Chapter 25: Surrender values

Question 1

List 5 reasons for not having a surrender value under a term assurance

Answer 1

• Low reserves and so there is little scope to pay worthwhile benefits
• Would increase withdrawal rates hence reducing profitability
• Premiums would increase to account for the additional benefit hence would reduce its effectiveness as the cheapest form of life cover
• It would increase risk of selective withdrawals

VANS R

Asset shares are quite VOLATILE, so it would be difficult to devise a surrender value scale that would treat policyholders fairly in relation to this
Low ASSET share
Asset shares can be NEGATIVE at later durations which would be hard to sell the idea of decreasing surrender values to policyholders, who may become disgruntled as a result
Cost of SELECTIVE withdrawals
To RECOUP losses on early lapses ( when the asset share is negative) by making some profit on later lapses ( when the asset share is usually positive)

Question 2

List the factors to consider in determining without-profits surrender values (10)

Answer 2

1. PRE
2. at early durations, premiums paid (surrender value cannot be lower than this) and illustrations given to policyholders
3. at later durations, must progress smoothly into the projected maturity value
4. asset share must not be exceeded
5. competition
6. avoid frequent changes (discontinuities can be unfair)
7. ease of calculation
8. capable of clear documentation
9. potential selection against insurer (surrender and re-entry)
10. the auction value

Question 3

Auction value

Answer 3

The value it would fetch if the policyholder were to transfer it as an ongoing policy to someone else. Such transactions are usually dealt with by specialized brokers.

Question 4

Advantages of using the auction value as the surrender value

Answer 4

1) Is an independent assessment of policy value
2) Is perhaps more likely to result in a value which the policyholder has to accept as fair

Question 5

Disadvantages of using the auction value as the surrender value

Answer 5

1) The underlying assumptions for auction values would probably be different to the company’s own assumptions
2) The auction value may fluctuate unpredictably
3) difficult to determine
4) value only known at point of sale

Question 6

How does asset share differ from supervisory reserves?

Answer 6

Asset share represents the money that the company has really accumulated in respect of any policy, while the supervisory reserves represent how much money the company must hold in respect of a policy

Question 7

List two ways in which the asset share may be averaged over time

Answer 7

1) If we do the asset share calculations every so often for practicality, we will be implicitly averaging over the period between calculations
2) Asset shares can be smoothed over a specified time period so that the impact of smoothing over that period is zero

Question 8

Retrospective policy value

Answer 8

Acc(past income) - acc(past outgo)

Represents the earned asset share at the date of surrender (or an estimate thereof) and thus represents the maximum surrender value the company could pay without making a loss.

Question 9

Advantages of the retrospective policy value as a surrender value

Answer 9

1) At early durations it will not look too unreasonable compared to premiums paid less initial expenses (assuming policyholders accept the expense deduction)
2) Not overly complex

Question 10

Disadvantages of the retrospective policy value as a surrender value

Answer 10

1) It does not say anything about the profit the company would have made if the contract were not surrendered
2) Hence it is not easy to ensure equity (either with continuing policyholders or any shareholders)
3) Except by chance, the surrender value will not run into the maturity value
4) Because the method excludes future benefits, it could produce surrender values that differ significantly from a realistic prospective approach

Question 11

Prospective policy value

Answer 11

EPV(future outgo) - EPV(future income)

Question 12

Advantages of the prospective policy value as a surrender value

Answer 12

1) If calculated on a realistic basis, it will produce a surrender value that represents what the contract is worth to the company (ie the cost of surrender is equal to the expected cost of the contract remaining in force)
2) Surrender value will run into maturity value for without-profits contracts
3) Relatively easy to use since it does not require any knowledge of what happened in the past
4) More likely to produce surrender values comparable to those available at auction

Question 13

Disadvantages of the prospective policy value as a surrender value

Answer 13

1) A realistic basis may produce very low or negative surrender values early in the term of the contract

Question 14

How will the surrender value for a unit-linked contract be calculated?

