confidence to let the team lead the way.

Product Development Staff

Product development can be highly seasonal work.

• • Full-Time Product Development Staff: Create two problems:
    • With staff devoted to product development, the tendency over time is to develop too many products.
    • Work expands to fill available time.
  • Ad Hoc Product Development Efforts: Disadvantages:
    • There may be no continuity in product development.
    • The company might not build product development experts, especially ones with insights into several key areas of knowledge such as marketing, actuarial, and implementation.
    • Without full-time focus, the product development process tends to be reinvented for each new product. There is little process improvement. The same mistakes tend to be repeated.
    • There is a strong tendency toward interdepartmental conflict.
  • Outside Expertise: 
    • Actuarial Consultants: Provide pricing support and expertise.
    • Reinsurers: Provide advice with reinsurance of a significant share of the mortality risk.

Pricing Strategy

Buyer-Oriented Pricing Strategy

• • Penetration Pricing: A company sets the price low enough to generate meaningful level of sales
  • Neutral Pricing: A company sets the price at a level that most buyers would consider fair
  • Segmented Pricing: A company sets the price different for different kinds of buyers
  • Skim Pricing: A company sets the price high so that it maximizes profit margins

Competitor-Oriented Pricing Strategy

• • Independent Pricing: A company sets the price without consideration of its competitors’ prices.
  • Cooperative Pricing: A company makes price changes in parallel with competitors.
  • Adaptive Pricing: A company reviews the prices of other companies to determine where to set their price relatively.
  • Opportunistic Pricing: A company sets prices below cost to drive out competition.
  • Predatory Pricing: A company sets price to a level where only the most efficient can survive.

Product Life Cycle

• • Development Stage
  • Growth Stage
  • Maturity Stage
  • Decline Stage: Basic strategies for survival in the decline stage:
    • Retrenchment: The company shifts its attention to its most profitable and defensible market niches.
    • Consolidation: 

Product Development Process

Market Research

• Reading: Section 2.5 – Market Research of Life Insurance Products and Finance: Charting a Clear Course

Product Designs

• Reading: Section 2.6 – Preliminary Product Design of Life Insurance Products and Finance: Charting a Clear Course

Determine Feasibility

Get input from various stakeholders within the company, for example:

• Regulatory barrier
• Implementation barrier
• Impact on company’s other products

To avoid these scenarios, get all stakeholders involved early.

Preliminary Pricing

• Often a company faces a tradeoff between having higher profit margins and having higher sales volumes.
• Reasons why a company might decide to lower prices below the point where profits are maximized include:
  • to increase brand awareness
  • to increase market share
  • to increase cross selling of more profitable products

Final Product Design

• Reading: Section 2.7 – Final Product Design of Life Insurance Products and Finance: Charting a Clear Course

Pricing Pitfall

• Previous: Some older variable annuities that offered a guaranteed minimum death benefit would reduce the death benefit dollar for dollar on withdrawals made from the policy account value. This allowed policyholders with account values lower than the guaranteed minimum death benefit to withdraw nearly all of their account value (leaving only enough to keep the policy in force) and have a paid up death benefit.
• Now: Most variable annuity contracts now reduce the guaranteed minimum death benefit proportionately to the reduction in the account value.

Product Implementation

Product implementation consists of:

• Calculating rates for every age, gender, risk class, face amount band, etc.
• Product filing and generating sales and marketing materials.

Streamline Process: Having the impacted parties engaged in the product development process the entire way.

• Reading: Section 2.8 – Product Implementation of Life Insurance Products and Finance: Charting a Clear Course

Product Filing

• In the United States, insurance is regulated at the state level. Companies have the option to file their products individually in each state in which they wish to sell that product.
• Alternatively, companies can file their products via the Interstate Insurance Product Regulation Commission (often referred to as the Interstate Insurance Compact or just the Compact). To promote consistency and efficiency, the Interstate Insurance Compact was formed as a way for companies to file their products with a large group of states at once.

Understanding Product Standards

• Reading: The policy standards for term insurance from the Compact (IIPRC-L-04-I – INDIVIDUAL TERM LIFE INSURANCE POLICY STANDARDS)

Product Management

The performance of the product, both sales and profitability, need to be continually monitored. Changes in dividends and other Non-Guaranteed Elements (NGE), such as the credited rate, may need to be made to keep the product competitive and profitable.

• Reading: Section 2.9 – Product Management of Life Insurance Products and Finance: Charting a Clear Course

Profitability Measures

• Reading: Sections 11.5 – Present Value of Life Insurance Products and Finance: Charting a Clear Course
• Reading: Sections 11.6 – Profit Measures of Life Insurance Products and Finance: Charting a Clear Course

Product Design Considerations

Regulatory Environment

Life insurance regulation can generally be broken down into two types

• • Contract Regulations
  • Solvency Regulations

Economic Environment

• • Unemployment
    When unemployment is high, people might less likely to be able to afford life insurance or may opt for low cost basic life insurance coverage such as term insurance. When unemployment is low, people might be able to afford higher amounts of coverage and may opt for savings oriented insurance products.
  • Interest Rates
    High interest rates might make products with declared credited interest rates (such as universal life insurance or fixed annuities) appear more attractive. Low interest rates might shift the focus away from accumulation (insurance as an investment) toward death benefit protection.
  • Stock Market Returns
    Optimism with regard to the stock market might make people more inclined to purchase variable products (variable annuities, variable life insurance) or indexed products (indexed annuities, indexed universal life) where the policyholder benefits from strong market performance.
  • Inflation
    If inflation is high, people might look for death benefits that increase over time or are indexed to inflation. They might look for premium patterns that increase over time rather than level premium patterns.

Taxation

• • Reading: Section 1.5 – Taxation of Life Insurance Products of Life Insurance Products and Finance: Charting a Clear Course

Distribution Channel

There are many different types of distribution channels. Depending on the needs of the consumer, the complexity of the products and the resources of the company distribution will take different forms.

Consumer Needs

• • Income Protection
  • Wealth Accumulation
  • Wealth Distribution
  • Estate and Legacy Planning

Commission Structure

Producer Compensation

Compensations:

• • • Commissions: which are generally based on premiums received (often higher in the first year).
    • Bonuses: such as a persistency bonus for policies that don’t lapse in the first 10 or so years
    • Expense allowances
    • Fringe benefits: such as retirement contributions or health insurance.
    • Chargebacks: where a company takes back commission paid for early termination.

Compensation structure Exploited by the producer:

• • • Action: not allow first year commissions plus first year cash surrender value to exceed the first year premium.
    • Why: This would create an incentive for agents to write policies on themselves or their family and friends and pocket the difference between the premium paid and the outlay from the company.
    • How to Avoid: monitor the business being sold and keep an eye out for any ways that your compensation structure could be exploited.

Churning

Heaped Commission: When all or most of the agent commission is paid up-front, when the insurance policy is first sold, this is referred to as a heaped commission.

Potential unintended consequence of heaped commissions:

• • • Churning: which occurs when producers encourage their clients to surrender their policies often and purchase new policies.

Pricing of Distribution Costs

• • • Costs should be reflected accurately and associated with the correct cost basis within a pricing exercise.
    • Should recognize sales expenses are not associated only with the acquisition of new business. Distribution costs, which include commissions for the insurance agent and the agency manager, will occur not just in the first duration of an insurance contract, but through the life of the contract as renewal commissions are paid and overhead costs associated with sales are incurred.

Reinsurance Arrangements

Reinsurers

• Reinsurers are most often brought in near the end of the product development process when most of the details of the product design have been determined through a Request for Proposal (RFP).
• The RFP summarizes the product specifications as well as preliminary details for the reinsurance terms.
• The RFP is typically sent to several reinsurers and requests a reinsurance quote (the cost of the reinsurance). Once the quotes are received, one or more reinsures are selected for the product and a reinsurance agreement (termed a treaty) is made which specifies the final terms of the reinsurance.

Automatic Reinsurance

Definition: Automatic reinsurance is a contractual arrangement of mutual obligations whereby an insurance company is allowed to cede to a specific reinsurer a portion of an insurance policy that the company has issued.

Ceding of Risk: This ceding of risk is subject to certain criteria, utilizes a predetermined cost, and does not require the reinsurer’s approval for that specific risk.

Obligation:

• The reinsurer is obligated to accept risks from all policies or contracts which meet the criteria for automatic reinsurance.
• The ceding company is obligated to cede all policies which meet the criteria unless they wish to submit the risk for individual consideration by the reinsurer. This individual consideration is called facultative underwriting.

Reinsurance Structure:

• Under the excess structure, only information about the lives that have face amounts above the retention is shared with the reinsurer.
• Under the first dollar quota share structure, the reinsurer gains more information about each life and therefore will be able to better study the experience once it develops.

Facultative Reinsurance

Usage:

• Excess capacity
• Underwriting assistance
• Shopping for competitive ratings
• Previous Facultative Submissions

Example:

As a pricing actuary at a reinsurer and you received a request for a facultative quote on a very large policy which is above the jumbo limit. What steps should you take?

1. Confirm all of the information provided from the cedant is correct and that the case is facultative by verifying the jumbo limit has been breached.
2. Once confirmed, we would check if we have any capacity to provide on this life, and, if so, price the life to see if we can support it on treaty terms while still achieving profit targets.
3. If so, then consider giving a facultative offer at treaty rates.
4. If not, then a there are a few options.
5. We could adjust the rates to see what would be appropriate to achieve profit targets; consider making a business decision to accept the case at a loss or consider revising the jumbo limit if it’s too low.

Product Risk Mitigation

Product Risks

• Reading: Pages 469 to 480 of Life Insurance Products and Finance: Charting a Clear Course

Risk Definitions

Insurance risk

• • Insurance risk is primarily the risk that mortality or morbidity exceeds expected levels. This risk can result from random fluctuations or from incorrect pricing assumptions.
  • The risk of other incorrect pricing assumptions, such as assumptions for persistency, expenses, and investment income, may also be included here or, alternatively, they may be added under the other risk category or even ignored.

Interest rate risk

• • Disintermediation Risk: Risk of selling assets at a loss to fund substantial cash outflows.

• • • This risk is important for products with cash values. If interest rates rise, policyowners can earn more on new policies or other investments. However, the insurance company’s assets are invested in long-term securities and don’t earn new money rates. If the policyholder withdraws funds and the insurance company has to sell assets to fund such withdrawals, the assets are sold at a loss because market value is lower at that moment.
    • This risk can be limited by matching assets and liabilities. It can also be mitigated by limiting exposure to products that allow unplanned cash flows with little or low penalty.
    • This risk is expressed as a factor which is a percentage of cash value or reserves. The factor percentage will decrease if there is a market value adjustment or a surrender charge.

• • Guarantee Risk: Risk that interest rate guarantees will exceed interest rates earned.
  • Liquidity Risk: Risk that assets can’t be sold fast enough to cover cash demand on liabilities. This is an important risk since assets are invested long-term, and some assets are hard to sell quickly at a fair price, while liabilities are payable on demand.

Interest spread risk

Interest Spread Risk is defined as the risk of insufficient interest spreads due to investment and pricing decisions. Many factors can cause the pricing spread not to be realized including:

• • Communication problems between the investment, pricing and administrative departments;
  • Assumed investment opportunities become unavailable;
  • Changes in interest spread between categories of investments (i.e. 10-year corporate bonds exceed risk free by 100 bps now but later only exceed risk free by 75bps);
  • Minimum interest rate guarantees prevent the company from earning the priced-for spread if interest rates drop;
  • Competitors force the company to credit a higher rate and accept a lower spread.
  • Interest Spread Risk is normally expressed as a percentage of solvency reserves net of policy loans and reinsurance.

Asset default risk

• • Determine the overall likelihood of default of an insurer’s portfolio: Weighted average of one-year default probabilities of each asset. However, only a portion of the default is included. The investment rate used in pricing should be net of these default costs.
  • Included: non-payment of reinsurance recoverables, off-balance sheet guarantees and contingencies.
  • Excluded: Policy loans are fully collateralized by the cash value and have no default risk.

Asset Default Risk = Weighted Average of Asset Default Risk Factors * (Solvency Reserve – Policy Loans)

Other risk

• • Products are misspriced
  • Lawsuits against the company
  • Poor management or fraud
  • Change in tax laws causing lapse or higher taxes than expected
  • Adverse publicity causing in-force policies to lapse
  • Policyholder behavior differs from that assumed in pricing
  • Change in accounting or valuation regulations that diminishes the company’s capital
  • Expenses grow faster than provided-for in pricing; for example, due to inflation or due to the expense of compliance with new regulations

Mitigating Product Risks

Anti-selection

• • What: Anti-selection occurs when a policyholder suspects or knows they have a higher than average likelihood of claim and uses that knowledge to get additional value out of insurance products.
  • Mitigating Anti-Selection Risk:
    • Reduce the premium increase after the level period. The narrowed premium jump(s) may be enough to keep healthier policyholders from leaving to get re-underwritten as the hassle will not be worth the saved premium.

