Module 6 Exercise: Blackmore Insurance Company

Note to candidates who are retaking FAP Module 6 after March 31, 2014: This exercise has many similarities to the exercise that was used in the previous version. Please read it carefully to be sure you identify the differences and answer accordingly. You are expected to complete original work that is distinct from your first submission.

Purpose & Goal

The primary purpose of this exercise is to enable you to apply some of the key learnings from Module 6. In this exercise, you will assess a model by determining its appropriateness. You will then provide recommendations for revising the model, identify requisite new inputs and assumptions, and identify resulting system or resources constraints. Finally, you will provide recommendations to maintain the model, which will include identifying data or systems required to monitor experience and identifying processes needed to implement model revisions.

Overview

You are an actuarial consultant retained by the Blackmore Insurance Company. Blackmore Insurance is a small insurance company that has been in business for the past ten years. They offer a limited line of individual insurance products targeted to the family and business markets. Alan Paice, who is vice-president of product development, has retained you to assist with some product changes Blackmore is contemplating. Specifically, Paice has asked you to assist in the pricing of their Universal Life (UL) product.

The following section describes the product and the proposed changes. You should assume this product complies with all regulations.

Product and Proposed Changes

Specifically, this section provides:

• A description of current product.

• Current pricing assumptions.

• Current pricing model.

• Proposed product changes.

Your assignment follows the description of the product and proposed changes.

DESCRIPTION OF CURRENT PRODUCT

For a general description of universal life products, please see the appendix.

Blackmore’s current UL product is offered from issue ages 16 to 75 with a minimum face amount of $100,000.  The only death benefit offered is option B, i.e., the amount paid at death is equal to the face amount plus the account value.

Charges are deducted monthly to cover the cost of insurance (COI). These charges increase on each policy anniversary as the probability of claim increases. The rate scale is set at issue and guaranteed not to change once the policy is issued. Charges are differentiated by current age, sex, and smoking status.

All policyowners must also pay a $5 expense charge each month to cover administrative costs. Expense charges and COI charges are deducted from the account value at the end of the month.

The minimum monthly premium is:

• The current cost of insurance charge multiplied by the face amount.

• Plus the monthly expense charge.

Blackmore’s UL product is flexible premium, therefore the minimum premium is only required for one year. Policyowners may choose to continue to pay these minimum premiums for the life of  the contract. Policyowners are allowed to deposit up to three times the minimum premium in a given calendar year.

The product offers two investment options:

• Option 1: A 5-year Guaranteed Interest Option. Each premium is deposited into an account with a maturity of five years. The interest credited on the account is set at the time of the deposit and guaranteed for the five-year period. W ithdrawals from the account to pay charges (such as cost of insurance or  expense charges) can  be  made without any market value  adjustment. Any other withdrawals, including transfers to other investment options may be subject to an adjustment depending on current market interest rates.

• Option 2: An Equity-Based Account. Each day an amount is credited to the account equal to the daily percentage change in the S&P 500 total return index minus the margin discussed below. The credited amount can be positive or negative. W ithdrawals from this account for any purpose are not subject to any market value charges.

To determine the rate credited on each investment option, the following margin is deducted from the gross earned rate. These margins are additional sources of revenue.

• Guaranteed Interest Option: 1.50%.

• Equity-based Option: 2.25%.

Funds can be moved between accounts subject to market value charges, if applicable.

In addition to market value charges, any withdrawals from the policy are subject to surrender charges. These charges are a percent of total amount withdrawn depending on the number of years since policy issue:

• Year 1: 100%

• Year 2: 85%

• Year 3: 65%

• Year 4: 40%

• Year 5: 15%

• Years 6+: 0%

Commissions are paid to advisors on the following basis:

• 50% of the first year minimum premium.

• Plus 5% of premiums in excess of minimum premium in the first year.

• Plus 0.25% of the total account value in the second and subsequent policy years.

First-year commissions are fully refunded to the company if the policy terminates any time during the first two policy years.

CURRENT PRICING ASSUMPTIONS

Blackmore’s pricing mortality assumption was developed five years ago. It is based on a combination of industry mortality experience with similar UL products and the company’s own  mortality experience. Management is not comfortable projecting any mortality improvements, so these are not reflected in the pricing mortality assumption.

Annual lapse rates for the product are assumed to be as follows:

• Year 1: 10%.

• Year 2: 9%.

• Years 3-10: 3%.

• Years 11+: 2%.

A policy is considered to have lapsed when:

• There are insufficient funds in the account value to pay the required charges.

• Or, the policyowner elects to terminate the policy and withdraw any remaining funds in the account value.

The company has a simple experience monitoring system for tracking mortality and lapse experience by policy year. The pricing interest rate for the product is assumed to be a level six percent. Paice explains that Blackmore has performed a projection of investment income on its current asset portfolio, which incorporates future cash flows, and feels comfortable with the assumption.

