Category Archives: life insurance

Retirement age inequality

Iafrica has a story about a court battle against different state retirement ages.

Can’t imagine this will go far in the short-term, but might be the beginning of a serious relook at normal retirement age, for men and women, and in in light of trends of extended retirement periods through “mortality improvements”. Mortality improvement is the lowering of mortality over time as a result of several causes, including better medical care, awareness of the dangers of smoking etc.

A two-day hearing of a case brought by a group of men challenging the unequal provision of the state old age pension to men at 65 and to women at 60 will begin on Tuesday.

Why premium size matters (more than you think)

Most people involved with insurance recognise that more premium is better (ceteris paribus of course). This is usually true (and occasionally not) but while some of the reasons are obvious, there are a variety of more subtle factors to take into account. This post will cover many of these factors, and point out a few cautionary tales around seeking large average premium size above all else.

When is value created?

For a particular product-type, it is usual for larger premiums to be more profitable than smaller premiums. By profitability here I mean the increase in shareholder wealth resulting from having sold that additional policy. The value creation at time of sale arises from:

  1. A customer relationship has been confirmed and cemented through an agreement to do business for a few months or many years. The customer relationship was already in the process of being developed in the period up to the sale (from broad advertising campaigns, brand-development, specific distribution channel contact and the quotation process). However, this is also true for any other industry, so we will restrict the analysis in this post to the “point of sale”.
  2. This customer relationship means that for short-term or annually renewable business, there is a non-zero probability of renewal, and this probability is likely to be higher than the probability of a random individual with no previous contact with the insurance company buying a new product under the same conditions.
  3. The costs of renewing an existing policy are usually lower than those of creating a new policy. (Policyholder and risk details are already captured on the system, the sales process is quicker, legal and regulatory compliance (for example, around identifying customers) is already complete and payment details / credit checks have been performed.
  4. For life insurance business, a long-term, legal contract has been entered into. Traditionally, these contracts can be cancelled at the option of the policyholder (usually with a fair and sometimes controversially unfair penalty). In spite of the cancellation option, signing a long-term contract provides some evidence that the policyholder has an intention to enter into a long-term agreement with the insurance company.

This list isn’t exhaustive, but it covers some important bases.

So why are larger premiums better?

Larger premiums are more profitable because:

  • Some marginal costs are fixed per policy
  • Larger policies are usually more persistent
  • Larger policies usually imply greater wealth, which usually means lower morality (check below for caveats!)
Some marginal costs are fixed per policy

Many actual marginal costs really are fixed per policy:

  • Policy form, posting, printing, filing etc.
  • Ongoing reporting and communication with the policyholder
  • Bank charges related to processing premium receipts and claim payments
  • Calls to the call centre
  • Valuation modelling costs (PC / Mainframe running time, purchase costs, electricity, coding, debugging)

Since the costs are fixed per policy, the greater absolute charges are matched against lower costs yielding a higher margin.

Larger policies are usually more persistent

No question this is subjective, but one only needs to consider the 25% – 50% first year lapse rates on low-income products with small sums assured and small premiums. Large policies are likely to be sold to educated consumers who are less likely to be hoodwinked by smooth-talking commission-driven salespersons.

One can understand logically how this could be true, and the data supports these conclusions as well.

Larger policies usually imply greater wealth, which usually means lower mortality

Fairly standard actuarial knowledge this. Higher income means better access to healthcare for current ailments. More importantly, high income now is strongly correlated with high income in the previous years, which implies consistently better access to good healthcare and thus better overall life expectancy. Moreover, higher income is correlated with higher education. Education is correlated with family having money, which is correlated with good healthcare since birth, which is positive for life expectancy. Certain diseases (particularly heart disease) are related to stress and high cholesterol, which are positively correlated with wealth and income and act in the opposite direction.

Lower mortality both means lower claims experience (for non-annuity risk products) but also means, very marginally, that persistency will be higher since dead policyholders don’t pay premiums. Since a portion of all premiums is earmarked for the repayment of initial expenses, the more premiums paid the higher the overall margin will be.

And what about the impact of discounted rates?

Absolutely right. Higher premiums often attract discount rates, including lower asset management fees, higher allocation rates and lower mortality charges. These cost elements shouldn’t be ignored in the analysis, but experience usually shows that the benefits outweigh these costs. Results may vary!

An element that is often forgotten is medical underwriting. Most underwriting manuals have limits below which certain components of the comprehensive underwriting process are omitted because they aren’t cost effective. Thus, for the largest policies, the underwriting cost are often the highest. Analysis of actual experience and the costs involved for this should provide reasonable estimates of this cost.

