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ILA-LPM C Flashcards

1
Q

List 3 flaws in the traditional approach to pricing life insurance

A
  1. Unit-based profitability analysis
  2. Cost-plus approach for setting price
  3. Allocate non-marginal expenses on a unit basis
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2
Q

Describe flaws in the traditional approach to pricing life insurance:

  • Unit-based profitability analysis
A
  • (unit = policy, premium, etc.)
  • Assumes total profit = profit per unit units sold (Q)
  • Problem: in reality, Q = f (P) and f’(P) < 0
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3
Q

Describe flaws in the traditional approach to pricing life insurance:

  • Cost-plus approach for setting price
A
  • same problem as unit-based profitability analysis
  • sets a price equal to cost of product + profit requirement
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4
Q

Describe flaws in the traditional approach to pricing life insurance:

  • Allocate non-marginal expenses on a unit basis
A
  • Problem: non-marginal expenses have no impact on optimal price
  • When maximizing (differentiating) total profit, NME vanishes
  • Overhead affects all choices equally and doesn’t vary with unit sales
    • Therefore it shouldn’t affect decisions to sell additional units
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5
Q

Describe the problem of open decision points in product development

A
  • Marketing and actuarial usually can’t agree on price
    • Marketing wants a lower price (higher sales)
    • Actuarial wants a higher price to cover cost and profit
  • The project stalls ⇒ “loops” through plan proposals and ends when:
    1. Time runs out
    2. Actuaries agree to get more aggressive with price
    3. Fatigue results in compromise
    4. One side triumphs through political power
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6
Q

Describe the 3 broad steps of decision making

A
  • Identify decision set (all available choices)
  • Evaluate financial consequences of each choice
  • Make the optimal choice based on expected consequences
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7
Q

List the key changes of macro pricing

A
  • Project-based analysis (instead of unit-based)
  • Use of purely marginal expense assumptions
  • Optimization of price
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8
Q

Who has the responsibility for final price decision?

A

Marketing

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9
Q

What are the primary advantages of macro pricing?

A
  • Maximizes chance of reaching an optimal price
  • Removes political considerations
  • Closely aligns incentives of actuarial and marketing
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10
Q

Describe the key advantages of project-based analysis

A
  • Key advantage: accounts for the law of demand
  • Projects production and profitability over the product’s expected shelf life
  • Typical shelf life is < 3 years
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11
Q

Describe 3 additional advantages of project-based analysis

A
  • Results show actual financial impact on the company
    • Easier for marketing/management to grasp than unit-based numbers
  • More accurately reflects capital and development costs
  • Allows for common sense decisions
    • Unit-based analysis conceals total profit
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12
Q

Describe why pricing should be an optimization process

A
  • Pricing should seek a profit-maximizing price
  • Consider a range of possible sales levels
  • In reality, profitability can only be optimized; it cannot be chosen
    • The optimal price may not provide enough total profit to justify the project
    • Solution: look for other projects
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13
Q

Define and describe the importance of marginal expenses in pricing

A
  • MEs can be eliminated by at least one option in the decision set
  • Overhead = expenses that exist for all courses of action
    1. Overhead expenses are irrelevant when evaluating the decision set
    2. Allocating overhead is misleading and overstates the economic cost of any action
    3. Use of overhead undermines value-based decision making
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14
Q

But did we cover the overhead?

A
  • This is a misguided question because:
    • We can’t choose a total profit level (that’s up to the market)
    • We can only optimize profit
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15
Q

Describe the relationship between marginal expenses and levels of decision-making

A

The level of decision making determines when a ME becomes a NME

  • Continue the company?
    • MEs: C-suite salaries, buildings, etc.
  • Enter the term market, VA market, etc.?
    • MEs: certain staff salaries, admin systems, etc.
  • Offer GLBs on the VA product?
    • Now the higher level MEs have become NMEs
    • At this level, pricing structures, admin system mods, etc. are MEs
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16
Q

Describe how the demand curve for life insurance products can be represented in the macro pricing process

A
  • The demand curve for ILA can’t be specified
    • Players are biased
    • ILA demand is complex and more of a “surface”
  • Solution: The Price-Production Graph
    • Shows a range of possible prices and production levels
    • Each row is a possible decision
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17
Q

Describe the macro pricing decision process when updating an existing product form

A
  1. Select a profit benchmark based on the existing product
    • This is the “no action” decision
  2. Actuarial projects various combinations of price and production level
  3. Show neutral pairs of price/production to marketing
  4. Marketing chooses its desired pair
    • Will never know if it was the optimal price
    • Marketing should make the final decision because:
      • They have incentive to max out production
      • They have the responsibility to meet production goals
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18
Q

Describe the macro pricing decision process when entering a new market

A
  1. Marketing creates a set of equal-effort price/production pairs
    • Choose a satisfactory pair
    • If none are satisfactory, expand decision set
    • Creates incentive for marketing to be diligent
  2. Management sets benchmark = min required profit to carry out the project
    • Same steps as updating an existing product forms
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19
Q

Describe how to account for product displacement in macro pricing

A
  • Displacement = lost sales on existing products result from sales of new products
    • As new product price decreases, displacement increases
    • Marginal Displacement Cost = Total Displacement - Residual Displacement
    • Residual displacement is the level of independent of new product price
    • Reflect marginal displacement in the price-production graph
      • Separate graphs for each existing product that will be affected
    • Distinguish between internal vs. external displacements (competitor-driven)
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20
Q

Describe the steps in the macro pricing algorithm

A
  • Steps 1–6: Product features, constraints, and possible prices
    • Competitive focus, external constraints, retail prices, competitive comparisons, unit-based ME, wholesale prices
  • Steps 7–11: Additional work to complete the price-production graph
    • Usages, sales profile, non-unit-based MEs, model office projections, price-production graph
  • Steps 12–15: Meet and either:
    • Marketing makes a choice => refine design, finish product detail and file
    • Determine scope of additional analysis
  • Step 16: Expand Decision Set
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21
Q

