CONTENTS

Chapter Title Page

No.

1 LIFE INSURANCE PRODUCTS 5

2 OFFICE PREMIUMS 14

3 POLICY VALUES 28

4 FURTHER LIFE CONTINGENCIES 46

5 REINSURANCE 67

6 DATA FOR VALUATION 74

7 SPECIAL RESERVE AND ADJUSTMENTS 79

8 SURPLUS AND ITS DISTRIBUTION 90

9 METHODS OF VALUATION 95

10 ASSEST VALUE 103

11 SURRENDERS AND ALTERATIONS 110

12 RISKS 117

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 CHAPTER 1

LIFE INSURANCE PRODUCTS

INTRODUCTION
The basic customer needs met by Life insurance contracts are protection and savings. The risk
of uncertainty of death is inherent in human life and this risk of uncertainty of death
particularly that of the breadwinner of the family gives rise to the necessity of some form of
financial protection.

There may be many contracts which aim to protect people (or their dependents) from the
financial consequences of unwelcome, unfortunate and sudden events, such as death or
disability. Other contracts are essentially investments, allowing the policyholder to build up
funds for specific needs such as an income in retirement, the repayment of a loan, passing on the
estate to the next generation or just a lump sum or periodical payments to spend on marriage or
education of the child etc.

Most of the contracts available now a day provide a mixture of saving and protection either on
conventional (non-unit linked) or unit linked platform.

1. TERM ASSURANCE PRODUCTS

A term assurance policy is an insurance contract between the insurer and the insured which
provides for a lump sum benefit payment on the death of the insured during the term of the
policy. The lump sum amount may be constant throughout the term of the policy or may
increase or decrease by a pre-specified amount set out at the time of writing the contract.

A term assurance contract offers a guaranteed amount of money set out at the time of writing
the contract. However, on survival of the life insured till the end of the specified term, usually no
amount is payable. In other words there is usually no maturity benefit under term assurance
policies.

However some insurers, now a day, keeping in view of the policyholders’ expectations, have
started offering some benefits like return of premiums or a portion of it on survival of the
policyholder at the end of the term.

The benefit as mentioned above are secured in exchange for a single premium at the start of the
contract or a series of regular premiums throughout the term of the contract or some shorter
period and is probably the least expensive way to purchase a substantial death cover.

This plan is most suitable for those who are initially unable to pay high premium as the income
is low, but they require life cover for a high amount.

This type of contract is the most basic form of policy which aims to protect people (or their
dependants) from the financial consequences of unwelcome unfortunate and sudden events,
such as death.

5
The decreasing term assurance can be useful for those who have availed of loan and would wish
to use it to repay the outstanding loan amount.

Some insurers allow an option to renew or take out further term assurance policy at the end of
the term of the initial policy without undergoing any further medical examinations. Such
contract is called the renewable term assurance policy.

Similarly if the term assurance policy allows as option to convert the policy into, say whole life
or endowment assurance, the policy is known as convertible term assurance policy.

At what point in time the conversion or renewal option is to be exercised depends upon the
terms of the policy which could be either at the inception of the policy or at specified time(s)
during the term of the policy.

Term assurance contracts are generally without profit contracts, although with profit and unit-
linked versions could be offered.

2. WHOLE LIFE PRODUCTS

A whole life policy is an insurance contract between the insurer and the insured which provides
for a lump sum benefit payment on the death of the insured at anytime during lifetime of the
insured. The lump sum amount may be constant throughout the term of the policy or may
increase or decrease by a pre-specified amount set out at the time of writing the contract.

A whole life contract offers a guaranteed amount of money set out at the time of writing the
contract, typically called the “sum assured” and is payable on death anytime during the lifetime
of the policyholder.

Some of the whole life policies provide for a lump sum payment when the policyholder reaches,
say age 80 or 100 years or on earlier death.

The benefit as mentioned above are secured in exchange for a single premium at the start of the
contract or a series of regular premiums throughout the contract or for a specified period.

Whereas the benefit amount in case of term assurance policy may not eventually be paid out if
the policyholder survives till the end of the term, the benefit payout is certain in case of whole
life policy and thus the whole life policy is usually costlier as compared with the term assurance
policy.

The whole life product is particularly useful for those having moderate income but require
considerable financial protection for the family. It can also be suitable for meeting estate duty
liability and other such needs.

Whole life contracts can be without profit, with profit or unit-linked. In case of with-profit
contracts the benefit payable on death increases by way of bonuses.

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3. PURE ENDOWMENT PRODUCTS
A pure endowment policy is a contract between the insurer and the insured which provides for
a lump sum benefit payment typically called the “sum assured” on the survival of the insured till
the date of maturity of the policy set out at the time of writing the contract.

However, on death of the life insured anytime during the specified term of the policy no amount
is payable. In other words there is no death benefit payable under pure endowment policies.

It can be observed that the characteristics of a pure endowment policy are exactly opposite to
those of a term assurance policy.

These types of products provide for some sort of financial assistance on survival of the
policyholder till maturity. Pure endowment policies now a day are rarely sold in India.

4. ENDOWMENT ASSURANCE PRODUCTS

Endowment assurance is a combination of term assurance and pure endowment in either
similar or different proportions where the assured benefits are payable either on the date of
maturity i.e. on survival till the end of the term or on death of the insured, if earlier.

Thus the Endowment Assurance policy can be explained as an insurance contract between the
insurer and the insured which provides for a lump sum benefit payment on survival of the
insured upto a known date and hence operates as a savings instrument and also provides a
significant benefit on the death of the insured before that date and hence also operates as an
instrument for providing financial protection for the dependents of the life insured.

Of all the policies sold in India, Endowment Assurance policies typically are the most commonly
sold policies.

Endowment policies can be of participating and non-participating types:

4.1 Without Profit (Non-Participating) Endowment Assurance

A without-profit endowment assurance contract offers a guaranteed amount of money set out at
the time of writing the contract, typically called the “sum assured” and is payable at the end of
the contract on survival of the life insured or on his earlier death.

The benefits as mentioned above are usually secured in exchange for a single premium at the
start of the contract or a series of regular premiums throughout the contract or some shoter
period.

However, the contract may be structured with a sum assured payable on death different from
that paid at maturity.

4.2 With Profit (Participating) Endowment Assurance

These types of contracts are typically referred to as the conventional with – profits insurance
contracts or the participating insurance contracts. These are similar to that of the without-
profits contract, except that the sum assured set out at the time of writing the contract is
7
expected to be enhanced with the addition of bonuses typically declared at the end of each
financial year. Once declared, the bonuses get vested with the policy and become guaranteed
payments.

Bonuses can also be declared in various other forms which may include:

(i) Regular Reversionary Bonuses:

a) Simple Reversionary Bonus

b) Compound Reversionary Bonus

c) Super-Compound Reversionary Bonus

Simple Reversionary Bonus is usually paid as a percentage of basic sum assured only, whereas
the Compound Reversionary bonuses are paid as percentage of the sum assured and the
reversionary bonus which has already vested with the policy. Under Super- Compound
Reversionary Bonus two different rates are applied - one on the sum assured and the other on
the accumulated bonuses already attached with the policy, the second rate typically higher than
the first.

(ii) A Special One-off Reversionary Bonus is usually paid in case of one-off special
circumstances that are unlikely to be repeated in future. This is to avoid creating
policyholder’s reasonable expectations (PRE) with regard to future regular bonus
declarations.

(iii) Terminal Bonuses may be paid along with the final claim amount of the policy. The
amount of terminal bonus may be determined as a percentage (which may vary by
duration of policy in force) of Sum Assured, or of total attaching reversionary bonuses or
of the total claim amount.

(iv) Regular Cash payments

(v) In the form of reduction in future premiums.

An endowment assurance may be used as a means of repaying the capital on an interest-only

loan. The borrower also takes out an endowment policy, the proceeds of which are designed to
repay the debt.

An endowment assurance may also be used as a means for saving money for retirement.

Endowment assurance contracts may also be used as a means of transferring wealth from, say,
parents to children. The basic idea is that a parent would pay the premiums but the benefit
would be payable to the child.

5. MONEY BACK PRODUCTS

A Money Back Policy is an insurance contract between the insurer and the insured which
provides for a certain percentage of the specified sun assured known as the survival benefit at
pre-specified periodic intervals including the sum payable at maturity alongwith accumulated
bonuses, if any. The sum assured along with the accumulated bonuses is also payable on the
8
death of the insured during the currency of the policy. The lump sum amount payable on death
may be constant throughout the term of the policy or may increase or decrease by a pre
specified amount set out at the time of writing the contract.

The benefit as mentioned above is secured in exchange for a single premium at the start of the
contract or a series of regular premiums throughout the term of the contract or some shorter
period.

This life insurance policy is preferred by those who require periodic payments during their life
time to match their liabilities.

6. UNIT LINKED PRODUCTS

Insurance Regulatory and Development Authority (Registration of Insurance Companies)
Regulations 2000, defines linked business as life insurance contracts or health insurance
contracts under which benefits are wholly or partly determined by reference to the value of
underlying assets or any approved index.

Unit liked products are a combination of insurance and investment, which provide to the
policyholder, in addition to the risk cover, an opportunity to choose to invest his money in
various funds usually debt, balanced and growth or equity funds offered by the insurance
companies. Insurers also provide options to the policyholders to switch among the funds. In the
process, thus most of the investment risk is borne by the policyholder and this increases
uncertainty of investment returns for the policyholder, who may suffer financial losses when
the market conditions are unfavorable.

Unlike in the traditional products where the charging structure may not be explicitly expressed,
the Unit Linked Products provide a transparent changing structure some of which may be
expressed as Premium Allocation Charge, Mortality Charge, Fund Management Charge, Policy
Administrative Charge or policy fee, fund switching charges etc.

The premiums received from the policyholder, net of premium allocation charges is paid into an
investment fund/funds chosen by the policyholder which buys a number of units which
represent a share of that fund belonging to such policyholder. Mortality charge, policy
administration charges etc. are deducted on a periodic basis by cancellation of units which are
used to cover the mortality risk of life assured and the cost of insurer’s expenses. Fund
management charges are adjusted from the Net Asset Value (NAV) on a periodic or daily basis.

The value of the investment fund depends directly on the value of the assets underlying the
fund. The value of one unit (known as unit price or NAV) is calculated periodically (usually
daily) as the value of assets of the fund changes. However, the policyholder’s share (i.e. the
number of units in policyholder’s account) will remain unchanged until some policy cash flow
like the deduction of charges, payment of a premium or payment of a claim occurs.

The value of an individual policyholder’s fund (or unit fund) at any time is the number of units
held in his account multiplied by the unit price. The policyholder’s fund value reflects the
performance of the underlying assets in the investment fund and the policyholder is entitled to
receive this fund value at the time of maturity or on earlier death or surrender of the policy.

9
This unit fund thus defines the policyholder’s basic benefit, which is payable usually on maturity
or earlier death or surrender of the policy. The policy may also provide some guaranteed death
benefit or maturity benefit.

The charges as mentioned above deducted from the premium or from the fund are credited to a
separate fund known as the non-unit fund. The non-unit fund may comprise of the charges the
insurer has deducted from such policies, which is income for the non-unit fund whereas the
actual costs incurred by the insurer are outgo from the non-unit fund and may include the
actual expenses and any additional claim costs over and above the value of unit fund.

Unit linked policies can be useful in achieving long-term financial goals which may include
financial planning for retirement, child’s marriage etc.

7. ACCUMULATING WITH PROFIT PRODUCTS

As the name suggests an accumulating with-profits policy participates in the surplus/deficit
arising out of specified business. Unlike in a conventional with profits policy where the bonuses
are usually expressed as a percentage of the sum assured, an accumulating with profit product
can be thought of as akin to a conventional participating product with series of single premium
policies where each addition of bonus can relate to each such single premium. On experience
being favorable a terminal bonus can also be paid on maturity of the policy. The guarantee, if
any, provided under accumulating with profit policy is usually lower than that under a
conventional with profit policy.

Accumulating with-profits policy can be issued on a unit linked platform in which case it is
known as Unitised with Profit policy, the key difference with a unit linked policy being the
manner in which the unit prices are determined under Unitised With-Profit policy.

The bonuses under Unitised With Profit policy can be by way of allocating additional units to
each policy without changing the unit price or by changing the price of the unit. The addition of
units in the first method is usually on an annual basis as a result of annual valuation while the
change of unit price can be on a daily basis.

8. ANNUITY PRODUCTS
An annuity policy is an insurance contract between the insurer and the annuitant where the
annuity benefits are secured in exchange for a single premium at the start of the contract or a
series of regular premiums over a specified number of years.

An annuity benefit is a regular series of payments made at successive periods (intervals) of

time. If all the payments are equal, then the annuity is referred to as level annuity, otherwise it
may be called a variable annuity. In case of a variable annuity the amount of annuity may be
increasing at a specified fixed rate or linked with a given index.

If the annuity payments are to be made for a definite period of time not depending on whether
the annuitant is alive or not, then the annuity is called annuity certain. If the annuity payments
are to be made during the life of a person then it is called a life annuity.

10
If the successive payments of the annuity are made at the end of each time periods, such annuity
is called as an annuity payable in arrears. If these successive payments are made at the
beginning of each time period, i.e. they are paid in advance then the annuity is called an annuity
due.

An immediate annuity commences after the payment of single premium by the policyholder.

As against immediately payable annuities, there are annuities known as deferred annuities. A
deferred annuity is an annuity postponed for a given period called the deferment period. A
deferred annuity can again be either a deferred immediate annuity or a deferred annuity due.

A deferred annuity accumulates wealth during the deferment or the accumulation period and
pays annuity during the payout period.

In case of deferred annuity the annuity payment starts after the deferment period or the
accumulation period. The mode of payment of premium can be either single premium or the
regular premium payable during the accumulation period or some shorter period.

The following types of life annuities are generally offered by life insurers in India:

i) Annuity payable during the life time of the annuitant.

ii) Annuity payable for a certain period (say 5, 10, 15 years) and thereafter during the life
time of the annuitant.
iii) Annuity payable during the life time of the annuitant with return of purchase price on
death of the annuitant.
iv) A Joint Life last survivor annuity payable at full or reduced rate to the surviving spouse
during his/her life time on death of the annuitant.
v) Annuity increasing at a fixed rate (say 3% or 5% p.a.) which may be a single / joint life
annuity.
These annuities meet the financial need for an income of the annuitant after his/her
retirement. Such contracts are predominantly without profit contracts, through with profit or
unitized annuities are also possible. In case of a with profit annuity the annuity paid to the
annuitant is a guaranteed amount plus a bonus declared by the insurer. In case of a unit linked
annuity, the insurer guarantees payment of a number of units periodically. The income for the
annuitant in such annuities is equal to the number of units payable multiplied by the unit price
(which varies on daily basis) and the same is therefore not guaranteed in monetary terms.

Example 1: Why does a term assurance policy cost less than an endowment or whole life
policy?

Solution:

The cost under a term assurance policy will be lower because a claim of sum assured is payable
under each and every endowment or whole life policy. On the other hand claim under a term
assurance policy is expected only on a relatively small proportion of policies.

Example 2: How an insurer may offer a renewable term assurance policy with an option to
renew the contract at the end of the term, without my medical examination?

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Solution:

The insurer can charge an extra premium to cover the cost of additional expected claims due to
exercising option of renewal. Further the renewal will involve much lower expenses than
writing completely new business and hence there will be saving of expenses for the insurer.

Example 3: Why an insurer does not offer surrender value under an immediate annuity payable
during the lifetime of an annuitant?

Solution:

There is severe anti-selection risk involved. The annuitant may surrender such an annuity when
he is having severe health problem and does not expect many more annuity payments anyway.

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EXERCISE 1
1. Arrange the following contracts in order of their costs:-
a) Endowment Assurance Policy
b) Whole life Policy
c) Money Back Policy
Give reasons also.

2. What types of life annuity contracts are offered by life insurers in India?
3. Is a whole life contract a savings contract or a protection contract?
4. Why pure endowment policies are not sold now by life insurers in India?
5. Why a special one-off reversionary bonus will not create PRE issues?
6. Which option under a term insurance policy is more beneficial to the life insurer and
why?
a) To renew the contract at the end of the term
b) To convert the policy into a whole life contract
c) To convert the policy into an endowment assurance contract of same term.

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 CHAPTER 2
OFFICE PREMIUMS
1. The calculation of net premium is based on the rate of mortality likely to be experienced
by lives to be insured and rate of interest likely to be realised by the Insurer. The identity
between present value of premiums and present value of benefits gives the net premiums
which is the quotient of value of benefits when divided by the appropriate annuity (i.e. P = A/ä).
With a heavy mortality table the value of death benefits will be more, as more persons will die
and receive benefits, whereas the value of annuities will be less, as less number of persons will
survive to pay premiums at various durations. The net premiums arrived at as above will be
more with a heavier mortality table. It is, therefore, necessary to take into account the type of
lives to whom the assurance policies or annuity policies are to be issued while selecting a
mortality table for the calculations of premiums.
If the lives to be assured belong to higher strata of society enjoying better living conditions, it is
natural to expect longer life and fewer deaths amongst them than in the case of lives who are
poor and live under unhealthy conditions. Persons living in cold climate generally experience
lighter mortality and longer spans of life than those living in tropical climates. Persons working
under unhealthy conditions such as coal mines, chemical factories and other industries where
they are exposed to heat, dust, fumes etc. usually experience heavy mortality. It is, therefore,
necessary to select that mortality table which reasonably reflects or approximates to the
mortality of the lives insured by an Insurer.
Whatever may be the care that is exercised in selecting a mortality table for the calculation of
premiums, it is likely that the actual experience may deviate from that underlying the table
selected. Selection of a table is nothing more than a reasonable and intelligent guess and the
actual experience may show variations which may not always be favourable. To protect the
interest of the Insurer in case of such an unfavourable experience, some safeguards have to be
provided in the premium. Such a provision is usually made as a small addition to the net
premium calculated on the basis of a selected table of mortality. This addition is known as the
loading for adverse mortality experience or simply ‘mortality loading’.

2. The effect of interest rates on insurance premiums is also significant as can be seen
from the following Whole Life Premiums at age 30 per 1000 sum assured (Morality – IALM (94-
96) modified ultimate) :

(1) (2) (3) (4) (5) (6)

Rate of interest 0 .04 .05 .06 .07 .08
4.2
Annual Premium 22.13 9.25 7.50 6.14 5.09 7

For a decrease in the rate of interest by 1% the increase in the premium ranges from 19% to
23% during the interest band of 4% to 8%. If no interest is taken into account the premium as
seen above is very high making insurance unattractive.

Insurance may, therefore, be made very attractive by assuming a high rate of interest in the
premium calculations. But, if the interest assumed cannot be earned, premiums charged will
prove to be insufficient and the Insurer will not be able to fulfill his obligations.

14
To avoid such a contingency, a slightly lower rate of interest than that which can confidently be
expected to be earned is usually assumed in the calculation of premiums. This method
automatically provides for a margin in the insurance premium by bringing out higher premiums
than those arrived at on experience basis. The difference between the two premiums calculated
on a cautious estimated rate of interest and the actually realised rate can be called ‘interest
loading’ in the premiums.

3. LOADING IN PREMIUM RATES FOR EXPENSES

So far in the calculations of premiums only mortality and interest have been taken into account.
No consideration has been given to the expenses that are needed by the Insurer in managing the
business.

Insurer usually employs field staff to approach the public and canvass them for insurance.
Insurance is not one of those commodities which are generally purchased without any selling
approach. It does not cater to any tangible individual need but provides financial security for
future, which even the educated persons find it necessary to be made aware of. Trained field
workers are, therefore necessary to create consciousness and awareness of insurance needs in
all classes of the society.

Persons employed for the above purpose are usually remunerated by way of commission on
premiums collected. In the first year of insurance a higher rate of commission is ordinarily paid
to the insurance intermediaries or agents, as these field workers are commonly known, for
expenses incurred by them and to provide sufficient incentive for them to bring more and more
persons into the insurance fold. The commission paid on second and subsequent premiums is at
a lower rate and is meant to encourage such insurance intermediaries or agents to provide post
sales service to the policyholders.

In addition to the employment of insurance agents to canvass life insurance business, an Insurer
usually employs salaried staff who acts as connecting links between it and the insurance
intermediaries or agents. They are typically known as Field Officers or Development Officers or
Sales Managers. The insurer establishes branches at suitable centers with a view to developing
business and providing services to the policy holders. Remuneration of these workers, though
fixed, have a bearing on their new business figures. There are other expenses which can be
classified under the heads of medical fees, printing and stationery and salaries of staff in the
new business department who scrutinize all proposals for insurance and issue the policy
contracts etc. The cost of stamp duty to be affixed on the policies issued and advertisement
expenses are some of the other expenses which fall under this group of expenses which arise
only at the time of selling an insurance policy but do not again occur during the currency of a
policy contract. All the above mentioned expenses are known as ‘initial expenses’ falling under
two broad categories:
(a) Expenses related directly to first year premium income like commission to agents etc.,
and expressed as a percentage of premium for the first year.

(b) Expenses depending upon or which can conveniently be related to new sums assured,
expressed as a fixed addition to premium for every unit sum assured.

Initial expenses, as described above, are to be incurred only once at the time of placing the
policies on books and do not occur thereafter during the currency of the contract. The expenses
during subsequent years will be much lower when compared to those in the first year. If
expenses of each year are to be added to the premium of that year, the uniformity of premiums
will be lost. Hence, all the expenses of 1st year cannot be added to the premium for 1st year
alone. A major part of the initial expenses has, therefore, to be distributed throughout the
15
duration of the contract.

Renewal expenses which are to be incurred by way of payment of commission to Agents in

second and subsequent years are expressed as a percentage of premiums.

There are also other expenses incurred in servicing the policy holders in issuing premium
notices, collecting premiums and accounting them, issue of receipts, attending to
correspondence, settlement of claims etc. Such expenses are neither related to the premium nor
to the sum assured. They are more or less related to number of policies in force and are best
expressed as a constant addition to the premium per unit sum assured.

Net premiums, when suitably adjusted to provide for the expenses and margins as described
above, are called office premiums. The office premiums for various plans of assurance and
annuity are given in the published tables of rates of the Insurers.

4. EXPRESSION FOR OFFICE PREMIUMS

The office premiums are obtained from the following relationship:

Value of Office Premiums = Value of Benefits + Value of Expenses

We now obtain general expression for office annual premiums, P1, to provide for the following
expense loadings:

(a) First year (initial) expenses: I1 per unit of premium and I2 per unit of sum assured.
(b) Renewal expenses relating to second and subsequent policy years: K1 per unit of
premiums and K2 per unit of sum assured (where I1> K1 and I2> K2).

In case of Whole Life Assurance for sum assured of S to a person aged x at entry, the expression
for office annual premium, P1, is given by

P1äx = S.A x + I 1P1 + I2.S + K1.P1ax + K2.Sax

= S.Ax + (I1 – K 1) P1 + K1P1äx + (I2 – K 2) S + K2.Säx

P1{äx - (I1 – K 1) – K 1äx } = S.Ax + (I2 – K 2) S + K2.Säx

SA x + (I 2 - K 2 ) S + K 2 .S ax
P1= ... (2. 1)
ax - (I1 - K1 ) - K1ax

(I 2 - K 2 ) S
SPx : n + + K 2S
ax : n
(I - K1 )
1- 1 - K1
ax : n

Dividing the numerator and denominator of (2.1) by x, we get

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 (I2 - K 2 ) S
SPx + + K 2S
ax
P1 = ... (2.2)
(I - K1 )
1- 1 - K1
ax

Similarly, in case of Endowment Assurance for Sum Assured of S to a person aged x at entry and
term of n years, the expression for office annual premium is

S.A x : n + (I2 - K 2 ) S + K 2 .Sa x : n

P1 = ... (2.3)
a x: n
- (I1 - K1 ) - K1a x: n

(I 2 - K 2 ) S
SPx : n + + K 2S
= ax : n ... (2.4)
(I - K1 )
1- 1 - K1
ax : n

5. BONUS LOADING IN PREMIUM RATES

While making assumptions in respect of mortality table, rate of interest and expenses for the
purpose of premium calculation, an Insurer takes conservative view, thus making some
provisions to safeguard his interest in the event of an adverse experience. It is not that the
experience is always adverse. In fact more often the experience will be favourable to the
Insurer.

With the phenomenal advances in medical science, there has been a continuous improvement in
mortality, more particularly of insured persons. As premiums were calculated on the basis of
the mortality experienced in the past the insurer earns handsome profits. These profits tempted
the Insurer in the past to offer a share in their profits to the policy holders with a view to
encourage them to go in for more insurance and to serve as an advertisement for the public
regarding the prosperity of Insurers. This is how the concept of profit sharing came into the
insurance industry.

Thereafter, to satisfy the wishes of profit minded people, a regular provision in the premium
began to be made for definite scales of profits to be declared as bonus. Such premiums with
definite provision for participation in the profits of the insurer, are known as with profit
premiums. The profit came to be distributed to policyholders after periodical actuarial
valuations in the form of bonus.

If the rate of bonus provided is b per unit sum assured per year, addition for bonuses in each
premium is given by b(IA)x ÷ äx for a whole life assurance policy.

Bonuses are generally declared as additions to sum assured for each year’s premium paid. They
thus form an increasing assurance of b per year the value of which is b(IA)x. The cost of bonus at
a particular rate is much less at young ages and for policies of early durations than at advanced
ages and for policies with short unexpired terms. To maintain the uniformity of premiums in
level premium system the total cost of bonuses for the whole duration of a policy has to be
distributed uniformly over all the premiums by dividing it with the relative annuity due äx .
Thus, b(IA)x ÷ äx
gives the addition to each premium for an anticipated annual rate of bonus of b per unit sum
17
assured. This addition for a definite bonus is called bonus loading in the premium.

Allowing for expense loadings as mentioned in section 3 and bonus loading of b per unit of sum
assured, the expression for office annual premium for a With Profit Whole Life Assurance is

SA x + Sb(IA) x (I 2 - K 2 ) S + K 2S a x
P1 ... (2.5)
a x - (I 1 - K1 ) - K 1a x

In case of a With Profit Endowment Assurance, the expression for office annual premium is

SA x : n + Sb(IA) x : n (I 2 - K 2 ) S + K 2S a x : n
P1
a x : n - (I1 - K1 ) - K1a x : n ... (2.6)

It has to be clearly understood that payment of with profit premium entitles the life assured
only to participate in the profits if any, of fund relating to with profit policies of the Insurer. If
there are no profits in a particular period because of unfavourable experience, the life assured
has no right to demand any bonus. In times of prosperity, when good profits are earned by an
Insurer, there is every possibility for a life assured to get bonuses far in excess of the provision
made in premiums by way of bonus loading. This possibility arises because of profits due to
margins provided in the premiums as a safeguard against unforeseen adverse experiences that
may arise in future.

The contribution of various sources of profits to the working of an insurer is analyzed below:

(a) Mortality experience: If more people die, more amounts have to be paid for death
benefits than expected or provided in the calculations. There is also the additional loss
in the premium income because of smaller number of survivors at each age to pay the
premiums.

(b) Interest experience: If the interest actually earned is less than the interest assumed in
premium calculations, the income by way of interest will be insufficient to maintain
the increase in the funds as originally anticipated.

(c) Expenses experience: Premium calculations are based on a particular scale of

expenses as already discussed. The actual expenses incurred may be in excess of the
provisions made. The outgo will then be more than expected or provided in the
calculations.

Under the above circumstances, an Insurer will incur expense losses and under
opposite circumstances the Insurer will make expense profit.

(d) Margins in premiums: An explicit constant addition to the premiums is sometimes

made to meet any other contingencies that may adversely affect the financial position
of the Insurer. Under normal conditions there will be no need for utilising these
margins, and mostly normal conditions will prevail. Thus the margins not needed go to
increase the profits.

18
 (e) Without profit policyholders have no right to share in the profits of the Insurer.
Margins for adverse contingencies are also provided in non-profit premiums. When
normal conditions prevail and when the margins are not used up, they go to increase
the profits of the Insurer. All these profits are available for distribution amongst with
profit policyholders if both with profit and without profit business are written in a
single fund. However, IRDA requires Indian Life insurers to maintain separate funds
for par and non-par policies. Most of the private insurers don’t distribute profits pertaining
to non-par policies among with profit policyholders.

Sometimes the profit distribution policy of an insurer allows distribution of profits arising from
non-par policies to with profit policyholders. In such case with profit policyholders have the
privilege of sharing in the profits contributed by others. However, in that case they have also
the responsibility of sharing in the losses of the Insurer arising from non-participating Fund, as
and when they arise, by foregoing the benefit of excess premiums paid by them for the definite
provision of bonuses. The bonus loading in with profit premiums can, therefore, also be
considered as a buffer to meet the losses due to unfavourable experience. Because of this bonus
loading, the need for an explicit constant addition to the with profit premiums to cover
unforeseen contingencies is not so great as in the case of without profit premiums, where no
such margin or buffer exists. No explicit addition is therefore made for contingencies in case of
with profit premiums.

The expressions for without profit plans with C per unit sum assured as constant addition for
contingencies are :

(a) For whole Life Assurance

S.A x + (I 2 - K 2 C) S + K 2S a x
P1 = ... (2.7)
a x - (I 1 - K 1 ) - K 1a x

(b) For Endowment Assurance

SA x : n + (I2 - K 2 C) S + K 2Sa x : n
P1 =
a x : n - (I1 - K1 ) - K1a x : n
... (2.8)

whereas the expression for with profit plan is given by relation (2.5) for Whole Life Assurance
and relation (2.6) for Endowment Assurance.

