chapter 5shodhganga.inflibnet.ac.in/bitstream/10603/3223/12/12_chapter 5.pdf · discussed in...

165

Chapter 5

Potential for Secondary Market Trading in Life

Insurance: Economic Viability of the market

5.0 Introduction:

The study of the potential for secondary market trading

in life insurance products calls for verification of two issues,

namely, the legal permissibility of the trading in India and the

economic viability of the market. The legal aspects are

discussed in chapter 3 while the present chapter delves into the

economic viability of trading in life insurance products in

India.

The economics of trading in life insurance products

involves an array of issues ranging from the cash surrender

value calculation as a basis for pricing of tradable life

insurance to the effects of trading in life insurance on the

primary market, and on the facilitation of the life insurance

linked securities. Since the present study aims at discovering

the potential for the trading in India, it is focused on examining

the need for the market and viability of the market. Thus, the

present chapter attempts to answer two questions:

1. What would be the potential market size in India for the

secondary market trading in life insurance products?

2. Would the potential market be economically viable?

166

This chapter deals with the demand for and profitability of the

secondary market trade in life insurance products in India, as

these are the fundamental criteria for evolution, survival and

growth of any market. Section 5.1 explores the proxy variables

to estimate the potential demand for the secondary market

trading in India. Section 5.2 provides the regression analysis of

the data on surrender amount paid, and number of policies

surrendered, lapsed and withdrawn. Section 5.3 provides

analysis of demand for trading in life insurance based on

survey of the informal sector.

Section 5.4 examines the financial viability of trading in

life insurance based on the profitability analysis. Section 5.5

provides analysis of the profitability of trading in endowment

products verified with empirical examples. This model is

further developed to examine how the returns can be enhanced

under certain conditions.

Section 5.5 discusses a model incorporating the stochastic

factor of life expectancy, with the help of an empirical

example.

Section 5.6 tries to explore the potential for life insurance –

linked bonds.

The chapter is summarized in section 5.7.

167

5.1 What would be the potential market size in India?

The potential market size for the secondary market trading in

life insurance products is determined by the estimation of

demand for the product.

Demand here is defined as the demand by the life

insurance policyholders, for the service provided by secondary

market trading. The ‘demand for secondary market trade in life

insurance’ is the demand for ‘the service of providing money

in exchange of the life insurance policy’ offered and sellers are

the policyholders willing to sell their policy rights.

Box 5.1

Definition of demand and supply in secondary market of life

insurance products for the purpose of the study

Demand for secondary market trade Supply in the secondary

market

Demand for the service of providing Supply of the service of

providing

Liquid cash for policy transfer liquid cash against the policy

rights

Consumers in secondary market are Suppliers in the secondary

market are

Policyholders selling the policy rights Provider firms purchasing

the life Insurance products

168

5.1.1 Estimating potential demand for trading in life

Insurance-Empirical Analysis:

Given that the secondary market trading in India is an

innovative concept, no literature is available in public domain

in India in this regard. The literature from other countries

pertains primarily to viaticals (the trade in impaired policies)

and life settlements (trade in policies of the elderly above 65

years of age). Due to the above reasons, this study relies on

proxy variables to estimate the potential demand for secondary

market trading in life insurance products from policyholders’

perspective.

The following analysis aims at estimating the demand

for the trading in life insurance products in India given the

market environment in India.

Table 5.1 shows that in 2003, the total number of

policies surrendered was 10, 97,333.This can be an indicator of

the demand, on behalf of the policyholders, for withdrawing

from the contract in exchange of the cash value.

The surrender value of Rs.2566.66 crores paid by the

Life Insurance Corporation of India could be regarded as an

indicator of the potential turnover of the third party firms. The

number of policies forfeited shows the policies, which do not

fetch any surrender value for the policyholder.

The policies reinstated are the policies revived before

being total lapse. The data shows that Rs.5332 crores worth of

policies is lapsed after acquiring the paid up value in this year.

169

This data gives us an idea about the potential market in India at

a glimpse, followed by a more detailed analysis in the

subsequent discussion.

Table 5.1

Surrender statistics of LIC of India for the

year 2002-03

No. of surrenders 10,97,333

Total surrender value paid Rs.2566.66 crores

No. of policies forfeited 85,99,146

No. of policies reinstated 13,34,718

Sum assured of policies

lapsed after acquiring paid

up value

Rs.5332 crores

5.1.2 Proxy variables to estimate the potential market size:

There are two factors, which indicate the demand for

trading in life insurance in India. One is the trading volume in

the informal sector. Even though the trade does not exist

officially in India, selling life insurance policies for money

value by way of absolute assignment is a common practice in

the informal sector. (Box 5.2, Page-199)

Since it is an informal trade, statistics on turnover,

volume, or pricing (cash values offered for policy) is

170

unavailable. The efforts to interview the moneylenders were

failed because of the reluctance of the operators to provide

detailed answers. The observations of the survey of the

policyholders are provided in section 5.2.3.

Second set of proxy variables for demand for trading in

life insurance in India, is the volume and value of surrenders

and lapse policies over the years. The factors leading to

surrender and lapsation are the same as the factors that will

influence the decision of the policyholders regarding the

selling of his policies in exchange of a cash value. Since the

market is nonexistent in the formal sector, statistics on

surrender and lapse policies and surrender amount paid by the

insurer, serves as a proxy for the potential demand.

The study uses the statistics of Life Insurance

Corporation of India for forecasting the market demand. The

reason for selecting LIC of India to estimate the demand is that

LIC of India is operating in the life insurance sector for last

fifty years, for this reason, the data forms a reliable sample for

statistical analysis. Moreover, the LIC of India statistics

represents a wide product variety and a wider consumer base.

The private insurers have entered the market after 2000; hence,

their accumulated sale being smaller the volume of surrenders

is smaller. The statistics provided by the private insurers is

insufficient to get dependable results. The data on lapse and

surrender is available in the annual reports and valuation

reports of the LIC of India. This study is based on the annual

reports of LIC of India.

171

The variables used for indicating the potential demand for

trading life insurance are:

1. The number of policies surrendered, lapse/forfeited and

withdrawn-indicates the potential volume of demand for

trading in life insurance.

2. The surrender amount paid by the LIC of India per annum-

indicates the value of the potential market for trading.

The interpretation of these proxy variables for the secondary

market is as follows:

a) The number of policies surrendered: The life insurance is

surrendered when the policyholder does not want to continue

the contract of life insurance and submits the policy rights to

the insurer. The insurer pays the non-forfeiture value in this

case.

In annual reports, the number of policies surrendered is

calculated for the period of the given report that is the given

financial year. If it is assumed that the trading in life insurance

exists then the third party firms can offer the cash values for

these policies, which the policyholders no more want to

continue. Thus, the number of surrendered policies indicates

the volume of business for the third party firm.

It should be noted that:

• The number of surrendered policies does not depend on the

policies issued in the current year. The commonly applied lock

in period for the conventional life insurance products is three

years. Hence, the policies surrendered are from the cumulative

172

pool of all the policies issued at least three years earlier to the

year of the report.

• Some policies are not absolutely assignable e g. Children’s

plans of LIC of India, policies on joint life. These might be

included in the data on total surrender, lapse and withdrawn.

However, for the lack of detailed information these non-

assignable policies cannot be excluded. However, it has a

negligible effect on the estimates about the market size, as the

proportion of these non-transferable policies in total pool is

insignificant.

b) The number of the policies lapse or forfeited: The lapse

policy of LIC of India indicates non-payment of the premium

(even after the grace period). After the date of commencement

of the policy if the premiums are paid for three consecutive

years, then the policy acquires paid up value. That is the policy

remains in the books of the insurer and the paid up value (Sum

assured *No. of premiums paid /the term) is paid to the

policyholder at the time of maturity or claim. If the premiums

are not paid for three years then the policy is regarded as

forfeited and does not acquire the paid up value. The

forfeitures indicate the policies that are withdrawn before

acquiring the non-forfeiture value. The premium payment is

discontinued before the three years lock-in period for these

policies. However, in some cases the lock in period varies

between two years to one year. The lapse policies are defined

173

as the policies, which have acquired the surrender value or the

non-forfeiture value.

The surrender is just one component of the demand for

trading in life insurance. The number of lapsed policies is also

important because it indicates the inability to continue the

policy.

As revealed by the survey of international markets, the

competition among the trading firms leads to a greater number

of well-informed policyholders and possibility of tapping of

these policies by the trading firm before these are forfeited. We

aim at detecting the need of the policyholders to withdraw

from the policy hence; the inclusion of forfeitures is necessary.

c) The surrender amount paid by the LIC of India per

annum is published in the revenue account outgo of the LIC of

India balancesheet.This amount projects the potential turnover

of the secondary market in terms of amount of cash value paid.

5.1.3 Period of the Study:

The data for surrender and lapsation is from the annual

reports of the life insurance Corporation of India. The data is

available in annual reports since incorporation of the LIC of

India in 1956; however, the data from 1963 is used for the

analysis. Before 1963, the data pertains to the calendar year

(January to December) while the data after 1963 is for the

financial year (April to March).

174

The study of LIC of India Annual Reports shows certain

changes in the reports according to the IRDA rules, hence the

statistics on surrender value paid is not directly comparable

after the year 2001 and the explicit comparable data on

surrender and lapse policies is not available in the annual

reports after 2003.

Therefore, the period for the regression analysis on

number of policies surrendered, lapsed/forfeited, and total

withdrawn is restricted from 1964 to 2003 while the period of

analysis on surrender value paid is restricted from 1964 to the

year 2001.

Another reason for restricting the analysis to the period

until 2003 is that, after this year the surrenders reflect the

impact of ULIPs. Implications and the effect of ULIP

surrenders are not comparable with the surrender of the

conventional non-ULIP products. Apart from the life insurance

cover, Unit Linked Plans (ULIPs) have a portion of units,

which can be surrendered at the net asset value any time after

the lock-in period. Sometimes schemes like New Fund Option

are also devised, which allow the policyholder surrender of

the units of earlier ULIP to purchase a newly launched ULIP

.Please refer to Annexure 5.1 for a detailed comment on ULIPs

and Trading.

Table no. 5.2 shows the trends in number of policies

surrendered, number of policies lapsed and number of policies

withdrawn during the year for the period 1963 to 2003.

175

This data is derived from the Annual Reports of LIC of India

for respective years.

Table 5.2

Number of Policies Surrendered, lapsed or forfeited and

total withdrawn21 Year(ended on

31 March)

By Surrender of

Policy(Number)

By Forfeiture or

Lapse(Number)

Total Number

Withdrawn

1963 58818 708346 767164

1964 53991 660130 714121

1965 70102 675898 746000

1966 57753 672870 730623

1967 67733 674659 742392

1968 71883 540578 612461

1969 81901 526829 608730

1970 96487 508214 604701

1971 108730 453828 562558

1972 127983 462754 590737

1973 154940 536411 691351

1974 135124 559326 694450

1975 162256 589057 751313

1976 237547 625705 863252

1977 341175 764670 1105845

1978 305692 786519 1092211

1979 250348 699327 949675

1980 240494 616386 856880

1981 214747 625627 840374

1982 208847 657526 866373

21 Annual Report ,(1956 to 2006-07)LIC of India, Appendix III Statement 2,Form DDD

176

Table 5.2 (Contd.)

Number of policies surrendered, lapsed or forfeited and

total Withdrawn

(Source: Annual Reports, LIC of India, 1963 to 2003)

Year(ended on

31 March)

By Surrender of

Policy(Number)

By Forfeiture or

Lapse(Number)

Total Number

Surrendered and Lapse

1983 229238 744422 973660

1984 246866 783435 1030301

1987 286817 1113154 1399971

1988 299795 1382877 1682672

1989 242807 1493189 1735996

1990 208452 1922586 2131038

1991 201314 2376881 2578195

1992 205489 2826442 3031931

1993 256516 3316749 3573265

1994 287529 3903274 4190803

1995 316906 4422319 4739225

1996 307324 4419079 4726403

1997 384617 4369474 4754091

1998 518753 4790887 5309640

1999 662769 5503132 6165901

2000 821807 6047770 6869577

2001 863895 6499525 7363420

2002 922811 7520968 8443779

2003 1097333 8599146 9696479

177

The percentage of surrender and lapse /forfeited policies to the

total number of policies issued by LIC of India has remained

more or less constant over the years. The following chart

shows the percentage of withdrawals through surrender and

lapse/forfeited policies to total issued during 2003.