Describe considerations when expanding the decision set

A
  • Canceling is only an option if the decision set allows it
  • If canceling is not an option, marketing must pick the best option
    • But they may “withhold it from the market”
  • If canceled, management will probably want to expand the decision set
    • Other possible product forms
    • Alternative product lines or even markets
  • Decision set expansion continues until one of these happens:
    1. Marketing finds an acceptable price-production pair
    2. Further expansion is impossible
    3. The top level of the company is reached (continue vs. discontinue enterprise)
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22
Q

List 4 ancillary effects of the macro pricing algorithm

A
  1. Reduced time for decision convergence
  2. Alignment of marketing and actuarial incentives
  3. Greater marketing responsibilities
  4. Subjective assumptions get closer scrutiny
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23
Q

Describe real world pricing approaches

A
  • Uses real world scenarios (uncalibrated to market conditions)
  • Discount rates include market risk premiums (higher investment income)
  • Uses best estimate assumptions without margins
  • Examples: IRR, premium margin, ROA, TEV
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24
Q

Describe risk-neutral pricing approaches

A
  • Uses risk-neutral scenarios
  • Requires market-consistent assumptions calibrated to current market prices
  • Reflects non-hedegable (insurance) risk using a CoC approach
  • Discount cash flows at risk-free rates or reference rate
    • Adjust discount rate for illiquidity
    • Gross of taxes and expenses (FCs)
    • Reference rate usually swap rate adjusted for liquidity
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25
Q

Formula for market-consistent value of new business

A

MCVNB = PVFP – CNHR – FC – TVOG

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26
Q

List the 4 components of market-consistent value of new business

A
  • PV Future Profits – PVFP (CEQ) and PVFP (Stochastic)
  • Time Value of Financial Options and Guarantees (TVOG)
  • Frictional Costs of RC (FC)
  • Cost of Residual Non-Hedgeable Risks (CNHR)
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27
Q

Describe PV Future Profits (MCEV)

A
  • Profits are post-tax, pre-CoC statutory book profits
  • CEQ = “Certainty equivalent” deterministic RN scenario
  • PVFP (CEQ) = PVFP (Stochastic) + TVOG
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28
Q

Describe Time Value of Financial Options and Guarantees (TVOG) (MCEV)

A
  • TVOG = PVFP (CEQ) – PVFP (Stochastic)
  • TVOG increase as the value of options and guarantees increase
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29
Q

Describe Frictional Costs of RC (FC) (MCEV)

A
  • FC = PV investment expense and tax on RC
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30
Q

Describe Cost of Residual Non-Hedgeable Risks (CNHR) (MCEV)

A
  • Reflects “cost” of wrong best estimate assumptions
  • CNHR is a capital cost borne by shareholders
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31
Q

Describe the 6 steps to calculate the cost of non-hedgeable risk

A
  1. Shock base model: Mortality +15%, Mortality –20% (Longevity), Lapse +/-50%
  2. Calculate MVNL = PV(Cash Outflows – Cash Inflows) for each shock
  3. Calculate shock values
  4. Calculate economic requirement at time 0
  5. CNHR = CoC0 = 6% x EC0
  6. Convert CoC value to a percentage of first-year premium
    • Use this factor throughout projection
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32
Q

Calculate shock values for cost of non-hedgeable risk (3)

A
  • Shockmort = MVNLmort - MVNLbase
  • Shocklong = MVNLlong - MVNLbase
  • Shocklapse = max(MVNLlapseUp, MVNLlapseDown) - MVNLbase
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33
Q

Formula for the components of traditional value of new business

A

TEV = PVFP (RW) – RW TVOG – RW FC

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34
Q

Describe the components of traditional value of new business

A
  • PVFP = PVDE on a RW basis
  • Can be deterministic or stochastic
  • Discount (hurdle) rate
    • Top-down company-level WACC
    • Bottom-up product-specific discount rate
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35
Q

What is the key omission in the formula for TEV and how does it relate to MCEV?

A
  • CNHR
  • Could theoretically calculate a cost of total risk (CTR)
  • Risk-adjusted real world value of new business:

RARWVNB = TEV - CTR

  • RARWVNB = MCVNB if company view of risk is the same as market’s
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36
Q

Describe the general pricing approach using real world traditional value of new business

A
  1. Project deterministic real world distributable earnings
  2. Adjust premiums until IRR ≈ 10–15%
  3. Calculate traditional measures (e.g. TEV) on a pre-tax basis
  4. Produce a deterministic source of earnings analysis
  5. Run stochastic and calculate TVOG = PVFP (RW Det) – PVFP (RW Stoch)
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37
Q

Describe the general pricing approach using risk-neutral market-consistent value of new business

A
  1. Project distributable earnings using a CEQ scenario (use RW premiums)
  2. Discount cash flows at reference rate or swap rate adjusted for liquidity
  3. Produce a deterministic source of earnings analysis
  4. Run stochastic and calculate MCVNB components (TVOG, etc.)
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38
Q

Describe how the profitability of life and annuity contracts varies between market-consistent and real world pricing approaches

A
  • MCVNB is always lower than TEV
  • Investment orientation lowers MCVNB, which assumes risk-free investment
    • Affects annuity products especially, but also UL
  • Options and guarantees lower MCVNB by increase TVOG
    • Big impact on ULSG and annuities with guarantees
  • High mortality and/or lapse risk lowers MCVNB by increase CNHR
    • Affects products with high lapse or mortality risk
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39
Q

List some MCVNB implementation challenges

A
  • Calibrating insurance liabilities to market variables is hard
  • Management concerns
    • Must reconcile MCVNB with traditional measures
    • MCVNB results are volatile
  • CNHR is understated unless you do nested stochastic
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40
Q

Contrast traditional pricing with risk based pricing

A
  • Traditional Pricing
    • Price to achieve IRR > hurdle rate
    • Assume risk premiums are earned before company is released from risk
  • Risk Based Pricing (Market-Consistent Pricing)
    • Discount rate reflects risks in each product
    • Risk premiums earned only when company is release from risk
    • Market-consistent valuation of options and guarantees
    • Uses risk-neutral scenarios
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41
Q

How is the market-consistent value of new business determined?

