Ch 26: Alterations

Question 1

Summary card

Answer 1

• Paid-up sums assured
• Policy alterations
• Proportionate paid-up method
• Equating policy values
• Profit on alteration

Question 2

There are 2 broad categories of alterations which can be made on conventional without profits contracts (excluding surrendering).

One of these is the ‘paid up’ (PUP) alteration.

Discuss this alteration in general terms (5)

Answer 2

Paid-up

Instead of paying SV on existing regular premium policy, PH receives PUP value/PUPsum assured.

1. PH can stop paying regular prems, and still receive some eventual benefit (becomes similar to single premium policy)
2. T&Cs of original contract unchanged, except SA is reduced reflecting no more future regular prems
3. effectively, policy value at PUP date used as single prem for new pol (excluding another round of init expenses)
4. basis used for PUP value might differ from SV for 2 reasons
   
   • costs of making pol PUP <> costs of paying SV
   • may be less mortality selection effect, because PH keeps pol in force
     
     • mortality selection likely more intense for SV=> expect SV basis to use lighter mortality than PUP value basis

Question 3

There are 2 broad categories of alterations which can be made on conventional without profits contracts.

One of these is the ‘general alterations’, excluding paid ups.

Discuss this group of alterations in general terms:

Why might such general alterations arise? (2)

Give examples of general alterations (4)

What key factor regarding consistency relates to proposed alteration terms proposed by insurer? (3)

Describe the link which arises between alterations and common occurences (4)

Answer 3

General alterations

Arise because life insurance contracts are long term

• PH maybe had sound idea of risks/needs when first purchased, but over time a mismatch arose btwn cover provided and current risks faced by PH
• to remove mismatch, PH may wish to buy additional contracts/alter current

4 examples of general alterations include

• change term of assurance (may include changing whole life to endowment)
• change type of contract eg from whole life to endowment
• changer sum assured
• change premium payable

It is important to note

• insurer will quote T&Cs for proposed alteration, but ultimately PH decides
• hence important that terms offered for a given alteration are consistent
  
  • with terms offered on other alterations eg SVs and
  • current terms offered for new policies

There is a link between alterations and common occurances

• we refer to these as being boundary conditions for each other eg
• reduce policy term to zero, equivalent to surrender
• reduce sum assured so no future prems required, equivalent to calc’ing PUP SA
• increase SA, similar to keep original pol + buy increment pol at curr prem rates

Question 4

Give 7 principles that should guide the calculation of terms to offer under general policy alterations

Answer 4

Afforability of offered benefits from insurer’s view

1. terms after alteration supportable by earned asset share; future benefits+expenses on altered pol shoun’t need more than
   
   • future prems after alteration plus
   • current asset share
2. profit expected from contract after alteration should be asme as that before, or alternatively same as expected amount had policy been written originally on its altered terms
3. costs associated with carrying out alteration should be recovered

Consistency with boundary conditions

1. T&Cs of new policy, consistent with paid-up sum assured, surrender values, and current premium rates (as relevant)

• as oustanding term changed to zero, prem charged consistent with difference btwn surrender and maturity value
  
  • (surrendering policy = limiting case of reducing policy term)
• prem after alteration approach zero as sum assured approach PUP value
  
  • (conversion to PUP = limiting case of reducing premium)
• prem after increased benefit/term consistent with terms on new/current pol
  
  • increased benefits=> terms consistent with additional prem for new pol with SA equal to proposed increase
  • if term extended => terms shold reflect current prem basis so far as extension is concerned
    
    • eg increased term for conventional endowment probably reduces premium, as same benefit payable later; level of impact dependant on duration of extension and impact of expenses on

Other principles

1. Fairness
   
   • any increase in benefit may be subject to additional evidence of health, to avoid potential anti-selection, depending in part on scael of alteration and when it occurs in policy’s lifetime
2. Lapse and re-entry
   
   • increases in premiums or benefits or term should reflect terms available for new busines, in particular to minimise risk of lapse and re-entry (issues: increased expenses, selection agains insurer)
3. Stability
   
   • small changes in benefits should result in small changes in premium

The principles set out in chapter 25 relating to this section also apply here

Question 5

What 2 broad methods do we have to calculate alteration terms?