Figure 5.1

Share of surrendered & lapse/forfeited policies in the total

policies issued for 2003

Share of Number surrendered,lapse&forfeited in Total Issued in 2003

1% 5%

94%

The percentage of surrenders and lapse or forfeiture has not

been alarming in case of LIC of India. Nevertheless, looked at

from a potential third party firm’s perspective the potential

market size for their business is lucrative in absolute numbers.

The market size for the trading in life insurance is concerned

more with the reservoir of policies lapsed and surrendered over

the years in absolute numbers shown in the Table no.1 above;

rather than the percentage of surrender and lapsation.

178

Figure 5.2 Number of policies Withdrawn during

1963 to 2003

Above chart shows the trends in number of policies

surrendered, number of policies lapsed or forfeited, and

number of policies withdrawn for the period 1963 to 2003.The

chart (Figure 5.2) shows an exponentially increasing trend of

the number of policies surrendered as well as lapse or forfeited

during year since 1985.

The exponential increase in the variables is justified by

the fact that the number of policies surrendered, lapse

/forfeited or withdrawn is the function of the cumulative

number of policies issued. The data of surrender pertains to the

surrenders during the year however these surrenders are not

from the policies issued in that year .Due to the lock- in period

of three years the surrenders are related to the policies issued

at least three years prior to that year. For example, the

surrenders in 2003 are not from the policies issued in 2003,

2002 or 2001.Generally, the policies issued up to 2000 can be

surrendered in 2003.

179

Similarly, lapse or forfeited policies are not necessarily from

the current year alone, the lapse /forfeiture measured in the

current year is fallout from earlier years’ cumulative number of

policies.

5.2 Log Linear Regression analysis:

This study attempts to estimate the potential demand for the

secondary market trading in life insurance products in India,

based on the log linear regression. The regression is fitted on

the natural logs of the series separately. The series used for

estimating the potential demand are the number of surrenders

{y1}, the number of lapsed or forfeited policies {y2}, and the

total number of surrendered and lapsed, i.e. the number of

policies withdrawn {y3} to indicate the volume of the potential

business. In addition to this we also run the regression on the

surrender amount paid per annum {vt}, to estimate the value of

business turnover.

180

5.2.1 Regression on Natural Log of Number of Policies

Surrendered (y1)

Following Chart shows the log linear regression line fit on Log

of Number of policies surrendered (y1).

Figure 5.3

Regression on natural log of number of policies

surrendered (y1)

The analysis of regression on y1 shows following results:

Ln( y1 )=0.0569 t – 100.432

t value for β1 =12.18521(0.000)

R2 =0.80057

181

5.2.2: Regression on Natural log of Number of Policies

Lapse/Forfeited


of Number of policies forfeited /Lapse (y2).

Figure 5. 4

Regression on natural log of number of Policies

Lapse/Forfeited

The analysis of regression on y2 shows following results:

Ln( y2)=0.078 t –140.582

t value for β1 = 14.96127(0.000)

R2 =0.85815

182

5.2.3 Regression on Natural Log of Total Number of

policies withdrawn


of Total Number of policies withdrawn (y3).

Figure 5.5

Regression on natural log of Total number of policies

withdrawn

Analysis of regression on y3 shows following results:

Ln ( y3)=0.0733 t –130.66

t value for β1 = 19.6548(0.000)

R2 =0.9126

183

5.2.4 Analysis of surrender value paid by LIC of India:

The analysis of Number of policies withdrawn,

lapse/forfeited and surrendered helps to estimate the potential

volume of business for the third party firms.

The analysis of surrender value paid by LIC of India for

each year can be considered as the proxy for the value of

potential business of the third party firm,in terms of cash value

paid to the policyholders.

Table 5.3

Surrender amount paid

( including surrenders of bonuses less reinsurance) Years Rs.Lacs

1964 437.96

1965 548.98

1966 512.11

1967 602.48

1968 670.99

1969 742.15

1970 869.14

1971 1059.98

1972 1285.56

1973 1859.44

1974 1490.74

1975 2484.99

1976 3104.84

1977 4917.75

1978 4930.47

184

Table 5.3 (Contd.)

Surrender Amount Paid

(including surrenders of bonuses less reinsurance)

Years Rs.Lacs

1979 4462.12

1980 4736.80

1981 4809.32

1982 5732.62

1983 7748.94

1984 8314.04

1985 9237.05

1986 11582.01

1987 13166.92

1988 14251.76

1989 13144.63

1990 15127.88

1991 12947.12

1992 16963.15

1993 72160.31

1994 34130.28

1995 38316.07

1996 46355.35

1997 56142.88

1998 75738.01

1999 101370.14

2000 130018.03

2001 169839.31

(Source: LIC of India Annual Reports, 1964-2001)

185

The regression analysis of the surrender value paid by the LIC

of India per year for the period 1964 to 2001 , can assist in

broadly giving an idea about the value of potential turnover of

the firms in terms of surrender value paid to the policyholders.

The comparable data on the surrender value paid is

available only for the period of 38 years from 1964 to

2001.This leaves 38 observations to apply the models.

The following diagram shows the trend in surrender

amount paid per year by LIC of India during 1964 to 2001.

Figure 5.6

Trend in Surrender Value paid per annum by

LIC of India 1964-2001

(Source: LIC of India Annual Reports, 1964-2001)

Above chart shows, the surrender amount paid per annum by

Life Insurance Corporation of India during 1964 to 2001.The

186

series is exponentially rising with a sharp rise for 1993, then a

sharp fall in 1994 and then the continuous rise at exponential

rate.

The series is first log transformed to get the natural logs

for each year.

Then the linear regression is applied by regressing t on

surrender amount paid that is Ln (vt).

5.2.5 Log linear Regression on the Surrender value/amount

paid by LIC per annum:

• This analysis is attempted with the limited objective of

finding out only a broad estimate of future surrender

value .It is admitted that this analysis does not claim to

estimate the actual future surrender value payments

accurately.

• The analysis is subject to the changes in life insurance

market, the product design, as well as external factors

like economic environment. E.g. with the introduction of

ULIPs the surrender value paid has acquired a totally

new dimension.

Nevertheless, the analysis serves the purpose of giving a

broad idea of the market potential for the trading firms in

form of the potential business, in terms of the cash value

paid.

187

The following chart shows the Log Linear Regression line

fitted on the series (vt).

Figure 5.7

Regression on natural log of surrender value paid

(Based on LIC of India Annual Reports, 1964-2001)

Analysis of regression on vt shows following results:

Ln ( vt)=0.1527 t –282.49

t value for β1 = 36.6739(0.000)

R2 =0.9746

Ln(Vt)= 0.1527 t- 282.49R 2 = 0.9746

0

5

10

15

20

25

30

1964 1974 1984 1994 2004 2014Years

Ln(Vt)

188

Table 5.4

Summary of the Log Linear Regression Analysis:

Series β0 β1 t value for β1

(p value) R2

No. of policies

Surrendered {y1}

-100.43

0.0569

12.18521(0.000)

0.80057

No. of policies

Lapse/forfeited

{y2}

-140.58

0.078

14.96127(0.000)

0.85815

No. of policies

withdrawn {y3 } -130.66 0.0733

19.6548(0.000)

0.9126

Surrender amount

paid {vt} -282.49 0.1527

36.6739(0.000)

0.9746

Business Projections based on above analysis:

Following Table 5.5 shows the business projections for

the secondary market in life insurance products. These

estimates are for eight years until the year 2012.The estimates

are based on the log linear regression analysis with confidence

interval of 95% on either side, subject to the reliability

estimates given in the Table 5.4 above.

189

Table 5.5

Business Projections for the Secondary Market Trading in

Life Insurance Products

Years

Number of

surrenders

Number of

Policies

Lapse/forfeited

Number of total

policies

withdrawn

Surrender

amount paid

per

annum(Rs,

Lacs)

2004 802590.6 6797055 11219905 164041.4691

2005 849582.2 7348450 12073216 191104.2816

2006 899325.2 7944576 12991424 222631.7934

2007 951980.7 8589061 13979465 259360.5701

2008 1007719 9285829 15042649 302148.6927

2009 1066721 10039120 16186692 351995.8043

2010 1129177 10853520 17417744 410066.4649

2011 1195291 11733986 18742421 477717.3579

2012 1265275 12685878 20167844 556528.9862

Above analysis is subject to the general limitations of the

regression analysis as well as the limitations of the proxy

variables.

• The analysis involves proxy variables for estimating the

demand for trading in life insurance .The criteria for

selection of these proxy variables are that these variables

should express the need on behalf of the policyholder to

exchange the policy for liquid cash (translated into

190

surrenders) and inability to continue the policy contract

(translated into lapse/forfeiture).

• These variables are fallout of cumulative number of

policies issued and the sum assured of policies sold over

a long period.

• The number of surrenders can be a direct representative

of demand for trading as the policy is actually

exchanged for the cash (except for the negligible amount

of non-transferable policies). However, the number of

lapse /forfeited includes a portion of forfeited policies

which are not viable for trading.

• The market conditions may change due to the change in

market structure, introduction of new products and

Government regulations. The projections are subject to

these changes.

5.3. Demand in the informal sector:

Another facet of estimation of demand for trading in life

insurance policies is the trading already existing in the

informal sector. The quantification of volume of this business

is very difficult. Nevertheless, a field survey of policyholders

was conducted to collect information on the lapsation and

surrender or sale of their policies.

191

5.3.1 Methodology:

The field survey proved to be challenging because:

• The empirical study of this aspect is not available in the

public domain except for the study from National

Insurance Academy (Balachandran, D’Mello, 1986).

• Since the list of withdrawing policyholders was not

made available from the insurance companies, it proved

practically difficult to identify the people with lapsed or

surrendered policies.

• Even though certain individuals and moneylenders were

detected to run the business of lending/giving money in

exchange of life insurance policies, the interviews or the

concrete proofs cannot be presented for the obvious

reasons.

Since the list of the target policyholders with lapsed or

surrendered policies was not available, the sample was selected

from a door-to-door survey of 1057 policyholders. Out of

these, we could identify 260 cases of lapsation and 25 cases of

surrender. These are from various urban, semi-urban, and rural

areas (in and around Pune, Ahmednagar, Solapur, Nanded,

Baramati, Dhule, Ratnagiri) in Maharashtra.

192

Two separate questionnaires are formulated for interviewing

policyholders with lapsed and surrendered policies

respectively22.

This survey gives a broad idea about the need of

liquidity and requirement of institutionalized arrangement in

this business. Nevertheless, the results should be treated as

exploratory findings and more work needs to be done in this

area.

5.3.2. Results of the survey 23:

a) Survey of policyholders with lapsed policies:

1. Profile of the policyholders:

• Out of 260 policyholders with lapsed policies,

36% were graduate and above level while 10 .38%

were uneducated.

• Income level: 37% had income lower than

Rs.60000 per year, 46.15% were between the

income range of Rs.60000 to Rs.1, 60,000 while

about 14% were with income above Rs.1, 60,000

per annum.2.69 % had no own income.

• Occupation: 20 % are salaried class,24%are

professionals,14% are entrepreneurs, while 40 %

22 Please refer to Annexure 5.3 for the questionnaires and Annexure 5.4 for the tabulation results. 23 Some percentage figures do not total to 100 because of non-respondents.

193

are agriculturists, 2% having other sources of

income.

• Number of dependents: approximately 80 % have

four or more dependents.

2. Purchase of Life Insurance:

• Decision to purchase insurance: about 25% say that

they have made their own decision while more than

60 % have made the decision by an insurance agent’s

consultancy.

• Purpose of buying life insurance: About 57% state

the sole reason for purchasing life insurance as

savings, while 27% state it as saving and security.

