An Introduction to CREDIT LIFE ASSURANCE

hannover life re

PREFACE
Following on from the highly successful series of publications dealing with profitable group life assurance, it is with pleasure that we present our latest publication which introduces the Credit Life Assurance business. Currently a rapidly growing line of business with high potential for profitability, it is appropriate that a substantive document detailing the essence of Credit Life Assurance be made available. Given that Credit Life assurance is a world wide phenomenon, with local idiosyncrasies separating one product from another, this publication is of global pertinency. Although comprehensive and self contained, this volume is not intended as the all encompassing, definitive Credit Life treatise. Rather, it is hoped that it will serve those already well versed in the intricacies of Credit Life business as an easy to hand, succinct reference, while providing those seeking to understand this business for the first time with a source of knowledge sufficient to engender an adequate degree of confidence and ability to satisfactorily manage such a portfolio. Debate and the constructive exchange of differing view points are always to be welcomed. The insurance industry can only but develop in such a climate. Should this publication go some way to stimulating such debate and hence ultimately lead to the refining and honing of the techniques and theories underpinning Credit Life Assurance, its purpose will have been achieved.

S MURPHY May 1997

CONTENTS
Click on the subject you wish to view

Section 1:

Introduction 1.1 Explosion of Consumer Borrowing 1.2 Arrival of Credit Assurance

4 4 4 5 5 6 7 7 7 7 9 10 10 11 12 12 13 14 14 15 16 17 17 18 20 20 20 20 20 20

Section 2:

Types of Credit Life Schemes 2.1 Types of Loans 2.2 Types of Cover 2.3 Premium Mode 2.4 Cover Term 2.5 Eligibility Requirements and Exclusions 2.6 Benefits Offered 2.7 Group or Individual?

Section 3:

Designing Credit Life Schemes 3.1 Principles of Good Design 3.2 Minimising Anti-Selection

Section 4:

The Underlying Risks 4.1 The Risks 4.2 Rating Factors

Section 5:

Pricing 5.1 Actuarial Assumptions 5.2 Pricing Formulae 5.3 Profit Testing 5.4 Unit Rating 5.5 Profits Sharing or Experience Refunds 5.6 Underwriting

Section 6:

Reinsurance 6.1 Accumulation of Claims 6.2 Catastrophes 6.3 Actual Experience Different from Expected Experience 6.4 Protection of Solvency 6.5 Commission

6.6 Profit Sharing 6.7 Financial Assistance 6.8 Technical Expertise 6.9 Financial Assistance 6.10 Technical Expertise Section 7: Policy Administration 7.1 Policy Contracts 7.2 Administration 7.3 Premium Collection 7.4 Claim Payment Section 8: Distribution 8.1 Distrbution Channels 8.2 Remuneration 8.3 Problem of Conditional Selling 8.4 Support Function Section 9: Reserving 9.1 Long-term Pricing 9.2 Yearly Renewable Business 9.3 AIDS Reserves 9.4 Catastrophe Reserves 9.5 Reserving Methods for Credit Disability Claims Section 10: Control Cycle for Profitable Credit Life 10.1 Concept of the Control Cycle 10.2 Measuring Profitability 10.3 Analysis of Surplus 10.4 Controls Section 11: Conclusion Appendix 1: Sample Policy Application Form Appendix 2: Sample Policy Document

20 20 20 20 20 22 22 23 23 23 25 25 26 26 26 27 27 27 29 29 29 30 30 30 30 32 34 35 36

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One
Credit assurance normally consists of life and disability assurance, with dread disease cover becoming more common. (Unemployment or redundancy insurance is sometimes offered as a rider benefit.) In general, credit life assurance pays off the loan outstanding if the insured borrower dies. Credit disability assurance provides either a monthly benefit equal to the loans monthly repayment if the insured is temporarily disabled or a lump sum equal to the outstanding balance of the loan on permanent disability. Therefore, credit life assurance is simply term life assurance whereas credit disability assurance can provide both traditional term life assurance as well as disability benefits. Credit assurance is often a valuable source of profit to lending institutions. However, it should be noted that in some countries (such as South Africa), it is illegal to have any form of profit sharing between brokers and financial institutions. Credit assurance can benefit the life office as an important source of protection business. As credit assurance is sold through the lending institutions branches and directly through stores and dealers, the life assurer increases its premium volume with little need to increase its agency force. This is a very efficient way of marketing insurance as it makes use of the lenders often vast distribution outlets. Credit assurance is a high volume, low premium operation that needs specialist knowledge and efficient systems to run smoothly. It can be very profitable to both the life assurer and the lending institution when managed and administered skillfully.

