Chapter 6

Question 1

What are the key features of life insurance contracts and how are they subdivided by investment type?

Answer 1

Key features of life insurance contracts:

• Long term
• Only one claim
• Claim amount/sum assured may be known
• For protection against death or ill health or savings
• Sold to individuals or groups

Subdivision by investment type:
•	Without-profit (non-participating)
•	With-profit (participating)
•	Unit-linked
•	Index-linked

Question 2

What is the key consideration from life insurance companies in contract design ?

Answer 2

Key consideration for companies in contract design is profitability.

Life insurance contract profits are made up of:
   Premiums net reinsurance premiums
\+ Investment income & gains
- Claims net reinsurance recoveries
- Expenses & commission
- Increase provisions (amount of money set aside now to meet future liabilities)
- Increase cost of capital
- Tax
= Profit

Question 3

Discuss underwriting, provision, NBS and capital and the investment strategy for life insurance contracts.

Answer 3

Underwriting:

• Process used to decide level of risk posed by potential policyholder.

Setting premiums:

• Formula or profit-testing model

Provision:

• Once cover starts the insurer is required by regulation to establish provisions.
• Basis may be more prudent then that for setting premiums.
• Regulator may require insurer to hold min level of solvency capital for security

New business strain and capital:

• If outgo is more than income.
• To write new business, life insurer
  requires some capital to make up difference.
• Over term of contract loss is recouped—premiums in subsequent years greater than expenses & provisions and capital solvency might be greater than claim—set at prudently high level

Investment strategy:

• Insurance company must consider characteristics of liabilities when determining investment strategy.

This means holding:

• Fixed-interest bonds to meet liabilities—guaranteed in money terms
• Real assets (index-linked bonds, equities and property) to meet inflation-linked benefits
• Equities and property for max returns
• Assets to match term of liabilities—mostly medium/long term—short term need to meet instant cashflow needs
• Assets denominated in domestic currency
• Derivatives to hedge options & guarantees

Question 4

What are the key risks faced by a life insurer?

Answer 4

Key risks to life insurer:

• Mortality, longevity & morbidity
• Investment risk
• Expenses, not met by charges & prem loading
• Early withdrawals before recovery of initial exp
• New business volumes too high—new business strain OR volumes too low, not enough business over which to spread overheads.
• Credit risk
• Operational risk

Monitoring experience:

• Long-term nature of LI contracts, important that incorrect assumptions about future experience are corrected or business will cont writing business on unprofitable terms.
• Analysis of surplus—break down any profits/losses into parts to help understand cause.

Question 5

What is the definition of an endowment assurance contract, how does it meet customers’ needs and does a group version exist?

Answer 5

For each product consider:

• Definition of benefits—benefit paid on death, maturity, surrender or another event
• Use of product to meet costumers’ needs
• Does group version exist

Pure endowment:

• Benefit on survival to known date—savings vehicle—lump sum for retirement/loan repayment

Endowment assurance: (without/with profit or unit-linked)

• Provides benefit on death of life insured before date—vehicle for providing protection for dependents
• May be allowed to surrender before maturity & receive lump sum
• Used as means of transferring wealth
• Used as means of repaying capital on loan
• Vehicle for saving for retirement
• Group version allow employer to provide benefits at retirement to employees

Question 6

What is the definition of a whole life assurance contract, how does it meet customers’ needs and does a group version exist?

Answer 6

Whole life assurance:

• Benefit on death of life insured whenever that might occur.
• No fixed term
• Means of providing for funeral exp or meeting any liability to tax (inheritance tax or death duties) arising on death of life
• Providing long-term protection to dependents
• Means of protecting some of expected transfer of wealth
• Without-profit contracts offer guaranteed sum assured on death
• With-profit contract initial benefits may be increased by bonuses
• Unit-linked whole life contract there is flexibility in level of death cover included – e.g. benefit= max of unit fund and sum assured
• No group version – usually funded by employers so natural to restrict life cover to employment period

Question 7

What is the definition of a term assurance contract, how does it meet customers’ needs and does a group version exist?

Answer 7

Term assurance:

• Benefit on death of life assured provided in occurs within the term selected at outset
• Normally no benefit on early termination =
  Increase risk of selective withdrawals—leaves pool of poor health lives
• Provides protection against financial loss for dependents
• Decreasing term assurance used to:

Repay balance outstanding under repayment loan

Provide income for family with children until they can fend for themselves

• Used by employer to provide benefit to dependents on death of employee while in employment
• Used by credit card company to indemnify them against loss when credit card balance not repaid because of death

Question 8

What is the definition of a convertible or renewable term assurance contract, how does it meet customers’ needs and does a group version exist?

Answer 8

Convertible or renewable term assurance:

• RT assurance term assurance with option to renew at end of original contract
• Appeal—renewal can be made without further underwriting
• CT assurance allows policyholder to convert TA into another contract, WL/EA
• Attraction of obtaining cheap death cover with certainty of being able to convert or renew original contract without health evidence provided
• Option for individual in scheme covered by group life policy to convert to form of individual arrangement when leaving scheme

Question 9

What is the definition of an immediate annuity contract, how does it meet customers’ needs and does a group version exist?

Answer 9

Immediate annuity:

• Single prem purchases the income which commences immediately after purchase
• Mostly without-profit or index-linked
• With-profit income paid will be a guaranteed amount + bonus added by insurer
• Unit-linked insurer guarantees paying number of units but income not guaranteed because income= no of units x unit price which will vary daily
• Meet financial need for income for remainder of life of insured
• Temporary annuity—limited period contract
• Group version used by employer to fund pensions for employees at retirement

Question 10

What is the definition of a deferred annuity contract, how does it meet customers’ needs and does a group version exist?

