introduction credit life
TRANSCRIPT
hannover life re®
An Introduction to CREDIT LIFE ASSURANCE
1
PREFACE
Following on from the highly successful series of publications dealing with profitable group lifeassurance, it is with pleasure that we present our latest publication which introduces the Credit LifeAssurance business.
Currently a rapidly growing line of business with high potential for profitability, it is appropriate thata substantive document detailing the essence of Credit Life Assurance be made available. Given thatCredit Life assurance is a world wide phenomenon, with local idiosyncrasies separating one productfrom another, this publication is of global pertinency.
Although comprehensive and self contained, this volume is not intended as the all encompassing,definitive Credit Life treatise. Rather, it is hoped that it will serve those already well versed in theintricacies of Credit Life business as an easy to hand, succinct reference, while providing thoseseeking to understand this business for the first time with a source of knowledge sufficient toengender an adequate degree of confidence and ability to satisfactorily manage such a portfolio.
Debate and the constructive exchange of differing view points are always to be welcomed. Theinsurance industry can only but develop in such a climate. Should this publication go some way tostimulating such debate and hence ultimately lead to the refining and honing of the techniques andtheories underpinning Credit Life Assurance, its purpose will have been achieved.
S MURPHY
May 1997
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Section 1: Introduction 4
1.1 Explosion of Consumer Borrowing 4
1.2 Arrival of Credit Assurance 4
Section 2: Types of Credit Life Schemes 5
2.1 Types of Loans 5
2.2 Types of Cover 6
2.3 Premium Mode 7
2.4 Cover Term 7
2.5 Eligibility Requirements and Exclusions 7
2.6 Benefits Offered 7
2.7 Group or Individual? 9
Section 3: Designing Credit Life Schemes 10
3.1 Principles of Good Design 10
3.2 Minimising Anti-Selection 11
Section 4: The Underlying Risks 12
4.1 The Risks 12
4.2 Rating Factors 13
Section 5: Pricing 14
5.1 Actuarial Assumptions 14
5.2 Pricing Formulae 15
5.3 Profit Testing 16
5.4 Unit Rating 17
5.5 Profits Sharing or Experience Refunds 17
5.6 Underwriting 18
Section 6: Reinsurance 20
6.1 Accumulation of Claims 20
6.2 Catastrophes 20
6.3 Actual Experience Different from Expected Experience 20
6.4 Protection of Solvency 20
6.5 Commission 20
CONTENTS
3
6.6 Profit Sharing 20
6.7 Financial Assistance 20
6.8 Technical Expertise 20
6.9 Financial Assistance 20
6.10 Technical Expertise 20
Section 7: Policy Administration 22
7.1 Policy Contracts 22
7.2 Administration 23
7.3 Premium Collection 23
7.4 Claim Payment 23
Section 8: Distribution 25
8.1 Distrbution Channels 25
8.2 Remuneration 26
8.3 Problem of Conditional Selling 26
8.4 Support Function 26
Section 9: Reserving 27
9.1 Long-term Pricing 27
9.2 Yearly Renewable Business 27
9.3 AIDS Reserves 29
9.4 Catastrophe Reserves 29
9.5 Reserving Methods for Credit Disability Claims 29
Section 10: Control Cycle for Profitable Credit Life 30
10.1 Concept of the Control Cycle 30
10.2 Measuring Profitability 30
10.3 Analysis of Surplus 30
10.4 Controls 32
Section 11: Conclusion 34
Appendix 1: Sample Policy Application Form 35
Appendix 2: Sample Policy Document 36
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INTRODUCTION
“A man’s debts should not live after him”
Morris Plan Insurance Society’s mottoFirst credit insurance company, 1917
1.1 Explosion of Consumer Borrowing
Earlier this century, the concept oflending to an individual based on hisfuture earning power was introduced andaccepted. Loans repaid in monthlyinstalments over a fixed period becamethe norm. The demand for consumergoods grew explosively after World War II,and consumers began to borrow so as topurchase modern consumer goods on aregular basis.
The growth of financial institutionswilling to lend have both satisfied andfuelled the demand for consumerborrowing. The popularity of credit cards,which allow the cardholder to borrow forany purpose, has taken consumerborrowing to new heights. For today’sconsumer, borrowing is easy andconvenient, even essential.
1.2 Arrival of Credit Assurance
Consumer borrowing rests on the centralpremise that the borrower can meet thedebt obligation from his future wages.Future earning power thus serves ascollateral for the loan. However, thiscollateral can be at risk when theborrower dies or becomes disabled.
As a result, insurance on the borrower’slife and ability to work was introduced toprotect the lender, by reducing bad debtsand default ratios, and the borrower, byeasing his financial difficulty. As such,credit assurance emerged to meet thespecific needs associated with consumerloan transactions for both the lender andthe borrower.
Credit assurance normally consists of lifeand disability assurance, with dreaddisease cover becoming more common.(Unemployment or redundancy insuranceis sometimes offered as a rider benefit.) Ingeneral, credit life assurance pays off theloan outstanding if the insured borrowerdies. Credit disability assurance provideseither a monthly benefit equal to theloan’s monthly repayment if the insured istemporarily disabled or a lump sum equalto the outstanding balance of the loan onpermanent disability.
Therefore, credit life assurance is simplyterm life assurance whereas creditdisability assurance can provide bothtraditional term life assurance as well asdisability benefits.
Credit assurance is often a valuablesource of profit to lending institutions.However, it should be noted that in somecountries (such as South Africa), it isillegal to have any form of profit sharingbetween brokers and financialinstitutions.
Credit assurance can benefit the lifeoffice as an important source ofprotection business. As credit assurance issold through the lending institution’sbranches and directly through stores anddealers, the life assurer increases itspremium volume with little need toincrease its agency force. This is a veryefficient way of marketing insurance as itmakes use of the lender’s often vastdistribution outlets.
Credit assurance is a high volume, lowpremium operation that needs specialistknowledge and efficient systems to runsmoothly. It can be very profitable to boththe life assurer and the lendinginstitution when managed andadministered skillfully.
SECTION One
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Credit Life Schemes
2.1 Types of Loans
Credit assurance is designed to fulfil aborrower’s loan obligation in the eventthe borrower dies or becomes disabled.With the evolution of lending practices,more complex credit assurance productshave been required to fulfil a loanobligation in the event of a claim.
A good starting point is to examine thevarious types of loans available:
2.1.1 Instalment Loans / Closed-ended Loans
Since instalment lending is thecornerstone of consumer credit, itaccounts for the majority of loansinsured by credit life assurers.These loans are for a fixedamount and term, and arerepayable in equal monthlypayments. The life assurance planinvolved is decreasing termassurance because theoutstanding sum assured reducesas the loan is paid off.
2.1.2 Level Loans
These are single payment loansextended for short-term personalborrowing and business loans –the loan is repaid in a singleamount at the end of the loanperiod. Level term assurance isusually used to cover this loan.These loans are often renewed,and on renewal, a new credit lifepolicy is issued.
Another type of level loan issuedis where interest payments aremade on a regular basis and thecapital amount is due at the endof the loan period. As above, levelterm assurance is used to coverthese types of loan.
2.1.3 Residual Loans
Residual loans provide formonthly instalment payments,plus a lump sum payment atmaturity. This may call for acombination of insurance plans.The instalment portion may becovered by decreasing termassurance, while the lump sumresidual payment is covered bylevel term assurance.
Most credit life assurers offeralternative packages to coverresidual loans. In order to retainsimplicity, the usual approachwould be to offer a decreasingterm assurance plan with asuitably loaded premium.
2.1.4 Open-ended Loans
Credit card borrowing is anexample of an open-ended loan,and the use of this type of loan isgrowing. Renewal premiums arepaid by the cardholder with theresult that upon death, theoutstanding balance of theaccount is paid off by the lifeassurance company.
Premiums may be based onindividual outstanding balancesor in many instances a flat rate ischarged for all participants in thescheme. Under the latterarrangement a maximum benefitamount is specified.