Only 14.61% purchase life insurance only for getting

insurance cover.

3. Reason for lapsation:

• 40% say that the policy is lapsed because they cannot

afford to continue it any more. 36% state that their

policy is lapsed because of their ignorance to pay

premiums, while 11.53% say that they do not think it

worthwhile to continue.

• Around 80 % said that there was a follow up from

life insurance agent or company to continue the

policy.

• 66 % think that there was a loss due to lapsation.

4. Life insurance vis a vis other financial assets:

194

• Approximately 50% of the surveyed had other

financial assets.

• Only 1.54% had liquidated assets other than life

insurance in past one year.

5. Revival: Around 61% said that they wanted to revive the

policy.

b) Survey of the policyholders who have surrendered their

policies :

1. Profile of the policyholders:

• Out of 25 policyholders who had surrendered their

policies, 28 % were graduate & above level while

24% were uneducated.

• Income level: 32% were below Rs.60, 000 per annum

level. 56% earned income between Rs.60,000 to

Rs.1,60,000.

• Source of income: 56% were salaried, 4%

professional, 12 % were entrepreneurs,32 % were

agriculturists, while the remaining had other income

sources.

• Number of dependents: 88 % had number of

dependents four and above.

195

2. Purchase of Life Insurance:

• Purchase of life insurance: 20% had made the

decision to purchase life insurance on their own, 64%

made the decision with an agent’s consultation.

• 48 % of the surveyed purchased life insurance with

the sole purpose of saving.

• 28 % purchased it for savings as well as security

purpose.24 % stated that they purchased it for the

insurance cover purpose.

• 56 % of these surrendering policyholders say that the

policy has not served the purpose they had in mind.

3. Reason for surrender:

• 64 % state that the reason for surrendering the policy

is the need for cash.

• 12 % say they could not afford to pay the premiums

while 20 % wanted money for some other purpose.

4. Use of surrender proceeds:

• 20% have used the surrender money for normal

household expense.

• 24 % have used it to purchase other assets 16 % have

used it to purchase life insurance out of which half have

shifted to other company’s products.

• 32% of the surveyed cases have used the money for

some special occasion like daughter’s wedding.

196

5. Decision to surrender influenced by:

• In 32% of the cases the decision to surrender is made

independently.

• In 44% cases it is made in consultation with the agent

and in remaining 20 % cases it is made with consultation

of friends.

6. Proportion of surrender with the life insurer:

• In 36% cases the policy is surrendered to the life insurer.

Out of the remaining 64 %, 8% state clearly that they

have surrendered with a local person, while 52% say that

they have surrendered at some other place than the life

insurer, 4% deny answering the question.

• Out of the surveyed cases 32% do not own any other

financial asset. However, none records to have

liquidated any other financial asset in the last one year.

5.3.3 Observations based on the Survey of policyholders:

The following observations are drawn from the field survey.

1. The incidence of lapse and surrender is not restricted to

any particular economic class, occupation .It is

observed in case of financial crisis or liquidity crunch.

2. The policies are absolutely assigned in favor of the

moneylenders for loans or cash value.

3. Initially, a loan amount is given which is invariably

lower than the cash value of the policy. The

197

policyholder agrees to mortgage the policy in hope of

repaying the loan but fail to repay in case of 99% of

the policies.

4. The clandestine market is prevalent and popular in

semi-urban industrial areas and newly developed

suburban areas. People especially in urban areas are

weary of clearly talking about the transactions in the

informal market. They categorically refused to reveal

the amount received in exchange of the policies and

also denied giving the contact of the purchaser.

5. Most of the times the seller policyholder is hesitant to

contact the office of the insurer as the policy is

purchased from an agent who is familiar and provides

a service at the doorstep, these policyholders are

unfamiliar with the offices and are reluctant to

approach the office of the insurer for surrender. In

most cases of lapsation the policyholders were ignorant

about the surrender or paid up clause, and were

enthusiastically enquiring many issues about life

insurance with the investigator.

6. In case of urban, small business class or shopkeepers,

the policies are purchased for tax rebate purpose and

the policyholders are least concerned about the

premiums and other benefits once the tax saving

purpose is served for that year.

198

Box 5.2

The trade in informal sector Scanned advertisements in local

newspapers

199

5.4 Financial viability of trading in Life insurance in

India:

The profitability analysis of secondary market trading in life

insurance in India is subject to two important constraints:

• The formal market is non-existent; hence, the reliable

data is unavailable.

• The market for life insurance in India would be

completely guided by the primary market conditions

in India, which are different from those existing in

USA, UK, Canada, or Singapore. Hence, the viability

of trading in India cannot be examined with the help

of the literature pertaining to other countries.

5.4.1 Profile of the primary life insurance market in India:

In India, life insurance is demanded more for the

purpose of tax saving and income yielding and less for pure

risk cover. This attitude leads to a product mix that is more

inclined toward the endowment and money back plans in

conventional insurance and ULIPs in new scenario24 rather

than the term and whole life plans. This fact has a direct

implication for the potential secondary market for the life

insurance products. The classification of the secondary market

24Discussion on ULIPs and the trading is provided in Annexure5.1.

200

trading mentioned in the first chapter is significant for the

Indian market.

Types of Secondary Market Trading

Viaticals Life Settlement Tradable Endowment

Impaired Whole life policy Whole life policy Endowment policy

This study focuses on the trade in endowment products

because of the following reasons:

• The percentage of whole life policies is less in India

although there is a large reservoir of lapsed

endowment products. To quote Parchure and Joshi

(2003),” Of course, all this is still in stark contrast

with the experience of the developing world where

traditional endowment assurance and money back

plans do more than 85% of life insurance business

and commercial pensions markets hardly exist. Only

some of the trends that have firmly manifested in the

developed countries will show themselves up in the

developing countries, most notably a rise in financial

markets’ volatility and fierce competition in the life

insurance market place. This is bound to impact

product design from the supply side. But from the

demand side the response is likely to be slow on

account of the slow progress on the growth of income

/ wealth and life expectancy. It may be conjectured

201

that it will largely result in finer market segmentation

with pure term assurance and/or unit linked plans

being sold to high income sections and traditional

plans continuing amongst the middle and low income

sections”. These primary insurance market trends are

crucial for the potential market for trading in life

insurance.

• The bequest motive is dominant in India as

compared to the western countries. Due to the

cultural factors, those with in-force whole life

policies are generally reluctant to sell the policy due

to strong bequest motive. The market for life

settlement products is significant in all other

countries where the trading exists but it would be less

significant in India.

• The resistance to trade in whole life products might

be high at least initially, due to moral issues since in

this case the benefit is only the death benefit, which

is acquired by the third party firms.

5.4.2 Potential Market Structure:

The following diagram exhibits the broad structure of

the potential market. The network of Third party firms,

202

investors, agents/brokers, would operate in between the

policyholders willing to sell their policies and the insurers.

Structure of the Potential secondary market trading in

life insurance in India

Returns Funds

policies

Commission

Cash value

Policy rights

Premiums Benefits

The viability of the market in terms of returns on

investment is discussed primarily from the perspective of the

provider firms. The potential market structure of the trading

business is supposed to be competitive with a large number of

firms acting as purchasers of policies as well as a large number

of sellers of the policies. In this case, the policyholders can

bargain for a better cash value. This type of market also may

lead to elimination of external and internal diseconomies of

scale and lower transaction costs.

Policyholder willing to

exchange policy rights for cash

Brokers/ Agents

Third Party

Trading Firms

(Providers)

Insurers

Investors

203

5.4.3 Basic model providing profitability condition:

Initially an elementary model is developed based on

empirical examples of life insurance products of LIC of India.

The assumptions of the model are,

a. The level annual premium products for endowment plans

are considered.

b. The provider pays cash value equal to the surrender

value. ( Box 5.3, page- 205)

c. Other parameters like taxes are excluded.

e. The death benefits are not considered since the focus of

this model is on the trade in endowment products.

This is a simple generalised model for level annual

premium endowment product. This formulation has a great

significance for the potential market because it provides an

estimate of profitability without including the death claim

.The returns are derived purely on the basis of calculated

financial returns at the maturity irrespective of the mortality

asumptions.

204

Box 5.3

Surrender Value: minimum benchmark price

In the presence of secondary market for life insurance products

the cash surrender value offered by the insurer serves as the

minimum benchmark price for the given product. The cash

surrender value is the amount made available, contractually, to

represent policyholder who is terminating his or her protection.

This value is intended to represent the pro-rata share of the

amount accumulated on behalf of the particular block of

policies from which the policyholder is withdrawing. The cash surrender value or Present Value of _ Present Value of

Non Forfeiture value = Future Benefits Future Adjusted

premiums

In view of the competition in the market for trading

in life insurance products the third party firms have to offer

competitive cash values for viable policies. This is the major

component of the total costs for third party firms.

The third party trading firms’ costs are determined by,

A. The Price of the tradable Endowment Product: The

pricing of tradable endowment product is determined by

the cash surrender value paid by the insurer. This value

can serve as a floor limit for the cash value offered by

the secondary market providers. If the value offered by

the provider is less than the surrender value, the

policyholder/seller has an option to surrender the policy

to the insurer.

205

B. The transaction costs of all kind like

1. Costs of procurement, and servicing

2. Administrative Costs of transfer

3. Present value of future premium payments

4. Revival amount if applicable

5. Costs of collecting funds/investors25.

The paid –up value is determined by the sum assured

plus the bonus accrued the number of premiums paid and the

term of the policy.

V= [(S.A. x Np /T) + Bonus Accrued ]

Where, V=paid-up value

S.A.=sum assured

Np =Number of years of premium payment

T= Term to maturity

Surrender value(Vs) is a proportion of paid-up value

Vs=λ (V) Where , λ = Surrender factor

25 The fixed costs are not considered here. These costs are minimized with the expansion of business and institutionalization of the market.

206

Cost to the trading firm can be given by

C=(Vs+R) /(1+ r)T-Np + Σ P/(1+r)N-Np +α

Where, C=present value of the total cost to the trading firm

R = Revival amount

P= Installment Premium

α = administrative, procurement and transfer costs

N=Premium paying Term T=Term to maturity

Np = Number of premiums paid by the policyholder

The earnings of the trading firm are determined by the

policy benefits like sum assured, bonus (Final additional

bonus, Loyalty benefit),’money back payments’ in certain

cases.

Earnings of the Trading firm can be given by

Ε = [S.A. + (β S.A.)*T]/(1+r)T

E =Present value of earnings

β = bonus rate26 /1000

The firm will be looking for, r such that,

(Vs+R) /(1+ r)T-Np + Σ P/(1+r)N-Np+ α = [S.A. + (β S.A.)*T ]

/(1+r)T

Or

0=(Vs+R) /(1+ r)T-Np + Σ P/(1+r)N-Np+ α - [S.A. + (β S.A.)*T ]

/ (1+r)T

26 Bonus is offered on with –profits policies. The bonus depends primarily on the insurer’s surplus and profits. On some conventional plans LIC offered guaranteed rate of bonus.

207

5.5 Empirical study of financial viability:

The following analysis applies the above simple model

to actual policies of LIC of India. The names of the

policyholders and policy numbers are kept confidential for the

obvious reasons but the real policy data is used. These

examples illustrate the profits which can be generated if the

trade takes place in these policies.

Methodology:

Step 1 computing the benefits:

The Simple model shows the returns based purely on the

financial, investment related element of the life insurance

product.

Assumptions:

1) For the sake of simplicity IRR is calculated based on yearly

compounding in all cases including the cases with monthly,

half-yearly or quarterly premiums.

2) The Visual Magic software for LIC of India products, is

used for calculations. Hence, the assumptions of this software

are applied for e.g. current and final additional bonus rates are

assumed to remain constant till the term to maturity.

208

Box 5.4

Why IRR?

IRR as compared to the other financial return criteria is useful

in those cases where the proceeds of the investment can be

repeatedly reinvested in the same type of project but scaled in

size.

It makes sense to select the project with the highest IRR to

achieve the greatest growth of capital.