Terminal and Chronic Illness Life Insurance Riders

Categories

• • Terminal illness rider
    Allows policyholders to accelerate a portion of their face amount when they have a life expectancy of less than “X” months.
    • Terminal illness is defined to occur when a physician certifies that the insured has a life expectancy of less than 12 or 24 months (depending on the state).
  • Chronic illness rider
    Allows policyholders to accelerate a portion of their face amount when they are unable to perform two or more activities of daily living (ADLs) without assistance from another person.
    • ADLs include: Bathing, Continence, Dressing, Eating, Toileting and Transferring
  • Critical illness rider
    Allows policyholders to accelerate a portion of their face amount when meeting the criteria for one or more of the listed critical illnesses that are covered by the rider.

Product Design

Terminal and chronic illness riders are designed such that the rider benefit qualifies for favorable tax treatment under section 101(g) of the Internal Revenue Code (IRC). Benefits are designed in 3 ways:

• • Actuarial discounting: the face amount received is reduced to account for the time value of money and survivorship.
    • The policyholder ends up with less than the face amount.
    • An administrative fee is usually charged at the time of acceleration.
  • Hold a lien (similar to a policy loan) against the death benefit in the amount of the cumulative accelerated death benefit plus interest.
    • The policyholder still pays premium for the portion of the face amount that is accelerated.
    • When the policyholder dies, the death benefit pays off the loan and there is no tax.
    • Usually applies for a whole life policy.
    • There is also usually an administrative fee at the time of the accelerated benefit.
  • Charging the policyholder an explicit additional premium at the time the rider is applied to the insurance policy.
    

     

Risks

Bringing in the option for the policyholder to accelerate their death benefit through the terminal or chronic illness rider adds morbidity risk but also adds more possibility for anti-selection.

Why:

• • For example, consider chronic illness riders under the actuarial discounting or lien approaches.
  • If an average morbidity assumption (i.e., not varying by gender, individual age and duration) is used to determine the acceleration offer on each case, then the acceleration will more often be taken by those who expect to live much longer than the average life expectancy implied by the offer.
  • Similarly, those expecting to die soon may be inclined to reject the offer so they can get the full benefit instead of the lower acceleration benefit.
  • Ultimately, the insurer may find itself in the position where the rider costs significantly more than anticipated.

Risk Mitigation

• • Supplemental underwriting: Consists of questions related to applicant’s medical history with respect to the triggers that are used to qualify for the acceleration benefit.
  • Limiting rider issue ages and/or adding cognitive testing at particular issue ages to further check the applicant’s health.
  • Choosing either the lien or actuarial discounting design which mitigate the risk by carving the benefit out of the death benefit face amount.
  • Limiting both the annual and maximum acceleration amount to some specific dollar amount: Usually limited to ensure benefit receives favorable tax treatment.
  • Limiting the maximum benefit to be less than 100 percent of the death benefit.
  • Rider form can inherit exclusions from the base contract, such as: Mental or nervous disorders, Alcoholism, Drug addiction, Act of war, Suicide or self-inflicted injury.
  • Requiring loss of ADLs as expected to be permanent (so those with temporary ADLs would not qualify) in the policy contract.
  • Can restrict issue of the rider to only those with standard health or some maximum rating if deemed substandard by the underwriter
  • Requiring that an approved licensed health care practitioner certifies the policyholder is unable to perform ADLs in the policy contract.
  • Contest-ability rights which typically mirror the base policy.

Risk Mitigation (Reinsurance)

Participation Depends on Product Type

• • • Reinsurance participation in chronic illness benefits depends on the product type. For example, 
      • If a chronic illness rider is attached to a permanent policy, then once the insured has met the triggers for the acceleration benefit, it is very possible that the policy will ultimately result in a death benefit claim, since the policy provides permanent (vs. term) life coverage.
      • Since permanent policyholders lapse less often, the average age increases which increases the likelihood of death.
      • Also, since these permanent policy individuals will likely not lapse, the discounting calculation will need to take into account a larger share of lost premium and interest.
    • Reinsurers will participate if they can get comfortable with the risk control measures.
    • Not all reinsurers are comfortable participating in a stream of payments to the insured (if that is an option to the policyholder); however, the reinsurer may instead make a one-time payment at death or lapse.

Attached to Term / Permanent Life

If a chronic illness rider is attached to a term policy, calculations are similar to those made when the rider is attached to a permanent policy, but:

• • • the portion of term policies that ultimately result in a death claim is significantly lower,
      • because the policy only provides coverage during the stated term (rather than for life, as is the case with a permanent policy).
    • The cost of offering the rider is higher on a term policy than a permanent policy. 
      • because policyholders who are in poorer health when the premiums jump may not be able to afford the policy and lapse resulting in no benefits. With the benefit acceleration they can access the benefit sooner without paying as many of the higher premiums.

This creates more uncertainty in the actuarial present value calculation.

Term Life Converted to Permanent Life

A similar argument holds when chronic illness riders are included upon conversion to permanent policies. In that situation,

• • • Risk Control Measure: require completion of the rider application if the policyholder wants to convert from a term policy without the rider to a permanent policy with the rider. Adding this application gives an opportunity to collect updated information on the policyholder which can then be used to deny the rider if something critical is found. An example would be a policyholder who converts to take advantage of the insurer as they know they have a condition that will qualify for acceleration that otherwise they couldn’t get under their current policy.

Other Considerations

• • • If writing company charges for the rider, how is the reinsurer compensated?
      • One way could be to pay the reinsurer a lump sum representing the present value. Another way could be to pay the reinsurer additional net premiums.
    • Should a YRT reinsurer wait until death to pay its portion of the Net Amount at Risk (NAAR)? If so, then what happens to a policy that accelerates a portion of death benefit and then lapses?
      • A reinsurer can pay its portion of the NAAR at acceleration or not. Whether a reinsurance benefit is paid in the acceleration and then lapse scenario should be agreed upon in advance in the reinsurance treaty.

•  

• • • •  

•  

Combination Life or Annuity with Long Term Care (LTC)

Main Products

• • Standalone LTC. Lapse supported.
  • Life/LTC Combination: Life insurance (UL, VUL, Indexed UL, Whole Life) with an LTC rider/benefit. Lapse not supported.
  • Annuity/LTC Combination: Annuity (mostly fixed but could be deferred, variable or fixed indexed) with an LTC acceleration or lien approach. Lapse not supported.

Standalone LTC Product Structure

• • Modern policies include LTC trigger requirements which specify that services be provided either as a result of the inability of the insured to perform at least two of the six ADLs, or as result of cognitive impairment.
  • Inflation protection must be offered as an option under NAIC LTCI Regulation requirements: Most common form is to increase daily maximum by 5 percent per year.
  • Policy benefits are usually limited by daily, weekly, or monthly amounts.
  • Periodic payments may be based on:
    • Expense-incurred designs;
    • Indemnity-based designs;
    • Disability-based designs.
  • Elimination periods commonly apply prior to benefit eligibility.
  • Ancillary benefits are common including:
    • Waiver of premium;
    • Care advisory services;
    • Bed reservation benefits;
    • Respite care benefits.
  • Regulation requires that premiums do not increase after age 65.
  • Policies are typically guaranteed renewable meaning the coverage cannot be canceled but the company may increase rates.
  • Lifetime level pay plans have been the standard premium structure.

Life/LTC Combination Product Structure

• • Life/LTC combination benefit payout structure is typically defined as an accelerated benefit where LTC benefit payments are accompanied by concurrent dollar-for-dollar reductions in the base life face amount.
  • Alternative structure is to use a lien approach:
    • Current base life values including NAAR and interest credited are unaffected by prior LTC payments.
    • Upon surrender or death, benefits are reduced by the lien.
  • Difference between the two structures is that the lien approach credits higher interest to policyholders but assesses higher COI charges since NAARs are not reduced.
  • Under an accelerated benefit rider design, the excess of the maximum pool amount over the cash value defines the NAAR.
  • Almost all life/LTC combination structures are based on a design under which benefit payments are based on a maximum LTC pool amount defined at issue, usually directly linked to the base life face amount.
  • Benefit payments reduce the remaining maximum LTC pool and base life face amount under most designs.
  • The cash value is reduced on a pro rata basis based on the benefit payment and the remaining maximum LTC pool amount.
  • Benefit payments under this structure are taken partially form the cash value and partially from the NAAR to the company.

Annuity/LTC Combination Product Structure

• • Annuity/LTC combination product payout structure typically begins with an accelerated benefit where LTC benefit payments are made from the annuity account value (AV) without surrender charge.
  • Benefit is paid monthly and is usually expressed as a percentage  of annuity AV at time of initial claim.
  • Three approaches:
    • Tail Design
      Benefits are paid first from the AV until the maximum accelerated benefit has been exhausted, followed by an EOB provision that continues LTC payments at the same monthly level.
    • Coinsurance approach
      Accelerated and independent benefits are paid concurrently in fixed proportions until the LTC benefit limit is exhausted.
    • Pool Design
      • Benefit payments are based on a maximum LTC pool amount defined at issue.
      • Excess of maximum LTC pool amount over the AV defines a NAAR.
      • Proportion of benefit payment that is an Accelerated Benefit (AB) increases  as the AV grows while the independent benefit portion decreases.
      • Benefit payments reduce the remaining maximum LTC pool and AV on a dollar-for-dollar basis until AV is depleted.
      • All remaining monthly benefits are independent benefits and are payable so long as LTC benefit triggers are met and maximum LTC pool has not been paid out in full.

Combination Life or Annuity Products with LTC

Importance: Learning about combination life or annuity products with LTC products is important because they are becoming increasingly popular due to taxation rules under the Pension Protection Act (PPA) which was enacted in 2006. Under this act, for tax-qualified LTC riders on life policies:

• • Charges are not considered distributions but will reduce basis (avoids immediate taxation).
  • 1,035 exchanges into combination plans are allowed.

Also, distributions from qualified riders attached to annuities are tax-free.

Risk Elements by Product

• Reading: Pages 24-26 of Quantification of the Natural Hedge Characteristics of Combination Life or Annuity Products Linked to Long-Term Care Insurance to get an overview of the risks for Standalone LTC, Life insurance combos and fixed deferred annuity combos

Standalone LTC

Key risks:

• • Persistency
    • Higher persistency reduces profits because more policyholders retain their coverage into the later durations where annual premium is insufficient to cover the claim costs.
    • Most adverse scenarios include:
      • Higher than expected lapsation in very early durations.
      • Lower than expected lapses in intermediate to later durations.
  • Investment returns
    • These products feature level premiums that contrast with a claim cost curve that increases dramatically with advancing age — this means there is significant investment return risk.
  • Morbidity (not meeting two of the six ADLs)
    • LTC morbidity risk includes high incidences and low terminations (death or recovery). Often the most expensive claims are related to conditions that disable but don’t kill (i.e., dementia or Alzheimer’s disease).

Life/LTC Combination

Key risks:

• • Mortality;
  • Investment returns;
  • Persistency;
  • Expense inflation (lesser concern).