The latter premium differs from the former by the bonus loading and the absence of margin for
contingencies.

6. ADEQUACY OF PREMIUMS
When an insurer requires premium rates for starting the business of insurance, it does not have its
own experience. Premiums have therefore to be calculated assuming:
(1) Mortality rates of a standard table already prepared and modified to reasonably reflect the
mortality of persons who are likely to be insured, (2) rate of interest which it is likely to earn
depending upon current market conditions and (3) expenses which should take into account the
proposed method of its working.

While preparing the table of premium rates, assumptions have necessarily to be made. The
profitable working of the insurer depends upon the adequacy or sufficiency of the premium
19
rates and its ability to manage the business well. Premiums are said to be adequate if actual
experience regarding mortality, interest and expenses follows reasonably close to the
assumptions made in their calculations.

There can never be an exact identity between actuals and assumptions. But variation should be
within reasonable limits. If the variations are very wide there is a case for revision of premiums.
Revision is essential when the variation is unfavourable and premiums charged are lower than
actually required on the basis of actual experience.

But when variation is favourable to the insurer and it is charging higher premiums than are
required on experience basis, it is not the usual practice to make a downward revision of
premium rates particularly under with profit policies as the favourable experience may
generate a higher rate of bonus to policyholders than originally contemplated. On the other
hand, it will be unfair to charge heavier rates of premiums than are required from Non-profit
policy holders as they cannot have any share in the profits of the insurer and the premium rates
may have to be reduced in their respect.

If the variations are very wide, a revision is always necessary even in case of with profit policies
for the simple reason that cost of insurance should not be unusually heavy and beyond the
reach of the common man.

It is, therefore, necessary to make a periodical comparison of the actual experience with the
expectation and no time should be lost in revising the premiums if their adequacy is suspect.
This test for adequacy is more important in insurance business as the real effect of inadequacy
cannot become apparent as long as the fund is increasing. Insurance contracts are essentially
long term contracts involving accumulation of funds which always increase with increasing flow
of business and may make a lay man believe that increasing funds are always an indication of
the growth and prosperity of the insurer. It is unfortunately not the increase that is the index of
prosperity but it is the rate of increase that gives the real position of the insurer. If the rate of
increase is not as anticipated and if the premiums are not adequate, then in spite of increasing
funds the insurer may be heading towards a disaster.

7. CONSISTENCY OF PREMIUMS
Premiums calculated as per methods already described, do not progress uniformly from age to
age. This is usually corrected by first calculating premiums at quinquennial ages and then
interpolating for individual ages in such a way that regular progression of rates is achieved.

Secondly, rates of premium for the various classes should be consistent with benefits offered. As
an example, we may take Children Deferred Assurances during deferment period and Pure
Endowment policies. In both policies there is no risk on the life of the assured during deferment
period. It may thus be argued that both classes must have the same rates of premium. But in the
former case there is the option to continue insurance without medical examination after the
child attains vesting age. In the latter case this option is absent. The option is more likely to be
exercised by persons who at the time of vesting age may be of indifferent health. To provide
against the antiselection against the insurer the premium rates for children deferred assurances
should be somewhat higher.

Thirdly, premiums for approximately similar durations should be consistent with the difference
in the type of benefits offered. As an example, an Endowment Assurance at age 20 maturing at
age 70 and Whole Life Assurance at age 20 premiums ceasing at age 70 should have different
rates of premiums. Both are 50 year term policies. In the latter case the benefit is payable on
death after age 70 if the assured survives the term of 50 years whereas in case of Endowment
20
Assurance the benefit is payable at the age 70 itself and therefore the premium should by less
under Whole Life Policy than Endowment Assurance premium. But the term being long when
interest will have its maximum influence, difference in premiums may not be brought out unless
the method of loading is properly selected for the calculation of office premium.

8. SELECT PREMIUMS
It is the practice of the insurers to get the lives to be insured medically examined by appointed
doctors or diagnostic centers in cases where the sum proposed exceeds a certain limit before
the proposals for insurance on their lives are entertained. The mortality of such selected lives is
expected to be comparatively light in the early years as they have been carefully selected. After
the policies have run for some years the effect of the medical selection will wear off. In India the
effect of selection has been observed to last only for a year or so.

It may, therefore, be argued that rates of mortality should be prepared for each age at entry
separately, but if this separation is taken to the logical end of life for each age at entry, the
number of tables required for all different ages will be too large and calculations of premiums
with so many combinations of tables will be difficult, if not impossible.

Premiums calculated with select rates of mortality during periods when selection is supposed to
exist and thereafter with ultimate rates are said to be select premium rates. They are naturally
lower than ultimate premium rates arrived at by using ultimate mortality rates throughout.

9. SELECTION AGAINST THE INSURER

However carefully a life office may select lives to be insured, there is always some selection
against the office. A person, who has reason to think that his standard of health is being average,
may prefer a whole life assurance or even term assurance under which the premium is smaller
thus securing greater protection for his outlay. A healthier individual on the other hand may
prefer an endowment assurance as he may regard protection for older age more important than
for his dependants after his death.

On theoretical ground it is advisable to use different rates of mortality for different classes of
assurance depending on their experience. But this is not practicable, as the method would
involve preparation of many mortality tables. The same object can be achieved by suitable
additions to the premiums of various classes.

For all schemes of insurance which are not popular, all the above considerations will apply with
equal validity. There is however, another point viz., the principle of averages will not work for
lack of sufficient number of policyholders. Either heavier rates of mortality or additional
margins are necessary if each type of insurance is to be self-supporting. In usual practice the
same mortality table is used for different plans of assurance.

Example 1 : Calculate office annual premium for a Whole Life Assurance for `20,000 to a
person aged 40. Provide for first year expenses at 55% of premiums and 17‰ sum assured;
and renewal expenses of 5% of premium and 6‰ sum assured.
Basis: IALM(94-96) modified Ultimate Table and 6% interest.

Solution

The office annual premium, p1, is given by

21
 P1ä40 = 20,000 A40 + .55 P1 + 340 + .05P1ä40 + 120ä40
= 20,000 A40 + .55 P1 + 220 + .05P1ä40 + 120ä40

P1{.95ä40 - .50} = 20,000 A40 + 220 +120ä40

P1{.95 × 14.850 - .50} = 20,000 × 0.15944 + 220 +120 × 14.850

P1 = ` 381.47

Alternatively, in the notations of section 4, S = 20,000, I1 = .55, I2 = .017, K1 = .05 and K2 =

.006. Relation (2.2) gives

(.017 - .006) (20,000)

20,000 0.01074 + + .006 20,000
1
P = 14.850
(.55 - .05)
1- .05
14.850

= ` 381.54

Example 2: For the data of Example 1, calculate office annual premium for a With Profit Whole
Life Assurance by providing a bonus loading of ` 25‰ per annum.

Solution

The office annual premium P1, is given by

P1ä40 = 20,000 A40 + 500(IA)40 + .50P1 + 220 + .05P1ä40 + 120ä40

P1{.95ä40 - .50} = 20,000 A40 + 500 (IA)40 + 220 +120ä40

P1 × 13.6075 = 20,000 × 0.15944 + 500 × 4.28 + 220 +120 × 14.850

P1 = ` 538.73

Example 3: Calculate office annual premium for an Endowment Assurance for `15,000 to a
person aged 35 for 25 years. Provide for first year expenses at 50% of premiums and 15‰ Sum
Assured; and renewal expenses of 5% of premiums and 6‰ Sum Assured. Basis: IALM (94-96)
modified Ultimate Table and 6% interest.

Solution

The office annual premium P1, is given by

P1a35 : 25 = 15000 A35 : 25 + .45P1 135 + .05P1 a35 : 25 + 90a35 : 25

P1 .95a 35 : 25 - .45 = 15000 A35 : 25 + 135 + 90a 35 : 25

22
 P1 {.95 × 13.220 - .45} = 15,000 × 0.25170 + 135 + 90 × 13.220

P1 × 12.109 = 5100.30

P1= ` 421.20

Example 4: From the date of Example 3, calculate office annual premium for a With Profit
Endowment Assurance by providing a bonus loading of 20‰ sum assured per annum.

Solution

The addition to the value of benefits will be

300
300 (IA) 35 : 25 R 35 - R 60 - 25M 60 25D 60
D 35
300
477488.90 143646.95 25 9977.36 25 225978.81
126184.01

= 1744.78

The office annual premium P1, is given by

P1 × 12.109 = 5100.30 + 1744.78

P1 = ` 565.29

Example 5: Calculate office annual premium for an Endowment Assurance for `15,000 to a
person aged 40 for 15 years. Provide for initial expenses at 55‰ sum assured, other expenses
at 8% of all premiums and constant expenses of 3‰ sum assured. Basis : IALM(94-96) modified
Ultimate Table and 6% interest.

Solution

The office annual premium P1, is given by

55 15
P1 15000 P40 : 15 .08P1 3 15
a 40 : 15
825
.92P1 15000 0.04230 45 761.09
10.111

P1 = ` 827.27

Example 6: Calculate office annual premium limited to 20 years for an Endowment Assurance
for ` 12,000 to a person aged 35 for a term of 30 years. Provide for initial expenses at `45 per
thousand sum assured, other expenses at 4% of all premiums during the premium paying term
and a constant expense of ` 3 per thousand sum assured after premiums cease and till the
expiry of the contractual period. Basis: IALM(94-96) modified Ultimate Table and 6% interest.

23
Solution

The office annual premium P1, is given by

P1a 35 : 20 = 12000 +12 45 + 04 P1a35 : 20 + 12 3 20|a35 : 10

.96 P1a 35 : 20 = 12000 A35 : 30 +540 36 a 35 : 30 a 35 : 20

.96 × P1 × 11.947 = 12,000 × .20106 + 540 + 36(14.115 – 11.947)

P1 × 11.46912 = 3030.77

P1 = ` 264.25

Example 7: Calculate the office single premium for an Immediate Annuity of `3600 per annum
payable monthly for 10 years certain and thereafter for life to a person aged 55. Provide for
initial expenses at ` 6 per thousand single premium and 5% of annuity payments. Basis: LIC(a)
(96-98) Ultimate Table and 8% interest.

Solution

The office single premium X, is given by

D65
X (3600 180) a (12)
10
a (12)
65 .006X
D55

5611.54
.994X 3780 6.7101 1.036157 8.2819 .458
13437.16

X = ` 40319.81

Example 8: For the data given below calculate office annual premium ceasing after 15 years or at
previous death by providing for first year expenses at 55% of premium and 17‰ sum assured and
renewal expenses at 5% of premium and 6‰ sum assured. Consider the policy on With Profit Plan
and provide for bonus loading of `0 per thousand sum assured per year. Basis: IALM (94-96)
modified ultimate Mortality Table and 6% interest.

Data for a Money Back Policy on (45) to secure the following benefits:

i) `1500 on survivance to the end of 5 years,

ii) `1500 on survivance to the end of 10 years,

iii) `3000 on survivance to the end of 15 years, and

iv) `6000 on death at any time within 15 years

Solution
The net annual premium P works out to be ` 337.05 as under:

Pa 45 : 15 = 1500 (A45 : 51 +A45 : 101 + 2A45 : 151 +4A451 : 15 )

24
 D50 D55 2D60 4(M 45 M60 )
9.999P = 1500
D45

1500
or 9.999P= 50608.61 36605.86 2x25978.81+4(13969.02-9977.36)
69049.98

or 9.999P = 3370.1398

or P = 337.05

The office annual premium P1, is given by

.50P1 66 120(IA)45 : 15
P1 = 337.05 + .05 P1 + 36.00 +
a 45 : 15 a 45 : 15 a 45 : 15

.50P1 66 120 6.14079

0.95P1 337.05 36.00
9.999 9.999 9.999

= 337.05 + .05P1 + 36.00 + 6.60 + 73.70

0.90 P1= 453.35

P1= ` 503.72

Example 9: Calculate office single premium under a 2-year Temporary Assurance for sum
assured of ` 20,000 on (40). Provide for expenses at 9% of single premium and 3‰ sum
assured. Basis: IALM (94-96) modified ultimate Mortality Table and 6% interest.

Solution

The office single premium x, is given by

x = 20,000 A401 : 2 + .09 x + 60

0.91x = 20,000 A401 : 2 + 60

M40 M42
= 20,000 + 60
D40

14913 14545.70
= 20,000 + 60
93535.60

= 20,000 × 0.00393 + 60

0.91x = 138.60

or x = ` 152.31

25
EXERCISE 2

1. Describe the nature of various types of expenses of an insurer.

2. Show how the provision for initial expenses and renewal expenses can be made in the
calculation of office premiums.

3. Discuss, giving suitable illustrations, the need for the Insurer to maintain consistency in
premium rates for various classes of policies.

4. Calculate office annual premium under a With Profit Endowment Assurance for `80,000
to a person aged 35 for term of 25 years. Provide for first year expenses at 60% of
premium and 16 per thousand sum assured, renewal expenses of 6% of premiums and 5
per thousand sum assured and bonus loading of 25 per thousand sum assured per year.
Basis : IALM(94-96) modified ultimate Table and 6% interest.

5. Calculate office annual premium under a Whole Life Assurance for `180,000 to a person
aged 37. Provide for first year expenses at 45% of premium and 16 per thousand sum
assured, and renewal expenses of 6% of premiums and 4 per thousand sum assured.
Basis: IALM (94-96) modified ultimate Table and 6% interest.

6. Calculate office annual premium limited to 20 years under a Whole Life Assurance for
`100,000 to a person aged 35. Provide for initial expenses at ` 35 per thousand sum
assured, further expenses at 7.5% of first year premium and subsequent years’
premiums during the premium paying term and a constant expense of ` 2 per thousand
sum assured after premiums cease and till the expiry of the contract. Basis : ILAM (94-
96) modified ultimate and 6% interest.

7. Calculate office annual premium limited to 20 years under a With Profit Whole Life
Assurance for `22,000 to a person aged 40. Provide for first year expenses at 55% of
premium and 12 per thousand sum assured, renewal expenses of 6% of premiums and 4
per thousand sum assured during the premium paying term and bonus loading of ` 30
per thousand sum assured per year. Basis: IALM( 94-96) modified ultimate Table and
6% interest.

8. Calculate office annual premium limited to 15 years under a With Profit Endowment
Assurance for ` 25,000 for a term of 25 years to a person aged 40. Provide for the
following :
(a) First year expenses at 45% of premium and 8 per thousand sum assured.

(b) Renewal expenses for the second and subsequent policy years at 7% of
premiums and 3 per thousand sum assured during the premium paying
term.
(c) A constant expense of ` 2 per thousand sum assured after premiums
cease and till the expiry of the contract.
(d) A bonus loading of `22 per thousand sum assured per year.
Basis: IALM ( 94-96) modified ultimate Table and 6% interest.

9. The basis adopted by a life office under Immediate Annuity Policies are :
(a) LIC (a) (96-98) ultimate Table and 8% interest.
Provision for expenses at 15 per thousand single premium and 4% of the

26
 annuity installments.
A person, aged 52, desires to buy an immediate annuity payable quarterly in arrear for
15 years certain and thereafter for life. Find the quarterly installment of the annuity
secured by a single premium of `25,000.

10. The expenses loadings made by an insurer in the calculation of office premiums for
Whole Life Assurances are :

(a) Initial expense of 65 per thousand sum assured.

(b) Expense of 5% of first year and subsequent year’s premiums.
(c) A constant expense of 3 per thousand sum assured.
Find the value of life annuity due at the age at which the removal of initial expense
loadings in (a) above results in a reduction of ` 5.48 in the office annual premium per
thousand sum assured.

11. Calculate office annual premium under a 7-year Term Assurance on (30) for a sum
assured of ` 300,000. The loading for expenses are: First year – ` 5‰ sum assured and
7½% of premium, Renewal – ` 3‰ sum assured and 5% of premium. Basis: IALM (94-
96) ultimate modified Table and 6% interest.

27
 CHAPTER 3

POLICY VALUES
1. In the previous chapter we have considered the values of benefits and expenses and the
value of gross premiums at the inception of insurance. If the premiums are just sufficient,
neither more nor less, the two values must be exactly equal as at the inception of contract.
However, the position is different after an insurance policy has run for some years when some
premiums have already been paid. The number of premiums payable in future will be less than
the number of premiums payable at inception. Therefore the present value of future premiums
at any intermediate time will be less than the present value at the beginning of insurance. On the
other hand, as the date of payment of benefit draws nearer the present value of benefit
increases as compared to the present value at the inception.

The equality between the value of benefits and expenses and value of future premiums
subsequent to the date of commencement of the policy no longer holds good for the simple
reason that the former has increased and the latter decreased. The gap between the two values
goes on increasing as the time of payment of benefit approaches nearer and nearer, particularly
where the nature of contract is such that the benefit is definitely payable at one time or the
other. To meet this increasing gap the insurer must build up a fund which goes on increasing
with time. The only source from which this fund can be built up is the premiums already
received plus interest earned less the claims paid. The amount so held out of past premiums is
known as the policy value or policy reserve and this should be equal to the difference between
value of benefits payable and value of future premiums receivable at a given point of time.

Under a policy where a benefit becomes definitely payable, the policy value on the date of
payment of benefit will be equal to the benefit itself.

It is important to mention that groups of persons, usually indicated by a life table, are always
taken into consideration in arriving at either the value of an assurance benefit, or the value of
future premiums. A policy value, which is the difference between the above two values or which
is the accumulation of premiums already received less claims paid in the past, has also to be
understood in the same way, as the average value of a policy when a group of similar policies is
considered. For an individual policyholder the policy value conveys no meaning as he is only
concerned with the sum assured payable to him in the event of a claim or he is concerned with
the premiums he has already paid. For those who had already expired the value of the policy is
full sum assured, which is ordinarily in excess of premiums received under those policies
accumulated with interest. This excess has to be met from the premiums of those who survive.
Thus policy value for those who survive cannot be the same as the premiums received with
interest but something less because of the deficit created by the contribution towards claims
that were paid.
2. TWO KINDS OF POLICY VALUES
The manner in which the idea of a policy value has been conceived suggests the existence of two
methods by which it can be derived. It has been explained as the amount held in hand by the
insurer out of past premiums to meet the difference between the value of future benefits and
the value of future premiums. Its value can, therefore, be obtained by taking premiums already
paid together with interest earned thereon, and deducting from them the outgo of past years on
account of claims. This is known as the retrospective policy value as it is a result of past
balances.

28
The alternative way is to find the value of assurance benefit at the time the policy value is
required and deduct from it the value of future premiums at the same point of time. This is the
prospective policy value, as it is derived from a consideration of the future.

If the experience of the insurer in regard to mortality and interest were exactly the same as
assumed in the premium calculations, then the accumulations of balances out of the premiums
paid in past should be equal to the difference between value of benefit and value of future
premiums payable at any point of time on the same assumptions. This brings out the fact that in
such as case the policy value would be the same whether obtained retrospectively from
balances of past premiums or prospectively on the basis of the future.

If, on the other hand, deaths in the past were much more than expected according to the
mortality table used in premium calculations, the outgo on claims would be more than expected,
leaving insufficient balances of premiums for accumulation. Such accumulations will be less
than the difference, at any time, between the value of benefit and value of future premiums.
Thus retrospective policy value will be less than the prospective policy value because of past
deficits, even though future deaths were to be as expected. A similar situation will arise if the
interest earned in the past is less than that assumed in premium calculations.

In the other case when past experience was more favourable with fewer deaths or larger
interest earnings than expected, retrospective policy value will be more than the prospective
value at any point of time, whether future experience is assumed as per the basis underlying the
premium calculations or as per the favourable experience of the past.

3. POLICY VALUE IN SYMBOLS

Just as value of assurance benefit at the inception is denoted by the symbol A with age and term,
if any, written at the right bottom end of A as suffixes to indicate the type of assurance, the
policy value at the end of t years from commencement of policy is denoted by the symbol tV. The
letter ‘t’ to the left represents the period elapsed after the issue of the policy, and ‘V’ stands for
value. The age and term (if any) to the right of V as suffixes relate to the original age and term on
the date of commencement of policy which also indicate the type of policy.

Policy values in symbols in respect of important plans of assurance are given below.

tVx is the policy value at the end of t years for a Whole Life Assurance of 1 on the life of a
person aged x at entry.

t Vx : n is the policy value at the end of t years for an Endowment Assurance of 1 on the life
of a person aged x at entry with the term of ‘n’ years.

t Vx1 : n is the policy value at the end of t years for a Temporary Assurance of 1 on the life of
a person aged x at entry with the term of ‘n’ years.

t Vx : 1n is the policy value at the end of t years for a Pure Endowment of 1 on the life of a
person aged x at entry with the term of ‘n’ years.

4. CALCULATION OF POLICY VALUE FOR UNIT SUM ASSURED

Prospectively, for a Whole Life Assurance policy value at time t, i.e. tVx is calculated as the
difference between the value of benefit at age x + t and value of future premiums at the same
29
age x + t. Value of benefit at age x + t is written as Ax + t. The future premiums at age x + t form an
annuity due at age x + t. The future premiums are payable at the rate of Px which is the annual
premium for entry age x years. Value of future premiums is given by

Px a x + t

t Vx = A x + t – Px a x + t ... (3.1)

Similarly for an endowment assurance,

t Vx : n = Ax + t : n–t – Px : n . a x + t : n–t ... (3.2)

5. NUMERICAL EXAMPLE-RETROSPECTIVE METHOD AND

COMPARISON WITH PROSPECTIVE VALUE
Consider, as an illustration, a group of 10000 policies, all effected at the same time on lives of exact
age 60. Each policy is 5-year Annual Premium Endowment Assurance with benefit of `100 payable
on survival to the end of 5 years. The net premium, ignoring expenses, for each policy on the IALM
(94-96) modified Ultimate Table and 6% interest is `17.35. Assume that IALM (94-96) modified
Ultimate mortality is experienced, rounding the number of deaths in group to the whole numbers.

The total premiums collected at the outset will be 10,000 × 17.35 = ` 1,73,500. During the first
year interest earned will be 1,73,500 × 0.06 = ` 10,410 and the number of death claims will be
10,000 × q60 (= 0.01307). The number of claims, adjusted to whole numbers, will be 131 for a
sum of ` 13100. The fund at the end of the year works out to

173500 + 10410 – 13100 = ` 170810.

For the second year the premiums paid by survivors will be 9869 × 17.35 = 171227. The fund at
the beginning of the year will be

170810 + 171227 = ` 342037.

Interest on this for the year will be 342037 × .06 = ` 20522. Death claims will be deducted for
9869 × q61 = (= 0.01439) = 142 lives for a sum of ` 14200. The fund at the end of the second
year will be

342037 + 20522 – 14200 = ` 348359.

The same calculations can be done for each subsequent year. The results for 5 years are given in
Table 1. The last column of the table gives the fund per survivor, which is the same as the
retrospective policy value per policy.

At the end of 1 year,

100(1 V60 : 5 ) = 100 A61 : 4 –17.35 a 61 : 4

= 100 (.79662) – 17.35 (3.593)

= 79.66 – 62.34
30
 = ` 17.32 (compared to ` 17.31 in Table 1)

At the end of the second year,

100(2 V60 : 5 ) = 100 A62 : 3 –17.35 a 62 : 3

= 100 (0.84214) – 17.35 (2.789)
= 84.21 – 48.39
= ` 35.82 (compared to ` 35.81 in Table 1)

TABLE 1

Year Premiums Total fund Interest Death Fund at No. of Fund per
received at at the at 6% claims the end survivors survivor
the beginning for the paid at of the (6) ÷ (7)
beginning of of the year the end year (3)
the year. year. of the (4) – (5)
year
(1) (2) (3) (4) (5) (6) (7) (8)
` ` ` ` ` ` `
1 175300 173500 10410 13100 170810 9869 17.31
2 171227 342037 20522 14200 348359 9727 35.81
3 168763 517122 31027 15500 532649 9572 55.65
4 166074 698723 41923 16900 723746 9403 76.97
5 163142 886888 53213 18400 921701 9219 99.98

We can compare the retrospective value obtained as above with the prospective policy value
calculated by using relation (3.2), that is, present value of benefit less present value of premiums
on IALM(94-96) modified Ultimate table with 6% interest.

Table 2 gives the prospective policy values at successive durations.

TABLE 2

Duration t Value of Sum Value of Prospective Policy Value

years Assured future 100 (tV60 : 5 )
100 A60 + t : 5–t premiums (2) – (3)
17.35
a 60 + t : 5– t
(1) (2) (3) (4)
0 75.40 75.39 0.01
1 79.66 62.34 17.32
2 84.21 48.39 35.82
3 89.09 33.43 55.66
4 94.34 17.35 76.99
5 100.00 0.00 100.00

31
 We see from Table 2 that when the benefit is certainly payable as in the case of an
Endowment Assurance Policy:
(a) Value of benefit increases with the term to the full sum assured by the end of the term.
(b) Value of future premiums decreases as the duration increases.
(c) Policy value increases from 0 at duration 0 to full sum assured at the end of the term.

Table 3 illustrates the progress of policy values from year to year under a Temporary
Assurance of ` 1000 payable on death to a person aged 30, if death occurs within 5 years.
The annual premium is ` 1.14631 on the basis of IALM(94-96) modified Ultimate Table and
6% interest.

TABLE 3

Duration t Value of Sum Value of future Prospective

years Assured premiums Policy Value
1000A130 1.14631 × ä30 + t : 5–t 1
1000 t V30
t : 5–t :5
(2) – (3)
(1) (2) (3) (4)
0 5.107 5.107 0
1 4.248 4.203 0.045
2 3.336 3.244 0.092
3 2.338 2.226 0.112
4 1.234 1.146 0.088
5 0 0 0

From Table 3 we observe that when benefit is not payable certainly as in the case of a
Temporary Assurance:

(a) Value of sum assured decreases with the term to 0 at the end,
(b) Value of future premiums decreases to 0 by the end of the term,
(c) Policy value first increases and then decreases to 0.

6. DERIVATION OF THEORETICAL EXPRESSIONS FOR POLICY

VALUE, tVx, BY THE RETROSPECTIVE METHOD AND
PROSPECTIVE METHOD
Let us derive the theoretical expression for the policy value, tVx, by the Retrospective Method
and demonstrate that this expression is equal to the policy value obtained by the prospective
method. For this purpose we take recourse to a life table and assume that each of 1x persons are
insured at age x for a unit sum assured under Whole Life Policy. The annual premium payable
by each person is Px on the basis of the same life table and rate of interest of i per annum.

The amount of premiums received at the inception will be Px.1x.

The accumulated value of these premiums at the end of 1 year at i will be Px.1x. (1 + i).

32
The number of death claims during the first year out of 1x persons will be dx for which the outgo
will be dx.

The balance available with the insurer at the end of 1 year will be Px.1x. (1 + i) – dx

The above expression represents policy value in respect of 1x + 1 survivors and the average
policy value will be

Px .1x (1 i) d x
1x 1

Vx 1
Px .1x (1 i) d x
Vx 1
1x 1

Px .D x C x
Dx 1

Dx Cx
Dx Px
Dx Dx
Dx 1
Dx
Px .ax : 1 - A1x : 1
Dx 1

Continuing this approach, the premiums received in respect of 1x + 1 survivors at the beginning of
the second year will be Px.1x + 1.

The balance will then be

Px .1x (1 i) d x Px .1x 1

Px .1x (1 i) Px .1x 1 dx

Allowing interest at rate i, the value of the above sum at the end of second year will be

(1 + i) {Px 1x (1 + i) + Px 1x + 1 - dx}
= Px 1x (1 + i)2 + Px 1x+1 (1 + i) –dx (1 + i)

The number of death claims for the second year will be dx + 1 for which the claim outgo will be dx
+ 1.

The balance at the end of the second year will be

Px.1x (1 + i)2 + Px.1x+1 (1 + i) –dx (1 + i) –dx+1

The above expression represents policy value in respect of 1x + 2 survivors. The average policy
value will be

Px .1x (1 + i) 2 + Px .1x +1 (1 + i) - d x (1 + i) - d x +1
1x 2

33
 Vx 2
Px .1x (1 + i)2 + Px .1x+1 (1 + i) -d x (1 + i) -d x+1
Vx 2
.1x 2

Px .D x Px .D x 1 - C x - C x 1
Dx 2

Dx Px Dx Dx 1 Cx Cx 1
Dx 2 Dx Dx

Dx
Px .a x : 2 A1x : 2
Dx 2

Proceeding on the above lines, the retrospective policy value at the end of t years, immediately
before payment of premium then due, will be

Dx
[Px .a x : t A1x : t ] ... (3.3)
Dx t

It may be noted that the accumulation of balance premiums should be at the same rate of
interest as assumed in the premium rates and the deaths are also assumed to be in accordance
with the mortality table adopted for premium rates. Further, expenses are ignored and
premiums used are net premiums only. When calculations are made in this way, the
retrospective policy value will be equal to the prospective policy value.

This is demonstrated below.

