Chapter 14_1-Surrender Values

Question 1

Outline the number of factors the should be considered when setting surrender terms? (4)

Answer 1

• Market practice
• Regulatory requirements (Regulation 5 LTIA)
• Difficulty of assessing suitable terms
• Cost of surrendering the policy vs. benefit on surrender

Question 2

Outline the fair profit approach to setting surrender terms? (2)

Answer 2

• The insurer set the surrender value such that the profit earned on the policy is the same as that the insurer would have expected to earned if the policy was held to maturity
• This approach is only possible in an inefficient market as in a fair market surrender values less than fair market value would be criticized as unfair exploitation

Question 3

Outline the fair market approach to setting surrender terms? (2)

Answer 3

• This approach is to provide a surrender value that approximates a fair market value of the policy
• This approach assumes a efficient market or that not would not be fair to provide a surrender value less that market value

Question 4

Outline the pragmatic approach to setting surrender terms? (3)

Answer 4

• A third approach is to determine a basis such that the it is almost certain to leave the office with a profit regardless of the investment conditions
• This approach is not necessarily concerned about fairness but reducing the offices exposure to anti-selection (which is still relatively fair to policyholders)
• In recent years this has led to complaints and legal challenges regarding surrender value

Question 5

Outline the fatcors and principles that should be considered when setting surrender values? (11)

Answer 5

• Policyholder reasonable benefit expectations
o Consistency with illustrative values to policyholders
o At early durations not too low compared to premiums paid
o At latter durations consistent with projected maturity values

• Takes into account regulation 5 of the LTIA and applies to investment business
• Takes into account accrued and future profit from the surrender policy (equity)
• Are based on smoothed earned asset share taking into account companies philosophy regarding maturing contracts
• Aggregate earned asset share is not exceeded over a reasonable period
• Consideration of competitor surrender values
• Not excessively complicated to calculated (taking into account administrative capabilities)
• Should not be subject to frequent change
• Capable of being documented and explained to policyholders

Question 6

outline the inpact on the profitability of the policy depending on the surrender terms? (7)

Answer 6

• If a policy is held to maturity (i.e. not surrendered) and the actual experience was more favourable than assumed in pricing then then a profit will be earned
• The profit is equal to the earned assets share and the guaranteed sum assured
• In order to ensure that surrendering and inforce policies are treated fairly appropriate profit needs to be extracted on surrender
• The may be achieved by calculating the surrender value as the prospective policy value using best estimate assumptions
• This allows the insurer to retained profit accrued to date as well as the expected future profit that would have been earned if the policy was held to maturity
• The profit accrued to date is the difference between earned asset share and the policy value under the pricing basis at surrender
• The discounted expected value of future profit is then set as the difference between the policy value on the pricing basis and the policy value on a best estimate basis

Question 7

outline the retrospective method for calculating surrender values? (2)

Answer 7

• Provided sufficient information and computing programmes can be written a company can keep an up-to-date asset share on file
• Otherwise it may choose to calculate retrospective reserves using parameters and formula that produce acceptable results

Question 8

outline the prospective method for calculating surrender values? (3)

Answer 8

• This is setting the surrender value equal to a prospective policy value
• The value of future benefits, plus expenses, less net premiums using estimates of investment returns, mortality and any other relevant experience parameters
• For with-profit contracts this will include the value of declared bonuses and future declarations

Question 9

Provide an analysis of the retrospective method for determining a surrender value? (9)

Answer 9

• The retrospective will represent the earned asset share on surrender or estimate thereof
• Represents that maximum surrender value the company can pay without making a loss
• At early durations the value will look reasonably comparable with premiums (although dependent on treatment of expenses)
• The retrospective method may not be suitable for a fair value approach as a prospective valuation is required to determine the market value
• Matching liabilities may lead to a fall in asset share when interest rates rise
• This may lead to lapse and re-entry for single premium bonds as well as regular premium products with a short duration
• These problems are less acute for with-profit polices due to market value adjustments
• The advantage of the retrospective method is that it has the advantage of returning a proportion of the assets share which is consistent with fair profits and fair value approaches
• Provided the necessary information is available to build up assets share the method in not overly complex