Overdraft facilities are anotherform of open-ended loans. Usuallylevel term assurance is used toprovide cover on the overdraftfacility. Cover and renewalpremiums for level term assuranceare linked to the overdraft facilityamount.
SECTION Two
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2.1.5 Variable Interest Rate Loans
Certain loans allow changes in theloan interest rate from time totime. These loans are madenecessary by the potentialfluctuation in interest rates.Mortgages are usually subject tovariable interest rates. If the sumat risk can be calculated on a dailybasis (previous day’s sum at riskplus one day’s interest lesspayments received), the cost ofinsurance can be determinedexactly and debited to theaccount daily. This method ofcalculating premiums is thus akinto universal costing – determiningdaily interest is referred to asinterest strip.
Figure 1 below compares theinsured amounts required undereach of the residual, instalmentand level loans:
Figure 1: Insured Amounts
2.2 Types of Cover
Two terms need to be defined:
Initial Net Indebtedness
Initial net indebtedness is defined as the
original amount of the loan plus theinsurance premium, where the originalamount of the loan is the cash advanced.Technically, the insurance premium neednot be included in the equation as theborrower has the option to pay thepremium in cash. However, this option israrely exercised.
Initial Gross Indebtedness
The initial gross indebtedness is theinitial net indebtedness plus thescheduled interest charges.
2.2.1 Net Coverage
Net pay off cover is where theamount of insurance covers thenet indebtedness of the loan plusany interest that has accruedbetween the latest payment andthe date of death. The calculationof premiums, refunds, reserves,and the amounts payable atdeath is complicated. Forexample, for closed-endedinstalment loans, the assurance isdecreasing term, but the decreaseis not uniform. The pattern of thedecrease is determined by theannual percentage rate of theloan and lending practices.
All open-ended loans are insuredwith net pay off cover, since theamount of the monthly paymentis not fixed – one such loan is thevariable interest rate loan. It canalso be used for closed-endedloans.
Single payment loans (usuallyshort-term loans for commercialuse) are sometimes insured withnet pay off cover. This results in anincreasing term assurance beingused, since the net indebtednessincreases as the interest accrues.
Residual Loan (Residual Portion)
Residual Loan (Instalment Portion)
Instalment Loan
Level Loan1000
500
0
1211109876543210
Term
Total Insurance In Force
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2.2.2 Gross Coverage
Gross coverage insurance coversthe gross indebtedness of theloan. Thus, if the loan is repaid byequal monthly instalments, themonthly payment is equal to theinitial gross indebtedness dividedby an appropriate annuity factor.
In the case of instalment loans,the appropriate type of assuranceto cover gross indebtedness is adecreasing term life assurance.
2.3 Premium Mode
As credit life policies tend to be arelatively small amount of insurance for ashort duration, the traditional premiumpayment mode has been single premium.Periodic premium billing would be toocostly – the costs involved wouldconsume most of the premium. Singlepremium business has the advantage ofgreater investment income, while lapsescan generate profits if no surrender valueis paid to the client.
Rates are usually expressed per R1000 ofinitial gross indebtedness for each year ofcover as this maintains administrativesimplicity.
Generally, single premium arrangementsare reserved for closed-ended loans.Indeed, in the case of variable interestloans a variation in the interest rate maywell result in an incorrect single premiumhaving been paid.
Where the sum at risk becomes greater orchanges, the resulting change in the sizeof the premium makes monthly premiumcollection a viable option.
2.4 Cover Term
This is usually the term of the loan suchthat the effective date and thetermination date of the insurance are set
by the corresponding dates of the loan.Therefore, voluntary termination by earlyrepayment of the loan implies that apremium refund must be paid based onthe cost of insurance of the remainingterm.
2.5 Eligibility Requirements and Exclusions
Wherever possible, the usualunderwriting considerations such as age,gender, health and the like, should befactored into the premium rates. Whensetting premiums for an institution, thelife assurer should obtain as muchinformation of the client portfolio aspossible.
However, the loan provider will probablytake a dim view of extensive underwritingrequirements, as potential business willbe lost. Thus, in many circumstances andcertainly in less sophisticated markets, itis possible that the underwriting is lessstringent (or even non-existent), and itmay well be just the maximum admissibleage that is considered. This may beacceptable because the sums at risk areusually small and the assumption can bemade that only the healthy, working liveswill obtain credit.
Most credit life is sold with a minimumnumber of exclusions, with suicideinvariably being one of the few included.Disability cover will usually excludeclaims arising from pre-existingconditions. Other common exclusions aredescribed in section 7.
2.6 Benefits Offered
2.6.1 Death
The basic benefit under credit lifeassurance provides for cover inevent of the death of principal orco-principal debtor, the purposebeing to protect the debtor interms of any financial agreement.
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2.6.2 Disability
Temporary Total Disability Benefit
This insurance provides a monthlybenefit while the insured isdisabled during the term of thecover. The types of loans involvedand the general practices of creditlife assurance also apply todisability. However, additionaloptions, such as waiting periods,need to be considered.
Total and Permanent Disability Benefit
In the event of total andpermanent disability the fullamount outstanding under thecredit agreement is paid, thebenefit being treated as anacceleration of the death benefit.
Waiting or Elimination Period
Credit disability policies canrequire the insured to remaindisabled for a certain minimumperiod of time before any benefitsbecome payable. This practiceeliminates short duration claimsand significantly reduces theclaim cost and premium charged.Credit disability benefits can bepaid on a retroactive basis(benefits are payable from thestart of the disability) or a non-retroactive basis (benefits areonly payable from the end of thewaiting period).
Usually waiting periods are ofminimal duration, as earlypayment is essential if the loanagreement is to be maintained.
Definition of Disability
The exact definition of disability isnot only important from a claims
point of view, but also has aninfluence on the price. The usualdefinition would be the inabilityto pursue any occupation as aresult of sickness or accident. Thealternative definition of own orsimilar occupation wouldnaturally lead to a higher claimsexperience and premium.
2.6.3 Dread Disease
Dread disease assurance can betaken out as a rider to the basiccredit life cover. The basic dreaddiseases are listed in section 4.The outstanding loan amount ispaid upon the first occurrence ofone of a specified list of dreaddiseases. As with the total andpermanent disability benefit, thisbenefit is also treated as anacceleration of the death benefit.
2.6.4 Unemployment Benefits
This is a benefit similar to thedisability benefit, where amonthly benefit is provided whilethe insured is unemployed. As thedanger of anti-selection issignificantly greater under thisbenefit, underwriting is a veryimportant, albeit not a simpletask. The employment history andexisting debt of the client shouldbe scrutinised. It is normal toplace a limit on the maximumamount of cover available.
This benefit may be written undera non-life licence. However, in thisinstance, care must be taken toensure that the premiums addedto the loan account do notcontravene the contents of theUsury Act.
2.7 Group or Individual?
Under a group policy, which is a contractinsuring multiple lives, the contractualrelationship is between the assurancecompany and the organisation dealingwith a group of borrowers. The borrowerscould be the employees of the company,clients of a finance house, etc.
Under an individual policy, thecontractual relationship is directlybetween the assurance company and theborrower.
From the borrower’s point of view, there islittle difference between the two types ofpolicies. From the insurer’s point of view,there is a difference in both thecontractual relationship and certainadministrative procedures. For example,under a group policy, a certificate ofinsurance is supplied to eachpolicyholder, while for individual creditlife policies, a complete policy documentmust be issued to each policyholder.
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10
Designing Credit Life Schemes
3.1 Principles of Good Design
3.1.1 The Social and Legislative Framework
The laws of insurance, taxationand credit arrangement form theframework within which theinsurance industry must operate.These laws are of primary concernto credit assurance schemes andplay a critical role in shaping thecredit assurance industry in anycountry. Clearly, any insurer that isinvolved in the credit assurancemarket would need to develop asound and thorough knowledge ofthe particular requirements andimplications of the prevailinglegislative environment.
3.1.2 Types of Credit InsuranceSchemes
A variety of institutions providecredit of one form or another totheir clients. Examples range frombanks, building societies and loancompanies to furniture retailers,auto dealers and other hirepurchase companies.