Answer 5

1. proportionate paid up values
   
   • approximate method
   • can be used to simplify calculation of PUP values
2. equating of policy values
   
   • most accurate method

Question 6

Describe the ‘Proportionate PUP values’ used for policy alterations

How does the method generally work? (4)

Answer 6

Method

• For without profit endowments, PUP may be calcd as
  
  • basic sum assured
  • multiplied by ratio of
    
    • total number of premiums actually paid to
    • those originally payable throughout the total term

Question 7

How does the proportionate PUP method of calculating policy alterations perform in terms of meeting the principles which should be considered when setting alteration terms (as discussion earlier in the chaper)?

Advantages (1)

Disadvantages (4)

Answer 7

Meeting principles

Advantages

• Simple to apply and explain to PHs

Disadvantages

• values too high at short durations: don’t allow for high initial expenses.
• values too low at medium durations: don’t allow for investment earnings.
• not consistent with surrender values
  
  • method will give PUP values from very beginning
  • surr value usually only available some time into policy, say 2 years when asset share positive (which contradicts offering PUP value from beginning)
  • usually expect PUP value to only be offered after surr value, as PUP policy still has renewal expenses (unlike surrendered contract) which need to be supported and would reduce earned asset share

Question 8

What is the overriding method used when calculating terms for policy alterations using equating of policy values?

(3)

Answer 8

• Value of contract before alteration
  
  • on a prospective or retrospective basis,
  • …can be equated to a prospective value after alteration
    
    • that takes into account
      
      • the requested changes to the terms of the contract.
• The method can essentially be used for any type of alteration, including conversion to paid up status
• .The alteration terms can be made appropriate in almost all circumstances, provided appropriate bses are chosen

Question 9

Consider the example of a without-profits whole life assurance, with benefits payable imediately on death, where:

• x = policyholder age at date of issue
• e = level annual expenses (incurred m times a year)
• f = normal claims expenses
• (PUSA)_t is the paid-up sum assured at policy duration t
• (SV)_t is the surrender value at policy duration t

State the equation of value that can be used to determine the paid-up sum assured at policy duration t

Answer 9

• (PUSA)_t*A_bar1(x+t) + f*Abar1_(x+t) + e*a^(m)_(x+t) = (SV)_t

*annuity factor should have double dots for ‘in advance’

• Strictly, e should be renewal expenses associated with paid-up policies, but in practice this distinction is rarely drawn - although we must make sure that we do not charge paid-up policies for future renewal commission, which will make a big difference
• PUP Sums assured for endowment can be determined in a similar way

Question 10

Consider the example of a without-profits whole life assurance, with benefits payable imediately on death, where

• x = policyholder age at date of issue
• e = level annual expenses (incurred m times a year)
• f = normal claims expenses
• _tV = policy reserve at time t prior to alteration
• _tV’ = policy reserve at time t after alteration
• P’ = future annual premium (paid m times a year)
• S’ = sum assured after alteration, payable immediately on death
• e’ = assumed future renewal expenses at date of alteration (incurred m times a year)
• C = cost of alteration

The policy is to remain a whole life assurance after alteration at time t, but for a different sum assured and premium. State and interpret an equation of value that can be used to determine S’ (for a given value of P’) or P’ (for a given value of S’)

Answer 10

• _tV = _tV’ + C
• _{=> t}V = S’*A_bar1(x+t) + f’*A_bar1(x+t) + e’a^(m)_(x+t) - P’*a^(m)_(x+t) + C

*we have essentually subsitituted the reserve calc/policy value for _tV’

*annuity factor should have double dots for ‘in advance’

