Ch17: Actuarial funding Flashcards
Actuarial funding
Technique whereby life insurance companies can hold lower reserves for unit-linked contracts to which it can be applied, and thus can reduce new business strain.
To reduce the strain, the company holds a smaller unit fund (reserve) at policy inception than would be expected to be bought for the given amount of premium. The missing units are then bought later on from the future management charges (ie need a charging structure that has higher levels of regular fund management charge)
How can actuarial funding be achieved?
- different fund management charges on “capital” units and “accumulation” units
- higher fund management charges on all units
What is the purpose of actuarial funding?
To reduce new business strain on (certain kinds of) unit-linked contracts
For what kind of product design would actuarial funding be useful?
- where at least one type of unit has relatively high fund management charges
- a surrender penalty would have to exist at least for an initial period of years
- may have a capital and accumulation unit structure (not necessarily a condition; any design for which the regular fund management charges are raised in order to recoup the initial expenses could be appropriate)
Explain the problem with this design if actuarial funding isn’t used
- mismatch between income and outgo
- large initial strain when a policy is sold
- mismatch by nature and timing - the fund management charges are investment-linked as they are proportionate to future fund values. This means that the amount of income received to pay for initial expenses is subject to investment risk.
How does actuarial funding reduce these problems?
Actuarial funding leads to a much increased positive net non-unit fund cashflows on early years’ premium allocations. This will significantly reduce the initial strain.
It will also eliminate the investment risk caused by the initial mismatch because the income is now in cash form. The income is now the difference between the premium paid and the unit reserve set up as a result of premium allocation, which is not subject to any investment risk.
What are the necessary conditions for actuarial funding to apply?
- the unit fund benefits must be contingent on death and (usually) on survival for a minimum period of years
- there needs to be sufficient regular fund management charges available. The limiting condition is that, after actuarial funding, prudently projected future net cashflows to the insurer remain positive
- there must be a unit surrender penalty imposed such that the unit reserve is not lower than the surrender value payable
How do you calculate the actuarially funded unit reserves?
The nature of the contingent payment means that we can discount the unit fund benefits as an endowment assurance, for a term equal to the residual survival period, using a maximum theoretical discount rate equal to the fund management charge.
The requirement to cover the regular outgoing cashflows usually forces us to discount the funds at a lower discount rate than the theoretical maximum.
Where capital and accumulation units are used, this rate may equal to the difference between the management charges on the two units.
What changes to net cashflows to the insurer occur as a result of actuarial funding?
- when a premium is allocated, an increased net cashflow to the insurer will occur because of the cost of allocation has been reduced
- net cashflows to the insurer during each subsequent year will be reduced because the fund management charge is based on a smaller unit reserve
- net cashflows in each subsequent year will also be reduced by the cost of rebuilding the unit reserve gradually back towards the face value.
- on death, an additional cost equal to the face value less the value of the units will be incurred
- on surrender, a reduced net cashflow to the insurer will be made compared with the non-funded position
