Chapter 13 - 15: Risks

Question 1

Income protection (IP) insurance in a particular developed country is highly competitive, which has led to substantial losses for all life insurers over the last five years.

The local regulator has decided to intervene to ensure that new IP policies issued are sold on a sustainable basis.

The regulator’s proposals include:
* a. A limit on the maximum benefit amount of 100% of policyholders’ net of tax income during the first six months of benefit payment and 75% thereafter; these limits are lower than benefit amounts currently offered by most insurers.
* b. A maximum benefit payment term of ten years; current products pay an income up to retirement age.
* c. A limit of five years on the period of guaranteed premium rates, after which premiums may be reviewed by the insurance company; current products are sold on a fully guaranteed basis.

i. Outline the likely impact on policyholders of each of the proposals. [3]
ii. Outline the main risks and challenges to insurance companies posed by the proposals [3]
iii. Outline the main advantages to insurance companies of the proposals. [2]

2021_s2

Answer 1

i.

Limit on amount (Proposal A)
* The proposed regulations place limits on the benefits that insurance companies may offer, which may mean that the reduced benefits may not fully meet financial needs of policyholders.

• Reduced benefits would mean lower premiums which would make these policies more affordable

Limit on benefit payment term (Proposal B):
* This limitation is likely to severely impact policyholder needs and resulting unappealing and unmarketable benefits from the perspective of most policyholders.

• It will have much less impact on policyholders closer to retirement age, and a larger impact on younger policyholders.

Limit on guaranteed term (Proposal C):
* This creates some uncertainty for policyholders who may not be able to afford large unexpected increases in premium rates.

• Steep increases could lead to policyholders lapsing and being left without cover

ii.

Risks and challenges:
* Products will need to be repriced and there might not be data available on claims and policyholder behaviour under new policy conditions.

• New product features may be unattractive to customers, leading to reduced sales and premium volumes, which may result in companies not recouping expenses.
• It is difficult to predict the impact of these changes under different economic conditions. This adds the uncertainty of the impact of these changes.
• If policyholders do not understand that benefits are governed by legislation, they will blame the companies for poor benefits leading to reputational risks for companies.
• The indirect impact of these regulatory changes may be lower future product innovation and greater standardisation.
• Product standardisation could lead to products being mostly differentiated by price and high competition could lead to unsustainably-low premium rates
• Changing administrative and other processes may be difficult and costly.

iii.
Advantages:
* There may be an improvement in the underwriting experience on these products due to the benefit reducing after six months, as this is likely to encourage some claimants to return to work leading to shorter average claim durations, depending on the length of the deferred period for these products.

• As the levels of guarantees offered are reduced, the capital requirements on these products should also reduce, helping improve the financial position of insurance companies in difficulty.
• Limiting benefits to ten years materially reduces the assumption risk for an insurer, as a short projection period improves the reliability of modelling for pricing and reserving purposes
• > It may also be easier to find investments of suitable matching terms.
• Limiting rate guarantees to five years also helps as any mispricing or worse than expected experience could be corrected for (at least partially) after a 5-year initial rate guarantee period
• > Although there are likely to be challenges in implementing premium increases in practice.
• Due to the competitive nature of the market, it might have been difficult to have implemented measures to make the product more financially viable without regulatory intervention.

Question 2

A life insurance company writes only conventional without profits business

i. List the sources of risk for the in-force business [4]

ii. Explain how new business can be a source of risk [8]

2005_s2 - uk

Answer 2

i.
* Accuracy of policy and other data

Variation in:
* Mortality experience
* Underwriting standards not consistent with premium assumption
* Investment performance
* Expenses
* Inflation
* New business mix or volume

The cost of guarantees and option
Impact of actions of competition
Actions of staff and directors (e.g. misselling)
Failure of systems and controls (including new business processing, claims handling, policy servicing)
Counterparty failure (e.g. reinsurer, issuer of corporate bonds)
Liquidity of assets held
Legal, regulatory or fiscal changes

Fraud from employees, customers or intermediaries
Aggregation or concentration of risk

ii.