Annuity/LTC Combination

Accumulation Phase

• • • Investment return risk
    • Lapse/surrender risk
    • Expense risk (lesser concern)

Annuitization Phase

• • • Mortality (higher mortality means higher profits)
    • Investment returns (higher returns means higher profits)
    • Lapses are not considered since policyholders under most of these plans are not allowed to discontinue their coverage

Using Combo Plan to Hedge Risk Elements

To analyze how the risks presented in a standalone LTC product can be hedged by changing the product design to combine it with a life or annuity product:

• Reading: Pages 27-28 of Quantification of the Natural Hedge Characteristics of Combination Life or Annuity Products Linked to Long-Term Care Insurance to learn more about three prototype product designs.
• Reading: Pages 9-19 of Quantification of the Natural Hedge Characteristics of Combination Life or Annuity Products Linked to Long-Term Care Insurance to see how each product design is affected under five different assumption shock scenarios

How Assumptions Impact Profit

• Higher incidence
  Hedged in both combo designs because policyholders are “cross funding” the first two years of coverage from their own policy values, diluting the impact of incidence increase versus stand-alone LTC. The effect is larger for the annuity versus the life combo.
• Higher active life mortality
  Hurts profits on life combinations, whereas it helps on stand-alone LTCI due to additional decrements that reduce long-term costs. The base plan component of life combos show higher losses than the overall package of Life plus LTC, but those losses are hedged by the inclusion of the LTCI components of the coverage. Note that since this combo is a single premium plan, the base plan sensitivity to mortality is lower than for a level premium plan. Annuity/LTC combos are less sensitive to mortality because higher mortality reduces the annuity base plan profits but this is offset by LTC rider gains from the higher mortality, particularly at older ages.
• Decreased investment returns
  Reduce profits for all three products as most cash flows occur up front. However, this reduces profit for the standalone product the most and the Annuity/LTC product the least.
• Decreased claim termination rates
  Reduce profits for the standalone LTC product because claimants will be projected to be on claim longer, however, this cost is dampened in the combo products due to the cross-funding from the policy values, particularly for annuities.
• Decreased lapses
  Reduce profit for the standalone LTC product because it is highly lapse supported (i.e. there are level premiums but increasing benefits as the policy ages so a material reserve develops)

Insurance sales agent risk

• Churning: Can be mitigated with chargebacks.
• Twisting: Can be mitigated with replacement monitoring.
• Rebating: Can be mitigated by not permitting it and/or by selling only where it is legal and to everyone.

Churning

When

Churning occurs when the life or annuity sales agent sells a product and then pushes the policyholder to lapse or switch to another product shortly after purchase so that the agent can earn more commissions. The policyholder may or may not be complicit in the scheme.

Example

Suppose a life or annuity product pays the salesperson a $100 commission per sale. Also suppose that the life or annuity product can also be surrendered at any time and the premiums are $10 per month. If there are no chargebacks, the agent can sell the product to a friend, earn $100, have them surrender the product after having only paid $10, netting them $90 from the insurance company. The agent can take advantage of this design by repeating this process and churning sales to make even more money from the insurer.

Risk Mitigation

Include chargebacks in the commission structure which reduces the commission if the policyholder surrenders the policy early (usually in the first year or two).

Twisting

When

Twisting occurs when an insurance agent replaces an existing policy with a new one by misleading the policyholder. The agent gains by making an additional commission.

Risk Mitigation

Monitor the volume of replacements as well as why they are occurring. Another way to mitigate it is to reduce the commissions on replacements.

Rebating

When

Rebating occurs when an insurance agent induces a client to buy an insurance or annuity product by offering to share some or all of their commission to them.

Example

Suppose someone would normally buy $500,000 of life insurance but, because of a first-year rebate from the insurance agent, they decide to purchase $1,000,000. Also suppose that the agent is now eligible to win a sales contest due to the extra sale. After the first year, the policyholder lapses the policy because the premiums are too high now that there is no more rebate from the agent.

This example illustrates two ways the insurance company can be left paying for the rebate:

• • • More sales triggering more outflows to pay for sales competition prizes;
    • Higher lapses after the first year.

Risk Mitigation

Not to allow rebating in the product sales process. Although the practice is mostly illegal, some states do allow rebating. In addition, if it is allowed, the rebates typically must be offered to everyone and not selectively to avoid discrimination and market conduct issues.

Distribution Channel Risks

When

Channel conflicts can occur when the goals and behavior of one channel or channel member conflicts with those of another. They can occur between different channels, between an issuing company and a channel, or between members within a channel. This can cause channel cannibalism, which occurs when sales from a new distribution displace those from an existing channel.

Risk Mitigation

By avoiding it.

• • Example: an insurer may use different distribution channels to market to different market segments so a company with an agency system might use direct mail to target customers not actively targeted by its existing distribution.

Surrender Charges

When

The risk of not recovering acquisition expenses due to early lapses.

Risk Mitigation

Include surrender charges in the product design to discourage early surrenders and help recover at least a portion of the acquisition expenses.

• • Example: many UL products have surrender charges in the first 10 to 20 policy years to minimize losses from early surrenders due to acquisition costs not being recovered. Surrender charges are usually a percentage of premium and can be as high as “X” percent early in the policy’s life; however, they usually grade off to zero after 10 to 20 years. The surrender charges are deducted from the account upon policy surrender.

Surrender Charges for Annuities

For annuities, surrender charges are generally back-end loads applied upon surrender.

• For Single Premium Deferred Annuities (SPDAs), the surrender charges normally decline over the surrender charge period and are usually a percentage of account value.
• For Flexible Premium Deferred Annuities (FPDAs), the surrender charges are usually a percentage of total account value and generally decline over five to 15 years. Other FPDA surrender charge designs include:
  • Surrender charges associated with each premium payment expressed as a percentage of premium, which grade off over a period of time that starts upon receipt of the premium.
  • Surrender charges expressed as a level percentage of the sum of the premiums paid during the previous “X” months.
  • Surrender charges which are a level percentage of the lesser of the account value or the last “X” years’ premiums.

Disintermediation Risk

When

Annuity writers take on disintermediation risk, which refers to the potential that policyholders may relinquish policies due to rising interest rates.

If interest rates rise too rapidly, then policyholders may surrender policies faster than expected, potentially resulting in cash flow obligations that exceed returns on investment assets. This may create a cash flow shortage if the annuity writer’s obligation to the contract holders exceeds the returns on the invested assets.

Risk Mitigation

Market value adjustments to annuity account value withdrawals

The annuity could be designed with a market value adjustment (MVA), which adjusts interim contract values for changes in the current interest rate since the beginning of the interest guarantee period.

Typically, surrender charges and MVAs would apply if the annuity is surrendered:

• • • before the end of a specified period, such as the interest guarantee period or the surrender charge period.
    • At the end of this specified period, there is no MVA; however, there may still be a surrender charge.

Market Value Adjustments = \(AV\times ((\dfrac{1+a}{1+b+c})^(n-t)-1)\)

MVA Account Value = Account Value – Market Value Adjustments

Cash Surrender Value = Account Value – Surrender Charge

Surrender Charge = MVA Account Value X Surrender Charge %

Interpretation:

• • • In the first scenario the MVA was the highest. The higher MVA mitigates the losses incurred by the annuity writer when they have to sell assets at a loss, due to an increase in interest rates, to pay out the early surrender.
    • In the second scenario, the opposite occurs and the annuity writer shares with the contract holder all or some of the gains on the sale of assets at a time when interest rates have declined.
    • In the third scenario, the annuity writer is putting a buffer on the current rates which increases the MVA, especially in the earlier years.

Account Value Enhancement

Surrender charges and MVA can both help to discourage early surrenders. Another way annuity writers improve persistency is with account value enhancements:

• • • Annuitization Bonuses
      Encourage maturing funds to remain within the company. The most common is a bonus equal to 2-10 percent of the account value on annuitization with the percentages often varying by the duration in which annuitization occurs (higher bonuses for later annuitization).
    • Persistency  Bonuses
      Encourage long term persistency without regard to annuitizations, for example, by applying a bonus equal to “X” percent of the account value on the 10th policy anniversary, provided the contract has not surrendered and is still in force at that time.
    • Bonuses on large account values
      Can discourage withdrawals and surrenders, and also encourage larger average premium contributions.

Policyholder Behavior Risk

The decisions that policyholders make with respect to the selection and use of benefits and guarantees.

Critical Illness Return of Premium on Surrender

Example: ROP of a CI in Canada

• • Anti-Selection Risk: PL can select whether to:
    • surrender the policy to get ROP or choose to persist, or
    • forego the ROP and instead persist if soon to claim the full benefit.

Risk Mitigation

• • Push the first ROP surrender point out to a later policy year
  • Return <100% of the premium
  • Offer the option at specific times

Basic Principles of Reserving

After successfully completing this section, you will be able to:

• Describe the basic theory of reserving.
• Explain basic release of risk concepts.
• Assess how to measure reserves.
• Explain how standards-setting bodies recognize measurement of reserves in financial statements.
• Explain the basics of stochastic reserving.

Basic Theory of Reserving

Reserves are established to meet those future obligations, taking into account future premiums, mortality rates, surrender / lapse rates, interest on invested assets, product features, regulations.

Types of Reserves

• Policy Status: Active Life vs. Disabled Life (for Waiver of Premium)
• Premium Type: Gross Premium vs. Net Premium
  • In a gross premium reserve, the amounts paid by the policyholder are considered in their entirety.
  • For a net premium reserve, only a portion of the gross premium paid, the portion that covers benefits, is considered in the analysis.
    In a net premium reserve, the reserve at time 0 is by definition equal to 0, as the net premium is defined as PV(Benefits)/PV(Gross Premiums) at issue.
• Assumptions: Prescribed vs. Company-specific vs. Mix
• Methods: Prescribed vs. Principles-based.
  • Within Principles-based, deterministic vs. stochastic.
  • Prospective vs. Retrospective vs. Both.
    • The amount of prospective reserves at a particular valuation date is derived by determining the present value of future benefits and subtracting the present value of future premiums.
    • Retrospective reserving begins at the point of issue and accumulates premiums to the valuation date, subtracting the accumulated value of benefits paid.
  • Real-world vs. Risk-neutral.

• Policy Issue Date

U.S. Statutory Reserves

The primary concerns are company solvency and, for certain products (albeit to a lesser extent), stability of premiums. Given this balance sheet focus, initial statutory reserves are generally higher than reserves used for any other purpose, e.g. GAAP or economic reserves.

Canadian Asset Liability Method (CALM)

Attempts to balance the competing priorities of company solvency and earnings emergence that is useful to the investor. Under CALM, the emergence of earnings will depend on the magnitude and characteristics of the Margins for Adverse Deviation (MfAD). The resulting increase over the Best Estimate (BE) liability, after application of the MFADs, is referred to as the Provision for Adverse Deviation (PfAD); this should not be confused with the PAD used in US GAAP FAS60 products. In US GAAP, the PAD is analogous to the MFAD.

US GAAP Reserves/IFRS

The purpose of the GAAP reserve methodology is to allow an investor to make a reasonable evaluation of a company by providing indications of profitability, particularly a company that is growing significantly. GAAP attempts to match earnings to the service(s) for which the policyholder is paying but uses revenue as a proxy. Having earnings emerge in proportion to revenue will have different results for different product types. IFRS uses many of the same GAAP principles but has earnings emerge in proportion to services rendered/risk released.

Reserve Methodologies under Various Bases

• United States Statutory
  • Annuities: Commissioners’ Annuity Reserve Valuation Method.
  • Life: Commissioners’ Reserve Valuation Method.
  • Captives: Actuarial Guideline 48.
• GAAP
  • Non-participating Life: FAS60/FAS120.
  • Investment Contracts: FAS91/FAS97.
  • Insurance Contracts with Embedded Derivatives: FAS133 / FAS157.
  • Profits Followed by Losses: SOP 03-1.
• Tax
  • References statutory methods.
  • Greatly simplified with Tax Cuts and Jobs Act signed in December 2017.

Reserve Movements

• Trending
  Dollar based or unitized? It’s important to review reserve movements on both a dollar amount and per unit basis, as small dollar amount movements during a product’s introductory period may mask issues that will arise when the in-force business grows. Similarly, small unit movements on a large in-force base can create large swings in reported income.
• Roll-forward approach
  The roll-forward approach is used to isolate the drivers of reserve movement from period to period, and thus identify the sources of earnings (both expected and actual)

Adequacy Testing

• Especially in accounting bases where assumptions are prescribed, or locked in at issue, over time, experience (mortality, lapse, and investment return) may deteriorate such that the reserve is no longer adequate for its intended purpose.
• This type of additional analysis takes different forms in statutory (asset adequacy analysis) and US GAAP (loss recognition testing).

Statutory Reserving

• Statutory accounting principles:
  • policyholder-based focus,
  • with a particular interest to ensure that a company is solvent and has the ability to pay future claims.
• Methodologies and Assumptions, which have been generally prescribed until the adoption of Principle-based Reserves (covered later), lead to a reserve that is conservative with the intent that adverse movements in interest rates, mortality, etc., would not compromise solvency.
• Statutory reserving, at its core, is driven by the Standard Valuation Law (SVL).

Release of Risk Concepts

How Earnings Emerge

• Reserves functions:
  • to ensure that the company has sufficient funds to pay its liabilities when they come due
  • to manage how earnings are released and reported
• Reading: Earnings Emergence – Insurance Accounting under Multiple Financial Reporting Bases

How Does Earnings Emergence Correspond with Each Reserve System

• Both the level of earnings and the rate at which they emerge will vary by reserving regime.
• The primary objective of each reserving methodology is different.
• Reserves do not impact the overall level of earnings for a block of business, but only adjust the timing.
• Lower earnings under a particular reserve system in the early years of a policy or block of policies must lead to higher earnings in later years for that same reserve methodology.