An internal charge of $100 per policy per year is included to cover all direct and overhead expenses associated with the product line. This is an internal expense to the company and is not paid by the policyowner nor reflected in their policy values. The company pays two percent of premiums each year in the form of premium taxes. The company makes its pricing and profitability decisions before taking income taxes into account. 1

Paice performs sensitivit y testing on the key assumptions, which are described below:

These sensitivity tests are performed whenever assumptions are updated.

CURRENT PRICING MODEL

Paice has provided a description of Blackmore’s current pricing model. It is a profit projection model developed in-house and set up as an Excel spreadsheet. 2   The model projects all policy cash flows and reserves using the current pricing assumptions discussed above.

This model includes a projection of account values to determine future benefits payable. It is assumed that

50 percent of premiums are invested in the guaranteed interest option and the balance is invested in the equity-based option. For projecting account values, Paice indicates that the model starts with the same long- term interest assumption as the company’s own asset portfolio. This is based on Blackmore’s current view that the assets backing the guaranteed interest option will earn five percent in the long term and the assets backing the equity option will earn seven percent. Since Blackmore expects the account balances to be equal, the six percent pricing interest assumption has been deemed to be appropriate.

The model also assumes a funding pattern for premiums. Paice mentions that they looked at total premiums for the last policy year as a function of the minimum premium and developed the below ranges for funding. (Figures are proportion of business based on face amount written.)

The pricing model uses a simplified assumption that 150 percent of the minimum premium is made each year on policies.

Each tab in the spreadsheet projects cash flows and reserves and determines profitability for each year as follows:

After-Tax Profits = Premiums + Investment income – Death benefits paid – Amounts paid on surrender – Commissions – Direct and overhead expenses  – Increase in reserves – Taxes.

Reserves are calculated as the present value of projected benefits and expenses less the present value of projected premiums using prescribed valuation assumptions.

1 For the purposes of this exercise, income taxes may be ignored.

2 Note that a copy of the pricing model spreadsheet is not provided for this exercise. The focus of this should be on model management and controls and not the detailed content of the model itself.

There are a total of 20 tabs in the spreadsheet:

• 5 issue ages (25, 35, 45, 55, 65)

• 2 sexes

• 2 smoking statuses

The results for the various tabs are aggregated in a summary sheet.  The company’s main profitability measure is premium margin, i.e., present value of profits divided by the present value of premiums. Both streams of values are discounted at the six percent pricing rate.

Paice explains that they have reviewed other models available from external vendors but have decided to develop a model in-house. His reasons for doing so can be summarized as follows:

• An internally developed model means that they have complete control over the calculations. There is no “black box.” Calculations can be easily modified on the spot without having to put in a request to the vendor.

• External models can be very complex and contain features that they will likely never use. The in-house model is much simpler to learn and use.

• Blackmore does not feel that the cost of an external model is justified. The company has been presented models that perform stochastic modeling of rates of return but has rejected them. Paice believes that this is a level of complexity that is not necessary to price company products and that the extra cost is not justified.

PROPOSED PRODUCT CHANGES

Universal Life sales for the past three years have been fairly flat and decreased slightly last year, as shown here:

• 2011 Premiums $10.5 million

• 2012 Premiums $10.7 million

• 2013 Premiums $10.2 million

Paice indicates that this is a concern for them for fear that they are losing market share. Blackmore’s marketing department completed a research project this year where they interviewed several leading advisors to determine which product features would generate the most interest. After completing the project, marketing presented a list of product ideas to management. Paice indicated that Blackmore wants to focus on the  more innovative concepts to  generate excitement without having to  reduce policy charges. Marketing’s list of enhancements included the following:

• Minimum Interest Guarantee. On the guaranteed interest account, they want to introduce a minimum floor on the account. The proposal is that the credited rate on this account will never drop belo w 2.0 percent. This would be guaranteed for the lifetime of the contract. Paice mentions that, even in this low rate environment, the credited rate on their account has not dropped below 2.0 percent, so this should be a zero-cost guarantee.

• Free Withdrawal Provision. Under this provision, the policyholder will be able to withdraw up to ten percent of their account value per year without incurring surrender charges. Paice mentions that they want this to be a controlled option, so the provision will only become active if the total return on the account value does not exceed three percent in a given year. Paice wants to position this as a form of “performance guarantee,” i.e., policyholders can withdraw some of their funds if the company does not deliver an adequate return.

• Performance Bonus. This feature comes into effect if the account value grows by more than 25 percent in the course of a policy year, either through additional premiums or through exceptional investment returns. If this condition is met, a performance bonus equal to 0.75 percent of the total account value will be credited to the policy at the policy anniversary. The bonus is payable only in policy years ten and later.