The various types of creditassurance schemes that mayevolve from these arrangementsare described in section 2.Following is a summary of theoptions to consider whendesigning a credit assuranceproduct. The details of the optionsare explained in other sections.
Table 1: Characteristics of Credit Life Insurance
Table 2: Characteristics of Credit DisabilityInsurance
3.1.3 Risk Cover
The insurer must have a goodunderstanding of the nature ofthe credit assurance risks whendesigning the plan. He mustunderstand, for example, thatindividual medical underwritingrequirements are minimal, assums assured are generally low.Also, the age distribution of the
Characteristics Options
Type of Loan Monthly benefit, Lump sum benefit
Elimination or Waiting Period Thirty, Sixty days
Elimination Period Retroactive, Non-retroactive
Type of Loan Instalment, Single payment, Combination,
Open-ended
Loan Conditions Term, Monthly payment
Loan Interest Rate Fixed, Variable
Number of Insured Lives Single, Joint
Benefit or Cover Period Full, Limited
Premium Mode Single premium, Monthly outstanding
balance
Pre-existing Conditions Covered, Excluded
Eligibility Requirements and Pregnancy, Suicide, War,
Exclusions Drug & alcohol related
Surrender Values None, Cash amount
Characteristics Options
Type of Loan Instalment, Single payment, Combination,Open-ended
Loan Conditions Term, Amount, Payment pattern
Loan Interest Rate Fixed, Variable
Number of Insured Lives Single, Joint
Type of Policy Group, Individual
Type of Cover Gross, Net pay off
Premium Mode Single premium, Monthly outstanding balance
Cover Period Full, Limited
Eligibility Requirements and Maximum age, Suicide, War, Exclusions Drug & alcohol related
Surrender Values None, Cash amount
SECTION Three
borrowers is difficult to obtain andso premium rates may be quotedon an age-independent basis.
A detailed study of the underlyingrisks is carried out in section 4.
3.1.4. Policy Conditions
Most commonly, a creditassurance contract between aninsurance company and thelender will be defined within asingle master policy, wherein therights and obligations of thevarious parties would be stated. Aguide to the clauses to beincluded in policy forms, such asthe definitions of terms and list ofexclusions are described in section7.1.
Note that under individualpolicies a contract is issued toeach policyholder. The contractwill be similar to conventionalcontracts issued by the lifeassurer.
3.2 Minimising Anti-Selection
Usage of life and disability incomeassurance differs by age, gender, healthstatus, etc. Although individuals cannotpredict their needs precisely, they willgravitate towards a program of optimumvalue, as it is in their economic self-interest. They will thus opt for themaximum benefit at the lowest cost tothemselves. This situation is generallyreferred to as anti-selection.
The simplest method of addressing anti-selection concerns is through the initialplan design and underwriting (front end)and through provisions restricting thepayment of claims (back end).
Another is by making the schemecompulsory. A guiding principle of groupassurance is that individual members
should have little scope to choosewhether or not to be on the plan or selectthe level of their own cover. For thisreason compulsory participation is themost agreeable arrangement for theinsurer. If eligibility is voluntary, aminimum enrolment level is set to ensureadequate participation in the plan.
The insurer may choose to reinsure aportion of the risk. If the product is new,reinsurance can add significant value byproviding risk capacity. Reinsurance isdiscussed in section 6.
Finally, it is important to understand thecompetitive environment for eachproduct in each market segment. A well-organised group operation will co-ordinate its entry into new markets andproducts with an understanding of whatwill be its competitive strengths andweaknesses. This would include fieldcompensation, field understanding ofproducts and premium ratecompetitiveness.
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The Underlying Risks
4.1 The Risks
4.1.1 Death
The development of any plan ofassurance against death requiressome means of assigningmathematical values to theprobabilities of death. The laws ofprobability can be applied tomortality statistics, and the resultis a mortality table that organisesthis data in such a way that it maybe used to estimate the course offuture deaths. Mortality statisticsare usually derived frompopulation statistics or statisticsderived from insured lives.Adjustments for increased futuremortality due to AIDS should alsobe taken into account althoughwe are generally looking at theshort-term.
4.1.2 Disability
The annual claim costs for adisability income benefit varysignificantly by occupationalclass. In general, the cost ofdisability assurance will varyaccording to age, sex,occupational class, waitingperiod, definition of disability andmaximum duration of benefits.However, as explained earlier,credit life is rarely that extensivelyunderwritten as premiums andsums assured are small. It istherefore necessary to control thecosts through a strict definition ofbenefits.
4.1.3 Dread Disease
Generally, insuring against theoccurrence of the “big three”,namely heart attack, cancer andstroke, makes up the greater part
of the dread disease premium,with kidney failure and coronarysurgery making up a substantialpart of the remainder of thepremium.
4.1.4 Loan Interest Rate
In the past, fixed interest loanscharacterised most consumerlending and the loan interest rateassumed by the insurer was not anissue. However, as explainedearlier, lenders, faced withpotential interest ratefluctuations, have made variable-rate consumer loans possible.Interest stripping is thusnecessary to calculate the riskpremium according to the actualsum at risk.
4.1.5 Investment Earnings
Insurers usually hold lifeassurance premiums for asignificant period before benefitsare paid. These funds, in largepart, are invested in income-producing assets, whose earningspermit the life assurancecompany to charge lowerpremiums than would otherwisebe the case. As policy reserves aresmall, the effect of a change in theassumed rate of interest is verysmall in credit life assurance.Companies therefore usually usea low rate of interest in thepremium calculation basis,resulting in an additional pricingmargin.
SECTION Four
4.1.6 Arrear Instalments
The insurer does not assume anycredit risk, which means that achange in the total interestcharged by the lender (which willinclude interest penalties if loanrepayments are in arrears) will not affect the pricing of theinsurance plan.
4.2 Rating Factors
4.2.1 Characteristics of Customer Base
Generally, a life office wouldcharge differentiated ratesdepending on the policyholder’slevel of risk. However, in credit lifeassurance, detailed information isnot always available, and theinsurer may have to rely on itsunderstanding of thecharacteristics of the customerbase when pricing the plan.
Some factors to consider are;
• socio-economic status of thegroup,
• average age of the group,
• common occupations of groupmembers,
• voluntary or compulsorymembership,
• smoker prevalence,
• sex distribution,
• geographic variations, and
• debtor-creditor relationship.(For example, if all the lender’scredit holders are covered by asingle policy, the creditor mustbe making new loans at areasonable rate such that the
current level of total insuredbalance can be maintained anddeveloped.)
4.2.2 Occupation
Disability contracts may be issuedon an occupational basis. Someoccupations are usually excludedentirely because of extremeoccupational hazard (e.g., somecredit assurance companies treatunderground mining as astandard exclusion).
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14
Pricing
5.1 Actuarial Assumptions
Generally, credit life policies are priceddifferently to ordinary individual life orgroup life assurance policies. The pricingassumptions will reflect the productdesign and the target market. Thefollowing are examples of theassumptions that could be used.
5.1.1 Loan Interest and Profile
The product design (e.g. level ordecreasing term assurance) willgenerally match the profile of theloan. The rate of interest chargedon the loan will be reflected in theassumed sum at risk at differentdurations of cover. The loan rateof interest will depend on the typeof credit provided, but should atleast be equal to the prime rate.
5.1.2 Interest
This should be consistent with thecompany’s expected returns frominvestment. However, thepremium rates are fairlyinsensitive to interest rateassumptions as the reserves arerelatively small. As such, arelatively conservative rate isusually used, in the region of 6%to 8% gross.
5.1.3 Expenses
Some of the administrative expenses involved in credit assurance are;
• commission,
• initial expenses for marketing and administration costs,
• renewal expenses,
• provision for expense inflation,
• stamp duty,
• allowance for work undertaken by the lending institution, and
• the costs of premium collection,claim settlement, conductingactuarial investigations,quotations for new and renewalterms, etc.
