Chapter 11 Pricing & Valuation in j _. Life Insurance cHUsSS CHAPTE NG & VALUATION IN LIFE AGENDA: 1. Insurance Pricing - Basic Elements A. Insurance Premium 2. Life Insurance Premiums ‘A Premium B. Rebates a) Rebate for Sum-Assured SS ) Rebate for Mode of Premium C. Extra Charges D. Determining the Premium — 1) Mortality and Interest. 2) Expenses and Reserves 3) Profit Policies and Bonus Loading 4) Surplus and Bonus 5) Bonus 6) The Contribution Method 7) Unit Linked PoliciesCHAPTER -11_ PRICING & VALUATION IN LIFE INSURANCE {Insurance Pricing - Basic Elements A. Insurance Premium - Price (expressed asa rate) paid by an insured for purchasing a - Transfer of risk to the insurer. surance policy. 2. Life Insurance Premiums A. Premium Premium rates in the form of table of rates (“Office Premium’). + Typically level annual premium. B. Rebates (Discount) a) Rebate for Sum-Assured «For high amount. Because the cost of services (underwriting, processing etc) is the same. ) Rebate for Mode of Payment - The more frequent the mode of payment (eg: monthly), the more the cost of service. C Extra Charges (Loadings) - For substandard lives (eg: health issues, occupational hazard etc) cHUsSS CHAPTER -11_ PRICING & VALUATION IN LIFE INSURANCE 2. Life Insurance Premiums D. Determining the Premium Premium rates in table (done by an actuary). Process of setting the premium are; i) Mortality (also called “Risk” premium) Interest rate j) Expenses of management iv). Reserves (Eg: Claims Reserves and Capital Reserves) ¥)_ Bonus loading (Eg: for Participating plan) 4) Mortality and Interest - Mortality is the chance/likelihood that a person ofa certain age would die in a given period, ‘Use "Mortality table” to provide an estimate of the rate of mortality for different ages. Eg: Mortality rate for age 35 is 0.0035 means out of 1,000 people 35 will die. insured. i Interest Rate - means insurer also earn interest from the premium. ¥ The higher the mortality rate, higher the premium because of higher risk The insurance rate for 000 MMK sum insured is therefore 1,000 x 0.0035 = 3.5MMK per 1,000 sum ¥ The higher the interest rate, the lower the premium because insurer makes money from interest. Therefore, they can charge lower premium.CHAPTER -11_ PRICING & VALUATION IN LIFE INSURANCE err 2 Life lsurance Premiums D. Determining the Premium [ie ae | Se Net Premium Sis [ anf ea Net Prem Moray erst aes 3p Gross Premium “+ Gross premium = Nef Premilim + Loading amount (Eg, Bonus loading, Risk loading) rhe amount of Loading depends on the below; D Adequacy ‘Total loading from all policies must be sufficient to cover the company’s total operating expenses. It should also provide a margin of safety. It should also contribute to the profits of the company. i) Pquity Expenses and safety margin should be equally or equitably shared and divided among various kinds or clas of policies (eg: each class of policy pay for its own costs) iii) Competitiveness Gross premium after loading should not be too high and costly for customers. cHUsSS CHAPTER -11_ PRICING & VALUATION IN LIFE INSURANCE 2. Life Insurance Premiums ili) & iv) Expenses and Reserves Life insurers have to incur various types of operating expenses: a) Agents training & recruitment 1b) Commissions (as % of premium) ©) Medical fees, policy stamps etc (higher the sum insured, higher the expenses) d) Overheads eg: Staff salaries, office space, stationery, electricity etc Allthese expenses are “loaded” to the net premium (to get gross premium). 