INTRODUCTION
A mans debts should not live after him Morris Plan Insurance Societys First credit insurance company, 1917 1.1 Explosion of Consumer Borrowing Earlier this century, the concept of lending to an individual based on his future earning power was introduced and accepted. Loans repaid in monthly instalments over a fixed period became the norm. The demand for consumer goods grew explosively after World War II, and consumers began to borrow so as to purchase modern consumer goods on a regular basis. The growth of financial institutions willing to lend have both satisfied and fuelled the demand for consumer borrowing. The popularity of credit cards, which allow the cardholder to borrow for any purpose, has taken consumer borrowing to new heights. For todays consumer, borrowing is easy and convenient, even essential. 1.2 Arrival of Credit Assurance Consumer borrowing rests on the central premise that the borrower can meet the debt obligation from his future wages. Future earning power thus serves as collateral for the loan. However, this collateral can be at risk when the borrower dies or becomes disabled. As a result, insurance on the borrowers life and ability to work was introduced to protect the lender, by reducing bad debts and default ratios, and the borrower, by easing his financial difficulty. As such, credit assurance emerged to meet the specific needs associated with consumer loan transactions for both the lender and the borrower. motto

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Two Credit Life Schemes

2.1 Types of Loans Credit assurance is designed to fulfil a borrowers loan obligation in the event the borrower dies or becomes disabled. With the evolution of lending practices, more complex credit assurance products have been required to fulfil a loan obligation in the event of a claim. A good starting point is to examine the various types of loans available: 2.1.1 Instalment Loans / Closedended Loans Since instalment lending is the cornerstone of consumer credit, it accounts for the majority of loans insured by credit life assurers. These loans are for a fixed amount and term, and are repayable in equal monthly payments. The life assurance plan involved is decreasing term assurance because the outstanding sum assured reduces as the loan is paid off. 2.1.2 Level Loans These are single payment loans extended for short-term personal borrowing and business loans the loan is repaid in a single amount at the end of the loan period. Level term assurance is usually used to cover this loan. These loans are often renewed, and on renewal, a new credit life policy is issued. Another type of level loan issued is where interest payments are made on a regular basis and the capital amount is due at the end of the loan period. As above, level term assurance is used to cover these types of loan. 2.1.3 Residual Loans Residual loans provide for monthly instalment payments, plus a lump sum payment at maturity. This may call for a combination of insurance plans. The instalment portion may be covered by decreasing term assurance, while the lump sum residual payment is covered by level term assurance. Most credit life assurers offer alternative packages to cover residual loans. In order to retain simplicity, the usual approach would be to offer a decreasing term assurance plan with a suitably loaded premium. 2.1.4 Open-ended Loans Credit card borrowing is an example of an open-ended loan, and the use of this type of loan is growing. Renewal premiums are paid by the cardholder with the result that upon death, the outstanding balance of the account is paid off by the life assurance company. Premiums may be based on individual outstanding balances or in many instances a flat rate is charged for all participants in the scheme. Under the latter arrangement a maximum benefit amount is specified. Overdraft facilities are another form of open-ended loans. Usually level term assurance is used to provide cover on the overdraft facility. Cover and renewal premiums for level term assurance are linked to the overdraft facility amount.

2.1.5 Variable Interest Rate Loans Certain loans allow changes in the loan interest rate from time to time. These loans are made necessary by the potential fluctuation in interest rates. Mortgages are usually subject to variable interest rates. If the sum at risk can be calculated on a daily basis (previous days sum at risk plus one days interest less payments received), the cost of insurance can be determined exactly and debited to the account daily. This method of calculating premiums is thus akin to universal costing determining daily interest is referred to as interest strip. Figure 1 below compares the insured amounts required under each of the residual, instalment and level loans:

original amount of the loan plus the insurance premium, where the original amount of the loan is the cash advanced. Technically, the insurance premium need not be included in the equation as the borrower has the option to pay the premium in cash. However, this option is rarely exercised. Initial Gross Indebtedness The initial gross indebtedness is the initial net indebtedness plus the scheduled interest charges. 2.2.1 Net Coverage Net pay off cover is where the amount of insurance covers the net indebtedness of the loan plus any interest that has accrued between the latest payment and the date of death. The calculation of premiums, refunds, reserves, and the amounts payable at death is complicated. For example, for closed-ended instalment loans, the assurance is decreasing term, but the decrease is not uniform. The pattern of the decrease is determined by the annual percentage rate of the loan and lending practices. All open-ended loans are insured with net pay off cover, since the amount of the monthly payment is not fixed one such loan is the variable interest rate loan. It can also be used for closed-ended loans. Single payment loans (usually short-term loans for commercial use) are sometimes insured with net pay off cover. This results in an increasing term assurance being used, since the net indebtedness increases as the interest accrues.

