Chapter 22 - Setting Assumptions (2)

Question 1

Define the term ‘embedded value’ [1]

2015_s2

Answer 1

Embedded value profit can be calculated as the sum of:

• The shareholder-owned share of net assets, where net assets are defined as the excess of assets held over those required to meet liabilities.
• The present value of future shareholder profits arising on existing business.

Question 2

List the assumptions that are required to calculate an Embedded Value for a withoutprofits life assurance business [3]

2015_s2

Answer 2

• Mortality rates and mortality improvements
• Disability rates
• Withdrawal rates
• Expenses and expense inflation
• Benefit inflation and claim sizes
• Premium collection rate
• Commission claw back rate (i.e. the rate at which commission claw backs is
  successful)
• Investment returns, valuation discount rate or valuation interest rate
• Volatility of investment returns
• Future asset mix
• Future new business volumes (may affect the future per policy expense assumption)
• Future changes in tax rates

Question 3

Define the embedded value of a life insurance company [1]

2018_s2

Answer 3

Embedded value is calculated as the sum of:
* The shareholder-owned share of net assets, where net assets are defined as the excess of assets held over those required to meet liabilities.

• The discounted value of future shareholder profits arising on existing business; often referred to as ‘present value of future profits’

Question 4

A well-established life insurance company sells whole of life insurance contracts. The solvency regime in the country stipulates that reserves are to be calculated on a prudent basis.

i. Describe briefly the traditional method for determining the embedded value of this life insurance company.[5]

2018_s2

Answer 4

Net asset value:

• The assets may be value at market value
• Or may be discounted to reflect ‘lock-in’ to the extent that assets backing solvency capital requirements are invested more cautiosly and as a result are expected to earn a lower return.
• The insurance liabilities are valued on the supervisory basis.

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• The future cashflows on the existing business are projected on the embedded value basis and are used to estimate the future shareholder profit.
• These cashflows include future premiums, investment income, claims and expenses, plus the release of supervisory reserves.
• The cashflows are discounted at an appropriate risk discount rate to determine the present value of future profits (PVFP)
• The risk discount rate incorporates a risk margin for unpredictability in the emergence of profit.
• The PVFP is effectively the release of any margins within the supervisory reserves relative to the embedded value basis used.
• The embedded value basis is usually a realsitic basis.
• The insurance liabilities used in the calculation of the present value of future profits are consistent with the insurance liabilities in the calculation of the net asset value, i.e. the projected future liabilities are on the supervisory basis.
• Tax on profits and investment returns is allowed for, as appropriate.

Question 5

i. State the main reasons a company would perform an analysis of Embedded Value profit. [2]

A life insurance company has just performed an analysis of Embedded Value profit and identified that the withdrawal experience on its term assurance business was higher than its assumptions.

ii. Discuss the likely impact of the higher withdrawals on its embedded value [5]

iii. Suggest possible causes of the higher withdrawals. [3]

The company wishes to understand the cause of these higher withdrawals and has decided to perform an analysis of its withdrawal experience.

iv. Describe how it might choose to subdivide its data in order to get a better understanding of the causes.

2008 - s2 - uk

Answer 5

i.
A company will analyse the change in its embedded value in order to:

• validate the calculations, assumptions and data used
• reconcile values for successive years
• provide management information
• provide detail to publish in its company accounts, for example, the value of new business written
• provide information as part of a prospectus for sale of the company

ii.

• The withdrawal itself will have no cost associated with it.
• ~
• The company will lose the value of future premiums, this will be offset by the expected value of claims that will no longer occur
• and any reduction in the expenses of managing the policy and paying the claim.
• There may also be a release of reserves.
• ~
• The impact on the embedded value will depend on whether the value of future premiums is greater than the expected value of the claims and expenses and the reserve release.
• ~
• Early on in the term of a policy you would expect the value of future premiums to exceed the value of future claims, expenses and reserve.
• ~
• So the embedded value will tend to reduce on lapse
• ~
• Over time the cost of claims increase as policyholder’s age whereas premiums are normally level.
• There is also likely to be an increase in reserve held
• ~
• It is possible that close to the end of the term of the policy the expected value of claims, expenses and reserve release exceeds the value of future premiums.
• ~
• So the embedded value may increase on lapse.
• ~
• The impact may also be distorted by reinsurance
• if the timing of reinsurance premiums and claims are not in the same proportion as the overall premiums and claims.
• ~
• In addition, there may be distortions from an uneven incidence of premiums
• for example, escalating premiums or premiums stopping before the end of the term of the contract.
• ~
• If the experience leads to a change in the assumption for future withdrawals, then there will be an additional impact on the embedded value.
• ~
• In addition, higher withdrawals may lead to higher per policy costs, which in turn reduces the embedded value.
• ~
• Higher withdrawals may be selective, which may affect the mortality assumption.

iii.

• It is possible that other companies have advertised lower premium rates such that customers can get the same benefits cheaper.
• ~
• The company may have even reduced its own rates leading to lapse and reentry.
• ~
• Advisors may actively review market rates and highlight opportunities for customers and encourage them to withdraw and take out other cover.
• ~
• Alternatively, mis-selling by advisers or the company may have led to inappropriate sales and higher subsequent lapse experience
• ~
• There may be an economic downturn, leading to customers having less money to pay premiums.
• ~
• The company may have recently suffered bad publicity
• ~
• This may be driven by the poor customer service.
• ~
• In particular bad publicity about its claims handling may reduce the confidence of the customer in the company.
• ~
• The higher level of withdrawals may be as a result of random fluctuations
• ~
• The original assumption may have been unrealistic

iv.

• The company is likely to subdivide data by duration from entry as experience may differ by the time a policy has been in force
• For example, there may be a higher incidence of lapses early on in the term.
• ~
• The company is also likely to split its data by source of business, different distribution channels may have different experience
• For example, business from advisors may be worse than through direct sales channels as advisors may more actively search for improved terms for their clients.
• ~
• In addition experience from different individual distributors may be different and the company may wish to look into this.
• ~
• The socio-economic grouping of customers may also be explored as customers in different groups may exhibit different behaviours
• Premium size or geographical location may be used as a proxy here.
• ~
• In addition the company may split data by the age or sex of the policyholder.
• ~
• The company may also want to isolate customers who had been accepted on loaded premiums.
• These may exhibit worse experience if medical conditions causing their loadings had cleared up such that they could now get cheaper cover.
• ~
• If different policy types with different options are in force, data may also be split into the distinct variants.
• ~
• Different premium payment methods may also be analysed as well as premium frequencies, for example separating out single premium policies.
• ~
• The company may split the data by type of term assurance (eg level term, decreasing term) to determine whether the higher withdrawals relate to a particular product type.
• ~
• The company may also split the data by original term, splitting the analysis into short term and longer term policies.
• ~
• The company may also take into account specific events that might affect withdrawal experience, for example, changes to the way the policy is taxed.
• ~
• The number of divisions used will depend in part on the volume of data available.
• The company will be keen to ensure each data cell used is credible such that results are meaningful.