From relation (3.3), we have:

Dx
Retrospective Policy Value Px .a x : t A1x : t
Dx t

1
Px N x Nx t Mx Mx t
Dx t

1
Px N x Mx Mx t Px .N x t
Dx t

But under a Whole Life Policy we have

Px. a x = Ax
Nx Mx
Px .
Dx Dx

Px .N x Mx

Therefore retrospective policy value

1
Mx t Px .N x t
Dx t

= Ax+t – Px. a x + t

34
 = Prospective Policy value (see relation 3.1)

Example 1: Give expressions for the prospective policy value and retrospective policy value at
the end of t years under an Endowment Assurance Policy, for a unit sum assured, effected on the
life of a person at age x for term of n years. Annual premiums under the policy are payable for a
maximum of n years. Show that the two expressions are equal. Ignore expenses.

Solution

Prospective Policy Value = Ax + t : n t

P.a x + t : n t , and

Dx
Retrospective Policy Value P.a x : t A1x : t ,
Dx t

Where P is the annual premium given by

P.a x : n Ax : n

P(N x – N x n ) Mx – Mx n Dx n
i.e.
Dx Dx
i.e. P(Nx – Nx+t) + P(Nx+t – Nx+n) = Mx – Mx+n + Dx+n

i.e. P(Nx+t – Nx+n) = (Mx – Mx+n + Dx+n) – P(Nx – Nx+t).

Now Prospective Policy Value

= Ax + t : n t
P.a x + t : n t
1
= (M x t – Mx n Dx n) – P(N x t – Nx n)
Dx t

1
= (M x t – M x n D x n ) – (M x – M x n Dx n ) P(N x – N x t )
Dx t
1
= P(N x - N x t ) - (M x - M x t )
Dx t

Dx P N x Nx Mx Mx
= t t
Dx t Dx Dx
Dx
= Px .a x : t A1x : t
Dx t

= Retrospective Policy Value

Example 2 : Give expressions for the prospective policy value and retrospective policy value at
the end of t years under a Whole Life Policy by single premium, for a unit sum assured, effected
on the life of a person at age x. Show that the two expressions are equal.

Solution

Prospective policy value = Ax + t

35
 Dx
Retrospective policy value P A1x : t
Dx t

Where P is the single premium under the policy, which is equal to Ax.

Prospective policy value

= Ax+t
Mx t
Dx t

1
Mx (M x Mx t )
Dx t

Dx Mx (Mx Mx t )
Dx t Dx Dx
Dx
Ax A1x : t
Dx t

Dx
P A1x : t
Dx t

= Retrospective policy value.

Example 3 : Give expressions for the retrospective policy value and prospective policy value at
the end of 35 years under a Whole Life Policy, for a sum assured of ` 5000/-, effected on the life
of a person at age 25. Annual premiums under the policy were limited to 30 years. Show that the
two expressions are equal. Ignore expenses

Solution

D25
Retrospective policy value P.a 25 : 30 – 5000 A125 : 35 , and
D60

Prospective policy value = 5000 A60,

where P is the annual premium given by

P a 25 : 30 = 5,000 A 25

i.e. P(N25 – N55) = 5000 M25.

Now retrospective policy value

D25
P. a 25 : 30 – 5000 A125 : 35
D60
1
P(N 25 – N55 ) – 5000 (M 25 – M 60 )
D60

36
 1
5000 M 25 – 5000 (M 25 – M 60 )
D60
1
5000 M 60
D 60
= 5000 A60
= Prospective policy value.

Example 4 : Give expressions for the prospective policy value and retrospective policy value at
the end of 5 years under an Endowment Assurance Policy, for a sum assured of ` 5000, effected
on the life of a person at age 25 and term of 30 years. Annual premiums under the policy are
limited to 15 years. Show that the two expressions are equal. Ignore expenses.

Solution

Prospective policy value= 5000 A30 : 25 – P.a 30 : 10 , and

D25
Retrospective policy value P.a 25 : 5 – 5000 A125 : 5 ;
D30

Where P is the annual premium given by

P.a 25 : 15 = A 25 : 30

i.e. P(N25 – N40) = 5000 (M25 – M55 + D55)

i.e. P(N25 – N30) + P(N30 – N40) = 5000 (M25 – M55 + D55).

i.e. P(N30 – N40) = 5000 (M25 – M55 + D55) – P(N25 – N30).

Now prospective policy value

= 5000 A30 : 25 P.a 30 : 10
1
5000 (M30 – M55 + D55 ) – P(N30 – N 40 )
D30
1
5000 (M30 – M55 + D55 ) – 5000 (M 25 – M55 + D55 ) P(N25 – N30 )
D30
1
P(N 25 – N30 ) 5000 (M 25 – M30 )
D30
D 25 P(N 25 – N 30 ) 5000 (M 25 – M 30 )
–
D30 D 25 D 25
D25
P.a 25 : 5 5000 A125 : 5
D30

= Retrospective policy value

Example 5 : Give expressions for the retrospective policy value and prospective policy value at
the end of t years under a Pure Endowment Policy, for a unit sum assured effected on the life of
a person at age x for term of n years. Annual premiums under the policy are payable for

37
maximum of n years. On the life assured surviving to n years, the sum assured becomes payable;
and on his death during the term of the policy, the total premiums paid are returnable without
interest.

Show that the two expressions are equal.

Solution

Dx
Retrospective policy value P.a x : t P(IA)1x : t ; and
Dx t

Prospective policy value Ax 1

t: n-t
Pt . A1x t: n-t
P(IA)1x t: n-t
P . ax t: n-t
,

Where P is the annual premium given by

Pa x : n Ax : n1 P(IA)1x : n

i.e. P(Nx – Nx+n) = Dx+n + P(Rx – Rx+n – nMx+n),

i.e. P(Nx – Nx+t) + P(Nx+t – Nx+n)= Dx+n + P(Rx – Rx+n – nMx+n)
i.e. P(Nx – Nx+t)= Dx+n + P(Rx – Rx+n – nMx+n) – P(Nx+t – Nx+n)

Now retrospective policy value

Dx
P.a x : t P(IA)1x : t
Dx t

1
P(N x – N x t ) – P(R x – R x t – tM x t )
Dx t

Substituting the value of P(Nx–Nx+t) in the above expression, we get Retrospective policy value

1
D x+n + P(R x R x+n nM x+n ) P(N x+t N x+n ) P(R x Rx t tM x t )
Dx t

1
D x+n + Pt M x t P(R x t R x n ) Pn M x n P(N x+t N x+n )
Dx t

1
Dx+n + Pt M x t Pt M x n P(R x t Rx n (n t) M x n ) P(N x+t N x+n )
Dx t

1
Ax t :n t Pt.A1x t: n t
P(IA)1x t: n t
P.a x t: n t

= Prospective policy value

Example 6: A special Endowment Assurance Policy is effected on the life of a person for a sum
assured of ` 5000 at age 30 years for term of 20 years. Annual Premiums are payable for 20
years or until death, whichever is earlier. The policy carries a guaranteed simple reversionary
bonus of ` 24‰ vesting at the beginning of each policy year. Give expressions for the
retrospective policy value and prospective policy value at the end of 15 years and show that the
two expressions are equal.
38
Solution

Total bonuses vested at the end of 15 years = 5×24×15 = 1800.

D30
Retrospective policy value P a 30 : 15 5000 A130 : 15 120 (IA)130 : 15 , and
D45

Prospective policy value (5000 + 1800)A45 : 5 120(IA)45 : 5 Pa 45 : 5

Where P is the annual premium given by

P a30 : 20 = 5000 A30 : 20 120(IA)30 : 20

i.e. P(N30 – N50) = 5000(M30 – M50 + D50) + 120(R30 – R50 – 20M50 + 20D50)

i.e. P(N30 – N45) + P(N45 – N50) = 5000(M30 – M50 + D50) + 120(R30 – R50 – 20M50 + 20D50)

i.e.P(N30 – N45) = 5000(M30 – M50 + D50) + 120(R30 – R50 – 20M50 + 20D50) – P(N45 – N50)

Now retrospective policy value

D30
P a 30 : 15 5000 A130 : 15 120 (IA)130 : 15
D45

1
P N30 – N 45 – 5000 M30 – M 45 –120(R 30 – R 45 –15M 45 )
D45

1
5000 (M M D ) 120(R R 20M 20D )
D 30 50 50 30 50 50 50
45

P(N N ) 5000(M M ) 120(R R 15M )

45 50 30 45 30 45 45

1
6800 M 45 - 7400 M50 7400 D50 120 (R 45 - R 50 ) - P(N45 - N50 )
D45
1
6800 (M 45 - M50 D50 ) 120(R 45 - R 50 - 5M50 5D50 )- P(N 45 - N50 )
D45

= 6800 A45 : 5 120(IA)45 : 5 Pa 45 : 5

= Prospective policy value.

7. OTHER EXPRESSIONS FOR POLICY VALUE

The policy value at the end of t years in case of a Whole Life Policy is given by

t Vx A x t – Px a x + t

39
 But Ax+t = 1 – d a x + t,

tVx = 1 – d a x + t – Px a x + t

= 1 – a x + t Px +d

ax t 1
1 (Since Px d ) ... (3.4)
ax ax

A similar relation can be established in case of an Endowment Assurance Policy also.

t Vx :n Ax t : n–t
– Px :n a x + t : n-t

= 1 – d ax t : n–t
– Px :n a x + t : n-t

= 1 – (Px n
d) a x + t : n-t

a x + t : n-t
1
ax : n
... (3.5)

Relations (3.4) and (3.5) will hold good for types of policies for which premium conversion
relationships are applicable.

Again, since Ax+t = Px+t. a x + t, the policy value can be written as

tVx = Ax+t – Px a x + t

= Px t .a x + t Px .a x + t

= a x + t Px + t Px

Px t - Px
... (3.6)
Px t d
Similarly,

t Vx :n Ax t : n–t
– Px :n a x + t : n-t

= Px t : n–t
.a x + t : n – t Px :n a x + t : n – t

=a x + t : n – t ( Px t : n–t
Px :n )

Px t : n –t
– Px : n
... (3.7)
Px t : n –t
d

Relations (3.6) and (3.7) enable us to calculate the policy value at time t if net premiums at ages
x + t and x are known; provided the type assurance is such that the benefit is definitely payable
at one time or the other.

8. SURRENDER VALUES
40
After premiums have been paid for certain minimum number of years under a life assurance
policy a life office will normally allow an immediate cash payment called a surrender value or
cash value, if the policy is cancelled. However, for certain types of policies such as temporary
assurances where the policy values are very small, surrender values are not usually granted.

The basis of surrender value of a life office will be such that it will give values less than the
reserves held in respect of the policies for the reasons discussed in Chapter 12.

9. PAID-UP POLICIES
A paid-up life assurance policy is a policy free from future premiums. The term is referred to
those policies effected by annual premiums under which the sum assured is reduced because
the policyholder does not wish to continue payment of premiums but also does not request for
payment of surrender value.

We may use the symbol W for a paid-up policy. Consider a Whole Life assurance originally
effected at age x which has been in force for t years. The policy value will be tVx. If the amount of
tVx is applied as a single premium, we have

tWx.Ax+t = tVx

t Vx
t Wx = ... (3.8)
A x+t
Alternatively, if a life aged x + t effected a whole life assurance with net premium Px, the sum assured
secured by annual premium, Px, is given by simple proportion as Px/Px+t. This is the sum assured
secured by annual premiums, Px, payable at or after age x + t. Therefore the sum assured already
purchased by the same annual premiums, Px, already paid is given by
Px
t Wx = 1 -
Px + t ... (3.9)
Relations (3.8) and (3.9) give identical values as

tVx A x +t Px .a x + t
A x +t A x +t
Px
1
A x+t a x+t

Px
1
Px+t

Similarly, the paid-up value of an n-year Endowment Assurance at duration t is

t Vx : n
t Wx : n = or ... (3.10)
A x+t : n t

Px : n
t Wx : n =1 ... (3.11)
Px+t : n t

In case of Endowment and Limited Premium policies, a paid-up policy is usually granted for a
sum assured proportionate to the premiums paid. Thus the paid-up sum assured will bear that
41
proportion to the original sum assured which the number of premiums paid bears to the total
number of premiums payable. This is known as the proportionate paid-up value, it is used for
convenience of calculation. Where the paid-up value is desired in the early years of the policy,
the theoretical paid-up value may be subject to a further reduction because the initial heavy
expenses would not have been fully recovered.

10. ALTERATION OF POLICY CONTRACTS

If a policyholder desires to have alteration of policy, viz., reduction in the term of the policy or a
change in the plan of insurance or an alteration in the premium paying term, the value of the
policy before alteration will not ordinarily be the same as the value it acquires after alteration, if
all the other terms of the policy remain unchanged. No alteration can, however, be allowed as a
result of which the insurer will be at loss by virtue of his requiring to set up higher reserves
consequent upon alteration. It is, therefore, essential to maintain equality of policy values both
before and after alteration by effecting suitable changes in the other terms of the policy. For
instance, if a policy of Endowment Assurance for 30 years is desired to be altered (after it has
remained in force for some years) to a term of 20 years only, either the sum assured has to be
reduced or premium has to be increased. Then only the policy value before alteration will be
identical, involving no loss to the insurer.

Example 7: A person now aged 30 has a Whole Life Assurance Policy for ` 15000 issued to him
10 years ago. He now desires the policy to be altered to an Endowment Assurance Policy for the
same sum assured maturing at age 60. Find the net annual premium he has now to pay. The
basis is IALM (94-96) modified Ultimate mortality with 6% interest.

Solution

Policy value before alteration

a 30
= 15000 1
a 20

15.938
= 15000 1
16.570
= ` 572.12

If P is the future annual premium required for the altered plan, policy value after alteration

= 15000 A30 : 30 – P ä30 : 30

As both policy values have to be equal

15000 A30 : 30 – P ä30 : 30 = 572.12

15000 (0.19205) – P(14.274) = 572.12

P = ` 161.74

Example 8: In the data of Example 7, if the policyholder desires reduction in sum assured,
keeping the premium payable as per the original contract unaltered, calculate the reduced sum
assured.

42
Solution

Policy value before alteration is ` 572.12

Net annual premium for the original policy

= 15000 P20
= 15000 × 0.00375
= ` 56.25

If S is the reduced sum assured, value of the policy after alteration

= S A30 : 30 – 56.25 ä30 : 30

S.A30 : 30 – 56.25 ä30 : 30 = 572.12

S(0.19205) – 56.25(14.274) = 572.12
S = ` 7159.76

Example 9: Find the net premium policy value at 6% interest of a Whole Life Policy for ` 8000
effected at age 35 which has been in force for 15 years and to which a reversionary bonus of `
2160 is attached. It is given that P35 = .00983 and P50 = .02351.

Solution

The value is (8000 + 2160) A50 – 8000 P35.ä50

= 10160 P50 ä50– 8000 P35 ä50
= (10160 P50– 8000 P35) ä50
10160 P50 - 8000 P35
P50 d

10160 .02351- 8000 .00983

.02351 .05660
= ` 2000.

43
EXERCISE 3

1. What is meant by a policy value? Explain how this value arises.

2. What are the conditions under which the two policy values, prospective and
retrospective, can be identical?

3. Explain how the difference in prospective and retrospective policy values arises.

4. Calculate the retrospective policy value at 6% interest at the end of 3 years for
Temporary Assurance of ` 1000/- for a period of 6 years on the life of a person aged 50.
Use the following mortality table on the basis of which a net annual premium of ` 9.26 is
charged.
Age x 50 51 52 53
1x 920 913 905 896
5. A person aged 45 is insured for ` 1000 for a term of 6 years with the following benefits.
(a) ` 200 payable on survival to age 47
(b) ` 300 payable on survival to age 49
(c) ` 500 payable on survival to age 51
(d) ` 1,000 payable at the end of year of death before age 51.

If the net annual premium is ` 151.04 find the retrospective policy value at 6% interest
at the end of 3 years before payment of the annual premium then due. The following life
table functions are given

Age x 45 46 47 48
1x 947 942 937 932
6. Find the prospective policy value in Example (5) given that a 48 : 3 2.638,
a 48 : 2 1.816 and a 48 : 1
.937

7. 15 years ago a person then aged 30 affected a Whole Life Assurance policy for ` 25,000
under which annual premiums at ` 191.04 are payable for maximum of 40 years. He
now desires to alter the policy into Endowment Assurance maturing at age 65 and
premiums ceasing at age 60 or on death, if earlier. Calculate the revised annual premium
payable on alteration on the basis of IALM (94-96) modified ultimate table at 6%. Ignore
expenses.

8. Prove that
tVx = 1 – (1 – 1Vx) (1 – 1Vx + 1) ... (1 – 1Vx + t – 1)

9. Prove that
Px t: n t
- Px : n
(a) t Vx : n
Px t: n t
d

Ax t: n t
- Ax : n
(b) t Vx : n
1 - Ax : n

1
10. If Px = .025, nVx = .279, and Px : n
.038 , find Px1 : n

44
11. A special Endowment Assurance Policy provides the following benefits :
(a) On death during the selected term, the basic sum assured together with total
premiums paid
(b) On survival to the end of the term, only the basic sum assured is payable.

A person effected the policy by annual premiums at age 25 for the term of 30 years. Give
expressions for the retrospective and prospective policy values at the end of 10 years
and prove that they are equal.

12. Show that the product of the reserve after t years for an annual premium n-year pure
endowment issued at age x, and the annual premium for a pure endowment of like
amount issued at the same age but maturing at the end of t years is constant for all
values of t.

13. A policyholder effected at age 35 an Endowment Assurance Policy by annual premiums

for 30 years. Immediately before the due date of the 21st premium he has requested for
alteration of the policy to mature at age 60. On the assumption that the office calculates
premiums and maintains reserves on the basis of the IALM (94-96) modified Ultimate
table at 6% find the revised annual premium per `1000 sum assured. Ignore expenses.

14. An assurance on the life of (x) is payable at the end of n + t years if (x) be then alive, or at
his death should this occur during the last t years of this period. If (x) dies during the
first n years the premiums paid are to be returned. Annual premiums are limited to n
years. Give expressions for the value of the policy by the prospective and retrospective
methods at the end of n + m years, and prove that these values are identical (m < t).

15. A policyholder effected at age 30 a 35-year Endowment Assurance Policy for a sum
assured of ` 10000 with guaranteed simple reversionary bonuses of 4% per annum
added on the payment of each premium. Immediately before the 20th annual premium
falls due, he desires to convert the policy into an ordinary non-profit Endowment
Assurance Policy for ` 10000 maturing at age 60 with an additional sum payable if he
survives to age 60. Existing bonuses are to be cancelled and the annual premium is to be
increased by 50%. Calculate the additional sum payable. Use mortality as per IALM (94-
96) modified Ultimate table at 6% interest.

45
 CHAPTER 4

FURTHER LIFE CONTINGENCIES

1. In the previous lessons it has been assumed that under assurance plans, where the
payment of the sum assured depended on the death of the life assured, such payment would be
made at the end of the year of death. In practice the sum due is paid immediately on proof of
death and of the title of the claimant. It, therefore, becomes necessary to modify the expressions
for assurance benefits already obtained to allow for this condition.

The symbols for the single premiums for the various classes of assurances, where the sum
assured is payable at the moment of death, differ from those employed in earlier lessons only by
insertion of a ‘bar’ over the letter A, that is, A .

If the deaths occurring in a year of age are uniformly distributed over that year, they can be
taken on the average, as occurring in the middle of the year. If, therefore, the sum assured is
payable at the moment of death it will, on the average, be paid six months earlier than assumed
1
in the expressions for Ax etc obtained in earlier chapters. We can therefore, write A A 1 i 2 .

Further commutation functions Cx , M x and R x are derived below:

We define
1
C Cx 1 i .... (4.1)
2

M Cx Cx 1 Cx 2 .......
1
(C x Cx 1 Cx 2 .......) 1 i 2

1
Mx 1 i 2 .... (4.2)

Rx Cx 2C x 1 3C x 2 .......

Mx Mx 1 Mx 2 .......
1
(M x Mx 1 Mx 2 .......) 1 i 2

1
Rx 1 i 2
..... (4.3)
We shall now derive expressions for present value of a unit assurance benefit where the sum
assured is payable at the moment of death.

(i) Temporary Assurance on (x) for a term of n years

Mx - Mx
A1x : n n
Dx
1
(M x - M x n ) (1 i) 2
Dx

46
 1
A1x : n (1 i) 2 ... (4.4)

(ii) Whole Life Assurance on (x)

Mx
Ax
Dx
1
M x (1 i) 2
Dx
1
Ax (1 i) 2 ... (4.5)

(iii) Endowment Assurance on (x) for a term of n years. In case of Endowment Assurance
the adjustment for immediate payment of claim does not effect the Pure Endowment
portion.

Mx - Mx n Dx n
Ax : n
Dx
1
(M x - M x n ) (1 i) 2 Dx n
Dx
1 1
A1x : n (1 i) 2 Ax : ... (4.6)
n

(iv) Double Endowment Assurance on (x) for a term of n years. Present value of this
assurance

Mx - Mx n 2D x n
Dx
1
(M x - M x n ) (1 i) 2 2Dx n
Dx

A1x : n 2Ax : 1n ... (4.7)

(v) Deferred Temporary Assurance on (x) for a term of n years with deferment period of t
years

Mx - Mx
t A1x : n t t n

Dx
1
2
(M x t - M x t n )(1 i)
Dx
1
t A1x : n (1 i) 2
... (4.8)

47
 (vi) Deferred Whole Life Assurance on (x)

Mx t
t Ax
Dx
1
2
M x t (1 i)
Dx
1
t A x (1 i) 2
... (4.9)

M x - (M x - M x t )
Also, t A x
Dx
Mx (M x - M x t )
Dx Dx

t Ax Ax A1x : t
... (4.10)

2. PREMIUMS PAYABLE m TIMES A YEAR

Earlier, we have derived expressions for net annual premium under various assurance plans on
the assumption that the premium is payable in yearly installments. However, premium may also
be payable in monthly, quarterly or half-yearly installments.

In case of an assurance there may be a provision that premiums which are payable more
frequently than yearly may cease with the last installment preceding the death of the life
assured. These premiums are called true premiums. The symbol for true annual premium
payable m times a year is P[m].

If the assurance provides for payment of sum assured at the end of year of death, premiums may
continue to be payable upto the end of the year of death. These premiums are called installment
premiums. The symbol for the installment annual premium payable m times a year is P[m].
[m]
If P x represents the net premium per annum to be paid for a Whole Life Assurance of 1,
payable at the end of the year of death of (x), a premium of 1 P[m]
x
being payable at the
m
commencement of each mth of a year that (x) enters upon, we have

Px[m] a (m)
x Ax

Ax
Px[m]
a (m)
x

a x
Px
a(m
x
)

ax
Px
m -1
ax
2m
48
 1
Px
m -1 1
1 ( )
2m a x

Px ... (4.11)
m -1
1 (Px d)
2m
In case of an Endowment Assurance of 1 on (x) for a term of n years

P[m]x : n a (m)
x: n
Ax : n
Ax : n
P[m]
x: n
a (m)
x: n

ax : n
Px : n
a (m)
x: n

We have,
m-1 Dx n
(m) ax : n (1 )
a x: n 2m Dx
ax : n ax : n

m-1 1 A x :1n
1
2m a x : n ax : n

m-1
1 P d Px : 1n
2m x : n
m-1
1 Px1 : n d
2m
Therefore,
Px : n
P[m]x : n ... (4.12)
m-1 1
1 P d
2m x : n

In case of Whole Life Limited Payment Policy

We have,
Ax t Px a x :
t Px(m) t
a[m]
x: t
a[m]
x: t

Px
t
... (4.13)
m-1 1
1 P d
2m x : t

Similarly in case of Limited Payment Endowment Assurance

49
 Px : n
t P[m]x : n
t
... (4.14)
m-1 1
1 P d
2m x : t

Relation (4.12) can be converted into the form

m-1 1
P[m]x : n 1 Px : n d Px : n
2m
m - 1 [m] m - 1 [m]
i.e. P[m]x : n P Px1 P d Px : n
2m x : n : n 2m x : n
m - 1 [m] m - 1 [m]
i.e. P[m]x : n Px : n P d P x : n Px1: n ... (4.15)
2m x : n 2m

Relation (4.15) shows that the true premium can be considered as made up of three parts
(i) The normal yearly premium Px : n ,

(ii) A yearly payment equal to the loss of interest on the true premiums due to delay in
payment of premiums, the average delay being m - 1 of a year, and
2m
(iii) A yearly premium for a temporary assurance for the duration of the premium paying
period to provide for the payment on death of a sum equal to the premiums not
payable in the year of death, this sum on the assumption of uniform distribution of
deaths being on the average

1 m-1 m-2 1
P[m]x : n . ......
m m m m

m - 1 [m]
. P x: n
2m

In case of installment premium the difference between the yearly premium P and the yearly
installment premium P[m] payable in m installments of 1 p[m] each is a matter of compound
m
interest and is due to the fact that whereas P is payable yearly in advance, P[m] is payable m thly
(or m times in a year) in advance during the same period. Thus

1 2 m-1
1 [m]
Px Px 1 vm v m ...... v m
m

m-1
1 [m] t
Px (1 d) From Binomial Theorem,(1 x) n 1 nx
m t 0 m

1 [m] (m - 1) (m)
Px m - d
m 2m

50
 m-1
P[m]
x 1- d
2m

Px
P[m]
x ... (4.16)
m-1
1 d
2m

Similarly, P[m] Px : n ... (4.17)

x : n m - 1
1 d
2m

Relation (4.17) can be converted into the form

m - 1 [m] ... (4.18)

P[m]
x: n
Px : n P d
2m x : n

Relation (4.18) shows that the installment premium can be considered as made up of two
parts:

(i) The normal yearly premium Px : n , and

(ii) A yearly payment equal to the loss of interest on the installment premiums due to the
delay in paying premiums, the average delay being m - 1 of a year.
2m

Relation (4.16) can be expressed as

1 2 m-1
1 [m]
Px P x 1 v m v m ...... v m
m
1 [m] (1 v)
Px 1
m
(1 v m )
d
P[m]
x
d (m)
d (m)
P[m]
x Px ... (4.19)
d

The ratio d(m)/d is not usually tabulated. It is, however, approximately equal to i
i ( m)

or 1 m - 1 i . We may therefore write

2m

m-1
P[m]
x Px 1 i ... (4.20)
2m

Relation (4.20) slightly overstates the value, whereas relation (4.16) slightly understates it.

51
3. COMPLETE ANNUITIES
A complete or apportion able annuity of 1 per annum payable m times a year during the life of
(x) is one under which a payment of 1/m is made at the end of each mth part of a year that (x)
survives and an additional payment is made at the death of (x) of an amount proportionate to
the time elapsed between the date of the last payment and the date of death. An annuity under
which this proportionate payment at the date of death is not made is known as curtate annuity.
A complete annuity is, therefore, equivalent to a curtate annuity with the addition of the
proportionate payment to be made at the death of the annuitant.

The value of a complete m-thly annuity of 1 per annum to (x) is represented by the symbol å (m
x .
)

The adjustment to be made for the proportionate payment at the death of (x) would be an
assurance starting at 0 immediately after each annuity payment and increasing uniformly to
1/m immediately before the following annuity payment is due. Since the average of this
assurance is 1/2m, an approximate expression for its value is 1 A x .
2m

1
Thus å (m)
x a (m)
x Ax
2m ... (4.21)

Similarly, for a complete temporary annuity it can be shown that

1 1
å (m)
x: n
a (m)
x: n
Ax : n
2m ... (4.22)

4. RELATIONSHIP BETWEEN POLICY VALUES IN SUCCESSIVE YEARS

In chapter 3 we have discussed the subject of policy values. We now obtain expression giving
relationship between policy values in successive years and discuss mortality profit/loss.

If each of 1x persons aged x effects a Whole Life Assurance on his own life, the number of
survivors at the end of t years will, on the basis of the mortality table, be 1 x+t, and the value of
each of their policies will be tVx. Also, in connection with each policy there will be a premium of
Px due, and if all these premiums be paid immediately the fund in hand will be 1 x+t (tVx + Px).
Examining this expression, we have
ax t 1
1x t ( t Vx Px ) 1x t 1- d
ax ax

ax t 1
1x t v-
ax

ax t
1x t v-
ax

Since ax+t = v px+t.ä x+t+1,

vp x t ax t 1
1x t ( t Vx Px ) 1x t v-
ax

52
 px t
ax t 1
v 1x t 1-
ax

= v 1x+t {1 – px+t (1 – t+1Vx)}

1x t t Vx Px 1 i 1x t 1 – px t 1 –t 1 Vx

1x t – 1x t px t 1x t p x t t 1 Vx

= dx+t + 1x+t+1 t+1Vx ... (4.23)

Relation (4.23) shows that the total reserve in hand at the commencement of a year, together
with the net premiums then due, both accumulated with interest, will just suffice to pay the sum
of 1 at the end of the year for each of the dx+t deaths occurring during the year, and also to
provide the reserves required at the end of the year in respect of each of the 1x+t survivors.

Relation (4.23) can be recast as

(tVx + Px) (1+i) = qx+t + px+t t+1Vx

(tVx + Px) (1+i) = qx+t + (1- qx+t) t+1Vx ... (4.24)

In more general form,

(tV + P) (1+i) = Sq+ (1 – q) t+1V

i.e. (tV + P) (1+i) = t+1V + q (S – t+1V) ... (4.25)

When a death claim occurs, the office has to pay the sum assured of S; whereas the reserve
in respect of the policy held by the insurer is only t+1V. The difference (S - t+1V) is known as
the death strain at risk.