Residual Loan (Residual Portion) Residual Loan (Instalment Portion) Instalment Loan Level Loan 1000 Total Insurance In Force

500

3 Term

0 5 6 7 8 9

10

11

12

Figure 1: Insured Amounts 2.2 Types of Cover Two terms need to be defined: Initial Net Indebtedness Initial net indebtedness is defined as the

2.2.2 Gross Coverage Gross coverage insurance covers the gross indebtedness of the loan. Thus, if the loan is repaid by equal monthly instalments, the monthly payment is equal to the initial gross indebtedness divided by an appropriate annuity factor. In the case of instalment loans, the appropriate type of assurance to cover gross indebtedness is a decreasing term life assurance. 2.3 Premium Mode As credit life policies tend to be a relatively small amount of insurance for a short duration, the traditional premium payment mode has been single premium. Periodic premium billing would be too costly the costs involved would consume most of the premium. Single premium business has the advantage of greater investment income, while lapses can generate profits if no surrender value is paid to the client. Rates are usually expressed per R1000 of initial gross indebtedness for each year of cover as this maintains administrative simplicity. Generally, single premium arrangements are reserved for closed-ended loans. Indeed, in the case of variable interest loans a variation in the interest rate may well result in an incorrect single premium having been paid. Where the sum at risk becomes greater or changes, the resulting change in the size of the premium makes monthly premium collection a viable option. 2.4 Cover Term This is usually the term of the loan such that the effective date and the termination date of the insurance are set

by the corresponding dates of the loan. Therefore, voluntary termination by early repayment of the loan implies that a premium refund must be paid based on the cost of insurance of the remaining term. 2.5 Eligibility Requirements and Exclusions Wherever possible, the usual underwriting considerations such as age, gender, health and the like, should be factored into the premium rates. When setting premiums for an institution, the life assurer should obtain as much information of the client portfolio as possible. However, the loan provider will probably take a dim view of extensive underwriting requirements, as potential business will be lost. Thus, in many circumstances and certainly in less sophisticated markets, it is possible that the underwriting is less stringent (or even non-existent), and it may well be just the maximum admissible age that is considered. This may be acceptable because the sums at risk are usually small and the assumption can be made that only the healthy, working lives will obtain credit. Most credit life is sold with a minimum number of exclusions, with suicide invariably being one of the few included. Disability cover will usually exclude claims arising from pre-existing conditions. Other common exclusions are described in section 7. 2.6 Benefits Offered 2.6.1 Death The basic benefit under credit life assurance provides for cover in event of the death of principal or co-principal debtor, the purpose being to protect the debtor in terms of any financial agreement.

2.6.2 Disability Temporary Total Disability Benefit This insurance provides a monthly benefit while the insured is disabled during the term of the cover. The types of loans involved and the general practices of credit life assurance also apply to disability. However, additional options, such as waiting periods, need to be considered. Total and Permanent Disability Benefit In the event of total and permanent disability the full amount outstanding under the credit agreement is paid, the benefit being treated as an acceleration of the death benefit. Waiting or Elimination Period Credit disability policies can require the insured to remain disabled for a certain minimum period of time before any benefits become payable. This practice eliminates short duration claims and significantly reduces the claim cost and premium charged. Credit disability benefits can be paid on a retroactive basis (benefits are payable from the start of the disability) or a nonretroactive basis (benefits are only payable from the end of the waiting period). Usually waiting periods are of minimal duration, as early payment is essential if the loan agreement is to be maintained. Definition of Disability The exact definition of disability is not only important from a claims

point of view, but also has an influence on the price. The usual definition would be the inability to pursue any occupation as a result of sickness or accident. The alternative definition of own or similar occupation would naturally lead to a higher claims experience and premium. 2.6.3 Dread Disease Dread disease assurance can be taken out as a rider to the basic credit life cover. The basic dread diseases are listed in section 4. The outstanding loan amount is paid upon the first occurrence of one of a specified list of dread diseases. As with the total and permanent disability benefit, this benefit is also treated as an acceleration of the death benefit. 2.6.4 Unemployment Benefits This is a benefit similar to the disability benefit, where a monthly benefit is provided while the insured is unemployed. As the danger of anti-selection is significantly greater under this benefit, underwriting is a very important, albeit not a simple task. The employment history and existing debt of the client should be scrutinised. It is normal to place a limit on the maximum amount of cover available. This benefit may be written under a non-life licence. However, in this instance, care must be taken to ensure that the premiums added to the loan account do not contravene the contents of the Usury Act.

2.7 Group or Individual? Under a group policy, which is a contract insuring multiple lives, the contractual relationship is between the assurance company and the organisation dealing with a group of borrowers. The borrowers could be the employees of the company, clients of a finance house, etc. Under an individual policy, the contractual relationship is directly between the assurance company and the borrower. From the borrowers point of view, there is little difference between the two types of policies. From the insurers point of view, there is a difference in both the contractual relationship and certain administrative procedures. For example, under a group policy, a certificate of insurance is supplied to each policyholder, while for individual credit life policies, a complete policy document must be issued to each policyholder.

