CHP 38

Question 1

Profit = revenue – expenditure (Income statement)

Answer 1

Because of the long-term nature of life insurance, the final profit cannot be determined until all the risks have gone off the books.
Waiting for this to happen before the next tranche of business can be written in not practical.
In order to monitor the progress of the business, it is needed to value outstanding liabilities – often annually.
Surplus = value of assets – value of liabilities
Surplus arising = (At+1 – Lt+1) – (At – Lt) or (At+1 – At) – (Lt+1 – Lt) = Profit (balance sheet)

Question 2

Impact of valuation basis

Answer 2

this will not impact the total surplus over a policy but only the timing.

Question 3

Analyse the surplus arising over a period in order to:

Assisting management decision making

Answer 3

• Show the financial effect of divergences between the valuations assumptions and the actual experience
• Determine the assumptions that are the most financially significant
• Show the financial effect of writing new business
• Identify non-recurring components of surplus, thus enabling appropriate decisions to be made about the distribution of surplus
• Provide management info
• Give info on trends in experience of providers to feed back into the actuarial control cycle.

Question 4

Analyse the surplus arising over a period in order to:

Providing information for other purposes

Answer 4

• Provide data for use in executive remuneration schemes

* Provide detailed information for publication in the provider’s accounts

Question 5

Analyse the surplus arising over a period in order to:

Data and calculation checks

Answer 5

• Validate the calculations and assumptions used
• Provide a check on the valuation data and process, if carried out independently
• Reconcile the values of successive years
• Demonstrate that the variance in the financial effect of the individual levers is a complete description of the variance in the total financial effect.

Question 6

2. Carrying out an analysis of surplus

Answer 6

Determining premiums, contribution and provisions for future liabilities, assumptions will be made. The difference between the assumptions and actual experience will give rise to surplus/profit (shortfall/loss).

Question 7

2.1. Projecting expected results

Answer 7

To analyse actual performance, one must first determine the expected values against which the actual values should be compared.
When analising experience it is usually needed to project items such as the revenue account and balance sheet as if the actual experience had been the same as expected when the business was written.
This involves building a model of the expected future experience.

Question 8

2.2. Modeling considerations

Answer 8

The bases for such an exercise will likely be models used when the products were developed.
The result of the initial product pricing models can be combined to build a complete model of the provider’s future revenue accounts.
It is important when building such a model to ensure that the elements of the revenue account are self-consistent in their own right. It is not sufficient to project premiums, investment income, death claims, lapses, etc. independently.
The model is developed by multiplying the profit test results by the expected number of contracts to be sold in each future year. Then in each future year, the number of contracts still in force from previous years needs to be added in. This will then give a model that can be used to build up the expected future progress of the business as shown by the revenue accounts.

Question 9

As time goes on, a model using actual volumes of business sold can be built up. Comparisons of actual results with this model will identify whether differences between actual and expected outcomes are due to:

Answer 9

• Differences between actual and expected experience, or

* Sales volumes being different from expected

Question 10

2.3. Comparison of different models

Answer 10

Actual revenue accounts showing actual experience can be compared against projections. This will answer questions such as:
• Has the provider earned more by the way of investment than expected when the product was designed?
• Has the cost of design bean more than what was allowed for/
• Have experience been what was expected – terminations such as death, lapse, surrender, claim etc., inflation?
The answers to such questions will give an initial indication of whether the profitability criterion used in the design is being met in practice. This can be used as feedback into the actuarial control cycle.

Question 11

3.2. Levers on surplus

Answer 11

Levers are the factors management can influence to increase value.

Question 12

Ways in which cost of payments and expenses can be managed:

• Reduce the likelihood of claims by:

Answer 12

o Review ongoing claims – e.g. get regular proof on incapacity for income protection
o Good underwriting – new business, claims
o Customer incentives not to claim – excess, bonus

Question 13

Ways in which cost of payments and expenses can be managed:

Answer 13

• Reduce the likelihood of claims
• Reduce claim / benefit amounts by reinsurance – limit volatility of claims, protect against large claims
• Control expenses
• Increase number of policies that renew / reduce lapses
• Investment policy that increases investment returns – subject to acceptable levels of risk
• Adopt an effective tax management policy

Question 14

3.4. Reducing claim / benefit amounts

Answer 14

• Use reinsurance
• Reduce future benefit payments – e.g. increase retirement age
• Minimize guarantees – e.g. make increases discretionary and not guaranteed
• Use of excesses – client must pay a small amount per claim

Question 15

3.5. Controlling expenses

Answer 15

• Reviewing expenses – see when expenses are rising
• Flexible charges / premiums
• Ensure claim expenses are commensurate with claim size

Question 16

4. Distribution of any surplus / profit arising

4. 1. Insurance companies with with-profit policyholders

Answer 16

For with-profit life assurance business some or all the distributable surplus is allocated to policyholders in the form of bonuses.
The structure of the bonuses and the manner in which they are paid will depend on the terms of the policy and the constitution of the company.
The constitution of the company may also determine the maximum proportion of distributed surplus that can be paid to shareholders. In some cases, this is determined by legislation.
Mutual companies have no shareholders and thus 100% goes to policyholders.

