Ch 38: Surplus and surplus management

Question 1

Define the terms ‘surplus’ and ‘surplus arising’

Answer 1

‘Surplus’ is the value of the assets less the value of the liabilities.

‘Surplus arising’ is the change in the value of the assets less the change in the value of the liabilities over a period of time. Surplus arising is equivalent to UNEXPECTED profit.

Often surplus arising is referred to simply as the surplus.

Where actual experience differs from expected experience, a surplus arises. Sales mic also differs from what was expected.

Question 2

List the reasons why providers analyze surplus

Answer 2

DIVERGENCE

• Divergence of actual vs expected (show financial effect / significance of)
• Information to management and for accounts
• Variance as a whole is equal to the sum of the variances from the individual levers.
• Experience monitoring to feedback into ACC
• Reconcile values for successive years
• Group into one-off / recurring sources of capital
• Executive remuneration schemes (data for)
• New business strain (show effects of)
• Check on valuation assumptions and calculations
• Extra check on valuation data and process

(Additionally, these reasons can be grouped into 3:

• assisting management in decision making
• providing information for other purposes
• data / calculation / assumption checking)

Question 3

Carrying out an analysis of surplus involves comparing what actually happened over the year against with what was expected to happen.

How would the expected experience be projected foreward?

Answer 3

• Use a model capable of projecting items such as the income statement (revenue account) and balance sheet on the expected experience basis.
• Usually such a model will already exist, for example the original pricing or profit testing model.
• It is important that the model is self-consistent, i.e. assumptions and different elements of the output are mutually consistent.
• The projected model output for each model point is scaled up by the expected number of contracts to be sold in each future year.
• Then, for each future year, the number of contracts still in force from the previous years need to be added in.
• This enables expected future revenue accounts and balance sheets for the business to be built up.

Question 4

Explain how the following would be isolated in an analysis of surplus exercise:

• sales volumes not being as expected
• mortality experience not being as expected

Answer 4

For sales volumes, the model described previously can be run a second time, but using the actual volumes of business sold, rather than the expected volumes. A comparison of the results of this model with the results of the first run of the model will show sales volume surplus.

For mortality, the model could be run a third time, this time using the actual number of deaths and actual benefits paid. A comparison of the results of this model with the results of the second run of the model will show mortality surplus.

(Remember step-wise analysis from class. Start by only changing one variable/assumption at a time, from “expected to actual”. Use this in surplus attribution analysis)

Question 5

Outline why it is important for an insurance company to conduct a periodic analysis of surplus

Answer 5

Analysis of surplus is an important part of the ‘monitoring the experience’ stage of the ACC.

It is necessary in order to provide feedback into the contract design and pricing process.

Many life insurance contracts are long term and general insurance claims may be long tailed. Waiting until all risks have gone off the books could take years. It is not practical to wait so long to find out whether a contract is profitable or not, since, in the meantime, many more tranches of business will have been written and the insurance company will not want to make the same mistakes.

Question 6

What are the main sources of surplus to a life insurance company?

Answer 6

Demographic factors:

• Mortality / morbidity
• Withdrawals
• New business volumes / new business mix

Economic factors:

• Premiums received
• Expenses, including commission
• Inflation (price and salary)
• Investment income and gains
• Tax

A change in the valuation basis or method used is a further source.

There may also be surplus / deficit arising from events such as counterparty failure or business restructuring.

Question 7

Define the term ‘levers on surplus’

Answer 7

Levers on surplus are factors that management can use to control the amount of surplus arising.

