Chapter 6: Life insurance products Flashcards
Key features of life insurance
- Often long term
- Typically only one claim
- Claim amount may be known
- Used for:
- financial protection against death or ill health
- savings - Can be sold on an individual or on a group basis
4 main investment types
- Without-profit
- With-profit
- Unit-linked
- Index-linked
Profit calculation for life insurance contracts
Premiums net of reinsurance premiums paid
+ investment income and gains
- Claims net of reinsurance recoveries
- Expenses and commission
- Increase in provisions
- Increase in the cost of capital
- Tax
= Profit
Factors to consider when designing a life insurance contract
- Profitability
- Meeting customer needs
- The type of benefit offered
- Marketability
- Competition
- Financing requirements
- Simple administration
- Consistency with other products
Assumptions needed in life insurance
- Premium rates per policy
- Sales volumes and mix of business
- Investment returns
- Expense levels
- Expense inflation
- Commission rates
- Mortality rates
- Morbidity rates
- Withdrawal rates
- Separate assumptions to calculate the provisions
- Solvency capital requirements
- Tax rates
- Reinsurance premium rates and recovery rates
Reasons why a life insurance company needs capital
- Meeting new business strain
- To cover unexpected events
- To give investment freedom
- To demonstrate financial strength
- For opportunities
- To smooth dividends / bonuses
- For development expenses
- To cover guarantees
What are some of the assets a life insurance company will hold?
- Fixed-interest bonds to meet liabilities that are guaranteed in money terms like a death benefit
- Real assets to meet benefits that are inflation linked
- Equities and property to maximise returns
- Assets to match the term of the liabilities
- Assets predominantly denominated in the domestic currency
- Some derivatives to hedge guarantees and options
What are some constraints for a life insurer’s investment strategy?
- Regulation
- The size of the free asset
- The need to be tax efficient
Key risks under life insurance contracts
- Mortality (too many deaths), longevity (living too long) and morbidity (sickness)
- Investment risks
- Expenses not met by premium loadings or charges
- Early withdrawals, before the initial expenses have been recovered
- New business volumes too high and hence new business strain, or too low and not enough business to spread the overheads
- Credit risk
- Operational risks
What items should a life insurer monitor to ensure that incorrect assumptions are corrected as soon as possible?
A life insurance company should monitor any item of experience related to profits:
1. Claim rates - mortality rates and morbidity rates
2. Withdrawal rates
3. Reinsurance premiums and recoveries
4. Competitors’ premium rates
5. Investment returns
6. Expenses
7. Sales volume and mix
Name 14 life insurance products
- Pure endowment
- Endowment Assurance
- Whole life Assurance
- Funeral insurance
- Term Assurance
- Convertible and renewable term Assurance
- Immediate annuity
- Deferred annuity
- Income drawdown
- Investment bond
- Income protection insurance
- Critical illness insurance
- Key person cover
- Long-term care insurance
Pure endowment and endowment assurance
A pure endowment provides a benefit on survival to a known date and hence operates as a savings vehicle, providing a lump sum on retirement, or a means of repaying a loan
An endowment assurance also provides a significant benefit on the death of a life insured before that date and, in this case, operates also as a vehicle for providing protection for dependants
This meets the following customer needs:
- Transferring wealth
- Repaying the capital on a loan
- Saving money for retirement
An endowment assurance could come in:
- without-profits
- with-profit, or
- unit-linked
A group endowment assurance would enable an employer to provide benefits at retirement and maybe also on death in service in respect of their employees.
Whole life assurance
A whole life assurance will provide a benefit on the death of the life insured whenever that might occur.
This meets the following customer needs:
- Providing for funeral expenses
- Meeting any liability to tax, such as inheritance tax
- Death duties, arising on the death of the life insured
- General purpose contract for providing long-term protection to dependants
A whole life assurance could come in:
- Without-profits which offer a guaranteed sum assured on death
- With-profit which increase the initial benefits by bonuses
- Unit-linked which offers considerable flexibility in the level of death cover included
There would not seem to be a consumer need for a group version of whole life assurance contracts, since group contracts are usually funded by employers for their employees, and it is therefore natural to restrict life cover to the period of employment, rather than offer it on a whole life basis.
Term assurance
A term assurance provides a benefit on the death of the life assured, provided it occurs within the term selected at outset.
The cost is considerably cheaper, as the policy will not pay out a benefit in every case.