5.1.4 Mortality
Population mortality rates (e.g.ELT14 for UK lives) may be abetter estimate of the expectedmortality experience than assuredlives rates. Tables such as theSA56-62 or SA72-77 are popularin the South African market. Asthe level of underwriting islimited, ultimate rates are used.Appropriate loadings for AIDS,lower socio-economic classes andhigh-risk occupations are thenadded to these rates.
5.1.5 Morbidity
This is usually expressed as a flatloading of mortality rates oralternatively, either of the CDT orGLTD tables could be used withappropriate adjustments.
5.1.6 Sum Assured
The sum assured in the event of adeath claim would be theoutstanding debt or credit facility.However, in order to avoidadministrative difficulties, sumsassured are often determined onan approximate basis, dependingon the loans in force at the startand end of the period ofinsurance. This approach is notrecommended and exactderivations are preferable.
SECTION Five
5.1.7 Guarantees
Single premium and levelpremium policy designs containan inherent guaranteed rate andcover over the term of the policy.
5.1.8 Cash Surrender Values
Cash surrender values may beavailable to the insured upontermination of a policy other thanby death or disability. The cashsurrender value is the reserveelement in every cash-valueassurance policy and is anequitable share of the amountaccumulated for that particularblock of policies from which thepolicyholder is withdrawing.
The cash surrender value is setsomewhat less than the profit-tested value of the plan. Some ofthe reasons for this include:
• Adverse financial selection inperiods of downturn when theinsurer’s standing may beweakened.
• Adverse mortality selection bythe allowance of liberalsurrender values.
• Contribution to a contingencyreserve or profits to absorbadverse fluctuations and toenhance the insurer’s overallfinancial security.
• The cost of surrendering thepolicy.
It is usually only single premiumpolicies that have surrendervalues. A typical surrender valueformula may have the followingelements:
where
t = duration
n = original term
c = factor to recoup outstandingexpenses
p = factor to recoup a portion ofexpected profit
f = adjustment factor to allow fordecreasing/level cover
SP = single premium
5.1.9 Competition
Premium rates are also influencedby non-actuarial factors such asthe need to be competitive or togain a sufficiently strong footholdin new markets.
5.1.10 Profit and Contingency Margins
Premiums must be loaded to allowfor the profit margin requiredfrom the class of business. It is alsonecessary to allow for a margin inthe pricing of the premiums totake into account any variationsin the factors in the pricing basis.
5.2 Pricing Formulae
The formula used for calculating a singlegross premium rate per individualmember per mille is as follows:
15
SVt = x (1 – c – p) x f x SPn – t
n
16
It should be noted that the rate i% is notthe loan interest rate, but rather the longterm rate of return that the office expectsto earn on its investments. In practice avery conservative rate is usually used (e.g. 6% p.a.).
The premium amount can also becalculated using cash flows, whichprecludes the use of commutationfunctions.
An annual premium can be derived bydividing the premium calculated aboveby an appropriate annuity factor, e.g.:
5.3 Profit Testing
For a large block of insurance policies, thenet cash flows may be estimated based ona set of actuarial assumptions, includingfuture interest rates, expenses andmortality rates. The net cash flows arepremium income less benefits andexpenses with interest on the block ofbusiness. The estimated profit is theaccumulated value of the net cash flows,based on the company’s anticipatedoperating experience. It represents thepro-rata share of the assets accumulatedon behalf of the block of policies to whichthe particular policy belongs. It is used totest the tentative gross premium rate forprofitability.
An accumulation-type profit test uses thefollowing formula:
Income – Outgo = Net Cash Flow
where
Income = Premiums + InvestmentEarnings
where
SA(t) = cover at time t (and SA(0) =initial loan)
expf = renewal expenses
Iexp = Initial expenses
exp%p = expenses as a percentageof gross premium
comm%p= commission payable
VAT% = VAT payable
overr% = Over-rider commission
profit%p = target profit margin as apercentage of grosspremium
tax% = Average tax rate
n = cover term
Dx = the commutation functionequal to vx lx
Cx = the commutation functionequal to vx+1 dx
i% = Rate of interest
v = present value of 1 due inone years time at rate i%
lx = the number of persons whoattain age x according tothe mortality table
dx = the number of persons whodie between ages x and x+1according to the mortalitytable
SP =1 – exp%p – comm%p (1 + VAT% + overr%) – profit%p(1 + tax%)
@i%
∑n-1
t=o
SA(t)Cx+t
Dx+ expf
Dx+t
Dx+ Iexp
AP =SP
ax:n-
Outgo = Expenses + Death Claims +Surrender Benefits + Change in Reserves
The following is an example of a simpleprofit test. Consider a simple termassurance with premiums payable yearly,claims payable at the end of the year andother details as shown in Table 3 below.
Using commutation functions, thetheoretical premium is R992.07. Table 4shows the development what happens ifexperience follows the assumptions usedin the premium calculation. As expected,in this example, there is neither a profitnor a loss.
The above cash flows should now be expandedto allow for differences in the actual andexpected experience of the office. The incomeside of the equation should be broken up intothe different sources of income from thebusiness sold, e.g. policy fee, investmentincome, etc. The outgo, on the other hand,should incorporate actual expenditure inselling the business, e.g. fixed and variable
expenses, commission, over-riding commission(if any), as well as claims.
The resulting cash flows can then bedetermined, allowing for different levelsof lapses, mortality and other variables.This process is known as sensitivitytesting. Different levels of sales volumescan be built into the model, to allow forthe resulting changes in expenses.
Single premium business is generallymore profitable than recurring premiumbusiness.
5.4 Unit Rating
As credit assurance involves low sumsassured, the premium rates generally donot depend on individual ages, or if theydo, they are based on broad age bandsonly. Consequently the assumedweighted average age of the insured livesis critical and it is important to haveknowledge of the target market beforesetting the premium.
It must be understood by the financialinstitution that the premium rates couldbe subject to amendment if theassumptions prove to be inaccurate.
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Table 3: Details of a Simple Term Assurance
Age 35 exact
Policy Term 5 years
Sum Assured R1 million
Mortality A67/70 ultimate
Real Return 5%
Expenses none
Year No. of Total Net Death Increase in Profit
policies in premium investment benefit mathe-
force at income income outgo matical
start of reserve
year
1 1.000 000 R992,07 R49,60 R855,77 R185,90 R0,00
2 0.999 144 R991,22 R58,86 R935,84 R114,24 R0,00
3 0.998 208 R990,29 R64,52 R1 032,24 R22,57 R0,00
4 0.997 176 R989,26 R65,60 R1 146,48 (R91,62) R0,00
5 0.996 030 R988,13 R60,96 R1 280,18 (R231,09) R0,00
Table 4: Profit Test for Regular Premium Term Assurance
18
5.5 Profit Sharing or Experience Refunds
The profit share or experience refund isthat portion of the compensation to thecredit provider that is contingent on theprofitability of the business. (CurrentSouth African legislation pertaining tocredit life business does not makeallowance for profit sharing.)
Insurers generally require that the creditprovider generate a minimum volume ofcredit assurance business beforequalifying for an experience refund. Theexperience of the business is evaluatedperiodically. A proportion of the profitsfrom a block of business (i.e. premiumsplus investment income less claims,expenses, tax and profits) is returned tothe producer.
The insurer can often recover priorexperience refunds if experience turnsbad by carrying it forward to futureaccounting periods. However, if the sumof all experience refunds is negative, theproducer is not responsible for the loss.
5.6 Underwriting
Credit life assurance is generallyarranged through the lending institution.The level of underwriting is thereforerestricted as having to meet strictunderwriting requirements could delaythe lending process. As a result, theinsurer usually relies on a maximum agelimit with little or no emphasis on medicalinformation.
5.6.1 Non-Medical Limits
Credit life assurance is generallyoffered to all borrowers withoutany existing serious healthproblems. To obtain a loan, theapplicant is necessarily inacceptable health and possessesthe ability to repay the loan.
For amounts of insurance below a
non-medical limit, medicalinformation is waived and theapplicant generally signs a simpledeclaration of health form.
Above the non-medical limit, theinsurer may require strictermedical underwriting. Medicalevidence in the form of a personalhistory questionnaire asking,among other questions, whetherinsurance has ever been declinedor if the applicant has sufferedfrom specific health disorders in the past 3 years, could be required.
