Unitised With P rofits Profits (UWP) Product and Issues in India Pradeep K Thapliyal

Unitised With Profits (UWP) Product and Issues in India Pradeep K Thapliyal

Contents ts Introduction New business levels in UK Contract design Issues Shareholders share surplus Regular and final bonus Market Value Reduction policy Reserving and capital UWP Versus Conventional with profits Unit Linked Contract Universal Life

Introduction o Unitised With Profits (UWP) contracts emerged in UK in 80s These are with profits investments expressed as unit linked policy UWP contracts are similar to unit linked contracts In unit linked contracts,unit related benefits are markto- market. In UWP, these are not mark to market Instead value of units in UWP has some discretion and guaranteed component In India, one company introduced UWP product in 2002 but subsequently withdrawn after a few years.

New Business level in UK NB volume in APE term 3.7% of total NB in 2007 down from 42.6% in 1985. In 2007, 85% of regular premium and 82% of single premium was UWP( ( Sources:-Centre for Risk and Insurance Studies, Nottingham University Business School)

New business level in UK with profits declined from GBP1129m in 1985 to GBP 643 m in 2007 ( Sources:-Centre for Risk and Insurance Studies, Nottingham University Business School)

Unit Price UWP contract design Unit growth rate pa decided by the company Unit growth rate may consist of a guaranteed rate and a regular bonus rate Unit price is increased daily at unit growth rate Another approach is to keep the price fixed and give guaranteed and bonus increases in the form of extra units The first approach of unit price increase is the most common

UWP contract design Guaranteed growth rate Guarantee that price of existing units will not fall or increase at a certain guaranteed rate This guaranteed growth rate may vary from 0% to 4% Regular bonus rate Unit growth rate over and above guaranteed rate Fund Value Value of units i.e. no. of units * unit price

UWP contract design Final bonus (or terminal bonus) Usually paid when units are encashed such as on maturity, death or surrender This is the final adjustment to bring face value of units closure to asset share of the policy Asset share reflect the actual experience of the fund including investment performance over the term of the policy Smoothing is applied to protect policyholder from large fluctuation in the market.

UWP contract design Market Value Reduction(or MVR) Applied when a policy is surrendered or units are switched into unit-linked funds Applied when asset share falls below that credited by way of bonuses due to adverse movement in asset prices. MVR is applied to bring payouts closure to asset share to protect interest of continuing policyholders MVR not applied on death and maturity No MVR guarantee may be available for a period or at certain points or on pre determined dregular withdrawals

Death benefit: UWP contract design usually higher of sum assured or fund value plus final bonus Maturity benefit: Fund value plus final bonus Surrender value: Fund value surrender charge + final bonus - MVR Charging structure : Same as in unit linked policies Premiums: Can be a level or variable or single premium Switching: often UWP option available in UL contracts along with other funds with switching facility.

UWP contract design A sample illustration of UWP contract UK Age at entry- 35 Charges: Policy term- 20 Nil Allocation period 12 months Premium Paying term- 20 Allocation rate thereafter 100% Annual Premium-150 GBP per month Sum assured- 27000 GBP Death benefit Higher of sum assured and fund value plus final bonus Maturity benefit Fund value plus final bonus Surrender value- Fund value surrender charge Bid-offer Spread 5% Fund management charge 0.75% pa Policy Fee 1.5 GBP per month Mortality Charges 100% A 67/70 Annual bonus rate: 6% nonguaranteed and 0% guaranteed

Shareholders share of surplus (a) 90/10 fund As with conventional with profits, 90% of all surpluses from various sources such as mortality, expenses investment etc goes to policyholders ld and 10% to shareholders May viable for mature stock or mutual company with large free assets Issues India: This is not suitable for a start up company as shareholders h have to fund 100% of deficit i but get back the capital via 10% of surplus when distributed. Because of this 90/10 rules, profitability is low in with profits products

Shareholders share of surplus (a) 90/10 fund For start up companies, deficit is high due to initial set up cost and diseconomy of scale. The shareholders may have to fund bonus up to 10 years of its operation depending on NB volume growth. In India shareholders are allowed to fund bonuses up to first 10 years of company operation Even for a company in its 8 th or 10 th year of operation, if NB volumes growth is large, with profits fund may show deficit due to new business strain alone Companies will be forced to control new business volumes to avoid adverse impact surplus to be compliant with regulations.

Shareholders share of surplus (b) 0/100 fund With profits component of UWP contract t is restricted t to investment surplus Transfers to Shareholders are related to charges net of cost In this approach, a company writes UWP business in unit linked fund ( 0/100 fund), usually as a separate company UWP part of fund is reinsured to a with profits fund with main company. All risk and expense charges including FMC go to 0/100 fund FMC is levied on asset share or through deduction from fund 100% of investment surplus goes to policyholders but do not share in mortality and expense surplus 100% of mortality and expenses surplus goes to shareholders but do not share in investment surplus

Shareholders share of surplus (b) 0/100 fund The shareholders get the capital back early depending on chare structure. Hence viable from profitability stand point The pricing of product become identical to that of UL products Can this approach be used in India? Since expense overrun and new business strain is borne by 0/100 fund, the with profits fund will start generating surplus from first year itself if investment return is positive The shareholders may require to fund bonuses because of smoothing

Shareholders share of surplus (b) 0/100 fund Can this approach be used in India? In this approach, expenses that are charged to with profit fund is mortality, expense and FMC charge. Hence no mortality and expenses surplus arise in with profit fund Section 49 of Insurance Act talks about surplus in with profit fund and does not talk about sources of surplus. Does this mean that t 0/100 fund approach is compliant to section 49? Does act or regulations allow such type of par products? Can reinsurance between funds be allowed?

