14.1 Surrender values Flashcards
Market practice
Regulatory reqs
Difficulty of assessing suitable terms
Costs of surrendering policy vs benefit on surrender
Underly fair profit and fair value approaches
Account for policyholders’ reasonable benefit expectations (RBE) in particular:
Be consistent with illustrative values provided to ph
At early durations, not appear too low compared with premiums paid, bearing in mind projections in marketing materials
At later durations, be consistent with projected maturity values
Take into account Reg 5 on early termination values, which forms part of LTIA and applies to investment business
Account for accrued and future profits from surrendering profits. Any profits at surrender measured as diff between EAS and SV paid
Based on smooth EAS, accounting for company’s philosophy regarding maturing contracts
Not exceed EAS, in aggregate over reasonable time period
Account for SV offered by competitors
Not be excessively complicated to calculates, accounting for co’s administrative capability
Not be subject to frequent changes unless necessitated by financial conditions
Allow for cost of effecting surrender
Capable of being documented and explained to phs clearly
Fair profit
Ph breaking contract»_space; co entitled to make same profit as if held to maturity
Set SV s.t. profit is made
Assumes inefficient market where person cant decide what profit to make
If efficient market, SV less than “fair” MV can be considered exploitative
Only works if no efficient market for second hand policies / ph no access to market
Surrender charge:
Can deduct
Assumes efficient market exists / unfair to take advantage of its absence
Surrender charge:
Can deduct- will ensure less than reasonable cost of finding another buyer if there’s a competitive market
Pragmatic approach
Use basis that is almost certain to leave insurer with profit regardless of investment conditions
Focuses on protecting company from anti-selection if markets depressed
May look fair to ph and since unaware of fair value- no complaints
Ad hoc concessions made if complaints
W/o profits
If policy matured, profit = EAS – benefit (if experience more favourable than pricing basis)
Must extract profit on surrender to treat surrenders and in-force =
Base SV on prospective policy value using best estimate»_space; SV is value of benefit that would have been received at maturity
Can retain profits to date + future profits
Profit at maturity=EASN-SA
PVProfit at maturity=EASt-VtBE
Profit accrued due to actual experience being better than pricing basis:
Profit to date=EASt-VtPB
Discounted value value of future profit=VtPB-VtBE
Profit on surrender=profit to date+future profit
EASt-SV=EASt-VtPB+VtPB-VtBE≫SV=VtBE
W/profits
SV must reflect w/p aim to distribute profits to ph
No profit / loss on surrender: SV = EAS
If less generous, since surrender is option- SV < EAS…remainder used to pay better benefits on death and maturity of remaining phs
W/o profits
If policy matured, profit = EAS – benefit (if experience more favourable than pricing basis)
Must extract profit on surrender to treat surrenders and in-force =
Base SV on prospective policy value using best estimate»_space; SV is value of benefit that would have been received at maturity
Can retain profits to date + future profits
Profit at maturity=EASN-SA
PVProfit at maturity=EASt-VtBE
Profit accrued due to actual experience being better than pricing basis:
Profit to date=EASt-VtPB
Discounted value value of future profit=VtPB-VtBE
Profit on surrender=profit to date+future profit
EASt-SV=EASt-VtPB+VtPB-VtBE≫SV=VtBE
W/profits
SV must reflect w/p aim to distribute profits to ph
No profit / loss on surrender: SV = EAS
If less generous, since surrender is option- SV < EAS…remainder used to pay better benefits on death and maturity of remaining phs
Use EAS to date to get SV if enough info and good enough computer programs or
Calc retrospective reserve using formula and parameters to produce acceptable results at durations needed
Must compare total AS to actual assets for consistency
Represents EAS or estimate of on surrender date- represents max company can pay without making loss on surrender
May look reasonable compared to premiums paid at early durations- will depend on how new business expenses are treated in AS calcs
Comparison with competitors depends on method and basis esp method used to determine charges for new business
Not overly complex if info available to build up EAS or determine suitable parameters.
Non-profit contracts
No independent meaning for non-profit contracts if using FV. Market value can only be determined prospectively.
Investment earnings related to matched portfolio of assets- value of assets fluctuates with changes in future interest rates
L-matching means fall in EAS if interest rates rise. Not fit with non-profit ph who expect to avoid fluctuations
So A invested in short-term interest bearing instruments and …
… call options for longer-term contracts to protect against future fall in interest rates
Losses on rises in interest rates may cause lapse and re-entry. May happen:
Single premium bonds where investment policy based on short-term cash rates w call options
Regular premium short duration contracts regardless of investment policy
With-profit
Short term fluctuations less severe than for non-profit
Due to smoothed asset shares
May still need market adjustment if market values deviate too much from smoothed EAS
To ensure fairness for policies near maturity, adj must reflect target maturity matching position within smoothing policy
Policies near maturity must align with expected payout, based on insurer’s smoothing approach
If sudden adjustment is made without considering maturity, some oh may receive too much or too little relative to expectations.