For large sums assured rigorousmedical underwriting could berequired. This degree ofunderwriting should be reservedfor a relatively small, but representative number of high risks.
5.6.2 Age Limitations
The degree of risk becomes largerat the older ages so that it may benecessary to include somerestrictions on the maximum ageat entry (e.g. age 60). A personabove this age will notautomatically be accepted butwill be required to produceevidence of insurability beforetheir insurance is made effective.In addition, such a person maypossibly be insured at non-standard rates.
Another reason for lowering theage limit, is that the allowance ofhigh maximum ages when usingunit rating, will result inunacceptably high premium rates.
5.6.3 Pre-existing Conditions
The borrower may have existingimpairments that may result infuture claims. (A pre-existingcondition is an impairment forwhich the insured has beentreated prior to the effective dateof the insurance.)
The standard exclusion is that theinsurer shall not be liable if theclaim is linked to any physicaldefect or infirmity of which the lifeassured was aware and which hadits origins prior to the issue of thepolicy.
5.6.4 Financial Underwriting
Although the lending institutionwill perform some financialunderwriting of the level of risk ofeach loan applicant, the insurershould be aware that theobjectives of the finance housewould not match those of theinsurer. For this reason somefinancial underwriting by theinsurer will be required for allloans. This will most commonlytake the form of the non-medicallimits discussed above. Theinsurer should also consider theinsurable interest, the size of theloan repayments and theinsurance premiums relative tothe assured life’s regular incomeas well as the risk of moral hazard.Note that anti-selection isreduced because in taking out theloan, the assured life is motivatedby the need for finance, not theneed for insurance.
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20
Reinsurance
Reinsurance may be defined as a device bywhich a life assurance company transfers all ora portion of its exposure under a life assurancepolicy to a reinsurer. Its primary purpose is toavoid too large a risk concentration. Creditinsurers could use reinsurance to protectthemselves in various ways:
6.1 Reducing Mortality Fluctuations
The main reason for reinsurance is toreduce the effect of adverse mortalityfluctuations, e.g. more persons dying thanexpected or those persons with largerthan normal sums assured dying. Thefluctuations could have a negative impacton the free reserves of the life office, if notallowed for by means of additionalreserves or reinsurance.
6.2 Accumulation of Claims
An accumulation of claims arising from asingle incident could have a detrimentaleffect on the reserves of the life office.Excess of loss reinsurance can be used tocover these types of losses.
6.3 Catastrophes
Catastrophe reinsurance is similar to theexcess of loss cover described above, butoperates at a much higher level.
6.4 Actual Experience Different from Expected Experience
Ventures into new markets are oftencharacterised by uncertainty. A reinsureris an ideal partner for such situations, bymeans of a quota share arrangement. Thereinsurer shares the fortune of the directwriter – premiums and claims are sharedby the two parties.
6.5 Protection of Solvency
Surplus reinsurance can be used toprotect the life office from large individual
claims. The reinsurer meets all claimsabove a certain retention level. Surplusreinsurance effectively smoothes theexperience of the life office, by removingthe peaks of the larger claims, leaving it toretain the smaller, less volatile claims.
6.6 Protection of Profits/Solvency
Stop loss cover can be used to protect theoffice against worse than expectedexperience of a credit life portfolio. Thereinsurer would meet claims if theexperience becomes worse than somespecified level, e.g. claims in excess of125% of the mortality table or abovesome specified loss ratio.
6.7 New Business Strain
Commission paid by the reinsurer to thelife office, may be utilised to offset someof the new business strain incurred by theoffice in writing the business.
6.8 Profit Sharing
Reinsurance treaties can be structured toincorporate profit sharing, whereby aportion of the profit emerging from theblock of business is returned to the lifeoffice.
6.9 Financial Assistance
Various other methods of financialassistance are available. One such methodis called “stochastic banking”, wherebythe profits expected to emerge in thefuture from a specific block of business, isadvanced by the reinsurer to the lifeoffice. This “loan” to the life office is thenrepaid from the emerging profits.
6.10 Technical Expertise
A reinsurer can offer the life office a widerange of expertise, ranging from productdesign and pricing, to underwriting,administration, claims handling andmarketing.
SECTION Six
The exact method of reinsurance –proportional or non-proportional, originalterms or risk premium, surplus or quotashare – should be discussed with thereinsurer. Similarly, the appropriateretention level – the level above whichrisks are transferred to the reinsurer –needs careful deliberation.
Factors to take into consideration include:
• Type of credit life assurance (e.g. group or individual).
• Size of the life office (i.e. size of free reserves).
• Size of the risks.
• Risk profile of the life office.
• Level of technical expertise required.
• Level of financial assistance required.
• Probability of an accumulation of risk or a catastrophe occurring.
21
22
Policy Administration
7.1 Policy Contracts
7.1.1 General Clauses
Definitions Clause
The definition clause defines theterms used in the policy.Significant definitions are those ofthe debtor, the creditor, theinsured debt and the creditagreement.
Benefits Clause
This clause describes the benefitspaid under the various life anddisability plans of insuranceoffered by the contract.
Provisions and Conditions Clause
This specifies the requirements aborrower must meet to be eligiblefor cover. A maximum age isusually specified.
Consideration and Premiums
This section specifies the amountand frequency of premiumpayments, as well as the amountpayable by the insurancecompany in event of a claim.
Grace Period
A one-month grace period isusually permitted for theremittance of the premium by thelender to the insurer.
Termination of Insurance Clause
These are the conditions oftermination. Cover on individualsinsured continues until naturalexpiration on single premiumbusiness, i.e. until the end of the
policy term. Monthly outstandingbalance business terminates onthe date that the loan becomespaid off.
Claims Clause
This defines the claim submissionprocess and also specifies thebeneficiaries under the policy.
Exclusions Clause
This section may be split into twocategories. The one category willdeal with exclusions that willapply to the death benefit, whilethe other will specify theexclusions linked to the disabilitybenefits. Typical exclusionsinclude suicide, drug or alcoholrelated injuries, pre-existingconditions and AIDS.
Duration of Cover.
The inception date of the policy, as well as the term of the cover.
Details of Life Assured, Beneficiary and Premium Payer
The life assured and premiumpayer need not be the sameperson. The beneficiary would bethe lending institution.
7.1.2 Individual Contracts
With individual credit lifeassurance, there is a contractbetween the borrower and the lifeoffice. Each individual is thusissued with a contract.
SECTION Seven
7.1.3 Group Contracts
Under group credit assurance, thecontract is between the life officeand the credit provider. A fullcontract is issued to the creditprovider, with each borrowerreceiving a certificate ofinsurance.
7.2 Administration
The administrative work entails thehandling of enquiries, maintainingadministrative records and the processingof claims. This includes the initial set-upof a new account, recording of the policyforms and rating calculation material andupdates due to changes in rates andclaims whenever necessary.
7.3 Premium Collection
7.3.1 Individual Contracts
For individual policies, theinstitution generally preparesweekly schedules and attachescopies of issued policies to theschedule. These schedules areeither accompanied by a chequeor a copy of documentationattesting to payment. Premiumsmay also be payable by debitorder in which case the life officeis responsible for premiumcollection via magnetic tape.
7.3.2 Group Schemes
For group schemes each accountsubmits monthly reportssummarising the business issuedand the refunds made.
7.3.3 The Reporting Process
The report preparation usually undergoes the following processes:
Incoming cheques are date-stamped and assigned a bookingidentification number that issubsequently verified and themoney is sent in for deposit.
Remittances are usually made by cheque.
Supporting documentation arecaptured and edited. This meansthat the policy data is checkedagainst the account master file containing informationconcerning policy limits, approvedplan of insurance and premiumrates.
Most insurers book the businessas received and later send acorrection if necessary. If age orterm is missing, an assumed ordefault value is coded andverification is soughtsubsequently.
Monthly outstanding balancebusiness is much simpler; thegroup premium rate is appliedand the compensation deducted.Errors are corrected in asubsequent report.
