Participating Policies

The policies we have looked at so far have all made payments which are
clearly defined at the outset. They include:
• Constant sum insured or annuity payment
• Payments that vary arithmetically or geometrically, with the rate of
increase (or decrease) being precisely defined in the policy document.
We now consider policies where a share of the profits arising from the
policy is given back to those policies.
• This means the size of future benefits is not known at the outset.
• Usually, the profit sharing involves increasing the size of future benefits.
• The profit returned to policies is called “bonus”.
• The UK syllabus calls these “With profit policies”. In Australia, they are
usually called “participating policies”, since that’s the label used in the
relevant Australian legislation, the Life Insurance Act 1995.
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Profits may arise from:
• Explicit loadings in the premium calculations
• Investment earnings exceeding assumptions
• Mortality being lower than expected (whole life, endowment insurance,
term insurance) or higher than expected (life annuity, pure endowment.)
• Operating expenses being lower than expected.
History
• When the life insurance industry first sold long term policies like whole
life policies and endowment insurances, they did not have reliable
mortality data, so they used conservative assumptions.
• The conservative assumptions caused large profits.
• Most of these insurers were mutuals (owned by their policy owners,
rather than having shareholders.)

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• Hence they distributed the profit back to the participating polices as
bonus.
Current practice
• For participating policies, the declaration of bonus has become a major
marketing feature.
• Bonuses are now explicitly allowed for in the pricing process.
• That is, we decide what bonus rates we’d like to declare and determine
the premium rate that will allow us to declare that level of bonus. The
major source of profit is thus an explicit loading in the premium rate.
• However, bonus rates are not guaranteed. Profit might still be better or
worse than planned for, due to experience being better or worse than the
assumptions, so the bonus rates declared might still differ from the
planned levels, but most insurers aim to keep bonus rates relatively
stable from year to year.

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• The marketing material for a policy may include “projections” showing
how the benefits would grow based on particular assumed bonus rates.
Which policies are participating?
• In Australia, whole life policies and endowment insurance are almost
always sold as participating policies.
• The UK syllabus also mentions life annuities. Some Australian insurers
have sold participating life annuities, but they are not common. Most
life annuities are instead sold with guaranteed compound increases,
either at a fixed rate or linked to CPI.
• The UK syllabus also mentions deferred annuities. These are not
encountered in Australia. (In Australia there is a superannuation rollover
product called a deferred annuity, but it not the same thing as the
deferred annuity described in this unit.)

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Types of Bonus
(a) Reversionary bonuses
• Increases to the sum insured declared on each policy anniversary.
• Once declared, they are guaranteed and cannot be removed.
• In practice, when a claim occurs, most insurers will add some bonus for
the fraction of a year since the last policy anniversary. Here we ignore
this, since we only learn how to value benefits that stay constant within
each policy year.
(b) Terminal bonuses

• Additional increases granted when a claim occurs.

• These are not guaranteed.
• Terminal bonuses tend to be used for unexpected profit where there are
doubts as to whether it will continue. For example, maybe we had

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 unexpectedly high investment returns, but we are worried the market is
overvalued and may be heading for a crash.
• Due to its unexpected nature, it is not planned for in premium
calculations, so we do not consider terminal bonuses further in this unit.
Types of Reversionary Bonus
Notation
Let S denote the initial sum insured.
Let b denote the bonus rate p.a.
Let St be the total potential benefit (initial sum insured + bonus) at time t,
t = 0,1, 2,… , immediately after the declaration of any bonus occurring at
that time.
Theoretically, bonuses may be

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1. Simple

• Arithmetic increases.
• St = S (1 + bt ) t = 0,1, 2,…
2. Compound
• Geometric increases.
• St = S (1 + b )
t
t = 0,1, 2,…
3. Super compound

• Also known as two-tiered reversionary bonus.

