Best Estimate Assumptions for Expense - Conducting an Expense Study, CIA Flashcards
Basic Steps/ Considerations of Expense Study
- Determine the Scope
- Collect Expense Data
- Check the consistency of data with internal and external reports
- Determine which expense will be excluded from BE expense Assumption
- Determine expense categories
- Determine the unit expense bases
- Classify expenses to categories
- Allocate expenses to categories
- Determine the unit of expense
- Perform reasonability checks
1. Basic Steps/Considerations of Expense Study
o Determine the scope
o Collect expense data
o Check the consistency of data with internal and external reports
o Determine which expenses will be excluded from best estimate expense assumption
o Determine the expense categories
o Determine the unit expense bases
o Classify expenses to categories
o Allocate expenses to categories
o Determine the unit expenses
o Perform reasonability checks
2. Study typically done on a single financial year
3. Should ensure consistency with prior period studies
Scope of Expense Study
- Unit expenses can be used for: product pricing, valuation of GAAP policy liabilities, operational management, transfer pricing, embedded value, budgeting, DCAT, and business planning
- Primary objective in this article is valuation of GAAP policy liabilities - If scope is different, actuary should determine how to modify results
- Scope should include all business of the company
- Though in certain cases it may be restricted to a subset (e.g. the company’s disability business or a particular region)
▪ Care must be taken to allocate expenses to each subset
o Investment expenses, IT expenses and other business functions may be charge to a line of business or operating unit by the use of transfer prices
Collecting the Expense Data
1. Data Sources for Expense Data
- General ledger or data warehouse (primary source)
- Agent/broker/payroll systems
- Staff payroll system
- Policyholder payment system
- Budget, business planning and financial reports
- Transfer pricing analysis, agreements, and reports
- HR systems
- Investment management systems
2. Units and Allocation Data Sources
- Policy/certificate administration and valuation systems
- Benefit payment systems
- Transaction files/systems
- Sales, financial and accounting reports
- Policy issue/underwriting systems and reports
- Budget and business planning reports
- HR and agency administration systems
Reconciliation of Expense Data
Actuary should reconcile internal and external reports for completeness and consistency
o Differences are identified and justified
o E.g. test that overhead expenses allocated to lines of business add up to the total for the company
Expenses Included/ Excluded from Valuation
- Should note how expenses related to special situations are treated to avoid distorting unit expenses
- Review treatment of expenses not allocated to a line of business (e.g. charged to surplus account)
- Administration and investment expenses related to segregated and mutual funds included in the study
- Those related to reinsurance also included in the study
Categorization of Expenses
1. Categorization can increase the complexity of the study but also increase the usefulness of results
- Actuary should determine the balance between level of detail in categorizing expenses, expense of accumulating the data, the benefit and the usefulness of results
2. Examples of different lines of business to categorize expenses
- Individual life, individual health, individual travel, group LTD, surplus, investments, individual annuities, individual disability, group annuities, group creditor life & health, group life, group health, reinsurance assumed, group travel, affinity, group out-of-country medical
3. Jurisdiction – another level of categorization
4. Categorization usually considers the way business is organized, priced or managed
- E.g. by state (group health), country (individual life) or several countries (investment operation)
- Categorization may move across product lines
- Examples of product line categorization:
▪ Individual – non-participating permanent, adjustable premium life, participating life, universal life, non-participating term, critical illness, health insurance, travel accident, variable life
▪ Annuity – payout annuities, RRIF/LIF, equity linked, variable annuities, deferred annuities, mutual funds, segregated funds
▪ Group – LTC, medical/hospital, critical illness, dental, LTD, STD, group term life, affinity life, group permanent life
- Not all expenses or activities need the same level of details
Unit Measurements
1. Must determine units used to calculate the expenses
2. Common unit measurements
a. Acquisition - # of policies issued, # of policy applications, sales commission, certificates issued, face/benefit amount, payment amount, issue premium
b. Administration - # of policies inforce, certificates inforce, service commission, premium income, # of billings, # of terminations, # of riders, deposit, face/benefit amount, fund value
c. Benefits - # of claims, face/benefit amount, # of terminations, claims paid, policy liability, fund value
d. Asset – market value, acquired value, disposal value, # of policy loans, amount of policy loans, mortgage payment, bond interest