Summing formula (4.25) for a group of policies, we have

(t V P) (1 i) t+1 V q (S - V).
t+1

This shows that, if the insurer has on its books a group of policies all renewable yearly on the
same date, the total reserves on any renewal date (including the net premiums then due),
accumulated at the end of the year, will be just sufficient to provide the reserves at the end of
the year for all policies which were in force at the beginning of the year and to increase the
reserves to the sums assured in respect of the death claims provided that the claims are exactly
in accordance with the valuation assumptions.

q (S - t 1 V) is called the expected death strain ... (4.26)

The amount which the office will actually need to have in hand at the end of the year will be

V
t+1 (S - V)
t+1
cl

53
In the above expression, the first term, that is V, is a summation in respect of all policies
t+1

which were in force at the beginning of the year but the second term, that is (S - t 1V) is a
cl

summation in respect of the policies which actually became claims during the year.

The expression (S - t 1V) is called the actual death strain. ... (4.27)
cl

If other factors such as expenses are ignored, the profit or loss made by the office during the
year must be equal to the difference between the amount which the office needs to have in hand
at the end of the year and the amount which it expected to need on the valuation basis. This
difference is the difference between the expected death strain and the actual death strain.

In actual practice, the position is complicated on account of factors such as expenses of insurer,
profit from excess interest and other sources, renewal of policies throughout the year, payment
of sums assured immediately on proof of death and title. However, it remains broadly true that
the mortality profit or loss is the difference between the expected death strain and the actual
death strain.

It should be understood that a mere comparison between the expected claims and actual claims
does not give a true indication of the mortality profit or loss made by the office. For example, it
is possible for the office to make a loss even if the actual claims are less than the expected; this
can happen if a large proportion of the claims occurs among policies with comparatively small
reserves.

5. EXTRA RISKS

A life office may not be in a position to accept all proposals at normal rates of premium. The
impairment may be because of a medical condition, hazardous occupation, etc. Theoretically
special terms should be calculated on the basis of special mortality tables. In practice this is not
possible because only a rough estimate of the probable extra mortality is likely to be available.
In this chapter accented symbols will be used for functions in the special mortality. Accordingly
the symbol P will be used to denote a net premium on the special mortality.

It is convenient to separate the premium calculated on the special mortality into two parts, the
normal premium and the extra premium. Thus the extra net premium is the difference between
the net premium on the special mortality and the net premium on the normal mortality.
Similarly the extra office premium is the difference between the office premium on the special
mortality and the office premium on the normal mortality.

One method of allowing for an extra risk is to rate up the age of the life proposed by some years.
For example, a person (x) who is subject to a medical impairment has proposed for a Whole Life
Assurance and the risk in his case may be presumed to correspond to normal risk in respect of a
person who is older than him by say, r years. Let P and P be the net annual premium for a unit
sum assured under normal mortality and special mortality respectively.

For a person aged x at entry, we have

54
 P = Px+r

And P = Px

The net annual extra premium is given by P – P = Px+r – Px ...... (4.28)

Another method of allowing for an extra risk is to charge the normal office premium and to
reduce the death benefit. The reduction in the death benefit is known as a debt or lien. The debt
may be a fixed amount for a period of years but it is usual to impose a debt which is reduced by
a level amount each year until it is extinguished.

The relationship between a debt and an extra premium can be obtained by equating the value of
the premiums to the value of the benefits on the special mortality basis.

Let us consider a Whole Life Assurance where, in lieu of the extra premium payable, the sum
assured is subject to an initial debt of tD reducing by D every year over t years. Thus the death
benefit is 1 – tD in the 1st year, 1 – (t – 1)D in the 2nd year and so on until it is 1 – D in the tth year;
and thereafter it is 1 for the (t + 1)th year and onwards.

Ignoring expenses, we have

Mx
Px a x Ax ........ (I)
Dx

Value of normal premiums = Pxä´x

Value of full sum assured = A'x

Value of debt

D
tC x (t 1)C x 1 (t 2)C x 2 ...... 1C x t 1
Dx

D
t(C x Cx 1 ..... C x t 1) (C x 1 2C x 2 3C x 3 ..... ( t 1)C x t 1)
Dx

D
t(M x - M x t ) (R x 1 Rx t (t 1)M x t
Dx

D
t Mx Mx t Rx 1 Rx t
Dx

D
t Mx Rx 1 Rx t 1
Dx
... (4.29)

Value of benefits subject to debt

55
 Mx D(tM x - R x 1 Rx t 1 )
Dx Dx

1
(1 tD)M x D (R x 1 Rx t 1 )
Dx

Thus we have

1
Px a x (1 tD)M x D (R x 1 - Rx t 1 )
Dx ...... (II)

(I) - (II) gives relationship between the extra premium and the debt, that is,

1
(Px - Px ) a x tDM x D (R x 1 - Rx t 1 )
Dx

D (tM x Rx 1 Rx t 1 )
or Px - Px
Nx ... (4.30)

In case of an Endowment Assurance for a term of n years which is subject to an initial debt of tD
reducing by D every year over t years (t < n), the value of benefits subject to debt

Mx Mx n Dx n D (t M x Rx 1 Rx t 1 )
Dx Dx

(M x Mx n Dx n )
Since Px : n a x : n ,
Dx

D
(Px : n - Px : n ) a x : n (t M x Rx 1 Rx t 1 )
Dx

D (t M x R x 1 Rx t 1 )
Px : n Px : n
Nx Nx n ... (4.31)

6. EXAMPLES

Example 1: On the basis of IALM(94-96) modified ultimate Table and 6% interest calculate the
net annual premium payable throughout life for a Whole Life Assurance of ` 15000/- on the life
of (45) where the death benefit is payable immediately on death.

Solution

The net annual premium, P, is given by

P ä45 15000 A 45

56
 M 45
P 15000
N 45
1
M 45 (1.06) 2
15000
N 45

15000 13969 .02 1.029563

973096.92

= ` 221.69

Example 2: On the basis of IALM (94-96) modified ultimate Table and 6% interest calculate net
annual premium for an Endowment Assurance for ` 10000/- on the life of (30) for a term of 30
years. Death benefit is payable immediately on death.

Solution

The net annual premium, P, is given by

P ä 30 : 30 10000 Ā 30 : 30

M 30 M 60 D 60
P 10000
N 30 N 60

(M30 M 60 )(1.06)1 2 D60

10000
N30 N 60

(16626.80 9977.36)(1.029563) (25978.81)

10000
2707752.93 282692.16

= ` 135.36

Example 3: On the basis of IALM (94-96) modified ultimate Table and 6% interest, calculate the
true quarterly premium for a Whole Life Assurance of ` 10,000/- on the life of (45). Death
benefit is payable immediately on death.

Solution

The annual premium, P, is given by

P = 10,000 P45 × (1.06)½

= 10,000 × 0.01436 × 1.029563

= ` 147.85

Using relation (4.11), the true annual premium P(4), payable quarterly, is given by

57
 0.014785
P(4) 10, 000
3
1 (0.014785 0.05660)
8

= ` 151.92

Therefore, the true quarterly premium

1
151 .92
4

= ` 37.98

Example 4: Using the data in Example 2, calculate the true monthly premium.

Solution

We have P30 : 30
= .01345

For using relation (4.12), we require P30

1
: 30

1 M 30 - M 60
P30 : 30
N 30 - N 60

(16626.8 - 9977.36)
1.029563
(2707752.93 - 282692.16)

= .00282

Using relation (4.12), we get

.01345
P(12) 10, 000
11
1 (.00282 0.05660)
24

= ` 138.27

The true monthly premium

1
138.27
12

= ` 11.52

Example 5: On the basis of IALM (94-96) modified ultimate Table and 6% interest calculate the
installment half-yearly premium for an Endowment Assurance of ` 5,000/- on life of (40) for 20
years. Death benefit is payable at the end of year of death.

58
Solution

The annual premium, P, is given by

P = 5000 P40 : 20

= 5000 × .02794

= `139.70

Using relation (4.17) the installment annual premium, P(2) is given by

.02794
P(2) 5, 000
1 1 4 .056604

= ` 141.71

The half-yearly installment premium is

1 2 141.71 Rs. 70.86

The installment premium may also be found using relation (4.19)

(2) d (2)
P 5, 000 P40 : 20
d
.057428
5, 000 .02794
.056604

= ` 141.73

The half-yearly installment premium

1 2 141.73 = `70.87

Example 6: Give expression for the present value of a complete annuity of ` 1000 per annum
payable in quarterly installments to (65)

Solution

Using the relationship (4.21), we get

o ( 4)
Present Value = 1000 a 65

= 1000 1
a (4)
65 A 65
8
1
1000 a 65 A 65 (1 i)1 2 .375
8

59
Example 7: On 1st January 1999, an Office issued a number of annual premium without profit
policies to a group of lives each of whom was then aged 35. All the policies were for a term of 20
years and were of the following types:

(a) Endowment Assurances under which the sum assured was payable on survival to the
end of the term or on previous death.
(b) Temporary Assurances under which the sum assured was payable only on death within
the policy term.
Calculate the profit or loss from mortality for the calendar year 2008 in respect of the
policies issued to this group of lives given the following data :

Type of Policy Sums Assured existing Sums Assured

on 31st December discontinued by death
2008 during 2008
Endowment Assurance ` 27,00,000 ` 17,000
Temporary Assurance ` 15,40,000 ` 4,000

Basis : IALM (94-96) Modified Ultimate Table and 6% interest

Assume that there is no source of decrement other than death and that all claims are
paid at the end of the year of death.

Solution

On 1 – 1– 2008, the age of all the policyholders will be 44 with outstanding term of 11 years.
We have q44 = .00283

(a) Endowment Assurances :

Sums Assured in respect of policies which were in force on 1 – 1 – 2008
= 27,00,000 + 17,000 = 27,17,000

Reserves in respect of above policies on 31–12–2008

a 45 : 10
27,17,000 1-
a 35 : 20

7.673
27,17,000 1-
11.947
= 9,71,998

Death strain at risk

= 27,17,000 – 9,71,998
= 17,45,002

Expected death strain

= .00283 × 17,45,002
= 4,938
60
 Actual death strain
a 45 : 10
17,000 - 17000 1-
a 35 : 20

7.673
17,000
11.947
= 10,918

Mortality loss = Actual death strain – Expected death strain

= 10,918 – 4,938
= ` 5,980

(b) Temporary Assurances :

Sums Assured in respect of policies which were in force on 1 – 1– 2008
= 15,40,000 + 4,000
= 15,44,000

Reserves in respect of above policies on 31-12-2008

15,44,000 (A145 : 10 - P35
1
: 20
a 45 : 10
)

M 45 - M 55
Now A145 : 10 =
D 45

13969.02- 11515.04
=
69049.98
= 0.03554
M 35 - M 55
And P35
1
: 20
=
N 45 - N 55

15759.14- 11515.04
=
1950839.25 443271.17
= 0.002815
Putting these values, the reserves
= 15,44,000 (.03554 - .002815 × 7.673)
= 21,524

Death strain at risk

= 15,44,000 – 21,524
= 15,22,476

Expected death strain

= .00283 × 15,22,476
= 4,309

61
 Actual death strain = 4000 – 4000 × .013941
= 4000 – 56
= 3,944

Mortality profit = 4,309 – 3,944

= ` 365

Example 8: A sub-standard life aged 40 effects an Endowment Assurance for `10,000 for a term
of 25 years. The office has decided to accept the risk by charging extra premium calculated on
the basis of rating up of age by 5 years for the first 6 years, by 3 years for the next 8 years and by
2 years thereafter. Calculate the extra annual premium. Basis IALM (94-96) Modified Ultimate
Table and 6% interest. Ignore expenses.

Solution

Let P and P be the annual premium on normal mortality and ‘rated-up’ mortality respectively.

P 10, 000 P40:25

= 10,000 × .02012
= 201.20

Value of a temporary annuity due to (40) for 25 years, allowing for rating up of ages
a 40 : 25

D51 D57 D51

a 45 : 6
a 49 : 8
a 56 : 11
D 45 D 49 D 45
= 5.169 + .68782 × 6.461 + .59358 × .68782 × 7.924
= 12.848

1
P 10,000 d
a 40 : 25

1
10,000 .05660
12.848
= 212.33

The extra premium is

P – P = 212.33 – 201.20
= ` 11.13

Example 9: An impaired life aged 35 wishes to effect an Endowment Assurance without profits
for a sum assured of ` 10,000/- for a term of 20 years. A life office assumes that he is subject to
mortality equivalent to that of a normal life aged 40. Calculate (a) the extra annual premium (b)
the alternative debt that should be charged, reducing by a uniform amount every year so that
the debt extinguishes at the end of 10 years. Basis IALM (94-96) Modified Ultimate and 6%
interest. Ignore expenses.

62
Solution

(a) Let P and P be the net annual premium under normal mortality and special mortality
respectively.

P 10, 000 P35 : 20

= 10,000 × .02710
= 271.00

P 10, 000 P40 : 20

= 10,000 × .02794
= 279.40

The extra annual premium

= 279.40 – 271.00
= `8.40

(b) Let 10 D be the initial debt reducing by D every year over 10 years. The death benefit is
10,000 – 10 D in 1st year, 10,000 – 9D in 2nd year and so on till it is 10,000 – D in the 10th
year and thereafter it is 10,000 for the years 11 to 20.

Value of premiums: = 271.00 ä

40 : 20

= 271.00 × 11.828
= 3205.39
D
Value of benefit 10,000 A 40 : 20
- 10M 40 R 41 R 51
D 40
D 10735.45
10,000 .33052
93535.60
= 3305.2 - .11477D

Equating value of premiums and value of benefits, we get D = 870. The initial debt is
` 8700 reducing by ` 870 every year over 10 years.

1
Rough Check : The average debt is 4350 and its value is 4350 A40 : 10 95. The value of
extra premium is 8.40 ä40 : 20 99.

Example 10: An impaired life aged 40 effected a non-profit Endowment Assurance by annual
premiums for ` 10,000 sum assured maturing at age 60. It was assumed that allowance could be
made for his impairment by charging the premium for an unimpaired life n years older and
accordingly he was charged an extra premium of ` 21.60. After 5 years he asks if the future
extra premiums can be waived and the policy be made subject to a debt which reduces by equal
annual decrements and runs off by the time he is 55. Calculate the debt in the first year after the

63
alteration. Ignore expenses and assume the sum assured is payable at the end of year of death.
Basis IALM (94-96) Modified Ultimate Mortality table (which may be taken to represent normal
mortality) and 6% interest.

Solution

Let P and P be the annual premium on the basis of normal mortality and special mortality.

P 10, 000 P40 : 20

= 10,000 × .02794
= 279.4

P 10, 000 P40:20

10, 000 P40 n : 20

Given 10,000 P40 n : 20

– P40 : 20 21.60

or P40 n : 20
0.0301

By trial and error, we get n = 6.

Consequent upon alteration, the value of extra premium should equal the value of debt. If, therefore,
10D is the initial debt reducing by D every year over 10 years, we have
D
21.60 a 51 : 15 10M 51 R 52 R 62
D51
D
21.60 9.7753 10 12616.03 - 234430.65 + 124012.62
47493.61
D = 637
Debt in the first year = ` 6,370

64
EXERCISE 4

1. On the basis of IALM (94-96) Modified Ultimate Table and 6% interest calculate the net
annual premium limited to 15 years for a Whole Life Assurance of ` 1,00,000 on the life
of (40). Assume that the death benefit is payable immediately on death.

2. Calculate the net annual premium for Double Endowment Assurance for basic sum
assured of ` 50,000 on the life of (35) for a term of 20 years. Assume that the death
benefit is payable immediately on death. Basis IALM (94-96) Modified Ultimate Table
and 6% interest.

3. Calculate the true monthly premium for a Whole Life Assurance of ` 1,00,000 on the life
of (50) where the premiums are limited to 10 years. Basis: IALM (94-96) Modified
Ultimate Table and 6% interest.

4. Calculate the true half-yearly premium for an Endowment Assurance of ` 50,000 on the
Life of (40) for a term of 15 years. Basis: IALM (94-96) Modified Ult and 6% interest.

5. A person aged 40, assumed to be subject to IALM (94-96) Modified Ultimate mortality,
desires to effect a Whole Life Assurance for ` 1,00,000. The life office quotes him the net
premium of ` 1000.00 per annum payable throughout life and the sum assured is
subject to a debt reducing uniformly over 15 years, so that the net premium charged is
made equivalent to the risk, calculated at 6% interest. Find the amount of the debt in the
first year.

6. A person now aged 50 has an Endowment Assurance of sum assured ` 10,000, effected
10 years ago at an annual premium, to mature at age 65. He will be subject to extra risk
for the ensuing year, such that q 50 = q50 + .01. In lieu of paying an extra premium, the
sum assured is to be temporarily reduced for the year. Assuming that the premium is
paid at the beginning of the year, the sum assured in the case of death at the end of the
year, and that the normal reserve can be made at the end of the year if he survives, what
reduction in sum assured should be made? Basis: IALM (94-96) Modified Ultimate Table
and 6% interest.

7. Five years ago a life then aged 40 effected a 20 year Endowment Assurance by annual
premiums for sum assured of ` 10,000. He was found to be impaired life which would
result in his experiencing extra mortality which could be represented by a constant
addition to his true age. He was accordingly charged extra of ` 14.10.
Now, immediately before payment of the 6th premium, he asks that the extra premium
be cancelled in future and that instead, if he should die before maturity date, a debt of
fixed amount should be imposed. Full sum assured would be payable if he survived to
maturity date.

On the basis of IALM (94-96) Modified Ultimate mortality Table and 6% interest,
calculate the reduced sum assured that would be payable on death in the first year of
alteration. Assume that claim payment will be made at the end of year of death. Ignore
expenses.

8. Non-profit 20 year Endowment Assurances for unit sum assured each were effected
simultaneously at net annual premiums, calculated on the basis of IALM (94-96)
Modified Ultimate mortality Table and 6% interest, on each of 1,00,000 lives aged
65
exactly 40 years. The mortality experience followed the IALM (94-96) Modified Ultimate
Table up to age 50. During the following two years the deaths were 610 and 700
respectively, and thereafter the rate of mortality followed the IALM (94-96) Modified
Ultimate Table. Exactly 6% interest was earned. Calculate the total profit or loss from
mortality during each of the two years following exact age 50. Assume that there is no
source of decrement other than death and that all claims are paid at the end of the year
of death.

66
 CHAPTER 5

REINSURANCE
1. INTRODUCTION
Reinsurance is a key tool used by insurers for countering claims volatility as well as writing
some of the bigger, new or inexperienced risks which the insurer would not have underwritten
otherwise. The risk may be bigger either due to large amount of cover or due to higher
probability of death/disability (say, under lives involving high extra risk) or both.

It is an arrangement whereby the reinsurer, in consideration for a premium, agrees to

indemnify the insurer (ceding company) against part or all of the liability assumed by the cedent
under one or more insurance policies, or under one or more reinsurance contracts.

The insurer is known as the direct writing company and has a contractual relationship with the
policyholder. The reinsurer does not have any contact with the policyholder at any stage. The
transfer of part or full risk from insurer to reinsurer is known as a “cession” and the act of such
transfer is referred to as “Ceding”.

2. NEED FOR REINSURANCE

The main reasons why a life insurer needs reinsurance are:

2.1 Sharing of Risk

(i) To limit exposure to large risks to limit the impact of few large claims on its profits.
For an insurer some of the risks may have very high payouts. Small to medium sized
insurance companies will cede a larger proportion of potentially large claim payouts
to reinsurer to limit their exposure against this eventuality.

(ii) To reduce claim volatility associated with the risk

The variance relative to the mean can be high because

a. There may be a small number of contracts for very high levels of cover
b. The lives insured may not be independent risks. Say, large number of
employees of a company working in an office or factory.
As the reinsurance involves cost-expenses and profits of the reinsurer, the insurer
will ideally like to achieve a balance between excess premium passed on to the
reinsurer and the increased risk of loss from adverse experience if less reinsurance
were to be used. The insurer will like to reduce the volatility of experience but at the
same time will not be using too much reinsurance, and hence not ceding too much
profit to the reinsurer.
(iii) To limit reinsurance involves risk of volatility of claim payouts from one year to
another for the insurer. Therefore reinsurance helps to achieve consistency of
profits of the insurer from one year to another.
(iv) To enhance the ability to write high sum assured and more risky business.

67
As, after reinsurance, the insurer retains only a portion of the risk associated with a contract its
ability to write more new contracts enhances.

2.2 Financing New Business Strain

Writing a new contract is associated with the new business strain i.e. if an insurer has to write a
new contract it will need capital to make good the shortfall in cash flow during initial periods of
the contract.

New business strain is the shortfall that arises when the capital requirements and initial
expenses for a policy exceeds initial premiums.

Many countries including India have a legal requirement for an insurer’s free assets to exceed a
predetermined statutory minimum, known as Required Solvency Margin (RSM). This statutory
minimum can be reduced to some extent if the insurer uses appropriate reinsurance
arrangements.

2.3 Technical Assistance

An insurer may wish to use the technical expertise of a reinsurer in the areas of product design,
system design, pricing the product, underwriting etc. when writing a new type of business
which may include covering unusual risks which the insurer is not familiar with.

This is particularly important when the insurer embarks on a new line or unknown area of
business where it has limited experience. The insurer thus effectively reduces its exposure to
risk of writing such new line of business as well as limits the risks arising out of its exposure to
unknown geographical areas.

2.4 Diversification of business

Reinsurance helps in diversifying the business since the insurer can retain small proportion of
more risks.

The reinsurance may initially be used more aggressively but once the insurer’s expertise and
confidence grows, it can gradually reduce the reinsurer’s involvement.

3. REINSURENCE CONTRACTS
The reinsurance contracts can be

a) Facultative or
b) By treaty
In case of facultative reinsurance each case is considered individually and the reinsurer is free
to quote whatever terms and conditions it sees fit to impose for that risk.

The insurer, in case of facultative basis, is under no obligation to offer the business to the
reinsurer, not is the reinsurer obliged to accept it.

This type of arrangement involves cost and requires complex administration. Under
Reinsurance by treaty both the insurer and reinsurer are obliged to compulsorily cede and

68
accept the business covered under the treaty in the manner as documented in the Treaty. The
treaty thus is on an obligatory/obligatory basis.

4. TYPES OF REINSURANCE
Following are two main types of reinsurance contracts:

(i) Proportional Reinsurance

(ii) Non proportional Reinsurance
Most life reinsurance is proportional, where the claim is shared between the insurer and
reinsurer in pre-specified proportions.

Where the insurer writes group business and requires insurance against catastrophe,
particularly when the claim is unknown, excess of loss (or non-proportional reinsurance) may
be used.

4.1 Proportional Reinsurance Contracts

There are two types of proportional reinsurance contracts:
a) Quota share and
b) Surplus.
Under proportional reinsurance, the reinsurer covers a pre specified and agreed proportion of
each risk. This proportion may be constant for all risks covered (called quota share
reinsurance), or may be different for different risks covered (called surplus reinsurance).

Under quota share reinsurance a constant proportion of each risk is automatically passed to the
reinsurer. The reinsurance treaty specifies the proportion to be ceded to the reinsurer.

Under surplus reinsurance, the treaty specifies a maximum level of cover retained by the
insurer which is called the retention limit.

So unlike in case of quota share reinsurance arrangement specifying percentages of each risk to
retain, the insurer in case of surplus reinsurance arrangement chooses a retention limit for the
risks.

4.2 Reinsurance Premium under Proportional Reinsurance

Contracts
We shall now look at how the reinsurance premium (the premium required by the reinsurer to
accept the risk) is determined.

There are two main ways to determine the reinsurance premium:

(i) Original terms

(ii) Risk premium

69
(i) Original terms
Original terms reinsurance involves the reinsurer accepting the agreed proportion of all the
risks under the contract. The reinsurer will be exposed to investment, claims and persistency
risks and will receive a proportionate share of each premium. As the ceding company carries out
all the administration, the reinsurer pays the ceding office a commission in respect of its share
of the expenses.

The direct writer receives a premium from the policyholder and pays R% of it to the reinsurer.
In return, the reinsurer will pay R% of all types of claims. In addition, the reinsurer will pay the
direct writer a “reinsurance commission”. This will reflect its share of the expenses paid by the
direct writer in writing and subsequently administering the business.

The insurance company sets the premium.

(ii) Risk Premium

Risk premium reinsurance is much more common, especially for contracts with a significant
investment element that the ceding office wishes to retain. In this case the reinsurer only covers
the claims arising from risks (such as death, disability, critical illness etc.) for which reinsurance
premium is charged.

The premium paid (to the reinsurer) is based on the sum at risk from year to year, expressed as
the sum insured less any accumulated reserve, for those policies in force at the time.

The reinsurer has no exposure to persistency or investment risks.

The reinsurer sets the premium rates which are based on its expected claims experience plus a
margin for expenses and profits. It will be independent of the premium charged by the insurer.

4.3 Non-proportional Reinsurance Contracts

Excess of Loss (XL) reinsurance is a non-proportional reinsurance cover where the liability for
large claims is capped for the insurer. The liability above the specified level is passed on to the
reinsurer subject to an upper limit. However, if the claim amount exceeds the upper limit of the
reinsurance, the excess will revert to the insurer.

There are three main types of excess of loss reinsurance; risk excess of loss reinsurance,
aggregate excess of loss reinsurance and catastrophe excess of loss reinsurance, the details of
which are beyond the scope of this course.

5. GENERAL CONSIDERATIONS BEFORE REINSURING

The insurers consider the following factors before deciding their reinsurance needs:

(i) Cost of Reinsurance Cover

Reinsurance premium includes expenses and profits of the reinsurer due to which there is a
possibility of reduction in the overall profit for the insurer. So, before going for reinsurance it is
necessary that the ceding company balances the cost of reinsurance against the risk of loss from
adverse experience. The essence is balancing the risk and return.

70
(ii) Counterparty Risk
The reinsurance is a contract between the insurer and the reinsurer. So far as policyholder is
concerned, the insurer retains the liability to the policyholder for the payment of benefits even if
the reinsurer becomes insolvent and cannot meet claim payouts as they become due under the
reinsurance contract. The greater the counterparty risk, the less valuable the reinsurance will
be to the insurer. Consideration of counterparty risk and hence the rating of reinsurers is an
important consideration.

(iii) Legal risk

Reinsurance is governed by a treaty between the insurer and the reinsurer. The treaty is a legal
contract and governed by the contract law. The reinsurance terms need to be looked into detail
before deciding on a reinsurance arrangement.

(iv) System risk

Reinsurance involves a number of additional administrative operations and reinsurers may rely
on the insurer performing them in a timely and accurate manner. The insurer needs to consider
expectations of the reinsurer in order to avoid problems in future. Generally such expectations
are set out in the treaty.

(v) Regulatory Risk

The risk of the possible regulatory requirements getting overlooked and the cost associated
with it.

6. REGULATORY PROVISIONS
Insurance Regulatory and Development Authority (Life Insurance – Reinsurance) Regulations,
2000 among other things provide that:

a) Every life insurer is required to draw up a programme of reinsurance in respect of lives

covered by it.
b) The profile of such a programme, duly certified by the Appointed Actuary, which shall
include the name(s) of the reinsurer(s) with whom the insurer proposes to place business,
shall be filed with the Authority, at least forty five days before the commencement of each
financial year, by the insurer.
c) No programme of reinsurance shall be on original premium basis unless the Authority
approves such programme.
d) Every insurer shall retain the maximum premium earned in India commensurate with his
financial strength and volume of business.
e) The reinsurer, chosen by the insurer, shall enjoy a credit rating of a minimum of BBB of
Standard and Poor or equivalent rating of any international rating agency.
Provided that placement of business by the insurer with any other reinsurer shall be with
the prior approval of the Authority.
Further, circular no. IRDA/Actl/LR/Ver 1/Jan 02 dated 01/03/02 under Schedule states

71
among other things that keeping in mind the need to retain maximum premium in the
country, insurers shall enter into arrangement for “Fixed amount” retention.

Further IRDA (Life Insurance - Reinsurance) Regulations, 2013 specify minimum

retention limits under different types of plans for life insurers according to the number of
years for which they are operating within India. This is with a view to maximize retention
within the country.

72
EXERCISE 5

1. What do you mean by reinsurance? Why is it necessary for a life insurer?

2. Describe the types of reinsurance arrangements an insurer may use to reinsure its
different types of business underwritten by it.

3. When will a life insurer need catastrophe reinsurance cover and why?

4. What considerations should a life insurer have before deciding its reinsurance needs?

5. What are the regulatory provisions in India in respect of reinsurance for life insurers?
What steps have been taken by IRDA to achieve maximum retention within the country?

6. Why is the rating of a reinsurance company important for a life insurer?

73
 CHAPTER 6

DATA FOR VALUATION

1. For carrying out the valuation, the insurer compiles the requisite data in respect of all
the policies which are in force on the valuation date. Prior to the advent of computers and
microprocessors, policy servicing was done with the help of Unit Record (Punched Card)
equipments. For each policy two cards were prepared, one for the purpose of premium
accounting and related functions and the other for the purpose of valuation and mortality
investigation. The latter cards, known as ‘Valuation and Mortality Cards’ were grouped
according to the following criteria:
(a) Policy class, i.e. Whole Life, Endowment, etc.
(b) Bonus Group, i.e. With Profits or Without Profits.
(c) Integral age of the life assured on the valuation date, i.e. year of valuation less office
year of birth.
(d) Integral outstanding term of assurance on the valuation date, i.e. office year of
maturity less year of valuation.
After preparation of the relevant schedules for each group with details such as sum assured,
vested bonus, annual premium, outstanding premium, etc., the valuation liability was obtained
separately for each group. The results for all the groups were aggregated for deciding the
amount of bonus to be allocated and also for preparation of the statutory returns. This process
used to take a considerable time.

