Life Insurance and Retirement Valuation

Tutorial 6: Balance Sheets, Processes and Assets

LIFE INSURANCE AND

RETIREMENT VALUATIONS

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 Life Insurance and Retirement Valuation
Tutorial 6: Balance Sheets, Processes and Assets

TUTORIAL 7

MODULE 12:
ANALYSIS OF SURPLUS

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 Life Insurance and Retirement Valuation
Tutorial 6: Balance Sheets, Processes and Assets

Housekeeping

• Assignment marking – results on 31 March

• Exam is on 22 April
o Do the question, do the question, do the questions ….
o Areas to focus on / more past questions

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 Life Insurance and Retirement Valuation
Tutorial 6: Balance Sheets, Processes and Assets

Analysis of surplus

• Aims to explain the difference between

actual experience and a valuation or other
expectation.
• Surplus is the excess of assets over policy
liabilities at a point in time.
• Change in surplus is
• (A1 – V1) – (A0-V0)
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 Life Insurance and Retirement Valuation
Tutorial 6: Balance Sheets, Processes and Assets

Components of surplus

A summary of the components that cause, or drive, changes in surplus is:

• returns on the original surplus;
• expected surplus, driven by deliberate prudence in the valuation basis or method
(e.g. explicit allowance for future profits);
• random fluctuations that impact cash flows but not the valuation basis; and
• other unexpected changes in experience, including new business and changes in
end-year assumptions.

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 Life Insurance and Retirement Valuation
Tutorial 6: Balance Sheets, Processes and Assets

Investment returns on opening surplus

The opening surplus, A0 – V0, tells us nothing about how we

expect V0 (or A0 for that matter) to change over the investigation
period. However, it is clear the investment return on the opening
surplus will form part of the total surplus at the end of the period.

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 Life Insurance and Retirement Valuation
Tutorial 6: Balance Sheets, Processes and Assets

Expected surplus

If the valuation basis is conservative or includes an explicit

allowance for future profits, there are in-built margins relative to
a best estimate basis. A surplus will arise naturally as these
margins are released.

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 Life Insurance and Retirement Valuation
Tutorial 6: Balance Sheets, Processes and Assets

Experience surplus

Due to the uncertainty involved in valuing future unknown cash flows, actual experience will
never turn out to be exactly as expected. Whilst experience profit or variations are contingent
on contract types, typical items which drive surplus arising for life companies are:
investment returns;
mortality;
morbidity;
expenses;
commission;
voluntary withdrawals;
fees from unit-linked business; and
new business.

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 Life Insurance and Retirement Valuation
Tutorial 6: Balance Sheets, Processes and Assets

New business

If the opening valuation only considers contracts in existence as

at the opening valuation date, then new business (or new
members for retirement funds) is an unexpected item in the
surplus arising.

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 Life Insurance and Retirement Valuation
Tutorial 6: Balance Sheets, Processes and Assets

Change in the basis

If experience over the period is different to expected (it is never

exactly as expected), the valuation basis may change to reflect
this. The opening basis can’t anticipate a change in basis at the
end of the period. If the end period basis is changed, this
contributes to another unexpected surplus. The end year valuation
on a new basis less its value on the opening basis capitalises the
effect of the change in assumptions. This is analysed as a
component of the total surplus arising.

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 Life Insurance and Retirement Valuation
Tutorial 6: Balance Sheets, Processes and Assets

Methodology – step through

Surplus 2. 7.
1. Expected 3. 5. 6. Change in
Investment 4. Expenses Actual
components surplus Claims Lapses basis
income surplus

Premiums Expected Expected Expected Expected Adjusted Actual Actual

Investment
Expected Actual Actual Actual Actual Actual Actual
return

Claims Expected Expected Actual Actual Actual Actual Actual

Expenses Expected Expected Expected Actual Actual Actual Actual
Lapses Expected Expected Expected Expected Actual Actual Actual

Actual
Actual
Allow for Step 3 plus surviving
End Year Expected end surviving
Expected actual As per Step 3 allow for policies on
Liability year portfolio policies on
claims actual lapses revised
revised basis
basis

Surplus Arising Expected Adjusted Adjusted Adjusted Adjusted Actual Actual

Impact of Impact of Impact of

Difference in Impact of Impact of Residual
  Economic Actual Actual
Surplus Actual Lapses New Basis Impact
Returns Claims Expenses

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 Life Insurance and Retirement Valuation
Tutorial 6: Balance Sheets, Processes and Assets

Simple example
The formulae in the textbook provide one way of thinking about
analysing the surplus.
 
It is important to realise that there is no right way and the
important part is to be consistent in moving from actual to
expected, or vice versa. The key confusion is mixing up actual
and expected.