Question 17

4. Distribution of any surplus / profit arising

4. 2. Other companies or corporate institutions

Answer 17

For all other corporate institutions, the surplus belongs to the shareholders. The only decision the directors have to make is what proportion to retain and what to pay out.

Question 18

4. Distribution of any surplus / profit arising

4. 3. Benefit schemes

Answer 18

Any surplus is usually retained in the scheme and used for:
• Enhance benefits of members
• Reduce future contributions of members and/or employer
Because benefit enhancements are hard to remove once added, changes in contribution rates are usually first choice.
In some jurisdictions it is possible for surpluses to be paid back to the sponsor and sometimes not.

Question 19

5. Issues surrounding the amount of surplus to distribute

5. 1. Life insurance companies

Answer 19

For a life insurance company the factors that will affect the amount of surplus distributed are:
•	Provision of capital
•	Margins for future adverse experience
•	Business objectives of the company
•	Policyholder expectations

Question 20

5. Issues surrounding the amount of surplus to distribute

Provision of capital and margins for future adverse experience

Answer 20

One of the main sources of working capital is to defer the profit distribution and retain capital.
Where with-profits are involved, there are a number of additional considerations. Premium rates for with-profits policies are higher than without-profits because it contains margins designed to generate profit what will be distributed to policyholders.
The pace at which the profit arises and the pace at which it is distributed may not be the same. If part of the profit is deferred, it will increase the company’s free assets in the mean time.
Where profit is not distributed as it arises, there will be a smoothing effect. Thus sometimes over and sometimes under, sustained over distribution will put strain on the free assets. Sustained under distribution is unlikely to meet PRE.
The extent to which it is possible to defer the distribution of profits depends on the form of the distribution.

Question 21

5. Issues surrounding the amount of surplus to distribute

Business objectives of the company and retention margins

Answer 21

With-profits life insurer will want to maximize distributions – improve competitive position by showing good returns. The counter argument is that excessive bonus declaration will leave the company with low free assets with which to withstand risk events.
The converse: the company that retains more to protect against risk events, ensure solvency, finance business growth and have investment freedom might find it hard to secure new business. This is because of poorer returns to policyholders.

Question 22

5. Issues surrounding the amount of surplus to distribute

Policyholder expectations

Answer 22

Failure to meet these expectations may lead to policyholder dissatisfaction and risk of losing current and new business.
In some countries this may form ground for supervisory authority intervention.

Question 23

5. Issues surrounding the amount of surplus to distribute
   5.2. Benefit schemes
   Legislation

Answer 23

Legislation is likely to be a major factor in determining the application of surplus or deficit.
E.g.:
• Benefits that have been promised will likely have to be paid even if no funds were set aside. There may thus be a legal obligation to the sponsor to make good any deficit.
• Benefit schemes may have prior ranking in the event of the sponsor’s insolvency.
• Legislation may require surplus to be used to increase benefits and category of member to benefit from this.

Question 24

5. Issues surrounding the amount of surplus to distribute
   5.2. Benefit schemes
   Scheme rules

Answer 24

Where legislation does not restrict the application of surplus or deficit, the sponsor can place restrictions when setting up the scheme. This may have been done to assure potential beneficiaries of safety even in adverse conditions or to avoid disputes when surplus does arrive.

Question 25

5. Issues surrounding the amount of surplus to distribute
   5.2. Benefit schemes
   Discretion of the sponsor / managers

Answer 25

If there are no detailed restrictions form the State or in the rules of the scheme, the sponsor or managers of the fund may be able to choose the use of the surplus or deficit.
In making these decisions, the risk exposure of various parties may be considered. E.g. if the sponsor must make good any deficit, it may be fair to award any surplus to the sponsor.
There may be situations where legal advice will be needed before any action should be taken.

Question 26

5. Issues surrounding the amount of surplus to distribute
   5.2. Benefit schemes
   Source of surplus

Answer 26

Take this into consideration, especially when applying the surplus or deficit to a certain category of beneficiary.
If the surplus or deficit is from a source with particularly volatile experience, it may be most appropriate to retain for future volatility. This approach is probably more likely:
• To be adopted for surplus as it may not be prudent to do for deficit.
• When the surplus or deficit is small relative to the value of liabilities or assets.

Question 27

5. Issues surrounding the amount of surplus to distribute
   5.2. Benefit schemes
   Industrial relations

Answer 27

The effect on industrial relations may influence the decision of what to do with surplus or deficit. The sponsor may be more generous due to industrial relations.

Question 28

5. Issues surrounding the amount of surplus to distribute
   5.2. Benefit schemes
   Speed of corrective action

Answer 28

It is likely that the speed required for the removal of deficit will be greater than that for surplus. A common approach for pension benefits may be deficits to be removed over a period of, say, 5 years. Surplus may be longer or may be over the remaining working term of current employees belonging to the scheme.

Question 29

5. Issues surrounding the amount of surplus to distribute
   5.2. Benefit schemes
   Beneficial tax treatment

Answer 29

Where funds set aside for benefits have beneficial tax treatment, it may be that surplus funds will not get this. It will also be likely for the sponsor to have to pay tax on surpluses paid back to the sponsor.

Question 30

Explain discounted covers (ART)

Answer 30

Provide full cover with no immediate need to finance the full undiscounted liability