A
  • VNB = PV Future Profits After Tax - Value of Options and Guarantees - CNHR - Frictional Costs of RC
  • Frictional Costs of RC - Investment expenses, taxes, etc.
  • CNHR = PV of 0–6% per year of non-hedgeable risk capital
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42
Q

How do you interpret the value of market-consistent value of new business?

A
  • VNB > 0 ⇒ product increases shareholder value
  • VNB = 0 ⇒ the minimum price for taking risk
  • Price product to maintain or increase franchise value
    • Franchise Value = PV Future NB Profits ≈ Market Cap - EV
    • Management gives input on final product charges
    • Must balance product charges with sales volume and capital requirements
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43
Q

What should you expect when looking at product performance on a market-consistent basis?

A
  • Products with more risk should show worse results than a products with less risk
  • Risk based pricing reflects risk in projected profitability
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44
Q

Describe factors affecting product performance on a market-consistent basis

A
  • Level of guarantees (e.g. interest rate guarantees, VA guarantees)
    • Higher guarantees ⇒ higher risk
  • Risk borne by company and shareholders
    • Example: as asset credit quality decreases, risk increases
  • Management’s ability to adjust policy values to mitigate adverse experience
    • Less ability ⇒ more risk
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45
Q

What types of products show better results on a market-consistent basis?

A

Winners: Products that emphasize insurance

  • Term life
  • Group life and health
  • UL and VUL that emphasize death protection
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46
Q

What types of products show worse results on a market-consistent basis?

A

Losers: Products emphasize investment earnings (savings)

  • Annuity products: payout annuities, immediate annuities, fixed deferred annuities
  • Variable products: VA, VUL
  • UL products that emphasize accumulation over death protection
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47
Q

Discuss trends in risk based pricing

A
  • US GAAP fair value measurement (FAS 157 and FAS 159)
  • European Insurance CFO Forum’s market-consistent embedded value principles
  • Economic capital approaches like Solvency II
  • M&A and securitization transactions
  • ALM practices
  • IFRS Phase II
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48
Q

Discuss trends in future benefits

A
  • Better targeting of profitable products
  • Understanding relative risks of products
  • Respond to competitors using these tactics
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49
Q

Write out the formulas for distributable earnings

  • ProdCashFlowt
A
  • ProdCashFlowt = Premt - Bent - Expt
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50
Q

Write out the formulas for distributable earnings

  • PreTaxSolvEarnt
A
  • PreTaxSolvEarnt = ProdCashFlowt + InvIncomet - SovResIncrt
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51
Q

Write out the formulas for distributable earnings

  • AfterTaxSolvEarnt
A
  • AfterTaxSolvEarnt = PreTaxSolvEarnt - Taxt
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52
Q

Write out the formulas for distributable earnings

  • DistEarnt
A
  • DistEarnt = AfterTaxSolvEarnt - ReqCapIncrt + ATInvIncRCt
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53
Q

Write the pre-tax earnings for solvency and stockholder earnings

  • ProdCashFlow(t) formula
A

=Prem(t) - Ben(t) - Exp(t)

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54
Q

Write the pre-tax earnings for solvency and stockholder earnings

  • PreTaxSolvEarn(t) formula
A

=ProdCashFlow(t) - InvIncome(t) - SolvResIncr(t)

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55
Q

Write the pre-tax earnings for solvency and stockholder earnings

  • PreTaxStockEarn(t) formula
A

=ProdCashFlow(t) + InvIncome(t) - BenResIncr(t) - DACAmort(t) + InvIncRC(t)

=PreTaxSolvEarn(t) + SolvResIncr(t) - BenResIncr(t) - DACAmort(t) + InvIncRC(t)

=ProdCashFlow(t) + InvIncome(t) - EarnRexIncr(t) + InvIncRC(t)

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56
Q

Compare timing differences with permanent differences (taxes)

A
  • Timing differences – differences in earnings that will eventually reverse
    • Tax authorities prefer higher tax revenue (higher assets lower liabilities)
    • Most common (and usually most significant) example:

TimingDiff(t) = SolvResIncr(t) - TaxResIncr(t)

  • Permanent differences – differences that will not reverse
    • Example: non-deductible investment income

PermDiff(t) = InvIncome(t) x NonTaxInvPct(t)

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57
Q

Write the formulas for calculating taxable earnings

A

TaxableEarn(t) = PreTaxSolvEarn(t) + TimingDiff(t) + PermDiff(t)

=PreTaxSolvEarn(t) + SolvResIncr(t) - TaxResIncr(t) + PermDiff(t)

=ProdCashFlow(t) + InvIncome(t) - TaxResIncr(t) + PermDiff(t)

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58
Q

Write the formula for calculating tax

A

Tax(t) = TaxRate x TaxableEarn(t)

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59
Q

Describe how negative taxable earnings can affect profitability

A
  • At the company level, total tax cannot be negative
    • New products will generate negative earnings
    • Smaller insurers may not be able to deduct first year losses
      • Results in higher capital and lower ROI
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60
Q

Describe the tax accounting treatment for capital gains and losses in the US

A
  • Capital gains are immediately taxable
  • Capital losses can only offset capital gains
  • Capital losses can be carried forward to offset future capital gains
    • Creates a timing difference
  • If carryforwards are not used within 3 years, they expire
    • Creates a permanent difference
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61
Q

Describe the tax on “investment income less expenses”

A
  • Attempts to tax the annual increases in policyholder value and to the insurer’s earnings
  • Some countries may use this or use it as a minimum tax

NOT used in the US or Canada

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62
Q

Formula for the tax on “investment income less expenses”

A

InvIncome(t) - Exp(t) = Ben(t) + SolvResIncr(t) - Prem(t) + PreTaxSolvEarn(t)

IETax(t) = IETaxRate x [InvIncome(t) - Exp(t)]

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63
Q

Describe tax on capital

A
  • Certain types of capital maybe subject to tax (e.g. par surplus)

TaxOnCap(t) = TaxCapital(t) x CapTaxRate(t)

  • Could be assessed in addition to tax on earnings or used as a minimum tax
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64
Q