7.4 Claim Payment
A credit life assurer’s claim proceduresmust accommodate the high volume oftransactions involved and the specialisednature of the product. Consistency ofclaim handling, timeliness of processingand adherence to policy provisions arethe guiding principles. Consequently,claims departments usually have aseparate administrative unit and anexamination unit so as to ease thepaperwork on examiners. This allows theexaminers to concentrate on theadjudication of the claim itself.
23
24
7.4.1 Death Claims
Unless the scheme has a freecover limit, death claims areusually investigated as rigorouslyas death claims arising from anyother line of business. The processis usually as follows:
The lender completes the loan balance and provides a death certificate.
The claim records are thenreviewed to check whether theinsured has previously filed adisability claim (bearing in mindthat such a claim, triggering anaccelerated benefit, woulddecrease the death benefit nowpayable) or initiated a duplicateclaim.
The examiner then steps in tocheck the age, cases of suicide (inwhich case the premium is usuallyreturned) and requests anAttending Physician’s Statementif necessary. The examiner’sdecision to deny a claim or acceptparticularly large claims ischecked by a supervisor beforecheques are issued.
7.4.2 Disability Claims
Disability claims require researchfor compliance with the policyform, which often contains moreexclusions than the credit lifeform. They are also moresubjective as an examiner mustassess the validity and severity ofthe claim on an on-going basisthroughout the period of theclaimed disablement. Thefollowing processes are particularto disability claims:
Open files are maintained forcontinued disability claims in the
payment status or pending claimsstill under investigation. Closedfiles are made up after a period ofinactivity.
In the examination process, fourquestions are uppermost in theexaminer’s mind:
• Is the claimant disabled?
• Has the disability occurredduring the policy term?
• Have all policy conditions been met?
• Are any policy exclusions applicable?
The most demanding part of claimsexaminations is checking the natureof the disability against pre-existingconditions.
Provision needs to be made fordisability claims involving more thanone payment (some claims extendover several years). For severe cases,the insurer may require a periodiccertification of continued disability, inwhich case it may be requested to paythe loan off rather than continue themonthly benefit payments.
The treatment of claims is monitoredby the insurer. Audits are performedin terms of client service turn-aroundtimes, samples of individual claimfiles, and complaint handling. Thepersonnel also undergo continuoustraining.
Distribution
8.1 Distribution Channels
8.1.1 Bancassurance
Of late, banks have expanded intolife assurance markets, not onlytraditionally through credit lifeassurance but also by selling avariety of “bundled” or“unbundled” products which aredesigned to suit an individual’srisk and return requirements. Themarketing of life assurance bybanking institutions has beendubbed “bancassurance”.
The appeal of bancassurance isthat it represents a leveraging ofthe existing activities of a bank. A retail bank typically has anestablished distribution networkand customer base. Furthermore,the volume of face-to-facetransactions between a bank andits customers is usually quite high. Face-to-face transactions,particularly those involving thepurchase of a bank product,provide the greatest leveragingopportunities.
When selling to referred bankingcustomers, bancassurance salesintermediaries often typicallyachieve sales productivity three orfour times higher than the lifeassurance industry average.Hence the use of these existingdistribution capabilities hasadvantages which can ultimatelytranslate into enhanced profitsand extra value added.
It is not uncommon for the banksto set up separate affiliates thatspecialise in financing. Thesefinancing institutions now makeup the majority of credittransactions.
8.1.2 Providers of Goods
Recent developments have seenan increase in the selling of creditprotection by stores and dealers.These types of credit plans willtypically include protection onvehicle financing and protectionfor departmental stores’cardholders. It must be noted thatthe sale of credit protection isopen to abuse by merchantsdealing in furniture and otherconsumer goods since there arecurrently no rules or legislationgoverning this type of business.
8.1.3 Direct Marketing
Solicitation via direct marketinginvolves contacting potentialcustomers without the use of asales person. Although directresponse marketing is growingrapidly, it is still a very smallpercentage of new life assurancepremiums.
Direct Mail
Direct mail campaigns aretargeted at the lendinginstitutions’ clients and make useof their customer data bases.
Telesales
Telesales are a follow-up servicethat may be introduced to thosewho have not taken up theinsurance at the point of sale. Theprocess involves having a list of allcredit transactions that have notbeen matched with a credit policyand contacting these individualswithin approximately ten days.These operations are sometimessub-contracted to specialists.
25
SECTION Eight
26
8.2 Remuneration
8.2.1 Head Office Sales Staff and General Agents
The main difference betweenhead office sales staff and generalagents is remuneration.
Most South African companiesemploy sales staff (as opposed toprocuring the services of generalagents), to promote their productand handle the interface betweeninstitution and underwriter. Theyare normally remunerated bymeans of a basic salary togetherwith an over-rider incentive basedon production.
Compensation to general agentsis commission driven and dependson the volume of businessproduced and possibly theprofitability of the business.Compensation could also be inthe form of over-rider commission.
8.2.2 Credit Provider/Lending Institution
Compensation to the creditprovider could be one or more of:
• Up-front commission -commission paid to the providerbased on net written premium.
• Service fees - reimbursement ofthe actual cost of offering the products.
• Experience refund
8.3 Problem of Conditional Selling
Often, when large loans are involved (forexample for luxury cars or for specialistmedical equipment), the financier makeslife assurance a condition for the grantingof a loan. In such a situation, it is in the
financier’s interest to obtain theinsurance for its clients as soon aspossible. Therefore a life assurer may finditself pressurised by the financier to issuethe required contract. The time constraintwill also put pressure on theadministrative resources of the insurer.
8.4 Support Function
In the credit assurance business, the salesarea plays a critical role and oftenextends beyond the usual responsibilitiesfound in other lines of insurance. Inaddition to soliciting new accounts, thesales force performs many servicefunctions. Sales people often train thecredit provider’s personnel, work with theprovider when problems arise andimplement rate changes and productmodifications. The sales force frequentlymonitors the financial experience of thebusiness and initiates corrective action.
A separate sales administration areaoften handles the administrativefunctions and maintains contact with theaccounts on day-to-day operationalmatters. This permits the sales force toconcentrate on personal contact and new sales.
Reserving
A reserve is an estimate of the amount ofmoney an insurer must hold for future claimpayments. It is an accounting timingmechanism, meaning that it serves to allocateprofits appropriately between differentaccounting periods.
The method of calculating reserves depends onwhether the cover is yearly renewable (e.g.group life cover), or priced on a long-term basis(e.g. individual cover for a 5 year term).
9.1 Long Term Pricing
When premiums are priced on a long-term basis, the usual net or grosspremium valuation methods used in lifeassurance are applied, adjusted for thespecific nature and experience of thebusiness.
9.2 Yearly Renewable Business
The following types of reserves arecommon when premiums are renewableon an annual basis, such as is commonunder group credit assurance:
• Unearned Premium Reserve (UPR)
• Notified Outstanding Claims Reserve(NOCR)
• Incurred But Not Reported Claims Reserve (IBNR)
9.2.1 Unearned Premium Reserve (UPR)
The UPR is based on theassumption that a portion of the original premium(commensurate with theremaining term and sum assured)must be put aside to pay futureclaims. Certain assumptionsregarding the incidence of riskover the term of the cover areneeded. The UPR is calculated by
multiplying the original grosspremium by an unearnedpremium factor. The unearnedpremium factor is further adjustedfor acquisition costs.
Single Premium Decreasing Cover
For single premium gross pay offcover and net pay off cover, the“Rule of 78” unearnedpremium factor is used. The “Ruleof 78” assumes an arithmeticprogression in successive capitalrepayments as opposed to thegeometric progression used incompound interest loan schedules(i.e. it is assumed that thedifference between eachconsecutive capital repayment isconstant).
where
n = the original term in months
t = number of full months remainingfrom the valuation date to theexpiration of the policy
acq = acquisition expenses
For single premium level cover,the “Pro rata” unearned premiumfactor is used. This assumes thatthe single premium can beapplied uniformly over the term ofthe assurance.