One final, even more subtle impact is that of statistical variation. Individual policyholders will die (and we are continuing with the focus on non-annuity risk products here) with a certain probability at each age. Thus, the overall distribution of the number of deaths in a year should follow a binomial distribution, ignoring catastrophes and the slight theoretical correlation between deaths of spouses. Since the number of deaths follows a binomial distribution, we can determine likely variation from the expected number of deaths using basic statistical methods. What this also shows us is that as the number of policyholders increases, so the percentage variation from the mean decreases due to the diversification benefit. I’m not going to go into the detail of this for now – those familiar with insurance should be comfortable so far.

So, ideally we want lots of policies. If we also want to hold the premium constant between two comparable companies (S and B) but where S has small premiums per policy and B has big premiums per policy, then S will have a greater number of policyholders than B and will experience less volatility in financial results through better diversification of risks. You can also think of this like every Rand (or Pound or Dollar or Euro) of benefit for a particular policyholder is perfectly correlated with every other unit of currency for that same policyholder. Either the policyholder lives and all units of currency don’t get paid, or the policyholder dies and every single unit of currency is paid out as the total Sum Assured. Thus, larger premiums make larger benefits make more correlation and less diversification. This slightly unusual way of looking at the problem is what most people are familiar with as concentration risk, except here we are considering concentration within individual policyholders. This increase in risk increases the economic capital required (and often the regulatory capital too) which will likely have a cost to be considered.

So large premiums matter

Most people involved in life insurance will intuitively feel that larger premiums are “better” or more profitable – here are some of the reasons why. Most of these reasons are familiar to actuaries, and if you give an actuary a little bit of time he or she will likely come up with these and some others as well. However, this article has focussed on premium size in the absence of other factors and incentives. I’ll post soon on an example of how the external environment can distort this natural operational conclusions.

Taxes – more than just a cost

Apparently, it was Benjamin Franklin who said “In this world, nothing can be said to be certain, except death and taxes.” Without going into a detailed analysis of whether death is certain, and whether there are tax-haven countries with sufficiently low taxes to stretch the point a little, I have some comments to make on the throw-away use of the word “certain”.

Taxes are not certain. Even if some amount of tax is unavoidable, the actual tax payable is not certain. This is not a massively complex idea, but does require a shift in mindset to consider taxes as something other than merely a cost that must be paid, something that reduces profits and returns to the owners of a business. I’m not even talking about optimising the amount of tax paid through careful tax structuring (which can be a good idea, if it is legal, and if the loophole stays open long enough to be beneficial, and if the extent of structuring makes business and moral sense).

I’m talking about considering the impact that tax has on business strategy, target market selection, business mix choices and competitive advantage.

A current example for me is the taxation of life insurance companies in Lebanon. Corporate tax on profits is 15% in Lebanon. However, for life insurers, the tax authorities have deemed it too difficult to nail down a clear measure of insurer profitability (another point for another blog, but in fairness to the tax authorities, insurers are rather notorious for adjusting actuarial reserves to arrive at the desired financial result …). Thus, insurers are taxed on “assumed profit” which is set to be 5% of revenue (mostly premiums written, which are considered as revenue, and investment income).

Some things to note:

  • The tax calculation is thus simple, which for most business is a good thing.
  • The effective rate of tax is then 15% x 5% x revenue = 0.75% x revenue.
  • If a company can make a higher margin than 5% of revenue, then they will benefit from the simplified tax system. If a company’s margins are thin and their net profit is less than 5% of premiums, they will pay a disproportionately large amount of tax.

The last point is where tax becomes interesting, and this is particularly ironic because in this case tax is more certain than usual (given it depends only on a single factor, revenue, rather than revenue and expenses). I’ll expand in my next posts on two important impacts this has for insurers and the economy as a whole.

Life insurers getting WACC’d by debt issues

Life insurers in South Africa have been stumbling over each other to issue long-term debt. The reason? Ostensibly to reduce their WACC and generate greater value for shareholders.

Common sense tells us that this is a sensible thing to do. Companies all over the world have been using debt capital to reduce their WACC by sharing the cost of financing the business with Mr Tax Collector. (The interest payments made to holders of the debt are tax-deductible expenses for the companies that issue the debt. Dividends paid to ordinary shareholders must be paid out of net-of-tax income.)

Take the example where the pre-tax cost of debt (yield to maturity on current debt or equivalently, the annualised coupon required on newly issued debt for the debt to be placed at par value) and cost of equity (a little more complicated, since the cost of equity depends on whether the equity is retained earnings or equity freshly issued through a rights offer, but will generally be based on a CAPM or APT-type model of the return required by shareholders) are equal at, say, 10%. The generic formula for the WACC is:

WACC = (1-t)*cost of debt*w + cost of equity*(1-w)

where t is the corporate tax rate and w is the percentage of total capital (measured at current market value and not book value) contributed by debt.

Thus, if w is 50%, then our WACC = (1-29%)*10%*50% + 10%*50% = 8.55%, which is lower than the 10% cost of equity. Thus, magically, but incorporating debt financing into our capital structure, we have lowered our cost of capital and increase the value of our company to our shareholders.

Or have we? Continue reading Life insurers getting WACC’d by debt issues