Whole Life Pricing Pricing exercise based on a collection of actuarial assumptions Assumptions generally divided into two sets Company specific: Mortality, Lapsation, Expenses, Dividends, etc. Prescription / affected by regulation 4
Whole Life Pricing Assumptions based on regulation Liability Valuation Amount and timing of reserves Increases to reserves are a statutory expense Nonforfeiture Benefits Minimum amounts and emergence of cash surrender values Risk Based Capital Amount of surplus needed to support writing of liabilities State and Federal Income Taxes; State Premium Taxes 5
Assumptions based on insurance regulation Reserve Valuation Life insurance valuation driven mainly today by the Valuation of Life Insurance Policies Model Regulation (generally effective 1/1/2000) Changes in most current laws focus much more on Term and UL valuation Whole Life valuation generally unchanged since 1980 Amendments to Standard Valuation Law Main components: Prescribed valuation method Prescribed Mortality Table; Currently 2001 CSO Table Most importantly, prescription of maximum valuation interest rates that change with the interest rate environment Maximum valuation interest rate for any calendar year of issue is based upon recent monthly averages of Moody s Corporate Bond Portfolio Index 6
Assumptions based on insurance regulation Reserve Valuation Recent maximum valuation interest rates for life insurance» Pre 1995: 5.00%» 1995 2005: 4.50%» 2006 2012 : 4.00%» 2013: 3.50% Impact from a 50 bp change in Valuation Interest Rate is approximately 2% profit margin for Level Pay Whole Life if no change in premiums Much larger for Short Pay or Single Premium Whole Life 7
Assumptions based on insurance regulation Reserve Valuation Interest Rate 5.00% 4.50% 4.00% 3.50% Reserve Expense Ratio 50.4% 52.5% 54.6% 56.9% Loss Ratio 73.0% 75.1% 77.2% 79.5% 8
Assumptions based on insurance regulation Nonforfeiture benefits Standard Nonforfeiture Law for Life Insurance from early 1980 s defines prescribed calculations for determining minimum benefits and emergence of cash values Companies can offer higher guaranteed benefits; law just specifies minimum amounts; IRS regulations may limit maximum values Cash value calculations take into account an acquisition expense allowance that suppresses early duration minimum cash values Similar to valuation law, interest rate is dynamic with market interest rate levels Nonforfeiture interest rate is 125% of valuation interest rate, rounded to nearest 0.25% Current nonforfeiture rate = 4.00% x 125% = 5.00%; 2013: 4.50%; One year deferral of implementing new rate is permitted by law 10
Assumptions based on insurance regulation Target Surplus Companies will price in an expense that mimics the effect of needing to hold capital amounts prescribed by Statutory Risk-Based Capital (RBC) rules to support the writing of the product Typically defined as percentages of reserves, premium and death benefit amount Taxes Mainly State Premium/Income Tax and Federal Income Tax Federal Taxation of Life Insurance Companies is a whole other white paper. 11
Assumptions based on company information Mortality: Actual Company experience, research and reinsurer input Lapsation: Actual company experience Expenses: Actual company experience and expected inflation Investment yield: Recent and future portfolio expected yields Company Dividend Formula: Create factors that allow for desired emergence of dividends, and are flexible as experience changes 12
Sample Whole Life Pricing Projection No Deaths and No Surrenders Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Premium 2,581,000 2,581,000 2,581,000 2,581,000 2,581,000 2,581,000 2,581,000 2,581,000 2,581,000 2,581,000 Investment Income (15,934) 147,113 276,105 406,482 540,945 679,168 817,902 958,892 1,102,535 1,250,506 Total Revenue 2,565,066 2,728,113 2,857,105 2,987,482 3,121,945 3,260,168 3,398,902 3,539,892 3,683,535 3,831,506 Death Benefits 0 0 0 0 0 0 0 0 0 0 Full Surrenders 0 0 0 0 0 0 0 0 0 0 Reserve Increase 0 1,840,216 1,882,599 1,922,547 1,954,659 1,983,985 2,015,418 2,052,803 2,094,635 2,131,883 Total Benefits 0 1,840,216 1,882,599 1,922,547 1,954,659 1,983,985 2,015,418 2,052,803 2,094,635 2,131,883 Commissions 1,664,745 196,801 194,672 190,413 192,543 78,411 77,559 76,707 76,707 76,707 Expenses 2,583,818 38,950 39,924 40,922 41,945 42,994 44,068 45,170 46,299 47,457 Premium Tax 45,168 45,168 45,168 45,168 45,168 45,168 45,168 45,168 45,168 45,168 Total Expenses 4,293,730 280,919 279,763 276,503 