Intensive Actuarial Training for Bulgaria

January 2007

Lecture 3 – Life Insurance Product Design &

UnderwritingBy Michael Sze, PhD, FSA, CFA

Agenda

• Fundamental principle of insurance

• Types of life insurance products

• Product design

• Underwriting

• Expense analysis

Fundamental Principle of Insurance

• Insurance cannot prevent bad things from happening

• It is intended to provide financial relief when bad things happen

• Basic idea of insurance

• Explanation of insurance terms

Basic Idea of Insurance

• A Person has the financial need to provide for another person.

• Under normal circumstances, the first person has enough resource to cover the obligations

• If some bad things happen, the first person may not be able to cover the obligations

• The person pays agreed amounts to a company• As long as the agreed amounts are paid• The company pays to the other person an agreed

amount of money when the bad thing happens

Explanation of Insurance Terms

• The insured (the policy owner)– The first person– May be a person or a company

• Potential loss– The finance need to provide

• The beneficiary– The other person, who receives the benefits

• Insurable interest– The finance obligation can be covered under normal

circumstances

Explanation of Insurance Terms (continued)

• Contingency– The bad thing to insure for– E.g. death, disability, sickness, etc.

• Premiums– Amount paid by the insured to the insurance company

• Insured amount (amount of coverage)– The agreed amount of coverage

• Insurance company– The company that receives the premiums to cover the

contingency

Explanation of Insurance Terms (continued)

• “In-force”– When premiums are continued to be paid– This is opposed to “lapse”, when the insured fails to

pay the premiums

• Occurrence– When bad thing insured for happens– Also called claim occurrence

• Claim settlement– The insurance company pays the agreed amount to the

beneficiary

Individual Life Insurance Products

• Purposes of individual life insurance

• Different categories of individual life– Term life– Permanent life– Universal life

• Must balance the need of the insurance with the risk taken up by the insurance company

Term Life Insurance

• Low premium, and low or no cash surrender value

• Coverage only lasts for a number of years, often ending at normal retirement age

• Fulfills the need of the insured for low cost insurance

• There is much anti-selection risk, and lapse risk for the insurance company

Types of Term Life Insurance

• Yearly renewable term– No need for renewal underwriting– Premium increases with age

• Decreasing term– Outstanding balance of loans or mortgage– Coverage ceases after the loan is paid off

• Term to 100– Similar to permanent life, but no cash value

• Additional features– Convertible to permanent life in some circumstances– Guaranteed renewable until a certain age

Permanent Life Insurance

• Whole life insurance, some with endowment• Long term protection for the insurance• Investment, mortality, and early lapse risk for the

insurance company• Level premium, with substantial cash value build-

up after the first few years• Typical riders include

– Premium waiver upon total and permanent disability– Accidental death and dismemberment

Universal Life Insurance

• Each year the insured is charge of mortality and expense

• Each year, the insured’s account value is credited with investment return less the charges

• Premium may be single, fixed, or flexible (as long as account balance is positive)

• On favorable investment experience, excess fund may purchase additional insurance

• On unfavorable experience, the insured must increase premium, or policy lapses

Product Design

• Product design team

• Focus on client needs

• Analyze competition

• Satisfy insurance company’s profitability needs

Product Design Team

• Understand the four phases of an insurance product:infancy, growth, mature, decline

• Team members:– Small number of knowledgeable decision makers

– senior management,

– internal experts (actuaries, administrators, salesmen),

– external experts (especially important for new products: actuaries, reinsurance companies, clients)

Focus on Client Needs

• “Push sell” strategy in the past

• “Pull sell” strategy now

• Understanding customer needs

• Interview current policy holders, potential policy holders,and lost policy holders

• Analyze the demography of the population, as well as the above three groups

Market Research

• Understand your competitors• Understand competitive products• Understand competitor’s pricing structure• Decide on the segment of the market to

penetrate and set pricing policy• Must have competitive price for consumers

and competitive commission to agents• Track competitors continuously

Pricing Structure

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

Pricing Structure (continued)

• Different pricing structures– Penetration pricing (predatory, low profit margin, high

commission)– Neutral pricing (adaptive to competitor prices)– Segmented pricing (opportunistic, on niche products)– Skim pricing (independent, high price on high demand,

low supply products: not usual in life insurance)

• Must perform detailed cost/benefit analysis• Must analyze impact on existing product of the

insurance company

Underwriting

• Purpose: Manage insurance risk• Method: Use risk classification• Process:

– Collect health statistics of applicant– Review data and ask for additional information if

necessary– Allocate applicant into proper risk class– Take proper action

• Must reflect company policy

To Manage Insurance Risk

• Reason: to protect the insurance company against anti-selection

• People with poorer health has greater chance of dying earlier

• Thus should pay higher premium• Proper premium will be charged on healthy lives• Prevent people from over-insuring risky cases• In extreme poor health: decline insurance

Risk Classification

• Purpose: To group applicant with the same health statistics together – risk class

• Proper premium can to charged for each class: standard, substandard rates

• For substandard classes: may impose other restrictions

• Goal: Actual claims experience tracks the premiums charged

Collection of Health Statistics

• Medical information with different degrees of detail – may occur in sequence– Simplified questionnaire

– Report from applicant’s family physician

– General medical examination

– Specialist examination

• Process reflects – Answers provided by the previous step

– Size of the insured amount

Other Data to Consider

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

Review and Further Evidence

• Should establish underwriting manual for uniform procedure

• If simplified health questionnaire show some medical history, need further evidence

• Extra examination fees incurred by insurance company prevents unacceptable risk

• Previous drinking or drug problems must be carefully researched

• Some insurance companies conduct interview of neighbors: bad practice

Risk Classification

• Healthy applicants are grouped into standard class: charged standard premium

• Non-smoker with good habits, etc are classified into privileged class: lower premium

• Higher risk cases are grouped into substandard classes, with proper action

Special Action on Substandard Risks

• Higher premium: rated premium

• Reduction in benefits

• Waiting period

• Exclusion of claims resulting from certain pre-existing conditions

• Rejection

Must Reflect Company Policy

• Most insurance companies only use rejection as the last resort

• Risk classification must reflect insurance company objective on targeted client base

• Strict rules for standard class: lower standard premium, but lesser standard cases

• Less strict rules for standard class: higher standard premium, broader standard class