Answer 14

The surrender value will typically be the bid value of the units, less any surrender penalty that applies.

This surrender penality may be:
- a % of the unit value
- a % of the premium

Question 15

List the considerations when setting a basis for a retrospective policy value calculation

Answer 15

1) Past experience
2) Smoothing of investment return
3) Competitive considerations
4) Marketing considerations
5) Profit-rentention
6) Prudence

Question 16

Discuss the influence of PRE when setting SVs in terms of

Discontinuance at short durations (4)

Answer 16

SVs likely compared to premiums paid (sometimes with interest), but usually asset share less than this

prospective policy value based on best estimates of future experience likely to be even smaller

insurers may feel obliged to accept losses/reduced profit on SVs several years into contract

Question 17

Discuss the influence of PRE when setting SVs in terms of

Discontinuance close to maturity (3)

Answer 17

where maturity benefit payable, PHs will expect SV prior to maturity to be consistent with this

SVs should progress smoothly at each year end into maturity value

achievable for without profits contracts: base SV on prospective policy values

Question 18

Discuss the influence of PRE when setting SVs in terms of

How they compare to auction values (4)

Answer 18

auction value is what policy obtained if PH transferred ongoing policy to someone else

auction values assessed independently hence PHs may accept as fair

often unsuitable, though

+difference in assumptions used

+values fluctuate unpredictably

Question 19

Discuss the influence of PRE when setting SVs in terms of

What was disclosed at new business (2)

Answer 19

new business sales sometimes accompanied by prospective SV illustrative values by duration (may be regulatory requirement)

potentially embarrassing if SVs given/quoted in financial press surveys differ significantly from new business literature

Question 20

Discuss the influence of Earned Asset Share when setting SVs according to following:

What does the asset share represent in general? (1)

What does using asset share for SV calcs mean in terms of profit/loss distributions (1)

How might we achieve averaging over time when using asset share for SVs? (3)

Answer 20

Asset represents money insurer has really accumulated in respect of policy, unlike supervisory reserve (represents how much money company must hold)

SVs must not exceed earned asset share in aggregate over a reasonable time period
The implication is

Basing SVs closely on asset shares implies distributing accrued profits/losses to PHs

Averaging over time for SVs can be achieved in 2 ways:

+Calculated once per year (implicit average)

+smoothed over a period which has to be decided

Question 21

List the assumptions that will usually be needed when determining a prospective surrender value basis (4)

Answer 21

1. Interest
   The expected returns on securities backing the liabilities will be the best estimate assumption.
   Consider the interest rate used in the premium basis if the company wishes to use a blended basis
2. Expenses
    The most recent expense investigation will be used.
    Only renewal expenses and claim expenses will be included.
    The company is unlikely to add margins since this would increase surrender
   values.
    Allow for renewal commission as paid.
    Allow for the expenses incurred in surrendering the policy.
3. Inflation
    Should be chosen to be consistent with the investment return assumption.
    The company may need both a price-inflation and an earnings-inflation
   assumption.
    The real return on index-linked government stock will give an indication of what
   might be a suitable margin below the full interest rate assumption.
4. Mortality (including the effect of selection)
    The basis chosen should reflect the expected future mortality of the surrendering
   policyholders.
    Since there is a guaranteed death benefit under endowment assurances it is
   reasonable to assume that surrendering policyholders would experience lighter
   mortality than those who do not surrender (for protection policies).
    The company could make an explicit allowance for lighter mortality.
    Select mortality could be used (although the nature of the selective process is
   not the same as that of the underlying standard table).
    Alternatively, the company could use unadjusted mortality experience and
   rely on other margins in the basis for differences in the mortality between
   those who surrender and policyholders who remain in force.
5. Tax (maybe)

Question 22

How might we determine the assumption basis for SV calcs using retrospective methods? (2)

Answer 22

If retrospective method is used in earlier years

company will need to examine its actual experience for all relevant factors (including investment earnings, expenses, mortality and tax).

may not follow past experience exactly for regular premium contracts (where policyholders are more likely to exercise financial selection against company) particularly regarding investment earnings, to smooth the value.