• Say bonus rates are b p.a. of the initial sum insured and c p.a. of the
previously declared bonus. In practice c > b .
• Recursive formula: St +1 = St + bS + c ( St − S ) , t = 0,1, 2,…
b b
• Direct formula: St = S  (1 + c ) + 1 −  t = 0,1, 2,…
t
c c
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Derivation of direct formula
St +1 = St + bS + c ( St − S )
= St (1 + c ) − ( c − b ) S
= α St − β
where α = 1 + c and β = S ( c − b ) . Successive substitution gives
S1 = α S0 − β
S2 = α S1 − β = α 2 S0 − αβ − β
S3 = α S2 − β = α 3 S0 − α 2 β − αβ − β
Hence we guess:

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 (
St = α t S0 − β 1 + α + ⋯ + α t −1 )
α t −1
=α S − β
t
α −1
(1 + c ) − 1
t
= (1 + c ) S − S ( c − b )
t
c
b b
= S  (1 + c ) + 1 − 
t

c c
The guess can be formally proved with mathematical induction (see tute
exercises). The result can also be derived by solving a linear difference
equation.
Australian Practice

• Since the late 1970s, new participating whole life and endowment
insurances were sold with super compound bonuses.

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• Prior to that, these policies were written with compound bonuses. Most
insurers still have some of those older policies in force.
• Simple bonuses are not encountered.
Premium Calculations

• The question will indicate the type of and level of desired bonus and we
load the premium appropriately.
• The breakeven premium still aims to have EPV(Future loss) = 0, so we
still aim to have
EPV ( Premiums ) = EPV ( Benefits )
• The benefits include the desired bonus.
• We already know how to value simple bonuses and compound bonuses.
We did arithmetic and geometric increases last week, where they were
guaranteed increases rather than planned but not guaranteed increases.
• The direct formula for super compound bonuses indicates we can value
benefits as a compound increase component and a level component.
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Policy value calculations
Bonuses are guaranteed once declared. Hence policy values must allow for
the actual past reversionary bonuses declared.
• These may differ from the planned level used in the premium
calculations.
Should they allow for future planned bonuses?
• Usually yes. Most valuations treat the business as a “going concern”. If
we don’t continue declaring bonuses on the in-force business, it will
damage our reputation and we will find it very difficult to sell any new
participating business.
• Occasionally no. Some regulators require insurers to demonstrate
solvency on a “wind-up” basis. That is, assuming the insurer is closed to
new business, demonstrate the insurer can still meet all its expected
liabilities arising from the in-force business. This severe scenario

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 usually assumes the insurer makes use of all legal means to minimise
liabilities, which might include never declaring another bonus.
Prospective or Retrospective?

• In practice, profit reporting and solvency testing use prospective policy

values.
• Prospective and retrospective policy values will be equal if they are
calculated on the premium basis, the premium was the break-even
premium allowing for planned bonuses, and declared bonuses exactly
followed the allowance in the premium.
• That is, it’s so uncommon that it’s not worth learning how to calculate a
retrospective policy value for a participating policy.
• So, in this topic, we only consider prospective policy values.

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Whole Life Example
The initial sum insured is $100,000. Death benefits are paid at the end of
the year of death. Premiums are paid annually in advance. The customer is
a male aged 30. Provide formulae which could be used to solve the
following problems.
Basis AM92 Select 6%.
(a) Find the premium assuming it includes a loading for a simple bonus
of 3% p.a.

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(b) 10 years later, immediately after the 10th bonus is added, declared
bonuses total $35,000. (This does NOT match the original plan.) Find
the prospective policy value on a wind-up basis with no allowance
for future bonus.

(c) Similarly, find the prospective policy value assuming future bonuses
at 4% p.a. (The TYPE of the bonus applied to a policy does not
change, so this means 4% p.a. simple.)

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(d) Determine the premium assuming compound bonuses at 1.923% p.a.

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(e) 10 years later, immediately after the 10th bonus is added, declared
bonuses total $20,000. (This does NOT match the original plan.) Find
the prospective policy value assuming future bonuses accrue at 2%
p.a.

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(f) Find the premium assuming there is a 2-tiered reversionary bonus,
with bonuses calculated at 3% of the basic sum insured and 5% of
existing bonus.