For NPV criterion, the selection of rate of interest used for

calculation makes the analysis difficult especially for a novel

product like TEP, which displays a peculiar risk return

composition.

Step 2: Estimation of the costs:

The difficulty in measuring the costs arises due to following

reasons.

1. The institutionalized market does not exist. The costs in the

informal sector are not representative of the formal sector costs

and not disclosed by the moneylenders and operators in this

market.

2. The experience of the third party firm in India (Chapter

209

6) shows that the firm incurs the following costs,

• Procurement Costs-to tap the sellers of the policies

• Processing costs- to verify the profitability providing

surrender values, preparing papers of assignment

• Servicing costs- paying premiums, revival amounts

• Marketing costs- to tap the investors.

• Capital costs –determined by the debt equity leverage

ratio27

• Fixed costs.

It is extremely difficult to provide actual estimates of

these costs on a percentage basis or per policy average cost

basis because empirical data is not available, even for the

business in organized markets in other countries.

The administrative costs will be varying according to;

• The number of policies purchased

• The surrender value per policy

• The number of times the policy is traded.

The standard accounting assumption of administrative

cost of 2% of the gross returns (defined as the difference

between the policy costs and the total benefits earned) can be

accepted for estimating the profitability. However, these costs

27 The nature of third party trading firm may be similar to that of a non-deposit taking NBFC. The matter of stipulating debt equity leverage norms for NBFCs is under consideration.(RBI,2006) Hence, a debt equity ratio range of 5:95 to 10:90 can be assumed.

210

are applicable to the overall enterprise and not to a particular

policy.

For example, the estimation of profitability based on the

administrative cost of 2% for a particular policy giving 12 %

gross returns after 5 years is fundamentally different than an

administrative cost of 2% calculated for the entire business of

Rs.2 crores over the year.

The administrative costs of a third party trading firm are

better described by the later method of spreading the costs over

the entire business volume rather than applying the

administrative costs to each specific transaction. For this

reason the individual examples worked below do not include

the transactions or administrative costs. We have included the

actual policy purchase costs of surrender value paid, revival

amount paid and the premiums in the working of the examples.

Step 3: The Viability of Investment:

The viability of investment or business is determined by the

comparison of the IRR with the alternatives available in the

market. For the sake of giving a broad idea about the viability

the IRR, net of the administrative costs can be compared with

the Term Deposits of nationalized banks with a comparable

term.

This method is simplistic method of estimating the

viability of this business because the viability of the business is

not determined by the return on a single policy but it depends

on the blocks of policies and their saleable value. The literature

211

in the other countries also highlights that the transaction costs

of this business are high however the business is thriving and

is believed to be profitable. The case study of the third party

firm in India revealed that the transaction costs are high still

the net returns for the firm can be around 12 % to 15% for the

endowment products (without including the death benefit).

The trading in life insurance products is a novel

financial instrument. It is difficult to compare the risk return

spectrum of this instrument, with any other financial

instrument in the market because the sovereign guarantee to

the Life Insurance Corporation of India and a portion of

guaranteed returns in form of guaranteed bonus renders this

instrument a near risk-less asset28.

Numerical illustrations of the simple model :

1. The policy costs include the cash value equal to the

surrender value quoted by the insurer, revival amount,

and future premiums.

2. The benefit includes the sum assured, Vested and future

as well as final additional bonus.

3. These examples show the return in the basic simple

model without considering any alterations in the policy.

28 It should be noted that, the returns are subject to the market dynamics. The effects of market changes on financial conditions and returns is uncertain .The change can decrease the return or increase the return. For example, in 2001, LIC of India announced that the bonus would accrue on the policy every three years instead of every five years. The trading firms could have benefited from this change.

212

4. The return also excludes the assumption of mortality

factor and death benefit. The return is purely based on

maturity claim.

5. The commonly used abbreviations are,

Pl-PPT-T=Plan number –premium paying term –term to

maturity

DOC =Date of Commencement,

SA=Sum assured,

SV=surrender value,

FUP=First unpaid premium,

DOP=Date of Purchase of the policy by the trading firm

213

EXAMPLE NO 1

14-15-15

SA=Rs.25000 DOP-27/05/2003

SV=Rs.27149 DOC-28/10/1991

Premium=Rs.177 monthly FUP-28/10/2002

Revival amount=Rs.1276 Paid up value=Rs.36633

Maturity amount=Rs.49375

Years Details Paid-up

Description Details Cash Flow (Rs.)

2003 SV -27149

SV+Revivalamount+5 monthly Premiums till Sept 2003 +12 monthly premiums for Oct2003to Sept 2004

-27149 -1276

-(5*177) -(12*177)

-31434

2004 0

12 monthly premiums for Oct2004to Sept 2005 2124 -2124

2005 0

12 monthly premiums for Oct2005to Sept 2006 2124 -2124

2006 Paid up value 36633 Maturity amount 49375 49375

10.50% IRR 12.14%

214

EXAMPLE NO 2 Plan Term PPT-112-15-08

SA=Rs.500000 DOP-12/06/2003

SV=Rs.140130 DOC-28/03/1998

Premium=Rs.14856 Quarterly FUP-28/09/2001

Revival amount=Rs.115372 Maturity amount=Rs.1187500

Paidup value=Rs.331250

Years Details Paid-up Description Details (Rs.)

Cash Flow (Rs.)

2003 SV -140130

SV+ Revival amount+2Quarterly premiums for 2002-03

140130+115372 + (2*14856) -285214

2004 0

4 quaterly premiums for 2003-04 (4*14856) -59424

2005 0

4 quaterly premiums for 2004-05 (4*14856) -59424

2006 0 0 02007 0 0 02008 0 0 02009 0 0 02010 0 0 02011 0 0 02012 0 0 0

2013 Paid up value 331250 1187500 1187500

IRR 8.98% IRR 11.90%

215

EXAMPLE NO 3 Plan Term PPT -75-20-20

SA=Rs.15000 DOP-30/06/2003

SV=Rs.7788 DOC-28/10/1990

Premium=Rs.107/Month FUP-28/01/2003


Maturity amount=Rs.23400 SB due in 2005 at 20% of SA Years Details Paid-up Description Details (Rs.) Cash

Flow (Rs.)

2004 SV -7788 SV +Revival+ 4 Mnthly Premiums till Oct 2003+ 12 premiums for Oct 2003 to Sept 2004

7788+654+(4*107)+(12*107) =

-10154

2005 0 SB-12 monthly premiums for Oct.2004 to sept 2005

3000-(12*107) = 1716

2006 0 12 Monthly premiums for Oct 2005-06

12*107= -1284

2007 0 12 Monthly premiums for Oct.2006-07

12*107= -1284


12*107= -1284


12*107= -1284

2010 Paid up value

14213 Maturity amount 23400= 23400

IRR 10.55%

IRR 11.55%

216

EXAMPLE NO 4 Plan Term PPT- 75-20-20

SA=Rs.15000 DOP-30/06/2003

SV=Rs.6650 DOC-28/10/1990

Premium=Rs.85.40/Month FUP-28/01/2003


Year Detail Paid-up Description Details (Rs.) Cash Flow (Rs.)

2003 Sv -6650 SV+Revival+3 monthly premiums till Oct. 2003

6650+765+ (3*85.4) -7671.2

2004 0 12 monthly premiums for Oct. 2003 to Sept. 2004 12*85.4 -1024.8

2005 0 SB-12 monthly premiums for Oct. 2004 to Sept. 2005

3000 -12*85.4 1975.2





2010

Paid up value 14213 Maturity amount 23250 23250

IRR 8.97% IRR 13.89%

217

EXAMPLE NO.5

Plan Term PPT 14-15-15

SA=Rs.10000 DOP-23/07/2003

SV=Rs.9268 DOC-14/12/1991





Description Details (Rs.) Cash Flow (Rs.)

2003 SV -9268

SV+Revival+4 premiums till Nov.2003+12 premiums for Dec. 2003 to Nov. 2004

9268+2230+ (4*72)+(12*72) -12650

2004 0

12 monthly premiums for 2004-05 (12*72)=864 -864

2005 0

12 monthly premiums for 2005-06 (12*72)=864 -864

2006


10.50% 10.83%

218

EXAMPLE NO. 6


SA=Rs.25000 DOP-03/07/2003

SV=Rs.27665 DOC-01/08/2001

Premium=Rs.24100


Years Details (Rs.) Cash Flow

(Rs.)

2003 SV -27665

2004 0

2005 0

2006 Maturity amount 37591

IRR 10.76%

219

EXAMPLE NO. 7


SA=Rs.5000 DOP-03/07/2003

SV=Rs.9818 DOC-01/08/1980






2003 SV -9818

SV+3 monthly premiums for May,June,July 2003+12 mnthly premiums for Aug 2003 -July 2004

9818+(3*22) +(12*22) -10148

2004 0

12 Monthly Premiumsfor Aug.2004 to July 2005 264 -264

2005


IRR 7.28% IRR 14.28%

220

EXAMPLE NO. 8


SA=Rs.50000 DOC-15/04/1998

Premium=R.2351/HYLY DOP-05/12/2008

SV=Rs.22457 FUP-15/04/2005

Paid-up value=Rs.8500

maturity value=Rs.77500

Revival amnt.=Rs.21952

Years Details Paid-up Description Details (Rs.) Cash Flow (Rs.)

2008 sv -22457 SV+Revival-SB (22457+29952) -12500 -31909

2009 0 premium Hly*2 2*2351 -4702

2010 0 premium Hly*3 2*2351 -4702

2011 0 premium Hly*4 2*2351 -4702

2012 0 premium Hly*5 2*2351 -4702

2013paid up value 33000

Maturity amnt=40% SA+accr bonus+FAB 77500 77500

IRR 8.00% IRR 10.72%

221

EXAMPLE NO 9


SA=Rs.50000 DOP-05/12/2008

SV=Rs.30939 DOC-28/06/1997

Premium=Rs.211Monthly FUP-28/11/2008

Maturity amount=Rs.111650 Paidup value=Rs.60192

Years Details Paid-up Description Details (Rs.)

Cash Flow(Rs.)

2008 Sv -30939

SV+6monthly premiums till May

2009 30939+ (6*211) -32205

2009 0 12 monthly premiums

from 2009-2010 (12*211) -2532


2010-2011 (12*211) -2532


2011-2012 (12*211) -2532


2012-2013 (12*211) -2532


2013-2014 (12*211) -2532


2014-2015 (12*211) -2532


2015-2016 (12*211) -2532


2016-2017 (12*211) -2532

2017 Paid p Value 60192 Maturity Amount 111650 111650

IRR 7.67% IRR 10.50%

222

EXAMPLE NO 10

Plan-Term -PPT-88-20-20

SA=Rs.50000 DOC-28/03/1990

Annual Premium=Rs.2585 FUP-28/03/2003

SV=Rs.41181 DOP-28/03/2002


Years Details(Rs.) Cash

Flow(Rs.)

2002 SV -41181

2003 Premium -2585

2004 Premium -2585

2005 Premium -2585

2006 Premium -2585

2007 Premium -2585

2008 Premium -2585

2009 Premium -2585


IRR 10.19%

223

EXAMPLE NO 11


SA=Rs.20000 DOP-02/05/2003

SV=Rs.11517 DOC-28/09/1990

Premium=Rs.172monthly FUP-28/04/1998


Revival amount =Rs.14247

Comment : In this case ,the trading firm would prefer the paid

up value than policy engineering.

The return in the above examples ranges between

10.19% to 14.28%. However, all policies may not have such

return for the trading firm, the return varies according to each

policy depending upon the benefits offered, previous premiums

paid, revival amount number of years remaining till maturity.

Some more cases are devised below showing returns less

than 10%. Of course some policies might not be viable at all



2003 SV -11517

SV + Revival+premiums

for 5 month still Sept 2003-SB

11517+14247+ (5*172)-5000 -21452

2004 0

12 monthly premiums for

2004-05 (12*172) -2064

2005

Paid up

value 14266 Maturity amount 27240 27240 IRR 11.30% IRR 7.98%

224

for trading if the returns are too low, the trading firms have to

evaluate the viability.