Question 10

Outline how subjective decision regarding expense allocation can influence retrospective reserves? (4)

Answer 10

o The expenses allocation between initial/acquisition expenses and renewal expenses influences estimation of assets share (which is influenced significantly by initial expenses)

o Overhead expenses also needs to be allocated to new business and renewal expenses (which may be influenced by marketing considerations)

o Care should be taken regarding the allocation of expenses to policies which are of different sizes

o Expenses will be net of tax to the extent that they are eventually deductible

Question 11

Provide an analysis of the prospective method for determining a surrender value? (6)

Answer 11

• On a realistic basis this will reflect the contract’s value to the company
• It may produce values that are significantly different from earned asset share
• Prospective method allows the separation of attaching bonuses and basic benefits
• The prospective method is sensitive to interest rate assumptions especially if the contract has a relatively long term
• The method is likely to produce surrender values which are comparable to competitors and auction values
• Unless a complicated basis is selected the method should be relatively straight forward as it doesn’t require information of the past

Question 12

outline the retention of profit regarding the surrender value calculation? (5)

Answer 12

• Profit retained is excess asset share over the surrender value
• If the insurer use a prospective method then the profit will depend on the basis used to calculated prospective policy value
• The profit retained can be split into profit earned (difference between asset share and policy value on the premium basis) and capitalisation of future profit (difference between policy value on the premium basis and surrender value basis)
• If the surrender value basis represent the future experience exactly then profit retained will be the same as if the policy was not surrendered
• One possible approach is to use a blended basis where surrender values are set using a premium basis at early durations and then move towards a best estimate basis at latter durations

Question 13

outline the setting of the interest rate assumption for prospective reserves? (4)

Answer 13

• This is likely to be the most important assumption
• The investment of assets to back liabilities reserves will produce investment earnings at current market rates
• Information is likely to be determined from the term structure of current interest rates
• There may however be reasons for departure and taking into account other cashflows

Question 14

outline the setting of the expense assumption for prospective reserves? (4)

Answer 14

• The company’s most recent expense investigation will indicate renewal expenses net of tax
• A fair profit approach would require margins in premium basis to be removed
• However a fair value basis will leave them in the valuation possibly allowing for a small reduction due to less economies of scale for the in-force book
• Allowance needs to be made for renewal commission as paid

Question 15

outline the setting of the inflation assumption for prospective reserves? (2)

Answer 15

• This should be set to be consistent with the investment rate assumptions
• The real return anticipated on index-linked government bonds i.e. give a suitable margin below the full interest rate assumption

Question 16

outline the setting of the morbidity/mortality assumption for prospective reserves? (5)

Answer 16

• Reflect the future expected mortality of the policyholder surrendering
• It might be assumed the mortality of policyholders surrendering will be lighter
• However the little information of such anti-selection
• The reverse may be more probable due to affordability issues due to medical expenses
• Although for short-term endowments mortality assumptions are less significant

Question 17

outline the calculation of surrender values for with profit contracts? (7)

Answer 17

• Most likely a blended approach will be suitable using retrospective calculations at early durations which then lead into a prospective approach
• Usually it is effective not to offer a surrender value in the first two or three years as asset share may be negative at early durations
• However there is likely to customer dissatisfaction with this approach
• Using the prospective method and only including the terminal bonus two to three years before maturity is seen as fair value
• To the extent permitted by regulation companies may allow attaching reversionary bonuses to be surrender separately (this is only possible using prospective approach)
• It would then be required to compare the sum to earned asset share (retrospective calculation) in order to determine an appropriate terminal bonus

• The calculation of the prospective value should be reasonable
o Not exceed earned asset share
o For simplicity allow same terminal bonus scale to be applicable to all polices