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Three
Table 1: Characteristics of Credit Life Insurance
Characteristics Type of Loan Loan Conditions Loan Interest Rate Number of Insured Lives Type of Policy Type of Cover Premium Mode Cover Period Eligibility Requirements and Exclusions Surrender Values Options Instalment, Single payment, Combination, Open-ended Term, Amount, Payment pattern Fixed, Variable Single, Joint Group, Individual Gross, Net pay off Single premium, Monthly outstanding balance Full, Limited Maximum age, Suicide, War, Drug & alcohol related None, Cash amount

Designing Credit Life Schemes

3.1 Principles of Good Design 3.1.1 The Social and Legislative Framework The laws of insurance, taxation and credit arrangement form the framework within which the insurance industry must operate. These laws are of primary concern to credit assurance schemes and play a critical role in shaping the credit assurance industry in any country. Clearly, any insurer that is involved in the credit assurance market would need to develop a sound and thorough knowledge of the particular requirements and implications of the prevailing legislative environment. 3.1.2 Types of Schemes Credit Insurance

Table 2: Characteristics of Credit Disability Insurance

Characteristics Type of Loan Elimination or Waiting Period Elimination Period Type of Loan Options Monthly benefit, Lump sum benefit Thirty, Sixty days Retroactive, Non-retroactive Instalment, Single payment, Combination, Open-ended Term, Monthly payment Fixed, Variable Single, Joint Full, Limited Single premium, Monthly outstanding balance Covered, Excluded Pregnancy, Suicide, War, Drug & alcohol related None, Cash amount

A variety of institutions provide credit of one form or another to their clients. Examples range from banks, building societies and loan companies to furniture retailers, auto dealers and other hire purchase companies. The various types of credit assurance schemes that may evolve from these arrangements are described in section 2. Following is a summary of the options to consider when designing a credit assurance product. The details of the options are explained in other sections.

Loan Conditions Loan Interest Rate Number of Insured Lives Benefit or Cover Period Premium Mode Pre-existing Conditions Eligibility Requirements and Exclusions Surrender Values

3.1.3 Risk Cover The insurer must have a good understanding of the nature of the credit assurance risks when designing the plan. He must understand, for example, that individual medical underwriting requirements are minimal, as sums assured are generally low. Also, the age distribution of the

10

borrowers is difficult to obtain and so premium rates may be quoted on an age-independent basis. A detailed study of the underlying risks is carried out in section 4. 3.1.4. Policy Conditions Most commonly, a credit assurance contract between an insurance company and the lender will be defined within a single master policy, wherein the rights and obligations of the various parties would be stated. A guide to the clauses to be included in policy forms, such as the definitions of terms and list of exclusions are described in section 7.1. Note that under individual policies a contract is issued to each policyholder. The contract will be similar to conventional contracts issued by the life assurer. 3.2 Minimising Anti-Selection Usage of life and disability income assurance differs by age, gender, health status, etc. Although individuals cannot predict their needs precisely, they will gravitate towards a program of optimum value, as it is in their economic selfinterest. They will thus opt for the maximum benefit at the lowest cost to themselves. This situation is generally referred to as anti-selection. The simplest method of addressing antiselection concerns is through the initial plan design and underwriting (front end) and through provisions restricting the payment of claims (back end). Another is by making the scheme compulsory. A guiding principle of group assurance is that individual members

should have little scope to choose whether or not to be on the plan or select the level of their own cover. For this reason compulsory participation is the most agreeable arrangement for the insurer. If eligibility is voluntary, a minimum enrolment level is set to ensure adequate participation in the plan. The insurer may choose to reinsure a portion of the risk. If the product is new, reinsurance can add significant value by providing risk capacity. Reinsurance is discussed in section 6. Finally, it is important to understand the competitive environment for each product in each market segment. A wellorganised group operation will coordinate its entry into new markets and products with an understanding of what will be its competitive strengths and weaknesses. This would include field compensation, field understanding of products and premium rate competitiveness.

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Four
of the dread disease premium, with kidney failure and coronary surgery making up a substantial part of the remainder of the premium. 4.1.4 Loan Interest Rate In the past, fixed interest loans characterised most consumer lending and the loan interest rate assumed by the insurer was not an issue. However, as explained earlier, lenders, faced with potential interest rate fluctuations, have made variablerate consumer loans possible. Interest stripping is thus necessary to calculate the risk premium according to the actual sum at risk. 4.1.5 Investment Earnings Insurers usually hold life assurance premiums for a significant period before benefits are paid. These funds, in large part, are invested in incomeproducing assets, whose earnings permit the life assurance company to charge lower premiums than would otherwise be the case. As policy reserves are small, the effect of a change in the assumed rate of interest is very small in credit life assurance. Companies therefore usually use a low rate of interest in the premium calculation basis, resulting in an additional pricing margin.