Describe the purpose and function of DAC tax

A
  • Temporarily increases taxable income as premiums are collected
  • Reversed out over the next 10 years
  • DACTaxAmount(t) = additions to DAC tax - deductions from DAC tax

TaxableEarn(t) = PreTaxSolvEarn(t) + TimingDiff(t) + PermDiff(t) + DACTaxAmount(t)

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65
Q

Describe the treatment of taxes under US GAAP (“stockholder”) accounting

A
  • GAAP accounting reports taxes on an accrued basis
  • Causes taxes to be a level % of pre-tax stockholder earnings
  • DefTaxLiab = liability (or asset if negative) for future tax payments
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66
Q

Describe the treatment of taxes under US GAAP (“stockholder”) accounting

  • Formula: Tax(t)
A

= TaxRate x TaxableEarnings

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67
Q

Describe the treatment of taxes under US GAAP (“stockholder”) accounting

  • Formula: AccruedTax(t)
A

= TaxRate x PreTaxStockEarn(t)

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68
Q

Describe the treatment of taxes under US GAAP (“stockholder”) accounting

  • Formula: DefTaxProv(t)
A

= AccruedTax(t) - Tax(t)

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69
Q

Describe the treatment of taxes under US GAAP (“stockholder”) accounting

  • Formula: AfterTaxStockEarn(t)
A

= PreTaxStockEarn(t) - AccruedTax(t)

=(1 - TaxRate) x PreTaxStockEarn(t)

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70
Q

Describe the treatment of taxes under US GAAP (“stockholder”) accounting

  • Formula: DefTaxLiab(t)
A

= DefTaxLiab(t-1) + DefTaxProv(t)

= TaxRate x [TaxRes(t) - EarnRes(t)]

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71
Q

Describe how the 2018 changes in US tax law will affect life insurers.

A
  1. Higher DAC tax rates (lowers A/T profits)
  2. New tax reserve method based on 92.81% scalar applied to stat reserve
    • Lowers A/T profits (less tax reserve to deduct)
  3. Reduction in tax rate from 35% to 21% (dominate change)
    • Increases A/T profits
  4. Scale RBC factors by a factor of (1-0.21)/(1-0.35) ≈ 122%
    • Lowers A/T profits (higher capital requirements)
    • No guidance from NAIC yet though
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72
Q

List and describe the products whose profit measures increased due to US tax reform

A
  • Current assumption universal life (CAUL)
  • Term under VM-20
  • Indexed universal life (IUL)
    • Insurers could lower COI or keep current pricing
  • Fixed indexed annuity (FIA) with GMWB
    • Insurers could increase option budget or keep current pricing
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73
Q

List and describe the products whose profit measures decreased due to US tax reform

A
  • Par whole life (WL) – may have illustration challenges
  • Term under peak statutory (XXX) and AG 48
    • Loss of tax leverage (less value in tax loss deductions)
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74
Q

Describe the following accounting-based profitability indicators.

  • Book Value Per Share
A

= Book Value/Total Shares

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75
Q

Describe the following accounting-based profitability indicators.

  • Price-to-Book Ratio
A

= Share Price/Book Value Per Share

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76
Q

Describe the following accounting-based profitability indicators.

  • ROE
A

= Shareholder Profits/Shareholder Equity

  • Advantages: Well understood, common
  • Disadvantages: meaningful only at portforlio level
77
Q

Describe the following accounting-based profitability indicators.

  • Operating Margin
A

= Operating Profits/Net Premiums

  • Advantages: Easy to compare
  • Disadvantages: doesn’t reflect timing, CoC, or riskiness
78
Q

Describe the following accounting-based profitability indicators.

  • General Expense Ratio
A

=General Operating Expenses

  • Advantages: Cross-company comparisons
  • Disadvantages: Meaningful only for comparing similar business
79
Q

Describe the following accounting-based profitability indicators.

  • Benefits Ratio
A

=(Policyholder Benefits + Changes in Reserves)/(Premiums + Other Charges and Income)

  • Advantages: Measures mortality/morbidity; easy to understand
  • Disadvantages: Short-term focus is misleading
80
Q

Describe the following accounting-based profitability indicators.

  • Lapse Ratio
A

=Lapsed Policies or Face/In-Force Policies or Face

  • Advantages: Indicates net persistency
  • Disadvantages: May not accurately reflect timing
81
Q

Describe the following accounting-based profitability indicators.

  • Return on Assets (ROA)
A

Return on Assets = Profit/Total Company Assets

  • Advantages: Easy to calculate; common for DAs
  • Disadvantages: Not good for life products: may be volatile
82
Q

Describe the following accounting-based profitability indicators.

  • Net Investment Result
A

= Investment Gains – Impairments

  • Good for products where this is important source of earnings
83
Q

Describe disadvantages of accounting-based indicators

A
  • Statutory focus is solvency, not income
  • Rules vary throughout world
  • Volatility of GAAP and IFRS earnings
  • Poor at comparing new and existing business
  • Not usually meaningful at the product level
  • Assumptions are locked in
  • No accounting for cost of capital
84
Q

Describe market-consistent embedded value

A
  • Assets are based on trading value
  • Liabilities valued using replicating portfolios
  • VIF highly sensitive to assumption changes
  • More downside interest rate risk (asymmetric)
  • Mortality and morbidity risk can be hedged (symmetric)
  • May get trumped by emerging standards (Solvency II, IFRS)
85
Q

Formulas for market-consistent embedded value (understanding profitability in life insurance)

  • MCEV
A

MCEV = VIF + Required Capital + Free Surplus

86
Q

Formulas for market-consistent embedded value (understanding profitability in life insurance)

  • VIF
A

VIF = PV Future Profits - Value of Options and Guarantees
- Cost of Non-Hedgeable Risks - Frictional Cost of Req. Cap.

87
Q

Formulas for market-consistent embedded value (understanding profitability in life insurance)

  • Required Capital
A

Required Capital = MV of Capital Allocated to Support Business

88
Q

Formulas for market-consistent embedded value (understanding profitability in life insurance)

  • Free Surplus
A

Free Surplus = MV of Any Extra Allocated Capital

89
Q

What are the components of an MCEV earnings analysis?