Some illustrations of policies with lower returns:

EXAMPLE NO.12


SA=Rs.100000 DOP-25/04/2008

SV=Rs.24345 DOC-20/09/2001

Premium=Rs.7005 yearly FUP-20/09/2005


Revival amount =Rs.23505 Years Description Cash

Flow(Rs.) Description Details(Rs.) Cash

Flow(Rs.)

2008

SV -24345 SV+Revival amount+Pre

mium for 2008

24345+23505 +7005

-54855

2009 0 Premium 7005 -7005

2010 0 Premium 7005 -7005

2011 0

Premium 7005 -7005

2012 0 Premium 7005 -7005

2013 0 Premium 7005 -7005

2014 0

Premium 7005 -7005

2015 0 Premium 7005 -7005

2016 Paid up value

47567 Maturity amount

165800 165800

IRR 8.73% IRR 7.68%

225

EXAMPLE NO.13


SA=Rs.25000 DOP-17/07/2004

SV=Rs.10234 DOC-28/03/1995



Years Description Details Cash Flow(Rs.)

2003 SV+8 monthly premiums till Feb 2004 10234+ (8*135) -11314

2004 12 monthly premiums for Mar 04 to Feb 05 (12*135) -1620

2005 12 monthly premiums for Mar 05to Feb 06 (12*135) -1620





2010 12 monthly premiums for Mar 10o Feb 11 (12*135) -1620

2011 12 monthly premiums for Mar 11o Feb 12 (12*135) -1620

2012 12 monthly premiums for Mar 12 Feb 13 (12*135) -1620

2013 12 monthly premiums for Mar 13 to Feb 14 (12*135) -1620

2014 12 monthly premiums for Mar 14to Feb 15 (12*135) -1620 2015 Maturity amount 54825

54825

IRR 7.43%

226

EXAMPLE NO.14


SA=Rs.35000 DOP-03/05/2003

SV=Rs.26973 DOC-28/03/1993




Years Description Cash Flow(Rs.)

Description Details Cash Flow(Rs.)

2003 SV -26973 SV +Revival amount+10monthly premiums till Feb 04

26973-4381-(10*259)

-33944

2004 0 12 monthly premiums for Mar04-Feb 05

(12*259) -3108

2005 0 12 monthly premiums for Mar 05-Feb 06

(12*259) -3108

2006 0 12 monthly premiums for Mar 06-Feb.07

(12*259) -3108

2007 0 12 monthly premiums for Mar 07-Feb 08

(12*259) -3108

2008 Paid up Value

42385 Maturity amount 66675 66675

IRR 9.46% IRR 8.48%

227

EXAMPLE NO 15


SA=Rs.10000 DOP-03/05/2003

SV=Rs.5145 DOC-28/03/1995




Years Description Details Cash

Flow(Rs.)

2003 SV +Revival amount+premiums

for 11 months

5145+1218+

(11*72)

-7155

2004 Premiums (12*72) -864

2005 Premiums (12*72) -864

2006 Premiums (12*72) -864

2007 Premiums (12*72) -864

2008 Premiums (12*72) -864

2009 Premiums (12*72) -864

2010 Maturity amount 17440 17440

IRR 6.31%

228

EXAMPLE 16


SA=Rs.100000 DOP-05/12/2008

SV=Rs.12060 DOC-28/03/2002

Premium=Rs.1271Quarterly FUP-28/03/2006




2008 SV+Revival amount+1 Premium –SB

-12060-5657+15000-1271

-13988

2009 4 quarterly premiums (4*1271) -5084



2012 4 quarterly premiums (4*1271) 9916















2027 Maturity Amount 185800 185800

IRR 8.93%

229

For the above examples, the rate of return ranges between

7.43 % to 8.48 %.

The return can be increased to an extent by policy engineering

to make the border line policies feasible for trade.

5.5.1 Policy ‘Engineering’:

The profitability can be enhanced by variations in the

policy according to the policy conditions on case-by-case

basis.

To increase the financial viability of the tradable product

the trading firms in UK use various techniques. These are

called policy-engineering techniques as the product is designed

and modified to generate higher returns. These techniques are

primarily used for trading in Endowments Assurance.

In the examples below, we have applied the policy

engineering techniques to certain products in India to examine

the change in profitability.

The profitability can be increased by making following

alterations in the policy:

• Alteration in the mode of payment

• Cancellation of the Double Accident Benefit (DAB)

• Alteration in the term

• Alteration in the plan

• Taking loans against the policy.

• Claiming paid-up value

230

• Splitting the policy to reduce the sum assured

• Advance premium payment.

In the following section we present a few examples of

LIC’s randomly selected plans. These examples show how the

return can be increased with the alterations in the policies. The

policy engineering is commonly resorted to by the third party

firms dealing in Tradable Endowment products in other

countries.

Following analysis empirically examines the effect on

profitability by application of policy engineering in case of

selected LIC of India products, with the help of various forms

of alterations.

• The assumptions in the earlier section are also

applicable for these examples.

• The return depends on the policy conditions and

factors like number of premiums paid.

• In case of policy alterations, all changes may not be

executed simultaneously.

The execution of policy alterations is discretionary on

case-by-case basis by the insurer firm. This may cause minor

changes in IRR .

‘Policy engineering’ some illustrations:

a) Cancellation of the Double Accident Benefit:

The cancellation of extra risk cover in form of Double

Accident benefit (DAB) results into lowering of the premium

as per the insurers policy conditions.

231

EXAMPLE NO 17 - DAB Cancellation


SA=Rs.100000 DOP-15/03/2005

SV=Rs.38989 DOC-22/10/1991



Premium without DAB =Rs.657-Rs.8.3=Rs.648.7


Survival Benefit due at 15th year from the commencement

date at 20% of SA


DAB cancelled

Cash Flow(Rs.)

2005 SV+ Revival amount+7 premiums till Sept.2005+12

premiums from Oct2005 to Sept 2006-

SB

38989+31547+ (7*657)+ (12*657)-

20000

-63019 -38989-31547-

(7*657)-(12*657-

8.3)+20000

-62919.4

2006 12 monthly premiums for Oct.2006-sept.2007

12*657 -7884 (12*648.7) -7784.4


12*657 -7884 (12*648.7) -7784.4


12*657 -7884 (12*648.7) -7784.4


12*657 -7884 (12*648.7) -7784.4


12*657 -7884 (12*648.7) -7784.4

2011 Maturity amount 155800 155800 155800 155800

IRR 8.82% IRR 8.93%

232

EXAMPLE NO.18 - DAB Cancellation


SA=Rs.35000 DOP-29/05/2003

SV=Rs.12371 DOC-28/06/1997


Maturity amount=Rs.62405 Premium without

DAB+Rs.252-Rs.2.91=Approx.Rs.249



DAB cancelled

Cash Flow(Rs.)

2003

SV+Revival amount+12

monthly premiums

12371+252+(12*252) -15647

12371+252+ (12*249) -15612.2

2004 premiums

(12*252) -3024 (12*249) -2989.2

2005 premiums

(12*252) -3024

-2989.2

2006 premiums (12*252)

-3024

-2989.2

2007 premiums (12*252)

-3024

-2989.2

2008 premiums (12*252)

-3024

-2989.2

2009 premiums (12*252)

-3024 -2989.2

2010 premiums (12*252)

-3024 -2989.2


Maturity amount 62405

IRR 9.26 % IRR 9.38%

233

EXAMPLE NO. 19 DAB Cancellation


SA=Rs.50000 DOP-30/06/2003

SV=Rs.23810 DOC-28/05/1992

Premium=Rs.2451/yearly

Revival amount=Rs.11327

b) Change of Mode: If the mode of payment is altered from

monthly or quarterly to yearly then some rebate is offered

by the insurance firms29.

29 This shows increased IRR if IRR is calculated with yearly compounding .However,

with monthly compounding the result may be different.


Flow(Rs.)

DAB

cancelled

Cash

Flow(Rs.)

2003 SV+Revivalamount 23810+11327 -35137 23810+11327 -35137

2004 Premium 2451 -2451 2451-50 -2401

2005 Premium 2451 -2451 2451-50 -2401

2006 Premium 2451 -2451 2451-50 -2401

2007 Premium 2451 -2451 2451-50 -2401

2008 Premium 2451 -2451 2451-50 -2401

2009 Premium 2451 -2451 2451-50 -2401

2010 Premium 2451 -2451 2451-50 -2401

2011 Premium 2451 -2451 2451-50 -2401

2012 Maturityamount = 110900 110900 110900 110900

IRR 9.66% IRR 9.73%

234

EXAMPLE 20: Change of Mode :


SA=Rs.100000 DOP-25/04/2008

SV=Rs.26821 DOC-20/02/1995

Premium=Rs.3794 half yearly FUP-20/08/2003

Maturity amount=Rs.150000 Revival amount =Rs.45550

Paid up value=Rs.65450 Pre. without DAB=Rs.3744 hl y

Survival benefit due in 2008 and 2010 at 20% of SA Years Description Details Cash

Flow (Rs.)

DAB cancelled & Mode

changed to yearly

Cash Flow (Rs.)

2008 SV +Revival

amount+1 half yearly premium till

Jan 2004-SB

26821+45550+

3794-20000

-56165 26821+45550+3794-20000

-56165

2009 2 hlf yly premiums (2*3794) -7588 7271 -7271

2010 2 hlf yly premiums -SB

(2*3794) -20000

12412 (7271)-20000 12729

2011 2 hlf yly premiums (2*3794) -7588 7271 -7271

2012 2 hlf yly premiums (2*3794) -7588 7271 -7271

2013 SB 20000 20000 20000 20000

2014 0 0

2015 0 0

2016 0 0

2017 0 0

2018 0 0

2019 0 0

2020 150000 150000

IRR 9.40% IRR 9.57%

235

c) Change of Term:

EXAMPLE NO. 21

Original data : Plan Term PPT 112-16-25

SA=Rs.500000 DOP-23/03/2003

SV=Rs.43952 FUP-28/05/2002

Premium yly =Rs.30704 DOC-28/05/1999


Paid up value=Rs.206250

Years Description Details Cash Flow (Rs.)

2003 SV+Revival+1 annual premium for 2003-04 43952+33731+30704 -108387

2004 premium 30704 -30704 2005 premium 30704 -30704 2006 premium 30704 -30704 2007 premium 30704 -30704 2008 premium 30704 -30704 2009 premium 30704 -30704 2010 premium 30704 -30704 2011 premium 30704 -30704 2012 premium 30704 -30704 2013 premium 30704 -30704 2014 premium 30704 -30704 2015 0 2016 0 2017 0 2018 0 2019 0 2020 0 2021 0 2022 0 2023 Maturity Amount 1812500

IRR 9.12%

236

The following illustration shows the change of term from 112-

25-16 to 112 -15-08.

For changing the term from 25 and premium paying term 16 to

term 15 and premium paying term 06 ,the new premium

=Rs.73141 and the maturity amount for 112-15-06 is

Rs.1187500.

Years Description Details Cash Flow (Rs.)

2003

SV+ Revival+ Premium arrears +interest arrears+1 annual

premium for 2003-04 -43952-191678.5

-73141-33731 -342502.5

2004 premium for 2004-05 73141 -73141

2005 0

2006 0

2007 0

2008 0

2009 0

2010 0

2011 0

2012 0

2013 0


IRR 10.18%

237

d) Plan change:

Example No.12 above -Return calculated after change of

plan.

Original : Plan Term PPT 133-15-15

SA=Rs.100000 DOP-25/04/2008

SV=Rs.24345 DOC-20/09/2001

Premium=Rs.7005 yearly FUP-20/09/2005

Maturity amount=Rs.165800 Revival amount =Rs.23505


After change of plan to 14-15 : Maturity amount =Rs.165000

Premium=Rs.6595yearly Years Description Details Cash

Flow (Rs.)

Plan changed to 14-15

Cash Flow (Rs.)

