Net Premium suited for CWP business! Not suited for CNP business though?

Hi all

Okay so say I want to compare the gross premium method and net premium method

General
Gross Premium Method: The method calculates an office premium using pricing assumptions(which explicitly allows for future expected expenses and future expected bonuses). The assumptions however are typically more best-estimate than prudent.

The reserve would then be calculated using this office premium, but with supervisory assumptions(which would again be more prudent) for mortality, interest, expenses and bonuses - now we will see that the office premium is not big enough to support the liabilities&expenses under the contract - and hence NBS(new business strain) arises(although also partly due to high initial expenses - if initial expenses were equal to renewal expenses, the NBS would be entirely due to the difference in bases?) So the capitalised loss would be equal to the NBS in this case?

Net Premium Method: The net premium is calculated using the supervisory assumptions(ie more prudent than the pricing assumptions) and does not take into account expenses and bonuses explicitly, although this can be done implicitly using a lower valuation discount rate. So to compare this with the gross premium method; the net premium will be (1)lower because of no explicit allowance for future expected expenses or bonuses, but then again will be (2)higher due to the supervisory assumptions being more prudent than the pricing assumptions. Point (1) can be offset if the valuation discount rate is suitably lowered, and this will make point (2) even more severe, leading to a higher net premium than office premium

Since for with-profit business we want a smooth emergence of profit (because we want our profits to match our expected liability, in this case regular reversionary bonuses for additions to benefits method; even more so in fact for revalorisation, since there we typically distribute profit as they arise - only judgement here is in the k% that we distribute and whether insurance profit is also distributed to policyholders; guessing that the contribution method would be similar to the additions to benefit method in this case or does it depend on how the profit is distributed, ie cash, premium reduction or addition to benefit?) the net premium method would be better suited in that it does not capitalise the difference between the bases upfront. If this capitalised difference is a loss, this would mean that the reserving method is showing that the company is not holding enough reserves(and free assets would be used to fund the difference?) than if it were to use the net premium method? this would increase the cost of capital.

So more or less I think(I hope!) I grasp why the net premium is more suited to with-profit business. I do however struggle with the net premium not being suited to net premium business - any help??

Sorry for the lengthy post, but I would really appreciate any help here!

 

Hi Newbie9,

You are partially correct but suspect you are trying to do too many things at once.

Let's take a step back and focus purely on reserving, i.e. let's ignore anything to do with how profit may emerge.

With-profits business: net premium valuation versus gross premium valuation.

Under the addition to benefits method, the policy (a conventional with profits contract) at inception will have a sum assured. Adding a reversionary bonus will increase the level of the guaranteed benefits (SA + RB).

Now let's consider how we would reserve for it.

Gross premium valuation:
We would determine the reserve on the supervisory basis by taking the SA + RB (accrued to date), expenses and the gross premium and work out the present value.

Net premium valuation:
We would determine the reserve on the supervisory basis taking the SA + RB (accrued to date) and the net premium and work out the present value.

Both premiums would be based as at the policy inception date.

For the GPV, this would have been worked out when the policy was priced and so will be known already.

For the NPV, we would recalculate what this is using the supervisory basis at the current valuation date.

Key points:
1. When determining the original gross premium, the insurer would have allowed for the bonus rates they intended to pay over the entire contract term.
2. When determining the net premium, only the sum assured would have been allowed for (future bonuses are ignored).
3. Implication: the gross premium is bigger than the net premium
4. Significance: The gross premium reserve is less than the net premium reserve.

The crucial point is that in valuing the benefits only the benefit accrued to date is reserved for under BOTH methods. It is therefore imprudent to use a GPV method because the gross premium allows for all benefits, i.e. future bonuses. On the other hand, the net premium does not as it is based only on the original sum assured. This is prudent.

This is quite important.

The new business strain point is a separate issue, which is dealt with separately. However, to steer you in the 'right' direction, NBS arises due to the difference between the premium and reserving basis. The initial expenses would be loaded into the premium and so is paid for by the customer.

Hope the above is helpful.

 

Net Premium not suited for CNP business though

Hi Mugano

Thanks, appreciate this! To try and sum it up, Net Premium reserves are larger than gross premium reserves for with-profit business, therefore more prudent. Thanks

The reason why I am asking about the emergence of profit, is since it is one of the principles of reserving and I guess I am trying to understand how that fits in.

