Policyholder behavior and renewal premiums International

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					          IAA Phase 2 Issue Discussion Paper – June 2005
Policyholder Behaviour, Renewal Premiums, Options and Guarantees

Introduction


IASB – Phase II of the Insurance Project and the objectives of the IAA
The IASB has given phase II of the insurance project high priority status. Phase II has
been underway since March 2005. The Board intends to produce a discussion
document as the initial output of Phase II in sometime after the end of 2005. The
discussion document is an important milestone in the development of an international
insurance standard.
The Board’s project plan, as documented in the January 2005 Observer Notes, includes
a list of topics for the discussion document. Among these are:
       •   Measurement: Should the measurement address options or guarantees
           embedded in a contract?
       •   Policyholder behaviour: Should the accounting model incorporate
           expectations about cash in flows and out flows that are a consequence of
           policyholder renewals or calculations of an insurance contract?
It appears likely that the Board will adopt a discounted cash flow measurement
technique for the valuation of insurance contracts. The topics of options and guarantees
and of policyholder behaviour are inter-related topics that have a significant bearing on
projected cash flows.
The IAA has undertaken its own project to produce discussion documents addressing
technical issues relating to the measurement of insurance liabilities. The IAA believes
that the discussion documents can be helpful to the Board in its deliberations regarding
accounting for insurance.


Scope of this discussion paper
This paper discusses the influence of options and guarantees, including renewal options
and cancellation rights, on the cash flows of insurance contracts. It presents common
approaches to the projection of cash flows, whether for the measurement of liabilities or
for other purposes, and it discusses possible approaches for an IFRS measurement
model. It includes a discussion of the topic of policyholder behaviour and its relevance
to the measurement of liabilities.
While not recommending an approach, the paper concludes by encouraging the Board to
adopt an approach that
•   uses established practices, rather than practices that may be more appealing
    conceptually, but that have not been tested and proven to be reliable,
•   covers the broadest range of products and features, in order to keep the number of
    accounting models as small as possible.
•   considers the issues relating to policyholder behaviour, renewal premiums and
    options and guarantees in the context of objectives of the measurement and takes



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          IAA Phase 2 Issue Discussion Paper – June 2005
Policyholder Behaviour, Renewal Premiums, Options and Guarantees

    holistic view to the measurement, in order to avoid selecting individual answers to
    specific issues that may not combine into a coherent accounting model.
The scope of this discussion paper is long-duration contracts, principally life insurance
and annuities. The discussion applies as well to some forms of health insurance, such as
individual disability and long term care. For convenience, the term life insurance is
intended to include all of these contracts. Also for convenience, this discussion paper
does not distinguish between the insured person and the policyholder, although they
need not be the same person. The discussion reflects that the paper’s focus is on
policies sold to individuals rather then on group contracts or reinsurance, although the
concepts are generally applicable to group contracts as well.


Related Topics
There are a number of other topics that have a bearing on this measurement of life
insurance liabilities, and that may have interdependence with policyholders’ behaviour,
renewal premiums, and options and guarantees. They are not addressed in this paper
except when they have a direct bearing on the topic. These topics include:
   1) Calibration of models – the calibration of models at contract inception and at
      subsequent reporting periods (the “day-two” problem)
   2) Basis for assumptions – whether current estimates or some other and the related
      topic of inclusion of adjustments for risk and uncertainty
   3) Discount rates
   4) Options in contracts retained by management, such as the option to adjust
      interest credited rates, that may influence policyholder behaviour and the take-
      up of options
   5) Embedded derivatives – which may require separate measurement to be
      consistent with IAS 39, Financial Instruments: Recognition and Measurement
      (IAS 39), depending on which accounting method is adopted for life insurances.
      A key contract issue will be whether that embedded derivatives are adequately
      considered in the measurement of life insurance liabilities even if the adopted
      approach is not a fair value measure.
   6) Unit of account