• if too much business is sold there is likely to be a higher capital strain than expected.
• This may lead to solvency problems
• In addition too much busiess may lead to operational difficulties.
• The customer service operation may not be able to cope with higher than expected demands and this may lead to a reduction in service standards.
• This may lead to an increase in surrender or policies not being taken up which causes a loss in embedded value.
• It may also lead to bad publicity or strained relationships with distributors which may adversely impact future sales and therefore profits.
• ## If too little business is sold then the lower income would not cover expenses incurred as expected.
• This would lead to lower profitability than expected on business written as more expenses would need to be spread over fewer policies.
• In addition variations in business mix may be a source of risk
• Different products may have different levels of profitability.
• If the mix is different to expected it is possible that the average profitabilityu will be reduced.
• In addition the capital requirements will differ for different products
• if a higher proportion of capital intensive products are sold than expected then this may lead to solvency problems.
• Changes in mix may also impact on the company’s operations as it may not have sufficient experitise to cope with growth in volumes of certain business
• The mix of business within a particular product can also be a risk.
• For example if average premium size is lower than expected this may lead to lower profitabilty.
• ## There is also a risk that business is lower “quality” than expected and surrenders are higher than expected.
• This may be due to differences in the socio economic group of customers.
• This may also be due to problems with underwriting
• Similarly it may be due to differences in the mix by distributor.
• There is also a risk that commission paid is not clawed back on surrender of policies due to practice of distributors.
• Actions of competitors may introduce risks through changes in their premiums or charges influencing the volume or mix of business achieved.
• In addition market movements may introduce risk to the profitabilty of new business for some products, for example Annuities,

Question 3

A leading life insurer is considering broadening its individual product range. It is considering launching income protection, critial illness, and long term care products. All contracts will be available only on an individual basis.

Describe the main product specific risks associated with each of these contracts. [5]

2005_st1_s1

Answer 3

Income protection

• The main risk relates to sickness transfer probabilities in the underlying multiple state model - claim inception and claim termination rates
  ~
  Other major risks include:
• Anti-selection risk
• Withdrawal risk - selective withdrawal
• Financial risk on withdrawals where asset share is negative

Critical Illness

• The main risk relates to rates of diagnosis of critical illness specified in the contract
  ~
  Other major risks include:
• Anti-selection risk
• Selective withdrawal
• Financial risk on withdrawals where asset share is negative

Long Term Care

• The main risk relates to transfer probabilities in the underlying multiple state model
• And to claim inception probabilities and transfer probabilities between claim states
  ~
  Other major risks include:
• Investment risk
• Expense risk
• Withdrawal risk - selective withdrawals
• Financial loss from withdrawals when asset share is negative
• Marketing / reputation risk since policyholders expectations may not be met

Question 4

A small life insurance company writes mainly term assurance contracts targeted at young families. Underwriting is used to assess the terms appropriate for new business. Past experience has shown that the mortality experience for this product line can be represented as a fixed percentage of standard mortality tables.

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

The company is also considering outsourcing its administration to a major company that carries out this service for numerous other life insurance companies. The life insurance company would pay for the development and data transfer costs.

The administration company would charge the life insurance company a fixed fee per policy, which would be guaranteed for 10 years and then be renegotiated for each subsequent 5 year period.

++++++++++++++++++++++++++++++++++

iii. Discuss why the company may wish to outsource its administration, including the advantages and disadvantages of the proposal. [10]

2008 - s1 - uk

Answer 4

Why outsource
* Competitiveness in the market may mean that expense control an is important issue for the company
* ~
* The company will want to increase profitability, and outsourcing may enable this.
* ~
* As the company is small it may be that it cannot achieve the same economies of scale as its competitors.
* ~
* Outsourcing may increase the new business capacity of the company
* ~
* It is possible that developments required, for example, regulatory changes are costing a disproportionate amount of teh company’s expense budget.
* ~
* The company may be finding it difficult to recruit and retain staff.
* ~
* It may be concerned that it has not and will not be able to maintain cost control and so costs may rise faster than its competitors.
* ~

Advantages

• The outsourcing company may have better customer service standards than those currently within the life company, leading to poteional better retention of policies.
• ~
• Entering into the arrangement will give greater certainty to the costs that the company will incur over the guaranteed period.
• This will enable greater confindence in pricing and reserving.
• ~
• The fee may result in lower fixed expenses.
• ~
• The outsoucer may have better IT systemns than the company and thus improve servicing overheads.
• ~
• By putting the business on the same IT platform as the outsourcers other clients, the company is achieving a greater economy of scale.
• ~
• The cost of future industry wide changes can be share with other companies.
• ~
• The development costs of new products may be reduced as the outsourcer may have experience of the new product types.
• ~
• If underwriting process is outsourced thne the life company may benefit from better underwriting service standards and reduced underwriting costs.
• ~
• This may free management resources for other areas of the business