2. When the Unit Record equipments were replaced by microprocessors, the valuation
process underwent a sea-change. Now a single record containing all the basic data in respect of
a policy was available on the magnetic tape. It was therefore possible to build a valuation extract
relevant to any valuation date. The use of microprocessor had made it possible to compute
valuation liability policy wise and aggregate the results of all the ‘in force’ policies for the
purpose of analysis and statutory groupings. Further, it was possible to obtain the results
quickly on different methods of valuation and different basis of valuation. At the same time
additional items necessary for an analysis of surplus would also be produced.

3. Now with the use of present age computers the valuation process and all other
investigations have been further simplified and more complicated as well as more accurate
results can now be possible very quickly. The computer programmes relating to the valuation
process carry out the following functions:
(a) Check the data for validity.
(b) Compute valuation parameters such as valuation age, outstanding term of assurance,
premium paying term etc. for each policy.
(c) Group the “like” policies aggregating the sum assured, vested bonus, annual
premiums, outstanding premium, extra premium, etc.

74
 (d) Compute the assurance factors and annuity factors having regard to the valuation
parameters and generate the value of sum assured, value of vested bonus, value of
future bonus, value of annual premium, value of expenses, etc.
(e) Print the accumulated group totals according to plan of assurance/annuity.

4. The policy wise data obtained comprise the following:

(1) Policy Number
(2) Data of commencement
(3) Plan of assurance/annuity.
(4) Original premium paying term: In case of Whole Life policies and Convertible Whole
Life policies (during the first five years or even at the end of five years, if they are
continuing as Whole Life policies), the premium paying term is dependent on age at
entry. In these cases, even if the premium paying term is not stated, the valuation
programme calculates the same. In respect of all other cases, the actual premium
paying term is stated.
(5) Additional Term: This refers to policy term – when policy term is different from
premium paying term. In case of Children Deferred Assurance plans, this refers to
deferment period. Whenever the policy term and premium term are the same, this
data is not required. Even in case of Whole Life, Limited Whole Life, Convertible Whole
Life (during the first five years or even at the end of five years, if the policy continues
as Whole Life) plans, even though the policy term is different from premium term, it
can be determined on the basis of age at entry and hence it is not stated.
(6) Sum assured: In case of ‘in force’ policies, the sum assured is to be stated. When a
policy becomes paid-up, the paid-up sum assured and vested bonuses can be
calculated on the basis of first unpaid premium. Therefore, even under paid-up
policies, the original sum assured is to be stated.
But in paid-up cases if the basic records do not contain the original sum assured, this
data may not be furnished; because the data of paid-up sum assured and vested
bonuses in such cases are obtained separately.
(7) Mode: In case of premium paying policies mode will be monthly, quarterly, half-yearly
or yearly. In case of other policies, what is stated is a paid-up policy or single premium
policy.
(8) Status of the policy: Whether reduced paid-up, fully paid-up, claim has arisen and it is
pending etc.
(9) Due date of first unpaid premium.
(10) Age on the date of commencement.
(11) Extra premium.
(12) Accident premium.
(13) Vested bonuses: This is to be stated in respect of paid-up policies where the paid-up
sum assured and not the original sum assured is available from original records.
(14) Whether participating policy or non-participating policy.
(15) Paid-up sum assured: This is to be stated only in respect of paid-up policies where the
paid-up sum assured and not the original sum assured is available from original
records.

75
 (16) Entry particulars: Whether the policy has come on the books due to new business,
revival, reinstatement of surrendered policy, missing policy reincluded or ‘transfer in’
(17) Exit particulars: The particulars to be furnished are date of exit and mode of exit. The
mode of exit may be lapsed without paid-up value, lapsed with paid-up value,
surrendered towards loans (foreclosure action), surrendered, maturity, death claim,
cancellation or transfer out.

5. Valuation of Non-standard Plans

In case of Children’s Deferred Assurance policies, there is no risk on the life of the child during
the deferment period. The liability is the cash option payable at the end of the deferment period.
The usual method of valuing these policies is by accumulating office premiums at such rate of
interest as will produce the cash option at the end of the deferment period (i.e. vesting date)
In the case of Temporary Assurances the sum assured is payable only if death occurs within the
selected term. The value of the policy will therefore be quite small. A reserve equal to one half of
the annual office premium under the policy will suffice. If the policy is a long term policy a
reserve of one year’s premium may be made. However, now-a-days with the use of computers
actual policy reserve may be computed instead of approximations. Further, requirements of
data under Unit-lined plans and different types of other plans may be different. The data
requirements are decided by the Appointed Actuary considering the benefits available under
the policy, the premiums/charges involved, options or guarantees provided under the plan etc.
The data requirements will therefore differ for different types of plans.

6. If the data maintained by the insurer is inaccurate or not updated then the results of the
valuation will not be accurate thereby compromising the stakeholders’ interest in general and
policyholders’ in particular. Further, this may lead to inappropriate distribution of discretionary
benefits to participating or with profit policy holders or incorrect benefits payments being made
to the policyholders. This may lead to policyholders’ dissatisfaction, a general loss of confidence
by the other stakeholders and may adversely impact the general reputation or the brand image
of the insurer thereby adversely affecting the business prospects of the insurer.
Incomplete and inaccurate data will also result in misleading disclosures in accounts or
statutory returns thus invoking regulatory intervention.
Any internal investigations carried out based on the incomplete or inaccurate data, may
ultimately lead to inappropriate advice to the company and the shareholders may have to
unnecessarily subscribe additional capital when actually it may not be required.

7. As a check, the current appropriately grouped policy data should be reconciled with
those used in the previous successive investigations. The following checks are made for each
group between two successive investigations:
i) Reconciliation of overall data
ii) Consistency of data
iii) Check on unusual values
iv) Analysis of surplus

8. Data at immediate previous investigation plus any new business written during the
period plus any other business coming on the books during the period as a result of
76
reinstatement or revival of policies etc. less the business gone off the books as a result of death,
maturity, surrender, lapsation without acquiring paid up value etc. during the period should
equal the policy data at the current investigation.
The above reconciliation of data checks can be used for the following items of data:
Number of policies
Sum Assured
Premium
Benefits Payable
Number of units actually allocated sub-divided by unitized fund or arising from switches
between unitized funds
All the movement data, in particular the claims data should also be checked with the
corresponding source data held separately and the accounts figures.

9. In addition the consistency checks also should be applied by comparing the ratios of
successive investigations e.g. the average sum assured, the ratio of basic sum assured to
premium, bonus per thousand sum assured etc.

10. Spot checks should be made for any unusually large or low or zero values of sum
assured, premium, bonus, impossible dates of birth etc.

11. An analysis of surplus arising out of various components of surplus and reconciliation of
the same from the previous valuation to the current one provides a check on the valuation data
and the valuation process, if carried out independently. It is discussed in more detail in Chapter

77
EXERCISE 6

1. List the items included in policy wise data under standard traditional plan policies.
2. List the items included in policy wise data under unit linked policies.
3. Why accuracy and completeness of policy data is necessary for a life insurer?
4. Describe the various checks used by the insurer in order to ascertain the validity of the
data for valuation purpose.
5. In respect of consistency checks, what relationship would you expect in respect of the
following when the figures for this year are compared with those of previous valuation:
i) Premium per thousand sum assured under different types of plans.
ii) Average sum assured under different plans
Give reasons also.

78
 CHAPTER 7

METHODS OF VALUATION
1. As a consequence of the level premium system, the premiums received by an insurer
during the early years of a policy are in excess of those actually required. These excess
premiums of early years are to be accumulated and kept in reserve to meet the shortfall in
future years when premiums receivable will be less than those actually required. All premiums
received for various types/plans of policy contracts are pooled together in Life Fund. From the
common pool payments by claims are made and expenses of the insurer are met, and no
individual account is maintained for each policy. The excess of the premiums and interest
income over the outgo from claims and expenses is to be invested with security and to the best
advantage.
It is necessary to have periodic investigation into the financial position of the insurer, the
principal feature of which is valuation of his assets and liabilities. In this chapter we shall deal
only with the valuation of liabilities. The valuation of assets is beyond the scope of this course.
However it should be noted that the method chosen to value assets should be consistent with
the method used for the valuation of liabilities.
2. The valuation of liabilities of an insurer is the process of arriving at the policy values of
various contracts in existence on the date of valuation. As the values can be arrived at in two
ways, methods of valuation are of two kinds; prospective and retrospective according as policy
values is arrived at prospectively or retrospectively. If the mortality rates, interest rates and
expense provision assumed in the valuation are identical with those in the premium basis, the
two methods would give the same result. Normally, the prospective method of valuation is
adopted.
3. The excess premiums accumulated will be equal to the prospective value of the policy at
any point of time provided the premiums are adequate and if the business progresses as
anticipated as per the basis on which the premiums are computed. The premiums charged by an
insurer include provision for expenses. Thus the Life Fund which is built up by the
accumulations of balance of premiums will be sufficient to meet the future liabilities only if the
outgo from office premiums on account of expenses and claims and additions to the premiums
on account of interest earnings are exactly those anticipated. Such conditions rarely exist in
practice. As such, the Life Fund on hand will never be exactly sufficient to meet the future
liabilities. It may either be in excess or in deficit. The necessity of valuation is, therefore, to
ascertain the adequacy of the Life Fund on hand.

4. Prospective Method of Valuation

The formula for a prospective policy value for a Whole Life Assurance is

t Vx A x t – Px äx t

where age as on the valuation date, known as the ‘valuation’ age, is x + t and is obtained by
adding the duration elapsed t, to the age, x, as on the date of commencement of policy. The age x
which may be age nearer birthday or next birthday according to the practice of the office, will be
integral number of years and the duration, t, will also be reckoned in integral number of years.
The value of ’t’ is generally obtained by taking the difference between the calendar year of
valuation and calendar year of commencement with suitable adjustment to allow for the month
of valuation and month in which policy commenced.

79
In case of an Endowment Assurance the prospective policy value is

t Vx : n Ax t : n-t
– Px : n äx t : n-t

The valuation age, x + t, is reckoned in the same way as in case of Whole Life Assurance, the
outstanding term, n – t, may be arrived at by subtracting the calendar year of valuation from the
maturity year with suitable adjustment to allow for month of valuation and month in which
policy matures.
5. Methods of Valuation
We now discuss the following methods of valuation:
i. Net premium method of valuation,
ii. Modified net premium method of valuation,
iii. Gross premium method of valuation,
iv. Gross Premium Bonus Reserve method of valuation.
6. Net Premium Method of Valuation
In the methods of valuation the question arises as to what premiums are to be taken into
account to calculate the policy value. The premiums received by the insurer are office premiums
which include expense loading over net premiums. As normally expenses incurred should not
be in excess of those provided for in the premiums, it would be sufficient if net premiums only
are taken into account in the valuation, and the entire expense loading is left for defraying the
future expenses. Similarly, the bonus loading is also left for declaration of bonuses in future.
However, the question arises as to which net premiums should be taken into account. It may be
argued that, as premium rates are based on certain assumptions of mortality and interest, the
policy values also should be calculated using net premiums based on original assumptions to
ascertain the divergence between the actual experience and assumed experience. But such a
comparison serves no practical purpose when conditions upto the time of valuation have
materially changed with possibilities of different future experience as regards mortality and
interest. In such a case steps should be taken to mitigate the effects of errors of initial judgment.
If this is not done and the past experience has been of an adverse nature which is likely to
continue, the valuation liabilities would be underestimated and the current financial position of
the insurer will not be correctly reflected. It is, therefore, essential to use such net premiums in
valuation as would be charged for new contracts on the basis of present and likely future trends
in mortality and interest.
The office premium for each policy is fixed and known, although at any valuation date the office
premiums of policies in force might be based on different scales introduced at various dates.
However, there is only one pure or net premium for each age at entry in case of Whole Life
Assurance and for each age at entry and original term in case of Endowment Assurance. This is
mathematically based on the ‘true’ rates of mortality and interest as estimated at the date of
valuation. Thus the principles of net premium method of valuation are:
(a) A ‘true’ mortality table combined with a ‘true’ rate of interest should be used for the
factors required to determine the value of the sum assured and any additions by way
of bonuses previously declared; and similarly for the factor required to value the
future premiums.
(b) The future premiums to be valued should be the net premiums calculated according
to the mortality and interest basis used for (a).
On this concept of net premium valuation the policy value starts with zero on the date of
commencement of policy (i.e. duration O), progresses with duration and finally reaches the sum
80
assured and declared bonuses. The difference between the office premium and net premium is
termed as valuation loadings. To the extent that these loadings are not absorbed by the actual
expenses or contingencies, they increase the assets, thus providing disposable surplus. If the
valuation basis and therefore the net premium remains unchanged and expenses and
contingencies do not vary, the loading surplus will also tend to be constant. If, therefore, the
three elements of mortality, interest and expenses do not vary from the valuation assumptions
the surplus will emerge each year so as to provide a constant cash bonus. If, however, the
bonuses were to be declared in reversionary form, the surplus emerging at successive
valuations would necessarily involve reducing reversionary bonuses.
If the life office follows the uniform reversionary bonus method of distribution of surplus, the
purpose would be served reducing the valuation rate of interest below that currently earned by
the Life Fund. The effect is that the excess of actual interest earned over the valuation rate of
interest results in the increasing policy value at successive durations, and the method leads to
the emergence of surplus in a way that approximates to its natural emergence.

Effect of Net Premium Valuation

Office expenses are of two types. Once is the heavy initial expenses and the other is relatively
smaller renewal expenses. The heavy initial expense has been distributed throughout the term
of the policy as a constant addition to the net premium. If the initial expenses for a whole life
policy at age 35 is `20 per thousand sum assured, then the constant addition to net premiums
on account of the initial expense on the basis of IALM (94-96) modified ultimate table and 6%
interest will be 20/ä35 = 20/ 15.460 = `1.29. Thus while out of first premium the amount spent
is `20, there is only a provision of ` 1.29 in it. The initial expenses may be more than the first
premium or a substantial portion of the first premium has been spent in the first year, leaving
no appreciable balance for accumulation to form the Life Fund. The fund in hand under such
circumstances cannot be equal to net liability or policy value. Because of this deficiency, it is not
correct to say that the fund is insolvent, as this deficit can be recouped from future premiums.

New Business Strain

In a net premium valuation, necessary reserves have to be set up at the end of first year of
insurance also; whether the actual balances of net premiums are on hand or not for the purpose.
The means to do so has to be found from sources other than the premiums for first year. The
only source to fall back upon is the fund built up from the working of the business written in
previous years. When policy reserves are thus set up for new policies not out of balances of new
premiums in hand, but out of balances from policies already on the books, the net result
amounts to an increase in the liability without corresponding increase in assets by way of
balance of premium income, and a decrease in the profits of the insurer which have been higher
if new business were not underwritten. This is demonstrated below.
If F is the fund on the current valuation date relating to policies in force on that date excluding
new policies issued since the date of preceding valuation and V is the corresponding policy
reserves then the profit or surplus S = F – V. Because of new policies if F1 is the addition to the
fund and V1 the corresponding policy reserves to be set up, then

Surplus or profit is given by

S1 = F + F1 – (V + V1)

= F – V + (F1 – V1)

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 = S – (V1 – F1), as V1 is greater than F1

Thus the surplus or profit that would have otherwise emerged has now been reduced by (V 1 –
F1) because of new business underwritten at heavy cost. The amount represented by (V 1 – F1) is
the new business strain on the fund.
New business strain is also felt because of the practice of insurers to make a cautious estimate of
future interest yield on the Life Fund and mortality experience in fixing the valuation bases. In
theory the likely future experience regarding mortality and interest should be the basis for
valuation. But in practice, because of the difficulty in making correct estimates of the future,
only cautious estimates of future experience with adequate margins are adopted in the
valuation. Such cautious estimates tend to increase the reserves for new business, as is the case
with reserves for existing policies. The new business strain is thus increased further.
It will be understood that the strain is the consequence of the method of valuation. So long as
the provision for expenses in future premiums takes into accounts the heavy initial expenses,
there is no cause of concern for the insurer about the strain. If, however, the present value to
actual expenses of first year and future renewal expenses were greater than the present value of
expense loadings contained in the office premiums, the strain will be real. When such is the case,
the insurer has to take immediate steps to cut down the actual expenses or revise the premium
rates.
Secondly, net premiums on the basis of experience adopted for the valuation based on estimates
for future have to be calculated for each valuation. This involves prohibitive labour whenever a
valuation is made. All this labour has to be gone through again whenever a change in the basis
for valuation occurs.

7. Modified Net Premium Method of Valuation

To allow for the heavy initial expenses of business, a slightly higher net premium, say, for next
higher age can be taken in arriving at policy values. In the expression for the policy value for
whole life assurance,
tVx = Ax+t – Px äx+t
Px is replaced by Px+1 that is, the premium for the next higher age. The modified policy value is

t Vx = Ax+t – Px+1 äx+t

= Ax+t – (Px - Px + Px +1) äx+t
= Ax+t – Px äx+t – (Px+1 – Px) äx+t
= tVx – (Px+1 Px )äx t

Modification reduces the net premium policy value by the value of the amount of difference
between the modified net premium and the net premium.
In the case of Endowment Assurance, the modified net premium will be for next higher ages
with corresponding reduction in the term, keeping maturity age same. The modified policy
value is

t Vx : n t Vx : n - (Px+1 : n-1 Px : n ) ax + t : n-t

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As ax t or ax t : n t gradually decreases with the increasing value of t, the deduction from net
policy value also gradually decreases so that ultimately both net premium policy value and
modified net premium value become the same.

As an illustration, consider an Endowment Assurance for ` 1000 to a person aged 45 for a term
of 10 years on the basis of IALM (94 -96) modified ultimate mortality at 6% interest. The net
premium will be
1000 P45 : 10 = 73.72

The modified net premium will be

1000 P46 : 9 = 84.33

The difference in the two premiums is 10.61

Table 1 shows the net premium policy value and modified policy value at durations 1 year to 10
years.
Table 1

1000 x 73.72 Net Premium 10.61 Modified Net

Duratio

a 45 + t : 10 - t
A 45 + t : 10 - t x Policy Value x Premium Policy
n

(2) – (4) Value (5) – (6)

(3) (3)

(1) (2) (3) (4) (5) (6) (7)

1 598.37 7.096 523.12 75.3 75.3 0.0

2 633.01 6.484 478.00 155.0 68.8 86.2

3 669.73 5.835 430.16 239.6 61.9 177.7

4 708.67 5.147 379.44 329.2 54.6 274.6

5 750.01 4.416 325.55 424.5 46.9 377.6

6 793.94 3.640 268.34 525.6 38.6 487.0

7 840.64 2.815 207.52 633.1 29.9 603.2

8 890.38 1.937 142.80 747.6 20.6 727.0

9 943.4 1.000 73.72 869.7 10.6 859.1

10 1000 1000 1000.0

Column (6) of above Table 1 shows the deduction from net premium policy value to arrive at
the modified net premium policy value. The deduction for the 1st year is the full net premium
reserve. It means that full first year premium is allowed for expenses of that year making the
modified net premium reserve zero. Thereafter the deduction from net policy value gradually
decreases making both policy values identical at the end of the term.

83
This modification gives relief only if a prospective method of valuation is adopted because a
higher premium is taken into account for deduction from value of benefits and a lower policy
value is obtained. For retrospective method of valuation, the first year premium or a
considerable portion of it should be ignored in accumulation.
8. Gross Premium Method of Valuation
In this method, actual office premiums receivable are taken into account. A certain percentage of
office premiums is thrown off to provide for expenses. The balance of the office premium is then
taken as the premium to be used in arriving at policy values. The percentage thrown off will
correspond to that which the total expenses bear to total premiums. Total expenses include first
year heavy expenses which will not recur again. Thus such an allowance will be too great for
business which has been on books for some time. On the other hand, if bare renewal expenses of
the existing business were reserved, no direct provision would be made for the cost of future
replacements of business, which is essential in a continuing concern.
Use of such an overall expense ratio, therefore, assumes that in future also the proportion of
new business to the old business will be maintained at the same level as at the date of valuation.
If the insurer has, at the time of valuation, been writing a higher proportion of new business as a
result of a drive for rapid expansion, it is likely that after some lapse of time, the proportion of
new business to old business may be considerably less than that at the time of valuation. In such
a case, it is justified to use a lower percentage of premium (expense ratio) in arriving at
premiums for valuation.
As per Rule 25 of the Insurance Rules, 1939 definite proportions of first year premiums are
allowed as first year expenses as given in following Table 2.

Table 2

Percentage of First Year

Term of Policy (Years) Premium allowed for initial
expenses
12 or over 90
11 82.5
10 75
9 67.5
8 60
7 52.5
6 45
5 37.5
4 30
3 22.5
2 15
1 7.5

After allowing percentages of first year premiums as above, the balance expenses are to be
related to renewal premium income which gives the renewal expense ratio. This percentage
84
only refers to renewal expenses. When new business is written at heavy cost, the percentage
allowance in a valuation out of office premiums for expenses should be more than the renewal
ratio as arrived at above.
Greater care is, however, needed in selecting this proportion for expenses at the time of
valuation.
In actual practice an analysis of expenses is carried out by which the expenses incurred are
allowed between ‘initial’ and ‘renewal’ cost of business and related to the corresponding
premium income so as to determine the cost ratio for new business underwritten and renewal
servicing and claims (renewal cost ratio).
Under gross premium method of valuation margins are kept between the interest assumptions
and mortality assumptions adopted in the valuation and those expected to obtain in the future.
The rate of interest adopted is considerably lower than the yield earned on the Life Fund. On the
other hand, the mortality basis adopted is heavier than the estimates of future experience.
Consequently, the method considerably overstates the liability and thus denies the due share of
surplus to the policyholders as bonuses. Further, it is not possible to say what would be the rate
of bonus that will be supported by the existing fund in the future.

9. Gross Premium Method for With-Profit Policies

In discussing gross premium method of valuation provision for expenses out of future
premiums has been considered. A percentage higher than the bare renewal expense ratio and
lower than the ratio of total expenses to total premium income is considered justifiable in an
expanding concern. The same percentage as applied to without profit office premiums is not
sufficient for with-profits office premiums as they contain bonus loading in addition to
expenses. Thus, a further provision for future bonuses has to be allowed for by throwing off a
higher percentage of the office premiums in arriving at valuation premiums. As an illustration, if
15% of office premiums are reserved for future expenses for a without profit policy, 20% or
more might be reserved in respect of with-profits policy premiums for bonus and expenses
together, depending upon rates of bonuses expected to be declared in future.
10. Gross Premium Bonus Reserve Method of Valuation
The gross premium method of valuation for with profits policies makes provision for bonuses
in an indirect way. The office premiums under with-profit policies contain a specific bonus
loading. If credit were taken for full office premiums less the deduction for expenses and a
valuation made on a realistic experience basis, then and additional item must be valued as a
liability, namely, the future bonus it is expected to declare. This is the feature that has given the
method its name of bonus reserve method.
A typical formula for the bonus reserve method of valuing the liability for a Whole Life
Assurance effected t years ago for a person then aged x with sum assured S, total declared bonus
of B and office premium SPx is

S B Ax + t bS IA x+t
– 1 – e SPx x äx + t .
The assurance, increasing assurance and annuity factors are based on the best estimates of the
experience of mortality and interest, and e is a realistic estimate of expenses per unit premium.
The rate of bonus which it is expected to declare in future, namely b, is assumed to be uniform
throughout the future duration of the contract.
In calculating premium rates, some safety margins are retained in the rates of interest and
mortality. Therefore, a small profit may be expected to emerge from these sources. Full rate of

85
anticipated bonus need not be treated as a specific liability in bonus reserve valuation. A slightly
lower rate of bonus than expected to be declared in future can be assumed in the valuation.
It can be argued that a bonus reserve method should give a clearer and more realistic picture.
The present known data are sum assured, existing bonuses, office premiums and current value
of assets. These are taken precisely into account. For the future, realistic long term estimates are
made of rates of interest, mortality, expenses and bonus. The method enables the rates of bonus
over the future to emerge in a smoother way. An increase or decrease in the rate of bonus
expected to be declared in future requires a much larger increase or decrease in the valuation
reserves than the cost of the immediate bonus. Further, a large appreciation or depreciation in
the value of the assets due to a change in the market rate of interest means a corresponding
decrease or increase in the valuation rate of interest, and hence an increase or decrease in the
reserves. In such circumstances, the bonus reserve method enables the bonus to be declared at
a rate more likely to be maintained over the longer term, irrespective of fluctuation in the
market value of assets and of periods of temporary prosperity or adversity.
This method has been criticized because it treats future bonuses as a liability. The true nature of
with-profit policies is that they only have a right to share in profits if they arise. But they have
no right to any definite rate of bonus. Making provision for a definite rate of bonus amounts to a
recognition of a definite liability for bonus. This may lead the policyholder to an erroneous view
that they have a right to the bonuses shown in the valuation.
Secondly, from the formula given above it is clear that if basis for mortality, interest and
expenses adopted for bonus reserve valuation are together more favourable than the
corresponding elements in premium basis, the valuation will capitalise the future surplus
arising from the difference in the basis. At the early durations this could mean treating these
cases as assets – often referred to as negative values. Care has to be taken to exclude this from
the valuation because the expected future profits represented by the negative values would be
realised only if the contracts remain in force. The capitalisation of future profits raises the
question of how it should be apportioned between bonus to be allotted for the present and that
for the future and the solution requires an exercise of judgement in the light of detailed analysis
of surplus and its trend. Since the future bonus is a factor in a bonus reserve valuation the bonus
earning power of new business becomes a relevant consideration and usually is regarded as an
important feature of any investigation for the purpose of distributing surplus. The current
scales of office premium for the various participating classes of assurance may be tested to
estimate their relative bonus earning power at different entry ages and policy terms by making
in effect bonus reserve valuation at duration ‘O’.

11. Concepts of Estate and Trading Profit

The valuation is an exercise in estimating probable future trends in respect of two very
uncertain factors, viz. trend of interest rates and of expenses of management over a very long
period. For this reason, the valuing actuary has to take a conservative view of the future trends,
especially as the premium rates are fixed for the whole duration of the contract which may last
over several decades. Consequently, the reserves brought out by the normal valuation may be
larger than what would be really required. The ‘estate’ is defined as the difference between the
value of assets held by the office and the assets which will in fact be required to meet the
liability, including future bonuses, in respect of existing policies. It is not possible for the insurer
to forecast accurately as to what assets will in fact be required to meet the liability under
existing polices, because such forecast would require an exact determination of the future
experience in the matter of mortality, interest and expenses . It is therefore possible to make
only a tentative estimate of the size of the estate. For this purpose, along with normal valuation
(done on any method) which will be on a conservative basis, the insurer does an internal
valuation by the bonus reserve method on somewhat closer to the current experience basis. In
such a valuation, future bonuses at the rates being declared currently would also be provided
86
for as a liability. The difference between the reserve brought out by such a valuation and by
normal valuation can be treated as the estate. Thus the estate is in the nature of a general
reserve for a trading company and provides a cushion against possible adverse experience in
future. It also provides necessary security for payment of both the basic sum assured and
current level of bonuses.
It is essential that the insurer distributes only the trading profit of the inter-valuation period as
bonus. It should be understood that the trading profit itself is a product of the valuation method
and bases and could alter if the valuation method or land bases are changed. Even in respect of
the current valuation method, the bonus that can be supported by the trading profit will depend
to a considerable extent on the changes made in the valuation bases. When the rate of interest
assumed in the valuation is increased with a corresponding increase in the provision for
expenses and future bonuses, the surplus disclosed may be the same as the trading profit.
However, because interest rate has been increase, the bonus that can be supported by the same
amount of surplus will be at a higher rate. Thus, even if it is accepted that the surplus disclosed
at the valuation by the method adopted correctly represents the trading profit of the inter-
valuation period, the valuation method by itself distorts and considerably reduces the actual
bonuses that can be supported by the surplus disclosed.
In making the valuation and deciding upon the level of reversionary bonus, the insurer should
keep in mind the “over-riding need” to ensure complete security both for the basic sum assured
and bonuses and also for maintaining the present level of reversionary bonuses in future. At the
same time the bonus system should also ensure the full return to the policyholder of the
contribution made by him to the estate during the currency of his policy when the policy goes
out of the fund by way of a claim. This can be done by declaring a terminal bonus in addition to
the normal simple reversionary bonus. The terminal bonuses, i.e., bonuses which would be
payable only to policies which result into claims by death or maturity during the inter-valuation
period, should be so determined as to ensure the principle of full return to the policyholders of
the contribution made by them to the estate during the currency of the policies. How to arrive at
the level of terminal bonuses for different types of policies with different durations is beyond
the scope of this course.