The Underlying Risks

4.1 The Risks 4.1.1 Death The development of any plan of assurance against death requires some means of assigning mathematical values to the probabilities of death. The laws of probability can be applied to mortality statistics, and the result is a mortality table that organises this data in such a way that it may be used to estimate the course of future deaths. Mortality statistics are usually derived from population statistics or statistics derived from insured lives. Adjustments for increased future mortality due to AIDS should also be taken into account although we are generally looking at the short-term. 4.1.2 Disability The annual claim costs for a disability income benefit vary significantly by occupational class. In general, the cost of disability assurance will vary according to age, sex, occupational class, waiting period, definition of disability and maximum duration of benefits. However, as explained earlier, credit life is rarely that extensively underwritten as premiums and sums assured are small. It is therefore necessary to control the costs through a strict definition of benefits. 4.1.3 Dread Disease Generally, insuring against the occurrence of the big three, namely heart attack, cancer and stroke, makes up the greater part

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4.1.6 Arrear Instalments The insurer does not assume any credit risk, which means that a change in the total interest charged by the lender (which will include interest penalties if loan repayments are in arrears) will not affect the pricing of the insurance plan. 4.2 Rating Factors 4.2.1 Characteristics of Customer Base Generally, a life office would charge differentiated rates depending on the policyholders level of risk. However, in credit life assurance, detailed information is not always available, and the insurer may have to rely on its understanding of the characteristics of the customer base when pricing the plan. Some factors to consider are; socio-economic status of the group, average age of the group, common occupations of group members, voluntary or membership, smoker prevalence, sex distribution, geographic variations, and debtor-creditor relationship. (For example, if all the lenders credit holders are covered by a single policy, the creditor must be making new loans at a reasonable rate such that the compulsory

current level of total insured balance can be maintained and developed.) 4.2.2 Occupation Disability contracts may be issued on an occupational basis. Some occupations are usually excluded entirely because of extreme occupational hazard (e.g., some credit assurance companies treat underground mining as a standard exclusion).

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Five
provision for expense inflation, stamp duty, allowance for work undertaken by the lending institution, and the costs of premium collection, claim settlement, conducting actuarial investigations, quotations for new and renewal terms, etc. 5.1.4 Mortality The product design (e.g. level or decreasing term assurance) will generally match the profile of the loan. The rate of interest charged on the loan will be reflected in the assumed sum at risk at different durations of cover. The loan rate of interest will depend on the type of credit provided, but should at least be equal to the prime rate. 5.1.2 Interest This should be consistent with the companys expected returns from investment. However, the premium rates are fairly insensitive to interest rate assumptions as the reserves are relatively small. As such, a relatively conservative rate is usually used, in the region of 6% to 8% gross. 5.1.3 Expenses Some of the administrative expenses involved in credit assurance are; commission, initial expenses for marketing and administration costs, renewal expenses, The sum assured in the event of a death claim would be the outstanding debt or credit facility. However, in order to avoid administrative difficulties, sums assured are often determined on an approximate basis, depending on the loans in force at the start and end of the period of insurance. This approach is not recommended and exact derivations are preferable. Population mortality rates (e.g. ELT14 for UK lives) may be a better estimate of the expected mortality experience than assured lives rates. Tables such as the SA56-62 or SA72-77 are popular in the South African market. As the level of underwriting is limited, ultimate rates are used. Appropriate loadings for AIDS, lower socio-economic classes and high-risk occupations are then added to these rates. 5.1.5 Morbidity This is usually expressed as a flat loading of mortality rates or alternatively, either of the CDT or GLTD tables could be used with appropriate adjustments. 5.1.6 Sum Assured

Pricing
5.1 Actuarial Assumptions Generally, credit life policies are priced differently to ordinary individual life or group life assurance policies. The pricing assumptions will reflect the product design and the target market. The following are examples of the assumptions that could be used. 5.1.1 Loan Interest and Profile

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5.1.7 Guarantees Single premium and level premium policy designs contain an inherent guaranteed rate and cover over the term of the policy. 5.1.8 Cash Surrender Values Cash surrender values may be available to the insured upon termination of a policy other than by death or disability. The cash surrender value is the reserve element in every cash-value assurance policy and is an equitable share of the amount accumulated for that particular block of policies from which the policyholder is withdrawing. The cash surrender value is set somewhat less than the profittested value of the plan. Some of the reasons for this include: Adverse financial selection in periods of downturn when the insurers standing may be weakened. Adverse mortality selection by the allowance of liberal surrender values. Contribution to a contingency reserve or profits to absorb adverse fluctuations and to enhance the insurers overall financial security. The cost of surrendering the policy. It is usually only single premium policies that have surrender values. A typical surrender value formula may have the following elements:

SVt =

nt x (1 c p) x f x SP n
where t n c = duration = original term = factor to recoup outstanding expenses = factor to recoup a portion of expected profit = adjustment factor to allow for decreasing/level cover

SP = single premium 5.1.9 Competition Premium rates are also influenced by non-actuarial factors such as the need to be competitive or to gain a sufficiently strong foothold in new markets. 5.1.10 Profit and Contingency Margins Premiums must be loaded to allow for the profit margin required from the class of business. It is also necessary to allow for a margin in the pricing of the premiums to take into account any variations in the factors in the pricing basis. 5.2 Pricing Formulae The formula used for calculating a single gross premium rate per individual member per mille is as follows:

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SP =
t=o

n-1

C D SA(t) x+t + expf x+t + Iexp Dx Dx @i%

1 exp%p comm%p (1 + VAT% + overr%) profit%p(1 + tax%)

where SA(t) = cover at time t (and SA(0) = initial loan) renewal expenses Initial expenses expenses as a percentage of gross premium commission payable VAT payable Over-rider commission

It should be noted that the rate i% is not the loan interest rate, but rather the long term rate of return that the office expects to earn on its investments. In practice a very conservative rate is usually used (e.g. 6% p.a.). The premium amount can also be calculated using cash flows, which precludes the use of commutation functions. An annual premium can be derived by dividing the premium calculated above by an appropriate annuity factor, e.g.:

expf Iexp

= =

exp%p =

comm%p= VAT% =

SP AP = ax:n

overr% = profit%p =

5.3 Profit Testing target profit margin as a percentage of gross premium Average tax rate cover term the commutation function equal to vx lx the commutation function equal to vx+1 dx Rate of interest present value of 1 due in one years time at rate i% the number of persons who attain age x according to the mortality table the number of persons who die between ages x and x+1 according to the mortality table For a large block of insurance policies, the net cash flows may be estimated based on a set of actuarial assumptions, including future interest rates, expenses and mortality rates. The net cash flows are premium income less benefits and expenses with interest on the block of business. The estimated profit is the accumulated value of the net cash flows, based on the companys anticipated operating experience. It represents the pro-rata share of the assets accumulated on behalf of the block of policies to which the particular policy belongs. It is used to test the tentative gross premium rate for profitability. An accumulation-type profit test uses the following formula: Income Outgo = Net Cash Flow where Income = Premiums Earnings + Investment

tax% n Dx

= = =

Cx

i% v

= =

lx

dx

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Outgo = Expenses + Death Claims + Surrender Benefits + Change in Reserves The following is an example of a simple profit test. Consider a simple term assurance with premiums payable yearly, claims payable at the end of the year and other details as shown in Table 3 below.
Table 3: Details of a Simple Term Assurance Age Policy Term Sum Assured Mortality Real Return Expenses 35 exact 5 years R1 million A67/70 ultimate 5% none

expenses, commission, over-riding commission (if any), as well as claims. The resulting cash flows can then be determined, allowing for different levels of lapses, mortality and other variables. This process is known as sensitivity testing. Different levels of sales volumes can be built into the model, to allow for the resulting changes in expenses. Single premium business is generally more profitable than recurring premium business. 5.4 Unit Rating As credit assurance involves low sums assured, the premium rates generally do not depend on individual ages, or if they do, they are based on broad age bands only. Consequently the assumed weighted average age of the insured lives is critical and it is important to have knowledge of the target market before setting the premium.

Using commutation functions, the theoretical premium is R992.07. Table 4 shows the development what happens if experience follows the assumptions used in the premium calculation. As expected, in this example, there is neither a profit nor a loss.
Table 4: Profit Test for Regular Premium Term Assurance Year No. of policies in force at start of year 1.000 000 0.999 144 0.998 208 0.997 176 0.996 030 Total premium income Net investment income

Death benefit outgo

Increase in mathematical reserve

Profit

1 2 3 4 5

R992,07 R991,22 R990,29 R989,26 R988,13

R49,60 R58,86 R64,52 R65,60 R60,96

R855,77 R935,84 R1 032,24 R1 146,48 R1 280,18

R185,90 R114,24 R22,57 (R91,62) (R231,09)

R0,00 R0,00 R0,00 R0,00 R0,00

The above cash flows should now be expanded to allow for differences in the actual and expected experience of the office. The income side of the equation should be broken up into the different sources of income from the business sold, e.g. policy fee, investment income, etc. The outgo, on the other hand, should incorporate actual expenditure in selling the business, e.g. fixed and variable

It must be understood by the financial institution that the premium rates could be subject to amendment if the assumptions prove to be inaccurate.