27
“Rule of 78” factor = (1 – acq) xt(t + 1)
n(n + 1)
“Pro Rata” factor = x (1 – acq)t
n
SECTION Nine
28
where
n = the original term in months
t = the number of full monthsremaining from the valuationdate to the expiration of thepolicy
acq = acquisition expenses
In general, the average of the“Rule of 78” and the “Pro rata”method are used to calculateunearned premium reserves forcredit disability assurance.
Recurring Premium Business
The same methods are applied torecurring premium business, thereserve being the “unearned”portion of the premiums alreadyreceived.
9.2.2 Notified Outstanding Claims Reserves (NOCR)
A NOCR is a reserve for claimsthat arose, and were reported tothe insurance company prior tothe accounting date, but for whichpayment was not issued by theaccounting date.
In disability assurance theclaimant may receive multiplepayments at different points intime. The NOCR in this instancewill be an estimate of the benefitsthat will be earned and paid afterthe accounting date fordisabilities that occurred prior to the accounting date.
The following table depicts such acontinuing claim.
9.2.3 Incurred But Not Reported Reserves (IBNR)
An IBNR claim is a claim arisingfrom an event occurring prior tothe accounting date, but whichwill only be reported to theinsurance company after theaccounting date. For example,assuming the accounting date tobe 31 December, the contingentevent could have occurred on 2October but the claim will only bereported on 8 January.
The IBNR can be calculated usingrun-off triangles that make use ofthe run-off patterns of the past toproject the expected number ofIBNR claims in the future. Othermethods include a percentage ofearned premiums or incurredclaims.
9.2.4 Alternative Methods
The loss ratio method isoccasionally used wheninsufficient data is available toapply one of the other methods, oras a quick check. The loss ratio isequal to incurred claims as aproportion of earned premium,which is total premium lessunearned premium. Subtractingpaid claims from incurred claimsgives the total claim reserves.
Time
Date ofTreatment
AccidentReported
Claimpayment
Oct 2 Dec 4 Jan 15Dec 31
Time
Date ofTreatment
AccidentReported
Claimpayment
Oct 2 Jan 8 Feb 1Dec 31
Time
Date ofTreatment
AccidentReported
Claimpayment
Oct 2 Nov 5 Jan 15Dec 31 Feb 15Dec 15
……
9.3 AIDS Reserves
With the increasing incidence of deathand disability caused by AIDS, insurershave made appropriate adjustmentswithin their reserving formulae. MostAIDS deaths arise between the ages 20 to 40. Under long-term pricing, themortality factors for lives falling in thisage range should therefore be adjusted upward to account for theincreased mortality.
AIDS is obviously less of a problem forannual renewable contracts, as rates canbe adjusted when needed.
9.4 Catastrophe Reserves
Rare occurrences and natural disasterscould result in ruinous claims. It istherefore necessary to set up a reserve forthis contingency. An indication of the riskinvolved can be found by examining thegeographical and occupational spread ofthe portfolio. As an alternative to settingup the reserve, reinsurance could also beused to manage the risk.
9.5 Reserving Methods for Credit DisabilityClaims
Since disability claim reserves are moresubjective and tend to fluctuate morewidely from year to year, (due toeconomic cycles, unemployment andclaim underwriting), reserving tends to bemore uncertain and daunting. Variousmethods or combinations of methods areused to set claim reserves.
In the case of the lag method, priorexperience is studied to estimate theaverage remaining period of disabilityafter the accounting date. Factors aredeveloped based on the time the insuredhas already been disabled at theaccounting date.
The total factor method recognises thatthe total claim reserve is the key value,thereby including a provision for IBNR. A “total” claim reserve is developedinitially from a factor method andsubsequent subsidiary calculations aremade to separate the total claim reserveinto its subdivisions.
For the case reserve method, aknowledgeable claims underwriterreviews each reported claim andestimates the remaining time ofdisability. The reserve is then theexpected product of the remainingmonths of disability and the claimant’smonthly benefit. This method isimpractical for large volumes of claims.
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30
Control Cycle for ProfitableCredit Life
10.1 Concept of the Control Cycle
All well-managed companies utilise aplanning and control cycle made up offour stages;
• strategic planning,
• tactical planning,
• performance monitoring, and
• control and readjustment.
Strategic planning defines the targetmarket, products and distribution systemsthat are co-ordinated to achieve thecompany’s profitability and solvencyobjectives.
Tactical planning provides theimplementation of the strategic plan. Thetactical plan involves the developmentand maintenance of all the managerialand distribution components that arerequired to carry out the strategic plan.
The third stage, performance monitoring,is used to determine whether the insurer’sstrategic and tactical plans are beingcarried out so as to meet the profitabilityand solvency objectives.
Effective performance permits controland readjustment, the fourth stage of thecontrol cycle. This involves the continuousreadjustment of tactics to achieve thestrategic plan.
10.2 Measuring Profitability
Successful operation in the creditassurance business requires that thefinancial results be measured andmonitored periodically. Accounts shouldbe reviewed regularly, with the financialstatements containing the informationon the profitability of the book of
business being drawn up.
The larger the group of lives, the greaterthe credibility that can be attached to theexperience of the specific group ofbusiness. The claims experience of a smallaccount fluctuates significantly fromquarter to quarter.
10.3 Analysis of Surplus
10.3.1 Loss Ratios
The basic concept involved in themeasurement of profitability is tomatch the premiums of the periodwith the claims of the sameperiod. Unearned premiumreserves and claim reservesprovide the accountingmechanisms to accuratelydetermine earned premium andincurred claims.
To accurately measure experienceover short time periods, thepremium must be earnedthroughout the term of the policy.The solution is to earn thepremiums in proportion to theclaims that are occurring. This canbe achieved using the Pro Ratamethod or Rule of 78.
The general formula for earnedpremiums is:
Written premiums for the period
+ Unearned premiums at thebeginning of the period
– Unearned premiums at the end of the period
Incurred claims is the proportionof the original premiums (theearned premiums) associatedwith claims that occurred prior tothe accounting date.
SECTION Ten
The general formula for incurred claims is:
Paid Claims
– Claim reserves at the beginningof the period
+ Claim reserves at the end of the period
The loss ratio (the incurred lossratio) can be calculated bydividing incurred claims by earnedpremiums. Of course, the true lossratio is not known until the blockof business goes off the books.
Various other methods exist forcalculating loss ratios. Paid lossratios (paid claims divided bywritten premium) and paid-earned loss ratios (paid claimsdivided by earned premium) tendto understate the loss experienceof a block of business in its earlyhistory. This can be seen in Figure 2:
Figure 2: Various Loss Ratios
10.3.2 Commission and Stamp Duty
Just as premium is earned duringthe term of the policy, the chargeto earnings for expenses must bespread over the policy term bydeveloping unearned expenseamounts. These are assets, as cashhas been paid out for expensesthat have a future value.
The formula for earned commissions and stamp duty is:
Commissions and stamp duty paid
+ Unearned commission andstamp duty at the beginning ofthe period
– Unearned commissions andpremium taxes at the end of the period
10.3.3 Expenses
A detailed expense analysisinvolves the allocation of totalgeneral expenses to individualaccounts. The study takes thetotal corporate expenses,allocates the expenses by line ofbusiness, and then subdivides theline expenses by function. Theresulting percentages can beincorporated into the assessmentof future profitability and can alsobe used for future pricing.
Common function groupsevaluated for an expense analysis are:
• Operating Departments
• Claims Administration
• Commission Accounting
• Policy Issue
31
Less
Rat
io (%
)
100
80
60
40
20
0
78 79 80 81 82 83 84Years
Paid Paid-Earned Incurred-Earned
32
• Premium Booking
• Sales
• Sales Administration
• Underwriting
• Service Departments
• Corporate Overheads
Some expenses (especially startup costs) will need to be spreadover the expected volume ofbusiness in the medium term future.
Sometimes the administration isprovided outside the life office, inwhich case the cost as apercentage of premium is easy toderive.
10.3.4 Investment Income
Income depends primarily on thelevel of commissions paid and thenature of any depositarrangement. For example,automobile dealer businessgenerally involves regular cash flow without any depositarrangement.