Background
It is the variability in cash flows of insurance contracts that makes their measurement
difficult. Options and guarantees in contracts are the source of much of the potential
variability in life insurance cash flows.
In this paper, options are those features that require a decision by the policyholder. The
decision may be a proactive one or it may be made by default. Examples of common
options include:




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          IAA Phase 2 Issue Discussion Paper – June 2005
Policyholder Behaviour, Renewal Premiums, Options and Guarantees

    •    the option to pay renewal or recurring premiums, which generally requires a
         proactive decision to make the payment,
    •    the option to cancel a contact, which is the default option in many contracts if a
         due premium is not paid
    •    the option to take settlement of a contract at maturity either in the form of a life
         annuity or in cash. Cash settlement may be the default option and the choice
         of a life annuity requires a proactive effort by the policyholder.
An attribute of options embedded in insurance contracts is that they not only have value,
but they must be thought of in terms of a take-up rate. The projection of cash flows
related to options depends on the extent to which the option is utilised. For example, if a
contract has a guaranteed annuity option at maturity and the company expects that 90%
of contracts that reach maturity will settle for the annuity option, then the take-up rate
for this option is 90%. Take-up rates, like many other variables, may depend on as
interest rates at the time of maturity, life expectancy in general and the health of the
policyholder specifically, or other factors.
Guarantees are those features which potentially provide value above market value, but
which do not require a decision by the policyholder. Examples of guarantees include:
    •    guarantee of the value of the contract
    •    guaranteed death benefit
    •    guaranteed premiums for renewal periods
Options and guarantees are not mutually exclusive concepts. For example, a contract
may provide a settlement option on maturity, and the value of the options may or may
not be guaranteed. A contract may have the cancellation rights, but the surrender value
may or may not be guaranteed. In financial terms, a guarantee is equivalent to an
option, as they both represent the potential for creating a value to the contract that is
greater than the value that the contract would have without the feature. The distinction
between the two terms is made here to assist in the discussion of life insurance cash
flows.
Options and guarantees in insurance contracts are ubiquitous. A list of common options
is found in Appendix A.
Often they are also inter-related. For example:
    •   for some contracts, the option to cancel a policy may be elected by not taking
        the option to pay a renewal premium
    •   in other products, not paying a premium may result in taking a premium loan,
        which may be a default option in the contract.
Another example of inter-dependence can be seen in the guaranteed minimum interest
rate. A contract that has a minimum rate is more likely to stay in force when rates are
low than when they are high. Nevertheless, the possibility that the minimum rate may
be valuable in the future may influence the policyholder to keep the contract rather than
to exercise the option to cancel it, even if it is possible to replace it with a new contract


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Policyholder Behaviour, Renewal Premiums, Options and Guarantees

that pays a higher rate of interest. If the new contract does not have a minimum rate
guarantee, the policyholder may decide that having the rate guarantee is more important
than receiving a higher rate of interest currently.
It is apparent that the value of an option or guarantee related to financial variables
depends on the economic environment. For example, when interest rates are low, a
guaranteed minimum interest rate guarantee has greater value than when interest rates
are high.
A characteristic of life insurance is that that an option or guarantee may have greater
value to one policyholder than to another. For example, a guaranteed premium rate for
renewal periods has greater value to a person whose health has deteriorated since
inception of the contract, as compared to the value to a person who has remained
healthy. A person who is healthy may be able to replace the insurance, whereas a
person who is not healthy may not have this possibility. This characteristic is an
important consideration that distinguishes life insurance contracts from most other
financial instruments; namely that the value of the contract or of embedded options and
guarantees is not intrinsic to the contract alone, but can depend on the insurability or
underwriting status of the insured person. Because the status of individuals is generally
not known and because the cash flows of contracts that depend on contingent events are
not predictable for a single contract, the valuation of insurance contracts is performed
on groups of contracts for which averaging and other statistical approaches are
appropriate. As a result, while it is common to refer to the value of a contract or to the
value of an option or a guarantee, what is meant is the average value for a group of
contracts.