e. Overhead - # of policies in force, certificates in force, premium income, fund value, surplus, required capital, employees, percent of non-overhead expenses
- Acquisition, administration and claim expenses usually vary by line of business and product type
a. Unit measures usually established at product line level
Classification of Expenses
- Expenses directly associated with policy activities
o E.g. salaries, commissions, benefits, supplies, rent, direct IT/hardware, direct support services, direct management, and associated taxes
1. Acquisition Related
▪ Acquisition expenses usually incurred before balance sheet date, so not considered for valuation purposes
* Still relevant to products that recognize unamortized acquisition expenses
▪ Not usually considered – new market or product line development, product design and pricing of new product in existing line, policy illustration development
▪ Usually considered in pricing, may be considered an acquisition expense – product redesign or repricing, recruiting and development of new sales representatives
▪ Usually included in pricing and considered an acquisition expense – sales to new customers (prospecting, sales interviews, policy illustrations, policy application and submission, policy placement), sales to existing customers (renewals, new coverage, changes to existing coverage)
▪ Sales Commissions
* Commissions, bonuses and overrides paid directly to sales representatives, and financing new sales representatives
* Exclusions – expenses of training, supplies or other reimbursements to new sales representatives, overrides paid to managers
* Usually split between first year, renewal, single, dump-in and trailer commissions
* Usually a percentage of premiums or deposits
▪ Distribution Expenses
* Developing new or revised products, advertising products for sale, maintaining the IT systems, overrides paid to managers of distribution system, and new agent expenses for training and set up
* Usually a percentage of commissions or premiums/deposits
▪ Issue Expenses
* Expense of issuing or declining to issue policies, certificates or contracts
* Unit expense is usually per policy issued, per policy and per thousand issued, or per policy issues within premium bands
* Expenses for declined policies usually spread over all placed policies
* Expenses for substandard ratings may be percent of extra premium charged or spread over all substandard policies
2. Administration Related
▪ Premium billing, Commissions and distribution, Premium collection, Anniversary activity (customer reporting, service calls), Dividend scale management, Coverage renewal processing, Experience studies, Customer tax monitoring and reporting, Reinsurance administration, Certificate administration (eligibility, benefits covered, dependents), Policyholder changes (address changes, ownership changes, marital status, beneficiary changes), In force illustrations, Policy loans, Adjustable features administration, Direct management (recruiting and staff development, managing admin areas)
* Basis may be per bill, per policy, per coverage renewed, etc.
▪ Policy Maintenance Expenses
* Maintaining and updating policy information, performing billing operations, par fund administration and dividends, call center service, in force illustrations, and policyholder statement mailings
* Vary by policy type
▪ Reinsurance Expense
* Related to administering reinsurance ceded on direct business and expenses associated with reinsurance assumed
3. Benefit Related
▪ Separated into categories that will be used in the valuation
▪ Benefit Processing Expenses
* All processing expenses related to any policy benefit for the related policies
* Reported on a basis consistent with claims
* Death claim, Accidental death claim, Long-Term care, Critical illness, Maturity claim, Disability payment, Reinsurance claim, Medical/dental/travel claim, Disability claim, Settlement option processing, Annuity payments
o Usually per claim or per $100 of benefit
▪ Termination Expenses
* Related to terminating policies in any manner (lapse, surrender or non-forfeiture)
o Includes commission, other distribution expenses, chargebacks, and expense of administering the payment of benefits
* Cash surrender, Automatic surrender, Contractual changes (reduced paid up, extended term, automatic premium loan, reinstatement, term conversion, group conversion), Lapse, Term expiry
o Usually per surrender, contract change, number of lapses, etc.
Classification of Expenses - Not directly related with Policy Activities
1. Investment Related
▪ Investment Expenses
* All expenses incurred within investment area, including commissions and expenses to acquire, maintain and dispose of investments
* May be separated into classes or by fund
* Acquisition of (bonds, equities, mortgages, real estate), Administration of asset classes (accounting, trustee, analysis of return, credit risk, etc.), Disposal of assets, Interest payments, Maturity of assets, Default of an asset, Mortgage renewal, Property management (renovations, building upgrades, repairs, maintenance, lease renewal), Head/regional office
o Usually per basis points of price, maturity amount, etc.
