Chapter 25 - Surrender values

Question 1

In a particular market there are two classes of without-profits whole of life products, “traditional” and “new-generation”.

Surrender values for these two classes of whole of life products are determined as follows:

• Traditional product class: Surrender values are the cumulative premiums paid up to the surrender date.
• New-generation product class: Surrender values are calculated using a blended approach of the return of the cumulative premiums paid for surrenders that take place on or before the second policy anniversary and the prospective method thereafter.

i. Explain the extent to which the surrender value method for each product class meets the principles for determining surrender values.[10]

2019_S2

Answer 1

The approach for determining surrender values should take the following principles into account:

• For both methods, whether the principle that the surrender value should take policyholder reasonable expectations into account is met depends on whether the calculated surrender values are consistent with the information provided to customers at the sales stage.
• Both methods are likely to meet this principle that the surrender value should not appear too low compared to premiums paid at early durations by definition of the surrender value.
• Traditional products are unlikely to meet the principle that the surrender value should be consistent with projected maturity values at later durations.
• 1. The guaranteed maturity value is should be higher than premiums paid as it takes investment earnings over the term of the policy into account.
• New-generation products are likely to meet the principle above as the prospective surrender value is likely to progress smoothly towards the maturity value over time.
• Traditional products are unlikely to meet the principle that the surrender value should not exceed the earned asset share in aggregate, over a reasonable period.
• 1. As, the surrender value is likely to be higher than the asset share at early durations and lower at later durations in the policy term.
• New-generation products are likely to meet the principle above as the prospective method is likely to be lower than the earned asset share.
• The traditional products do not meet the principle that the surrender value should produce a reasonable contribution to profit of the insurer and maintain equity with continuing policyholders and shareholders.
• 1. There will be losses at early durations and excessive profits at later durations.
• Whether above principle is met for new generation products depends on whether the basis used for the prospective method allows the insurer to recover the losses at early durations and produce a profit that is not excessive after the second policy anniversary.
• Traditional products are unlikely to meet the principle that the surrender value should avoid selection against the insurer.
• 1.As early surrenders are encouraged and later surrenders are discouraged.
• For new-generation products surrenders prior to the second policy anniversary may be encouraged, but the effect may be less severe than for the traditional products.
• Surrender values for traditional products are not consistent with those for newgeneration products, thus do not take the approach taken by all competitors into account.
• Consistency of surrender values across new generation products depends on the basis used for the prospective method.
• Traditional products are likely to meet the principle that the surrender value should avoid discontinuities by duration.
• New-generation products are unlikely to meet this principle as there is likely to be a discontinuity at the second policy anniversary where the method changes.
• Both methods are likely to meet the objective that the surrender value should not be subject to frequent change, unless the basis for the prospective method is changed frequently.
• Both methods are likely to meet the objective that the surrender value should not be excessively complicated to calculate, unless the basis is complicated for the prospective calculation for the new-generation products.
• Both methods are likely to meet this principle that the surrender value should be capable of being clearly documented.

Question 2

New-generation product class: Surrender values are calculated using a blended approach of the return of the cumulative premiums paid for surrenders that take place on or before the second policy anniversary and the prospective method thereafter.

A new life insurer operating in the market plans to launch a new-generation without-profits whole of life product.

The insurer is in the process of choosing between an “original premium” basis and a “best-estimate” basis for determining the surrender values under the prospective method.

Describe the amount of profit that will arise on surrender under each of the two bases. [3]

2019_s2

Answer 2

Profit arising for each of the bases under consideration for the prospecitive method of determining surrender values:

• The total profit retained by the insurer is the excess of the earned asset share over the surrender value paid (EAS - SV)
• This can be seperated into two parts:
• 1. The profit earned to date (EAS - SV^(p))
• 2. And the capitalised value of the profit that will arise in future due to differences between the original premium rate assumptions and the surrender value assumptions (SV^(p) - SV)
• Where SV^(p) is the prospective surrender value on the original premium basis.
• At early durations there will be a loss on surrender where the asset share is lower than than the premium paid to date or the prospective surrender values.
• After early durations the profit earned to date is the difference between actual experience and that assumed in the original premium basis.
• The value for capitalised future profits will be:
• <> zero if the original premium basis is used for determining the surrender value; and
• <> equal to expected future profits as if the policy had not been surrendered, if the best estimate of future experience is used.
• Depending on how the expenses relating to the policy surrender are allowed for in the charge for the surrender, these expenses may reduce profits

Question 3

A man purchased a without profits endowment assurance with a 25 year term on his 40th birthday. The sum assured of £50,000 is payable at maturity, or at the end of the year of death if earlier. He pays a premium of £1,000 annually in advance.

He has just reached his 50th birthday and has not yet paid the premium due at that date. He has decided that he no longer wishes to use this type of policy for the purpose of savings and would prefer to invest directly in equities. He has therefore requested a calculation of the surrender value and paid-up sum assured for his policy.

The insurance company calculates surrender values using a prospective calculation method.

Paid-up sums assured are based on an equation of value using the surrender
value as the current policy value. The following assumptions are used:

Mortality: AM92 Ult
Interest rate: 6.0% p.a.
Renewal expense: £35 per annum for premium-paying policies
£20 per annum for paid-up policies

Renewal expense inflation: 1.92% p.a.
Claims expense: 0.5% of benefit on death and maturity
Alteration expense: £100 on surrender and alteration

i. Calcualte the surrender value to which the policyholder would be entitled [7]

ii. Calculate the paid-up sum assured to which he would alternatively be entitled [5]

iii. DIscuss the other key issues that the policyholder should consider before making a decision [5]

2007-s2-uk

Answer 3

i.

Surrender value = Present value of {Benefits + Claim expenses + Renewal expenses - Premiums} - Alteration expense

Present value of benefits = 50 000 x A_50:15] @ 6% p.a. = 50000 x 0.43181 = 21590.5

Present value of claims expenses = 0.5% of present value fo benefits = 0.005 x 21590.5 = 108

Expense inflation = 1.92%

Since 1.0192 / 1.06 = 1/1.04, can use annuity factor at 4% p.a. to allow for future inflation of renewal expenses

Assume renewal expenses are incurred annually in advance, in line with premium payments.

Present value of renewal expenses = 35 * a_due_50:15] @ 4% = 35 x 11.253 = 393.9

Present value of premiums = 1000 x a_due_50:15] @ 6% p.a. = 1000 x 10.038 = 10038

Alteration expense = 100

So surrender value = 21590.5 + 108 + 393.9 - 10038 - 100 = 11 954.4

ii.

Let the paid-up sum assured be denoted PUSA

This is then calculated from:

Surrender value = Present value of {Paid-up benefits + paid-up claim expenses + paid-up renewal expenses}

Present value of paid-up benefits = PUSA x A_50:15] at 6% = 0.43181 x PUSA

Present value of paid-up claims expenses = 0.005 x PUSA x 0.43181

Present value of paid-up renewal expense = 20 x a’‘_50_15] @ 4% p.a. = 20 x 11.253 = 225.1

Surrender value from part (i) = 11 954.4

So:
11954.4 = PUSA x 0.43181x 1.005 + 225.1
PUSA = 27 028.0

iii.
The change in risk exposure should be considered:

The maturity benefit under this policy is guaranteed whereas the value of equity shares is volatile

This risk is increased if the equities purchased are not well diversified

This means that there is greater downside risk if investing in shares

But there is also greater upside potential

If the policyholder decides to surrender the policy and invest the proceeds into equities then he loses the whole guarantee.

if he makes the policy paid-up and invest future premiums into equities then he retains part of the guarantee

The policyholder therefore needs to take into account his attitude to risk

The change in protection cover should be considered:

This policy is not just a savings policy, it is also a protection policy: the death benefit is considerably higher than the surrender value.

if the policyholder decides to surrender the policy then he loses this extra death benefit cover.

if he makes the policy paid-up then it reduces significantly

Depending on his personal circumstantes - this protection might be important

Other issues to consider:

It will be necessary to consider the tax implications of the surrender and investment in equities.