Term assurances do not normally have any benefit paid on early termination.
This meets the following customer needs:
- Provides protection against financial loss for the assured’s dependants
- A decreasing term assurance can be used to repay the balance outstanding under a repayment loan, or
- to provide an income for a family with children following the death of the income provider until such time as the latter can fend for themselves.
The group equivalent of a term assurance can be used by an employer to provide a benefit to dependants on the death, while in employment of an employee.
Can also be used by a credit card company to provide a benefit on death equal to the balance outstanding on a credit card.
Any supplier of goods with payment in instalments could use a term assurance to cover the risk that recovered goods are less valuable than the outstanding loan balances due on death
Convertible or renewable term assurance
A renewable term assurance is a term assurance with the option to renew at the end of the original contract. The appeal lies in the fact that the renewal can be made without further medical underwriting.
A convertible term assurance allows a policyholder to convert the term assurance into another type of contract, such as a whole life or endowment assurance. The point(s) at which conversion is allowed will vary depending on the particular policy conditions
This meets the following customer needs:
- These contracts combine the attractions of a term assurance, in terms of offering cheap death cover,
- with the certainty of being able either to convert to a permanent form of contract when it can be afforded, or
- to renew the original contract for a further period of years, all without health evidence being provided.
A comparable group arrangement would be the option for an individual in a scheme covered by a group life policy to convert to some form of individual arrangement on leaving the scheme.
Immediate annuity
A single premium purchases the income, which commences immediately after purchase.
Annuities are predominantly without-profit or index-linked
With-profit and unit-linked annuities are possible.
With-profit annuities have the income paid to the policyholder with a guaranteed amount plus a bonus added by the insurer.
Unit linked annuities have the insurer guarantee to pay a number of units. However, the income is not guaranteed, as it is equal to the number of units multiplied by the unit price, which will vary on a daily basis
This meets the following customer needs:
- Financial need for an income for the remainder of the life of the insured after for example, retirement.
- or for an income during a limited period, for example to pay school fees of the insured’s children.
A group version of the contract can be used by an employer to fund for pensions for employees at or after retirement. These are essentially just collections of individual annuities.
Deferred annuity
Deferred annuities can be used when there is a time between the date of purchase and the date when the income stream is required to start.
Usually the policyholder pays regular premiums for a period up to the specific ‘vesting date’, after which the policyholder will be paid regular income from the vesting date.
This meets the following customer needs:
- Enables individuals to build up a pension that becomes payable on retirement from gainful employment
- At the vesting date an alternative lump sum may be offered as a part or all of the pension, to pay off for example a house loan.
The group equivalent of a deferred annuity can be used by an employer to fund for pensions for employees. In particular, a group contract may be used when an employer closes an occupational pension scheme to buy out the benefits with an insurer.
Income drawdown
Under an income drawdown arrangement, instead of buying an annuity the fund remains invested and the member withdraws an amount of the fund each year.
There may be legislative restrictions on the:
- amount of the fund that can be withdrawn each year
- age at which drawdown must cease and a pension must be purchased
This meets the following customer needs:
- One of the main drivers is that, should the member die before having to secure and annuity, the member’s heirs can inherit the balance of the fund.
The income drawdown product will be sold to individuals as a way of meeting their retirement needs.
Risks for the member of an income drawdown contract
- If only the income earned on the fund is taken each year, the member’s income could be volatile
- If too high a level of income is taken, the capital could potentially reduce to zero before the member dies, leaving the member dependent on the state at the end of their life
- The charges taken in relation to administering the arrangement may be high
- The remaining fund on the member’s death may be insufficient to provide adequate benefits for a dependant
- There may be a tax charge on the residual fund on the member’s death
Investment bonds
These are single premium contracts, normally whole life, designed to enable policyholders to invest for the medium to long term.
A policyholder can usually make withdrawals, however these may incur penalties, and there could be restrictions on the frequency with which withdrawals can be made.
On death, the bond will pay a lump sum, which could have a guaranteed minimum, but is likely to depend on the return earned on the investment chosen by the policyholder or their advisor.
They are typically written on a unit-linked or investment-linked basis.
This meets the following customer needs:
- To earn a higher return on funds that are not currently required to meet their needs
- The life insurance element ensures a minimum payout on death, which could be passed on to the policyholder’s family or used to meet costs such as funeral costs or inheritance tax liabilities
- As the policyholder need additional funds, they can withdraw money from the bond.
