notes

1. Lecture Notes: Life Assurance
Lecture 8: The general business environment (2)
By Omari C.O
1 The general business environment
Objective: Describe the effect of the general business environment including the impact on
level of risk to the insurer, in terms of:
• Types of expenses and commissions including influence of inflation
• Economic environment (including developing/ volatile economies and risky markets)
• legal environment
• regulatory constraints and opportunities
• fiscal constraints and opportunities
• professional guidance constraints and opportunities
1.1 Introduction
In this lecture, we describe the main kinds of expenses, and we study the economic, legal, regu-
latory, fiscal and professional influences that may affect the way that life insurance companies
operate.
1.2 Types of expenses and commissions including influence of in-
flation
A life insurance company will incur costs in running its business, being commission payable
to salespeople, and management expenses.
Usually, initial commission is payable on the acquisition of a new policy, and renewal com-
mission is payable each time a renewal premium is paid. If a policy lapses, part of the initial
commission may be recoverable and there will be a risk of non-recovery.
Management expenses consist of expenses that are incurred directly when new policies are
written (new business) or maintained (in-force business), and overhead expenses that a com-
pany has to incur regardless of the amount of new business it writes and the business it has in
force. Thee overheads would include, for example, the costs of general management, at least
part of the costs of a company’s service departments (such as IT and HR), and the cost of
accommodation.

2. Life Assurance
There may also be expenses associated with terminating a policy, for example the cost in-
volved in making a death claim payment on a whole life insurance.
These expenses would be split in various ways in order to determine, for example, the ex-
pense loadings to be built into premium rates.
The term “overheads” can be used to mean a number of different things. Here it is firstly
used to refer to any type of expenses that is not specifically associated with policy activity
(ie with its set up, maintenance or termination). An example might be the cost of electricity
used to run the company’s offices and computer systems.
There is a profitability risk that these loadings will prove insufficient to meet the actual
expenses incurred.
At a simpler level, risks can arise if a company finds it cannot contain costs, including the
rate at which they increase due to inflation.
Inflation affects underlying costs which in turn influence the level of expenses allocated to
policies.
Many underlying costs are directly or indirectly linked to wage and salary levels. Others
are influenced by the general level of prices or by the prices of particular commodities. Pub-
licly available data, eg retail price index, national average earnings index, and similar data
internal to the life insurance company, can be used to decide what assumptions to make about
general price, future wage or specific price inflation.
A particular difficult aspect of managing a life insurer’s costs arises from the fact that new
business may well be cyclical compared with the more predictable base of ongoing renewal
and in-force business. A significant part of operating expenses arises from the need to employ
experienced staff and if any of these are laid off in response to a downturn in new business,
re-employing similar quality of staff may prove difficult when the new business improves again.
The company would therefore like to have much more flexibility with regard to the num-
ber of new business staff that it employs from time to time, whereas this is much less of an
issue with regard to staff employed on renewals.
1.3 Economic environment
The state of the economy in which an insurer operates will carry risks for the insurer. The
availability of asset types, and their short- and long-term expected yields, will determine how
well an insurer can choose investments and the probability of securing the return assumed
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when setting premium rates.
From the consumers’ point of view, insurance products may be seen as more or less attractive
compared with other available investments (or not investing at all).
Economies in which the investment markets are more volatile will tend (other thing being
equal) to have more expensive insurance products and possibly less take up of them. The
insurers will tend to have relatively higher capital requirements as a result of increased un-
certainty of investment return. This will increase the cost of capital and so increase product
charges and premiums.
An insurer investing in more risky/speculative markets is likely to seek a greater expected
rate of return on capital, and hence there is a relatively greater risk of the required return not
being achieved.
This is an additional reason for increasing the cost of capital, as it will mean a higher risk
discount rate will be used for discounting profits.
1.4 Legal environment
Assuming a politically stable operating environment in which the legal processes of contract
law operate efficiently, the written contract between insurer and policyholder should normally
avoid any significant legal risk.