Question 4

A life insurance company has a portfolio of conventional without profit endowment assurances.

i. Give the formula used for calculating the surrender value on a prospective reserve basis, defining all terms used. [4]

ii. Outline the principles that should be taken into account when determining the surrender value. [4]

As an alternative to surrendering the policy, there is an option for the policyholder to make the policy paid up for a reduced sum assured.

iii. Describe the additional considerations that should be taken into account when calculating the paid up sum assured. [3]

2008 - s2 - uk

Answer 4

i.
(S + f) A^-_ x+t: n-t] + e x a* * ^(m) _ x+t:n-t] - G x a * *^(m) _ x+t:n-t] - C

where :

S is the sum assured
f is the normal claim expense
x is the age of the policyholder at date of issue
t is the duration of the policy since inception
n - is the term of the endowment
m - is the frequency of the premium
G - is the annualised premium
C - is the cost of surrender
e - is the annual expense from administering the policy

ii.
The surrender value should take into account:

• policyholder’s reasonable expectations
• fairness to both existing customers and those customers remaining
• not exceed the asset share, in aggregate, over a reasonable period of time
• should not appear to low at early duration compared to the premiums paid and projections given at new business stage.
• competitors’ offerings.
• be consistent with maturity values at later durations.
• be consistent with what the sum assured would be if the outstanding term was reduced to zero
• not be subeject to frequent changes, unless economic conditions dictate
• not being excessively complicated to calculate
• be capable of being documented.
• profit on surrender should be consistent to as if the policy had not been exiting.
• the lapse and re-entry risk of setting too high a surrender value
• the need for compliance with any regulations or professional guidance.

iii.

Additional considerations for paid up sum assured:

• there is a need to consider expenses not just for making the alteration to the contract, but also the ongoing maintenance expenses.
• the effect of mortality selection likely to be less than for surrendered policy because policy remains inforce
• the paid up sum assured should be consistent with surrender values.
• the surrender value should be the same before and after conversion
• the paid up sum assured should be supported by the earned asset share, at the date of conversion, on the basis of expected future experience
• the paid up sum assured should, at later durations, be consistent with projected maturity values allowing for premium not received.
• the paid up sum assured should be consistent with an alteration where the premium is reduced close to zero
• the profit taken at being made up should be consistent to as if the policy had stayed premiium paying.

Question 5

The surrender value of a with profits policy is normally set by reference to the asset share underlying the policy

Explain why the surrender value might differ from the asset share [6]

1999 - s1 - uk

Answer 5

• Because of the impact of initial expenses, the asset share at early durations may be negative
• ~
• Even if it is positive, it may be considered too low to meet policyholders’ reasonable expectations, given the premiums paid
• Hence, the surrender value may be set above the asset share.
• ~
• Competitive pressures may force the company to pay surrender values in excess of asset shares at some durations
• This is particularly so where surrender values appear on the quotation issued to prospective policyholders.
• ~
• The company may have a policy of paying benefits above asset share to with profits policies, in order to distribute part of its Estate, which it considers it no longer requires, or may pay less if it wishes to build it up.
• ~
• The company may seek to make profits from discontinued policies through a deduction from the underlying asset share.
• ~
• This may then be used to improve the benefits under maturing policies.
• ~
• Alternatively, it may represent a charge to the company’s Estate for the capital provided during the period the policy has been in force.
• ~
• The benefits at maturity under a with profits policy are smoothed
• The company will probably wish to adopt a similar approach under normal circumstances to the benefits payable on early discontinuance.
• ~
• The asset share is likely to fluctuate from day to day.
• For practical reasons, the company will want to maintain a more stable surrender value.
• ~
• Hence, even if the surrender value is targeted to be equal on average to the asset share, it is likely at times to depart from it
• ~
• The asset share may not make allowance for profits from miscellaneous sources.