Disadvantages

• The company is no longer directly in control of customer contact.
• As a result, the company will wish to agree the service standards that the outsourcer should apply to ensure that the company does not suffer from customer dissatisfaction and consequential brand damage.
• ~
• if underwriting process are outsourced then the life company will suffer from a loss of control over those processes and may experience a fall in underwriting standards.
• ~
• The company is liable for the migration and development costs and risks inaccuracies and work not being completed on time
• These costs will be crucial in the business case justifying the decision.
• ~
• The life company will have limited control over these costs, as a significant proportion will be incurred by the outsourcer.
• ~
• There will be an increased policy size risk due to having a fixed fee per policy.
• ~
• There may be limited control over the fees that will be charged at each renogotiation.
• ~
• If the rise is significant the company may have to move the business back in-house or to another outsourcer.
• The likelihood of this will depend on the existence of other outsource companies and ease of migration.
• ~
• Being a comparatively small company the level of influence the life company will have over the oursourcer will be limited, especially when it comes to renegotioation of fees or service standards.
• ~
• Term assurance and whole of life are relatively straightforward contracts to administer and so it may be possible to move them quite easily
• ~
• However, it would be better to agree some principles regarding the possible increase in fees in order to reduce the need to move the book again.
• ~
• There may be brand damage resulting from possible redundancies, as well as the costs associated with such redundancies.
• ~
• The company will need existing staff to make a success of the migration .
• ~
• Maintaining morale through the period of unceratainty will be a challenge.
• ~
• There is a potential for a loss of expertise and with it a loss of product knowledge.
• ~
• Whilst a substantial section of the company’s expense base will have been outsourced, there will be some elements remaining and so there will be some variability left.
• ~
• The company would need to consider the risk of administration company defaulting.

Question 5

A well established proprietary life insurance company has decided to start selling a new type of regular premium with profits endowment assurance contract.

The product is aimed at the parents of young children. It has a term to maturity of 20 years and is taken out on a single life basis. Each year regular bonuses are added to the initial sum assured. Payments of benefits are at the durations set out in the table below.

Duration : Benefit payable
14 years : 25% of Initial Sum Assured
16 years : 25% of Initial Sum Assured
18 years : 25% of Initial Sum Assured
20 years : 25% of Initial Sum Assured plus Regular and Terminal Bonus

If the parent taking out the policy dies at any time during the policy term, a death benefit equal to the initial sum assured is payable and all future premiums are waived. The benefits at duration 14, 16, 18 and 20 are also still payable.

In the event of the death of the child no further premiums or benefits are payable and the policy ceases.

No surrender benefit is payable during the first two years of the contract, although a surrender benefit is payable thereafter.

i. Discuss the advantages and disadvantages of this product for a young couple who have just had their first child [10]

ii. Discuss the risks that the insurance company should consider when launching this contract. [16]

2008 - s2 - uk

Answer 5

i.
Advantages

The advantages of this product for a young couple who have just had their first child are:

• The product provides both a benefit on the death of a parent and benefits when the child is a teenager and hence offers a good mix of savings and protection benefits.
• ~
• The product provides staggered lump sum benefits, which can be used to pay for education fees at key ages during a child’s secondary and tertiary education.
• The parents will be able to use the lump sums to meet expenses such as private school/college and university fees, board/lodging fees at university, school trips, and private tuition
• ~
• They could equally use it for other things, to improve the family’s financial security, such as paying off a home loan.
• ~
• The final benefit payable at duration 20, which includes all of the accumulated bonuses and final bonus, is likely to be a fairly large sum (compared to the payouts at duration 14, 16 and 18)
• and could be used, for example, to pay off any debts that the child has accrued whilst at university,or to provide a deposit for the child’s first property (either buying or renting).
• ~
• The product also provides life insurance cover in the event that the parent taking out the policy dies during the policy term,
• which will be useful in providing some financial security for the child in the event of the early death of the parent.
• ~
• The fact that future premiums are waived in the event of the parent’s death is an added advantage since it means that the policy will still provide the lump sum series of payments during the child’s secondary and tertiary education, even if a death benefit has already been paid out.
• ~
• It is possible that there will be some tax advantages to the parent taking out this policy, either the premiums payable throughout the policy term may be deductible from taxable income,
• i.e. income tax relief will be received on the premiums, or the final maturity/death benefit may be paid free of income tax.
• ~
• The product is regular premium and with profits, meaning that the parent taking out the policy starts saving regularly, the product introduces a savings habit, which may not currently be there.
• Also the parent benefits from receiving smoothed investment returns during the term of the policy
• ~
• Whilst we are not told the investment strategy of the with profits fund it is likely that the with profits fund will be invested, to some degree, in equities and hence will provide a positive real rate of investment return over the long term in excess of that which could be earned by investing in less aggressive investments, for example, in a bank/building society deposit account.
• ~
• A policy written on a single life basis will be cheaper than one written on a joint life first death basis.
• ~