PADs/MFADs

• The underlying assumptions are expected to be best estimate plus
  • a provision for adverse deviation (PAD, from US GAAP FAS60 products, IFRS), or
  • margin for adverse deviation (MFAD, from Canada Source of Earnings)
• PADs/MFADs depend on:
  • the comfort level the actuary has with the BE assumption.
  • whether the company has significant credible experience
  • the extent to which the company has control over the emergence of experience (e.g. expenses)
• PADs/MFADs are intended to cover moderately adverse experience, generally defined as about one standard deviation.

Measurement of Reserves

Balance Sheet Intangibles

• Balance sheet intangibles include:
  • Deferrable Acquisition Costs (DAC): Costs that vary with and primarily relate to the acquisition of new business.
  • Value of Business Acquired (VOBA): Used in purchase accounting. Similar to DAC in that it represents the cost of acquiring the business that needs to be amortized over time.
  • Goodwill: Amount of the purchase price over the value of the assets and liabilities; represents the value of the business being acquired that is not separately identifiable.

Characterization of Costs

• Deferrable Acquisition Costs: Vary with and directly relate to the acquisition of new business.
• Non-Deferrable Acquisition Costs: Acquisition costs that do not meet standard for deferability.
• Direct Maintenance Costs: Costs associated with maintaining records and processing policy transactions.
• Investment Expenses: Expenses associated with maintaining an investment portfolio and charged against investment income.
• Overhead: Indirect costs that cannot be attributed to acquisition, maintenance or investments; generally, the costs remaining after the above have been determined.

Note: while cost and expense are used interchangeably, a cost is not an expense until it is recognized in the financial statements.

FAS60 Treatment

GAAP distinguishes between traditional contracts (FAS60) and non-traditional contracts (FAS97)

For FAS60:

• premiums are recognized as revenue when due, and
• a net GAAP reserve established.
  • The net GAAP reserve represents the present value of future benefits and related expenses less the present value of future net premiums.
  • The net premium is the portion of the gross premium needed to cover all benefits and expenses.
  • All present values reflect assumptions for investment earnings, mortality, morbidity, lapses, expenses, etc.
  • The assumptions include provisions for adverse deviation and, because they are locked-in at issue, the net premium will be a constant percentage of the gross premium.

The difference between the gross premium and net premium, or loading, is:

• the expected profit that will be recognized if experience matches your assumptions exactly.
• This will emerge as a constant percentage of premium. Implicitly, DAC is amortized as a percentage of premium under FAS60.

Profit will also emerge on FAS60 products as experience other than assumed occurs. Part of this is the release of the Provisions for Adverse Deviation built into the net GAQAP reserve:

• If no adverse deviation in Mortality, then profits will emerge in relation to Net Amount at Risk
• If no adverse deviation in Investment Yield, then profits will emerge in relation to Invested Funds/Investment Income
• If no adverse deviation in Lapse Rates, then profits will emerge in relation to Excess of a) Benefit Reserve – DAC Balance over b) Cash Value
• If no adverse deviation in Expenses, then profits will emerge in relation to Expenses incurred

Loss Recognition

When

If emerging experience is such that the present value of future premiums, together with the existing reserve, will not be sufficient to provide for future benefits and expenses, then a loss recognition event occurs.

How

DAC is then amortized to the extent necessary to remove the premium deficiency; if this is insufficient to do so, then the reserve is increased to the extent necessary. This should not produce future income under current best estimate assumptions.

FAS97 Treatment

FAS97 was developed to deal with non-traditional, universal-life (UL) type contracts. Because UL gives the policyholder the flexibility to vary the timing and amount of premium payments, matching expense and profits to premiums created the possibility for widely varying, misleading results. Instead of premiums, FAS97 products use Estimated Gross Profits (EGPs) as the basis for amortization of DAC. EGPs are the expected margins from mortality, investment earnings spreads, contract administration costs, surrender charges, and any other fees.

A typical method for amortizing DAC under FAS 97 is to develop a k-factor at issue that computes the present value of deferrable acquisition costs as a percentage of the present value of EGPs; this k-factor is then applied to each period’s actual gross profits to determine the amount of DAC to be amortized.

Negative Gross Profits

If there are negative gross profits in a reporting period, they should not be used to determine the DAC amortization. Instead, a separate amortization basis that is consistent with the initial expected emergence of profit should be used.

Unlocking

• Assumptions are not locked-in for FAS97
• If there is assumption change, k-factor is recalculated as of issue
• Any resulting changes in the current DAC balance are reported in the current period

US Purchase GAAP (PGAAP)

Under US GAAP, when a life insurance company is purchased, the assets and liabilities must be restated at their fair market value. Certain balance sheet items may be restated, created or eliminated.

• All invested assets are set to their fair market value; for most assets, this is easily ascertained.
• Any DAC is eliminated, as that was a measure of the business’ value to the predecessor company and will be replaced by VOBA, the value of the business to the acquiring company.
• Reserves are restated at their fair market value using the acquiring company’s view of the appropriate level of assumptions.
• Deferred taxes are then restated using the new values of assets and liabilities.
• Goodwill is the balancing item to make equity equal the purchase price.

VOBA Amortization

VOBA amortization follows the same rules for FAS60 and FAS97.

• For FAS60, it is amortized over premiums using the earned rate of the underlying portfolio.
• For FAS97, it is amortized over gross profits using the credited rate of the underlying policies.

IFRS Purchase Accounting

Under IFRS, you need to determine VOBA and Goodwill in much the same manner. Rules for IFRS are:

• Fair Value of Liabilities (FVL): Can be determined using Actuarial Appraisal method, FAS157 (fair market value) or existing economic capital models
• PGAAP Reserve: Determine under acquirer’s accounting policies
• Deferred Tax Liability (DTL): Corporate tax rate applied to difference between IFRS liability value and FVL
• VOBA: Equals PGAAP reserve – FVL (hence value of PGAAP reserves determines value of VOBA

Goodwill: Equals Purchase Price – (Fair Value of Assets + VOBA – PGAAP Reserve – DTL)

Standard Valuation Law

• The Standard Valuation Law is the authority for how statutory reserves are computed in the United States.
• Regulations are adopted periodically to:
  • define methodologies for new product types
  • close loopholes
• Actuarial Guidelines provide guidance on the application of regulations and the SVL

Statutory Reserving for Annuities

Section 5a of the Standard Valuation Law contains the CARVM, the method by which statutory reserves for annuities are calculated:

• Reserves according to the commissioners annuity reserve method for benefits under annuity or pure endowment contracts, excluding any disability and accidental death benefits in the contracts, shall be the greatest of the respective excesses of the present values, at the date of valuation, of the future guaranteed benefits, including guaranteed nonforfeiture benefits, provided for by the contracts at the end of each respective contract year, over the present value, at the date of valuation, of any future valuation considerations derived from future gross considerations, required by the terms of the contract, that become payable prior to the end of the respective contract year. The future guaranteed benefits shall be determined by using the mortality table, if any, and the interest rate, or rates, specified in the contracts for determining guaranteed benefits. The valuation considerations are the portions of the respective gross considerations applied under the terms of the contracts to determine nonforfeiture values.
• Admittedly there is a lot to digest here (see highlights), but the key is that the CARVM is the greatest present value of guaranteed benefits over guaranteed premiums (gross considerations). Note, however, the term “greatest”, which indicates multiple possible outcomes that need to be determined. Actuarial Guideline XXXIII, “Determining CARVM Reserves for Annuity contracts with Elective Benefits” clarifies the application of CARVM when optionality, such as surrender or annuitization, is available to the policyholder. In capturing new product designs after the original writing in 2015 there were modifications for Guaranteed Minimum Withdrawal Benefits (GMWBs) when the account value has been exhausted.

Variable Deferred Annuities AG 43 and VM-21

• CARVM requires that reserves for variable annuities be based on the greatest present value of future benefits, and further regulation stipulates that it reflect the variable nature of the benefits.
• AG 43 provides that the reserve be equal to a Standard Scenario amount plus the excess, if any, of the reserve calculated using stochastically generated scenarios and prudent estimate assumptions.
• The Standard Scenario uses a deterministic path for future fund performance; the fund performance for the stochastically generated scenarios must meet defined calibration standards.
• The resulting stochastically generated reserve is a Conditional Tale Expectation (CTE) level reserve at the 70th percentile.

Statutory Reserving for Life

Section 5 of the Standard Valuation Law contains the Commissioners’ Reserve Valuation Method, which defines the reserve to be:

• The “excess, if any, of the present value, at the date of valuation, of the future guaranteed benefits provided for by those policies, over the then present value of any future modified net premiums therefor. The modified net premiums for a policy shall be the uniform percentage of the respective contract premiums for the benefits such that the present value, at the date of issue of the policy, of all modified net premiums shall be equal to the sum of the then present value of the benefits provided for by the policy.” In addition, there is a positive adjustment to the modified net premiums, defined as the excess of (1) over (2), as follows:
  1. A net level annual premium equal to the present value, at the date of issue, of the benefits provided for after the first policy year, divided by the present value, at the date of issue, of an annuity of one per annum payable on the first and each subsequent anniversary of the policy on which a premium falls due. However, the net level annual premium shall not exceed the net level annual premium on the nineteen-year premium whole life plan for insurance of the same amount at an age one year higher than the age at issue of the policy.
  2. A net one-year term premium for the benefits provided for in the first policy year.

The methods used to reserve according to CRVM may vary, but theoretically should arrive at similar results.

Types of Life Statutory Reserves

Mean vs. Mid-terminal

A terminal reserve is the present value of future benefits over the present value of future net premiums at the end of a policy year, after all premiums have been paid (typically assumed to be annual) and all claims have been made. If the valuation date lined up with the issue date of a particular policy, then the reserve would be known. However, in nearly all cases, the issue date does not fall on a valuation date, and so adjustments need to be made.

That’s where a choice can be made, to use interpolated mean reserves or interpolated terminal reserves:​

• • Interpolated terminal reserves are exactly as advertised: the interpolation of terminal reserves between the last policy year-end and the next.
  • Interpolated mean reserves are the reserves interpolated between the beginning of the current policy year to the end of the policy year. The reserves at the beginning of the year are t-1Vx + P, as it is assumed the annual premium is paid immediately before the beginning of the year.

Each of these methods introduces a bias:

• • For interpolated mean reserves, the reserve is overstated if policies pay premiums more frequently than annually. Therefore, a deferred premium asset needs to established, for the remaining modal payments that have not been paid in reality yet have been assumed in the reserve calculation.
  • For interpolated terminal reserves, the reserve is understated because it has not been assumed that the annual premium has been paid. Therefore, an unearned premium reserve needs to be established.

Timing of Assumptions

A key consideration in any statutory reserve calculation is the assumed timing of premiums and claims.

• • Curtate: Curtate reserves assume that premiums are payable at the beginning of each policy year and death benefits are payable at the end of the policy year of death.
  • Semi-continuous: Semi-continuous reserves are calculated reflecting the fact that death benefits are generally payable shortly after death with interest from the date of death to the payment date, and assuming that net premiums are payable annually at the beginning of each policy year.
  • Fully Continuous: Fully continuous reserves are those that result from the assumption that premiums are payable continuously throughout the year and that death benefits are generally payable shortly after death with interest from the date of death to the payment date.

Regardless of the method chosen, there are certain adjustments to be made that get to proper total reserves.

Section 1.3 of “U.S. Tax Reserves for Life Insurers”

See also Sharp TSA 95v47

Types of Tables

An ultimate mortality table defines probability of death at age t given survivorship to age t-1. Ultimate tables may vary by gender, smoking status, and other criteria (underwriting class) but once a table is selected, rates within the table only vary by attained age. Ultimate tables typically exclude data for recently issued policies and represent mortality rates that a policy will ultimately achieve after the effects of underwriting wear off .

By contract, select-and-ultimate tables  are based more on policies that have recently been issued and typically exhibit lower mortality rates than individuals who are already insured, due chiefly to the fact that they have just undergone underwriting. Select and ultimate tables may vary by gender, smoking status, and other criteria (underwriting class) but once a table is selected, rates within the table only vary by issue age and policy duration. At the end of the select period, the mortality rates for a given insured equate to ultimate.

In a methodology where we are using modified net premiums that equate to the present value of future benefits (with adjustments), there is a significant (and maybe even unintuitive) effect.