Answer 10

Deferred annuity (including personal pension):

• Used when time between date of purchase and date when income stream required
• Contract paid for by single or regular prem during deferred period
• Enable individuals to build up pension that is payable on retirement
• At vesting date of annuity alternative lump sum may be offered so meeting any need for cash sum, cash option
• Same aims but more flexible by combining endowment assurance with immediate annuity starting at maturity
• Group version used by employer to fund for pensions for employees

Question 11

What is an income drawdown, how does it meet customers’ needs and what are the pros and cons?

Answer 11

Income drawdown:

• Instead of buying annuity to fund remains invested and member withdraws an amount of funds yearly
• May be income earned on fund or may include some of fund capital
• At retirement member transfer their accumulated fund from defined contribution to income drawdown product
• Small accumulated funds—income drawdown not suitable—charges imposed by insurance comp to manage the product will be significant
• Legislative restrictions on;
  Amount of fund withdrawn each year
  Age at which drawdown must cease and pension must be purchased
• Main attraction—should member die before securing annuity, heirs can inherit balance of fund
• Advantages:
  Earn return on invested funds
  Flexibility in terms of how much to take each years as income
  Annuity rate currently poor
• Risks:

Member’s income volatile, if only income earned on fund yearly
Too high income level—capital potentially reduce to zero before death—dependent on state

Charges taken in relation to administering arrangement may be high
Remaining fund on death may be insufficient to provide for dependents
Tax charge on residual fund on death

• Sold to individuals to meet retirement needs

Question 12

What is an investment bond, how does it meet customers’ needs and does a group version exist?

Answer 12

Investment bonds:

• Single prem contracts, normally whole life, designed to enable policyholder to invest for medium to long term
• Usually can make withdrawals—may incur penalty for first few years
• Restrictions on frequency of withdrawals later
• On death bond pays lump sum—depends on return earned by investment
• May be guarantee that lump sum can’t be less than original single prem invested
• Unit-linked or investment-linked
• Purchased by individuals

Question 13

What is an income protection insurance, how does it meet customers’ needs and does a group version exist?

Answer 13

Income protection insurance:

• Enable individual to provide income for themselves and dependents in event of insured risk occurring
• Insured risk—long-term sickness or incapacity due to accident or illness
• Terminate at retirement age, do not provide benefits for first period of claim
• Used by employer to provide sick pay scheme for employees

Question 14

What is a critical illness insurance, how does it meet customers’ needs and does a group version exist?

Answer 14

Critical illness insurance:

• Provides cash sum on diagnosis of critical illness
• Meets important need for financial security
• Specific critical illnesses covered will be explicitly listed
• Normally without-profit or unit-linked
• Benefit may be offered in stand-alone form- contract only covers critical illness—doesn’t pay out on death
• Benefit may be offered as a rider benefit on another contract

Benefit attached to another contract—acceleration of death benefit
This means contract will pay out on first occurrence of death or diagnosis
Or
Rider benefit act as additional benefit—potential for two sums assured
Once on critical illness and again on deaths
Max possible payout=total of two sums assured

• Group version of stand-alone used by employer to provide financial security to employees in event of critical illness

Question 15

What is a key person insurance, how does it meet customers’ needs and does a group version exist?

Answer 15

Key person cover:

• Life and/or critical illness policy taken to cover life of key person within business
• Pays lump sum benefit to business which is used to:

Buy out individual for partnership
Cover loss of profits
Meet cost of finding replacement

• Benefit payable may be based on loss of profits to business or related to salary of key person
• Purchased by company for own benefit

Question 16

What is a long-term care, how does it meet customers’ needs and does a group version exist?

Answer 16

Long-term care:

• Used to help provide financial security against risk of needing home or nursing home care as elderly person
• Could pay all cost of care for life or provide cash lump sum or annuity to contribute
• Paid for by single or regular premium
• Group version would enable employer to provide long-term care cover to employees and spouses

Question 17

What is a without-profit contract and when is it most appropriate?

Answer 17

Without-profit contracts:

• Life insurance has no discretion over amount of benefit payable
• Key feature—guaranteed non-discretionary nature
• Costumer knows at outset both premiums and benefits
• Most appropriate when primary customer need is protection
• Less risk than with-profit or unit-linked

Question 18

What is a with-profit contract and when is it most appropriate?

Answer 18

With-profit contracts:

• Policyholder is entitled to receive part of surplus of company or sub-fund within company
• Insurer & policyholder share the profit
• Most appropriate when customer need is saving
• Involve some guaranteed benefits and some discretionary
• Factors involved in setting levels on bonus:

Wish to smooth benefits for year to years—keeping back some profit from good years to help bad ones

Policyholder expectation—past bonus distributions by company

Competitors

Adhering to regulatory limits to payouts

Question 19

What is a unit-linked contract and when is it most appropriate?

Answer 19

Unit-linked contracts:

• Unitised contracts whose value of units directly attributable to underlying value of invested assets
• Operate by paying policyholder prems into pooled investment funds
• Policyholders share of fund represented by units
• Benefit at maturity depends on performance of underlying assets & charges
• Protection element may exist, e.g. death benefit might be:

Fixed sum
Value of units
Percentage of value of units

• Thus, very versatile
• Enables consumer to either obtain higher expected level of benefit for given prem

Or
- Pay lower expected prem for given level of benefit

• Because consumer accepts element of risk—investment risk which all lies with consumer

Question 20

What is an index-linked contract and when is it most appropriate?

Answer 20

Index-linked contracts:

• Enables consumer to obtain benefit that is guaranteed to move in line with performance of index specified
• Premiums may also move in line with same index or fixed in monetary terms