▪ Property Management Expenses
* Repair, renovation, upgrade, maintenance, insurance and other expenses related to general operation of all real estate properties
2. Taxes Other Than Income Tax
▪ Premium tax rates vary by jurisdiction and are expressed as percentage of premiums (less cash dividends)
* Premium tax excluded from other expenses in determining unit expenses
* Use weighted average premium tax rate for company
* Includes value added taxes
* Investment Income Tax (IIT) usually determined separately from valuation expenses
3. Corporate and Overhead Expenses
▪ Separated into categories only as detailed as needed for valuation unit
▪ Financial Reporting
* All financial reporting, accounting, tax compliance and corporate and audit functions
(1) Corporate actuarial functions
- Valuation of policy liabilities, Dynamic Capital Adequacy Testing (DCAT), Earning analysis (embedded value, etc.), Capital analysis and management, Risk management programs and reporting, Long-term projections for planning, Related research
(2) Financial reporting and accounting functions
- Maintenance of general ledger and data warehouse, preparation of financial statements, tax planning
- Actuarial functions related to product pricing and design, marketing, administration, etc. usually excluded
▪ Human Resources
* Payroll, benefit accounting, staff training expenses
* Sales training for sales personnel usually excluded
▪ Information Technology
* Expenses related to operating and maintaining current IT systems usually allocated to their supporting function
▪ Legal
* Legal expense except those related to direct expenses are handled similarly to Other Corporate
▪ Other Corporate
* Examples – Expenses associated with CEO, COO, etc., Expenses associated with Board of Directors, Admin expenses of financing, restructuring or merging, Unallocated expenses associated with CFO
* Others may be included if they are centralized and not easily allocated (e.g. cafeterias, fitness facilities, printing, premises management, strategic research, investor relations, etc.)
Allocation of Expenses
- Methodology needed to allocate corporate and overhead expenses to expense classes
o Activity-based and transaction-based methods often used for allocating direct expenses
o Other methods for corporate or overhead expenses
o May need to use a proxy for practical purposes (e.g. policies in force) - Allocation of some expenses may be to other expenses (which are then allocated to line of business, jurisdiction or product)
o Hierarchy is important to establish early in the process to avoid double- or under-counting
1. Transaction-Based
a. Uses number or amount of transactions in admin or accounting system to allocate expenses
b. Usually used for direct expense allocations
c. Base assumption (all transactions are equal in expense) is often too simplistic
▪ To overcome this, transactions are weighted to reflect complexity or expense
* Size or amount of transaction may be used with number of transactions as proxy for complexity
2. Activity-Based
a. Similar to transaction-based except for level of detail for capturing transactions and expenses
▪ Activity-based goes into greater detail
▪ Example of “activities” for death claims – recording of claim received, notifying reinsurer of claim received, sending file to reinsurer for review, internal review of claim, claim investigations, approval from reinsurer, communication of approved claims, processing of funds, communication of disputed claims, claims appealed, litigation and settlement, processing of funds
3. Time Study-Based
a. Individuals track time spent on various activities
4. Expense-Based
a. Considers management time relative to the expenses they manage
▪ Variations – all expenses managed, staff salary expenses only, direct expenses only, direct and some allocated expenses such as rent, equipment, furniture and fixtures
o Often used for direct line management, indirect expenses and overhead
o Common examples – sales management expenses as pct. of commissions paid, premium taxes as pct. of premiums paid, direct management as pct. of staff salaries, divisional overhead as pct. of other divisional expenses, portion of corporate overhead as pct. of capital required, investment overhead expenses as pct. of assets
5. In Force-Based
a. Proxy for transaction- or activity-based allocation where transaction counts are not available
▪ May need relative weightings because expenses might not vary directly in relation to in force statistics
b. Sometimes used for overhead expenses
6. Staff-Based
a. Used for staff support functions such as HR, payroll, sales payroll, cafeteria and facilities
b. Considerations – whether full-time, temporary and contract employees are weighed equally, whether distinction is made between agent, brokers and other distributors
Unit Expenses
- Consider level of detail for categorization, unit measurements used, classification of expenses and methods to allocate expenses
- Must determine appropriate base for valuation purposes
- Considerations in Determining a Base for Unit Expenses
a. Characteristics of Ideal Base for Unit Expenses
▪ Represents direct underlying relationship between the base and the underlying expenses
▪ Easily projected in valuation using existing bases in company’s valuation systems (e.g. policies in force, claims, billings, lapses, or renewal)
b. Example for disability claim unit expenses – sum of expense per initial claim, expense per payment, expense per adjudication re-check, expense per $100 of claim, and expenses per litigated case
c. Considerations to Complete Expense Study to Determine Best Estimate Assumptions for Valuation
▪ Limited number of base units available from valuation system
▪ Detailed expense information from the study
d. Where bases do not exist, actuary may use a reasonable compromise that balances the expected difference between the practical base and the desired base
Testing and Reconciliation
- Compare unit expenses determined in expense study to unit expenses in available external studies or actuarial models
- Investigate differences/discrepancies
- Compare to past expense studies
- Compare units from company reports plus expenses excluded from the study
- Source of Earning Analysis
- Identify trends in expenses for potential need to conduct new expense study
- Identify errors in results of expense study