Question 8

Give examples of how claim FREQUENCY can be controlled

Answer 8

1. Monitor claims experience
2. Good underwriting of new business
3. Good claims management systems
4. Eligibility criteria
5. Tight policy wording
6. Customer incentives not to claim (e.g. no claims discount)
7. Policy excesses

Question 9

Give examples of claim / benefit AMOUNTS can be controlled

Answer 9

1. Monitor claims experience
2. Reinsurance
3. Good claims management systems
4. Provide rehabilitation services (income protection insurance)
5. Reduce future benefit payments, e.g. by increasing the age of eligibility or by removing an inflation link.
6. Tight policy wording
7. Keep guarantees and options to a minimum
8. Policy excesses

Question 10

Give examples of how expense surplus can be controlled

Answer 10

1. Expense budgeting and monitoring
2. Variable charges / premiums
3. Ensure that underwriting and claims expenses are commensurate with the size of the claim
4. Policy excesses so that small claims (and the associated expenses) are avoided.

Question 11

Give examples of how a provider can increase the number of contracts that renew or reduce the number that withdraw.

Answer 11

1. Monitor renewal / withdrawal experience
2. Issue renewal notices
3. Have automatic renewals
4. Maintain competitive premiums
5. Offer loyalty discounts
6. Provide good customer service and claims handling
7. Undertake marketing activities to promote the brand.
8. Impose surrender penalties / offer no benefit on surrender
9. Claw back commission from brokers on policies that are written.

Question 12

Give examples of how the provider can reduce the likelihood of an investment return deficit.

Answer 12

1. Matching (nature, term, currency)
2. Subject to this, select investments to maximize overall return
3. Diversification by asset class and by stocks within a class.
4. Track an index or competitors’ fund allocations
5. Select low variance investments
6. Tax-efficient investments
7. Controls on investment expenses
8. Monitor investment experience

Question 13

Give examples of how a provider can adopt an efficient tax management policy

Answer 13

1. Utilize tax allowances fully
2. Use tax-efficient investments
3. Pay tax on time to avoid penalties

Question 14

Outline the issues to consider surrounding the amount of surplus that a life insurance company should distribute

Answer 14

1. Constitution of the company - mutual => 100% to policyholders, proprietary => split between the shareholders and with profit policyholders or 100% to shareholders if there are not with profit contracts.
2. Provision of capital - deferring the distribution of surplus is a source of capital. Whether deferral is possible depends on the form of the distribution.
3. Margins for adverse experience - the pace of distribution is unlikely to match the pace at which profit arises. Sustained over-distribution drains free-assets; sustained under-distribution may not meet policyholders’ expectations.
4. Business objectives - maximizing distributions to improve competitive position (and generate business) vs maintaining surplus (as a cushion against risk, for writing new business and investment freedom).
5. Stakeholders’ expectations (shareholders and policyholders) - failure to meet these may lead to loss of business or supervisory intervention.

Question 15

List 4 used of surplus in a benefit scheme

Answer 15

1. Enhance benefits
2. Reduce contributions
3. Return to sponsor (not always allowed)
4. Retain as a cushion against adverse experience

(Once enhanced, benefits cannot be removed/reduced)

Question 16

Outline 8 considerations that will affect how, when and to whom a DB pension will distribute a positive surplus.

Answer 16

1. Legislation, and whether this dictates which categories of members should have priority for the distribution of surplus.
2. Tax, since surplus funds may be excluded from beneficial tax treatment.
3. The scheme rules, which may deliberately have placed restrictions on the use of surplus to avoid potential disputed should it arise.
4. Discretion of the sponsor / scheme managers
5. Risk - for example, if the sponsor bears the risk of making good any deficit, it may be felt that the sponsor should benefit from any surplus.
6. The source of the surplus - e.g. does it ‘belong’ to certain members? Does it arise from a volatile source/ In which case may it be retained?
7. Preserving industrial relations with members and other employees
8. Speed of corrective action - distribution of surplus is likely to be at a slower pace than that used if deficit was being amortized instead.

Question 17

What is meant by “good claims underwriting”?

Answer 17

Underwriting at the claims stage (or loss-adjusting) can help both to REDUCE excessive claims and identify fraudulent claims.

A provider can put measures into place to prevent fraudulent claims, such as:

• medical/death certificates
• pictures of damages
• reports by damage/loss assessors
• evidence of business continuity incidents