Discuss how the policy proceeds to the policyholder might change as a result of actuarial funding (Part of the solution follows) As the annual management charge is smaller the maturity benefits will be higher. Those policyholders that surrender early in the term will receive less. However, those that surrender late in the term may well receive more as the lower management charge may more than compensate for the surrender penalty. The death benefit paid is the bid value of units and hence the change will be as for maturity benefits. As per the example by acted in this chapter, the number of units bought at the beginning of each year which are equal to the ones without actuarial funding. These units reflect the ENTIRE FMC although the actual FMC is less since it is levied on the actual number of units bought. In that case, how can the solution say that the maturity and the death benefits will be HIGHER if we are only ensuring that we buy the same amount of units to REPLACE THOSE without actuarial funding?
This question asks how the introduction of actuarial funding will change payouts. Yes, I'd agree that actuarial funding involves buying back the missing units so that the maturity/death values are the same as without actuarial funding. But this is not enough for the marks on offer. However, actuarial funding will make the contract more capital efficient. As a result the insurer will be able to reduce the charges for cost of capital on the contract, ie the fund management charges can be lower. So we'd expect an actuarially funded contract to have lower charges and hence higher maturity/death payouts than a contract without actuarial funding. Best wishes Mark
Thanks for the response Professor! However, actuarial funding will make the contract more capital efficient. As a result the insurer will be able to reduce the charges for cost of capital on the contract, ie the fund management charges can be lower. I don't quite see a relation between FMC and cost of capital. I can understand that less capital would imply lesser strain and hence a lesser cost of capital. I am not sure of how this cost is accommodated in the calculations though. So we'd expect an actuarially funded contract to have lower charges and hence higher maturity/death payouts than a contract without actuarial funding. The maturity/death benefits are unit related. I wonder why would the benefits increase just because the company is taking some credit for future FMC. I understand that actuarial funding would alleviate the initial capital strain for the company. The policyholder is ignorant of this arrangement and just sees the Unit account which is the same as would have been without actuarial funding since we continue buying the units.(Surrender value is anyway the actuarial funded value..so no risk for the company there). The company would stand to gain, the policyholders would get what they would have got anyway, isn't it?
Yes, I'd agree that the policyholders don't see what is happening with actuarial funding, so the company could keep charges the same. However, consider two companies Y and Z. Both companies sell identical unit-linked policies with the same fund management charge (5% on capital units). As the contracts are identical we'd expect them both to have the same market share (100 policies each). Company Y does not use actuarial funding. It has a large new business strain. The net present value of the profits are 20 for each policy. Company Z does use actuarial funding, so that it has no new business strain. As the contract is more capital efficient the net present value of the profits are 50 for each policy. Company Z then decides that it can undercut company Y. It reduces its charges to 4.5% so that its profits are now 30 for each policy. Company Z then attracts all the business from Company Y. So Z sells twice as many policies and makes 200x30=6,000 instead of 100x50=5,000. In fact, Z may sell even more policies as some policyholders will now be prepared to buy the contract that previously thought it too expensive. Company Y cannot afford to respond by cutting charges too as its profit per policy would drop to zero. I know this is a simplified example. But it shows that its better for a company to sell lots of highly profitable policies (with actuarial funding) than sell lessprofitable policies (due to high cost of capital). It is better to share with the policyholders the extra profit generated by actuarial funding as the increased sales more than compensates. Best wishes Mark
By the way, The exam report implies that the annual management charges will be lower on the CURRENT policies. Wouldn't the lower management charges prove to be inadequate to buy the units to make up for the shortfall for the actuarial funding since the original higher management charge is the rate we use for the actuarial funding factor? Or you are implying that the reduction in the cost of capital for these existing contracts will be more than sufficient to buy the shortfall units despite a lower management charge? Regards,
We have to use (no more than) the annual management charge actually used to calculate the actuarial funding factor. So, if the company cuts the charge, it will have to reduce the amount of actuarial funding too. Best wishes Mark
I agree! I think I had misread the solution earlier. I believe the report meant that the Fund management rate could be reduced to pass on the savings in the cost of capital. I was misreading the "lower annual management charges" as the lower amount of charges due to the lower units purchased due to actuarial funding, and I thought that the report meant that these lower amounts of fund charges was what led to higher unit fund. By the way, could you please let me know the reason that lower management charges will be required since there is less to be paid to surrendering policyholders when actuarial funding is used? Prior to actuarial funding they were paid the bid value anyway. It was not as if the company had a higher fund management charge because it had to give the bid value. Regards,
The surrendering policies have a lower payout (at least in the early years) with actuarial funding because of the surrender penalty. Best wishes Mark
Yes, I agree! Honestly, I feel that it becomes a circular argument then. ..On the one hand it is like capitalizing the higher fund management charges (FMC) and then saying that since we have a lower strain we pass on the benefit to the policyholders in the form of lower annual management charges. If they lower FMC then the benefit of actuarial funding is going to reduce anyway and so the initial strain is not going to reduce much!
Maybe new business strain without actuarial funding is 500. If we introduce actuarial funding on the existing fund charges of 5% we can reduce the strain to 50. But then we reduce to charges to say 4.5% and get strain of say 150 - so a significant drop in charges and in strain (500 down to 150) and everyone is happy. Best wishes Mark
Thanks! Some questions in the past exam papers seem pretty much out of reach for me, especially considering the time that is alloted