May require frequent updates so not practical
Fits well with fair profit and fair value approaches because it is based on the policy’s actual accumulated asset share.
Practical for the pragmatic approach, as it provides surrender values that can be easily explained to policyholders.
If data is available, the method is not too complex, but allocating expenses (e.g., new business vs. renewal) involves subjective decisions.
Expense Allocation Issues
Understating new business expenses: If more costs are allocated to renewal expenses, new business expenses will seem lower, making retrospective reserves look higher than they should be.
Overhead & lapse losses: These can be assigned differently to new or renewal business, affecting surrender values—often influenced by marketing strategies.
Policy size impact: If expenses are allocated per policy but premiums were set as a percentage of premiums, smaller policies may have disproportionately lower asset shares and might always remain negative.
Tax Considerations
Expense deductions depend on taxable income; fast-growing insurers or those with little taxable income may struggle to deduct expenses immediately.
A gross basis might be used initially until each policy generates enough taxable income to offset its expenses.
PV benefits, expenses net premiums using investment return, mortality and other experience parameter estimated
Must include declared bonuses and future profits for w/p
On realistic basis, produce SV representing policy’s value
» can quantify how much profit has been earned from non-profit contracts
For w/p can produce values significantly diff from EAS.
Can fix by setting bonus structure s.t. projected maturity values consistent with projected EAS
Allows separate value to be given to basic SA and attaching bonuses.
Useful for ph surrendering just attaching bonuses
For both types of contracts, may depending on basis, may give values that seem unreasonable to phs at early durations.
At longer durations, prospective reserves meet objectives of pragmatic approach if TB excluded.
May not be true in few years before maturity of endowments
More likely to produce comparable SV to those at auction and comparable to competitor’s contracts. Based on basis.
Easy since unless complicated basis
Profit retention:
Retrospective method profit: profit made to date: eas - sv
Prospective method profit = profit to date + capitalised value of profit due to diff between OP and SV assumptions
If SV assumptions reflect future experience: total profit is as if no surrender
If SV assumptions = OP assumptions: only profit made to date
» Can choose between BE and OP basis to adjust profit
Blended basis: OP basis near entry and BE closer to maturity
Retrospective:
If FV used, use past experience for relevant factors
Regular premium: may not follow past experience exactly to smooth the value, esp wrt investment earnings on matched portfolio»_space; MAY LEAD TO LAPSE AND RE-ENTRY
Interest
A backing reserves will earn current market rates
Future premiums and interest earnings will be at future rates
Can use term structure of current rates
May deviate from above to avoid anomalies / account for other CFs
E.g. non-profit annual premium policy reserves may be matched by non-profit annuity reserves
Must be consistent with rate in premium calc
Argument 1 that must be > RFR due to credit risk from insolvency
Argument 2 that insurer packaging investment element of contract, so must be approximate to those in market
Expenses
Recent expense investigation to set renewal expenses net tax
Fair profit: remove margins used in OP
Fair value: leave in but can reduce if surrenders were at level that would reduce EOS and lead to increased costs
Make allowance for renewal commission as paid
Inflation
Consistent with investment return assumptions
Real return on index-linked govt bonds ~ suitable margin below full interest rate assumption
Tax
In policyholder and corporate funds
Can use gross/ net interest rates to account for tax
Must consider CGT
Mortality
Must reflect future expected mortality of ph’s surrendering
Can assume surrenders have lighter mortality- no such evidence
Reverse probable if e.g. terminally ill people have financial difficulties and hence surrender»_space; may use higher q(x) and augmented SV
Can ignore q(x) for short term endowments as not much effect
Can blend between retrospective and prospective
Pragmatic approach can be rough and ready
No SV in first 2-3 years is rough approx. to EAS (might even be negative)
May be complaints about surrender penalties relative to premiums paid.
Fair value
So prospective approach, incl. just terminal bonuses in first 2-3 years before maturity is also rough approximate fair value
Reversionary bonuses:
Depends on legislation, but …
… can allow attaching reversionary bonuses to be surrendered separately
Can’t determine retrospectively, need prospective values for basic benefits and attaching bonuses separately
If surrendering bonuses was presented as intrinsic part of contract- inappropriate to apply penalties on their surrender
Must compare sum of these to retrospective value (EAS or proxy) to determine terminal bonus
Prospective values may use best estimates of future experience and consistent rates of future reversionary bonuses. Must ensure result of reversionary bonuses is reasonable:
Not exceed EAS
For simplicity, value must preferably allow company to use at maturity, same terminal bonus scale for contract as one where no bonuses had been surrendered.
Same as w/o profits
Less need for margins since w/p ph absorb risks of deviations from experience…
… but must consider degree of equity between surrenders and remaining ph
Interest accounts for expected return on assets contracts invested in, likely equity and property
Value highly sensitive to reversionary future bonus rates assumed