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 Life Insurance and Retirement Valuation
Tutorial 6: Balance Sheets, Processes and Assets

Simple example
Suppose an entity has assets of $100 and has to pay a liability of $200 in exactly three years. Premiums of $50
are due tomorrow, and one day after the start of the next two years.
The reserves are calculated using the following basis:
• expected expenses are 10, 15 and 25 in six, 18, and 30 months’ time respectively;
• the discount rate and investment return rate are10%;
• mortality may be ignored;
• lapses may be ignored; and
• tax can be ignored.
During the year, actual investment returns were 0% and actual expenses of $20 was incurred just before the end
of the year. The year end-valuation basis did not change.
Calculate the surplus arising.
Analyse the surplus arising into:
• Investment surplus
• Return on opening surplus
• Expense surplus

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 Life Insurance and Retirement Valuation
Tutorial 6: Balance Sheets, Processes and Assets

Simple example
The surplus arising is the difference between the surplus at the end of the year and the surplus at the start of the
year.
Surplus = assets less liabilities.
Opening assets = 100
Opening liability = 200v3 + 10v0.5 + 15v1.5 + 25v2.5 – 50(1+ v + v2) @ v = 1/1.1
= 55.72,
Thus, the surplus at the start of the year is 100 – 55.72 = 44.28.

Assets at the end of the year will be calculated using actual movements.
Closing assets = (100+50)*(1+0%) -20 = 130.
Closing liability = 200v2 + 15v0.5 + 25v1.5 – 50(1+ v) = 105.81.
The surplus at the end of the year is 130 – 105.81 = 24.19.

Thus, the surplus arising is 24.19 – 44.28 = -20.09

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 Life Insurance and Retirement Valuation
Tutorial 6: Balance Sheets, Processes and Assets

Simple example
Investment return
We compare the actual value of assets with those expected if we earned the valuation interest rate. Note that we
are working from actual to expected so all unanalyzed items are on actual values.
The investment surplus = actual value of assets less expected value of assets
= 130 –[ (100+ 50)*1.1 – 20] = - 15
Since we have analysed investment returns, we now move forward using expected interest
Return on opening surplus
44.28*0.1 = 4.43
Expense surplus
Actual expenses incurred were 20 at the end of the first year and expected expenses were 10 at mid-year. The
expense surplus is:
10 * 1.1^0.5 – 20 = -9.51
Reconciliation
The three components sum to -15 + 4.43 – 9.51 = -20.08 
The difference of 0.01 is likely due to rounding.

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 Life Insurance and Retirement Valuation
Tutorial 6: Balance Sheets, Processes and Assets

Question
Adapted from Life 2B assignment 2005, S1 paper 2
You have been asked to perform an analysis of profit for your company’s block of new term insurance policies. The
company has just written 300,000 of these policies. Each policy is for a 10 year term, has a sum insured of $100,000
and premium rates as per the following table: of $1.50 per mille (ie per $1,000 of sum insured).
Other assumptions are:
• Initial expenses 40% of premium
• Renewal expenses 7% of premium (including first year)
• Renewal expense increase factor 4% pa
• Mortality 0.10%
• Surrenders 10%
• Earning rate 6%
• Capital 50% of premium

There are no retained earnings at commencement. Shareholders supply any necessary capital to support the reserves.
Initial expenses are assumed to occur at the beginning of the year. All other movements are assumed to take place
throughout the year.
When calculating the decrement table, assume deaths occur prior to withdrawals. This is to simplify the maths and
have the answers as consistent as possible for marking.
The profit carrier should be death claims and the capital adequacy reserve should be set up at the beginning of the year,
even though premiums are received mid year.

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 Life Insurance and Retirement Valuation
Tutorial 6: Balance Sheets, Processes and Assets

Question a
It is currently the end of the first policy year and experience has been exactly
as expected. You have been asked to provide an analysis of profit for year 1.

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 Life Insurance and Retirement Valuation
Tutorial 6: Balance Sheets, Processes and Assets

Question b
Calculate the total cash to be returned to shareholders at the end of the first
year.

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 Life Insurance and Retirement Valuation
Tutorial 6: Balance Sheets, Processes and Assets

Question c
It is now the end of year 2 and you are again asked to perform an analysis of
profit. The following actual figures are provided and it has been decided that
there will be no change to the basis. Lapses have increased at the same time
that the mortality has reduced to the extent that the change in reserves is
negligible and therefore the end Year 2 reserve does not alter. Please provide
your analysis and determine the amount paid to shareholders at the end of
year 2.
Premium received $40,806,529
Death claims on sum insured $13,486,500
Expenses $3,105,468
Interest earned $3,695,124
Policy reserve at end yr 2 $15,502,031

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 Life Insurance and Retirement Valuation
Tutorial 6: Balance Sheets, Processes and Assets

Question d

Perform an experience analysis for year 2.

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 Life Insurance and Retirement Valuation
Tutorial 6: Balance Sheets, Processes and Assets

Another question

Your homework ….

Life 2B April 2011 question 1

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 Life Insurance and Retirement Valuation
Tutorial 6: Balance Sheets, Processes and Assets

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Published January 2020
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