12. Special use of Retrospective method

In case of Pure Endowment policies and Children Deferred policies during deferment period,
there is no risk cover. Provisions are usually made for return of premiums with or without
interest in the event of death of life assured in case of such policies. As the policy value at any
time should not be less than the benefits guaranteed, a retrospective method of valuation is best
suited. The policy values are calculated as accumulation of certain percentage of premiums paid.
The percentage is so chosen that policy values are not less than the guaranteed returns and that
the margins left cover the expenses also.

13. Valuation of Unit-linked policies

In case of unit-linked policies the insurer receives income from the charges. The outgo under
such business is the expenses incurred by the company and the claims paid to the policyholder
in excess of the unit reserve. A gross premium cash flow method is used to value liability under
such contracts.
There are two types of liabilities under a unit-linked policy:
i) the liability relating to the value of units, and
ii) the liability relating to administration expenses, mortality/morbidity claims
and guarantees, if any known as non-unit reserves.

87
Unit reserve is calculated as the number of units multiplied by their value. Non Unit reserve is
calculated by projecting expected cash flow from the policy, i.e. income from charges less outgo
in the form of claims, expenses and guarantees, if any which is more complicated and is beyond
the scope of this course.

14. Regulatory provisions

The Insurance Act, 1938 and IRDA (Assets, Liabilities and solvency Margin of Insurers)
Regulations, 2000 govern the method and bases of valuation under life insurance policies in
India. Section 13 of Insurance Act requires the valuation of liabilities and an investigation into
the financial condition of the business transacted by life insurers in India to be made every year.
Further schedule II-A of IRDA (Assets, Liabilities and Solvency Margin of Insurers) Regulations,
2000 deals with valuation of liabilities – Life Insurance. It provides the method of determination
of mathematical reserves under each contract underwritten and serviced by the insurer. It
explicitly prescribes prospective method of valuation to be used while determining
mathematical reserves.
Prior to IRDA regulations insurers were required to submit returns to the Government of India
in form H whenever a valuation was made, setting forth the values of sums assured and
bonuses, if any, the values of office premiums and net premiums and policy values as net
liability. These particulars cannot be got if retrospective method of valuation is adopted as it
gives policy values, i.e., net liability as a difference between accumulations of past premiums
and accumulations of past expected/actual claims. Thus, out of necessity, prospective method of
valuation was prevalent even earlier.

88
EXERCISE 7

1. What is meant by valuation of an insurer? Explain how it is necessary.

2. What is a net premium method of valuation?
3. What are the advantages and disadvantages of a gross premium valuation as compared
to net premium valuation?
4. What is meant by renewal expense ratio of an insurer? Discuss the relationship of this
ratio with the provision for expenses in a gross premium valuation.
5. Discuss the various aspects that have to be considered in fixing the provision for future
expenses in a gross premium valuation.
6. Describe the various methods available in valuing with-profit policies with reference to
the provisions for future bonuses.
7. Give an expression for bonus reserve policy value under an Endowment Assurance,
making provision for future expenses. Explain the various symbols used in the
expression.
8. Explain the concepts of estate and trading profit. What is the justification for payment of
terminal bonus at the time the policy results into a claim?
9. Why should a life insurance policy have a reserve?
10. What do you mean by “New Business Strain”? Why does it arise? Give an expression for
the new business strain on the fund.
11. When is the use of retrospective method of valuation justified?
12. Explain the method used in the valuation of unit-linked policies.
13. What are the present regulatory requirements in respect of method of valuation under
life insurance policies?

89
 CHAPTER 8

SPECIAL RESERVES AND ADJUSTMENTS

1. INTRODUCTION
Policy value in respect of each policy is calculated as per the method of valuation adopted by the
insurer. Valuation liability is the total of such policy values in respect of contracts in force on the
date of valuation. It is necessary to provide for special reserves and adjustments as under to
arrive at the final valuation liability:

(i) Allowance for actual incidence in premium income,

(ii) Adjustment for outstanding premiums,
(iii) Reserve for early payment of claims,
(iv) Reserve for revival of lapsed policies,
(v) Provision for expenses in respect of fully paid up policies,
(vi) Provision for expenses in respect of reduced paid up policies,
(vii) Reserve for elimination of negative values and
(viii) Exchange fluctuation reserve.

2. Allowance for Actual Incidence in Premium Income

The value of a policy, if required on a policy anniversary date i.e. after a complete number of
years since inception, is easily calculated by the formula tV = A-Pä . Usually valuations are done
as on 31st of December of a year or at the close of any particular period such as the financial year
ending with 31st March. On such a particular date all policies of the insurer cannot have their
policy anniversaries. Dates of commencement will be different for different policies and as such
dates of payment of annual premiums will be spread over the year, but not necessarily
uniformly. To allow for this incidence of premium income, dates of premium payments are
assumed to fall on the nearest 31st March, if the last day of March, is the valuation date. In this
way premiums falling due in first half of a financial year (referred to as ‘A’ premiums) are
assumed to fall on the previous 31st March. With this assumption, future ‘A’ premiums
constitute an annuity due on a valuation date. There premiums, therefore, are valued by the
annuity factor ä . ‘B’ premiums (falling due in second half of a financial year) are assumed to fall
due in next 31st March, thus forming an immediate annuity. They are thus valued as immediate
annuity with the factor ä. Thus the above method automatically allows for the actual incidence
in premium income.

3. Adjustment for Outstanding Premiums

In the valuation methods described in Chapter 7, it is assumed that premiums are paid annually.
Premiums are also paid in half-yearly, quarterly or monthly installments. In such cases there
will be some installments of premiums which have not yet fallen due for payment on the
valuation date. In the case of yearly mode of payment, the premiums would have been paid or
become due prior to or on the valuation date and therefore no adjustment to the value of future
premiums is needed. In case of other modes, the valuation formula does not provide for the
installment of premium which would fall due after the valuation date until the next policy
anniversaries. As an illustration, if the valuation date is 31st March 1990, under a policy effected
90
on 5.7.1980 on quarterly premium basis, the 10th policy year starts from 5.7.1989. The quarterly
premium due dates for this policy year will be 5.7.1989, 5.10.1989, 5.1.1990 and 5.4.1990. As on
the valuation date, the premium due on 5.4.1990 would not have become due for payment. This
installment of premium is definitely payable even if the life assured dies before the due date, i.e.
5.4.90. If, however, the policy anniversary falls during the period 1st April to 30th June and the
mode of payment is quarterly, there would not be any outstanding premium on 31 st March, as
all premiums in respect of a particular policy year would fall due before that date. Payment of
premiums more frequently is a concession in the manner of payment and any unpaid
installments of premiums for the policy year, current on the date of death, are to be recovered
from the claim amount. Such unpaid installments of premium of the current policy year which
have not fallen due as on the valuation date are known as outstanding premiums. They are all
receivable by the insurer after the valuation date. Therefore, while ascertaining the value of
future premiums at the time of valuation, the total of outstanding premiums is added to the
value of the future annual premiums. This addition for outstanding premiums makes due
allowance for the mode of payment of premiums, and it reduces the policy value.

4. Reserve for Early Payment of Claims

In arriving at the policy value, it is assumed that the sum assured payable on death is paid at the
end of year of death. On the assumption of uniform distribution of deaths throughout the year,
deaths would take place on an average in the middle of the year, that is, at the end of 6 months
from the policy anniversaries. In principle, the death claim is payable immediately after death,
but there will be some time lag in reality between the date of death and date of final settlement.
If the average of this time lag is 2 months, it implies that the valuation formula understates the
policy value to the extent of interest on account of early payment of claim by 4 months. To
eliminate this loss of interest, addition of interest for one-third of a year on the values of sum
assured is made to the total of policy values in respect of policies which can become payable
only on death of the life assured. Provision for interest for 4 months is given as an instance. The
insurer is free to decide on the number of months in the light of his own experience.
In a net premium valuation, this provision for payment of claims earlier than assumed in the
valuation formula is made by the addition of interest for 4 months on the policy value (i.e. net
liability) but not on value of sum assured. The reason is that the net premium arrived at on the
same assumptions as value of sum assured, viz. a delay of 6 months in the settlement of claims,
also needs an addition of interest for 4 months. In the case of a gross premium valuation
because of several margins in the loadings, such an addition to the value of premiums is not
considered necessary.
Endowment assurances and similar typers of assurance consist partly of temporary assurance
and partly of the pure endowment payable on survival. The adjustment for early payment of
claims is required on the first part only of the contract and since this is much the smaller part,
unless the period of assurance is exceptionally long, the adjustment is usually ignored. However,
if a provision is thought necessary, it can be made at half the rate for whole life assurance, i.e. an
addition of interest for 2 months on value of sum assured in gross premium valuation and on
net liability in net premium valuation should suffice.

5. Reserve for Revival of Lapsed Policies

For the purpose of valuation, only policies in force as at the date of valuation are included. As on
the valuation date, there will be many policies which are in lapsed condition and which can be
revived subsequent to the date of valuation. After the revival of a policy, the insurer must be
able to set up a reserve equal to the policy value of the revived policy on the date of revival.
Otherwise, at the time of next valuation when such revived policy is valued, there will be strain
on the Life Fund due to proper reserves not having been set up at the time of revival. The

91
reserve so needed may not be provided entirely from the premium payable on revival. Excesses
from premiums paid prior to the state of lapse are already included in the Life Fund. A
Prospective valuation, however, does not by itself set up any liability for such excesses since the
lapsed policy is not included in the business to be valued. Hence, provision has to be made in the
valuation to meet the strain of maintaining reserves in respect of policies that may be revived
after the valuation date. This provision depends upon the non-forfeiture regulations of the
insurer. An estimate is made about the policies under lapsation where liability to revive exists
and about the percentage of revivals based on past experience. Based on these estimates, a lump
sum provision is made, as an average fixed amount for every thousand sum assured. This
addition to the valuation liability is known as reserve for revival of lapsed policies.

6. Provision for Expenses in Respect of Reduced Paid-up Policies

The Limited Payment policies become fully paid up after all the premiums have been paid.
During the period a policy is in paid-up state, expenses will continue in respect of enquiries for
loans, valuation and declaration of bonuses in case of with profit policies. The expenses needed
after the cessation of premiums will be less than the expenses during premium payment period.
Provision for such expenses is generally made as an addition to the value of sum assured of a
constant amount for each year of assurance after the premiums cease. The constant amount, say
C, which is a proportion of the sum assured is valued as a deferred annuity, i.e. C t/ä where t is
the period after which premiums cease. If this provision in case of without profit policies is, say
`5 per thousand sum assured, it may be `7 per thousand sum assured in case of with profit
policies to provide for higher expenses in connection with declaration of bonuses after the
premiums cease.

7. Provision for Expenses in Respect of Reduced Paid-up Policies

In the case of paid-up policies for reduced sums assured, where no further premiums are
payable, expenses have still to be incurred by the insurer as long as the policies remain on the
books. The expenses will be in connection with occasional enquiries about position of their
policies or loan values. Some expenses are also incurred in connection with periodical
valuations. To meet these expenses, a lump sum provision may be made. It is also possible to
make allowance for these expenses as an annuity of a fixed amount, usually a proportion of sum
assured for the unexpired term to maturity or for whole of life in the case of whole life paid-up
policies.

8. Reserve for Elimination of Negative Values

In a net premium valuation policy value tV = A – Pä is always positive giving a value for the
policy at the end of first year of insurance itself. In a gross premium valuation or bonus reserve
valuation, a percentage of office premiums is valued as valuation premium. In arriving at office
premium from net premium, the effect of distributing heavy initial expenses over all the
premiums is a decreasing percentage addition with the increase in the rate of premium. Where
the office premium rate is low, as in long term policies, the additions for initial expenses in high.
In such cases, the provision for heavy initial expenses and renewal expenses together exceed the
provision for expenses in a gross premium valuation. Pä, will exceed the value of the sum
assured A, giving for the policy value A-Pä, a negative value. The total of valuation liability will
be reduced by these negative policy values. This in effect treats a policy with negative value as
an asset in the valuation. No policy can, however, be treated as an asset as it will not be
realised, if the policy lapses. All such negative values have therefore to be eliminated in the
valuation. This is done by separating the types of policies at various durations on the valuation
date where negative values arise, and reducing the value of premiums taken credit for in the

92
valuation to the value of sums assured in respect of such policies. This reduction in the value of
future premiums increases the policy value from negative values to zero.
The adjustment as detailed above is either made directly by deduction from the value of future
premiums or by addition of an equal amount to the net liability showing it as a reserve for
elimination of negative values.

9. Exchange Fluctuation Reserve

If there are policies issued in foreign currencies, the exchange rate at the time of payment of
claims may make it necessary to find additional resources other than policy reserves. To meet
such adverse fluctuations in rates of conversion of currencies, a special provision is made called
currency reserve or exchange fluctuation reserve. However, the law of the foreign country in
which the business is transacted usually requires the reserves of its policyholders to be invested
only in local currency. To the extent investments are made in foreign currency no exchange
fluctuation reserve in needed.

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EXERCISE 8

1. Explain how the necessary adjustment in the valuation liability is made to allow for
other than yearly modes of payment of premium.
2. What is the rationale for creating a reserve for early payment of claims? Explain how the
reserve is calculated.
3. Explain the need for making provision for expenses in respect of fully paid-up and
reduced paid-up policies in a valuation.
4. What do you understand by negative values? How do they arise? What treatment is
given to negative values in a valuation?
5. Explain why provision is needed for the revival of lapsed policies at the time of
valuation. Indicate the method of arriving at this provision.
6. What is exchange fluctuation reserve? When it is not needed?

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 CHAPTER 9

SURPLUS AND ITS DISTRIBUTION

1. INTRODUCTION
In this chapter we shall discuss different sources of surplus, the reasons of arising of surplus
and the estimation of surplus from main sources. Various methods used for distribution of
surplus and their advantages and disadvantages are also covered in later part of the chapter.

2. Profit
In life Insurance business, profit arises, broadly, because of the margins provided in the bases
adopted for premium calculations regarding mortality, interest and expenses and also on
account of other factors such as lapses, surrenders, etc. Profit also arises when actual experience
is more favourable than that assumed at the time of premium calculations. Valuation of the
policy contracts of an insurer is made at intervals to ascertain the financial effect of the actual
experience in comparison with that initially assumed.
If the experience of an insurer is the same as that assumed while calculating premiums, in a
valuation subsequently made on the basis on which premiums were calculated, the difference
between Life Fund and valuation liability represents the profit arising out of margins provided
in premiums. On the other hand, if subsequent experience was more favourable than the
original estimates, valuation on the same basis as for the premiums, would reveal not only the
profit arising out of margins in the premiums but also the profit arising out of favourable
experience upto the time of valuation. This is because of the fact that Life Fund at any time is the
result of accumulations of balances of premiums already received. These balances are the excess
of premiums after meeting the claims and expenses of respective years. Because of favourable
experience, claims were less and probably expenses also were less i.e., the outgo from income
was much less than was anticipated. Prospective valuations on the basis adopted for calculation
of premiums bring about the liability that would arise if premium assumptions are to be
realised in future. The excess of the Life Fund over the valuation liability is the result of margins
in premiums and also the favourable past experience.
If valuation of the contracts is made on favourable experience basis, valuation liability generally
takes into account the continuation of the existing favaourable experience in future also. Thus a
still lower liability is shown. The excess of Life Fund over this liability consists of margins in
premiums, past favourable experience and also future favourable experience.
If, however, subsequent experience is unfavourable resulting in heavier claims and/or lesser
interest yield and/or heavier expenses than anticipated, valuation on premium basis brings out
a profit less than what was originally expected. In fact there may even be a loss. This valuation
ignores future adverse experience that may arise as judged from past if such past experience
was temporary and future experience still appears to be favourable and different from the past.
However, if past adverse experience is likely to continue in future, then valuation needs to be
made on actual past experience basis. A valuation on the actual experience basis assumes
continuation of the same adverse experience in future also and brings out a still higher liability
reducing the difference between Life Fund and valuation liability still further. The result may be
a loss instead of profit.
Life Fund which is the result of accumulation of excess of income over outgo is always kept in
the form of various investments which yield regular interest income. Life Fund at any time
depends on the value of the investments constituting the fund. If current rates of interest are
higher than those prevailing at the time of investments of Life Fund, investments depreciate in
95
value. If interest rates have fallen there may be appreciation in the value of investments. Thus if
values of investments are always revised to bring them in line with current market conditions,
Life Fund varies from time to time and these variations affect the profit. Usually an investment
reserve fund is built up out of the incomes of various years. All minor changes in the values of
investments are met from this fund without writing up or down the Life Fund. A detailed
discussion of the valuation of investments is, however, beyond the scope of this course.

3. Surplus
Valuations are very rarely done on the basis assumed for calculation of premiums. In selecting
the basis for valuation regard is always had to the actual present experience. Even if the
experience assumed in premium calculations has been reproduced, it is not usual to adopt the
same rates of mortality, interest and expenses in the valuation of net liability. The present
experience may not be reproduced in future. A proper valuation has to take into account not
only the actual present mortality experience but also future trends of mortality. This is
necessary, because of the fact that the existing contracts will subsist for varying periods in
future. Even if an attempt is made to forecast the future experience as closely as possible on the
basis of past experience and future trends it is not possible to predict it with any degree of
certainty. It is possible that the future experience may turn out to be worse. In such an event
losses may easily arise. To prevent such a contingency the practice is to use, for this purpose of
valuation a life table based on heavier rates of mortality than those that are actually being
experienced. This method provides a safety margin for adverse fluctuations.
Similarly in the case of interest a rate of interest based on conservative estimate, is adopted for
the valuation. Present trend of events enables the present interest earnings to continue in future
also. But as rate of interest depends upon many factors like supply and demand of money, fiscal
and taxation policy of the Government, difference in prices between home market and world
markets etc., it is not possible to be definitely sure of the rates of interest at which future
investments would be made. Some of the existing investments which mature for payments may
have to be reinvested. Balances of premiums after meeting outgo have also to be regularly
invested at different intervals. It may not be possible to make new investments in future at
favourable rates as in immediate past. If future yields go down drastically, the favourable
position now disclosed may not continue for long. It is, therefore, customary to use in the
valuation a rate of interest which is lower than that now being earned. This margin allowed in
the rate of interest brings out a higher net liability in the prospective method of valuation. Even
if new investments are made at attractive rates, it is desirable to take a cautions view and keep
the valuation rate of interest low. Increased interest earnings would enable the insurer to
declare higher rates of bonus in future.
Some margin in expenses also is kept by reserving a slightly higher percentage of office
premiums than is actually needed.
With safety margins provided in the bases chosen, the net liability brought out in the valuation
is, of necessity, higher than the actual liability. The profit thus disclosed in a valuation is not the
actual accumulated profit arising out of margins in the premiums. It is something different. It is
usually less than the actual profit. It would be still less, if more margins are kept in the valuation
bases.
The excess of Life Fund over valuation liability arrived at by using bases different from those
employed in premium calculations is termed surplus as it is not profit in the real sense of the
term. With changes in valuation bases different surpluses can be revealed, through the actual
profit does not change. In other words, valuation does not reveal the real profit. A portion of the
profit has been retained for margins the balance being shown as profit accrued during the
intervaluation period.

96
4. Sources of Surplus
In the foregoing discussion it has been seen that surplus is a function of the valuation bases.
During the period between one valuation and another valuation the experience might have
either remained the same or varied much from that of the previous years. Statutory valuations
are generally conservative. Actual experience is usually more favourable than assumed in the
valuation. The divergence of the actual experience from that assumed in the valuation should
result in surplus. All the three bases regarding mortality, interest and expenses contribute to the
surplus.
Anything received in excess of the valuation assumptions is surplus. Surplus from mortality
arises when experienced rates of mortality are lower than those assumed in the valuation. For
every policy contract a reserve is held by the insurer. It is the valuation liability. If claim arises
at a particular time, the cost of the claim for the insurer is sum assured less the reserve already
held i.e., the policy value ‘V’. This cost i.e., sum assured minus policy value i.e.,(S-V) is known as
death strain. In respect of all claims of a year the insurer has to pay the amount of death strain
for such policies. At a particular age, if the total sum assured is S and if the valuation reserve in
respect of all such policies is V then (S-V) is the amount at risk in respect of all policies of the
group aged x. If Qx is the valuation rate of mortality for the group and qx is the actual rate of
mortality experience, then
Qx (S - V) is expected death strain and
qx (S - V) is actual death strain met.
The difference between expected strain and actual stain is the surplus due to mortality or
simple mortality surplus.
Thus Mortality Surplus = (Qx – qx) (S – V)

For all age groups, if this difference is worked out, the total for all such differences is the
mortality surplus for all such policies of the company for that valuation period.

Similarly surplus arises from interest, if actual interest earned is more than that assumed in the
last valuation. It I is the actual interest earned and if A & B are funds at the beginning and end of
the year then interest expected to be realised on the mean fund, at valuation rate i, should be
i. Difference between I and i is the interest profit provided all the surplus of
previous year had been distributed. Otherwise, interest on any surplus carried forward also has
to earn interest at valuation rate i,
Surplus from favourable expense position arises because of the lower expenses incurred than
those provided for in the valuation. If P’ is the total of office premiums received and P is the total
of premiums taken credit for in the last valuation, then P’ –P is the expense loadings. If actual
expenses are only E then P’ – P – E is the total of excess provision in expenses. On the
assumption that premiums are received uniformly throughout the year, there should be an
interest income also on an average for 6 months on the above profit. Thus loading profit which
is the same as profit due to lower expenses can be put as
i
(P’ – P – E) 1
2
There will also be surplus from miscellaneous sources like surrenders, special fees etc. Surplus
may accrue on account of profit being made on sale of investments or on redemption of
securities.
The surplus from different sources during a valuation period can be compared with similar
surplus of previous valuation period keeping the valuation bases unaltered. With change in
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valuation bases, surpluses are not comparable as the disclosure of surplus varies with valuation
assumptions.
Such an analysis of surplus for each intervaluation period brings out the divergence form actual
experience to that assumed in the valuation. Any divergence can be easily set right by a change
in the corresponding valuation basis.

5. It may be considered necessary to vary the valuation basis in one or more respects from
the one used on the previous valuation either as a result of variation in actual experience or on
account of expected different experience in future or both.
Changes in actual experience are bound to arise as estimates of the elements in the office
premium scale are not going to be realized throughout the long duration of the policies. Such
changes will influence the profits accruing during the intervaluation period. If the rate of
interest realized increases, premiums will prove to be more than sufficient and a real profit will
be made and vice versa. This will hold good, whether valuation bases are changed or not. It is,
therefore, evident that profit or loss which arises from a change in the actual experience will
emerge from year to year, if the valuation bases are maintained as before. In the case of profits
there may be no objection for their gradual emergence on the score of preserving stability
instead of showing all profits at once and thereafter less profits or no profits. But in the case of
losses, this cannot be allowed. It is not safe and proper to pass on the losses to subsequent
years.

6. The effect of a reduction in the valuation rate of interest is to bring about a higher net
liability. Life Fund remains as before as it is not going to be altered by changes in valuation
basis. The Office immediately sustains an apparent “loss” by a substantial reduction in surplus.
Higher policy values or reserves have been set up. But such high reserves may not be needed as
per experience because there is no change in experience. The surplus that is now absorbed by a
reduction in rate of interest will gradually emerge as apparent surplus in future years. Whether
policy values are maintained high or low in the end i.e., by the time the terms of the policies
expire, their values have to either vanish or be equal to the benefits. Low values as well as high
values reach the same end. Thus the surplus withheld at a point of time has to be released
subsequently. By a reduction in rate of interest policy values or reserves are increased and thus
profit is held up gradually in increasing amounts and then released gradually during later years.
It is, therefore, evident that a change in valuation basis cannot affect the profit earning power
but only affects the incidence of surplus. Changes in actual experience affect the profit earning
power also.

7. Surplus is a lump sum amount revealed in a valuation of assets and liabilities. If all the
policy contracts are on without profits premiums, then the whole surplus belongs to the insurer
only. If there are any shareholders who have put in capital into the business, the entire surplus
after meeting taxation goes to them. If the surplus arose as a result of charging premiums much
in excess of what are required, considerations may arise purely at the will of the Insurer, if any
share of profits can be allotted to the policyholders, though they have no right to share in the
profits. Many insurers had, in the past, to serve as a publicity for attracting more members,
distributed a portion of profits among policyholders, though the policy contracts did not provide
for such distribution. The distribution of a portion of profits in such cases is generally made by
way of enhancing benefits (i.e. the sum assured) for same amount of premiums.
When with profit premium policyholders are also there, the bulk of surplus is their property as
they paid for the right to share in profits. As shareholders place their capital at the disposal of
the insurer to serve as a guarantee to the policyholders, they are entitled to a small portion of
surplus as per terms laid down in the constitution of the Insurer and subject to the provisions of
98
law in this respect. The balance of surplus in Shareholders Company or the full surplus in a
Mutual Company belongs to the with-profit policyholders. The following paragraphs deal with
its distribution among them.

8. Fair distribution: (Contribution Method)

Surplus arises mainly from three sources - mortality, interest and expenses. It is a result of
excess payments collected from policyholders. In fairness, the surplus that arose out of
overpayments should go back to those persons who contributed to this amount in strict
proportion to their overpayments. This method of division therefore requires the calculations of
the overpayment in each premium at each age and for each type of policy. Such a calculation is
impracticable even in this age of super computers.
Another point of be considered is that valuation, based on conservative estimates of interest,
mortality and expenses, does not reveal the real profit. Some portion of profit is withheld. The
surplus thus shown by a valuation does not exactly relate to the overpayments in premiums.
Greater amount of profit may be withheld for a particular type of policy than for others
depending upon the nature of provisions made. In such a case where surplus is partly the result
of some arbitrary action, distribution according to excess payments is not necessarily the fair
basis.
Instead of arriving at excess payments out of each premium, surpluses may be distributed in
proportion to premiums paid taking excess payments as in proportion to premiums paid during
the valuation period. This is an approximation to the contribution system. A policy on which 3
years’ premiums are paid during the intervaluation period will get more bonus than the one on
which only 2 years’ premiums are paid. These bonuses may be paid in cash. If the rate of bonus
is to tbe maintained in future years also, it is necessary that cash sums available each year for
each policy should be the same. Valuation has to be performed for such a distribution in a way
as to produce same cash surpluses throughout for each policy.

9. Reversionary Bonus System

Bonuses under this system are declared as percentage additions to sums assured and payable
along with sum assured. If bonus rates are uniformly maintained in future years also, the system
in effect gives the same rate of bonus when the policy is to run for a longer term and also for a
policy which is nearing maturity. Cost of bonus, therefore, for a policy which has a long term to
run is less than that for a policy which is having a short term to run. In other words, a policy gets
bonus in early years of insurance whose cost is less than the cost of bonus receivable in future
years. This method, therefore, requires increasing surplus amounts at successive valuations of a
policy. In the early years of insurance some profit has to be withheld and basis of valuation has
also to be selected to suit the purpose by selecting a rate of interest less than that earned and/or
by reserving more expenses out of office premiums than are required.
Advantages of this method are:
(i) Surplus funds still remain with the insurer and can earn further interest.
(ii) Policyholders will be having increased interest in maintaining their policies by
paying further premiums because of attraction of increasing value of insurance.
(iii) The system admirably fits into the usual conservative valuations on stringent
bases to attain stability.
(iv) The system is easily understood by policyholders.

99
 (v) All with profit premiums can be loaded for a specific rate of bonus as increasing
addition to sum assured. The bonus system therefore fits into the method of
calculation of premiums.
(vi) The bonuses declared in excess of the provision in premiums arises out of safety
margins in premiums i.e., out of overpayments in premiums. But for simplicity it
has also been declared as reversionary addition to sum assured though this is not
fair on theoretical grounds.
10. Uniform Compound Reversionary Bonus System
By this method reversionary bonus addition of each year is of an increasing nature. Bonuses of a
particular year are declared as a percentage of sum assured and bonuses so far declared. Bonus
is in effect not on sum assured only but also on existing bonuses. By this method, additions to
sum assured are of an increasing nature and give better incentive for policyholders to continue
their contracts.
11. Bonus in reduction of premiums
Surplus of a valuation is utilised in reduction of existing premiums receivable. In this method a
stage may arise when there will be no balance premium to be reduced further. Then again for
the surplus of subsequent years reversionary bonus system has to be adopted.
The disadvantage is that surplus is distributed in a way on cash basis and thus the profit earning
capacity of the insurer gets gradually diminished by loss of premium income, and consequent
depletion of funds.
12. Tontine Bonus
This system is popular in America. Bonus is distributed after a certain period to the survivors
then existing. This is achieved by excluding the first few years, say, five years, for every policy
from participation of profits. For claims that arise before the period prescribed, no bonus is
declared. This system may be preferred by a young insurer with a desire to conserve his
resources by avoiding the necessity for early distribution of surplus. Policies resulting into
claims at early distributions do not receive a portion of surplus to which they have contributed
and hence they are penalised.
13. Discount Bonus
In anticipation of a certain rate of bonus, premiums are reduced by an appropriate amount. If
future bonuses are higher than those anticipated, the balance bonus is credited to the policy
holders. If on the other hand, bonuses at any time fall short of the anticipated rate, balance
premium will be recovered from policyholders. The defects of this system are obvious.

14. Interim Bonus

Bonuses are declared on the basis of the results of a valuation for all policies in force as on the
date of valuation. But before next valuation is made some policies become claims either by
death or by maturity on expiration of the term. These policies will therefore not get any regular
bonus declared at the time of next valuation as they will not be in existence by the next
valuation date. For this purpose interim bonus, usually at the same rate as regular bonus
declared at last valuation, will be provided.
Interim bonuses paid in respect of such policies are already debited in the accounts of relevant
years.

