10 Simple Things That Can Go Wrong in UL Pricing Chris Fievoli, FSA, FCIA CIA Annual Meeting June 29, 2005

#1 - Mortality

CIA Annual Meeting Session LOOKING BACK…focused on the future Why be concerned about mortality? Longevity continues to improve Impact of AIDS has been absorbed into experience Continual improvement in underwriting techniques However, mortality improvements are not necessarily a good thing

CIA Annual Meeting Session LOOKING BACK…focused on the future “Death supported” business Can occur on lapse-supported reinsured UL policies A product with no reinsurance should exhibit normal sensitivity However, assume mortality risk is 100% reinsured A death claim then has the same impact as a lapse Improvement in mortality is equivalent to lower lapses (and lower profitability) Where is the crossover point?

CIA Annual Meeting Session LOOKING BACK…focused on the future Evidence of death support is negative mortality PfAD Can be mitigated by choosing lower level of reinsurance What if mortality improves in the future?

CIA Annual Meeting Session LOOKING BACK…focused on the future Pricing Implications Need to look at mortality improvements Is reinsurance still necessary then? Does reinsurance treaty allow for recapture? Would recapture terms make treaty less desirable from ceding company standpoint?

#2 - Lapses (As Always)

CIA Annual Meeting Session LOOKING BACK…focused on the future Lapse rates on Level COI continue to decline Well under 2% after duration 7 (2003 CIA study) On joint policies – lapse rates approach zero after duration 10 Reflects sophistication of use in estate planning markets Still limited experience in ultimate durations

CIA Annual Meeting Session LOOKING BACK…focused on the future Setting of expected lapse rates Do we expect further reductions in the future? How sensitive are pricing results? Lapse-based capital 2003 changes base capital on additional PAD May amplify exposure to lapse issues

CIA Annual Meeting Session LOOKING BACK…focused on the future Lapses and alternate COI structures Several companies now have YRT scales stopping before age 100 Rates will need to be “loaded” to cover future costs that are being waived Does this reverse sensitivity to lapses? Can we expect any future lapses when a coverage no longer has charges?

#3 – Minimum Interest Rate Guarantees

CIA Annual Meeting Session LOOKING BACK…focused on the future What minimum interest rate guarantees are out there? Typically apply to GIAs within a UL policy Usually apply to 5-, 10-, and 20-year GIAs Range of guarantees is 1% to 3% Higher guarantees on longer terms

CIA Annual Meeting Session LOOKING BACK…focused on the future According to 2005 Munich Re Pricing Survey Only two companies include a charge for guaranteed renewal rates Only one company stochastically modeled interest rate guarantees

CIA Annual Meeting Session LOOKING BACK…focused on the future What guarantees are currently in effect? Week of May 25, 2005 Sample of 8 companies 1 company was crediting 5-year guaranteed rate 4 companies were crediting 10-year guaranteed rate 3 companies were crediting 20-year guaranteed rate

CIA Annual Meeting Session LOOKING BACK…focused on the future Approach to modeling minimum interest rate guarantees Adapt model to include GIAs only Question – how is profitability affected without spreads from other investments? Run paths with and without guarantee in effect PV of difference in profitability is cost of guarantee

CIA Annual Meeting Session LOOKING BACK…focused on the future Issues to consider in modeling of interest rate guarantees What CTE level is relevant? How to reflect this in pricing? Additional spread, or additional capital appropriation? Long-term rates of return Do you assume persistence of current low rates? Include scenarios where rates drop significantly lower?

#4 – Premium Persistency

CIA Annual Meeting Session LOOKING BACK…focused on the future What level of premiums are you expecting in the long run? Will policyholders continue to over-fund, or will they drop or suspend premiums? Future economic conditions How dependent upon future premiums is your pricing? No industry experience to draw upon

#5 – Underlying Investment Returns

CIA Annual Meeting Session LOOKING BACK…focused on the future UL can be viewed as a hybrid of two products Pure insurance protection Savings portion that allows tax-deferred growth Can be used to pay future charges

CIA Annual Meeting Session LOOKING BACK…focused on the future Long-term return assumption especially important for insurance portion Especially level COI, where future mortality costs are pre-funded Investment returns are required to fund future mortality costs Appropriateness of asset strategy Must balance returns against capital cost

CIA Annual Meeting Session LOOKING BACK…focused on the future Long-term growth assumption on account values Is it as important? Yes – will greatly affect future account balances, which will affect spreads collected How will policyholders behave in the future? Will they shift investments to lower spread options if conditions warrant? What is the impact on pricing?