Particular cae, however, is needed with regard to those areas of the contract where the insurer
has discretion. In this event, the insurer is at risk of:
• some principle related to PRE acting unfavourably to the office – for example, the flex-
ibility it would like to adopt in declaring differing levels of bonus across with profits
policies may be constrained.
A company may well be legally required to distribute profits in a way that is “con-
sistent with PRE” However, PRE is very difficult t pin down in a legal sense, and
interpretation might only be settled by court rulings in particular cases. (nevertheless,
such things can and do happen, so they can have as much effect in constraining insur-
ance company behavior as a more precise requirement.) In any case, companies would
no wish to be taken to court in the first place, and they will always have a desire to keep
their policyholders happy so as to improve their company image and increase sales. In
this way, a rather loosely defined PRE requirement might even have greater constraining
influence than might a more rigidly defined rule.
• Unfair contract terms voiding clause of the contract – for example, if a contract confers
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a right for the charges on unit-linked contracts to be increased by a fixed annual rate
which is considered unfair in the country concerned, the legal process may act to void
the clause. A particular risk is that the ability to review charges at all is removed
completely, rather than the clause being replaced with a percentage increase which is
acceptably lower than before.
In most cases it would be hoped that these kinds of issues would be sorted out during the de-
velopment of any product. So if legal requirements prevented certain kinds of charge increases
from being made, then the product design would not incorporate such features. naturally
this puts a constraint on product design; which could ultimately mean that whole classes of
business might not be offered if insurers felt they were too risky.
A compounding difficulty here is that insurance contracts span many years and are hence
open to developing legal cultures, interpretations, and court judgements.
So one of the biggest risks here is that new legislation could be introduced that could change
the legal contract between the insurer and its existing policyholders. For example, it might
prevent a company from making further increases in charges on existing policies under which
increases could hitherto have been made.
Beyond the written contract, legal risks may arise from inconsistencies between the policy
document and any other relevant representations made by the company or its agents.
For example, an intermediary may have told a client that a policy had a certain feature
that, in reality, it did not possess. The client, having taken out (and maybe even claimed
under) the policy, later finds out the discrepancy and makes a complaint to the regulator.
The insurer may well lose money (and face) if the complaint were to be upheld.
(Naturally we will assume that the intermediary did not tell the falsehood deliberately!)
1.5 Regulatory constraints and opportunities
Governments may impose restrictions on the way that life insurance companies
operate. The aim of such restrictions is usually stated to be the protection of the
policyholder.
Historical experience has shown that insurance companies could not always be trusted to
manage their affairs appropriately without legislative control. People who take out long-term
insurance contracts are giving large sums of money to insurance companies, often over very
long periods of time, in return for a “promise” by the company to pay the contractual sum
assured at some (often distant) future date. The public needs to have well-founded confidence
that insurance companies will still be in business and able to honour their obligations when
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policyholders claim. Without this confidence people will be reluctant to buy insurance, and
will therefore be denied this essential financial service as a result (in other words, taken to the
extreme, the industry will fail). Countries have therefore found it necessary ro regulate their
insurance industries in order to ensure the security of the policyholders’ interest (ie that the
companies should not become insolvent), thereby achieving the necessary public confidence
in the industry to the benefit of both parties (the public receives service and the insurance
companies do business).
Although the restrictions will usually meet this aim, they may also have the effect of either
restricting innovation or reducing the benefits that could otherwise be given to policyholders.
The following are the more common of such regulatory restrictions.
1. A restriction on the type of contract that a life insurance company can offer.
For example, in Italy, there are six classes of life insurance product, based on contract
type. For example, unit-linked business is one class. Companies have to be authorized
separately for each class. Some companies may be authorized to write only one or two
of the six classes.
In South Africa, life insurance contracts have to be of term at least five years. This
was introduced to prevent competition with banks for short-term contracts.
2. Restrictions on the premium rates or charges, that can be used for some
types of contract.