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We will not consider how to determine policy values under two-tiered
bonuses. While the formula given for St can be adjusted to cope with past
bonus rates differing from planned future rates, in practice the problem is
likely to be solved by a projection system that can apply a recursive
formula, rather than by using assurance functions.

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Equality of Prospective and Retrospective Policy Value
Logically, this belongs in the previous topic, where benefits were
guaranteed, but there wasn’t time, so it’s landing here. (Or it could be
placed in the next topic, since it can also be adapted to allow for operating
expenses.)
Let the potential Premium at time t be Pt , t = 0,1, 2,…
Let the potential Survival benefit paid at time t be St , t = 1, 2,3,…
Let the potential death benefit for year t be M t , t = 1, 2,3,… We assume this
is paid at end of year of death, which is time t.
These are functions, not random variables. They tell us how big a cash flow
is IF it happens.
With appropriate values set to zero, this structure covers a wide range of
policies.

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Whole life: St = 0 , t = 1, 2,3,…
n-year Endowment Insurance:
Pt = 0 , t = n, n + 1, n + 2,…
M t = 0 , t = n + 1, n + 2, n + 3,…
St = 0 everywhere except t = n
Life annuity:
P0 is the single premium. All other Pt = 0
M t = 0 for all t.
The premiums occur at (think just after) the start of the year and the
benefits are paid at (think just before) the end of the year.

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 M 1 , S1 M t , St
P0 P1 Pt

0 1 t

For the EPV of premiums to equal the EPV of benefits, we require

P0 + P1v 1 p x + P2 v 2 2 px + … = M 1vqx + M 2 v 2 1 | qx + M 3 v 3 2 | qx + …
+ S1vpx + S2 v 2 2 p x + S3v 3 3 p x + …
Move all items referring to cash flows in the first t years to the LHS and
everything else to the RHS. Write the probability terms on the RHS as
fractions.

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 P + Pv p + P v 2 p + … + P v t −1 p 
t −1 t −1 x
 0 1 1 x 2 2 x

 − ( M 1vqx + M 2 v 2 1 | qx + M 3 v 3 2 | qx + … + M t v t t −1 | q x )

 
 − ( S1vp x + S2 v 2 2 p x + S3v 3 3 px + … + St v t t px ) 
 
t +1 d x + t t + 2 d x + t +1 t +3 d x +t + 2
 M t +1v + M t +2 v + M t +3v + …
 lx lx lx 
 t +1 l x + t +1 t +2 l x +t +2 t +3 l x +t +3

=  + St +1v + St + 2 v + St + 3 v +… 
 lx lx lx 
  l l l  
 −  Pvt
t x +t
+ Pt +1 v t +1 x + t +1
+ P t +2 v t +2 x +t +2
+ … 
  lx lx lx  
Dx t lx
We know = (1 + i ) .
Dx +t lx +t

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 Dx t lx
Multiply the LHS by and the RHS by (1 + i )
Dx +t lx +t
 P + P v p + P v 2 p + … + P v t −1 p 
t −1 t −1 x
 0 1 1 x 2 2 x

 − ( M 1vqx + M 2 v 2 1 | qx + M 3v 3 2 | qx + … + M t v t t −1 | q x )
Dx

Dx + t  
 − ( S1vpx + S2 v 2 2 px + S3 v 3 3 p x + … + St v t t p x ) 
 d x +t 
2 d x + t +1 3 d x +t + 2
 M t +1v + M t +2 v + M t +3 v + …
 l x +t l x +t l x +t 
 l x +t +1 2 l x +t +2 3 l x +t +3

=  + St +1v + St + 2 v + St + 3 v +… 
 lx +t l x +t l x +t 
  l x +t +1 l  
 −  Pt + Pt +1v + Pt + 2 v 2 x +t + 2 + …  
  l x +t lx +t  
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That is tV − = tV +
We have assumed the policy values are calculated on the premium basis
and that the premium calculation does not include any profit loadings.
If premiums were paid more frequently, say monthly, we’d need to adjust
the premium expressions to allow for this, but essentially the same method
works.
Operating expenses (next topic) can also be easily built into the above
structure.

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