Investment bonds are purchased by individuals
Income protection insurance
The contract enables individuals to provide an income for themselves and their dependants in the even of the insured risk occurring.
The most common insured risk is long-term sickness or incapacity due to accident or illness.
These contracts typically terminate at retirement age, and do not provide benefits for the first period of any claim.
In the first period of a claim, it is assumed that the insured will have other resources, for example, a company sick pay scheme or state benefit provision.
The group equivalent can be used by an employer to provide a sick pay scheme for employees.
Critical illness insurance
The contract provides a cash sum on the diagnosis of a ‘critical’ illness, which could be used for nursing and other care.
It therefore meets an important need for financial security in the event of contracting such illnesses.
Policies are normally without-profit or unit-linked.
In a stand-alone contract, no benefit is paid on death.
Alternatively, the benefit may be offered as a ‘rider’ benefit on another contract.
A group version of the stand-alone contract could be used by an employer to provide financial security for employees in the event of contracting a critical illness.
Key person cover
A life and / or critical illness policy taken out to cover the life of a key person within a business.
The benefit payable may be based on loss of profits to the business, or related to the salary of the key person
This lump sum can be used to:
- buy out the individual from the partnership
- cover any loss of profits as a result of the loss of the key person
- meet the costs of finding a replacement
Key person insurance is purchased by a company for its own benefit, covering particular employees.
It is unlikely to be purchased as a ‘group’ version covering many employees
Long-term care insurance
The contract can be used to help provide financial security against the risk of needing either home or nursing-home care as an elderly person. The contract could pay for all the costs of care throughout the remainder of life, or could provide a cash lump sum, or an annuity, to contribute towards the costs of care.
A claim is payable if the policyholder is deemed to have reached a specified level of disability.
The different levels of care will differ between one contract and another, but typically may include:
- cost of care in own home
- cost of being cared for in a residential home
- cost of being cared for in a residential nursing home
A group version of the contract would enable an employer to provide long-term care cover to employees and their spouses and parents.
Without-profits contracts
A life insurance contract is without profit if the life insurance company has no discretion over the amount of benefit payable, i.e. the policy document will specify at outset either the amount of the benefits under the contract or how they will be calculated.
So the key feature is that its guaranteed, and non-discretionary in nature.
Without profits tend to be most appropriate when the primary customer need is protection.
This certainty means less risk for the policyholder than on a with-profit or unit-linked contract.
With-profit contracts
A life insurance contract is with profit if the policyholder is entitled to receive part of the surplus of the company or of a sub-fund within the company. The extent of the entitlement is usually at the discretion of the company.
These contracts tend to be most appropriate when the customer need that the contract is addressing is saving.
Savings contracts will tend to have premiums invested in riskier assets than do without-profit contracts, with higher expected returns that are used to form the basis of the discretionary benefit entitlement.
It is typical for a with-profit contract to involve some guaranteed benefits and some discretionary.
The factors that come into play when setting levels of bonus include:
- the wish to smooth benefits from year to year, so keeping back some of the profit from the good years, to help in the bad years
- policyholder expectations
- looking at what competitors are doing
- adhering to regulatory limits on payouts.
Unit-linked contracts
Unit-linked contracts are unitised contracts whose value of units is directly attributable to the underlying value of the invested assets.
Unit-linked contracts operate by paying policyholder premiums into pooled investment funds, and the policyholder’s share is represented by units.
Any of the types of contracts can be written in a unit-linked form, although normally only contracts with a significant investment element are written in this way.
The benefit paid at maturity depends on the performance of the underlying assets and the level of charges levied by the insurance company.
This makes unit-linked policies very versatile.
A unit-linked contract enables consumers either to obtain a higher expected level of benefit for a given premium or to pay a lower expected level of premium for a given level of benefit, than under a comparable non-linked version.
In addition, a unit-linked contract can offer flexibility in the types and levels of cover included and the ability to vary premiums according to need.
Index-linked contracts
An index linked contract enables the consumer to obtain a benefit that is guaranteed to move in line with the performance of an index specified in the contract.
Normally the index will be an investment or economic one.
Premiums may move in line with the same index, or may be fixed in monetary terms.
Typical economic indices that might be used include retail or other appropriate price indices.
Suitable investment indices might be the major domestic equity market indices of any country, or more broadly based international equity indices.
Also, links might be made to other asset classes such as fixed interest.