Statutory Reserving for Fixed Premium

Non-Interest Sensitive Life (Term / Whole Life)

All life policies are subject to the Commissioners’ Reserve Valuation Method (CRVM). This section deals with two types of products: whole life and term. We break down the reserving of these policies into two phases: pre-2000 and 2000+.

Prior to 2000, SVL paragraph 5 (CRVM) dictated that the only required time horizon over which to determine the modified net premiums was the lifetime of the contract. In addition, extra reserves (deficiency reserves, defined in SVL Section 8) could arise if the modified net premiums exceeded the gross premiums due from the policyholder, using the same mortality and interest as using in the CRVM calculation (often called the “basic” reserve).

For term policies, where a level premium period is followed by substantially higher premiums, this method (often called the “unitary” method) would result in very low reserves being held.

To combat this, in 2000, a major development went into effect: the Valuation of Life Insurance Policies Model Regulation (MDL-830). In addition to evaluating the reserve using all future guaranteed premiums in the determination of the valuation net premiums, additional requirements were put in place to require that a policy be “segmented” and a separate valuation net premium established for each segment. A segment generally is defined as a period in which the increase in gross premium does not exceed the increase in mortality rate. For a level term policy, the year in which premiums would jump typically defined a new segment. Section 6 of MDL-830 relates to other-than-universal life policies (section titled “Calculation of Minimum Valuation Standard for Policies with Guaranteed Nonlevel Gross Premiums or Guaranteed Nonlevel Benefits (Other than Universal Life Policies))”

MDL-830 does not apply to whole life policies because benefits and premiums tend to be level. In addition to changes in the basic reserve, deficiency reserves were refined by allowing mortality to vary by company experience where credible (typically called X-factors) to adjust standard valuation mortality. X-factors are subject to certain tests which determine the percentile of historical claims experience within a claims distribution (retrospective testing) as well as projecting death benefits under X-factor mortality and comparing to death benefits projected under best-estimate assumptions (without recognition of future mortality improvement).

For Interest Sensitive Life

Universal life products, at a minimum, provide life insurance coverage as long as the fund value is positive. Because interest sensitive life products typically do not require periodic premiums, and policyholders can fund their policy differently, some accommodations must be made to fit these products into the CRVM structure. The Universal Life Model Regulation clarifies the application of CRVM. In general, premiums are defined as the periodic level premiums that mature the policy at maturity, and the reserve is the present value of future benefits less present value of guaranteed maturity premiums (GMPs), multiplied by a fundedness ratio. The fundedness ratio, defined as the current fund value over the fund value assuming GMPs have been paid to date, is intended to increase the reserve when funding lags and is capped at 1.

Secondary Guarantees

Some interest-sensitive products offer coverage, even if the fund value is zero or negative, as long as either a specified premium has been paid to date, or the value of a separate tracking account (often called the shadow account) is positive. These “secondary guarantees” are valued under Regulation Section 7, and reserving requirements are further clarified under Actuarial Guideline 38.

Section 8 details a nine-step valuation method for the secondary guarantee, which at its core is a sliding scale between a reserve assuming minimum premiums paid each year (and a net single premium reserve assuming the conditions of the secondary guarantee are fully satisfied.

The ratio used in the interpolation is based on the shadow account balance (or excess of paid premiums over required specified premium) over the amount required to fully fund the guarantee as of the valuation date.

Taxing Times Grid

Variable universal life products may also be subject to Actuarial Guideline: XLIII Statutory and Tax Issues (Taxing Times Supplement published by the Taxation section), which clarifies requirements related to the guaranteed minimum death benefit feature with which some policies are equipped.

Principle-based Reserves for Life Products

Effective January 1, 2017 (with a three-year transition period), reserves for newly-issued life insurance products are subject to VM-20. Reserves are based on as many as three metrics (less if certain exclusions apply):

• Net Premium Reserve (NPR) (seriatim, formulaic reserve)
• Deterministic Reserve (modeled, gross premium reserve)
• Stochastic Reserve (modeled, PV of accumulated deficiencies, with a CTE measure)

Aside from the NPR, which is a seriatim calculation designed to define a floor for reserves, the intent of PBR is to determine appropriate reserve levels based upon company experience, specific product features, investment strategies, etc. Significant margins are applied to assumptions (esp. mortality) and a process exists to grade from company experience to industry; the timing and speed of the grading depends on credibility and number of years of sufficient data (last duration in which the study has 50 claims).

Aggregate Statutory Reserve Tests

After statutory reserves have been computed correctly for each policy, there is an overarching question that remains: “are my reserves adequate under moderately adverse conditions?” This question must be answered by the Appointed Actuary annually as required in VM-30 under Asset Adequacy Analysis.

Asset Adequacy Analysis can take several forms, some of which may not be valid for all circumstances. Also, the scenarios to be run are not prescribed (though may be superseded by state requirements) and the definition of adequacy is determined by the Appointed Actuary.

Tax Reserving

On December 22, 2017, President Trump signed Tax Cuts and Jobs Act of 2017 (TCJA), a nearly 1,100 page document which brought widespread tax reform. Taxation of life insurance companies underwent significant changes within TCJA, and particular to this memo, tax basis reserve calculations were heavily modified, whereby the changes are considered in the determination of taxable income. Tax basis reserve calculations are set forth in Internal Revenue Code Section 807 (“807”). The changes to 807 under TCJA brought more consistency between Statutory and Tax reserving. A company whose entire Statutory reserve balance was based purely on Statutory methodologies (CARVM for annuities, CRVM for life) and was devoid of permitted practices (reserving methodologies that are not consistent with existing statutory requirements but have been allowed by the company’s state of domicile), reserve strengthening via reduced interest rates or increased mortality, etc., would have tax reserving that would not require additional runs and could be derived from the various components of Statutory.

Key movements to get to this point included:

• Defining NAIC methods as of date of valuation, rather than date of contract issuance (think of AG43, which applied to all in-force VA contracts, not just prospective, creating a disconnect between current Statutory and required Tax basis reserving).
• Setting the tax valuation rate equal to statutory, by removal of the Applicable Federal Interest Rate, which served as a floor for tax valuation.
• Going silent on mortality table usage, implying use of the same Commissioners’ Standard Ordinary tables.

The tax reserve is defined in 807(d)(1):

• Non-variable: min(Stat Reserve, max(CSV, 92.81% * reserve under 807(d)(2))).
• Variable: max(Contract CSV, Variable Account Value) plus 92.81% * max(0, reserve under 807(d)(2) – max(Contract CSV, Variable Account Value)).

The tax reserve is defined in 807(d)(2):

• “The amount of the reserve determined under this paragraph with respect to any contract shall be determined by using the tax reserve method applicable to such contract.”

The tax reserve is defined in 807(d)(3):

• Defines the tax method as CARVM for annuities, CRVM for life. The major difference remaining between Statutory and Tax reserves is that deficiency reserves are required for Statutory, but are not allowed for Tax.

GAAP Reserving, in General

Similar to Statutory accounting, GAAP provides a framework by which a minimum level of consistency is attained through the determination of authoritative standards, which are set forth by the Financial Accounting Standards Board (FASB).

Differences quickly arise between the two due to:

• Audience (regulators for Stat, investors, management, lenders for GAAP)
• Focus (solvency for Stat, earnings emergence for GAAP)
• Revenue / expense recognition (immediate for Stat, smoothed over time for GAAP)
• Classification of products
• Investments: Book value for Stat, Market Value for GAAP
• Assumption setting: Conservative for Stat, Best-estimate for GAAP

GAAP Reserving for Income Annuities – Payouts

Life contingent (existence of mortality risk).

• FAS60/120 requires determination of a benefit reserve based on best-estimate assumptions and yields, with a degree of provision for adverse deviation. 
  • PV(Future Benefits).
  • Might also have a maintenance reserve (to cover maintenance expenses), calculated similarly as PV(Maintenance Expenses) under same assumptions.
• No DAC, since FAS60/FAS120 require amortization of deferred acquisition costs based on premiums, and most income annuities are single premium.
• Assumptions are locked in at issue (not updated each valuation period) until reserves are determined to be insufficient based upon a Gross Premium Valuation (GPV).
• Additional liabilities (not reserves) arise if a situation exists in which profits are followed by losses, even if the GPV < Net GAAP liabilities.
  • If the initial reserve is less than the premium applied, then a deferred profit liability (DPL) needs to be calculated and reduced over time in proportion to reserves.

Certain only:

• If there is no mortality risk (i.e., premium applied to buy 10 years of guaranteed benefits, with no continuation after the 10 years), then a FAS 91 methodology is applied to solve for the interest rate that equates the present value of benefits to the premium applied less commission. 
• Future period reserves use the discount rate previously determined.

GAAP Reserving for Deferred Annuities

Non-indexed deferred annuities, per FAS 97, use account value as the reserve.

If indexed, then FAS133 applies, as there is an embedded derivative in the product (crediting is based upon the performance of an external index, typically the S&P 500).

• Other considerations:
  • Excess benefit reserves (which may arise when account value <= 0).
    • Originally presented under SOP 03-1, now part of ASC 944.
    • Death benefits, guaranteed lifetime withdrawal benefit riders, and annuitizations are considered.
    • Review slides 30-44 of “GAAP Basics for Deferred Annuities.

Deferred Acquisition Costs:

• Amount that can be deferred based upon ASU 2010-26.
  • Incremental direct costs associated with a successful contract acquisition.
    • Commissions are typically the biggest item.
    • Other costs that are directly related to acquisition activities.
• For deferred annuities, amortize according to EGP.
  • “k-factor” = PV(deferrable acquisition costs)/PV(EGP)
• Calculation is dynamic.
  • Replace estimated gross profits with actual as time goes on.
  • Revise estimated gross profits for new experience.
  • Recalculate at issue.
• Review slides 17-28 of “GAAP Basics for Deferred Annuities.

Sales Inducement Assets:

• Day-One bonuses, paid at time of deposit, e.g., 2 percent of premium.
• Enhanced interest bonuses -“higher than normal.”
• Persistency bonuses paid to persisting contracts.
• e.g., 10th anniversary “deferred bonus.” 
• Amortization based upon EGP, just like DAC.

k > 1 (from DAC and SIA) may imply a write down is necessary, as deferred costs may not be able to be recouped.

GAAP Reserving – For Non-Interest Sensitive Life

FAS 60 covers non-interest sensitive life policies (under long-duration contracts).
FAS 60 requires determination of a reserve based on best-estimate assumptions and yields, with a degree of provision for adverse deviation. 

• Net Level Reserve.
• k % = PV of benefits / PV of gross premiums.
• Benefit net premium = k % ×gross premium.
• Benefit reserve = 𝐵𝑅𝑡= PV of benefits – PV of benefit net premium. 
• Similar to payout annuities, a maintenance reserve may arise.
  • Net level reserve.
  • k % = PV of maintenance expenses / PV of gross premiums.
  • Maintenance net premium = k % ×gross premium.
  • Maintenance reserve = 𝐸𝑅𝑡= PV of expenses –PV of maintenance net premiums.
  • Reserve = 0 if the expenses are a constant percent of premiums .

DAC will exist, since FAS60 requires amortization of deferred acquisition costs based on premiums, and most income annuities are single premium.
Assumptions are locked in at issue (not updated each valuation period) until reserves are determined to be insufficient based upon a Gross Premium Valuation (GPV).
Additional liabilities (not reserves) if a situation exists in which profits are followed by losses, even if the GPV < Net GAAP liabilities.

GAAP reserving for Interest Sensitive Life

Non-indexed deferred annuities, per FAS 97, use account value as the reserve.
If indexed, then FAS133 applies, as there is an embedded derivative in the product (crediting is based upon performance of an external index, typically the S&P 500).
Other considerations:

• Excess benefit reserves (which may arise when account value <= 0).
  • Originally presented under SOP 03-1, now part of ASC 944.
  • Death benefits, guaranteed lifetime withdrawal benefit riders, and annuitizations are considered. 
  • Review slides 30-44 of “GAAP Basics for Deferred Annuities.”

Deferred Acquisition Costs:

• Amount that can be deferred based upon ASU 2010-26.
  • Incremental direct costs associated with a successful contract acquisition.
  • Commissions are typically the biggest item.
  • Other costs that are directly related to acquisition activities.
• For deferred annuities, amortize according to EGP.
  • “k-factor” = PV(deferrable acquisition costs)/PV(EGP).
• Calculation is dynamic:
  • Replace estimated gross profits with actual as time goes on.
  • Revise estimated gross profits for new experience.
  • Recalculate at issue.
• Review slides 17-28 of “GAAP Basics for Deferred Annuities.”