If the capitalised loss/profit that the notes keep on referring to is not the new business strain, then what is it referring to?

Also I see I made an error in my last sentence!
I do not understand why the Net Premium method is not suitable for Conventional non-profit business

Any thoughts?

 

1. Reserving principle: the profit emergence point relates to not arbitrarily changing the stat basis to prevent insurers manipulating the timing of profit recognition.

Holding reserves does not affect how much profits you earn, just when you get it.

2. Capitalisation of profits: I would need to double check the notes but I suspect this relates to what I've already described in the earlier post. (the gross premium includes all loadings on the premium basis).

3. NP: the benefit is set and fixed at outset. Setting up reserves using a GPV method therefore is not imprudent because the full benefit is captured in the valuation.

The main reason why you'd use a net premium valuation is to deal with the increasing nature of with profits benefits.

Benefits do not increase with non profit business and so using this method is unsuitable.

 

Hi Mugano

Thanks for taking the time to reply!

1. Reserving principle
Agree that reserves does not affect how much profit you earn, but when it is earned (ignoring the cost of capital though - the larger the reserves the more tied up your capital is in lower expected yielding assets than otherwise being the case?)

An extract from the notes:
"The method of calculation of the reserves from year to year should be such as to recognise profit in an appropriate way over the duration of each policy and should not be subject to discontinuities arising from arbitrary changes to the valuation basis

We discuss the point about recognising profit appropriately in Section 2 below.

The Core Reading says that the method should not be subject to discontinuities arising from arbitrary changes in the valuation basis."

From what is stated above I believe they are two seperate issues to deal with - 1) recognise profit appropriately to fit expected bonus distributions and 2) not to manipulate the reserves which will result in the profit shown for the year in question.

Section 2 goes on to say
"To allow for future regular reversionary bonuses, the valuation method and assumptions should be chosen that:
...
on the supervisory valuation assumptions, future surpluses are projected to emerge in a suitable pattern and amount so as to match future regular bonus
...
This means that we wish to control the way that our surplus emerges over time, in order to distribute profits over the policy term in the way that policyholders expect."

2. Capitalisation of profits
New Business Strain = V0+ - A0+
where V0+ = Reserve just after first premium has been paid and
A0+ = P0+ - E0+
where P0+ is the office premium received on day 1 and
E0+ is the initial expenses

so we can see that NBS arises due to the reserve being calculated on more prudent terms than the office premium(pricing basis) AND the extent to which initial expenses is allocated over the whole of the policy duration(small bit of every premium payable is allocated to initial expenses)

I still believe that the capitalisation of profits they are referring to is basically referring to NBS.

If I am missing something, please feel free to correct me. I really am here just to get a better understanding of how everything fits in and appreciate the time you are taking to answer my questions!

 

1. Reserving principle

Agree. Ignoring the cost of capital

2. Capitalisation of profits

New business strain would be paid out of the insurers free assets on day 1. You would want to minimise your NBS to enable you to write more business, which is discussed in the course.

The key point here is that NBS is 'captured' within the insurers free assets.

When you subsequently do your valuations, you look forward and forget what has happened in the past.

At these points in time it is more prudent to use an NPV compared with a GPV for the reasons I described earlier.

Managing NBS is the insurer's problem, regulators are concerned about the security of policyholder benefits and holding sufficiently prudent reserves.

Hope that helps

 

Hi Newbie

Just a quick post to ensure that your understanding of the capitalisation of future profits is aligned to the notes.

As mugono pointed out, the capitalisation for the GPV method relates to recognising alll the future loadings for expenses, expected bonus rates, profits and margins on top of these. With a sufficiently prudent reserving basis these loadings will not be capitlised since the reserving basis will lock these future loadings into the reserves, but only if you consistently allow for all expected (priced for) benefit and expense outgo. Your loadings for the initial expenses won't be "used" to cover any future expenses or benefits and should be capitalised on day 1 thereby offsetting the new business strain related to expense only. However, new business strain also relate to the design of your product (premium frequency etc), how prudent the regulator wants your reserving basis to be (overly prudent basis may not allow much of your loadings for initial expense andcost of capital charges to capitalise onday 1) and the capital requirements. So, the GPV method should allow better relieve of new business strain if the reserving basis permits than the NPV method, even with zillmerisation.

Apologies for the bulky response.
Hope it helps.