Regular bonus -determination The following factors are investigated Returns earned in the funds in recent years Investment return expected in future Any cost of guarantees, Amount is determined by projecting Asset share for specimen policies on a central estimate of investment return and a constant regular bonus rate is chosen that allows required margin for final bonus Usually investment income is distributed through regular bonuses

Regular bonus -issues Company need to decide what would be the mix between regular and final bonus How frequently bonus rate will vary and effective communication of the same to policyholders to manage PRE Regular bonus are easily comparable to return offered by other saving products e. g. fixed deposit The competitive pressure may lead to start with high regular bonus rate leaving small cushion for final lbonus UK faced situation where regular bonus rate were high than supported by investment return This may increase capital inefficiency

Final bonus UWP contracts provide flexibility to increase or decrease premium Thus premium may not necessarily be level. Two contracts maturing at tthe same time may have very different tinvestment t history Investigating equity for cohorts of business maturing at the same time used in conventional with profits business may not be appropriate p for UWP contracts. The asset share approach used for conventional policies may not be useful without appropriate adjustment which could be complex

Final bonus Asset share by units purchase date( or vintage approach) Asset share is calculated for units grouped by date of purchased usually by calendar year of purchase i.e. for each vintage of units Final bonus is declared for each vintage of units by comparing asset share with value of units Total final bonus in a regular premium policy is the sum of final bonuses for units purchased in each year. Administratively i i complex as vintage of units have to be recorded for ever

Shadow fund approach Final bonus Asset share is calculated in the same way as unit linked fund When a policy is purchased office creates two unit records (a) unit purchased at published price and (b) units purchased at shadow unit price Shadow unit price reflect actual investment performance of fund The asset share of the policy is the value of shadow units

Final bonus Shadow fund approach Difference between M & E charges and AMC deducted from shadow fund with actual mortality cost and expenses need to be allowed for if fund is 90/10 No such adjustment needed for UWP written in 0/100 fund Similarly il l profit from other sources needs to be allowed dfor Administratively less complex that Vintage approach The existing unit linked system can be used to create parallel unit records

Bonus- smoothing policy Company needs to specify and communicate cate its smoothing policy both for regular and final bonuses to manage PRE Need to decide on average what % of asset share will be paid in long run Less smoothing may apply on surrender it order to protect continuing policyholders Need to define smoothing policy around points where no MVR guarantee is available Need to decide duration of glide path for smoothing Cost of smoothing should be neutral over long term in normal circumstances

Market Value Reduction(MVR) Needs to define MVR and its operation and circumstances in which this will apply and communicate the same very clearly to manage PRE In UK, this term historically defined and applied differently by different companies creating confusion Consistency between what is communicated to policyholders ld and what is practiced is very important Non-application of MVR for long time may create expectation that no MVR will apply in future too In past in UK, many companies did not apply MVR in adverse investment conditions No use of MVR may create higher reserving requirements

Reserving and capital UWP unit linked or non-unit linked? Section 1 (b), schedule II A, IRDA regulation (ALSM) 2000, defines universal life contracts means those contracts that are presented in an unbundled form. The contracts where policyholders have an option to invest in units of insurer s s segregated fund(s) shall be treated as linked business ; and others shall be treated as non-linked business. If UWP is offered as an option in Unit linked contract, the UWP can be treated as unit linked contract for reserving purpose If there is no flexibility to invest in segregated fund and only option is UWP, the contract can be treated as nonlinked

Reserving and capital Can UWP be treated t as universal life as this is also an unbundled contract But, there is no separate valuation rules for universal life Which means non-linked reserving regulation will apply Clarification from the IRDA would be required If treated as unit linked contract then reserves is sum of -unit reserve e i.e. face value of units - Non-unit reserves Do we need dto allow for future bonus in non-unit reserve as these are not guaranteed?

Reserving and capital If UWP is treated as universal life or non-linked, GPV would apply May need to keep higher of GPV or unit value GPV valuation ation require to reserve e for vested bonus as well future bonuses including terminal bonus, tax and any transfer to shareholders Projection of future bonuses will be required This also implies that reserve is expected to be vary close to asset share i.e. small free assets There is less possibility of mature business providing a capital support

Reserving and capital A higher regular bonus and lower final bonus mix may give rise to higher additional reserve due higher guaranteed element If company offers no MVR guarantee, the reserves for guarantees will further increase. This may increase capital requirement for the product More pronounced effect for single premium policies The UWP fund usually has sizeable equity investment. This makes ALM very important for UWP contract. In absence of developed derivative market it may become difficult to hedge investment guarantee.

UWP versus Conventional With profits Bonus cost is lower in early years in UWP. Guaranteed build rate is lower as compared to conventional % of SA in conventional V/s % of premium invested in UWP UWP charging structure can be made very capital efficient e.g. very low allocation rate Simple presentation of with profit concept. Easier to understand bonus expressed as% of fund than % of SA UWP offer more flexibility

UWP versus unit linked Both contract tare very similar il in design Surplus is taxable in UWP Unit linked more tax efficient and have higher investment flexibility UWP provide investment guarantee in a managed fund with high equity content Investment guarantee can be available in unit linked UWP more complex to operate UWP is less transparent than unit linked

UWP versus Universal life Universal life similar to UWP in design Universal life more capital efficient i being non-par Almost all of fund invested in fixed interest type portfolio as there is no final bonus systemstem Final bonus system allows UWP fund to be invested in equity type of assets Thus, provide investment guarantee along with potential of higher return UWP more complex to operate

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