Such restrictions have been common in many European countries and in some States in
the United States. The rates themselves might be restricted, or certain elements of the
premium rate basis, such as mortality and interest, might be controlled.
3. Requirements relating to the terms and conditions of the contracts offered,
for example with regard to how paid-up policy and surrender values are to
be calculated.
Customers and regulators in a number of countries have been concerned about poor
value for money on early withdrawal from life insurance contracts. High initial ex-
penses, including up-front commission, are responsible for this problem. One possible
solution is for regulators to impose minimum values (for example specified percentages
of premiums paid). Alternatively, where policy values are calculated on a prospective
basis, the basis for the calculation could be specified or restricted.
4. Restrictions on the channels through which life insurance may be sold or re-
quirements as to the procedures to be followed or the information required
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to be given as part of the selling process.
For example this might involve:
• minimum training requirements for insurance salespeople,
• the right of cancelation of contract by the policyholder
• he illustration of possible maturity values and surrender values, perhaps on specified
or restricted bases.
Where bases, for illustrative values are not restricted, experience shows that (wildly)
over optimistic projections can result.
5. Restrictions on the ability to underwrite, for example a prohibition on the
use of the results of genetic testing, or to differentiate between different
classes of policyholder, eg males and females.
In New Zealand, anti discrimination law prevents life insurers refusing to insure anyone,
whatever their state of health. However, insurers are allowed to charge an appropriate
premium for the risk.
6. An indirect constraint on the amount of business that may be written.
In most countries there are regulations regarding the minimum level of mathemati-
cal reserves that must be held, often combined with minimum requirements regarding
the solvency margin of the company.
These regulations have the effect of firstly limiting the capital available within a com-
pany to write new business and, secondly effectively placing a minimum requirement on
the finance required to write a contract.
The capital that a company has available to write new business is, broadly speaking,
the supervisory value of its assets minus the supervisory value of its liabilities (including
any required solvency margin (RSM)). This difference is sometimes referred to as the
“free assets”, “free capital”, or “free reserves” of the company.
If the company uses up more than the amount of its free assets in writing new business
(or any other way) it will be insolvent in the supervisors’ eyes. Quite simply, the larger
the value of supervisory reserves plus RSM that the insurance company has to hold to
satisfy the regulators on the existing in-force business, the smaller the free assets and
hence the capital available for writing new business.
What is more, the bigger the reserves plus RSM that have to be set up for for any
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new contract, the greater the amount of the limited capital available that will be used
up when the new contracts are written.
7. The regulatory framework within a country may limit what a company would
like to do in terms of investment. There may be restrictions on:
• the types of assets that a life insurance company can invest in
• the amount of any particular type of asset that can be taken into account
for the purpose of demonstrating solvency
• the extent to which mismatching is allowed at all.
For example, in some countries there is a requirement to hold minimum proportions of total
assets in certain types of investment, such as government stock or bank deposits. Investment
in assets perceived to be risky, such as equities, property and derivatives, might be restricted
(eg to x% of total funds or liabilities) or even forbidden.
An alternative is to allow largely unrestricted investment, but to permit only a certain per-
centage of some asset classes to count when demonstrating statutory solvency. For example,
equities might only be allowed to count for 25% of assets in demonstrating solvency. So a
company with, say, 40m in equities and 60 in gilts would only be able to show assets of 80m
in its statutory balance sheet.
Another approach adopted in some countries focuses on preventing over-concentrations in
individual assets (eg the shares of one particular company), rather than in particular asset
classes. For example, a restriction that shares in any one company may amount to no more
than 1% of the assets used to demonstrate solvency.
The regulatory environment can also affect the choice of assets through their
relationship with the investment assumptions used to value the liabilities. A
particular asset distribution may allow a company to use a higher investment
assumption and thereby reduce the value of the liabilities and increase the free
assets. Typically, however, such distributions will not enable the company to
maximize the expected investment return.