Projecting cash flows
There are varying practices for projecting life insurance contractual cash flows,
depending on the purposes. The practices relate to, among other things, differing
approaches to reflecting options and guarantees and to incorporating policyholder
behaviour.
Projections can be either deterministic or stochastic. In a deterministic model the
assumptions can either be prescribed (by regulators, for example) or judgementally
selected by the actuary. If judgemental, projections can be current estimates of the
future cash flows, perhaps adjusted to reflect risk and uncertainty. Deterministic
projection can use single scenarios or they may be multiple scenarios in order to
consider a range of possible future cash flows.
Stochastic models usually involve multiple scenario projections. The underlying
economic scenarios are produced by scenario generators. Economic scenarios are
typically sets of future risk-free interest rate curves, spreads to risk-free rates, and equity
growth rates. The scenarios are produced as equally-likely or with weights to reflect
their relative likelihood. Contract cash flows are projected for each scenario, reflecting
the influence on cash flow of the underlying economic conditions in each scenario. The
economic conditions can affect policy values, the values of options and guarantees,
policyholder behaviour, and other variables.




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Policyholder Behaviour, Renewal Premiums, Options and Guarantees

A hybrid approach is to use stochastic models to determine the adjustments to cash
flows in a single, deterministic scenario needed to reflect the risks and uncertainty. This
approach allows for a scientific basis for reflecting the risk and uncertainty, but avoids
the need to produce multiple scenarios, which can be highly time-consuming, in the
short time available for preparing financial statements.
Projections are usually either realistic or risk-neutral. A complete discussion of realistic
versus risk-neutral projections is beyond the scope of the paper, but the significance of
the difference is that
    •   in realistic scenarios, asset growth rates reflect spreads to risk-free rates, which
        in turn are reflected, as appropriate, in contract values. As discussed further
        below, other variables, such as take-up rates for options are generally realistic,
        considering past patterns of policyholder behaviour, although option prices may
        in fact be based on market-consistent or risk-neutral techniques.
    •   in a risk-neutral projection, all assets are assumed to grow in value at risk-free
        rates. Policy values and in the values of options and guarantees are projected
        consistently with the underlying economic variables. Typically variables that
        reflect policyholder behaviour, such as payment of renewal premium,
        cancellations, and take up rates are either prescribed or realistic. Although
        conceivable, it is not a common practice to model economically rational
        policyholder behaviour. This point is discussed further below.

Policyholder behaviour
It is a common observation that policyholders do not always make decisions that are
economically optimal to themselves. A key question to be answered in the selection of
a measurement model is whether or not projected cash flows should reflect realistic
policyholder behaviour. This issue is central to the decision regarding inclusion of
future premiums
Incorporating realistic assumptions about policyholder behaviour is common in profit
testing, planning, liability adequacy testing, and in measurement models in many
company’s existing accounting policies. In the insurance industry, there are well-
established projection techniques and practices that incorporate policyholder behaviour.
The assumptions for the variables that depend on policyholder behaviour are supported
by abundant evidence of past policyholder behaviour. The fact that policyholders do
not always behave in the way that it might appear to be to their advantage to do so can
be explained by factors such as:
   o The influence of agents or others on an individual’s decision making
   o A cash demand or other personal matters that affect decision making
   o Brand loyalty
   o Lack of initiative
   o Lack of sufficient benefit to justify the effort to make a more rational decision