• Return of Cost of Insurance Charges. This feature returns all COI charges paid during the first ten years of the policy. At the tenth contract anniversary the benefit is paid and the customer will forfeit the benefit upon surrender before the tenth contract anniversary

In addition, the company has committed to spending $8 million to repackage and promote the new features of the product.

Your Assignment

Paice has asked you to prepare a proposal and a work plan for modifying Blackmore’s pricing model to incorporate the product changes listed above. Your report, written as a memorandum to Paice, should follow the steps associated with the Model Control Cycle and include the following sections:

• Assessment of the Current Model. This section should include:

• Confirmation of the problem you have been asked to solve

• Identification of existing model including any risks associated with it

• An assessment of the appropriateness of the current model

• Inputs, assumptions, and constraints associated with the current model.

• Recommendation for Model Revisions. This section should include:

• General recommendations for changes to the model

• Inputs and assumptions required for the new model

• Identification of any system or resource constraints

• Recommendation for Sensitivity Testing Improvements. This section should include:

• General recommendations for improvements

• Model revisions necessary to implement recommendations

• Recommendation for Maintenance of Model Going Forward. This section should include:

• Data and systems required to monitor future experience

• Processes to implement future revisions to the model

A Note About Pasting Tables

If you need to insert Excel tables into your document, then you must follow the instructions below to copy and paste it from Excel into your Word document (do not “Paste as Picture” or “Insert Object”).  Do not use Word’s “Insert, Table, Excel Spreadsheet” function, since this will not paste your table in the correct format.  Pasting a table as a picture or as an object will result in an  automatic disqualification of your submission. (Graphs pasted as pictures are not affected by this requirement.)  If you cannot get the pasted table to fit on the page, you can right-click on it and select “AutoFit to Window”.

Steps for pasting tables (for Windows versions of Word/Excel):

1.   Copy the cells from your Excel spreadsheet.  If you use the Copy command on the Home tab, do not select the option to “copy as picture”.

2.   In your Word document, turn on the “Show/Hide Paragraph Marks” feature.

3.   In your Word document, right-click where you want to insert your table.

4.   In the menu that pops up, under Paste Options, select any of the first four options:

a.   “Keep Source Formatting”

b.   “Use Destination Styles”

c.   “Link & Keep Source Formatting”

d.   “Link & Use Destination Styles”

5.   If you have “Show/Hide Paragraph Marks” turned on, you should see small circles at the end of each cell in your table.  This is how you can know whether or not you have pasted your table correctly.

Steps for pasting tables (for Mac versions of Word/Excel):

1.   Copy the cells from your Excel spreadsheet.  If you use the Copy command on the Home tab, do not select the option to “copy as picture”.

2.   In your Word document, turn on the “Show All Nonprinting Characters” feature.

3.   In your Word document, right-click where you want to insert your table.

4.   In the menu that pops up, click Paste (not Paste Special).

5.   If you have “Show All Nonprinting Characters” turned on, you should see small circles at the end of each cell in your table.  This is how you can know whether or not you have pasted your table correctly.

As You Complete Your Tasks…

Your name should not appear anywhere in your submission, or in the filename, or in any way identify you as the author. If you believe you should refer to yourself in the context of an answer, use “FAP Candidate” instead of your actual name.

Appendix: Description of Universal Life Products

A Universal Life (UL) product is a life insurance product differentiated by having flexible premiums and a flexible death benefit. Unlike traditional products, where a required periodic premium is payable for a fixed death benefit, a UL product is “unbundled,” i.e., the individual components of the policy are visible to the policyholder.

To pay for a UL policy, the policyholder deposits premiums into an account within the policy. Each month, amounts are deducted from the account to pay for mortality and expense costs. The mortality cost is a specified rate per thousand multiplied by the current amount of insurance in effect for the policy. In addition, amounts are deducted to cover other expenses associated with the policy. Common expense charges are per policy, percent of face amount, or percent of premium.

The timing and amount of the premiums are at the discretion of a policyholder, who only needs to ensure that the balance in the account is sufficient to pay mortality costs and other charges. The account value including any excess amounts is eligible to earn interest.

The amount of insurance depends on the death benefit structure of the policy. Each policy must have a specified face amount. Policyholders may opt to have a level death benefit, option A, in which case the amount payable on death is the face amount. Another option is option B, where the amount payable on death is the face amount plus the account value.

Mortality costs are based on the “net amount at risk.” For option A, the net amount at risk is the face amount less the account value. For option B, the net amount at risk is equal to the face amount.

The account within the policy could actually comprise several investment options. Policyholders can select the options in which to invest their money and make transfers between options within the policy. They also have the option to withdraw funds from the account. Depending on the policy structure, there may be a charge for these withdrawals.