A
  1. New business
  2. Unwinding of existing business
  3. Experience variances and assumption changes
  4. Economic variances
90
Q

Describe the advantages and disadvantages of the following MCEV-based profitability indicators

  • MCEV
A
  • Advantages: Measures long-term value; harmonized
  • Disadvantages: May be volatility or not understood by investors
91
Q

Describe the advantages and disadvantages of the following MCEV-based profitability indicators

  • MCEV Earnings Analysis
A
  • Advantages: Understand MCEV drivers
  • Disadvantages: Can be volatile
92
Q

Describe the advantages and disadvantages of the following MCEV-based profitability indicators

  • Value of In-Force (VIF)
A
  • Advantages: Shows BV net of relevant costs
  • Disadvantages: Can be volatile
93
Q

Describe the following MCEV-based profitability indicators

  • Value of New Business (VNB)
A
  • Advantages: Understand value of NB
  • Disadvantages: May be overly optimistic
94
Q

Describe the following MCEV-based profitability indicators

  • New Business Margin
A

= VNB/NB Premiums

  • Advantages: Compare to expected profit margins
  • Disadvantages: May be overly optimistic
95
Q

Describe the following MCEV-based profitability indicators

  • Return on MCEV
A

= MCEV Earnings/MCEV

  • Advantages: Complements ROE
  • Disadvantages: May be overly optimistic
96
Q

What are the 3 primary sources of earnings for insurers?

A
  1. UW Results - mortality, health, lapse products
  2. Investment Results - savings products
  3. Investment management fee income - unit-linked products
97
Q

What are the primary sources of earnings for insurers and the risk factors that affect them?

  • Underwriting Results
A

Underwriting Results – mortality, health, lapse products

  • Worse-than-expected claims or surrenders
  • Adverse selection and moral hazard
  • Frequent product churning
98
Q

What are the primary sources of earnings for insurers and the risk factors that affect them?

  • Investment Results
A

Investment Results – savings products

  • Insurer’s asset allocation
  • Market performance
  • Level of guarantees
  • Investment expertise
  • Policyholder loss sharing
  • Duration mismatch
99
Q

What are the primary sources of earnings for insurers and the risk factors that affect them?

  • Investment Management Fee Income
A

Investment Management Fee Income – unit-linked products

  • Market volatility
  • Policyholder behavior
100
Q

Compare the earnings emergence patterns between insurance and investment products for each of the account standards:

  • US statutory
  • US GAAP
  • IFRS
  • CALM
  • Market-consistent balance sheet (Solvency II)
A
  • 10-year level term followed by ART (pure insurance)
    • US stat: heavy first year losses
    • Solvency II and CALM: large first year profits
    • US GAAP and IFRS: smoothest earnings
  • Single premium fixed deferred annuity (pure investment)
    • US stat, Solvency II, and CALM: high first year profits
    • US GAAP and IFRS: smoothest earnings
101
Q

Describe the focus of each accounting standard:

  • US statutory
  • US GAAP
  • IFRS
  • CALM
  • Market-consistent balance sheet (Solvency II)
A
  • Balance sheet focus: US statutory and Solvency II
    • No mechanism to defer early gains/losses
  • Income statement focus: US GAAP and IFRS
    • Various mechanisms to defer profits
  • Dual focus: CALM
    • Mostly driven by PfAD release
102
Q

How do earnings emerge for term insurance for US statutory?

A

large initial loss followed by high annual profits

  • Year 1 loss driven by:
    • Non-deferral of high acquisition costs
    • Large initial reserves (mostly deficiency reserves)
  • Year 2+: larger positive earnings than other bases (release of reserves)
103
Q

How do earnings emerge for term insurance for US GAAP?

A

very stable earnings each year

  • DAC offsets acquisition costs and defers
  • Income emerges in proportion to premiums and as PADs are released
104
Q

How do earnings emerge for term insurance for CALM?

A

GPV front-ends profits

  • No mechanism to defer gains at issue
  • PfAD release drives profits after first year
105
Q

How do earnings emerge for term insurance for IFRS?

A

very stable (similar to but not quite as stable as US GAAP)

  • CSM defers profit, then releases over time
  • Large spike at end of level period (risk adjustment release)
106
Q

How do earnings emerge for term insurance for Solvency II?

A

similar to IFRS, but much larger initial gain

  • No CSM to defer profit
107
Q

How do earnings emerge for fixed deferred annuities for US GAAP?

A

very stable each year

  • DAC offsets acquisition costs and defers
  • Income is based on fees and investment margins
108
Q

How do earnings emerge for fixed deferred annuities for US statutory?

A

large year 1 profit, followed by a declining then rising pattern

  • Falls through SC period (CARVM reserve Account Value)
  • Rises substantially after SC period
109
Q

How do earnings emerge for fixed deferred annuities for CALM?

A

GPV front-ends profits (highest of all methods)

  • No mechanism to defer gains at issue
  • PfAD release drives profits after first year
110
Q

How do earnings emerge for fixed deferred annuities for IFRS?

A

very stable and very similar to US GAAP

  • CSM defers profit, then releases over time
111
Q

How do earnings emerge for fixed deferred annuities for Solvency II?

A

very high year 1 profits (2nd only to CALM)

  • No CSM to defer profit
112
Q

Describe the effect of various slope-introducing variables (SIVs) on GAAP ROI for a level term product

  • Positive sloping SIVs
A

(cause GAAP ROI to rise)

  • DAC interest rate
  • GAAP mortality > pricing
  • GAAP interest rate
113
Q

Describe the effect of various slope-introducing variables (SIVs) on GAAP ROI for a level term product

  • Negative sloping SIVs
A

(cause GAAP ROI to fall)

  • DAC tax > 0
  • RC on assets and reserves > 0
114
Q

Describe the effect of various slope-introducing variables (SIVs) on GAAP ROI for a level term product

  • Stat reserve method
A
  • Unitary: positive sloping
  • XXX segmented: negative sloping
115
Q

List variables that change the level of GAAP ROI but not slope

A
  1. Premium rate per thousand and policy size
  2. Slope and level of mortality rates
  3. Lapse rates (as long as GAAP = pricing)
  4. Earned interest rate on required capital
  5. Tax rate
  6. Reinsuring with coinsurance
  7. Commissions and expenses (both direct and ceded)
  8. Required capital based on direct premiums
116
Q

Categorize GAAP ROI = IRR

A

Level GAAP ROI conditions are not possible in practice!