Unearned Revenue Liability (URL)

• Liability for amounts assessed to compensate insurer for services to be performed in future periods so are not earned in period assessed.
  • Charges must be deferred and amortized similar to DAC.
  • Example: First Year Per Policy Load higher than ongoing years.

k > 1 (from DAC less URL) may imply a write down is necessary, as deferred net costs may not be able to be recouped.

GAAP Aggregate Tests

Similar to what we saw in statutory reserving, even if the calculations are all performed correctly, an overarching question must be asked. For statutory it was: “Are my statutory reserves sufficient?” For GAAP, depending on the product type (FAS 60 vs. FAS97) the question might be: “Are my net GAAP liabilities sufficient?” or “Can I recoup my deferred costs?” 
FAS97 (Deferred Annuities and Interest-Sensitive Life):

• If aggregate k-factor > 1, may need to write down deferred amounts such that k=1.
• “Aggregate” means k-factor from DAC + SIA – URR.

FAS60 (non-interest sensitive life):

• Perform gross premium valuation to determine if PV(Benefits and Expenses) less PV(Gross Premiums) > Benefit Reserve + Maintenance Reserve – DAC.
  • If so,
    • Reduce (remove) PAD from Benefit Reserves, Maintenance Reserve, DAC.
    • Write-down the DAC.
    • Establish a premium deficiency reserve = GPV –GAAP net liability. 
  • If not,
    • May still need to set up additional liability if profits are followed by losses.
  • Also, perform GPV analysis for current years issues to determine if DAC is recoverable (i.e., k < 1).

GAAP Targeted Improvements Summary

Trend

FASB’s new guidance, Accounting Standards Update 2018-12, Financial Services—Insurance (Topic 944): Targeted Improvements to the Accounting for Long-Duration Contracts (the “ASU”), is the largest change in US GAAP Reporting for life insurers in the last 40 years. It revises key areas of the accounting and disclosures for long-duration insurance and investment contracts.

As of December 2018, the following changes are proposed:

• • DAC (all products): Expenses amortized in relationship to insurance in force (rather than gross premiums or EGP).
  • Effective Date: The guidance is effective for calendar year-end public business entities on January 1, 2021. 
  • FAS60 products:
    • Annually recalculate net premiums using historical experience and updated assumptions (no more lock in)
    • Difference recorded in cumulative catch-up adjustment to net income 
    • Discount rate based on a reference high quality fixed income portfolio 
    • Change in liabilities due to change in discount rates recorded in Other Comprehensive Income 
  • Disclosures: Additional disclosures are required, including disaggregated roll forwards of the liability for future policy benefits, policyholders’ account balances, market risk benefits, DAC, and sales inducements.

Impact

The FASB’s objective is to improve, simplify, and enhance accounting for long-duration contracts. A significant impact to reported earnings and increased earnings volatility are expected.  Furthermore, the implementation effort will require significant changes to systems, process, and controls, and requires the accumulation of data that has not previously been captured and include in the actuarial models in the format and grouping needed for the measurement.

Canadian Statutory and GAAP Reserving

In Canada, current accounting policies for the measurement of insurance contract liabilities follow the Canadian Generally Accepted Accounting Principles (GAAP) methods of valuation described in sections 2100 to 2300 of the Standards of Practice that govern actuarial practice in Canada. Different from the U.S., there is only one set of books in Canada for insurance contract measurement, i.e., Canadian statutory reserve is equal to Canadian GAAP reserve.

The fundamental method for calculating insurance contract liabilities is the Canadian Asset Liabilities Method (CALM).

CALM

What is CALM?

The amount of insurance contract liabilities using the CALM for a particular scenario is equal to the amount of supporting assets, including reinsurance recoverables, at the calculation date that are forecast to reduce to zero coincident with the last liability cash flow in that scenario.

What do you need to know about CALM:

• • Prescribed method used to determine the value of insurance contract liabilities.
  • Uses projections of both assets and liabilities under various scenarios (deterministic or stochastic).
  • Projections go to end of last liability cash flow.
  • Iterative process Goal: determine adjusted initial assets that have zero surplus after last liability cash flow.
  • Value of insurance contract liabilities = the financial statement value of the adjusted initial assets.

How CALM Works – Example 1

Below is a simple example to illustrate how CALM works:

• • Asset:
    • Zero coupon bond with maturity in 5 years.
    • Current market value of $1,000. 
    • Current statement value of $900. 
  • Liability: $1,280 guaranteed payment payable in 5 years. 
  • Flat interest rates of 5 percent for 5 years. 
  • Asset in 5 years will be worth $1,280. 
  • At the end of duration 5, it can pay off liability payment, without any surplus/deficit. 
  • Reserve at valuation date is statement value of asset, i.e. $900.

How CALM Works – Example 2

Below is an example to illustrate how the different investment strategy impacts reserves at the valuation date.

Liability:

3 year GIC – initial deposit of $100, with guaranteed yield 5 percent per year.

Investment strategy 1: Invested Asset is always 1-Yr Zero Coupon Bond.

Investment strategy 2: Invested 1-Yr Zero Coupon Bond for the first year then 2-Year Zero Coupon Bond after year 1.

Key CALM Components

Under CALM, to calculate reserves, an actuary needs key four components:

• • Asset cash flows
  • Liability cash flows
  • Margin for adverse deviations
  • Interest Rate Scenarios

Asset Cash Flows

Asset cash flows includes maturity payments, interest payment and dividends. Asset cash flows may be scenario-dependent.

Asset cash flows are projected based the following assumptions:

• • • Asset defaults for fixed income (FI) assets

• • • • Asset can no longer make payments
      • Vary significantly by asset class
      • May vary by term

• • • Non-fixed income assets

• • • • Examples: equity, real estate, some derivatives
      • Growth rate and income rate assumptions

• • • Investment expenses

Liability Cash Flows

Liability cash flows are projected based on the following assumption.

• • • Term of the liability: Take account of renewals and constraints on insurers’ ability to adjust term.
    • Policyholder reasonable expectations: Used as guidance for determining cash flows that are subject to insurer’s discretion. E.g. participating policy dividends, premium for adjustment policies.
    • Mortality: Include future mortality improvement assumptions; apply different considerations for life insurance and annuity business.
    • Morbidity: include future morbidity improvement assumptions.
    • Lapse: Consider lapse support vs. lapse sensitive policies. May vary with economic scenarios, i.e. dynamic lapse assumptions.
    • Expense: Include inflation assumptions which may be economic scenario dependent. Include tax payments in Canada: Investment income tax (IIT), premium tax, capital tax.

Margin for Adverse Deviations

Per the Canadian Institute of Actuaries (CIA)  Consolidated Standards of Practice (CSOP), scenario-tested assumptions should include no margin for adverse deviations; and each other needed assumption, whose best estimate should be consistent with the scenario-tested assumptions should include MfAD. Some considerations to arrive an appropriate MfAD include:

• • • The degree of uncertainty of the expected assumptions.
    • Larger MfAD used for assumptions that are based on less credible data.
    • Prescribed ranges in SOP for each assumption.
    • MfAD can be increased above high range point for unusually high uncertainty or if necessary to produce adequate provision for adverse deviations (PfAD).
    • The need to perform testing to establish proper size and direction of MfAD (margin always increases the liability value).

Interest Rate Scenarios

Per the CSOP, interest rate scenarios are sed to calculate insurance contract liabilities could be deterministic or stochastic scenarios.

Stochastic Reserving: Deterministic Interest Rate Scenarios

CSOP describes the base interest rate scenario and eight prescribed scenarios for CALM. The interest rate scenarios are comprised of the current risk free curve as of valuation date, ultimate risk-free rate, and credit spread. Under each prescribed scenarios, different shocks/modifications are made to the interest rate curve for the base scenario.

In addition to the prescribed scenarios, which would be common to the calculation of insurance contract liabilities for all insurers, the actuary may also select other scenarios that would be appropriate to the company.

Stochastic Reserving: Stochastic Interest Rate Scenarios

Where the interest rate scenarios selected are stochastically modelled, the actuary’s calibration of stochastic interest models should meet the criteria for risk-free interest rates as promulgated from time to time by the Actuarial Standard Board (ASB).

Where valuation is performed using stochastic interest scenarios, the actuary would book reserves between CTE (60) and CTE (80), where the CTE stands for the Conditional Tail Expectation and CTE (x) is defined as the average of those values that are above the xth percentile of the range of liability values produced by the entire set of modelled scenarios.

The provision for adverse deviations for interest rate risk for both deterministic and stochastic applications would be measured as the difference between the reported insurance contract liabilities and the insurance contract liabilities resulting from the application of the base scenario.

Stochastic Reserving

Principle-Based Statutory Reserves (PBR)

Statutory reserves for life insurance and annuities in the US have traditionally been calculated on a deterministic, formulaic basis with prescribed assumptions for mortality and interest; they also made no allowance for future lapses and thus required a full reserve to be held for each in-force policy. There are some clear advantages to this approach:

Advantages

• • Uniformity of approach allows for ease of comparison across companies with similar product offerings
  • Defined assumptions and methodology minimize the audit burden of state insurance departments

Disadvantages

• • Prescribed assumptions are slow to respond to change (economic, underwriting, etc.)
  • The approach is ill-equipped to respond to product innovation
  • It does not reward or punish companies for sound or unsound risk management
  • If the methodology produces punitive reserves, there is an incentive to create products that meet the letter of valuation but not the intent, resulting in reserves that don’t have the desired level of conservatism
  • If the methodology produces inadequate reserves, there is no clear mechanism for quickly adapting
  • Deterministic reserves, even with a provision for adverse deviation, cannot capture certain risks and mitigants. Equity risk and derivative assets are one example of risks that can only be assessed on a stochastic basis.

As life insurance product innovation in the 1980s and 1990s put pressure on the existing statutory valuation framework, the states responded with several interim measures to maintain a desired level of conservatism. There was recognition within the industry that a principle-based reserve methodology was both necessary and desirable to develop appropriate reserve standards.

Conditions PBR Must Meet

A principle-based valuation must meet the following conditions:

1. Quantify the benefits and guarantees, and the funding, associated with the contracts and their risks at a level of conservatism that reflects conditions that include unfavorable events that have a reasonable probability of occurring during the lifetime of the contracts. For policies or contracts with significant tail risk, reflects conditions appropriately adverse to quantify the tail risk.
2. Incorporate assumptions, risk analysis methods, and financial models and management techniques that are consistent with, but not necessarily identical to, those utilized within the company’s overall risk assessment process, while recognizing potential differences in financial reporting structures and any prescribed assumptions or methods.
3. Incorporate assumptions that are derived in one of the following manners:
   • The assumption is prescribed in the Valuation Manual.
   • For assumptions that are not prescribed, the assumptions shall:
     • Be established utilizing the company’s available experience, to the extent it is relevant and statistically credible; or
     • To the extent that company data is not available, relevant, or statistically credible, be established utilizing other relevant, statistically credible experience.
4. Provide margins for uncertainty, including adverse deviation and estimation error, such that the greater the uncertainty the larger the margin and resulting reserve.

• •  

• • •  

•  

PBR Condition #1

The quantification is done using a cash-flow projection model that starts with the current assets underlying the liability and then projects both asset and liability cash flows under a number of stochastically generated paths. Each path constitutes one scenario; the stochastically-generated assumption is usually something that is path-dependent (equities or interest rates), but there has been some movement to including stochastic mortality or lapses. For each scenario, take the negative of each year end statement value of assets, and find the greatest PV as of the valuation date. That greatest PV plus the starting assets is the reserve for that scenario. The tail risk is then addressed by taking an appropriate level of CTE (generally 70) of the scenario reserves. Non-stochastic assumptions can be addressed through PADs.

PBR Condition #2

Assumptions and analysis should be consistent across multiple platforms that may be used within a company, e.g. ERM and GAAP reporting. Specifically, there should only be one set of Best Estimate assumptions, although the PADs for different uses may differ where appropriate.

PBR Condition #3

This provision of PBR allows the company to reflect reasonable expected improvements in certain assumptions due to risk management efforts to the extent that they are backed by credible company experience or relevant industry experience. There are limits and exclusions on the ability of the company to reflect only its own expectations.

PBR Condition #4

This is a standard requirement for any reserving methodology that provides for margins for uncertainty or adverse deviation. Greater uncertainty requires higher PADs.

Governance Requirements for PBR

There are specific requirements for oversight and governance if a company is using PBR to set its statutory reserves, specifically to establish procedures for corporate governance and oversight of the actuarial valuation function consistent with those described in the Valuation Manual.