2008 SV+Revival amount+Premium

for 2008

24345 +23505 +7005

-54855 -54855

2009 Premium 7005 -7005 -6595

2010 Premium 7005 -7005 -6595

2011 Premium 7005 -7005 -6595

2012 Premium 7005 -7005 -6595

2013 Premium 7005 -7005 -6595

2014 Premium 7005 -7005 -6595

2015 Premium 7005 -7005 -6595

2016 Maturity amount 165800 165800 165000 IRR 7.68% 7.99%

238

EXAMPLE NO.22

Policy engineering for a single case:

We illustrate the systematic policy engineering to increase IRR

with the help of following example.

The details are as follows: Plan Term PPT 88-20-20

SA=Rs.100000 DOP-28/04/2004

SV=Rs.34094 DOC-28/05/1995

Premium=Rs.2600 half- yearly FUP-28/11/2001

Maturity amount=Rs.165800 Paid up value=Rs.78250


Step 1 IRR calculated with original data. Years Paid up

Details Paid up amounts

Description Details Cash Flow (Rs.)

2004 SV -34094 Sv + Revival + premium for 2004-05

34094+14758 +(2600*2)

-54052

2005 0 premium (2600*2) -5200

2006 0 premium (2600*2) -5200

2007 0 premium (2600*2) -5200

2008 0 premium (2600*2) -5200

2009 0 premium (2600*2) -5200

2010 0 premium (2600*2) -5200

2011 0 premium (2600*2) -5200

2012 0 premium (2600*2) -5200 2013 0 premium (2600*2) -5200 2014 0 premium (2600*2) -5200 2015 Paid up

value 78250 Maturity value 223900 223900

IRR 7.85% Approx.IRR 8.91%

239

Step 2 IRR calculated after cancelling DAB.

Step 3 IRR calculated after cancelling DAB and changing

mode of premium payment to yearly. Years Cancel DAB

DetailsCancelled

DAB Cash Flow (Rs.)

Mode change Description

Mode change Details

Cash Flow(Rs.)

2004 SV + Revival + premium

without DAB for 2004-5

-34094-14758

-(2550*2)= -53952

Sv + Revival + premium for 2004-5

-34094 -14758 -(5019)

-53871

2005 premium without

DABcalculated for2005-06

-5100 annual premium

calculated with yearly

mode for2005-06

5019 -5019

2006 Premium -5100 Premium -5019






2012 Premium -5100 Premium -50192013 Premium -5100 Premium -50192014 Premium -5100 Premium -50192015 Maturity

amount223900 Maturity

amount 223900

IRR 9.01% Approx.IRR 9.09%

240

Step 4 Changing the plan from

Table No.88-20 to Table No.14-20 Years Change of Plan

to 14-20Details

Details Change of Plan to 14-20

Cash Flow (Rs.) 2004 SV + Revival +

premium for 2004-5

-34094-14758-4752

-53604

2005 premium without DAB

4752 -4752


4752 -4752


4752 -4752


4752 -4752


4752 -4752


4752 -4752


4752 -4752


4752 -4752


4752 -4752


4752 -4752

2015 Maturity amount 220100 220100 IRR 9.17%

241

Step 5 : Loan taken at revival used to finance the policy

cost in initial year

Years Loan at Revival used to finance the initial policy purchase cost Description

Loan at revival used to finance initial policy purchase cost Details

Cash Flow (Rs.)

2004

[Sv + Revival + premium for 2004-5] –Loan amount

[34094+14758+4752] -39331

-14273

2005

Annual premium calculated with yearly mode for2005-06 +interest on loan @ 9% compounded half yearly 4752+3619 -8371

2006 Annual premium+interest 4752+3619 -8371





2011 Annual premium+interest 4752+3619 -83712012 Annual premium+interest 4752+3619 -83712013 Annual premium+interest 4752+3619 -83712014 Annual premium+interest 4752+3619 -83712015 Maturity amount 20100-39331 180769

IRR 9.45%

242

Step 6 : Changing Plan and Term

from Table no.88-20 to Table no.14-16

30 For change of term LIC charges 8% half yearly compounded interest rate on the premium difference for each of the previous year since date of the change of term to the date of commencement.


Flow

(Rs.)

2004

SV+Revival amount + premium for

2004-05 + Premium arrears with

interest30

-34094-14758-6149-

14206

-69208

2005 Premium 6149 -6149

2006 Premium 6149 -6149

2007 Premium 6149 -6149

2008 Premium 6149 -6149

2009 Premium 6149 -6149

2010 Premium 6149 -6149

2011 Maturity amount for 14-16 190300 190300

IRR 10.31%

243

Step 7 Loan taken at revival used to finance the initial

policy cost after change of plan and term

Years Loan at Revival used to finance the initial policy purchase cost

Description

Loan at revival used to finance initial policy purchase cost Details

Cash Flow (Rs.)

2004 [SV + Revival + premium for 2004-5] –Loan amount

[34094+14758+6149+ 14206]-39331

-29876

2005 Annual premium calculated with yearly mode for2005-06 +interest

on loan @ 9% compounded half yearly

6149+3619 -9768

2006 Annual premium +Interest 6149+3619 -9768





2011 Maturity amount for 14-16 – loan 190300-39331 150969

Approx.IRR 11.45%

244

In the above example,

• The IRR in original case was 8.91% .

• After DAB cancellation it increased to 9.01% .

• The alteration in mode of payment raised it to 9.09%.

• The alteration in the plan raised IRR to 9.17%.

• If the loan is taken at this stage to finance the policy

cost, IRR increases to 9.45%.

• The alteration in plan and term from 88-20 to 14-16

raises IRR to 10.31% in this illustration.

• If the loan is used to finance the policy cost, and plan –

term 14 –16 is applied, the IRR increases to 11.45%.

This policy engineering and the extent to which the return can

be increased is determined by policy conditions and provisions

offered by the life insurance firms.

Paid up Maturities :

There are some policies, which are lapsed and the date of

maturity is within 4 to 12 months. These policies are paid up

policies in the sense, they fetch the paid up value on maturity

.The third party firm can purchase this policy by offering the

policyholder the paid up value plus the bonus accrued. This is

the value, which the policyholder would be receiving from the

insurer on the date of maturity in case of the paid up policies.

If the third party firm purchases the policy, the policyholder

gets the same amount earlier, on the date of purchase; the third

party firm receives the guaranteed return. The amount of

245

investment as well as the return is pre-specified ,fixed and

guaranteed in all these cases of paid-up maturities.

Following examples illustrate these unprecedented returns.

EXAMPLE NO.23 Paid up Maturity:

Plan –PPT-Term -14-25-25

SA 20000

Premium =Rs.807 yearly Revival amount=Rs.4907

DOC-26/04/1984 Paid up value=Rs.16000

FUP-04/04/2004 Accrued bonus=Rs.26420

DOP-12/2008 Date of Maturity -26/04/2009

Cash value =paid up value + accrued bonus

= Rs.16000+Rs.26420=Rs.42420

i =(1+r)n -1= 0.504983672 Hence Annualised IRR = 50.49%

Year Description Details Cash Flow (Rs.)

Dec-08 (paid up +vested bonus)+Revival (-16000-26420)-4907 -47327

Apr-09

Maturity amount =SA+ accrued bonus+Final

add.bonus 26420+20000+1000+5000 52420 IRR for 4 months 10.76%

246

EXAMPLE NO.24 Paid up Maturity

Plan –PPT-Term 75-20-20

DOC-01/04/1989 DOP-05/12/2008

DOB-13/08/1958 FUP-01/04/2004

SA=Rs.20000

cash value=paid up value +accrued

bonus=Rs.1000+19080=Rs.20080

Revival amount=Rs.8197.5

i =(1+r)n -1 =0.656601312 Hence Annualised IRR = 65.66%

Year Description Details Cash Flow

(Rs.)

dec.2008

cash value +

revival 28277.5 -28277.5

april.2009

Maturity amount

=SA+ accrued

bonus+Final

add.bonus 8000+19080+1000+4000 32080

IRR for four months 13.45%

247

EXAMPLE NO.25 Paid up Maturity:

Plan –PPT-Term 75-20-20

DOC-10/04/1989 DOP-05/12/2008

DOB-22/02/1961 SA=Rs.30000

FUP-10/04/2005 Revival amount=Rs.9177

Cash value=paid up value +accrued

bonus=Rs.3600+Rs.30390=Rs.33990

i =(1+r)n -1 = 0.61838702 Hence Annualised IRR = 61.83%

Year Description Details

Cash Flow(Rs.)

Dec-08

Revival amount +

cash value -33990-9177 -43167

Apr-09 Maturity amount 12000+30390+4800+1500 48690

IRR for four months 12.79%

248

Importantly, the third party firms purchasing the policies may

offer higher cash value to the policyholder depending on the

estimated value of the policy. In the institutionalized market

with a larger number of participants and competition among

the firms, this is not difficult to visualize. The following table

shows the hypothetical illustration of higher cash values for

the above examples.

Example

No.

Original

SV

(Rs.)

IRR

(%)

Higher Cash

value(Rs.)

IRR

(%)

2 6650 13.89 7315(10%higher) 12.63

5 9818 14.28 10318(Rs.500 more) 11.59

6 27665 10.76 28665(Rs 1000 more) 9.46

7 7788 11.55 8566(10% more) 10.22

8 140130 11.90 145130(Rs.5000more) 11.75

11 27149 12.14 29149(Rs.2000 more) 9.97

9 30939 10.5 31939(Rs.1000 more) 10.19

21 22457 10.72 23457(Rs.1000 more) 10.17

249

5.5.2 Stochastic model of Returns to the Trading Firm:

The model in section 5.4 ignored the death claims while

only financial benefits were considered. By including the

stochastic factor of death benefit the earlier model can be

evolved to generate interesting returns to the trading firm.

The cost equation {C=(Vs+R)/(1+ r)T-Np + Σ P/(1+r)N-Np } as

well as earnings equation {Ε = [S.A. + (β S.A.)*T ]/(1+r)T }

in the earlier model can be modified where ‘r’ depends upon

the probability of survival in the respective year.

From the Life table we get the probability of survival for each

age.

1- Pr (death)=Pr (survival)

Year rt Pr E

1 r1 dt/l t (dt/ l t ) [S.A.+ (β t S.A.)]

2 r2 dt+1/ l t (dt+1/ l t )[S.A.+ (β t+1

S.A.)]

3 r3 dt+2/ l t (dt+2/ l t )[S.A.+ (β t+2

S.A.)]

. . . .

. . . .

. . . .

T Σ

rT

Σ dT/ l

t

Σ (dT/ l t )[S.A.+ (β T

S.A.)]

250

Mathematically Expected Return is

E(r) = Σ Tt=N rt (Σ Tt=N Pr)

E(r) = Σ Tt=N rt [Σ Tt=N (dT/ l t )]

E(r) = Σ Tt=N rt (dT/ l t)[S.A.+ (β T S.A.)]

The above analysis can be presented separately for whole life

and endowment assurance plans.

Whole Life Assurance:

Under the whole Life Assurance Contracts, the sum assured is

paid when the policyholder dies.

The sum assured, the number of premiums paid and the policy

term determine the paid up value.

V=(S.A. *Np )/T

where,V= Paid up value

S.A.= sum assured

T=term to maturity

Np =Number of years of premium payment

Surrender Value is determined by paid up value and surrender

factor.

Vs = λ V

The cost for the trading firm can be given by

CNp = (Vs + R) +Σ T K= Np p/(1+r)k-Np

The benefit received by the third party firm

ENp = S.A./(1+r)T + β [S.A./(1+r)T]

Where,

S.A./(1+r)T =present value of the sum assured β [S.A./(1+r)T] =

present value of the bonus accrued where, β is the bonus

factor/1000 .

251

This policy benefit will be paid only in the event of the death

of the policyholder (or at a certain maximum age eg.80 yrs. in

case of LIC of India).

Since the receipt of benefit by the third party firm depends on

the probability of life expectancy of the policyholder, hence

the benefit amount is a stochastic variable.