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There are undoubtedly other factors, many of which are not known. The phenomenon
of policyholder behaviour is just one example of financial decision making that is not
always apparently optimal. There is a growing field of study regarding economic
behaviour. Economists recognise that people frequently make decisions that cannot be
explained by objective financial consideration alone. They are giving credence to what
insurers have considered in pricing contracts for decades; namely, that there is a pattern
or behaviour that is not fully explained by financial considerations but is sufficiently
well understood to make reasonable assumptions for pricing and for valuation.
Policyholder behaviour is not constant. It can vary with economic conditions, for
example, and it is influenced by contract features, and as surrender charges or market
value adjusters. Observed patterns may change, suddenly or gradually, when
policyholders, as consumers become more sophisticated in their decision making.
Hence cash flow projections and measurement models that are based on assumptions
about policyholder behaviour run the risk that experience will deviate from
assumptions.
As noted before, the optimal financial decision for a policyholder may not be apparent
to the insurer or to a third party, as it may depend, for example, on the health of the
insured. Hence models that incorporate policyholder behaviour based on observed
patterns implicitly reflect the influence of personal conditions in decision making.
The topic of incorporating policyholder behaviour into accounting models is discussed
at greater length in a paper previously submitted to the Board entitled “Conceptual
Framework – thoughts from W.Paul McCrossan”. It is attached as an Appendix.


The used of behaviour in accounting measures has precedent. Mortgages loans often
contain an option to the borrower to prepay the principle of the mortgage without
penalty. The measure of a mortgage loan asset under IFRS reflects an assumed
prepayment “speeds”. The prepayment speeds are based on realistic expectations and
are adjusted for emerging experience, whether an amortised-cost or a fair-value measure
is used.


Renewal Premiums
One of the most important options in life insurance contracts is the option to continue or
to renew coverage by paying renewal premiums. Typically the collection of renewal
premiums can not be enforced by the insurer. Their payment is totally at the option of
the policyholder. This option is singled out for discussion because inclusion of future
premiums in the measure to liabilities can be construed to be recognising an asset that
the entity does not own or control. It has been a subject of much interest and debate in
the Board deliberations to date.


Why include renewal premiums in the measurement of liabilities?
The case for including future premiums has several supporting factors.



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Policyholder Behaviour, Renewal Premiums, Options and Guarantees

•   The measurement method is discounted cash flows. As premiums are contractual
    cash flows, excluding them overlooks significant cash flows.
•   Future benefits are often dependent on future premiums. In order to get a proper
    measure of the future benefits, it may be necessary to consider future premiums.
•   Measurement without future premiums may not be prudent, as the term is used in
    the Framework, namely,
        “Prudence is the inclusion of caution in the exercise of the judgements needed in
        making the estimates required under conditions of uncertainty”.
    As future obligations under the contract depend on future premiums, measures may
    not be prudent if they do not consider future premiums. As discussed further
    below, the effect on the measurements of liabilities of including future premiums
    depends on the approach taken. Hence it is not certain that inclusion of future
    premiums is more prudent than exclusion of future premiums. The inclusion of
    future premiums allows the measurement model to manage the effect on the
    measurement by the specific approach taken. Excluding future premiums from the
    measurement of liabilities leaves the effect uncertain.
•   For contracts with an option to pay renewal premiums, the alternative to including
    premiums in the measurement of the liabilities is to value the option to renew as an
    embedded derivative. This approach is conceptually sound, but it may not be
    practical, as
    o   It may not be feasible to separately value the option as it is too inter-related with
        other cash flows in the contract
    o   As with any option, its value is a function of future cash flows and hence
        requires consideration of future premiums in some fashion. For this reason, it
        may in fact be unavoidable to consider future premiums in order to measure the
        liability.
•   If measurement of the liability does not include future premiums, there may be
    difficulties in defining an internally consistent conceptual approach to amortisation
    of deferred acquisition costs and to liability adequacy testing, if these are a part of
    the accounting model.
•   The concern about recognising an asset that should not be recognised can be
    addressed in a couple of ways.
           o The question is not one of recognition. An insurance contract is a
             financial liability that must be recognised. The issue relates only to the
             measurement of the liability, specifically, should the projected cash
             flows used in the measurement of the liability include future premiums.
           o Issuing an insurance contract with recurring premiums is analogous to
             issuing a single premium contract and financing the purchase. The
             financing arrangement is essentially a loan. The loan is secured by the
             value of the insurance contract (albeit the value of the loan may at times
             – eg, in early policy durations - exceed the value of the insurance



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               contract, as the future premiums must not only fund the obligations of
               the insurance contract but must also recover the insurer’s acquisition
               costs). The lion value can offset the liability value. While this concept
               is useful to gain a perspective on the cash flows, in practice insurers do
               not measure either implicit single premium or the value of the loan, but
               only the measure of the net cash flows.