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5.5 Profit Sharing or Experience Refunds The profit share or experience refund is that portion of the compensation to the credit provider that is contingent on the profitability of the business. (Current South African legislation pertaining to credit life business does not make allowance for profit sharing.) Insurers generally require that the credit provider generate a minimum volume of credit assurance business before qualifying for an experience refund. The experience of the business is evaluated periodically. A proportion of the profits from a block of business (i.e. premiums plus investment income less claims, expenses, tax and profits) is returned to the producer. The insurer can often recover prior experience refunds if experience turns bad by carrying it forward to future accounting periods. However, if the sum of all experience refunds is negative, the producer is not responsible for the loss. 5.6 Underwriting Credit life assurance is generally arranged through the lending institution. The level of underwriting is therefore restricted as having to meet strict underwriting requirements could delay the lending process. As a result, the insurer usually relies on a maximum age limit with little or no emphasis on medical information. 5.6.1 Non-Medical Limits Credit life assurance is generally offered to all borrowers without any existing serious health problems. To obtain a loan, the applicant is necessarily in acceptable health and possesses the ability to repay the loan. For amounts of insurance below a

non-medical limit, medical information is waived and the applicant generally signs a simple declaration of health form. Above the non-medical limit, the insurer may require stricter medical underwriting. Medical evidence in the form of a personal history questionnaire asking, among other questions, whether insurance has ever been declined or if the applicant has suffered from specific health disorders in the past 3 years, could be required. For large sums assured rigorous medical underwriting could be required. This degree of underwriting should be reserved for a relatively small, but representative number of high risks. 5.6.2 Age Limitations The degree of risk becomes larger at the older ages so that it may be necessary to include some restrictions on the maximum age at entry (e.g. age 60). A person above this age will not automatically be accepted but will be required to produce evidence of insurability before their insurance is made effective. In addition, such a person may possibly be insured at nonstandard rates. Another reason for lowering the age limit, is that the allowance of high maximum ages when using unit rating, will result in unacceptably high premium rates.

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5.6.3 Pre-existing Conditions The borrower may have existing impairments that may result in future claims. (A pre-existing condition is an impairment for which the insured has been treated prior to the effective date of the insurance.) The standard exclusion is that the insurer shall not be liable if the claim is linked to any physical defect or infirmity of which the life assured was aware and which had its origins prior to the issue of the policy. 5.6.4 Financial Underwriting Although the lending institution will perform some financial underwriting of the level of risk of each loan applicant, the insurer should be aware that the objectives of the finance house would not match those of the insurer. For this reason some financial underwriting by the insurer will be required for all loans. This will most commonly take the form of the non-medical limits discussed above. The insurer should also consider the insurable interest, the size of the loan repayments and the insurance premiums relative to the assured lifes regular income as well as the risk of moral hazard. Note that anti-selection is reduced because in taking out the loan, the assured life is motivated by the need for finance, not the need for insurance.

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SECTION

Six
claims. The reinsurer meets all claims above a certain retention level. Surplus reinsurance effectively smoothes the experience of the life office, by removing the peaks of the larger claims, leaving it to retain the smaller, less volatile claims. 6.6 Protection of Profits/Solvency Stop loss cover can be used to protect the office against worse than expected experience of a credit life portfolio. The reinsurer would meet claims if the experience becomes worse than some specified level, e.g. claims in excess of 125% of the mortality table or above some specified loss ratio. 6.7 New Business Strain Commission paid by the reinsurer to the life office, may be utilised to offset some of the new business strain incurred by the office in writing the business. 6.8 Profit Sharing Reinsurance treaties can be structured to incorporate profit sharing, whereby a portion of the profit emerging from the block of business is returned to the life office. 6.9 Financial Assistance Various other methods of financial assistance are available. One such method is called stochastic banking, whereby the profits expected to emerge in the future from a specific block of business, is advanced by the reinsurer to the life office. This loan to the life office is then repaid from the emerging profits. 6.10 Technical Expertise A reinsurer can offer the life office a wide range of expertise, ranging from product design and pricing, to underwriting, administration, claims handling and marketing.

Reinsurance
Reinsurance may be defined as a device by which a life assurance company transfers all or a portion of its exposure under a life assurance policy to a reinsurer. Its primary purpose is to avoid too large a risk concentration. Credit insurers could use reinsurance to protect themselves in various ways: 6.1 Reducing Mortality Fluctuations The main reason for reinsurance is to reduce the effect of adverse mortality fluctuations, e.g. more persons dying than expected or those persons with larger than normal sums assured dying. The fluctuations could have a negative impact on the free reserves of the life office, if not allowed for by means of additional reserves or reinsurance. 6.2 Accumulation of Claims An accumulation of claims arising from a single incident could have a detrimental effect on the reserves of the life office. Excess of loss reinsurance can be used to cover these types of losses. 6.3 Catastrophes Catastrophe reinsurance is similar to the excess of loss cover described above, but operates at a much higher level. 6.4 Actual Experience Different from Expected Experience Ventures into new markets are often characterised by uncertainty. A reinsurer is an ideal partner for such situations, by means of a quota share arrangement. The reinsurer shares the fortune of the direct writer premiums and claims are shared by the two parties. 6.5 Protection of Solvency Surplus reinsurance can be used to protect the life office from large individual