• Provide to the commissioner and the board of directors an annual certification of the effectiveness of the internal controls with respect to the principle-based valuation. Such controls shall be designed to assure that all material risks inherent in the liabilities and associated assets subject to such valuation are included in the valuation, and that valuations are made in accordance with the Valuation Manual. The certification shall be based on the controls in place as of the end of the preceding calendar year.
• Develop, and file with the commissioner upon request, a principle-based valuation report that complies with standards prescribed in the Valuation Manual.

Insurance Administration, Underwriting, and Claims

After successfully competing this section, you will be able to:

• Explain basic insurance administration and how actuaries are involved.
• Describe underwriting regimes, applications, preferred criteria, and screening tests.

Policy Administration

Introduction

Life insurance policy administration is a process that is used to manage a number of core processes, including rating, quoting, issuing, and renewals. Administration of a life insurance policy is very important. A policy owner has a contract with the insurance company and is entitled to receive the benefits as described in that contract. In this section, you will get an overview of how policy administration works, how the various departments contribute, as well as how an actuary is involved. There are many instances when an actuary might be called upon, especially if something is not being administered properly. Actuaries play a vital role in ensuring policy owners receive their contractual obligations while also supporting the health of the insurance company.

How is a Policy Administered?

Here are some of the departments and functions that all must work in coordination to successfully administer a policy:

• Policy Issuance/ New Business
• Claims
• Information Technology
• Legal
• Actuarial
• Investments
• Accounting
• Client
• Services
• Reinsurance
• Treasury
• Marketing
• Underwriting

Getting a Policy Issued

At a high level, the process to issue a policy begins when the application is sent to the insurance company. You will see an example of an application later in this module. After the application is received by the insurance company, the underwriting review begins. You’ll learn more about the underwriting process later in this module, but the goal of this review is to determine whether the applicant can be insured, and if so, how to classify the risk. The company will then make an offer to the applicant.

If the applicant accepts, the policy will be issued. A policy form will be generated including:

• Application;
• Illustration;
• Guaranteed values;
• Policy provisions.

From that point, the applicant has become a policyowner and is finished with the application process, but there is much more left for the insurance company to do.

System Implementation

Getting a product set up and running on an administrative system requires planning, programming, and testing. An actuary will be involved in delivering the product design and mechanics of how the product will operate. This will likely include:

• Providing values, rate tables, and calculation formulas.
• Validating and testing tools to ensure the administrative system is operating correctly.
• User Acceptance Testing to “signoff” on the values and calculations, for example:
  • 7702 / 7702A calculations;
  • Premium calculations on traditional life insurance products;
  • Cost of insurance charges, expense charges, policy fees, surrender charges, interest crediting on universal life products;
  • Shadow account calculations for secondary guarantee UL products;
  • Market Value Adjustment calculations;
  • Annuitization calculations – period certain and/or life contingent;
  • Death Benefit accelerations for terminal, chronic or critical illness claims.

Illustrations

A life insurance policy illustration is a set of projections, prepared by the actuarial department of the insurance company. It shows how a policy will perform over an insured’s lifetime and includes financial projections for each year.  Illustrations are an important sales tool for many life insurance and annuity products. Illustrations give potential owners a hypothetical projection of how the policy will perform, as well as the guaranteed worst case scenario.

The Illustration Actuary will be responsible for ensuring the product design is accurately represented in an illustration and that all regulations are satisfied.  At this point, the actuary must also ensure that the illustrations are accurately presented to potential owners.

The implementation of a product into illustration software will require:

• Calculation rules detailing the exact mechanics of how account values are developed, and benefits would be paid;
• Tools for sample calculations and testing;
• Significant testing and sign-off that the software is accurate;
• Filed certifications signed by the Illustration Actuary.

Annual Statements

The annual statement is a report sent to the policyowner providing the status of the policy every year.

This will typically include:

• Dates included in reporting period.
• Policy value at the end of the previous reporting period.
• Policy value at the end of the current reporting period.
• Total amounts credited to and debited from the policy during the current reporting period.
• Current Death Benefit at the end of the current reporting period.
• Amount of any outstanding loan at the end of the current reporting period.
• Net cash surrender value at the end of the current reporting period.

An actuary will often be involved in ensuring that the values presented in the annual statement are accurate and cover all aspects required by the Life Insurance Illustrations Model Regulation and Universal Life Insurance Model Regulation.

Data

Getting accurate data from the administrative systems is a critical aspect of many actuarial roles, for example:

• Financial reporting data must be accurate and timely. Finding errors in data extracts could result in the need to restate earnings or reserves. There must be enough time to do analysis with tight deadlines at month-end, quarter-end, and year-end.
• Assumption setting data is necessary to perform experience studies. With the introduction of Principle- Based Reserving, having credible company data is even more important than it has been in the past. Principle-Based Reserving (PBR) allows an insurer to reflect its own unique experience and risks in calculating reserves. PBR utilizes simulation models to estimate the level of reserves needed to cover future claims.
• In-force management data is used to monitor trends to decide on management actions such as promoting or curtailing sales or changing non-guaranteed elements of a product.

Reading: Chapter 6 and 8.3 of Statutory Valuation of Life Individual Life and Annuity Contracts (Claire, Lombardi, Summers, 5th Edition)

Audits and State Examinations

Actuaries might be called upon to provide calculations proving the administrative system is working correctly. This can be significant task involving multiple actuarial functions as well as other administration staff.

• Are policy values and benefits calculated as promised in the policy form?
• Are the correct inputs pulled from the administrative system for valuation and financial reporting?

Client Services Inquiries

The Client Services team fields a vast number of requests from agents, policyowners, and beneficiaries. These requests might be routine in nature, such as an address or billing change. They could also be something more complex such as a change in coverage, withdrawal, loan, or nonforfeiture option. An actuary might be involved if there is a calculation needed or an inquiry as to how a certain value was developed.

What happens with policyowner complaints and how might an actuary get involved?

An actuary might be needed for assistance with:

• Custom illustrations: There could be limitations to the software that need to be calculated manually.
• Policy value verification:  Questions regarding charges or credited interest to a policy’s value could require a manual calculation
• Calculations for Legal / Compliance:  There can be inquiries on a single policy or entire class of policies. Precision is required, especially if there is a complaint, litigation, or correction involved.
• Responses to State Department of Insurance:  Regulators want to ensure that consumers are being treated fairly and within the boundaries of their contracts. Actuaries can be very helpful in explaining the mechanics of a policy as well as providing calculations.

Conservation

Once a policy is issued to an applicant, it’s important to understand how long that policyholder will stay with the company. Lapse and persistency are important assumptions and can be affected by both internal and external behaviors.  If the right relationship is cultivated with the policyholder, they can stay with the company for a long time, holding the current policy and potentially buying other products as well.

Manual Calculations

There could be administrative system constraints that the actuary must complete manually, for example:

• “Day 2” items: In general DAY 2 items are not considered and planned at the beginning of the project and arise close by the project deadline. A manual calculation is needed because a product feature did not get implemented onto the administrative system at the time of product launch.
• Sometimes a specific feature might be too costly or time intensive to be programmed or have the administrative system modification implemented. It could be cost beneficial to have an actuary do the calculations manually, when needed. In this case, it might someday no longer be cost effective if the volume reaches a tipping point.

Correction Projects

What if there was an error in the administrative system? An actuary might be called upon to ensure any calculations are corrected and that all policyowners receive the benefits that they were promised and entitled to contractually.

Sometimes this correction entails “rebuilding” policies from many years back when an error occurred. The actuary will work closely with the Legal, Client Services, and IT departments to ensure the policies are administered correctly going forward and all policyowners are compensated fairly. Actuaries will be involved to make sure that all communications with policyowners are accurate and helpful.

Claims Administration

Paying a claim is the most significant result of an insurance policy. Actuaries might be involved if:

• There was a misstatement of age or sex. The benefit amount might need to be adjusted higher or lower based on the corrected insured.
• Calculations are needed for any additions or deductions that need to be included in the payment amount.
• Settlement options other than Lump-sum payment are chosen. Calculations, especially for life-contingent payouts, might not be automated.
• Accelerated death benefit calculations are needed for a terminal or chronic illness. These benefits can require a simple calculation, such as applying a percentage to the full death benefit or they can include a deduction based on the life expectancy and present value of future benefits expected on the policy.

Changes to Non-Guaranteed Elements

A part of product management includes determining when, and by how much, a non-guaranteed element (NGE) of a product should be changed.  A non-guaranteed element is any element within an insurance policy that affects policy costs or values that is not guaranteed or not determined at issue and that may provide a more favorable value to the policyholder than that guaranteed at the time of issue of the policy. Such elements can include premium rates, cost of insurance rates, expense charges, and interest credited rates.

Making a change to thousands of policies takes care and coordination. It is imperative that all policies are treated appropriately and that the execution of the changes goes exactly as expected.

Disclosures to policyowners and regulators must be timely and communicate how the policies are changing. If effective, letters to policyowners can prevent confusion and allay concerns.

Illustration systems will need to be updated in coordination with the administrative system. An increase in the volume of requests for in-force illustrations can be expected as policyowners will want to know how their policies will be affected.

Regulators are paying attention to how companies are implementing changes to NGEs and are developing requirements in the interest of protecting the consumer.

What types of requirements might companies expect?

• Disclosures in the policy form.
• Filed form and actuarial memorandum.
• Period of time between reviews of non-guaranteed elements.
• Approval by Board of Directors for non-guaranteed elements.
• Describing non-guaranteed elements and current scale being used.
• Specific notifications and disclosures sent to policyowners and regulators prior to change being made.
• Describing the process if the company were to make an adverse change to the current scale of non-guaranteed interest crediting rates or charges.

Reading: ASOP 2 Nonguaranteed Charges or Benefits for Life Insurance Policies and Annuity Contracts.

Actuaries Play a Key Role

Actuaries’ contributions in operations and execution aren’t as well-known as some more traditional actuarial roles, but clearly actuaries play a vital part in the successful administration of policies. Realistically, actuaries are valuable resources in all aspects of an insurance company and should be relied upon for their expertise to ensure that products are operating in a manner that promotes the company’s financial health as well as delivering what is promised to the policy owners.

Underwriting

Underwriting is not a traditional area in which actuaries work but is a key part of the life insurance process. Underwriters work to determine an applicant’s level of risk relative to a particular product. While these risks can come in different forms such as medical, lifestyle, or financial, they all could dramatically effect whether an individual is a “good” risk or a “bad” risk. Actuaries use this risk assessment in the pricing process to appropriately set assumptions for various products.

Risk Classification and Anti-Selection

• Risk classification is a way of creating one or multiple groups that share the same risk characteristics, whether good or bad.
• Anti-selection (or adverse selection) occurs due to information asymmetry between the applicant and the insurance company. The applicants may know they have a certain risk profile but the insurer is unable to properly identify it. For example, if an applicant has a medical condition, he or she may try to “select” against an insurer by finding a company that does not underwrite for that particular condition.

Reading: Section 2 of the report “Underwriting Types in Life Insurance in the United States – Yesterday, Today and Tomorrow” and think about how these two concepts will factor into the underwriting process.

Introduction to Underwriting Regimes

Section 2 of “Underwriting Types in Life Insurance in the United States – Yesterday, Today and Tomorrow” mentions a few different types of underwriting but let’s focus on just three: fully underwritten, simplified issued, and guaranteed issue. These three regimes represent the varying degrees of underwriting a company will go through to assess whether an applicant has the appropriate level of risk for a product.

• On one end of the spectrum is fully underwritten business. Underwriters will ask an extensive list of questions and order multiple medical tests for fully underwritten business, in order to more accurately predict and refine the level of risk.
• On the opposite end of the underwriting spectrum is guaranteed issue business. As its name suggests, guaranteed issue business is near certain to be issued to an applicant. The underwriting is typically extremely limited and is generally limited by only eligibility requirements, i.e., within a specified age range or an active member of an eligible group. With such little information provided, risks are generally combined in broad buckets.
• The third underwriting regime falls somewhere in the middle of the spectrum. Simplified issue tries to find a middle road that combines the speed and efficiency of guaranteed issue business, while maintaining some degree of risk assessment from fully underwritten business.

What range of policy sizes do you think a company would feel comfortable issuing in the three different underwriting regimes?

Companies will likely match the size of an issued policy with the associated level of risk. In this instance, the level of risk is best determined through the amount of information available. A company would know little to nothing about an applicant for a guaranteed issue policy and thus would want to keep the policy size small, usually $25,000 or less.

• • Simplified issue policies have more questions and tests but not a complete picture and can have maximum policy sizes in the $250,000-$500,000 range.
  • Fully underwritten policy sizes can reach into the tens of millions with a wide array of information available on the policyholder.