Finally there may be a regulatory requirement to allow for mismatching. This
could involve the possible setting up of an investment mismatching reserve. The
more a company decides to invest in risker assets with a higher expected return,
the higher could be any such resulting reserve. This would increase the value of
the liabilities and reduce the available free assets.
There may be regulations specifying what changes in conditions should be considered for
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the purpose of determining a mismatching reserve, or such guidance might come from a pro-
fessional actuarial association or the regulatory authorities. Alternatively the decision might
be left to the individual actuary’s professional judgement.
Another regulatory constraint which might be important is the method required to value
the assets. For instance, in countries where assets are valued at book value, there is a disin-
centive to invest in property because any increase in value in the properties could only be seen
after sale, and having to sell frequently would be expensive and inconvenient. Even simple
equity investment is less attractive in such a country, since gains can only be seen on sale and
there will be times when the company might not want to sell.
The wider regulatory environment
The wider regulatory environment in terms of which institutions are allowed to
transact life insurance type business is also important. In practice, life insurance
companies are likely to have the monopoly of providing pure protection benefits,
but not of providing savings benefits.
Other pooled savings vehicles are likely to exist, for example unit trusts and investment
trusts in the UK, or their approximate equivalents in the US, mutual funds and investment
companies. Direct investment in shares or other assets will also be an option for some indi-
viduals.
The other institutions offering savings contracts, for example banks, will usually
be subject to different regulatory controls from life insurance companies, leading
to a non-level playing field with regard to the terms on which such contracts can
be offered.
The differences may be to the benefit or detriment of insurance companies. Possible examples
of a sloping playing field include:
• different for demonstrating capital adequacy,
• different rules on advertising of products,
• different rules for benefit illustrations
The regulatory environment is likely to have a significant effect on the design of the contracts
sold by life insurance companies, as the companies will want to make the best use of any
regulatory opportunities available to them. Conversely, contract design will have to take into
account any constraints imposed.
Question 1.1. The regulatory authorities in a particular country have just introduced a re-
quirement for life insurers to illustrate, to prospective policyholders, withdrawal values for each
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of the first ten years of contracts. Comment briefly on how this change may affect contract
design and benefits paid to policyholders on unit-linked endowment assurances.
1.6 The fiscal regime
1.6.1 Approaches to taxation
Life insurance business may be taxed in a number of different ways. The most common
methods are:
• A tax on the annual profits of the business, where broadly profits means the excess of
the change in the value of the assets over the change in the value of the liabilities.
• Tax payable on investment income less some or all of the operating expenses of the
company.
In addition, there may be a tax on premium income.
One way of looking at the two above approaches is that they recognize different aspects
of the nature of a life insurer. The “profits” approach recognizes that a life insurer, at least if
it has shareholders, is a company trying to make a profit like any other.
The “investment income” approach could be though of as treating the insurer as a group
of individuals pooling their resources for investment. If the investment return of individuals
is taxed then it is logical that this return should be taxed if it is earned within a life insurance
company.
1.6.2 The profits approach
The profits calculation described above essentially measures taxable profit as the increase in
the free assets of the company over the year, where free assets is defined as the value of assets
minus the value of liabilities. (Any required solvency margin may or may not be added to the
value of liabilities in this calculation). Let us define:
A0 = Assets at start of year
A1 = Assets at end of year
V0 = Liabilities at start of year
V1 = Liabilities at end of year
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Then profit would be stated as:
1. (A1 − A0) − (V1 − V0)
2. (A1 − V1) − (A0 − V0) ie increase in free assets over the year
Generally the reserves used will be the supervisory reserves, because this limits the life in-
surer’s freedom to manipulate the amount of the reserves and hence the taxable profit. It
would also be unfair on insurance companies to use reserves in the tax computation which
are calculated any less prudently than the supervisory reserving basis. This is because the
company is only allowed to distribute profits which are earned in excess of the supervisory
reserves, so a tax assessment on profits bases on smaller reserves would be asking the company
to pay tax on profits before they have actually been earned.