Disadvantages

• Since the product combines both protection and savings elements it is likely to be relatively expensive,
• certainly much more expensive than if the parent just took out term assurance.
• ~
• We are told that the couple are young and have just had their first child, hence they are unlikely to have a high level of disposable income to spend on a savings policy
• and a term assurance may be more suited to their budget.
• ~
• The product is only to be taken out by one of the parents and hence only provides life insurance cover for the parent taking out the policy
• In addition the future benefits are no longer received if the child were to die
• ~
• Even though they have had a child, it is likely that the couple need life insurance to cover both parents;
• either both parents will work, or in the event that one of the parents stays at home to care for the child, in the event of their death, life insurance cover would be useful to provide money to pay for childcare.
• ~
• The product invests in a with profits fund.
• The couple may not like the lack of transparency associated with investing in a with profits fund and they may prefer to invest in, say, a unit-linked contract, instead
• ~
• Similarly, a with profits savings policy from an insurance company may be seen as an expensive option, due to the high charges that the insurance company may take
• and the couple may prefer to take, for example, a joint life term assurance policy, and invest regularly in a different savings vehicle such as unit funds/mutual funds.
• ~
• The pattern of benefits offered may not match the needs of the parents, for example, they may need a regular payout each year between ages 11 and 16 for the product to meet regular school fees.
• the product could be made more attractive if the parent had some choice at outset regarding the pattern of benefit payouts.
• ~
• Inflation may erode the value of the fixed interim payments to the policyholder.
• ~
• No surrender in the first two years will mean that the policyholder will not be able to recover any value from the premiums paid in, if their financial circumstances change.
• ~
• Due to the likely high premiums, the couple may find it difficult to maintain paying the premiums if their joint income falls substantially
• for example, if one of them falls sick or has a serious accident.
• the product might be more attractive if it were to offer rider benefits to cover such eventualities.

ii.

The risks that the insurance company must consider in launching this contract include:

Investment risk
* This is a savings contract and hence the main risk is that the product fails to meet the levels of investment return expected by the policyholder.
* ~
* Investors will expect a reasonable level of real return, in the form of regular and terminal bonuses, throughout the term of the policy.
* They may compare the regular bonuses received during the policy term to investment returns on bank deposits or on savings in unit trusts/mutual funds.
* ~
* The company must invest in assets that will maximise the returns to the policyholders for an acceptable level of investment risk in accordance with the way the insurance company’s with profits fund is marketed and was described to the policyholder at inception.
* ~
* The insurer will have to take into account any local regulations, which may govern the asset classes that the insurer may invest the with profits fund in.
* ~
* In addition the profile of guarantees and payouts may influence the investment strategy and constrain investment freedom
* ~
* There is a risk that the returns on the with profits fund are poor in relation to other insurers’ with profit funds
* and hence, for example, the insurer may struggle to sell this business in sufficient volumes if the insurer has a reputation of providing poor with profits payouts (e.g. measured by surveys in the financial press).
* ~
* Investment risk can be passed back to policyholders via reduced bonuses,
* however this will also impact the level of shareholder profits and the future marketability of the product.
* ~
* The company runs the risk of the return being insufficient to meet the guaranteed benefits on the policy.

Mortality risk

• Whilst the product is a mixture of savings and protection, death benefits are provided and hence there is a mortality risk to the insurer
• ~
• In particular, the death strain on early deaths will be higher than a regular endowment product due to the double benefit provided under the contract of both payout of the sum assured and the provision of the maturity proceeds, with waiver of premium.
• ~
• The insurer is exposed to the risk of deaths early in the policy term, when the death benefit will far exceed the policy’s asset share.
• ~
• The insurer will usually try to minimise this risk through appropriate underwriting.
• ~
• The insurer will deduct mortality charges from the asset share of each policy to pay for the mortality risk that the policy represents.
• ~
• If the insurer reinsures the mortality risk, it will be exposed to the risk of the reinsurer defaulting.
• ~
  Apart from early deaths, the risks to the insurer are:
• a. at a portfolio level, that there are generally more deaths than expected such that the mortality charges taken in aggregate are insufficient to meet the death benefits paid out in excess of asset shares.
• ~
• b. that policyholders generally die earlier than expected, meaning that, under the waiver of premium benefit, the premiums are paid by the insurance company for a longer period than expected i.e. the company has underestimated the cost of providing the waiver of premium benefit.
• ~
• If child mortality has been allowed for, the company is at risk from fewer child deaths than allowed for in the pricing assumptions.
• ~
• Mortality risk can be passed back to policyholders via reduced bonuses, however this will also impact the level of shareholder profits and the future marketability of the product.