• _tV
  
  • ​is calculated for the policy at alteration date, according to its original sum assured, premium, and policy conditions
• This equation says that
  
  • {old policy value} + {value of new premiums} =
  • {value of new benefits} + {value of new expenses} + {alteration expenses}, or
  • [EPV of income} = {EPV of outgo}

Question 11

When encountering an ‘equating policy values’ questions in an exam setting, what are some key steps which may help solve the question? (6)

Answer 11

1. Start with equating values using an equation of the form:
   
   • old policy value = new policy value + alteration expenses
2. Decide whether to use a prospective or a retrospectve reserve
   
   • question should state method to use for pol value calculations
   • if nothing is specified, use prospective values
3. Renewal expense assumption
   
   • unless otherwise stated, expenses expressed as a % of premium will relate to the premium that applies to the reserve calculation (new or old) concerned
4. Use of ultimate vs select mortality
   
   • unless otherwise stated, any policy value calc’d at time t years through an existing policy will be calc’d assuming mortality appropriate to lives of select age [x] + t.
   • so for all cases where AM92 mortality is assumed, reserves calculated for t>= 2 (greater than select period) will use ultimate mortality (irrespective of whether the lives were select or ultimate lives at age x)

Question 12

In terms of meeting the principles that should be followed when calculating alteration terms, outline the main advantages (5) and disadvantages (1) of equating policy values to calculate alteration terms.

Answer 12

Advantages

1. Will produce consistent surrender values before and after alteration if the same methods and assumptions are used as for calculating surrender vals
2. For an extension of tem or increase in benefit, use of the current premium basis to calculate the before and after alteration policy values would ensure consistency with the terms for new contracts (unclear if other bases would)
3. There will be consistency betwen the terms for alterations, surrender values and conversions to paid-up status, if the same bases are used
4. Assuming the same basis is used for before and after policy values, the method is stable
   
   • stable: minor alteration => minor premium change/whatever changed
   • unstable: minor alteration=> major premium change/whatever changed
5. Provided the policy value before alteration isn’t greater than the earned asset share, and the basis for the policy values after alteraion is not weaker than a best estimate basis, the alteration terms should be affordable.

Disadvantages

1. Lapse and re-entry may be possible - the company would need to check the revised premium against that for a completely new contract

Question 13

Give a brief overiew of what factors to consider when determining the basis used for setting alteration terms (4)

Answer 13

Consider:

• No assumptions are required for the proportionate paid up approach
• We need a set of assumptions for equating policy values, and shold consider the following
  
  • The expected profit from the alterered contract
  • What kind of assumptions to use
  • Impact of selection

Question 14

What does the total profit from an altered contract depend on? (2)

Answer 14

Total profits on an altered depends on the relationship between

• the method and basis for calculating the policy value before alteration, which determines profit “released” at time of alteration
• the method and basis for calculating policy value after alteration, which determines the profit expected to emerge over remaining contract term

Question 15

What profit will be “released” at alteration date for the various bases used for the policy value before alteration? (3)

Answer 15

The profit released at alteration date will be

(can be thought of as profit for a surrender)

• full expected profit under unaltered policy, if realistic/best estimate prospective val used for policy value before alteration
• no profit at all, if earned asset share is used for policy value before alter
• something between, if prospective value using a basis incorporating margins is used for policy value before alteration

Question 16

What profit will be expected to emerge from the alteration date, over the remaining life of the altered contract, for the various bases used for the policy value after alteration (2)

Answer 16

Expected profit emerge from alteration date over remaining life of altered policy will be

(can be thought of as profit for a new contract)

• no profit at all, if realistic prospective value used for policy value after alter
• profit corresponding to margins in assumptions, if prospective value using a basis incorporating margins is used for policy value after alteration

Question 17

Impact on expected profit example

Sum assured for without profits endowment is being doubled and oustanding term reduced from 15 years to 10 years. Is equating policy values on realistic basis suitable method/basis of alteration? (5)