CIA Annual Meeting Session LOOKING BACK…focused on the future May be useful to look at the two pieces separately Is the insurance coverage self-supporting? What levels of cross-subsidy exist? Does over-funding always mean higher profitability?

#6 - Management Expense Ratios and Investment Accounts

CIA Annual Meeting Session LOOKING BACK…focused on the future Average spread is 290 bp (Munich Re Survey, 2005) Marketplace is under pressure to reduce management fees Exchange-traded funds

CIA Annual Meeting Session LOOKING BACK…focused on the future Do higher MERs deliver the value? Median MER of Canadian Equity funds 2000 – 2.34% 2005 – 2.64% But: 80% of actively managed mutual funds fail to beat low cost passive index fund National Post, June 4, 2005 Consumers will start to put the pieces together

CIA Annual Meeting Session LOOKING BACK…focused on the future Does your product still work under a lower MER? May need to Reduce bonuses Reduce compensation Increase prices on other elements of product How sensitive to pricing is change in MER? Likely quite sensitive

CIA Annual Meeting Session LOOKING BACK…focused on the future Is there a practical limit on investment options? Additional overhead of multiple fund offerings Could policyholders diversify away fund manager expertise? Value associated with MER is negated

#7 - Illustration and Sales Practices

CIA Annual Meeting Session LOOKING BACK…focused on the future What is a realistic rate to use in illustrations? 6% net rate implies almost 9% gross rate (assuming average MER of 290 bp) Is this too aggressive for a long-term return assumption? Will the policy deliver the values the buyer thought it would?

CIA Annual Meeting Session LOOKING BACK…focused on the future Bonus structures Some companies have bonuses that are triggered by a threshold rate of return i.e. additional bonus paid if return exceeds 5% An illustration run at 6% will pay the bonus each year However – actual returns could fluctuate above and below 5%, and still average to 6% Actual bonus collected will be less than illustrated

CIA Annual Meeting Session LOOKING BACK…focused on the future Focus on long-term values Many advisors still look at 40 th year cash values Realistic measure of value? Would be valuable to also show probability of survival to that age (after mortality and lapses)

CIA Annual Meeting Session LOOKING BACK…focused on the future Customer expectations How significant are the differences in illustrated vs. actual performance? Very limited experience at longer durations (i.e. 20+) Will customers view shortfalls in performance as the company’s responsibility?

CIA Annual Meeting Session LOOKING BACK…focused on the future YRT as a replacement for Term Lower initial costs may be attractive Are policyholders prepared for increases in costs? Product structures may alleviate this i.e. require higher first-year minimum premium Are your products being sold as permanent coverage, or shorter duration term coverage?

#8 - Modeling Shortfalls

CIA Annual Meeting Session LOOKING BACK…focused on the future Are all product features modeled properly? E.g. joint last-to-die with COIs to first death Requires multiple contingent account value growth paths Not handled by conventional pricing software Multiple coverages Do you model policies, or individual coverages? Are death benefits options (i.e. account value on first death) adequately modeled?

#9 - Shifts in Mix of Business

CIA Annual Meeting Session LOOKING BACK…focused on the future Level COI vs. YRT COI Market is moving towards YRT COI From 40% in 2001 to 50% in 2004 Pricing challenges with Level COI Lower lapse rates Lower interest rates More capital intensive (especially lapse capital)

CIA Annual Meeting Session LOOKING BACK…focused on the future If your Level COI sales are more than 50% of your UL portfolio, you are possibly being selected against How sensitive are your profit results to shifts in business mix? How soon can a trend be recognized?

#10 – The Disaster Scenario

CIA Annual Meeting Session LOOKING BACK…focused on the future What if tax deferral of life insurance was rescinded? What proportion of your UL business is sold for insurance protection as opposed to tax deferral? How dependent is your product line on UL sales? What level of fixed expense support would be lost?

CIA Annual Meeting Session LOOKING BACK…focused on the future Conclusions: 1. Several things can go wrong. 2. Murphy’s Law: If anything can go wrong, it will. 3. O’Toole’s Commentary: Murphy was an optimist 4. UL pricing actuaries must be ever vigilant.