Income is calculated as premiums,less commissions and premiumtaxes (e.g. stamp duty). A cashflow analysis is performedreflecting each element of paidexpense against the premiumincome flow. An assumed rate isapplied to the flow of funds,generally using representativeshort-term interest rates, in orderto estimate the level ofinvestment income.
10.3.5 Tax
This is required if the insurerwishes to determine profitabilityafter tax. The level of tax incurredunder this class of business isusually calculated usingapproximate methods.
10.3.6 Profit Criterion
The profit criterion can be set as aproportion of any statisticrelevant to the book of business.Examples include expressing it asa percentage of the premium (e.g.10% of premium), or as apercentage of the capital requiredto finance the business (e.g. 15%of capital).
10.4 Controls
Given that the principal quantitativeobjectives relate to growth and profit, itfollows that the factors to be controlledare the revenue and expenditure items,such as new business premium, renewalpremium, investment income, claims and expenses.
New business and renewal premiums arecontrolled by managing the elements ofthe marketing mix. The potential foracquiring new business and retainingexisting business is higher when productsand services are designed to meetcustomer’s expectations, the price is lowerthan the price offered by competitors, andcustomers perceive that the products andservices will meet their expectations at aprice which is favourable.
Control can be exercised overinvestments by establishing aninvestment committee to review currentinvestment philosophy by considering, inparticular, the asset/liability profile ofthe group portfolio, the target assetmixes and liquidity requirements.
The claim administration cycle provides thecontrol mechanism for the claims item.
Expense control is largely a matter ofcontrolling the number of staff and theirsalaries and wages which usually makesup more than half of total expenses. Theeffective use of technology, productivityimprovements and partnershiparrangements between management andstaff should all contribute to minimisingexpenses. Other factors includeunsuccessful quoting, stamp duty andinefficient distribution channels.
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34
Conclusion
Credit assurance emerged to meet the specificneeds associated with loan transactions. Thispublication serves to illustrate key aspects ofsuccessful and profitable credit life assurance.As with any industry, an insurer involved in thecredit life industry should first develop a soundknowledge of the prevailing competitive andlegislative environment before proceeding tohis own product development.
The types of credit life assurance products inthe market are best introduced by exploringvarious credit transactions. Another aspect forconsideration is whether to issue group orindividual insurance plans. Based on thesefindings the insurer can begin the process ofdesigning a suitable credit assurance scheme.
Like other insurance products, the pricing ofcredit assurance schemes is also based on theexpected values of the risks involved. Variousactuarial techniques can be employed toassess these risks as well as to attach suitablevalues to the reserves necessary for futureclaim payments.
Alongside the design and pricing issues liethose of marketing and administration.Naturally, there are policy administrationprocesses and successful distributiontechniques that are particular to credit life assurance.
Continuing control and monitoring isfacilitated through the introduction of acontrol cycle to suitably readjust thecompany’s initial strategic plan. Profitabilitymeasures and analyses are all useful tools thatcan be used at each stage of the creditassurance process.
In conclusion, a strong technical and strategicapproach towards managing credit assurance business as advocated in this publication will provide the foundation for a profitable operation.
SECTION Eleven
SAMPLE POLICY APPLICATION FORM
Loan Balance Protection Insurance Proposal Schedule
Name of Creditor: ________________________________________________________
Branch Name: ________________________________________________________
Account Number: ________________________________________________________
Name of Debtor: ________________________________________________________
Date of Birth: ________________________________________________________
Occupation: ________________________________________________________
Address: ________________________________________________________
Particulars of Loan
Amount of debt (VAT inclusive): _______________________
Period of Cover (Months): _______________________
Premium Payable: _______________________
Frequency of Premium Payments: _______________________
Declaration
I, name of the life assured, declare that to the best of my knowledge and belief:
I am in good health and free from disease or disability or symptoms thereof and I am not receivingany regular medical treatment and have not done so in the last 12 months and the assurance doesnot replace any other existing assurance with any life assurer.
This policy has been effected by me voluntarily and has not been made a condition of granting creditby the Institution. I agree that if the above declaration is not true, this assurance shall be null andvoid.
Signed at on the day of 20
SIGNATURE OF THE ASSURED SIGNATURE OF OFFICIAL OF INSTITUTION
35
APPENDIX One
36
SAMPLE POLICY DOCUMENT
The insurer undertakes in favour of the lifeassured named in the Proposal Schedule to paythe benefits described in this policy subject to:
The receipt by the Insurer of the correct premium(s);
The terms and conditions containedherein or endorsed hereon.
DEFINITIONS
Creditor The institution as named in theproposal schedule.
Debtor A natural person named in theproposal schedule who isindebted to the Creditor.
Insured Debt The gross invoice value,together with agreed or legalinterest thereon, of goods soldand delivered or servicesrendered on credit owed by theinsured debtor to the insured interms of a valid contract thatspecifies credit terms not morefavourable to the insured debtorthan those specified in therelevant credit limit and whichdoes not exceed the relevantcredit limit of such insureddebtor.
Credit Limit The maximum aggregateamount due at any one time bya particular insured which isindemnified under the policy.
BENEFITS
Death An amount equal to but notBenefit exceeding the balance of the
indebtedness as herein defined.
Total and In the event of the total and Permanent permanent disablement of the Disability life assured occurring prior to
the attainment of age 65 and
before the expiry of the term of the credit agreement anamount equal to the deathbenefit shall be payable by theInsurer.
Temporary If, before the policy anniversaryTotal preceding the life assured’sDisability 65th birthday and the expiry of
the term of this policy, the life assured is prevented, as aresult of illness or bodily injury,from earning his normal incomefollowing any occupation forwhich the individual is suited,taking education, training andexperience into consideration,the Insurer shall pay, after thedeferment of 30 days, themonthly instalment agreedupon under the creditagreement referred to in theproposal schedule.
Provisions The Insurer’s liability in terms ofand this policy shall not, under anyConditions circumstances:
• Extend beyond the 65thbirthday of the life assurednamed in the proposalschedule.
• Extend beyond the earlytermination or the settlementdate of the credit agreement.
• The insurer shall not beobliged to make any paymentin respect of any event arisingdirectly or indirectly from ortraceable to intentional self-inflicted injury, suicide orsuicide attempt.
APPENDIX Two
Premiums In the event that the premiumor premiums actually paid to theInsurer are incorrectlycalculated so that they are infact insufficient to pay for thebenefits in the proposalschedule then writtennotification thereof shall besent by the Insurer to thecreditor as well as to the lifeassured. If the error is correctedwithin the grace period, the fullsum assured will be maintained.
Grace Period Where premiums are payable bymeans of other than a singlepremium the life cover of thepolicy as set out in the proposalschedule will be maintained bythe Insurer for a period of graceof 30 days beyond the due dateof any outstanding premium.Should this period of grace beexceeded without theoutstanding premiums beingreceived by the Insurer thecover will lapse and the Insurer’sliability under this proposalschedule will cease.
Termination The Insurer’s liability in terms ofof Insurance the policy shall cease in the
event the indebtedness in respect of which the policy wasissued has been paid in full orwhen it would have been paid infull had the life assuredcomplied with his obligation tothe creditor as originallyundertaken whichever eventshall happen first.
Claims A claim shall be lodged in theform specified by the Insurertogether with all supportingdocumentation required by theInsurer. Once the Insurer hassatisfied itself as to theoccurrence of the insured eventand the validity of the claim theInsurer shall notify the insuredin writing of its basis forsettlement of the claim andshall pay the claim on that basis.
Exclusions The Insurer shall not be liable inrespect of any event arisingdirectly or indirectly from ortraceable to any of thefollowing events:
• War, whether war be declaredor not, from warlike action,civil war, insurrection, riot, civilcommotion or other acts ofviolence originating from anypolitical or civil unrest.
• Engaging in aviation otherthan as a fare-payingpassenger on a regular routeof a recognised airline.
• Intake of illegal drugs or thepresence of alcohol exceedingthe legal limit.
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