Answer 17

Reduced sum assured and reduced oustanding terms

• using realistic basis for policy value
  
  • before alteration takes full expected profit from original contract
  • after alteration takes no future expected profit over remaining term
  • hence overall expected profit unchanged
• given that policy has increased in size (sum assured doubled), it’s likely that an increase in profit would be required, so this method isn’t really ideal

Question 18

Impact on expected profit example

For without-profits alterations, is there ever anything wrong with equating policy values using premium basis? (7)

Answer 18

Using premium basis for without profits alterations

1. depends on which premium basis used!
2. original premium basis
   
   1. highly unpredictable; conditions may have changed since pol incepted
3. current premium basis
   
   1. often a good choice for without profits alterations
   2. pol val before alter: normally extract some profit (earned asset share)
   3. pol val after alter: produce some more profit (due to margins)
   4. if policy size increases (reduces) expected profit wil normally rise (fall), which will often seem reasonable

Question 19

What assumptions would we use for setting alteration terms? (1)

What might be the behaviour of these assumptions when setting alteration terms? (2)

Comment on the choice between select and ultimate mortality when setting alteration terms (2)

What other kind of assumptions might be required when setting alteration terms, which we won’t find from the current premium basis? (1)

Answer 19

The assumptions used would be

• those implicit in the pricing of a new contract issued at the alteration date to provide benefits before alteration and benefits after alteration eg mortality, interest rates, expenses, etc

The assumptions might be

• prudent (with margins), or
• realistic (without margins)

The choice between select and ultimate mortality in the mortality assumption

• will likely depend on whether medical evidence is required before the alteration is proceeded with
• if so => probably implies select mortality, due to underwriting effect

Assumptions might also be required for

• alteration expenses

Question 20

What is the key consideration regarding selection when setting alteration terms? (2)

Answer 20

Company must consider whether

• the alteration terms expose it to the risk of selection
  
  • financial selection
  • mortality selection

Question 21

Give an example of selection for a term assurance that may arise from alterations (4)

Answer 21

Example for term assurance

• extending term on a term assurance => obvious mortality selection
• although note that alterations are rarely allowed on term assurances
  
  • policy values are low
  • they are sold cheap to administer simple policies

Question 22

Give an example of selection for without profits endowment that may arise from alterations (3)

Answer 22

Example from without profits endowment

• extending term of without profits endowment => subtle mortality selection
• extending term will decrease premium, increasing sum at risk in short term, and also give rise to sum at risk later than expected
• however, this is not such a major issue, and major underwriting less likely

Question 23

Briefly describe the process of setting alteration terms for unit-linked contracts

What is the general framework for calculating alteration values for unit linked contracts (1)

Answer 23

• When converting to paid up status, units attaching to the contract at the date of conversion will remain attached, possibly after deduction of any penalty that applies.

Question 24

Briefly describe the process of setting alteration terms for unit-linked contracts

Discuss the use of a penalty on alteration for unit linked contracts (5)

Answer 24

• Insurer may need to apply a penalty at alteration date, depending on alteration eg for premium reductions
  
  • this is essentially due to need to recover initial expenses
  • to extent that altered policy can’t recover initial expenses, penalty may be required
  • options for penalty include
    
    • penalty equal to expected diff in future charges
    • accept cross subsidies (some alterations=> more future charges, some imply less future charges); opens insurer to MOB risk
    • if volume of alterations small, insurer may feel benefit of penalties not worth negative marketing

Question 25

Briefly describe the process of setting alteration terms for unit-linked contracts

Discuss the use of contractually allowed alterations for unit linked contracts (2)

Answer 25

• Common for insurers to only allow contractual alterations on unit linked
  
  • pension products, increases and decreases in premiums and changes in retirement date would normally be allowed.
  • some unit linked whole life contracts can allow increase or decrease to premiums and sums assured.