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15. Guaranteed Additions
Guaranteed Bonus is not in effect a bonus at all. It is only a guaranteed addition to the Sum
Assured for every year, the policy is in force. A policy with this benefit is having no right to share
in the profits or surplus of the actuarial valuations. They are in effect Without Profit policies.
Persons who do not wish to rely upon the bonus earning capacity of an insurer prefer to have a
definite rate of bonus which is guaranteed. They can as well go in for without profit policies. But
the desire to have increases in sums assured which look like bonuses, brings some admirers for
these plans also.

16. Bonuses are declared whenever a valuation of the assets and liabilities of an insurer is
performed. Valuations are usually performed as per statutory requirements. The purpose of a
valuation is normally to ascertain the progress of its working and to determine the excess in the
Life Fund that can be distributed as surplus or profit. When Bonus is declared an additional
liability is created against the Life Fund. Before creating such definite liability of Bonus, it is
necessary to ascertain whether the excess shown in the Life Fund is a result of favourable
experience likely to continue, or is the result of a chance occurrence not likely to be repeated in
future. Experience of individual valuation periods may show wide variations in the fund because
of varying temporary influences.
Sufficient time has, therefore, to be allowed between one valuation to another valuation to make
sure that the growth of the Life Fund is steady. In the case of small insurers a longer period is
needed to make sure about the progress of their funds. Whereas in the case of big insurers with
millions of policies on books, a smaller period should be sufficient to ascertain the distributable
surplus.
Rates of bonus declared as a result of the surplus revealed at the time of valuation, are usually
for full year’s premiums paid during the intervaluation period. If on the date of valuation full
year’s premium is not yet paid in respect of any policy, the bonus allowed for that year is subject
to the payment of the premium for the current year in full. If valuation date is 31st March 1990
and if the anniversary of a policy, with quarterly mode of payment of premiums, fell due on, say
the 18th day of January 1990, the bonus for the policy year current on the date of valuation is
payable in full, only if the three remaining premiums due in April, July and October 1990 are
also paid. Otherwise the bonus may be either proportional or nothing at all.

17. Because of the necessity of preserving the stability of Bonus rates once declared,
Valuations with a view to distribute Bonus are always done on a stringent basis leaving
sufficient margins in the rate of interest, expenses and also possibly in the rates of mortality.
These margins act as a buffer against any adverse experience that may result under
unfavourable conditions not anticipated in advance. Without such margins future bonus rates
are likely to fluctuate depending on the experience of individual years.
Valuations are performed to ascertain the distributable surplus only if the financial stability is
beyond doubt. When the financial stability is suspected, it is necessary to know the actual
position whether the liabilities can be met in full, with the assets available. There is no need in
such cases to have any margins in the bases adopted for valuation of liabilities. The actual
experience, after taking into consideration the distribution of the assets and the possibility of
the continuation of the present experience, should be the basis for valuation to decide solvency
of the insurer. A valuation for this purpose is known as “solvency valuation.”

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EXERCISE 9

1. Distinguish between profit and surplus in life insurance business.

2. Explain the effect of changes in the valuation bases on
i. Profit
ii. Surplus
3. “Actuarial Valuations provide for many margins and bring out higher liability than is
actually needed depriving the existing policyholders from their legitimate right to a
share in the actual profit, and saving for the future generation at the expense of the
present Policyholders”.
Discuss the above statement.
4. Explain simple reversionary bonus system of distributing surplus and bring out the
advantages of this system in comparison with the other systems in vogue.
5. What is meant by fair distribution of surplus? Discuss how far this could be achieved.

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 CHAPTER 10
ASSET SHARE
1. INTRODUCTION
In recent times the asset shares have become useful tool in the financial management of
conventional with-profit life insurance business. The holders of with-profit policy often have no
control on the level of discretionary benefits and the ultimate payouts to such policyholders
depend heavily on the insurer treating them fairly or otherwise. The insurers are increasingly
using policy payouts as a proportion of asset share to ensure that policyholders are treated
fairly and their reasonable expectations are taken care of. For example some insurers may
define that its most of the policy payouts should be in the specified range usually expressed as a
percentage of the asset share. In some countries the regulators may have prescribed the limits
within which most of the insurers’ policy benefit payouts should fall. For example with effect
from 31 December 2005 the new Financial Services Authority (FSA) rules relating to treating
with-profits policyholders fairly require all insurers writing with profit business must specify
target ranges around 100% of unsmoothed asset share within which 90% of the maturity
payouts must lie. The same target ranges apply to surrender payouts as well.

In simple way the asset share of any policy can be described as the accumulation of premiums
paid rolled up with actual earned rates of investment return, less expenses and the cost of any
life cover. The concept of asset share can be applied to individual policies, or to a group
of policies with similar terms and conditions issued approximately at the same time.

Thus the asset share of a policy, or group of similar policies, is the accumulation of

● Premiums
● Investment income

Realized Capital gains or Losses

Profits from without-profits business (at the discretion of the insurer)

Surrender profits on with-profits business

Allocations from the free estate

Less

● Initial and Renewal expenses

Initial and Renewal Commissions

● Cost of providing life cover including other policy benefits and options

● Tax (Policy stamp, Service Tax and the Tax paid on Surplus)

● Transfer of Profits to shareholders,

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 ● Cost of capital required to support new business strain in initial years, and

● Contribution to the free assets

 For smoothing of bonuses

 For greater investment freedom.

2. Surrender profits on with-profits business

Surrender profit can be allocated by cash flow addition to the asset share or by addition as an
adjustment to the investment return. Under cash flow addition approach the surrender profit
which is the difference between surrender values and the corresponding asset shares is
determined each year which is then spread as a cash flow item among the remaining with-profit
policies or the remaining policies in the cohort of policies contributing the surrender profit
depending upon the insurer’s policy on asset shares. Under adjustment to the investment return
the surrender profit is allocated by a suitable increase in the investment return spreading the
surrender profit among the remaining with-profit policies or the remaining policies in the
cohort of policies contributing the surrender profit depending upon the insurer’s policy on asset
shares.

3. Profits from without-profit business

If the insurer’s surplus distribution policy allows proportion of surplus from without profit
business to be distributed among with-profit policies then such proportion of surplus is
incorporated in the calculation of asset share. As the Indian Regulations allow 100% of the
surplus from Non-profit business to the shareholders, the transfer of any surplus from without-
profit business to with-profit policyholders will be at the discretion of the insurer.

4. Allocations from the estate

The contribution from free assets for smoothing of bonus to with-profit policyholders can be the
net addition to or the net deduction from the asset share depending upon the direction of
transfer of free reserve. The availability of free reserve provides flexibility or the investment
freedom to the insurer thus affecting its ability to take higher investment risks for higher
expected investment returns.

5. Initial and Renewal expenses including commissions

The deduction in respect of Initial and Renewal expenses include all the acquisition and
maintenance expenses associated with the policy including any initial and renewal commissions
paid to the intermediaries. An appropriate proportion of any overhead expenses incurred by the
insurer is also included as an expense deduction while calculating the asset share of a policy or
group of similar policies.

6. Cost of providing life cover and other policy benefits

As the asset share calculation captures the actual cash flow movements the cost of death benefit
is usually obtained by multiplying the sum assured with the probability of death at that age.
Some insurers allow, in their calculation for asset share, for the possibility of policyholders
exercising the option to surrender their policy. Surrender gain arises if the guaranteed
104
surrender value offered by the insurer is within the policy’s asset share. However, if the
guaranteed surrender value exceeds the policy’s assets share surrender loss arises. This
surrender loss or gain is usually deducted from or added to the asset shares, as the case may be,
of the continuing policyholders.

7. Tax (Policy Stamp, Service Tax and the Tax paid on Surplus)
Any tax paid as policy stamp, service tax and the tax paid on surplus by the insurer should be
deducted from the policy’s asset share. Similarly any tax liability to be incurred on investment
income and realised capital appreciation should also be deducted from the policy’s asset share
depending upon the manner of tax treatment of unrealised capital gains in the country where
the insurer is located.

8. Transfer of Profits to shareholders

The actuarial surplus arising as a result of the valuation of policy liabilities of the insurer is
distributed among the policyholders and the shareholders in the ratio usually prescribed by the
regulators. Thus any transfer of surplus to the shareholders should be deducted from the asset
share. Presently the Indian Regulations prescribe not more than 10% of the surplus from with-
profit business to be transferred to the shareholders.

9. Cost of capital to support new business strain

We have earlier seen that the premium paid by the policyholder at start of the policy less high
procurement cost in the first year viz. commission paid to the agent and other expenses
incurred in procuration of business, expenses incurred on routine and special medical reports,
other underwriting expenses, policy stamps, expenses connected with the issuance of policy
document, setting up of policy records etc. is not sufficient to cover policy reserves and the
regulatory solvency margin requirements at that point. This gives rise to new business strain
which is funded either by injection of capital from the shareholders or by the existing
policyholders or by both. These policyholders or the shareholders effectively provide loan to the
new policyholders to fund the new business strain. The shareholders get some money back as a
reward for investing money to fund the new business strain, by way of transfer to shareholders.
For policyholders the cost of this “loan” provided at inception by other policyholders and/or
shareholders is deducted from the policy’s asset share. For later durations when the asset share
becomes positive the policy may now be funding new business strain of other policies and in
those years the cost of capital will be an addition to the asset share of the policy.

10. Contribution to the free assets

Depending upon the bonus smoothing policy, an insurer usually aims at smoothing the returns,
by way of bonus, to the with-profit policyholders to protect the policyholders from the
fluctuations of the market returns. The insurers may choose to distribute less than the asset
share when market conditions are good thus providing for the free reserves to be used to
support the bonus distribution when the market conditions are adverse. This contribution to
free assets can be the net addition to or the net deduction from the asset share depending upon
the direction of the transfer of free reserve. The availability of free reserves also provides
flexibility or the investment freedom to the insurer thus affecting its ability to take higher
investment risks for higher expected investment returns.

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11. Mathematical Determination of Asset share
To understand the concept of asset share let us consider the cash flows that usually occur when
a contract is written. As it has been discussed in earlier chapters, an insurer incurs relatively
high business set-up costs which may include costs incurred in establishing office spaces,
setting up the distribution channels, hiring and training the administrative staff etc. The insurer
also incurs the cost to pay initial commission to the provider of the business, for example the
company’s own salesperson or agent or the intermediary for procuration of new business. This
means that in the first year, the cash flow i.e. income less outgo is often negative or small
positive. This cash flow deficit in the initial years gives rise to new business strain or initial
capital strain.

Further, the regulatory authorities require that sufficient policy reserves be set aside to ensure
that the insurer is able to meet its policyholder obligations whenever they arise. Additionally,
the regulator also requires the insurer to maintain the Required Minimum Solvency Margin as a
measure of further security to the policyholders. Thus more capital gets tied up than required to
meet the policy benefit payouts.

At time 0, immediately after the policy has been issued, if the first premium, regular or single,
received is P0, initial expenses incurred including commission is E0, the supervisory reserve is R0
and the required solvency margin is S0, then the initial capital strain C0 can mathematically be
expressed as

C0 = P0 – E0 – R0 – S0

In the above expression C0 will be negative. Further, the asset share can also be expressed as

A0 = P0 – E0

Thus the initial capital strain can also be expressed as the excess of supervisory reserve and
required solvency margin over initial asset share.

12. Asset Share by an example

Let us try to understand the asset share in a little more detail with the help of an example.

A group of endowment assurance policies each with a sum assured of ` 100000 and an annual
premium of ` 7000 all issued on 1st January, 2010. During the year 2010, the expenses incurred
on each such policy are `10000, the actual investment return is 10% p.a., and mortality is .002.
During the year 2011, the expenses incurred is `1000, the actual investment return is 10% p.a.,
mortality is .003 and during the year 2012, the expenses incurred is ` 900, the actual
investment return is 10% p.a., mortality is .004. It is further assumed that the expenses are
incurred at the start of year at the time of premium payment and the claims are paid at the end
of the year.

Ignoring all other components contributing to the asset share cash flows, the asset share per in
force policy at the end of year 2010 would be:

(7000- 10000) * 1.1 – (100000 * .002)

AS2010 = -------------------------------------------------- = - 3507
( 1 - .002)
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The asset shares per in force policy at the end of year 2011 and 2012 would be:

(-3507 + 7000- 1000) * 1.1 – (100000 * .003)

AS2011 = --- ---------------------------------------------------- = 2450
( 1 - .003)

( 2450 + 7000- 900) * 1.1 – (100000 * .004)

AS2012 = ----------------------------------------------------------- = 9041
( 1 - .004)
When a contract is written just before the receipt of first premium the asset share of a policy or
group of policies is zero. From the premium received at the start of each year deduction is made
for the expenses incurred at the beginning of the year and the net cash flow is rolled up with
actual earned rates of investment return and the cost of life cover is deducted from this. This
resulting net cash flow is then divided by the number of survivors at the end of the year. This
process is repeated for the subsequent years.

The asset share, each year can thus be calculated recursively by using the following general
expression:

(ASt + P – Et) * (1+it) – SA*qx+t

AS t+1 = --------------------------------------------
1 – qx+t

Where, ASt is the asset share at the start of t th year (or end of (t-1)th year)

ASt+1 is the asset share at the start of t+1th year (or end of t th year)

P is the level annual premium under the policy

Et is the expenses incurred at the beginning of t th year

it is the investment return earned during the t th year

SA is the death benefit sum assured payable at the end of year of death

q x+t is the actual mortality rate for the t th year

In practice the cash flows arising out of other components as well are incorporated in the
calculation of asset share. For simplicity they have not been considered here.

13. Applications of asset share

Insurers are increasingly using asset shares as a benchmark to determine the level of policy
payouts of with-profit business portfolio and to manage the policyholders’ reasonable
expectations.
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The management of with-profit business essentially involves the management of level of
reversionary bonuses typically declared as a result of valuation at the end of each financial year
as well as the level of terminal bonus. The aim is to ensure equitable distribution of profits
among the shareholders and the policyholders and also among different generations and classes
of with-profit policyholders. Thus, if the total policy benefit payout is to be equal to the asset
share, the terminal bonus should be equal to the difference between the earned asset share and
the benefits guaranteed at the inception of policy plus any reversionary bonuses already vested
with the policy. The process of declaration of annual reversionary bonuses involves calculation
of bonus earning capacity of different insurance plans to ensure that the total benefit payout
always remains within the earned asset share. The bonus earning capacity gives the maximum
rate of annual reversionary bonus that can be sustained if the assumptions based on which the
bonus earning capacity is calculated is achieved in practice. The policy payout may, however,
vary from the earned asset share in view of insurer’s policy of smoothing the benefit payout. We
have discussed in the introductory paragraph of this chapter that the insurers and sometimes
the regulators generally define the range usually expressed as a percentage of the asset share
within which most of its policy payouts should fall.

The smooth progression of the policy benefit payout is also important for the fact that some of
the policyholders may choose to surrender their policies before maturity. If the insurer pays
surrender benefit more than the asset share, then there will be surrender loss equal to the
excess of the surrender value over the asset share at surrender. If the insurer pays surrender
benefit lower than the asset share, then there will be surrender profit equal to the excess of
asset share over the surrender value. This surrender profit or loss is reflected in the asset share
of the remaining with-profit policyholders or the remaining policies of the cohort of policies
contributing surrender profit or loss. Insurers therefore use asset share as a guide to set the
surrender value. The surrender values are usually set at a level that they do not exceed earned
asset shares, in aggregate, over a reasonable time period.

We have seen in the example mentioned above that the asset shares in the initial years can be
negative. If the policy is withdrawn when the asset share is negative the insurer incurs loss as
the development costs are not recovered in full, which could be financially onerous. Thus
insurance companies usually make appropriate allowance for such early withdrawals.

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EXERCISE 10

1. Define Asset Share of a life insurance policy and explain, in brief, different components
used in the accumulation of the asset share of a policy.

2. Describe the following while working out Asset Share of a life insurance policy:
a) Surplus from without-profit business
b) Surplus arising from surrenders
c) Allocation from the estate
d) Transfer of profit to Shareholders

3. Determine mathematical expression of an Asset Share and the initial Capital Strain
under a life insurance policy.

4. A with-profit regular premium endowment policy has been issued on 1st January 2008
with premiums of ` 10,000/- per annum paid annually. Following is the actual
experience of the life office during next three years:

Year 2008 2009 2010

Investment return (%) 10.4 9.8 8.2

Mortality (per thousand) 2 2.2 2.4

Expenses (`) 10,540 300 295

The sum assured under the policy is `1,50,000/-. Assuming that expenses are incurred
at the beginning of policy year while claims are paid at the end of the year, calculate the
asset share of the policy at the end of year 2010.

You may assume net effect from other sources of surplus as well as charges for use of
capital to be nil.

5. In the above question what will be the asset share of the policy if following changes are
made in the assumptions:
a) Expenses are incurred at the end of policy year
b) The net effect of other sources of surplus and charges for use of capital
put together is a reduction in the yield of 0.4% per annum.

6. What are the applications of Asset Share in the management of life insurance business?

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 CHAPTER 11

Surrenders and Alterations

1. INTRODUCTION
A person entering into an insurance contract for a particular period may decide not to continue
payment of premium after sometime by stopping paying further premiums. If natural premiums
were paid under a term assurance policy, the cost of benefit for each year the person remained
in insurance pool would have been met by the premium for that year.

In the case of level premium, however, the position is different. In the early years of a term
insurance contract, the premiums paid are in excess of what is required to cover the cost of
benefits. The excess is meant to meet the deficiency in the later years. But when the insurance
contract is dropped and the life assured does not want insurance cover any longer, the necessity
of reserving any portion of premiums already paid for meeting the deficiency is not there.

When the assured discontinues insurance, in equity, he is entitled to a refund of the excess so
paid. This refund is known as Surrender Value meaning the cash value payable on a complete
curtailment of the policy with no more obligations for the life company to the policyholder. The
surrender values may be on guaranteed or non-guaranteed terms depending upon the practices
of the insurer, the insurance industry and the regulatory environment.

2. Various considerations in allowing surrender of a policy

In cancellation of the contract before the expiry of its term various other considerations may
also arise. In actual practice, however, the surrender value is much less than its theoretical
equivalent mentioned here. The reasons are mentioned below.

If the actual balances in full are allowed as surrender value, the cost of only death/disability
benefits being very small, there is a possibility that many lives that are healthy even after
attaining advanced ages may prefer to withdraw looking to the handsome amount available on
withdrawal. This may lead to larger proportion than originally contemplated of impaired lives
among those who continue their insurance. Such a selection against the insurer may bring about
claims by death at a higher rate than what was assumed in the mortality table used while
pricing of the contract.

The second consideration is that in times of financial stringency, people may prefer to withdraw
their surrender values, if they are attractive particularly when the money is scarce. The insurer
may not be in a position to meet the heavy demand for withdrawals in such times as the insurer
may not be able to realize its investments at short notice without much detriment and loss to
the insurer.

Moreover at such times, the return on fresh investments is very high. If many policy holders
surrender their policies, the premium income of the insurer will be seriously depleted. This
would not only deprive the insurer of an opportunity of earning higher rates of interest on new

110
monies but will endanger its financial position, as the proportion of premium spent on expenses
will increase.

Thirdly, the actual excess in the premium of the policy cannot be assessed with any precision as
the calculation of premium itself is only an estimate of the future likely experience which may or
may not reproduce itself in future.

For these main reasons the full excess of premium already paid cannot be refunded on
surrender. Suitable deductions are made taking in to account the above considerations. The
balances still remaining are only allowed as surrender values. Such balances are unattractive
and are not frequently demanded. Surrender values so arrived at are not easily understandable
to the public who do not have the necessary technical knowledge. To conform to the
requirements of the law and regulations, minimum surrender values are generally guaranteed
as a percentage of premiums already paid at various durations of the policy after the policy has
run for certain minimum period.

In case of unit-linked contracts the surrender value is usually the unit fund value held in the
policyholder’s account less a possible surrender penalty. The surrender penalty may be a
percentage of the unit value. Sometimes the charge for initial expenses may be in the form of
reduced allocation rate or bid-offer spread. As these charges in such cases are effectively
expressed as a percentage of premiums, the surrender penalty can also be expressed in the form
of percentage of premium.

In case of unitized with-profit contracts the surrender value is usually the value of the current
benefit amount, less a possible surrender penalty. In addition a market value reduction may
also be applied in such contracts.

The surrender terms are usually specified in the policy contract document.

3. Product types where surrenders are normally not allowed

There are few products where typically the surrender values are not offered of which two main
types are Term Assurance and Life Annuity in Payment. For term assurance products the asset
shares are either negative or very small and the life office would want to use the retained asset
share, if any to meet the increased mortality cost. This may be as the lives that are likely to
surrender their policies will generally include those who are in good health and thus the mortality
experience of the remaining policyholders may worsen.

The term assurance asset shares tend to be negative initially due to higher expenses involved in
the first year of policy. Moreover they tend to be volatile in line with the fluctuation with claim
experience making any surrender amount volatile. Further any surrender amount after deducting
the expenses in determining and administering surrender values would be negligibly low. Also the
life office may have made a loss on early withdrawals where the asset share would have been
negative and the life office may try to recoup some of these early withdrawal losses by
making profits from later withdrawals. In view of these considerations no surrender value is
offered in case of Term Assurance contracts.

As regards life annuities in payment is concerned, those who are in poor health are most likely to
surrender their annuity contracts and as such offering a surrender value would expose the life
111
office to significant anti-selection. The policyholder who is in ill health and not expecting to
receive more than few annuity payments is more likely to surrender his annuity policy than the
one who is in good health and expecting to receive annuity payments for a longer time.

It is therefore usual for the life offices not to allow surrender in respect of annuities in
payment. This, however, applies in case of Life Annuity only. In case of Annuities payable for
life with return of capital (ROC) on death, surrender value may be offered. Similarly
surrender value may be offered in case of an Annuity payable for a period certain and
thereafter for life, if the surrender request is made in the period certain. If the request for
surrender is received after certainty period is over, surrender may not be allowed.

4. Principles involved in the determination of surrender terms

The life offices may find it obligatory to meet the reasonable expectations of the policyholders
while setting the surrender scales. Further Regulations and the industry practice followed in
India on benefit illustration makes it mandatory for the life offices to disclose guaranteed and
non-guaranteed surrender values at different durations of each type of policy.

The surrender value should not exceed the aggregate earned asset share over a reasonable
period of time. The amount of surrender value is usually determined at the discretion of the
insurer. If the surrender value amount net of surrender cost is equal to the asset share then
the asset shares of the continuing policyholders will not be affected. If, however, the
amount of surrender values is lower than the asset share then such policy will contribute
some profit from the surrender and thus the asset shares for the continuing policyholders
would be higher in case of with-profit policies. In case of non-profit policies such surrender will
contribute profits for the shareholders.

While setting the surrender scales the life office should be fair not only to the surrendering policies
but also to the continuing policies. The surrender value should take into consideration that the
policyholders may have surrendered their policies at a time when the economy was in bad condition
and the insurer had to pay guaranteed surrender value in excess of the earned asset share, the result
being sharing of loss by the continuing policyholders. This fact should be reflected in the asset share
calculation for the remaining policyholders. Further, on surrender of a policy at some durations,
the life office may wish to make profit of the same amount it would have made had the contract
continued for its full term.

In early years of the policy, the policyholder may naturally compare the surrender value with
the premiums he has paid till the date of surrender or the accumulated value of premiums paid
at some rate of interest. However, in the first or initial few years the asset share of the policy
may well be negative or a very small positive. If the asset share is negative the life office incurs
losses. Further, in these early years the prospective policy value based on best estimates of
future experience (future expected investment earnings, future expected expenses and future
expected mortality experience of the surrendering policyholders less the costs of surrender)
may be even smaller. It can thus be seen that even if the life office allows surrender based on the
prospective value of the policy, such surrender value may be too low compared to the premiums
paid.

112
The surrender value offered by a life office may be seen by a policyholder as poor value to his
money. It might be in relation to the premiums paid by the policyholder or in comparison with
the surrender value offered by other life offices. Such policyholder may be dissatisfied which
may eventually adversely impact the sale of new policies for the life insurer offering poor
surrender terms.

The life offices therefore decide not to pay surrenders during initial few years (say, first or first two
years) when the asset share is negative or the prospective policy value is very small.

Alternatively the life office may accept loss and pay the surrender value which does not appear too
low as compared to the premiums paid and recoup these losses or reduced profits by penalizing
later surrenders.

However, the payment of surrender value more that the asset share has its own implications and at
times may be difficult to justify. This arrangement effectively penalizes the continuing
policyholders as these policyholders cross subsidize the policyholders exiting by way of early
surrenders equal to the difference of the surrender value and the asset share of the exiting policy.
The life office, for regulatory or marketing reasons, may find it difficult to reduce the surrender
value in future. Further, if the early surrenders (where the surrender value is higher than the asset
share) are more than expected the financial loss to the life office may be particularly onerous.

Similarly it is natural for the policyholder to compare the surrender value, at later durations of the
policy, with its maturity value .Thus the surrender value, during the later durations of the policy,
should progress smoothly into the maturity value of the policy. The life office may derive the
surrender value from asset share for with profits business and from prospective policy values
for without-profits business to ensure that the surrender value progresses smoothly to the
maturity value.

To achieve the above objectives, therefore, retrospective calculation is made for early duration
surrenders, while for later duration surrenders a prospective calculation is made. The
surrender value table is prepared by the life office usually considering both the retrospective
and the prospective calculation. The surrender value payable should be ensured to be within the
asset share at least at a gross level if the life office were to avoid incurring financial losses. In
other words, the total surrender payout over a period should be less than aggregate asset share
in order that the life office does not incur losses from such surrender payouts.

Further, the life office may wish to retain some profit from a surrendering policy which will
depend on how the life office calculates the surrender value particularly with regard to the
treatment of future profits. The profit also depends upon the difference between the asset share
and surrender value at the time of surrender.

Surrender values should be simple to calculate, easy to administer and not be subject to frequent
changes. They should be capable of clear written documentation. Further the surrender values
offered by the insurer should appear in line with those offered by the competitors.

5. Effect of surrenders on future profits and policy reserves

The life office is also required to keep reserves against each policy under which there is a liability.
The risk associated with surrender is that the timing and rate of surrender during a specified
113
period is extremely difficult to predict in advance as there may be unusual external triggers
creating panic leading to higher proportion of withdrawals than expected and provided for while
pricing the product or valuing it. It is essential, therefore, that the life office keeps sufficient
reserves at all times to meet the surrender payout should everyone decides to withdraw at once.

If the policy is surrendered between two valuations dates a profit equal to the excess of the
supervisory reserve at the time of surrender will be made over the surrender value paid at that
time. Thus the supervisory reserve calculated assuming that no surrender in future will take
place is usually higher than the one calculated allowing for future surrenders. It is therefore
generally prudent to assume no surrenders in the supervisory valuation.

Where the life office guarantees minimum surrender value and if these guaranteed surrender
values are more than the statutory reserves then the future surrender of such policies will result
in supervisory losses.

The life office should therefore keep additional reserve equal to the difference between the
guaranteed surrender value and the supervisory reserve. In India the regulation requires that
the life insurers keep supervisory reserves at least equal to the Guaranteed Surrender Value
(GSV).The additional reserve over and above the supervisory reserves to ensure that the life
office keeps reserves at least equal to the Guaranteed Surrender Value is called the Guaranteed
Surrender Value Deficiency Reserve (GSV Deficiency Reserve).

6. Paid – up values
Where the policyholder stops payment of premium under a policy and does not apply for
surrender of the policy, the insurer may allow such contracts to continue for a reduced benefit
amount without the requirement of paying further premiums. These contracts where no further
premiums are received are called paid-up contracts. However the reduced benefit under a paid
up contract may not be a good value for the premium as the surrender value may be much less
than the premium already paid by the policyholder. In initial years, the surrender value may be
zero in which case the policy lapses and no benefit becomes payable. These lapsed or paid-up
contracts may be revived later for full benefit amounts as per the terms and conditions set by
the insurer.

The paid-up values may be calculated by equating the surrender value of the policy at the
time of discontinuance of payment of premium under the policy to the present value of the
paid-up benefits to be offered plus the expected future expenses under such paid-up policy.
The cost of surrendering a policy may differ from the cost of making the policy paid up.

The paid-up value should be consistent with the surrender value which means that the
surrender value before and after conversion to the paid-up status should be approximately
equal. Similarly, at later durations these should be consistent with the projected maturity
values.

In case of Endowment and Limited Premium payment policies, a paid-up policy is usually
granted for a sum assured proportionate to the premiums paid. In other words, the paid-up sum
assured bears the same proportion to the original sum assured which the number of premiums
paid bears to the total number of premiums payable. This is known as the proportionate paid-
up value and is used for the convenience of calculation. Where the paid-up value is desired in
114
the early years of the policy, the theoretical paid-up value may be subject to a further reduction
because the initial heavy expenses would not have been fully recovered. For with-profit
policies, whether the paid-up policy would continue to participate in future bonuses or not
would depend on the type of bonuses declared by the life insurer.
Proportionate paid-up values are usually higher at short durations, because they do not allow
for the high initial expenses. At medium durations, on the other hand, they tend to be too
low because no allowance is made for investment earnings.