117
Q

List general factors to keep in mind for SOE

A
  1. Focus on significant profit drivers
  2. SOE is an art
  3. Internal management tool
  4. As sophistication of analysis increases, understanding decreases
  5. SOE principles are independent of accounting regime
118
Q

What are the 3 traditional objectives of SOE analysis?

A
  • Link profits directly with significant economic and actuarial drivers
    • Traditional income statements are not very good at this
  • Evaluate actual profits relative to valuation assumptions
  • Evaluate actual profits relative to other expectations (e.g. plan/forecast, pricing)
119
Q

How can SOE be used as a management tool?

A
  • SOE expectations should be realistic
  • Benefits of using pricing assumptions for expected basis
    • Promotes alignment of earnings and pricing objectives
    • Actual results are feedback for pricing
    • Pricing assumptions are usually already in an SOE-like format
  • Should connect management actions/responsibilities with results
  • SOE shows how different business units performed
  • Common earnings language for international companies
120
Q

List requirements for implementing an SOE analysis framework

A
  • Need program that does projections of SOE
  • Must choose a level of precision
  • Must account for effects from changing formulas
  • Must account for timing differences in accruals
  • Include riders, supplemental benefits, etc.
  • Reinsurance impact
  • Formulas used will change by type of product
121
Q

List challenges when implementing an SOE analysis framework

A
  • As level of detail increases, credibility decreases
  • Complex products are logistically hard
  • Updating actuarial assumptions
  • Reconciling data across different systems
122
Q

Write out the Fackler reserve formula

A

(Vt + NP - ME) x (1 + ig) - qx(w) x CSV - (qx(d) x DB) = tpx x Vt+1

123
Q

Write out all the pieces of the FAS 60 analysis of change in reserve:

  • Renewal Net Premium
A
  • GAAP Basis
  • +l*xNP
  • Actual’ or Plan’’ Basis
  • +l*xNP
124
Q

Write out all the pieces of the FAS 60 analysis of change in reserve:

  • Beginning Reserve
A
  • GAAP Basis
  • l*xVt
  • Actual’ or Plan’’ Basis
  • l*xVt

*where (qx’ - qx)Vt+1 = experience adjustment on death or lapse

125
Q

Write out all the pieces of the FAS 60 analysis of change in reserve:

  • Tabular Interest
A
  • GAAP Basis
  • +l*x(ig)(Vt + NP - ME)
  • Actual’ or Plan’’ Basis
  • +l*x(ig)(Vt + NP - ME)
126
Q

Write out all the pieces of the FAS 60 analysis of change in reserve:

  • Reserve Released on Death
A
  • GAAP Basis
  • -l*xqx(d)DB
  • Actual’ or Plan’’ Basis
  • -l*x [qx(d)DB + (q’x(d) - qx(d))Vt+1]

*where (qx’ - qx)Vt+1 = experience adjustment on death or lapse

127
Q

Write out all the pieces of the FAS 60 analysis of change in reserve:

  • Reserve Released on Lapse
A
  • GAAP Basis
  • -l*xqx(w)CSV
  • Actual’ or Plan’’ Basis
  • -l*x [qx(w)CSV + (q’x(w) - qx(w))Vt+1]

*where (qx’ - qx)Vt+1 = experience adjustment on death or lapse

128
Q

Write out all the pieces of the FAS 60 analysis of change in reserve:

  • Ending Reserve
A
  • GAAP Basis
  • l*x(1px)(Vt+1)
  • Actual’ or Plan’’ Basis
  • l*x(1p’x)(Vt+1)
129
Q

Write out the formulas for calculating SOE variance directly:

  • Profit Margin Variance
A

Actual’-to-Plan’’ Variance:

lx x GP - lx x GP = 0

130
Q

Write out the formulas for calculating SOE variance directly:

  • Inv. Inc. Experience Variance
A

Actual’-to-Plan’’ Variance:

lx x (i’ - i’’) x (Vt + NP - ME)

131
Q

Write out the formulas for calculating SOE variance directly:

  • Mortality Experience Variance
A

Actual’-to-Plan’’ Variance:

lx x (qx’‘(d) - qx‘<span>(d)</span>) x (DB - Vt+1)

132
Q

Write out the formulas for calculating SOE variance directly:

  • Surrender Experience Variance
A

Actual’-to-Plan’’ Variance:

lx x (qx’‘(w) - qx‘<span>(w)</span>) x (CSV - Vt+1)

133
Q

Write out the formulas for calculating SOE variance directly:

  • Expense Experience Variance
A

Actual’-to-Plan’’ Variance:

lx x (ME’’ - ME’)

134
Q

Write out formulas for a FAS 97 SOE analysis

  • FAS 97 Profit
A

= Profit Margin + Investment Spread + Claims Experience
+ Expense and DAC Experience

135
Q

Write out formulas for a FAS 97 SOE analysis

  • Profit Margin
A

= (COI Charges - Expected Claims Paid) + Expected Spread Income + (Expense Charges - DAC and ME Funding)

136
Q

Write out formulas for a FAS 97 SOE analysis

  • Investment Experience
A

= (Net Investment Income - Interest Credited) - Expected Spread

=”Investment Spread” - Expected Spread

137
Q

Write out formulas for a FAS 97 SOE analysis

  • Claims Experience
A

= - (DB - Account Value) + Reserve Released on DB

138
Q

Write out formulas for a FAS 97 SOE analysis

  • Expense and DAC Experience
A

= DAC and ME Funding - Expenses - DAC Amortization + DAC True-Ups

139
Q

What are the shortcomings of artificial value measurement systems?