Product types and premium features
In order to discuss possible approaches to considering future premiums, it is helpful to
have a summery of the major life insurance products that have recurring premiums.
•   Fixed premiums: most term assurance and many endowment and whole of life
    contracts have premiums that are fixed in the amount and the timing (due dates) of
    future premiums. They may be level (uniform) or they may vary; for example, they
    may increase with attained age or at certain policy durations. When a premium is
    not paid, the contract either
           o   terminates, as is usually the case for term assurance,
           o   becomes paid up, is surrendered for cash, or is settled by some other
               nonforfeiture option, if the contract has a settlement value,
           o   has the premium paid by a policy loan; that is, the policy’s value is
               reduced by the amount of the premium that is due and the contract
               carries on with a reduced value. This possibility can occur at any
               premium due date on which the policy value is sufficient to “pay” the
               premium. If the value is not sufficient, the contract terminates. Note
               that generally the premium loan can be repaid by the policyholder at any
               time and that interest accrues on the policy loan balance, which is also
               taken from the contract value.
    The projection of future premiums for these contracts must consider the utilisation
    of cancellations and other options, such as premium loans.
•   Indeterminate premium: these are similar to fixed premiums, except that the
    insurer has the ability to adjust premium within certain limits. Generally the ability
    to increase premiums is for a class of contracts, not for a single policyholder. There
    may be guaranteed maximum premiums, and premium increases may require
    regulatory approval. The projection of future premiums requires an assumption
    about future premium adjustments.
•   Flexible premiums: many contracts allow the policyholder to make deposits to the
    contract’s account value at any time and for any amount. These are common in the
    United States, for example, for universal life insurance. For these contracts, the
    premium is flexible and the insurance coverage is paid for by deductions from the
    account value, known as risk charges or as charges for the cost of insurance. The
    coverage remains in force as long as the policy’s account value is sufficient to pay
    the risk charge. The projection of future cash flows depends on assumptions about
    how often and how much premium is paid.



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Approaches for considering future premiums
Possibilities for projecting future premiums include
•   Assuming that all future premiums are paid. The projected premiums may be
    gross premiums (the premium paid by the policyholder) or they may be net
    premiums. A “net” premium is the premium that would be required, under the
    basis of valuation, to exactly provide for the contract’s benefits. A net premium is a
    theoretical premium, but can be thought of as the gross premium less the company’s
    margins for profit. The basis for the net premium can be either
       o realistic, including current estimates (with or without margins for
         uncertainty) for mortality, interest, and expense, or
       o prudent, perhaps as determined by insurance regulators, to consider, for
         example, mortality and interest alone. This is sometimes referred to as the
         technical basis.
•   Assuming that no future premiums are paid. This approach, as has been discussed,
    would treat the contracts as one for the period of coverage that is paid for by the
    initial premium, or the remaining period of coverage if no further additional
    premiums are paid. It would require that the option to renew be treated like an
    embedded derivative.
•   Incorporating policyholder behaviour into the projection of cash flows. For future
    premiums, this would mean setting an expectation for their payment based on
    observations of past payment patter, trends in experience, and other environmental
    factors. Premiums can be either gross or net, as in the first possibility.
•   Assuming that a premium is paid if paying the premium is the rational decision.
    Under this approach, a calculation is made of the economic value of the contract and
    this is compared to the value of the contract just before the premium would be paid.
    If the economic value is greater than the value on surrender, then the measurements
    model assumes that the rational decision is to pay the premium. If the economic
    value is less than the surrender value, it assumes that the premium is not paid. An
    application of this technique is found in a paper on pricing participating life
    insurance with recurring premiums and with cancellations options, written by Anna
    Rita Bacinello and published in the North American Actuarial Journal1. In the
    article, Bacinello calculates the “fair” premium of a contract on the assumption that
    the premium is paid if the value to continue the contract is greater than the value to
    surrender. Hence at each payment date, either all contracts surrender or they all
    continue. The fair premium is the mean of the discounted cash flows of a stochastic
    set of scenarios. Projected cash flows in each scenario extend to the point at which
    the value to continue falls below the value to surrender, or to maturity if this does
    not occur. The calculations presume that the contracts are sold in an efficient
    market with low frictional costs.
    The advantage of this approach is that it is consistent with the pricing of other
    financial instruments. The disadvantages are that