The expected amount of benefit received by the third party

firm can be measured as: E(ENp) = E {S.A./(1+r)T + β

[S.A./(1+r)T]}

E(ENp) = {S.A./(1+r)T + β [S.A./(1+r)T] } * q

The third party firm will pay the premium as soon as the

policy is transferred in its name. But it is entitled to pay the

premium only till the life of the policyholder. In other words,

the cost to the third party firm in this model is subject to the

life expectancy of the policyholder. The cost i.e. CNp depends

on the probability of life of the policyholder hence it is a

stochastic variable.

The expected cost for the third party firm in this case can be

measured as follows:

E [CNp] = (Vs +R) +Σ k-Np q x+Np p/(1+r) k-Np

For Endowment Insurance,

Let the benefit be H,

H depends on the present value of premiums.

Let V denote the present value factor.

E(H) = Σ T-Np-1 k=0 q x+Np+k Vk+1 +V T-Np T-NpPx+Np

252

Where,

x = policyholder’s age at the date of commencement of the

policy

Np = Total number of premiums paid by the policyholder

T =Term to maturity

k =Number of premiums paid by the third party

E(H) = Σ T-Np-1 k=0 [ d x+Np+k /I x+Np] Vk+1 + V T-Np [Ix+T/ Ix+Np]

E(H) = A1x+Np:T-Np + A1

x+Np:T-Np

Ax+Np- : T-Np = A1x+Np:T-Np + A1

x+Np:T-Np

If the sum assured is S then expected value of benefit is,

S. Ax+Np- : T-Np=S. A1x+Np:T-Np + S.A1

x+Np:T-Np

The policy cost is,

CxNp =Vs +R +p.qk

qk =the probability of death after k years.

The expected cost of the policy is;

E(CxNp) = Vs +R +p Σ T-Np-1

k=1 Vk. q x+Np+k

Where, Vs = Surrender value

R = Revival amount

= Vs +R +p Σ T-Np-1 k=1 Vk+1. q x+Np+k

= Vs +R +p A 1 x+Np :T-Np-1

Profitability Condition for the third party firm is given by,

E(H)/ E(CxNp) =1

253

Empirical example estimating expected return including the

probability of survival:

The examples for real policies of LIC of India are worked out

for estimating the return with maturity / death benefit.

• Probability based on LIC of India 1994-96 life table for

Male Normal Life (Please refer to Annexure 5.2)

• Expected Return is determined by Probability of Death *

Benefit

• Benefit for each year = bonus/1000of SA * number of

years + Sum assured.

• Expected IRR is the product of each year’s IRR given

the mortality and the mortality factor.

5.5.3 Illustration of Return based on life expectancy:

The details of the policy are as follows,

Plan term ppt-14-10-10 DOC -23/02/2001

Sum assured=Rs.100000 DOB-04/02/1967

Premium=Rs.10376/year Date of purchase-Feb.2002

Surrender amount=Rs.42478

Bonus for each year =(Rs.50/1000 of SA multiplied by No.

of years= Rs.5000)

254

Step 1: Calculating Returns for each year

Year Details Policy

Cost per year (1)

Policy Benefit subject to (4)

(2)

IRR Subject

to Column

(4)

Probability of Death

(4)

2006 SV+Premium -52854 125000 136.5 0.002053 2007 Premium -10376 130000 126.33 0.002248

2008

-10376 13500044.05

0.002418

2009

-10376 14000024.01

0.002602

2010

-10376 14500015.09

0.002832

2011

0 150000

12.24 0.99689 #

Step 2: Calculating IRR for Each Year@

Year 2006 2007 2008 2009 2010 2011 SV+

Premium 72146 -52854 -52854 -52854 -52854 -52854

136.50% -10376 -10376 -10376 -10376 -10376 130000 -10376 -10376 -10376 -10376 126.33% 135000 -10376 -10376 -10376 44.05% 140000 -10376 -10376 24.01% 145000 -10376 15.09% 150000 12.24%

@ Figures in percentages show the IRR for respective year in the event of the death of

the policyholder.

255

Step 3: Calculating the expected IRR

Year

(1)

Age

(2)

Probability

(3)

IRR for respective year (%)

(4)

(5)=(3)*(4)

2006 40 0.002053 136.50 0.197088

2007 41 0.002248 126.33 0.28399

2008 42 0.002418 44.05 0.106513

2009 43 0.002602 24.01 0.062474

2010 44 0.002832 15.09 0.042735

2011 45 0.99689 # 12.24 12.20193

E(IRR)= Σ[(3)*(4)] 12.97788 # Note: For the Endowment product, at the maturity, the benefit is received on survival,

hence, Pr (Survival)=1 – Pr(Death)=(1- 0.00311 )

Above example offers expected return based on stochastic

element that is the probability of life of the policyholder.

5.6 Securitising the endowment product pools-Formulation

of ‘Endowment -linked Bonds’:

In a more sophisticated form the trade does not end at this

point. There is a generation of a unique class of derivatives in

form of life insurance linked securities .In life settlements

industry, the life insurance backed securities are already

introduced, and are generating excited response from the

investment banks and hedge funds. Even mutual funds are

256

seriously thinking of these securities after the latest wash down

of the financial markets. These are described as “The most

recent and perhaps intriguing development introduced by Wall

Street”, (Goldstein, 2007)

Life endowment assurance –backed securities:

Recently the concept of life settlement-backed securities

is discussed in actuarial field. This study tries to explore the

potential for life endowment assurance –backed securities.

Securitization of endowment policies can be visualized as

follows:

Step 1. A financial intermediary, typically an investment

bank, acquires a series of tradable endowment policies by

setting a wing a special purpose vehicle to acquire the policies.

Step 2. The policies are aggregated by rate of return and term

to maturity into a pool

Step 3.The pool is divided into fractional securities, and

sold to investors, according to their preferences.

Step 4. The investor receives a contract right over an

obligation to pay the benefits on maturity of the policies.

If we allow for incorporating the life expectancy based

death benefit, then the securitization is very similar to the life

settlement backed securities where the flow of amount

determined by the life expectancy will be generated with an

important difference of certainty of maturity benefit at the end

of the term.

257

The survival benefits or maturity benefits irrespective of the

longevity risk will be the important difference between the life

settlements backed security and an endowment –backed

security.

In case of endowment –backed security all investors

enjoy a smooth stream of income as the endowment policies

mature, irrespective of the longevity of the insured. The most

attractive feature of these securities is that they have a very

weak if any correlation with the short term market volatility.

Hence, these securities are of potential importance for

investors like hedge funds and mutual funds for hedging

against the market uncertainties.

The risk-return pattern of endowment –backed security

would be similar to a fixed income security with yield

deviation within a very narrow range.

We attempt to devise an illustration of how the tradable

endowments can be bundled to form ‘Endowment Assurance –

Backed Bonds or securities.

The following table shows some of the cases in the

numerical examples in the last section sorted according to the

maturity date.

The bonds or fixed –income securities of different

maturities are formed by bundling the policies with similar

maturity terms (since the date of purchase). The policies with

different terms also can be combined.

258

Illustration of Policies bundled with same term to maturity

Illustration Based on

Example No.

Term to

Maturity

(Years)

Investment weighted

IRR (%)

1 7&11 3 12.71

2 1,5, &6 4 11.39

3 14,8 6 9.69

4 10,12,18 9 8.83

Bundling of policies with different terms to maturities:

Policies are bundled to deliver positive cash flows after

certain years .In the following example the cash inflow is at

the end of 3years, 4years and 6 years.

Years Cash flows of

E.G.No.7&11

Cash flows of

E.G.No.1,5,6

Cash flows of

E.G.No.8,14,22

Bundled cash

flows

1 -21665 -71749 -65853 -159267

2 -264 -2988 -7810 -11062

3 27821 -2988 -7810 17023

4 106206 -7810 98396

5 -7810 -7810

6 144175 144175

10.48%

259

Comments on Life endowment Backed Securities:

• The above example should be treated as essentially a

first approximation of this type of instrument. It intends

to give a rough idea of the possibilities offered by the

deepening of the market, once an institutionalisation of

the market occurs. The informal market does not provide

the deepening of the secondary market for life insurance

products.

• The deepening of the market can be visualized with

large volume of policies traded, large number of market

participants, which can be achieved only after

institutionalization of the market.

• Above illustration shows that the yield of Life

Endowment –backed securities is not related with the

term to maturity it is related to the profile of the

products backing the security. The factors like the

number of premiums paid before the policy is traded,

revival amount and surrender value, premium

installment, and the benefits offered for each life

insurance product determine the return. Hence, it is not

directly comparable to any other financial instrument.

260

5.7 Summary:

a. The regression analysis though subject to certain

limitations, shows the extent of need for the

opportunity to exchange the life insurance product as

a liquid asset. This need translated into the demand

for the service of providing cash for life insurance,

unleashes a market for third party firms to the extent

of Rs. 5332 crores according to 2003 data on

surrender. This estimate indicates an enormous

market even if some discounting is allowed.

b. The return varies on case-by-case basis. The factors

determining profitability are, the number of years the

premiums are paid by the policyholder, whether the

policy is lapsed, amount required for revival, the

number of premiums to be paid, the policy conditions

and benefits offered. Not all policies offered for

purchase might be equally profitable; some are not

profitable at all.

c. These returns are comparatively high related to the

equivalent (compared with the similarly risky)

substitutes. This is the reason why the tradable

endowments market has flourished in UK.

d. Especially, in India, the tradable endowments have an

unparalleled risk-return composition due to the

sovereign guarantee to the LIC of India in particular

and an extremely well regulated life insurance sector

in general.

261

e. The tradable endowments firms usually do not count

on the death benefit. (McGurk, 1999) Their profit

calculations rest on the purely financial returns and

not on the stochastic factor.

f. The stochastic model unleashes an interesting arena

of possibilities and returns. Nevertheless, the

implications as regards the sale of impaired policies,

effect on the policy reserves of the insurers and moral

hazards are evident. These issues are discussed in the

later chapters.

262

Annexure 5.1

ULIP and the Trading in Life Insurance Products

For last few years Unit Liked Investment Products (ULIPs) have

been the buzzword in the life insurance sector. The discussion on

potential for secondary market trading in life insurance products cannot

be complete without examining the implication of (ULIPs) for trading in

life insurance products.

General outline of the product:

ULIP is life insurance product that provides for the protection as

well as flexibility in investment. The premium paid, less the charges

(administrative, fund management, insurance cover charges, allocation

charges), is used to buy units in the fund. This fund can be equity, bonds,

debt, and money market, according to the ULIP holder’s choice. The

investment is at the price of the fund units at the day of investment. The

ULIP holder gets more units if the price on the day of investment is

lower and vice versa. More units are added to the fund as the client pays

premiums. In order to pay the monthly costs equivalent number of units

is cancelled and is computed as cost to be deducted divided by unit price

of the day. The ULIP holder has the choice to sell the units (to the

insurer) any time after the lock in period, generally after three years’

premium payment. The ULIP holder can sell the units when the fund

value is high. The value of the fund depends upon the unit price, which in

turn is determined by the market value of the underlying assets. Fund

value=Unit price * number of units.

In addition to this investment element, the risk cover is provided

in form of the death benefit.

Evolution: The private life insurance firms have initiated ULIPs.

ULIPs are regarded as a path-breaking innovation in the life insurance

sector, nevertheless the commonly observed rule, ’Need is the Mother of

Invention ‘ is applied in case of creation of ULIPs. The policyholders’

need for flexibility and the insurers especially the private insurers’ need

263

of successful fund management under the pressure to perform in

competitive environment are the factors generating this product

innovation.

The life insurance involves long-term fund management and

liability. This has been difficult for the newly established private firms to

handle. The performance conscious firms needed, to show boosted sales

matched with easy liability –a combination offered by ULIPs. Hence,

ULIPs are here to offer flexibility and convenience to the insurer

translated into business growth. At present, the ULIPs of various private

firms and the L.I.C.of India bag approximately 80% of the market share

in life insurance market. L.I.C. of India has sold 1.96 crore Unit Linked

Policies and 1.8 crore of non-unit-linked policies during the year 2007-

08.

Impact on Trading in Life insurance:

• ULIPs impact on trading in life insurance is complex. ULIPs are

an effort to achieve growth in business by recognizing the need of

policyholders to have more liquidity attached to the life

insurance.