279,655 166,572 166,795 167,045 168,174 169,332 Pre-Tax Net Gain from Operations (1,728,664) 606,978 694,743 788,432 887,630 1,109,611 1,216,689 1,320,044 1,420,725 1,530,292 Dividends 0 223,000 321,000 392,000 496,000 604,000 711,000 818,000 926,000 1,066,000 Federal Income Tax (538,952) 193,517 182,978 183,964 175,327 208,265 201,336 193,105 183,588 165,980 Post-Tax Net Gain from Operations (1,189,712) 190,462 190,764 212,468 216,303 297,346 304,352 308,939 311,138 298,312 Total Target Surplus Effect (210,837) (13,980) (13,475) (12,913) (12,227) (11,485) (10,754) (10,083) (9,449) (8,730) Distributable Earnings (1,400,549) 176,482 177,290 199,555 204,076 285,861 293,598 298,856 301,689 289,582 Policies IF Beg of Year 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 Deaths 0 0 0 0 0 0 0 0 0 0 Lapses 0 0 0 0 0 0 0 0 0 0 Policies IF End of Year 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 Policyholder IRR: Cash Dividends and Cash Surrender Value Paid to Policyholder Premiums Paid by Policyholder Policy Year 10: -7.1% Policy Year 40: 3.4% Policy Year 20: 1.6% Policy Year 50: 3.5% Policy Year 30: 3.2% Policy Year 60: 3.5% 16
20 Year Internal Rate of Return = 14.72% 17
Sample Whole Life Pricing Projection Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Premium 2,581,000 2,295,915 2,167,974 2,057,444 1,952,035 1,870,951 1,792,738 1,717,237 1,661,497 1,606,996 Investment Income (16,122) 130,579 231,516 323,493 408,433 491,478 567,074 636,756 708,283 776,841 Total Revenue 2,564,878 2,426,494 2,399,489 2,380,937 2,360,469 2,362,429 2,359,812 2,353,993 2,369,780 2,383,838 Death Benefits 51,755 69,116 87,957 104,654 122,640 137,819 154,822 170,673 188,172 209,694 Full Surrenders 0 0 67,842 132,076 152,771 197,785 239,771 209,249 239,184 267,688 Reserve Increase 0 1,545,734 1,421,907 1,302,001 1,239,566 1,147,751 1,060,578 1,070,970 1,015,891 957,471 Total Benefits 51,755 1,614,851 1,577,706 1,538,731 1,514,978 1,483,355 1,455,171 1,450,892 1,443,247 1,434,853 Commissions 1,664,745 175,064 163,519 151,788 145,622 56,839 53,872 51,036 49,380 47,760 Expenses 2,583,857 34,701 33,604 32,705 31,825 31,283 30,744 30,205 29,977 29,744 Premium Tax 45,168 40,179 37,940 36,005 34,161 32,742 31,373 30,052 29,076 28,122 Total Expenses 4,293,769 249,943 235,063 220,498 211,607 120,864 115,989 111,293 108,433 105,626 Pre-Tax Net Gain from Operations (1,780,647) 561,701 586,720 621,708 633,884 758,211 788,652 791,807 818,101 843,358 Dividends 0 198,216 269,353 312,077 374,528 437,013 492,766 542,867 594,383 661,509 Federal Income Tax (557,146) 179,045 153,441 142,060 116,221 130,529 114,625 91,430 76,547 56,019 Post-Tax Net Gain from Operations (1,223,500) 184,440 163,927 167,570 143,135 190,669 181,261 157,511 147,172 125,829 Total Target Surplus Effect (186,581) (337) 206 1,740 825 2,189 3,463 1,948 2,968 4,016 Distributable Earnings (1,410,081) 184,102 164,132 169,310 143,960 192,858 184,724 159,459 150,140 129,846 Policies IF Beg of Year 1,000 889 840 797 756 724 694 665 643 622 Deaths 1 1 1 1 1 1 2 2 2 2 Lapses 110 49 42 40 30 29 28 20 19 19 Policies IF End of Year 890 840 797 756 725 695 665 644 623 602 Note ratios of Dividends to Pre-Tax Gains 20
20 Year Internal Rate of Return = 6.24% 21
Anatomy of a Dividend Three components: Mortality, Interest and Expense Uses an excess approach where expected experience is compared to conservative estimates Dividend = (QV - QE) NAR Excess Mortality + (IE - IV) MR Excess Interest + (A GP) + K Expense 26
Anatomy of a Dividend Mortality (QV - QE) NAR QV = Statutory valuation mortality rate QE = Expected mortality rate NAR = Net Amount of Mortality Risk, generally equal to the base policy Face Amount less the policy reserve Pricing mortality is typically well below valuation mortality, generating a positive mortality dividend 27
Anatomy of a Dividend Interest (IE - IV) MR IE = Credited interest rate (the Dividend Interest Rate ) IE determined as Earned Rate less spread Example: Earned Rate less 100 bps IV = Valuation interest rate MR = Mean Reserve, the average reserve being held in a policy year Interest is typically above valuation interest rates, generating a positive interest dividend 29
Anatomy of a Dividend Expense (A GP) + K GP = Policy Gross Premium A, K = Multiplicative and additive factors used to mimic maintenance expenses as a function of the gross premium In some cases, the expense factor is additionally expressed as a function of the policy Face Amount 31
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