Lapses and surrenders risk

• We are told that no surrender value is payable during the first two years of the policy term.
• During the first two years, the asset share is likely to be negative, due to the high initial expenses of setting up the policy and paying commission etc.
• ~
• Hence, even though no surrender value is to be paid out during this period, there is still a risk of higher than anticipated early surrenders/lapses
• since the asset share is negative during this period and the company will make higher losses than expected if early surrender rates are higher than anticipated.
• ~
• Profits are likely to arise for shareholders as a proportion of the regular bonus declaration each year.
• Hence more surrenders than expected will lead to a lower volume of in-force business and a lower stream of profits for the shareholder.
• ~
• Some lapse risk may be passed on to the customer through lower bonuses.
• ~
• At later durations, the level of risk depends upon the relationship between the asset share and the surrender value.

Capital risk

• It is likely that it will take significant amounts of capital to write this line of business since new business strain is likely to be present during the initial years of the contract.
• ~
• The company is likely to deduct from asset shares a charge for the use of capital.
• ~
• There is a risk that this charge is set too low to adequately compensate the other with profits policyholders, if the free estate in the with profits fund is used to provide the capital support
• ~
• If additional capital is required to be provided by shareholders to support the free assets in the with profits fund to allow the writing of this business, then it may be that the capital charge is set too low to adequately compensate the shareholder for this use of their capital
• ~
• There is also a risk that the shareholders may not be willing to support the with profits fund in this way given that they are likely to get their profits back through, for example, a 90/10 gate.
• ~
• There is also an opportunity cost risk, in that the capital required may be better utilised for some other purpose,
• for example, launching a different product line (that is not so capital intensive), developing an alternative distribution channel and so on, that may produce greater investment returns.

Expense and volume risk

• There is a risk that the company underestimates the expenses (both development and regular ongoing expenses) that it incurs to administer the policy and that have been loaded into the premium charged.
• ~
• In deriving the expense assumptions, the insurance company will have made assumptions regarding the likely volume of new business that will be written as a result of launching this product.
• ~
• If the company writes less business than expected, then the company may not recoup the development costs that it has sunk into launching this product.
• ~
• Again, to an extent, expense risk may be passed on to customers through the bonus structure.
• ~
• If the company writes more business than expected then there are two risks.
• Firstly, the company may not have sufficient capital to support the writing of so much new with profits business
• Secondly, the company’s systems and operational staff may find it difficult to cope, causing backlogs and complaints in respect of issuing policies.
• ~
• There is a risk of a change in the mix of business being different to that assumed in the pricing, leading to an incorrect expense loading, for example, premium size
• ~
• The inflation assumption used in pricing may have been insufficient resulting in expenses growing at a faster rate than assumed.

Marketing and competition risk

• There is a risk that the company may market or sell the product inappropriately through certain distribution channels.
• For example, if the product is sold through a direct agency force, the agents may exaggerate the likely returns on the product to potential policyholders to secure a sale
• Hence there is the risk of a mis-selling scandal in the making.
• ~
• There is a risk that the product may look uncompetitive when compared to with profits products being offered by the insurance company’s competitors.
• This could be due to the benefits offered for a given premium, the type of riders that might be available, or just generally poorer investment performance resulting in lower bonuses and final payouts to policyholders
• ~
• There is also a risk that the product may appear expensive when compared to other investment options, for example, investing in unit trusts and taking out a term assurance policy to provide the death benefit
• ~
• Even if this product proves attractive, competitors may quickly copy it or improve the attractiveness of their features thus reducing sales potential
• ~
• There is a risk that the company has mis-read the demand in the market and that either there is no demand for the product, or there is demand, but for a different type of product, for example, a unit-linked version rather than a with profits version.
• ~
• There is a risk that the product is too complex and hence it will be difficult to train the sales force selling the product and difficult for them to sell/explain the product to potential customers.
• ~
• There may be a reputational risk to the company of ceasing the policy in the event of the child’s death

Administration / Systems issues

• There is a risk that the company underestimates the level of IT development work required to amend the insurer’s IT systems to be able to cope with the administration of this product.
• ~
• This is especially the case if this is the first time that the company has launched a product that offers multiple benefit payouts, since this may require complex system changes to cope with this.
• ~
• If the systems take much longer to amend than expected, it may result in a delayed launch for the product, which may be harmful if the company has announced its intention to launch the product.
• ~
• If administration staff are not adequately trained on the product features customers may be misled.
• ~
• In addition, fraud is possible, for example, if the company is not notified of the death of the child.
• ~
  Other potential risks include:
• changes to the tax or regulatory regimes
• concentration or aggregation of risk
• general system, data or control failures