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              o the approach is not common in practice for pricing or for other purposes
                and its use as a measurement model would require extending the
                concepts to other products. This would require, for example,
                considering how to make a determination of not only whether paying the
                premium or surrendering the contract is optimal, but whether some other
                option is optimal, such as the option to take a premium loan or the
                flexible-premium option.
              o As Bacinello notes, the paper does not bring into consideration the
                health of the insured, which would affect the calculation of the
                economic value of the contract.
    The concepts in the paper would require further development before they could be
    put into application as an accounting measure. While they show that it is possible to
    conceive of an approach based on rational behaviour, they also demonstrate the
    challenges of applying such an approach to insurance contracts
•   Including future premiums if the measure of the liability is greater than if they
    are excluded. This approach is similar to recognising the value of the option to pay
    premiums only if it is a liability. It is prudent, but it is impractical. It is often not
    feasible to test contracts across the range of possible premium-payment patterns to
    know when inclusion of premiums is conservative. Performing repeated
    measurement to determine which premiums should be considered in not only
    burdensome, it can be seen as favouring a biased valuation over principled
    approached to measurement.



Tentative decision of the Board
In the Basis for Conclusions to IFRS 4, the board presented its tentative decisions with
regard to phase II of the insurance project. One of these is a tentative decision
regarding the inclusion of future premiums. IFRS 4, BC 6(d) states,
       “The measurement of contractual rights and obligations associated with the
       closed book of insurance contracts should include future premiums specified in
       the contracts (and claims, benefits, expenses, and other additional cash flows
       resulting from those premiums) if, and only if:
       (i)     policyholders hold non-cancellable continuation or renewal rights that
       significantly constrain the insurer’s ability to reprice the contract to rates that
       would apply for new policyholders whose characteristics are similar to those of
       the existing policyholders; and
       (ii)      those rights will lapse if the policyholders stop paying premiums.”
This decision addresses whether premiums are included, but it does not specify the
approach. It could be applied with any of the approaches discussed above, except the
second one. It requires clarification for contracts for which policyholders have the
ability to “stop and go” by taking advantage of flexible premium features or policy loan
options. Stopping premiums may eventually cause continuation or renewal rights to
lapse, but it would not be apparent unit the contracts terminated if this were the case.


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Policyholder Behaviour, Renewal Premiums, Options and Guarantees


ACLI/IAA Joint Research Project
The effects of the approach to renewal premiums are illustrated in a paper produced as
the output of a joint research project of the American Council of Life Insurers and the
International Actuarial Association. The results of the research were also presented to
the IASB’s Insurance Working Group in August of 2004. The research show that
reported profits and losses are sensitive to the approach and that results can appear
anomalous, as compared to expectations developed in pricing contracts, when premiums
are not considered in the measurement of liabilities.


Other options and guarantees
The considerations discussed above in relation to the option to pay renewal premiums
apply generically to other options and guarantees in contracts. The key questions that
must be addressed, expressed in general terms are:
Can they be considered in projected cash flows or should they be valued separately?
As with renewal premiums, many options and guarantees are inter-related with each
other and separation is not practical. It is doubtful that an approach could be found
where the value of the entire contract would be equal to the sum of the values of the
options considered separately plus the value of the host contract. It is even difficult to
identify the host, as cash flows throughout the contracts may be subject to options and
guarantees. When separation is not practical, the alternatives are to either,
   o project cash flows with current estimates or on a prescribed basis, with
     adjustments for cash flows or to discount rates, to reflect the uncertainty
     presented by the existent of options and guarantees, or
   o use multi-scenario techniques to explicitly consider the possible cash flows that
     can result from the presence of the options and guarantees.