Question 23

How can the SV assumptions used impact insurer’s retained profit? ( 6 )

Answer 23

Prospective method SV assumptions used can impact insurer’s retained profit

if SV assumptions represent exactly future experience (best estimate), then total profit retained will be same as if contract had not surrendered

if SV assumptions same as premium basis assumptions, then profit retained will equal profit made to date

suitable choice - btwn best estimate & premium basis can adjust profit retained in line with desired aim of insurer

possible approach uses blended basis

start with premium basis near entry (retaining profit earned to date)

….and running into best estimate basis closer to maturity

how quickly it runs into best estimate basis depends on how quickly it can start retaining same profit as form non-surrendered contract

Question 24

For prospective method SV calc, show how insurer profit retained on surrender can be split into (a) past profit and (b) capitalised value of future profit by considering SV calculated on the premium basis (5)

Answer 24

Prospective method profit retention

depends on relationship between SV assumptions vs office prem assumptions

if profit allowance contained solely in assumption margins used to calc office premium then profit retained can be specified as

(EAS - SV’) + (SV’ - SV”),

where
EAS = earned asset share
SV’ = prospective SV using office premium assumptions
SV’’ = prospective SV using surrender value basis assumptions.

1st part, (EAS - SV’), represents the profit that’s been made to date

2nd part, (SV’ - SV’’), represents capitalised value of profit that will arise in future.

Question 25

What do we mean by ‘profit retention’ in context of SVs? (2) What other important feature must be checked when deciding on method for SV calcs? (2)

Answer 25

Profit retention relates to excess of earned asset share over SV paid, the higher SV paid compared to asset share, the less profit we retain Also important to check for lapse and re-entry risk due to chosen basis

Question 26

Calculate SV: Choice of method How might we use retrospective and prospective methods for the eventual SV calculations? (1) In early years/policy durations what do we have to pay particular attention to when calc’ing SVs? (3) Discuss the use of retrospective method throughout policy duration for SVs (1) In later years/policy durations what might we do for SV calcs? (4)

Answer 26

For eventual SVs produce a table of SVs by policy duration which is a blend of retrospective and prospective values, subject to min value of zero In early years, a) The company would not want to pay more than the asset share on average over a reasonable period of time. However, basing the surrender value on the asset share means that the company will not make a profit on surrender. b) pay close attention to actual expenses incurred (particularly initial expnses) c) At very early durations:  the asset share is negative because initial expenses have not been recovered; and  the company cannot avoid losses on surrenders (even if no surrender value is offered at these durations). d) Some cross-subsidy is therefore always required between early surrenders and surrenders at later durations. e) other factors are of lesser importance in short term retrospective values are likely to be more natural approach Theoretically, could just use retrospective throughout policy duration for SVs but can become increasingly difficult to find right combo of factors to produce values which run into maturity if calc had to be done by devising some independent formula and setting parameter values for it After earlier years a) prospective methods more convenient, since only necessary to value future benefits, premiums and expenses b) main difficulty is deciding appropriate interest rate thus difficult to apply at short durations and, hence, long outstanding…because small changes in interest rate => big effect on SV c) calculated using the original premium basis, then the company broadly retains profits accrued up to the surrender date. d) Basing the surrender value on the prospective realistic reserve allows the company to capitalise all the profits it is expecting to make on the contract, both past and future but is unfair to surrendering PH hence a basis in between the realistic basis and the premium basis is preferred

Question 27

Outline ways in which the approach to setting surrender values could be changed in order to increase the profit made on surrenders. (4)

Answer 27

 Consider using a basis that is closer to the realistic prospective reserve (particularly at later durations) thus reducing surrender values.  Include a condition that the surrender value may not be higher than the asset share when the prospective approach is applied  Move from the retrospective basis to the prospective basis at an earlier duration. to retain more profit.  Include/increase a margin for profit in the surrender value expense assumptions.