• Nevertheless, ULIPs are backed by certain circumstantial factors

like favourable upturn in the stock index, high rate of economic

growth.

The trend in other countries like USA and Europe reveals that the

market settles at the product mix of 70 % to 75% for the

conventional insurance products and 30% to 25 % of the ULIPs.

According to the latest press release by LIC of India, M.D.

MR.D.K. Mehrotra, LIC wants to maintain the percentage of non-

linked policies at 52%, leaving the balance for unit linked

products.(The Financial Express, May 16.2008)

In his interview with The Economic Times, May 30, 2008

Mr.D.K.Mehrotra has re-emphasised the move to promote

conventional policies. To quote Mr. Mehrotra,” An insurance

264

company cannot depend only on Unit-Linked insurance plans. In

the long run conventional products have to be focused upon.” He

added that, these policies ensure stability for the corporation as

well as the policyholders. Last year the composition was 82:18 in

favour of ULIPs while this year LIC tried to have 70:30 mix

between ULIPs and conventional plans.

After the recent crash of stock market and the looming danger of

recession, the glamour of ULIPs is already fading.

• The morale of the story is product innovation, and competition

are the signs of a live market, and these are the ‘risks that any

entrepreneur in any market cannot shun away from. In India, the

potential market size for trading is not affected by the ULIPs

because the market size for TEP depends on the reservoir of

already issued policies over a long term and not on the policies

issued currently.

265

Annexure 5.2

LIC of India Life Tables

266

Annexure 5.2 (continued)

LIC of India Life Tables

267

Annexure 5.3

Questionnaires for the Policyholders

Questionnaire 1 for Surrendered policies

The field survey on Study of life insurance policyholders

___________________________________________________________

Name of town: Name of Insurance Co.

A)Particulars of surrender:

Sum Assured : _____________

Plan/type of policy :____________

Policy Number: _______________

Duration of continuation:________

Total Premium Paid: ___________

Surrender Value Received :Rs.________________

Loss on surrender:__________________________

B)Particulars of Policy holder:

1.Name: (Begin with

Surname)_______________________________________________

2.Gender of policyholder: M F

3.Address:__________________________________________________

4.Educational Background:_____________________________________

5.Income per annum:Less than Rs.60,000/-

Between Rs.60,000/-andRs.1,60,000/-

Between Rs.1,60,000/-andRs.3,00,000/-

Above Rs.3,00,000/-

268

6. Main source of income: Salary (Specify service)

Profession

(Dr.CA.Self employedetc.)

Business (Specify)

Dividend,Rent ,Interest

Agriculture

Other(Specify)

7.Family Size i.e.No. Of dependents(Including Self) : One

Two

Three

Four

Four +

8.Decision to purchase insurance influenced by whom?:

None else

Friends

Agents

Same Life Insurance Company

Different Life Insurance Company

Other

9.Why you had purchased life insurance policy( which is surrendered)?

Saving

Insurance

Tax saving

Other

10.Do you think that the policy served the objective you had in mind?

Yes

No

269

11. Reason for Surrender: Need for Cash

Could not afford to continue premiums payment

Not worth continuing

( Due to changed needs, other options etc)

Any other

Specify_______

12.Use of surrender proceeds:

Normal Household expense

Purchase of assets/investment

(Specify)________________

Purchase of life insurance

Same company

(Specify) _______________

Different company

(Specify) _______________

Expenditure for special occasion(marriage etc.)

Any Other Use______________

13.Decision to surrender influenced by: None else

Friends

Agents

Other

14. Where did you surrender the policy?

Life Insurance Company office

Any other local person,

Through agent

Specify details :

___________________________________________________________

270

15.If surrendered in insurance company office:

Information and service given satisfactorily

Advise given to consider other option like loan

Surrendered immediately__________________

Any other comment: ______________________________________

16.Do you have other financial assets? Yes No

If yes,specify

Insurance

NSC

UTI/MF

BankDeposits

Shares

Sugar factory shares

Bonds

17.Did you liquidate/sold any financial assets other than life insurance in

last 12 months?

No Yes

If yes specify the assets sold/liquidated___________________________

271

Annexure 5.3 (continued)

Questionnaire 2 for Lapse/Forfeited Policies

The field survey on Study of life insurance policyholders

Name of town: Name of Insurance Co.

A)Particulars of surrender:

Sum Assured : _____________

Plan/type of policy :____________

Policy Number: _______________

Duration of continuation:________

Total Premium Paid: ___________

Surrender Value Received :Rs.________________

Loss on surrender:__________________________

B)Particulars of Policy holder:

1.Name: (Begin with

Surname)_______________________________________________

2.Gender of policyholder: M F

3.Address:__________________________________________________

4.Educational Background:_____________________________________

5.Income per annum: Less than Rs.60,000/-

Between Rs.60,000/-andRs.1,60,000/-

Between Rs.1,60,000/-andRs.3,00,000/-

Above Rs.3,00,000/-

272

6. Main source of income: Salary (Specify service)

Profession

(Dr.CA.Self employedetc.)

Business (Specify)

Dividend,Rent ,Interest

Agriculture

Other(Specify)

7.Family Size i.e.No. Of dependents(Including Self) : One

Two

Three

Four

Four +

8.Decision to purchase insurance influenced by whom?:

None else

Friends

Agents

Same Life Insurance Company

Different Life Insurance Company

Other

9.Why you had purchased life insurance policy (which is surrendered)?

Saving

Insurance

Tax saving

Other

10.Why you had purchased the life insurance policy which is lapsed?

________________________________________________________

273

11. Reason for lapsation : Ignorance to pay premiums

Could not afford to continue

Not worth continuing

(Due to changed needs,other options etc.)

Any other

Specify_____________

11.Was there any follow up from the agent/ life insurance company to

continue the policy? Yes

No

12.Do you think that you have incurred loss due to lapsation ? Yes

No

13.Do you have other financial assets? Yes No

If yes,specify , Insurance

NSC

UTI/MF

BankDeposits

Shares

Sugar factory shares

Bonds

14. Did you liquidate/sold any financial assets other than life insurance in

last 12 months?

No Yes

If yes specify the assets sold/liquidated ___________________________

15.Would you like to revive the policy ? Yes

No

16.Comments ______________________________________________

274

Annexure 5.4

A) Tabulation of the Lapsation experience of the L.I.C. policy

holders based on field survey of 260 policyholders.

Gender of policy holders:-

Total No. of

Observation

Male Female

260

(100)

243

(93.46)

17

(6.53)

Educational Background:-

Income per annum :- ( in Rs.)

Main sources of income :-

Total No. of

Observation

Salary Profession

(Dr. CA,

self

employ)

Business Dividend,

Rent,

Interest

Agriculture Other’s

260

(100)

53

(20.38)

62

(23.84)

37

(14.23)

9

(3.46)

104

(40)

12

(4.61)

Total No. of

Observation

Primary Secondary H.

Secondary

Graduate

&Above

Uneducated

260

(100)

7

(2.69)

85

(32.69)

46

(17.69)

95

(36.53)

27

(10.38)

Total No. of

Observation

>60,0

00

60,000-

1,60,000

1,60,000-

3,00,000

No Individual

income

260 (100) 97(37.

30)

120 (46.15) 36 (13.84) 7 (2.69)

275

Family size No. of dependents (Including self)

Who influenced the decision to purchase insurance?

Why you had purchased Life Insurance Policy? (Which is lapsed?)

Total No. of

Observation

Saving Security or

insurance

Saving &

Security

Other’s

260 (100) 148

(56.92)

38 (14.61) 69 (26.53) 5

(1.92)

Reason for lapsation

Total No. of

Observation

One Two Three Four & above

260 (100) 0 (0) 5 (1.92) 46 (17.69) 209 (80.38)

Total No.

of

Observatio

n

None else Friends Agent Other’s

260(100) 64 (24.61) 32 (12.30) 158 (60.56) 10 (3.84)

Total No. of

Observation

Ignorance to

pay premiums

Could not

afford to

continue

Not worth

continuing

Any

Other’s

260 (100) 94 (36.15) 104 (40) 30 (11.53) 46(17.69)

276

Was there any follow up from the agent/company to continue the policy?

Do you think that you have incurred loss due to lapsation?

Do you have other financial assets?

Did you liquidate any of financial assets other than life insurance in last

12 months?

Would you like to revive the policy?

Total No. ofObservation Yes No

260 (100) 209 (80.38) 51(19.61)

Total No. of

Observation

Yes No

260 (100) 171 (65.76) 89 (34.23)

Total No. of

Observation

Yes No

Insurance NSC UTI/MF BK.

Deposit

Shares Bonds

260(100) 82(31.53) 3(1.15) 0 (0) 56(21.53) 47(18.07) 2(0.76) 136(52.30)

Total No. of

Observation

Yes No

260(100) 4(1.54) 256(98.46)

Total No. of

Observation

Yes No

260(100) 160(61.53) 100(38.46)

277

Annexure 5.4 (Continued)

B) Tabulation of the Surrender experience of the L.I.C. policy

holders based on field survey of 25 policyholders.

Gender of policyholder:

Educational Background:

Income per annum:

Main source of income:

Family Size i.e. No. Of dependents (Including self):

Total No. of

Observation

One Two Three Four & above

25(100) 01(04) 0(0) 01(04) 22(88)

Total No. of

Observation

Male Female

25 (100) 22 (88) 03 (22)

Total No. of

Observation

Primary Secondary H.

Secondary

Graduate

&Above

Uneducated

25(100) 0(0) 06(24) 06(24) 07(28) 06(24)

Total No. of

Observation

<

60,000

60,000-

1,60,000

1,60,000-

3,00,000

No Individual

income

25(100) 08(32) 14(56) 02(08) 01(04)

Total No. of

Observation

Salary Profession

(Dr. CA,

self

employ)

Business Dividend,

Rent,

Interest

Agriculture Other’s

25(100) 14(56) 01(04) 03(12) 01(04) 08(32) 01(04)

278

Decision to purchase insurance influenced by whom?

Why you had purchased life insurance policy

(That is surrendered)?

Do you think that the policy served the objective you had in mind?

Reason for Surrender:

Total No. of

Observation


25(100) 05(20) 03(12) 16(64) 0(0)

Total No. of

Observation

Saving Security or

insurance

Saving &

Security

Other’s

25(100) 12(48) 06(24) 07(28) 01(04)

Total No. of

Observation

Yes No

25(100) 10(40) 14(52)

Total No. of

Observation

Need for

Cash

Saving

Could not

afford to

continue

Not worth

continuing

Any

other

25(100) 16(64) 03(12) 01(04) 05(20)

279

Use of surrender proceeds:

Total No. of

Observation

Normal

Household

expense

Purchase

of

assets/inv

estment

Purchase of life

insurance

Expenditure

for

special

occasion

Others

Same

company

Different

Company

25(100) 05(20) 06(24) 02(08) 02(08) 08(32) 00(00)

Decision to surrender influenced by:

Where did you surrender the policy? (Company office, any other local

person, through agent specify in details):

If surrendered in insurance company office:

Total No. of

Observation

Information

given

satisfactory

Information

not given

satisfactory

Advice

given to

consider

other

option like

loan

Surrendered

immediately

25(100) 15(60) 03(12) 03(12) 05(20)

Total No. of

Observation


25(100) 08(32) 03(12) 11(44) 02(08)

Total No. of

Observation

Company office local person Other’s

25(100) 09(36) 02(08) 13(52)

280

Do you have other financial assets?

Total

No. of

Observa

tion

Yes

No

Insurance NSC UTI/

MF

BK.

Deposit

Shares Sugar

factory

shares

Bonds

25(100) 07(28) 04(16) 0(00) 01(04) 01(04) 04(16) 0(00) 08(32)

Did you liquidate any of other financial assets in last 12 months?

Total No. of

Observation

Yes No

25(100) 0(00) 24(96)

chapter 5shodhganga.inflibnet.ac.in/bitstream/10603/3223/12/12_chapter 5.pdf · discussed in...

Documents