With an approach based on profit the focus is usually on shareholders’ profit. Profit dis-
tributed to policyholders on with-profits policies may well be automatically excluded from the
profit calculation. For example, where policyholder bonus increase the liabilities at the end of
the year (V1) the value of those bonuses would be excluded from the profit figure. Similarly,
if cash bonuses are paid out to policyholders these reduce the end of year asset figure (A1).
1.6.3 The investment income approach
First it is worth pointing out that “investment income” is not always the precisely correct
term, although it may frequently be used colloquially. The taxable amount may include some
or all capital gains, as well as investment income.
Allowing a deduction for expenses is reasonable because such expenses must reduce any re-
turns actually available to policyholders or shareholders.
To get a full picture of the impact of taxation on investment return one must consider the
total effect of taxation within the life insurance company and on the benefits received by the
policyholders.
1.6.4 The effect of the fiscal regime
Within a particular country, different types of life insurance business may be taxed on different
methods.
“Different types” here could refer to various possible classifications of business. For example,
business classed as “pensions” might be taxed differently from other business. Other possibil-
ities could include different treatment of with-profits and unit-linked business, or of “savings”
and “protection” polices.
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This can means that it is lower cost for the consumer if certain forms of benefit can be
offered as one type of business rather than another.
The taxation treatment of life insurance business may make life insurance more or less at-
tractive as a savings medium than contracts offered by other savings institutions, subject to
a different fiscal regime.
Tax concessions available to individuals may make the sale of certain types of contract easier.
The tax treatment in the hands of policyholders of policy proceeds can distort buying habits.
The last three paragraphs illustrate the point that the overall attractiveness of a life in-
surance product compared with other products (be they from life insurers or other savings
institutions) depends on a combination of:
1. the taxation treatment of premium paid, in particular whether the premiums are de-
ductable from the individual’s taxable income in full, in part or not at all.
2. the taxation of the life insurer’s funds during the life of the contract, and
3. the taxation treatment of the eventual policy benefits.
As with the regulatory environment, product design will want to make the best use of any
opportunities provided by the fiscal environment. On the other hand, the ability to avail of
favourable taxation treatment may force constraints on product design.
For example, tax authorities may be keen that pure savings business should not be “dressed
up” as life insurance in order to secure favourable tax treatment where this exists. If so, they
might therefore specify minimum levels of life cover necessary to secure tax concessions.
This would then represent both an opportunity and a constraint. The tax concessions might
allow a competitive product to be produced, but the design would have to include at least the
minimum level of life cover.
It should be noted that both the fiscal and regulatory environments are very significant drivers
of product design in the insurance industry.
Taxation risk
Taxation can change over time so it is important to bear this in mind when
benefits are guaranteed over the long term.
Existing policies are usually not immune from the effects of changes in taxation (methods
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or rates), so the company has a risk of making less (net) profit than anticipated from any
policy as a result of future taxation changes.
1.7 Professional guidance
We look at the professional guidance constraints and opportunities that may exist.
Actuarial associations will often issue professional guidance for actuaries advising
life insurance companies. These will typically give such actuaries a framework of
points that they need to consider in carrying out their responsibilities in order to
maintain professional standards.
The extent to which this is considered necessary will depend on the extent to which actu-
aries’ scope for judgement is limited by legislation, which will vary from country to country.
As such, professional guidance should not restrict the actions of actuaries and may even
provide protection against pressure from proprietors to agree to courses of action that may
not be in he best interests of policyholders.
Actuarial associations may also issue professional guidance on the interpretation of govern-
ment regulations. This may typically arise where the government does not want to overly
prescriptive in its requirements so as not unduly to restrict the actions of life insurance com-
panies. The government will then look to the actuarial profession to set limits as it were, on
what would be acceptable behavior.
To the extent that professional guidance adds safeguards as to the proper running of life
insurers, it effectively provides an opportunity for insurers to encourage consumers to invest
in life insurance products. Such products should then be lower cost and more flexible on
account of enjoying an appropriate, but not undue and over costly, regulatory regime.
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