4 Insurers incur 2 types of expenses 1) New business expenses Substantial in inital years. Also required by law to keep reserves to meet obligations. - Expenses & Reserves are higher than initial premiums received by life insurer in the initial years. - Initial outflow is only recovered from subsequent year premiums. Thus, cannot afford to have large no of policies lapsed in initial years. ii) Renewal expenses Lapses and contingencies ~ Actual expenses may be different from assumptions due to lapses and withdrawals.CHAPTER -11_ PRICING & VALUATION IN LIFE INSURANCE 2. Life Insurance Premiums -v) Bonus Loading - for Participating (With Profi Policies Net Premium = Mortality Rate + Interest Gross Premium = Net premium + Expenses & Reserves + Contingencies + Bonus loading Mortality + Interest Age] SA] woraiiy | meresr [ner Texpenses | ReSev® ] Risk | Bonus | OFOS ewig | kisk kate | ate % | Premium Losing [Loading} Premium 1s | 1000 | 0002 | % MMK | MMK | _MMK | MMK | MMK | MMK 19 | 1000 | 00024 1000] 0.0028 1000 | 0.00% alalale cHUsSS CHAPTER-11_ PRICING & VALUATION IN LIFE INSURANCE 2. Life Insurance Premiums Surplus and Bonus: aa 2) Determination of Surplus and Bonus Seplis Aseete Leal Insurers do valuation of assets and liabilities to: {)Toassess the financial tate of the company (eg: solvent or insolvent). ii) Todetermine at end of accounting period) any surplus for policyholders & shareholders + Liabilities are all future payments/claims that have to be made by insurer, less of all premiums expected to VEETTIlilCHAPTER -11_ PRICING & VALUATION IN LIFE INSURANCE 3 Ways of Valuing Assets '). Book value (eg, Depends on Accountant) ii) Market value (eg. Depends on Market) iii) Discounted Present Value- In order to understand Discounted Present Value, first we have to understand “Present Value” and "Future Value” Rate of Return 8% Present Value Future Value $1 ga year later Discounted Present Value cHUsSS CHAPTER -11_ PRICING & VALUATION IN LIFE INSURANCE 2. Life Insurance Premiums How Surplus and Bonus are distribut Surplus + Surplus is for Participating “With Profit life policy (as Dividend/Bonus) ~ Also for increasing company’s basic capital (equity or net worth) and financial soundness. Allocating the Surplus {) For solvency requirement. ii) Free up your Assets (insurer can use them for various purposes like business expansion) Bonus Bonus is paid in addition to the basic benefit payable under a policy contract. ‘As an addition to basic sum insured Eg: 6OMMK per every One Thousand Sum Insured (or 6%). Most common bonus is “Reversionary Bonus” (All bonuses once declared, cannot be canceled). They are called "Reversionary” because the policyholder only receive them when there isa claim by death or maturity, Also payable on surrender (but policy must be atleast few years). Bonuses are part of liabilities of the company.CHAPTER -11_ PRICING & VALUATION IN LIFE INSURANCE 2. Life Insurance Premiums 4 Types of Reversionary Bonuses imple Reversionary Bonus (Eg: As % ofsum insured, Fixed GOMMK every year) Compound Bonus Bonus on a bonus”. I year 6%x1000 SA = 6OMMK, 2 year 6% x 1060 SA = 63.6, "year 6% x 1123 SA ‘Terminal Bonus (eg: on death or maturity) ‘The Contribution Method (Means where the source of surplus that is contributed from) - Adopted in North America ‘+ Surpluses may come from 3 sources below, then distributed from these savings: i) Excess interest i) Mortality savings iil). Expenses savings + Surpluses may be distributed in the form of a) Dividends in cash b) Accumulate dividends to the policy ©) Adjustment or reduction in premium cHUuUsS » CHAPTER -11_ PRICING & VALUATION IN LIFE INSURANCE 2. Life Insurance Premiums Unit Linked Policies (This isa repeat of Chapter 9) Designed to overcome the limitations in Traditional Life “With Profit” policies. Traditional policies bonuses is determined by valuation of the insurer's assets and liabilities only once a year, hence not directly reflect the value of the assets. No direct link to company’s performance, hence not transparent. + Non Traditional Unit linked policies involve a different design of products as follows: a) Unitizing - Benefits (Eg-cash value) are determined by value of units in the fund. b) Transparent Structure - Charges, value of units of fund. ©) Pricing- Insured decides what amount of premium to pay (subject to min). @) The Bearing of Investment Risk - Insured bears the investment risk and hence the unit values in hisaccount. Premium is divided into 3 parts; \_ tavestment J Premium 6 200) ') Policy Allocation Charge -"To pay for Agents’ commission, policy set up costs, administrative costs, fees ete i) Mortality charge iil) Balance after the above are allocated to the purchase of units.