Intensive Actuarial Training for Bulgaria - Life Insurance Product Design & Underwriting

1. Intensive Actuarial Training for Bulgaria January 2007 Lecture 3 – Life Insurance Product Design & Underwriting By Michael Sze, PhD, FSA, CFA

2. Agenda • Fundamental principle of insurance • Types of life insurance products • Product design • Underwriting • Expense analysis

3. Fundamental Principle of Insurance • Insurance cannot prevent bad things from happening • It is intended to provide financial relief when bad things happen • Basic idea of insurance • Explanation of insurance terms

4. Basic Idea of Insurance • A Person has the financialneed to provide for another person. • Under normal circumstances, the first person has enough resource to cover the obligations • If some bad things happen, the first person may not be able to cover the obligations • The person pays agreed amounts to a company • As long as the agreed amounts are paid • The company pays to the other person an agreed amount of money when the bad thing happens

5. Explanation of Insurance Terms • The insured (the policy owner) • The first person • May be a person or a company • Potential loss • The finance need to provide • The beneficiary • The other person, who receives the benefits • Insurable interest • The finance obligation can be covered under normal circumstances

6. Explanation of Insurance Terms (continued) • Contingency • The bad thing to insure for • E.g. death, disability, sickness, etc. • Premiums • Amount paid by the insured to the insurance company • Insured amount (amount of coverage) • The agreed amount of coverage • Insurance company • The company that receives the premiums to cover the contingency

7. Explanation of Insurance Terms (continued) • “In-force” • When premiums are continued to be paid • This is opposed to “lapse”, when the insured fails to pay the premiums • Occurrence • When bad thing insured for happens • Also called claim occurrence • Claim settlement • The insurance company pays the agreed amount to the beneficiary

8. Individual Life Insurance Products • Purposes of individual life insurance • Different categories of individual life • Term life • Permanent life • Universal life • Must balance the need of the insurance with the risk taken up by the insurance company

9. Term Life Insurance • Low premium, and low or no cash surrender value • Coverage only lasts for a number of years, often ending at normal retirement age • Fulfills the need of the insured for low cost insurance • There is much anti-selection risk, and lapse risk for the insurance company

10. Types of Term Life Insurance • Yearly renewable term • No need for renewal underwriting • Premium increases with age • Decreasing term • Outstanding balance of loans or mortgage • Coverage ceases after the loan is paid off • Term to 100 • Similar to permanent life, but no cash value • Additional features • Convertible to permanent life in some circumstances • Guaranteed renewable until a certain age

11. Permanent Life Insurance • Whole life insurance, some with endowment • Long term protection for the insurance • Investment, mortality, and early lapse risk for the insurance company • Level premium, with substantial cash value build-up after the first few years • Typical riders include • Premium waiver upon total and permanent disability • Accidental death and dismemberment

12. Universal Life Insurance • Each year the insured is charge of mortality and expense • Each year, the insured’s account value is credited with investment return less the charges • Premium may be single, fixed, or flexible (as long as account balance is positive) • On favorable investment experience, excess fund may purchase additional insurance • On unfavorable experience, the insured must increase premium, or policy lapses

13. Product Design • Product design team • Focus on client needs • Analyze competition • Satisfy insurance company’s profitability needs

14. Product Design Team • Understand the four phases of an insurance product:infancy, growth, mature, decline • Team members: • Small number of knowledgeable decision makers • senior management, • internal experts (actuaries, administrators, salesmen), • external experts (especially important for new products: actuaries, reinsurance companies, clients)

15. Focus on Client Needs • “Push sell” strategy in the past • “Pull sell” strategy now • Understanding customer needs • Interview current policy holders, potential policy holders,and lost policy holders • Analyze the demography of the population, as well as the above three groups

16. Market Research • Understand your competitors • Understand competitive products • Understand competitor’s pricing structure • Decide on the segment of the market to penetrate and set pricing policy • Must have competitive price for consumers and competitive commission to agents • Track competitors continuously

17. Pricing Structure • Need to be profitable to cover • Future adverse experience • Surplus for future business development • Dividend to policy holders • Investment return on capital • Must reflect tax treatment of insurance products

18. Pricing Structure (continued) • Different pricing structures • Penetration pricing (predatory, low profit margin, high commission) • Neutral pricing (adaptive to competitor prices) • Segmented pricing (opportunistic, on niche products) • Skim pricing (independent, high price on high demand, low supply products: not usual in life insurance) • Must perform detailed cost/benefit analysis • Must analyze impact on existing product of the insurance company

19. Underwriting • Purpose: Manage insurance risk • Method: Use risk classification • Process: • Collect health statistics of applicant • Review data and ask for additional information if necessary • Allocate applicant into proper risk class • Take proper action • Must reflect company policy

20. To Manage Insurance Risk • Reason: to protect the insurance company against anti-selection • People with poorer health has greater chance of dying earlier • Thus should pay higher premium • Proper premium will be charged on healthy lives • Prevent people from over-insuring risky cases • In extreme poor health: decline insurance

21. Risk Classification • Purpose: To group applicant with the same health statistics together – risk class • Proper premium can to charged for each class: standard, substandard rates • For substandard classes: may impose other restrictions • Goal: Actual claims experience tracks the premiums charged

22. Collection of Health Statistics • Medical information with different degrees of detail – may occur in sequence • Simplified questionnaire • Report from applicant’s family physician • General medical examination • Specialist examination • Process reflects • Answers provided by the previous step • Size of the insured amount

23. Other Data to Consider • Beside health statistics, it is important to consider other risk factors such as • Occupation • Height and weight • Smoking or not • Drinking • Dangerous sports and hobbies • Place of residence

24. Review and Further Evidence • Should establish underwriting manual for uniform procedure • If simplified health questionnaire show some medical history, need further evidence • Extra examination fees incurred by insurance company prevents unacceptable risk • Previous drinking or drug problems must be carefully researched • Some insurance companies conduct interview of neighbors: bad practice

25. Risk Classification • Healthy applicants are grouped into standard class: charged standard premium • Non-smoker with good habits, etc are classified into privileged class: lower premium • Higher risk cases are grouped into substandard classes, with proper action

26. Special Action on Substandard Risks • Higher premium: rated premium • Reduction in benefits • Waiting period • Exclusion of claims resulting from certain pre-existing conditions • Rejection

27. Must Reflect Company Policy • Most insurance companies only use rejection as the last resort • Risk classification must reflect insurance company objective on targeted client base • Strict rules for standard class: lower standard premium, but lesser standard cases • Less strict rules for standard class: higher standard premium, broader standard class