7. Alteration of Policy Contracts

Some insurers allow alterations under an existing policy, e.g. change in sum assured, change in
term of the contract, or change in type of policy etc. The alteration in the policy involves cost of
alteration and further may be costly to administer. If a policyholder desires to have alteration
under his policy, viz., reduction in the term of the policy or a change in the plan of insurance or
an alteration in the premium paying term, the value of the policy before alteration will not
ordinarily be the same as the value it acquires after alteration, if all the other terms of the policy
remain unchanged. No alteration can, however, be allowed as a result of which the insurer will
be at loss by virtue of his requiring to set up higher reserves consequent upon alteration. It is,
therefore, essential to maintain equality of policy values both before and after alteration by
effecting suitable changes in the other terms of the policy. For with-profit policies the insurer
needs to decide whether to leave the face value of attaching bonuses unchanged and further
should ensure that the surrender value of the altered policy does not exceed the total policy
value. It is also essential that the risk under a policy should not increase on effecting alternation
to avoid selection against the life insurer.

115
EXERCISE 11

1. State with reasons the life insurance plans under which no surrender value is offered by
the life insurers.

2. What is the basic reference point in deciding an appropriate surrender value under a
traditional or unit-linked policy and why? Explain.

3. Why should an insurer not offer surrender value equal to the asset share of the policy?

4. Why should an insurer not allow surrender under an annuity payable for a period
certain and thereafter for life after the period certain is over ?

5. What are the principals involved in the determination of surrender values under life
insurance policies?

6. What may be the effects of surrenders on future profits and policy reserves of a life
insurer?

7. Explain the principals involved in determining paid-up values under life insurance
policies.

8. Explain with reasons the various principles involved in allowing alterations under a life
insurance policy.

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1. INTRODUCTION
The concept of insurance is based on the concept of risk sharing - resources are pooled together
and any profit as well as risk is shared between the insurer and the policyholders. In the process
of doing the business the insurer has to put a reasonable value on various factors affecting the
business, viz. the likely number of deaths, the expense levels, the expected yield on investments
etc. Over the years there will always be variations, favourable and unfavourable, between these
assumptions and the actual experience.

Thus in the process of providing insurance the insurers assume various kinds of risks viz. the
economic (e.g. market) risk, non-economic (e.g. insurance) risk, operational risk etc.

The insurer, depending upon its risk appetite usually endeavors to mitigate some of its risks by
appropriate business practices or by transferring them to third parties e.g. reinsurers. The risks
that cannot be eliminated or transferred are left with the insurer to be managed. Some of the
risks which the insurers find are too large and cannot be transferred or managed are not
accepted by them. Such risks are declined by the insurers.

2. Various risks and their Mitigation

The following paragraphs shall discuss the various risks involved while carrying out life
insurance business and the possible methods of mitigating them.

2.1 Economic Risks

2.1.1 Market risk

Market risk refers to the risk of the uncertainty of future earnings of an insurer resulting from
movements in interest rates, foreign exchange rates, market prices and other factors. Market
risk can be further classified as interest rate risk, equity, real estate and other asset value risks,
currency risk and related credit risk.

2.1.1.1 Interest Rate Risk

Interest rate risk is the risk that the insurer shall incur significantly higher cost on funding the
policyholder benefits, than anticipated at the time when they were priced or risk of losses when
future cash flows from assets and liabilities are not well matched and the values of assets
and liabilities change significantly by different amounts as a consequence of interest rate change
in the market. It is particularly important for an insurer to monitor and control the level of the
exposures of investment instruments with intermediate and long maturities as they can be
especially sensitive to market interest rate changes.

The first of two most common types of interest rate risk is the reinvestment risk, when interest
rates are low and asset levels are high which becomes more prominent when liabilities are
guaranteed while asset scenarios are unknown. The second is disinvestment risk, when assets
are required to be sold when prices are low and interest rates are high.

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The insurers usually have liability with long durations, may be as high as 50 years in case of, say
deferred annuities or whole life policies. Considering the fact that the assets of such large
durations may not be available in the market the insurer may have to reinvest its assets at an
unknown interest rate in future. The risk to the insurer in that case is that the reinvestment rate
of interest is lower than expected or assumed while pricing or valuation of contracts and hence
the return ultimately may be inadequate for the guaranteed liability which the asset is backing.
It is therefore important that the assets and liability cash flows are continuously monitored to
ensure that the insurer is always in a position to meet its insurance claims obligations as and
when they arise.

The major objective of asset liability management is to ensure that sufficient assets of
appropriate nature and duration are held by the insurer to ensure that the insurer at all times
meets its liabilities as and when they become due. Further where the liabilities are driven by
asset performance as in case of with-profit policies, care should be taken that the policy holder’s
reasonable expectations are met.

The Asset Liability Management Process encompasses all the factors that can cause assets and
liabilities to expose the insurer to potential downside financial risks and involves strategic
management of assets and liabilities of the insurer. This is with the aim to achieving sustained
business growth while maintaining an optimal balance between risk and return ensuring that
the policyholders’ reasonable expectations are taken care of and the liabilities are fulfilled as
and when they arise. This includes the process of identifying, formulating, implementing,
monitoring and reviewing the asset liability strategies in order to achieve planned financial
objectives, given a clearly defined set of risks and risk tolerances and the constraints in pursuing
the strategy.

An insurer should have a proper system of management of structural market risks for which
it can set up an Asset Liability Management Committee. The Asset Liability Management
Committee will usually be responsible for developing and maintaining appropriate risk
management policies and procedures, setting up the insurer’s risk/reward objectives and
assess policyholder expectations, formulating and implementing optimal ALM strategies and
meeting risk/reward objectives. This may include defining the risk appetite of the insurer and
laying down the risk tolerance limits, monitoring risk exposures at periodic intervals and
revising ALM strategies wherever required.

2.1.1.2 Market Value Risk

Equity, real estate and other similar assets involve the risk of losses resulting from adverse
movements of market values of these assets to the extent that the value of liabilities backed by
these assets does not move in line with the movement of market value of these assets. This may be
the case in case of Non-profit or without profit contracts. Further such risk may not arise under
unit-linked contracts where the liability under unit-fund might move in line with the movement of
the value of assets. Also such risk to some extent can be managed under with-profit contracts by
adjusting future bonuses; however, it might have adverse effect on insurer’s future business
volumes and policyholders’ reasonable expectations.

The equity exposure should be closely monitored so that the potential downside risk to the
insurer is within the tolerance limits.

2.1.1.3 Currency Risk

Currency risk is the risk of losses resulting from adverse movements in exchange rates if
liabilities and assets backing these liabilities are denominated in different currencies. The
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insurer should continuously monitor the movements in exchange rates and its corresponding
impact on the cash flows. In India life insurers are not allowed to invest in currencies other than
rupee. The currency risk for life insurers in India should not arise.

One method of mitigating the currency risk, wherever it arises is to have both the liabilities and
assets backing these liabilities denominated in the same currency. An alternative way of
matching, if liabilities and assets backing these liabilities are denominated in different
currencies, is to hedge the currency risk by use of appropriate currency options. The details of
the currency options are beyond the scope of this subject.

2.1.2 Liquidity Risk

Liquidity risk is the risk of losses if the insurer is forced to sell assets at unfavourable prices to
meet the cash flow requirements as and when they arise as it might be holding insufficient
liquid assets supporting the liabilities.

To manage this risk the insurers usually establish and maintain liquidity management systems,
to assess their current and future cash flow requirements. A significant proportion of such cash
flow may constitute of expenses and policyholders’ obligations. To manage this risk the insurer
has to put in place appropriate plans to ensure that they hold sufficient liquid funds at all times.

The insurer can manage its liquidity risk by actively monitoring the asset-liability cash flow
matching positions. The core objective is to ensure that the insurer is in a position meet its cash
flow requirements on a daily basis and is able to withstand a period of liquidity stress, with a
high degree of confidence. The level of liquidity risk which the insurer will be prepared to
undertake i.e. the risk tolerance limit should be appropriate for the insurer’s business strategy
and within the predefined overall risk appetite of the insurer.

2.2 Insurance Risks

2.2.1 Mortality Risk
The risk associated is that the actual experienced mortality turns out to be more adverse than
assumed in the models. It is important to note the possible reasons why the actual mortality
may be different from that assumed while carrying out various investigations.

The risk may arise because of the model used to estimate the mortality itself is not
representative of the future trends. Even if the model is correct the parameter used may not
correspond to the group of lives to be insured and hence the actual mortality experienced may
be more adverse than assumed in the model. The quality of data being used has an impact on
the parameter being used and thus the complete and accurate data may reduce the parameter
risk. Further, the exposed to risk and the death data should be reasonably large to avoid any
random fluctuations. However, it is important to note that even a very high volume of data may
not completely remove the random fluctuation risk.

It should be understood that however good and reasonable the past data may be, any future
developments which cannot be predicted with certainty, may make it redundant or irrelevant
for use and hence the past data should be updated regularly for any such future developments
before they are put to use.

One of the ways to mitigate the mortality risks is to allow for adequate margins for any adverse
deviation in the mortality rates used for future projections involving financial decisions.

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Underwriting assists the insurer in identifying the substandard lives whose mortality is
expected to be heavier than the standard lives and helps the insurer in managing the risk by
charging an appropriate extra premium in proportion to the additional risk such substandard
lives bring to the insurer. This helps in reducing or removing the risk of anti-selection so that
the actual mortality experienced does not deviate too far away from the expected mortality used
while pricing the product.

2.2.2 Expense Risk

A new insurer incurs relatively high business set-up costs which may include costs incurred in
establishing office spaces, setting up the distribution channels, hiring and training the
administrative staff etc. and then subsequently incurs expenses to procure and maintain the
business.

Life insurance is usually sold by approaching the prospective customers and canvassing them a
suitable plan of insurance. Insurance companies for this purpose employ field personnel
including insurance intermediaries known as insurance agents. These agents are usually
remunerated by way of commission which is generally paid as a percentage of premiums
brought in by them to compensate for the expenses incurred and to provide sufficient incentive
for the efforts made by them in procuring the business. The commission paid on second and
subsequent year’s premiums is at a much lower rate compared to the first year. Subsequent
year’s commission is meant to encourage insurance agents to provide post sales service to the
policyholders.

The field personnel (known as Sales Managers or Development Officers) are required to recruit,
train and supervise the insurance agents and to procure business through them. They are
remunerated by a combination of fixed and variable pay where variable component depends on
the quantum of New Business procured by them.

The insurer also sets up branches at various centers for procuring business and providing
services to the policy holders and employs salaried staff to oversee administrative functions.

The expenses are broadly categorised in two parts viz. initial expenses and renewal expenses.
Initial expenses are incurred at the time of procuring and placing the policies on books of the
insurer. Initial expenses include remuneration of those staff whose services have direct bearing
on new business numbers, medical fees, printing and stationery and salaries of staff in the new
business department, the cost of stamp duty to be affixed on the policies, advertisement
expenses etc. which arise only at the time of selling an insurance policy.

The ‘initial expenses’ can further be subdivided into the following broad categories:

(i) Expenses which relate directly to the first year premium income like commission to
agents, service tax etc., and are expressed as a percentage of first year premium income.

(ii) Expenses incurred on medical fees, stamp duty etc. depend on the Sum Assured of the
policies and are expressed as a percentage or per thousand of the sum assured.

(iii) Expenses which relate to the number of new contracts sold such as stationery, dispatch,
salaries paid to the staff in the new business department etc. and are expressed as ‘per
policy’ expenses.

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The expenses during subsequent years are much lower when compared to those incurred in the
first year. Though the initial expenses are incurred upfront, a major part of the initial expenses
are distributed throughout the duration of payment of premium of the policy and thus charging
level premium throughout the premium paying term from the policyholder.

The renewal expenses incurred may include expenses incurred on salary of the staff involved in
providing service to the policyholders, renewal commission paid to the insurance agents to
encourage them to provide post sales service to the policyholders, issuance of premium notices,
collection and accounting of the premiums, settlement of claims as and when they arise etc.

These ‘renewal expenses’ can also be subdivided into the following broad categories:

(i) Expenses which relate directly to the renewal premium income like subsequent year’s
commission to agents, service tax etc., and are expressed as a percentage of renewal
premium income.

(ii) Expenses which relate to the number of contracts in force viz. salary paid to the staff
Involved in providing services to the policyholders, overhead expenses like legal
expenses etc. and are expressed as ‘per policy’ expenses.

In view of high initial costs, a new insurer is likely to have expense overruns in the early years of
its operation before it achieves break even. The break even is achieved when in-force business
of the insurer becomes sufficiently large so that the expense loadings built into the premiums
charged from the policyholders become sufficient to meet the actual expenses being incurred by
the insurer.

There is however a risk that the future level of renewal expenses and expense inflation may be
higher than assumed in the pricing.

As mentioned earlier the initial expenses are incurred upfront and a major part of the initial
expenses is distributed throughout the duration of the contract and is recouped gradually over
the currency of the policy. If the policy is withdrawn in early years the risk to the insurer is that
it will not be able to recover its heavy initial expenses. Similarly, the actual inflation may be
higher than that assumed in the pricing basis and as such the expense loading may not be
adequate to cover the actual expenses.

The actual expenses vis-a-vis those expected as provided in the assumptions while pricing the
product and while valuing it, should therefore be monitored on a continuous basis and action
such as cost control etc. should be pursued wherever possible as soon as they move away
significantly from the assumed level.

2.2.3 Withdrawal Risk

From the earlier section it may be referred that an insurer incurs heavy initial expenses in
writing a new contract and such expenses are amortised over the premium paying term of the
policy. If the policy is lapsed or withdrawn early, the insurer is at a risk that it will not be able to
recover its full initial costs and therefore the benefits payable after withdrawal i.e. the paid-up
value or the surrender value need to be adjusted considering the remaining initial costs
unrecovered. However, the insurer may not be able to recover the full costs due to regulatory or
marketing reasons.

The risk to the insurer is further increased as such lapsed or withdrawn policies are on healthy
lives due to selective withdrawals. The mortality experience of the remaining policyholders is

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thus likely to be heavier than expected and the risk to the insurer is that its mortality charges
will be inadequate to meet the future death claims.

Though the insurer may allow for such withdrawals in the pricing of the product, the actual
withdrawals may be higher than expected. Further with more lapses and surrenders there will
be fewer policies than expected for spreading the expenses incurred leading to increase in per
policy cost which may result in lower profitability for the insurer than expected.

2.2.4 Life Insurance Product designs

Life insurers offer different types of products which provide a mixture of savings and protection
benefits. Such products may be without profit plans, with profit plans and unit-linked plans.

Under a life insurance plan the protection cover, whether payable on death, disability or
sickness is always guaranteed. However, the benefit payable on survival may either be
guaranteed, partly guaranteed or non-guaranteed.

The plans under which the benefits payable on survival are also guaranteed are known as
without profit contracts. If the insurer sells such products and if the actual investment return
achieved is lower than allowed for in pricing of the contracts, then the insurer will make a loss.

The investment risk is lower under with-profit contracts as if investment returns are lower than
expected then the insurer may reduce future bonuses. However, still there is a guaranteed sum
and all the declared bonuses which need to paid. Also the policyholders’ expectations may limit
the scope for reduction of future bonuses.

Under a unit-linked plan all the investment risk is borne by the policyholder and not by the life
insurer. However, the charges, particularly the fund management charge is linked to the fund
size and hence such charges are reduced if the investment performance is poor. Also the poor
investment performance, particularly relative to competitors may damage future sales of new
contracts and the insurer may suffer indirectly due to poor investment performance under such
unit-linked existing business.

Sometimes insurers offer guarantees and options in their products in order to make them
attractive. Initially the guarantee may look small such as the maturity proceeds under a 10 year
unit-linked endowment assurance plan are guaranteed to the extent of premiums paid or
premiums accumulated at, say 3% per annum. In such cases the risk to the insurer may be that
the unit fund of policies, net of charges, is less than the guaranteed sum and the insurer in such
cases has to make good the shortfall.

Life insurers offering annuity contracts suffer from the longevity risk, i.e. if the annuitants
survive longer on average than allowed for in the pricing by the insurer, the insurance company
will incur losses. There are significant investment (or reinvestment) and expense risks also.
Further these contracts are subject to anti-selection risk i.e. annuities are bought by those who
are in reasonably good health which cannot be removed by underwriting.

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2.2.5 Mix of New Business
A significant change in the risk profile of the insurer or capital needs for the insurer may occur
due to change in the mix by nature and size of insurance contracts or change in the mix by
source.

2.2.5.1 Mix by nature and size of contracts

A change in the mix of business by nature may occur due to class of business, (say, the
proportion of annuity business written in the overall business), type of contracts (say,
protection versus savings), contract design (say, proportion of traditional and unit-linked) and
premium frequency (say, single versus regular or the proportion of quarterly or monthly
contracts under regular) etc. The various risks involved in the business or the capital needs to
write the business may vary due to any of these aspects. For example, a unit-linked contract
may require less capital. A contract with higher premium frequency (say, quarterly) may be
associated with higher lapsation or withdrawal risk.

Similarly different mix by size of the contract will also bring different risks. Generally higher the
size of the contract, higher may be the profitability and lower may be the withdrawal risk.

Sometimes an insurer may offer some contracts which are priced with competitive rates
keeping the premium rates or charges low. However, if the mix of such contracts changes i.e. if
such contracts are sold more than what was desired, then the insurer might not be able to cover
its overall expenses as there will be insufficient contribution from such contracts.

2.2.5.2 Mix by source

Some of the parameters adopted in pricing of the contracts such as mortality rate, expenses or
withdrawal rate may vary due to the source ( or distribution channel) of procuration of
business. It is because the expenses of distribution may differ by channel. Similarly withdrawal
experience of business sourced from brokers may differ from that of tied agency channel.

Life insurers may charge same price for a product sold through any of its sales channel, in spite
of different expected experience. It would therefore assume some sort of mix by source while
deciding different assumptions for pricing of the contracts. If the mix turns out to be different
than assumed, the insurer may make a profit or loss due to actual experience of various
parameters being different than assumed.

2.2.6 Volume of New Business

A life insurer my face problems if it writes too much or too little business. This is because the
company will need capital and other administrative resources to write and service the business
on its books. If the business written in any period is too much or too little than the resources
available to it, the company may face problems which an extreme cases may even lead to
insolvency.

While the insurers work for increase in numbers including the top line, it is worth noting that
sale of each life insurance policy requires capital to finance its large acquisition expenses ,the
reserve required to be kept against each such policy and any additional margins required by the
local regulations for prudent reserving and explicit solvency margin, if any. It is therefore
imperative that the insurers need to have sufficient capital to write new business.
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Usually the expenses incurred by the life insurance company under a life policy in the first year
are disproportionately large due to high procurement cost in the first year, routine and special
medical reports, other underwriting expenses, policy stamps, expenses connected with issuance
of policy document, setting up of policy records etc. The expenses incurred in the second and
subsequent years are much lower.

The premium paid by the policyholder at start of the policy less high procurement cost in the
first year is not sufficient to cover policy reserves and regulatory solvency margin requirements
at that point. This gives rise to new business strain which is defined as a cash flow deficit,
arising when the first premium paid by the policyholder under a new policy is insufficient to
meet commission, other acquisition expenses and policy reserves including solvency margin.

Thus the insurer’s ability to write new business depends on its ability to provide for the
additional capital to meet the new business strain. The insurer cannot therefore write unlimited
new business policies with limited capital resources. Further, a higher actual capital strain than
expected may lead to regulatory solvency issues.

It can thus be observed that the sale of a significantly higher volume of new business may lead
to insolvency of the insurer if the available capital resources become inadequate. Similarly sale
of a significantly lower volume of new business than assumed in pricing of the product may
lead to a risk of losses to insurer as it will not be able to recoup the fixed acquisition costs
which have already been incurred.

The insurer also requires administrative resources including underwriters, the necessary
infrastructure, viz the space, the manpower, the Information Technology support etc. for
procuring and maintaining the business. If the new business sold is significantly large, it puts
strain on the entire infrastructure and there is a risk that the existing infrastructure may not be
able to cope up with the volume of new business. This may impact the policy servicing.

The requirement of higher reserve results in lower surplus available for distribution to with-
profit policyholders and the shareholders. This may further lead to policyholders’ reasonable
expectations not being met and hence increase in surrenders. This also tarnishes the brand
image of the insurer which may adversely impact future new business and hence the
profitability.

There is also a risk that the shareholders may be required to inject further capital for writing
new business and maintaining the existing business in order to take care of policyholders’
reasonable expectations.
The insurer should, therefore, closely monitor the new business underwritten in each period
and take appropriate steps wherever necessary.

2.2.7 Counter party Risk under Reinsurance Arrangement

As already discussed, the chapter on Reinsurance, the reinsurance is a process by which a part
of the liability under a contract is passed on to another company, known as reinsurer. However,
so far as contract between the life assured and the insurer is concerned, the full liability even
after entering into a reinsurance arrangement rests with the insurer. The risk here is that the
reinsurer is not able to fulfill its part of obligation, perhaps due to financial difficulties, and the
life insurer has to make payment which otherwise was expected to be received from the
reinsurer. It is therefore usual to consider credit rating of the reinsurers before entering into
reinsurance contract. Indian Regulations provide for minimum credit rating of BBB in case of
life reinsurance arrangements.

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2.2.8 Management Actions
Within the consolidated risk management policies, there is authorization for management to
deal with risks. The risk management policies call for specific action plans, with clear lines of
accountability for each risk.

The two key stakeholders, the policyholders and the shareholders, may have different
approaches on the tradeoff between the risk of insolvency and expected returns which at times
may be conflicting. For example the management may take decisions such as maximizing new
business volumes for competitive reasons or for maximizing shareholder earnings which
increases its risk profile to such an extent that it can no longer be supported by the available
resources.

There may be other examples of management actions like reduction in premium, increase
in bonuses etc. primarily aimed to have an edge over the competitors with no support from
the available resources, and if the insurer is cash deficient there is a risk of insolvency. On
existing business with reviewable charges the management may, for marketing reasons, choose
not to increase the charges inspite of adverse experience. The impact of these decisions can then
be compounded if greater volumes of new business are sold.

An effective risk management policy quantifies each of the risks identified and provides for
sufficient capital. If there is an appropriate risk management policy in place, and if it is
established that the management will act in the manner as envisaged in the approved risk
management policy of the insurer then the net additional capital requirement can be reduced.

For example, if the insurer can apply management actions to mitigate against market risks, with
the assumption that management would reduce future bonuses or surrender values when
required, the market risk net of management action can be taken as nil or a reduced quantity
and hence no or reduced additional capital may be required to be provided for market risk.
However if it is established that, for some market reasons or for policyholders’ reasonable
expectations, the management would not reduce the future bonuses or surrender values when
required, or the speed of reduction is much lower than expected, then appropriate additional
capital is required to be set aside for this.

2.3 Operational Risks

Operational risks are the risks of losses resulting from inadequate or failed internal processes,
people and systems leading to fraud or mismanagement within the organization itself or from
external events. Examples include the dominance of a single individual, lack of plan to recover
from an external event having impact on the insurer’s functioning, dependence on third party
for outsourced functions the responsibility of which still rests with the insurer etc.

Such risks may also arise from the failure of controls, perhaps due to insufficient or no monitoring.
The insurer can thus manage its operational risks by putting in place and maintaining a
comprehensive system of internal controls and policies including the system of audit to
continuously identify deviations, if any, from established policies, procedures and norms and
also to ensure data security and accuracy. There is, however, always a risk of making mistakes
even if the insurer has put in place proper control and systems resulting into financial losses.
Nevertheless the insurer can reduce its risk through better management control if the roles and
responsibilities of management and employees are properly spelt out.

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Presently the insurers are increasingly using comprehensive modern techniques in their
administrative, marketing and policy servicing operations to improve their business
procuration activities and quality of servicing to the clients.

Though this eliminates the possibility of human errors associated with the operations, it
introduces the automation related risks which might prove more risky. The insurer can also
manage its risk by putting in place Information and Technology (IT) security policy which may
include the integrity and validity of data, the protection of all the insurers’ data, software and
hardware, insurers’ ability to recover effectively and efficiently from disruption and by ensuring
that security measures taken are sufficient to reduce the risk to acceptable levels.

Keeping several backups of its digitalized data at different places and with different authorized
persons may help in prevention and recovery of data loss due to accidents like fire, bugs etc. The
insurer can also insure against damage brought about by fire and natural disasters.

The insurer also faces risk caused by the deliberate intent of fraudulent claims by the
policyholders which can be mitigated by the process of claims underwriting including obtaining
appropriate death certifications and verifying the misrepresentations of facts at the time of
taking of policy by the policyholder.

2.4 It may be observed from the foregoing discussion that an insurer is exposed to
various short term and long term risks and it is important to understand the nature of each risk
and its impact on the finances of the insurer. It is also important to understand that while some of
the risks may be independent and hence can be quantified separately; other risks may be
correlated and thus may be more complex to be quantified. The insurers, for this purpose, use
various financial projections methods to assess the financial impact of various possible risks
including simple deterministic model or more complex stochastic model with probability
distribution functions as risk parameters, thus allowing for the correlations between the
parameters.

The quantification is beyond the scope of this course.

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EXERCISE 12

1. What are the broad risks faced by a life insurer and how they are dealt with on a macro
level.

2. Describe briefly the risks faced by a life insurer in selling without profit, with profit and
unit-linked contracts.

3. A regular premium whole life insurance and an immediate life annuity are said to be
mirror image of each other and both are subject to anti-selection risk. Discuss the
similarities and dis-similarities of anti-selection risk involved in both types of contracts

4. Discuss the various economic risks faced by a life insurer while carrying out life
insurance business.

5. Describe the Asset Liability Management Process and discuss the ways in which it is
used to mitigate some of the economic risks faced by the insurers.

6. Discuss the liquidity risk faced by life insurers and the ways used by them to manage it.

7. Discuss in brief the various insurance risks faced by a life insurer.

8. Discuss the significance of mortality risk in case of term insurance contracts as also the
ways used by life insurers to manage such risk.

9. What is the broad categorization of various expenses incurred by life insurers in selling
and servicing of life insurance contracts?

10. What do you understand by the expense risk faced by life insurers? Discuss the factors
which give rise to such risk.

11. Describe the withdrawal risk faced by life insurers and discuss its significance as also
the ways used by life insurers to mitigate such risk.

12. Describe the risks involved for a life insurer due to mix of new business in various ways.

13. What do you understand by the risks faced by a life insurer due to high or low volume of
new business? How significant may it be for a life insurer?

14. Discuss the counter party risk under reinsurance arrangements. How is it managed by
the life insurers?

15. Describe the various types of operational risks faced by life insurers and the methods
used by them to control such risks.

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MISCELLANEOUS EXERCISE

1. A with profit whole life and a non-profit whole life both have an initial sum assured of
` 1, 00,000. All other things being equal, which would have the higher premium, and
why?

2. The expense loadings made by an insurer in the calculation of office premiums for whole
Life Assurance are:

(a) Initial expense of 15 per thousand sum assured,

(b) Expenses of 6% of first year and subsequent year’s premiums, and

(c) A renewal expense of 3 per thousand sum assured.

Find the office premium per thousand sun assured under the plan if the removal of
initial expense loadings in (a) above results in a reduction of `1.52 in the office annual
premium per thousand sum assured. The interest rate assumed is 6% per annum.

3. Proved that:

4. An Endowment Assurance for ` 1,00,00 sum assured effected on a life aged 35 for 25
years, with the condition that in the event of death before maturity, in addition to the
sum assured being payable all premiums paid are to be returned without interest, has
the policy been in force for 10 years.

On the basis of IALM (1994-96) modified ultimate table for mortality and 6% interest,
find the amount of the free policy, payable at age 60 or earlier death, which can be
granted for the surrender of the assurance,

(a) If the premiums paid are still to be returned in the event of death before age 60.

(b) If the premiums paid are not so returnable. Ignore expenses.

5. Prove that:

6. If Px is 2%, Py is 5% and the rate of interest is 6%, what is the amount of the paid up
policy which a man aged “y” should receive on the surrender of a whole life policy which
he took out at age “x” ,

(i) If he bought it by payment a single premium?

(ii) If he has been paying the whole life annual premium?

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7. Prove that:

Px P1
x :t
tV x
Px :1
t

8. A life aged 40 effected a whole life assurance, the number of annual premiums being
limited to a maximum of 25. At the end of 10 years he ceased payment of premiums, the
eleventh being unpaid, and was granted a paid-up term assurance for the original sum
assured for such a period as the value of the policy secured. Using IALM (1994-96)
modified ultimate table of mortality and 6% interest, find the term of the paid up
assurance policy. Ignore expenses.

9. Given 10V40 =0.12976, P40 =0.01312, q50 = 0.00772 and i =6%, find 11V25

10. Prove algebraically that:

11. Proved that:

12. A Whole Life Assurance for a sum assured of `1,20,000 subject to annual premiums was
effected 15 years ago on a life then aged 35. The assured now desires to reduce the sum
assured to ` 1,00,000, and in addition to pay `8,832 in cash in order to convert the
contract into an Endowment Assurance for `1,00,000 sum assured, the annual premium
to remain the same.

Find, on the basis of IALM (1994-96) modified ultimate mortality table and 6% interest,
the age at which the Endowment Assurance should mature.

Also ascertain what cash sum would be required in order that the Endowment
Assurance shall mature at age 60.

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