A
  1. Mask true value in a company
  2. Mislead managers about key risks
  3. Vary greatly across product lines and countries → comparisons are difficult
  4. Overly conservative
140
Q

How are insurers financial intermediaries?

A
  1. Liability-driven financial intermediaries
  2. Reduce policyholder’s credit exposure
141
Q

How do insurers create value?

A
  1. Selling contracts for more than the production and frictional costs
  2. Achieving investment returns greater than base CoC benchmark
142
Q

Franchise Value

A

= Total Company MV - Economic Net Worth

143
Q

Total Company MV

A

= sum of:

  1. Future profits on current business
  2. Future profits on future new business
144
Q

Economic Net Worth

A

= MV Assets - Economic Value of Liabilities

145
Q

What are the components of an insurer’s cost of capital, and how is it different from a leveraged investment fund?

A

CoC = opportunity cost of shareholders’ capital

  • An insurer’s CoC is higher than a leveraged investment fund’s CoC

Insurer CoC = Base CoC + Frictional Costs + Liquidity Value + Option to Default

Base CoC = Benchmark Portfolio Return - Replicating Portfolio Return

146
Q

Basic steps to establish a replicating portfolio

A
  1. Project liability cash flows (premiums, claims, expenses, etc.)
  2. Project frictional costs
  3. Calculate net liability cash flow at each future point in time
    • Net CF = Premiums – Claims – Expenses – Frictional Costs
  4. Economic Liability = PV(Net CF) at risk-free rate
147
Q

Replicating Portfolio MV formula

A

= Economic Value of the Liabilities

= Long zero-coupon bonds to match years with negative net – Short zero-coupon bonds to match years with positive net CF

148
Q

Replication risk

A

inability to find a portfolio that replicates liability cash flows

149
Q

List 4 kinds of frictional capital costs

A
  1. Agency Costs
  2. Cost of Financial Distress
  3. Regulatory Restriction Costs
  4. Double Taxation
150
Q

Describe Agency Costs

A
  • Compensates Shareholders for:

Lack of transparency

  • Value:

5–200 bps of total capital

151
Q

Cost of Financial Distress

A
  • Compensates Shareholders for:

Risk of insurer insolvency

  • Value:

10–20% of market value

152
Q

Regulatory Restriction Costs

A
  • Compensates Shareholders for:

Not being to use capital elsewhere

  • Value:

0–200 bps of restricted capital

153
Q

Double Taxation

A
  • Compensates Shareholders for:

Taxes paid on income before it can be distributed to shareholders

  • Value:

Tax Rate x Taxable Income

154
Q

What are the 5 drivers of the cost of risk-taking?

A
  1. Base CoC
  2. Double Tax
  3. Cost of Financial Distress
  4. Agency Costs
  5. Regulatory Capital Costs
155
Q

What are the 5 drivers of the cost of risk-taking?

  • Base CoC
A
  • Base CoC – Minimum benchmark return for asset management
156
Q

What are the 5 drivers of the cost of risk-taking?

  • Double Tax
A
  • Double Tax – Insurers may seek low-tax investments
157
Q

What are the 5 drivers of the cost of risk-taking?

  • Cost of Financial Distress
A
  • Cost of Financial Distress – Franchise value size drives risk capital / risk transfer needs
158
Q

What are the 5 drivers of the cost of risk-taking?

  • Agency Costs
A
  • Agency Costs – Mitigate by increasing reputation value
159
Q

What are the 5 drivers of the cost of risk-taking?

  • Regulatory Capital Costs
A
  • ​Regulatory Capital Costs – Driven by regulatory environment
160
Q

Describe an insurer’s liquidity value

A
  • Liquidity Value
    • When the insurer earns a spread over risk-free rate by investing in less liquid assets
161
Q

Describe an insurer’s option to default

A
  • Insurer’s Option to Default
    • An insurer won’t be able to pay its liabilities if insolvent
    • Adds risk to insurance cash flows—from policyholder’s perspective
    • If an insurer defaulted, franchise value would be hurt
162
Q

What are the key points relating to an insurer’s liquidity value and option to default?

A
  • Both are an asset relative to the existing liabilities
  • Value = difference in PV of insurance cash flows. . .
    1. Discounted at risk-free rates
    2. Discounted at risk-free rates plus a spread (e.g. 50 bps)
  • Both are part of restricted capital (can’t be distributed)
163
Q

How do you calculate economic profit?

A

Economic Profitt = Net CF after Frictional Costst + InvReturnt - (EVLt - EVLt-1)

InvReturnt = Replicating Portfolio MVt - Replicating Portfolio MVt-1

164
Q

Describe the treasury function and performance attribution analysis

  • Treasury function and transfer pricing
A
  • Treasury function and transfer pricing
    • Separates underwriting profits from investment gains/losses
165
Q

Describe the treasury function and performance attribution analysis

  • Insurance attribution analysis
A
  • Insurance attribution analysis
    • Impact of new business
    • Deviations from expected experience
166
Q

Describe the treasury function and performance attribution analysis

  • Investments attribution analysis
A
  • Investments attribution analysis
    • Asset allocation effects
    • Currency selection
    • Stock selection
    • Sector selection
167
Q

How can a company set economic value targets?

A
  • If actual economic profit > expected economic profit, share prices increases
  • Base on long-term interest rates
  • Consider impact of new business
  • Benchmark against other companies
168
Q

How can a company set incentive compensation?

A
  • Link directly to economic value creation
  • Reward good decisions on an ex ante basis (before risks are realized)
  • Don’t give managers a free put option
  • Don’t based incentives solely on economic profit for high-risk business with
  • extreme swings
  • Suggested approach:
    1. Set baseline target bonus
    2. Adjust bonus based on manager or business unit performance
169
Q

List 2 types of non-economic methods of estimating insurance profitability

A
  1. Embedded Value = PVDE
  2. RAROC = PV(Economic Profit) / (Risk Capital)
170
Q

Describe embedded value as a non-economic method of estimating insurance profitability and what are it’s shortcomings?

