SP2 - IAI Nov 2020 Exam

[Bharti Singla]

Qus. 1 (iii) A proprietary life insurance company writing significant volumes of with profit business had recently undertaken an analysis of embedded value profit. It was observed that the lapse experience on its with profits business was significantly higher than assumed.
Explain the likely impact on the Embedded Value of the higher than expected lapses on its with profit business.

Ans. I am pasting few lines of the solution in which I need clarity:
'Based on the higher lapse experience, the insurer may further decide to change the reserving basis in its PVFP calculations. If the reserving basis is modified to allow for the impact of higher lapses, it would result in higher reserves, lower net assets, higher PVFP but possibly lower EV'.
This would happen as the increase in PVFP would be lower than the reduction in net assets under traditional embedded value approach as the risk discount rate is expected to be higher than the assumed projected investment return.

My question is:
Why the company would increase the reserves if lapse experience is higher than expected? Is it because of the fact that lesser policies will contribute now to the overhead/expenses? Also, company may have saved some reserves on the extra policies lapsed, and if there is no or little benefit payable to the policyholders lapsing the policies, then the company may use this extra reserves to meet its liabilities. Can anyone please elaborate?

 

[Mark Willder]

Qus. 1 (iii) A proprietary life insurance company writing significant volumes of with profit business had recently undertaken an analysis of embedded value profit. It was observed that the lapse experience on its with profits business was significantly higher than assumed.
Explain the likely impact on the Embedded Value of the higher than expected lapses on its with profit business.

Ans. I am pasting few lines of the solution in which I need clarity:
'Based on the higher lapse experience, the insurer may further decide to change the reserving basis in its PVFP calculations. If the reserving basis is modified to allow for the impact of higher lapses, it would result in higher reserves, lower net assets, higher PVFP but possibly lower EV'.
This would happen as the increase in PVFP would be lower than the reduction in net assets under traditional embedded value approach as the risk discount rate is expected to be higher than the assumed projected investment return.

My question is:
Why the company would increase the reserves if lapse experience is higher than expected? Is it because of the fact that lesser policies will contribute now to the overhead/expenses? Also, company may have saved some reserves on the extra policies lapsed, and if there is no or little benefit payable to the policyholders lapsing the policies, then the company may use this extra reserves to meet its liabilities. Can anyone please elaborate?

Hello Bharti

We need to be a little bit careful with the phrase lapses. Some people use it in its strictest sense to mean that the policy ceases without a surrender value being paid. However, that is unlikely to be the case for with-profits contracts as they normally pay a surrender value. So we should consider how the surrender value relates to the reserve.

It may be that the surrender value is bigger than the reserve, eg a return of premiums on early lapse, in which case the reserve will need to increase to cover these extra costs. But yes, you could also be right that the reserve goes up due to higher per policy expenses.

Best wishes

Mark

 

[Bharti Singla]

Hi Mark,

Thanks for the explanation, that makes sense.
I just have one follow-up question : what is the difference in lapse and surrender in context of SP2 exam?

 

[Mark Willder]

Hi Mark,

Thanks for the explanation, that makes sense.
I just have one follow-up question : what is the difference in lapse and surrender in context of SP2 exam?

Hi Bharti

Strictly speaking a lapse occurs when the contract stops with no surrender payment. A surrender occurs when the policy stops and a surrender value is paid. But some actuaries use the word "lapse" to mean all withdrawals including surrenders.

If an exam question is unclear, then state your assumptions.

Best wishes

Mark

 

[Bharti Singla]

Thanks Mark!