Chapter 1 - Relationship Of Product Pricing And Underwriting Flashcards
Product pricing process
The cost of “raw materials” is not known at the time of determining the life insurance price. Cannot be determine until there isn’t another policy holder. Mortality expectations, expenses, interest rate, etc must be based on reasonable, or actuarially supportable, gleaned from past experience.
Strategy Determination
Various strategic directions can be carried out as long as 2 key items are considered.
1) organization must have the skill set to appropriately analyze the risk being considered. $100,000 for a 50 yr old vs $5M for a 30 yr old.
2) organization must be realistic about underlying cost of different offerings. Quick sale vs a completely underwritten policy.
Profitability expectation
Large component of expected profit margins is pressure for a competitive price in the marketplace.
Another component is the assignment of surplus.
Theoretically all ventures, expected returns should correlate with underlying risk present.
Surplus
Capital that is held above and beyond the expected needs of the products in order to ensure, with a very high probability, that all policyholder claims will be met.
Four Types of Risk types of risk to be covered by the assigned (or allocated) surplus
- C1 – Asset Risk
- C2 – Insurance Risk
- C3 – Interest Rate Risk
- C4 – Business Risk
Surplus Asset Risk
The risk that the assets supporting the product line lose some or all of their value.
Surplus Insurance Risk
The risk that the price of the insurance product provided is inadequate. This could occur primarily from the mis-estimation of the underlying expected mortality or the introduction of a risk not contemplated when the product was priced (i.e., influenza epidemic, HIV infection, or mortality event that materially changes the expectations of the underlying mortality curve).
Surplus Interest Rate Risk
The risk that assets must be sold at a loss in order to meet the cash needs of a policyholder. This risk (and the management of it) has precipitated a significant amount of industry work aimed at matching the liability cash flows of a product with the cash flows of the invested assets. This risk management process is known as asset/liability management or ALM.
Surplus Business Risk
This is a “catch-all” category of risk management to cover anything not specifically included in the C1, C2, or C3 category.
Which surplus risk is most associated with term insurance
C2 – Insurance Risk
Pricing Components
Several building blocks in product design – underwriting is key to one of the building blocks.
- Mortality
- Lapse Rates
- Expense Levels
- Interest Rates
Pricing Components – Mortality
Single biggest cost in life insurance product.
Being overly aggressive by ½ to 1 table (25%) can erode all of the expected profitability.
Actuaries look at the dynamics of large groups, underwriters look at the absolute risk of the individual. I.e., underwriters build the large group of homogenous risks that actuaries quantify.
Pricing Components – Lapse Rates
Largest decrement affecting the number of policies ultimately in force.
Impact on profitability depends on when the lapse occurs. If it occurs when the premium collected is greater than the mortality cost for the duration, then a lapse will hurt profitability. If a lapse occurs when the premium collected is less than the mortality cost then profitability will generally improve.
(Early duration lapses – hurt profitability, late duration lapses – improve profitability).
Pricing Component – Expense Levels
Represents – agent compensation, corporate overhead, support of an agency system, advertising, and underwriting expenses. Some policy sizes and issues ages, the cost of obtaining an additional requirement cannot be justified in the mortality savings that would occur. 4 important factors.
Underwriting expectation should not make a decision based upon the expected duration of the policy.
Pricing Component – Expense Levels – 4 Factors
- The cost of a requirement
- The corresponding mortality savings i.e., protective value) that occurs due to the obtainment of a requirement.
- The proposed insured’s adverse reaction to being subjected to a battery of requirements for the desired level of coverage.
- The time taken to issue a policy.
Pricing Component – Interest Rate
Term products – very little asset accumulation (cash value)
Whole Life/Universal Life – significant asset accumulation component.
Traditional products keep the investment risk with the company while variable products shift most of the investment risk to the policyholder.
No ties to the underwriting process.
Pricing Component – Interest Rate -> Components established by regulation
- Reserve Basis
- Non-forfeiture Laws
- Surplus Need
- Tax Law
Reserve Basis
Standard are established by state regulation and are generally consistent across the nation (in Canada by federal government). Standards include an underlying mortality table, maximum interest rates, and methodology to be used. This is to make sure enough of the premium earned in the early duration is held until the time when group of policyholders ages and probability of death is greater than the premium received. Err in favour of policyholders.
Non-forfeiture Laws
For policies that have a level premium structure, the policyholder, in essence, pays too much for coverage in the early duration of the contract and no enough in later years. These laws allow for the return of excess premium in the form of cash value (net of allowing the company to recover its expenses), if the policyholder chooses to lapse the policy.
Surplus Needs
A safety net needs to be provided, beyond the level of reserves being held, in case experience turns out to be much worse than expected. This safety net is referred to as capital requirements or risk-based capital (RBC).
Tax Law
In US, states can levy a tax that is normally collected on the premium revenue that is received by an insurer. Federal taxes pain by an insurance company are income based and are affected by three main components:
- Corporate tax rate
- Tax Reserve
- DAC (deferred acquisition cost) tax
Tax Reserves
Since the level of reserves decreases profitability, the lower the reserves are, the higher insurer’s current income is, thus increasing the tax burden.
DAC Tax
Upon issue of a policy, there are several immediate expenses - DAC is a way to disallow full deductibility of acquisition expenses in the year they were incurred, but rather to force them to be recognized over 10 year period.
Corporate Taxes in Canada
At the federal level, taxes relate primarily to the company’s income (federal income tax), and at the provincial level they relate to premiums (provincial premium tax).
To price a product…
Schedule out a series of expected expenses and couple that with a stream of premium payments to produce a profit that meets the corporate requirements for the product.
Should also be checked to see that agent compensation and consumer competitiveness are appropriately met.
Relationship of pricing to Underwriting - Price Development
- Setting the underwriting requirements
2. Reasonableness of the pricing expectation
Setting the Underwriting Requirements
Two Components
- Verifying information obtained from the proposed insurer
- Discovering information that is either new to or is being concealed by the proposed insured
* * Protective Value **
Protective Value
The relationship of mortality savings from a requirement to the cost of administering the particular requirement.
Protective Value Issues
- Which requirements identified the underlying impairment. (Important to not double or triple the value of identifying impairment).
- Proposed insured behaviour (not taken policies d/t length of time to complete)
- Look to competitors when establishing u’wing requirements.
Reasonableness of Pricing Expectations - Issues
- Judgement of value of underwriting requirements - no right or wrong parameters.
- Interaction of the underwriting process (includes the underwriting requirements as well as the quality if the staff interpreting and making decision on such information) and the resulting mortality results.
Implementation and Maintenance of Pricing Expectations
- Changes to Underwriting Requirements/Guidelines
- Expectations - ie preferred class
- Competitive, price sensitive case- making exceptions to allow large cases
- Early warning/feedback mechanism - through claims and audits