There can absolutely be overlap in amounts offered through different underwriting regimes, but this gives a general sense of the stratification concept.

Combining Risk Classification, Anti-Selection, and Underwriting Regimes

How would the choice of an underwriting regime affect anti-selection and risk classification?

Anti-selection expectations need to be incorporated into the pricing for a given underwriting regime. Guaranteed issue business will attract applicants that are otherwise unable to purchase a fully underwritten policy because of a known impairment. Impairments increase the likelihood of a claim, which will lead to relatively higher pricing.

Anti-selection is also a risk on fully underwritten business. Insurance companies tend to “win” the risks for which they don’t screen. For example, a company could have a quite extensive application that asks about many different impairments. However, if there is no question that screens for diabetes, a company will likely see a larger number of diabetic applicants. Applicants are intelligent and will look for weakness in the underwriting process.

Proper risk classification requires enough information to be able to sort risks into distinct groupings. This level of information is limited for guaranteed issue business. However, with the wide array of information available on fully underwritten business, multiple groupings can be created in order to give the best price to the best risks.

Preferred Underwriting

The prior reading touches on preferred underwriting. This is the practical application of risk classification on fully underwritten and, to a lesser extent, simplified issue business.

Preferred underwriting began in the early 1980s in the United States with the onset of the smoker distinction. Companies began recognizing that nonsmokers were less risky than smokers and began differentiating the pricing. In the late 80s and early 90s, companies saw the information that was available in blood and urine and were able to identify “preferred” risks where an individual was less likely to die relative to a “standard” risk. Through the course of the 90s and into the 2000s, companies worked on refining this process. It’s not uncommon to see risk class structures today that have three or four non-smoking classes and a couple of smoking classes.

An important concept to consider when discussing risk stratification is Preservation of Deaths. This is the idea that if you remove preferred lives from a pool, the residual lives have a higher level of mortality than the original pool. You can’t improve your overall mortality by pushing more applicants into a preferred class.

Substandard Underwriting

The preferred underwriting evolution did not solely focus on “preferred” risks. It also tried to distinguish risks that were worse than standard or “substandard.” Substandard risks typically have multiple impairments that compound on each other. These individuals are more likely to die than someone issued as “standard.” Similar to the different levels of “preferred” risks, there are varying degrees of substandard-ness. This is commonly measured in a table rating, where additional tables indicate higher mortality, with one table corresponding to 25 percent additional mortality. For example, a Table D rating translates into four additional tables of 25 percent, meaning 100 percent extra mortality. A Table D rating means the applicant is twice as likely to die as a “standard” or non-rated applicant.

Substandard risks can be profitable if priced appropriately. A company could take the approach of loading premiums by the same amount as the mortality load. In our example, if mortality is double that of a “standard” risk, then the premium would also be twice as much. For individuals that are highly substandard, this causes insurance to be quite expensive.

Keep in mind labels like “standard” and “preferred” can be used as marketing terms and companies may use them differently. It’s possible that products may be developed which classify degrees of low substandard-ness as “preferred” and higher substandard-ness as “standard.”

There are situations where an individual’s risk profile is simply beyond what the company would be willing to accept, even with a substandard rating. In this case, the applicant would be declined for insurance.

Situations to Use Underwriting Tools

It’s important to understand the different situations where a test may be useful or not. Here are a few examples:

• Motor Vehicle Reports (MVRs) provide information about an applicant’s driving history. They provide insight into the risk of accidental death, particularly from a reckless driver or someone with a history of Driving Under the Influence (DUI). MVRs are commonly ordered for all ages but provide the most relative value for applicants ages 16-35. This is because accidental deaths are a higher percentage of causes of death at younger ages, before other medical impairments have begun to manifest.
• A financial statement gives a summary of an applicant’s financial position including assets, properties, investments, estate, etc. Financial underwriting stems from the need to understand why an applicant would need the insurance. If an applicant applies for a $10 million policy, the insurance company wants to ensure there is need for that amount of coverage. Therefore, financial statements tend to only be requested for higher face amount policies.

Underwriting tests and tools are constantly evolving as insurance companies seek new ways of understanding risk faster.

Pharmaceutical database checks have grown from just an awareness of an applicant’s medications to building a predictive model around the holistic view of all the applicant’s medications. A model may try to look at the entire medication list and either give it a color classification of red, yellow, or green or may assign a score representative of the level of risk.

Companies are also pursuing information from electronic health records. This could give a quick awareness of all of an applicant’s diagnoses from medical visits. This would be information very similar to what is seen on an Attending Physician Statement (APS) but would be available in a matter of minutes vs. weeks. Similar to the pharmaceutical checks, companies could try to build predictive models and scoring algorithms around health records.

Another area for predictive model development is using consumer credit behavior scoring. Credit companies have tried to translate public available information, driving history, credit scores, etc. into a score that accurately predicts mortality risk. The benefit of these models are that they are fast and don’t require intrusive testing of the applicant, such as drawing blood. It’s important to note that data used in these models must be compliant with the Fair Credit Reporting Act (FCRA) in the United States. In order to protect the consumer, adverse action against a policyholder cannot be taken with non-FCRA compliant data. This is a fast-evolving area for life insurance and companies need to take extra caution to ensure they meet all regulatory demands when using predictive models and credit information.

Which underwriting tool is the most important to use in the underwriting process?

There is not one tool that is more important than the others at a high level.  It’s important to use the correct tools for the current situation.  If you are looking at a younger population, tools that screen for “accidental” death risks, like a Motor Vehicle Report, are important.  A financial statement is important when considering large face amount policies to ensure the applicant has the appropriate need for that amount of life insurance.

Field Underwriting Manual

A field underwriting manual is commonly provided to an insurance company’s sales force to aid in the initiation of the risk assessment process. The field underwriting manual details an insurer’s underwriting philosophy and gives guidelines on when different underwriting tests will be sought. Let’s focus on three important components of the field underwriting process: the policy application, the age and amount requirements grid, and the preferred criteria.

Policy Application

The policy application tells the insurance company that an applicant is interested in purchasing a policy. The agent typically helps the applicant fill out some portion of the application to begin the process. Some companies utilize a tele-underwriting process or an internet-based program to collect the information.

Whatever the collection method, the applicant will commonly provide personally identifying information such as name, date of birth, address, occupation, etc. The insurance company needs to know who the applicant is. The application will also include information around the type of plan the applicant is selecting, who the beneficiary would be, and how premiums would be paid. This is the administrative piece of the application.

Medical vs. Nonmedical Questions

The application will also begin the risk assessment of the applicant. This comes in two forms – medical and nonmedical.

• Medical: The medical questions try to identify any impairments the applicant has. Depending on how refined the mortality needs to be for the product, this list of questions can be quite extensive or relatively brief. Questions may be grouped into categories that are easier for the applicant to follow like cardiovascular, cancers, psychiatric, etc.
• Nonmedical: The nonmedical questions focus on risks from an applicant’s life style. This will cover topics such as criminal history, motor vehicle history, and avocations. An insurance company could also ask whether the applicant has any history with other insurance companies. Particularly, the insurance company would be interested in whether the applicant had previously been declined or rated, which would suggest prior underwriting issues.

Sentinel Effect

The application questions will also likely be accompanied by a fraud statement, reminding the applicant that they should be honest and any attempt at fraud could be met with criminal penalties. The fraud statement can look like boilerplate language that many glance over. However, it provides a sentinel effect for the insurance company in an attempt to avoid anti-selective behaviors.

A sentinel effect is the tendency for applicants to be more truthful in their responses if they believe there is a screening mechanism that would identify lies or create penalties. This starts to focus on the behavioral aspects of application development. Application design has been proven to influence applicant responses and can encourage more truthful responses.

Policy Application Example

Applications can be longer or shorter than this example but it will give you a flavor for the kind of information sought. The authorization section of the application has been excluded for sake of simplicity but is a required element.

It is important to understand that an application can vary widely depending on the insurance company and even the product being applied for within a given company. There can also be differences between applications for fully underwritten, simplified issue, or guaranteed issue. Keep in mind this application is only meant to be one example of what an application may look like.

• Reading: Sample Individual Life Insurance Application

Is it important for a company to carefully consider the layout and format of the policy application?

It depends on the goals of the company.  If they simply wish to gather all of the necessary information, then the layout of the application isn’t critical as long as the applicant can reasonably follow it.  However, if a company is trying to encourage truthfulness and provide a high quality consumer experience, the format can be very important.  Statements of truthfulness or fraud near medical questions help remind an applicant to be honest in responses.  Similarly, avoiding harsh or accusatory questions like criminal history upfront can help ease an applicant into the process and make the experience more tolerable.

Age and Amount Requirements Grid

The second component of the field underwriting process that we’ll focus on is the age and amount requirements grid. The requirements grid will have an applicant’s age on one axis and the amount of insurance applied for on the other axis. An underwriter or agent can then easily use the grid to see what tests need to be ordered. The requirements are minimal for younger ages and smaller amounts and will typically increase in robustness as an applicant’s age or amount of insurance increases.

Preferred Criteria

The last component of the field underwriting process that we’ll look at is the preferred criteria. Preferred criteria are the practical application of the risk classification and preferred underwriting topics we discussed previously. An insurer’s preferred criteria set will generally list each of the available risk classes and limits on each underwriting test for an applicant to quality for that risk class. Agents and underwriters can take the information provided on the application and see, with a degree of certainty, how “preferred” an applicant may be.

From the preferred criteria example, you can see that as you cross over certain test thresholds, your assessed risk class will either move up or down based on how “preferred” the underwriting would view you. Some tests can knock you down to “standard” immediately while others can take smaller steps on the spectrum. You should also see that smoking status is a key differentiator.

Company philosophy on how strict underwriting rules are upheld can vary. Some companies are very rigid and will tightly hold to the rules in place. Others may use exceptions or alternatives where certain positive criteria can offset other negatives. For example, very good blood pressure and cholesterol results could offset a slightly worse Body Mass Index (BMI) that would typically prevent an applicant from moving into a higher preferred risk class. Internal pressures may also cause an underwriter to consider an exception-based decision, particularly from sales-related departments. An agent may push for a better risk classification to beat a competitor and place the case. This all falls under the company’s risk tolerance levels.

Emerging Issues

Accelerated Underwriting

Everything we’ve touched on thus far reflects the current state of the underwriting process. However, that process is constantly evolving and changing. Insurance companies are seeking new ways to underwrite applicants faster and less invasively while also maintaining accuracy.

This streamlined process commonly falls under the tagline of Accelerated Underwriting. Accelerated underwriting, also called “express underwriting,” is making it faster and easier for people with good health and good credit to obtain life insurance. With it, you can get a regularly priced life insurance policy of up to $1 million or more without a medical exam. Insurance companies have approached the topic a variety of ways but the ultimate goal is to improve the consumer experience. One way is for an insurance company to use “fast” tests to identify applicants that are likely “good” risks. Predictive analytics, credit scores, prescription profiles, MVRs, and Medical Information Bureau Inc. (MIB) hits can be generated within a matter of minutes. If an applicant meets certain thresholds under these tests, the insurance company may be comfortable with the level of risk and proceed to an instant issue. Companies can see dramatic improvements in application issuance turnaround times, moving from weeks to days or hours. If the applicant doesn’t pass the initial screening, the fully underwritten process could continue as normal.

Exams and fluids, such as blood and urine, provide great information on an applicant’s risk level, but acquiring those fluids take time and the process can be uncomfortable. Accelerated Underwriting endeavors to provide a similar level of risk identification but with less invasion.

Genetic Testing

Genetic testing could be a valuable source of an individual’s predisposition to develop an impairment. It’s easy to see this as a natural evolution of the family history questions that are prevalent in applications today. However, it is important to understand who will have access to this information. As the article notes, the risk for anti-selection is substantial. An individual may receive results that they are genetically predisposed to a given impairment and decide to purchase a policy to provide protection, but may not be required to disclose that information to the insurance company. This information asymmetry could lead to problems with anti-selective behavior.

It’s also important to note that like a family history question, genetic testing would not guarantee someone has an impairment, just whether they are predisposed to developing it.

Data Privacy

Information on an individual has exploded recently with the onset of the internet, big data, and social media. This can be valuable in determining the risk level of an individual, but personal rights to an individual’s personal data must be considered. An insurance company might attempt to aggregate information from social media, credit scores, publicly available financial information, electronic medical records, and more. This could be a striking amount of information gathered on the policyholder. Data privacy laws are a major regulatory topic right now. An insurance company needs to find the right balance of understanding an applicant’s risk level versus the right to privacy.