Should policyholder behaviour be realistic or economically rational? Part of the
difficulty, whether options are separated or not, is that the value of the entire contract
depends not only on the value of options, but on take-up rates as well. An economically
rational approach would assume that the policyholder elects an option if and only if that
is the optimal economic decision. As discussed in connection to the option to pay
renewal premiums, such an approach to take-up rates may be difficult to apply and may
in fact not exist in current practice.
The alternatives to assuming economically rational behaviour are to prescribe a basis,
such as that the option is always utilised, or to incorporate realistic assumptions about
policyholder behaviour into the take-up rates.




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The demand deposit floor
One option in contracts that has drawn the attention of the Board is the option to
surrender a contract for its current value. While terms for products with cancellation
rights vary, they all entail a put option for a value that is referred to as the demand
deposit value. IAS 39 stipulates that the fair value of a contract can not be less that the
amount available on demand. This floor liability is reasonable for financial instruments
traded in efficient markets. It presents a problem, however, when it is imposed on a
measurement method for insurance contracts. A calculated value that is less than the
demand deposit does not necessarily imply that the policyholder has the ability to
replace the contract at a lower cost than amount that the policyholder can receive by
surrendering it. Typically, transaction costs may make this impossible. Further there
may be taxes payable or other factors that make replacing the contract inadvisable,
although these factors may not be reflected in the measure. For example, if a contract
has a calculated measure of 100 and a demand deposit value of 110, it may that the cost
to replace the contract is greater than 110 because of commissions, taxes or other factors
not considered in the measure of the liabilities. In addition, the calculated value is
likely to be an average value for a group of contracts. It will not reflect that some
policyholders have had their health deteriorate and are no longer insurable. For them,
replacing a contract may not be possible at any price. The alternative calculation, one
which is specific to the health and other underwriting considerations specific of each
insured, would require information that is generally not available and would be
impractical to obtain.
It may be that a large disparity between a contracts value and its demand deposit value
would correspond to a greater take-up rate of the put option than would occur when the
difference is small or nonexistent. In an approach that incorporates policyholder
behaviour, the dynamic nature of surrender rates would capture this possibility.


Summary and conclusions
Policyholder behaviour, renewal premiums and the proper consideration for options and
guarantees in the measure of liabilities are inter-related topics. In particular, as
insurance products are priced and managed on the expectations of certain amount of
renewal premiums, and as obligations under contracts may depend on the extent of
renewal premiums. Their inclusion in the measurement of insurance liabilities is
sensible. The alternative, which is to exclude premiums from projected cash flows,
nonetheless must consider future premiums in the measure of the value of the option,
but may not be practical for many contracts.
The inter-related nature of many options and guarantees, including the options and
guarantees, makes it difficult, if not impossible, to consider many options singly. More
often, cash flow projections either are deterministic, with adjustments to reflect the
uncertainty in cash flows presented by the existence of options and guarantees, or they
are multi-scenario projections to directly consider the influence of options and
guarantees on potential cash flows. Either way, policyholder behaviour is generally
incorporated on a prescribed basis or based on realistic expectations developed from
observed patterns of past behaviour.




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Based on the considerations in this paper, we recommend that the Board take a practical
approach to the development of an insurance standard. A practical approach would
•   use established practices, rather than practices that may be more appealing
    conceptually, but that have not been tested and proven to be reliable,
•   cover the broadest range of products and features, in order to keep the number of
    accounting models as small as possible.
•   consider the issues relating to policyholder behaviour, renewal premiums and
    options and guarantees in the context of objectives of the measurement and to take
    a holistic view to the measurement in order to avoid selecting individual answers to
    specific issues that may not combine into a coherent accounting model.




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