A

Embedded Value = PVDE

  • Biased toward higher-yielding assets
  • Ignores frictional costs other than regulatory restrictions
  • Regulatory capital charges are highest for lowest yielding assets
  • Does not easily accommodate options and guarantees
171
Q

Describe risk-adjusted return on capital (RAROC) as a non-economic method of estimating insurance profitability and what are it’s shortcomings?

A

RAROC = PV(Economic Profit) / (Risk Capital)

  • Assumes all capital costs are proportionate to economic capital
  • Hurdle rate is based on CAPM, which ignores frictional costs
    • Don’t use CAPM for CoC!
  • Only considers capital in first year
  • Discounts expected returns at the expected earned rate
  • Creates incentives to take investment risk
172
Q

Define the following:

  • VM-20
A
  • VM-20 – VM section containing PBR methodology
    • Replaces XXX and AG38 with principles-based approach
    • Reserve is generally much lower (especially term)
173
Q

Define the following:

  • Model 830 Reserves
A
  • Model 830 Reserves (a.k.a. XXX or AG38 reserves)
    • XXX = US stat reserving for term
    • AG38 (“AXXX”) = US stat reserving for ULSG
174
Q

Define the following:

  • AG48
A
  • AG48 – governs XXX/AG38 financing transactions
    • Insurers often finance the excess XXX/AXXX reserve
    • Methods: securitizations, captive reinsurance, etc.
175
Q

Describe how reserves are determined under VM-20

  • Excess Reserve: SR
A
  • SR = aggregate stochastic CTE 70 reserve
    • Same liability cash flows as DR
    • Asset performance and discount rates vary by scenario
    • Calculate the greatest PV of accumulated deficiencies (GPVAD) for each scenario
    • CTE 70 = average of the 30% worst GPVADs
176
Q

Describe how reserves are determined under VM-20

A

VM-20 Reserve = NPR + Excess Reserve

177
Q

Describe how reserves are determined under VM-20

  • NPR
A
  • NPR = formulaic reserve with prescribed assumptions
    • Valuation interest rate locked in at issue
178
Q

Describe how reserves are determined under VM-20

  • Excess Reserve
A

Excess Reserve = max(DR, SR) - NPR, if any

179
Q

Describe how reserves are determined under VM-20

  • Excess Reserve: DR
A
  • DR = deterministic gross premium reserve (PV Ben - PV Gross Premiums)
    • Mix of prescribed and experience assumptions
    • Discount rate and experience assumptions can change after issue
180
Q

Describe how the following will impact level term profitability.

  • Changing from the 2001 CSO to 2017 CSO mortality table
  • Changing from XXX to VM-20 reserving
A
  • Before VM-20 (under XXX stat reserving)
    • Financed products are most profitable
      • Heavy tax benefit since tax reserve = unfinanced XXX reserve
    • 2017 CSO helps non-financed but hurts financed (reduces tax benefit)
  • After VM-20 and 2017 CSO:
    • Non-financed products are better off
    • Financed products are worse off
181
Q

Describe how the following will impact ULSG profitability.

  • Changing from the 2001 CSO to 2017 CSO mortality table
  • Changing from AG38 to VM-20 reserving
A
  • Before VM-20 (under AG38 stat reserving)
    • Financed products are most profitable
      • Heavy tax benefit since tax reserve = unfinanced AG38 reserve
    • 2017 CSO hurts (deficiency Vx’s counteract relief)
  • After VM-20 and 2017 CSO:
    • Immaterial impact on non-financed products
    • Financed products are worse off
182
Q

Describe key product design considerations for companies who plan to continue selling term and ULSG products after VM-20

A
  • Financing XXX/AG38 reserves generates heavy tax benefits
    • Highest IRR and lowest surplus strain
  • Tax benefits are higher under 2001 CSO mortality than 2017 CSO
  • VM-20 lowers reserves but eliminates tax benefits (assuming no financing)
  • Term writers that do NOT finance reserves will have higher profits
    • Or be able to lower premiums to gain competitive advantage
  • Term and ULSG writers that finance reserves will see profits fall
    • May have to raise premiums
    • May have to change (simplify) ULSG product design
183
Q

Describe the impact of the following sensitivities to level term and ULSG products priced under VM-20:

  • Reduce gross premium by 10% (term only)
A
  • Reduce gross premium by 10% (term only)
    • Significantly hurt term IRR (cut in half)
    • Key point: lower GP hurts cash flow AND increases DR
184
Q

Describe the impact of the following sensitivities to level term and ULSG products priced under VM-20:

  • Mortality improvement assumed in pricing is not realized
A
  • Mortality improvement assumed in pricing is not realized in DR
    • Hurts IRR slightly due to loss of tax benefits (tax Vx lower)
    • Key point: tax benefits are maxed when VM-20 reserve = NPR
185
Q

Describe the impact of the following sensitivities to level term and ULSG products priced under VM-20:

  • Assume discount rates set at pricing are never changed
A
  • Assume discount rates set at pricing are never changed
    • No impact on term since NPR prevailed already
    • Hurt ULSG profits since max(DR, SR) > NPR
186
Q

Describe considerations for the following issues as companies transition to pricing
under VM-20:

  • Possible changes to ULSG design
A
  • ULSG designs may get simpler since AG38 goes away
  • ULSG products may begin emphasizing accumulation more (or offer ROP)
    • VM-20 requires low ultimate T100 lapses for minimally funded ULSG
    • Higher accumulation values = higher incentive for policyholder surrender
    • If companies can justify higher lapse rates, VM-20 reserve will fall
187
Q

Describe considerations for the following issues as companies transition to pricing
under VM-20:

  • Small vs. large companies
A
  • Smaller companies may be less competitive due to lack of credible experience
188
Q

Describe considerations for the following issues as companies transition to pricing
under VM-20:

  • Reinsurance pricing
A
  • Reinsurance pricing will become more robust, but must be done just as fast
189
Q

Describe considerations for the following issues as companies transition to pricing
under VM-20:

  • Allocating aggregate reserves
A
  • Aggregate SRs must be allocated to cell level for pricing
    • More of an issue for ULSG since SR is more material

ILA Track (5 decks)

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