20

The exact method of reinsurance proportional or non-proportional, original terms or risk premium, surplus or quota share should be discussed with the reinsurer. Similarly, the appropriate retention level the level above which risks are transferred to the reinsurer needs careful deliberation. Factors to take into consideration include: Type of credit life (e.g. group or individual). assurance

Size of the life office (i.e. size of free reserves). Size of the risks. Risk profile of the life office. Level of technical expertise required. Level of financial assistance required. Probability of an accumulation of risk or a catastrophe occurring.

21

SECTION

Seven
policy term. Monthly outstanding balance business terminates on the date that the loan becomes paid off. Claims Clause Definitions Clause The definition clause defines the terms used in the policy. Significant definitions are those of the debtor, the creditor, the insured debt and the credit agreement. Benefits Clause This clause describes the benefits paid under the various life and disability plans of insurance offered by the contract. Provisions and Conditions Clause This specifies the requirements a borrower must meet to be eligible for cover. A maximum age is usually specified. Consideration and Premiums This section specifies the amount and frequency of premium payments, as well as the amount payable by the insurance company in event of a claim. Grace Period A one-month grace period is usually permitted for the remittance of the premium by the lender to the insurer. Termination of Insurance Clause These are the conditions of termination. Cover on individuals insured continues until natural expiration on single premium business, i.e. until the end of the This defines the claim submission process and also specifies the beneficiaries under the policy. Exclusions Clause This section may be split into two categories. The one category will deal with exclusions that will apply to the death benefit, while the other will specify the exclusions linked to the disability benefits. Typical exclusions include suicide, drug or alcohol related injuries, pre-existing conditions and AIDS. Duration of Cover. The inception date of the policy, as well as the term of the cover. Details of Life Assured, Beneficiary and Premium Payer The life assured and premium payer need not be the same person. The beneficiary would be the lending institution. 7.1.2 Individual Contracts With individual credit life assurance, there is a contract between the borrower and the life office. Each individual is thus issued with a contract.

Policy Administration
7.1 Policy Contracts 7.1.1 General Clauses

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7.1.3 Group Contracts Under group credit assurance, the contract is between the life office and the credit provider. A full contract is issued to the credit provider, with each borrower receiving a certificate of insurance. 7.2 Administration The administrative work entails the handling of enquiries, maintaining administrative records and the processing of claims. This includes the initial set-up of a new account, recording of the policy forms and rating calculation material and updates due to changes in rates and claims whenever necessary. 7.3 Premium Collection 7.3.1 Individual Contracts For individual policies, the institution generally prepares weekly schedules and attaches copies of issued policies to the schedule. These schedules are either accompanied by a cheque or a copy of documentation attesting to payment. Premiums may also be payable by debit order in which case the life office is responsible for premium collection via magnetic tape. 7.3.2 Group Schemes For group schemes each account submits monthly reports summarising the business issued and the refunds made. 7.3.3 The Reporting Process The report preparation usually undergoes the following processes:

Incoming cheques are datestamped and assigned a booking identification number that is subsequently verified and the money is sent in for deposit. Remittances are usually made by cheque. Supporting documentation are captured and edited. This means that the policy data is checked against the account master file containing information concerning policy limits, approved plan of insurance and premium rates. Most insurers book the business as received and later send a correction if necessary. If age or term is missing, an assumed or default value is coded and verification is sought subsequently. Monthly outstanding balance business is much simpler; the group premium rate is applied and the compensation deducted. Errors are corrected in a subsequent report. 7.4 Claim Payment A credit life assurers claim procedures must accommodate the high volume of transactions involved and the specialised nature of the product. Consistency of claim handling, timeliness of processing and adherence to policy provisions are the guiding principles. Consequently, claims departments usually have a separate administrative unit and an examination unit so as to ease the paperwork on examiners. This allows the examiners to concentrate on the adjudication of the claim itself.

23

7.4.1 Death Claims Unless the scheme has a free cover limit, death claims are usually investigated as rigorously as death claims arising from any other line of business. The process is usually as follows: The lender completes the loan balance and provides a death certificate. The claim records are then reviewed to check whether the insured has previously filed a disability claim (bearing in mind that such a claim, triggering an accelerated benefit, would decrease the death benefit now payable) or initiated a duplicate claim. The examiner then steps in to check the age, cases of suicide (in which case the premium is usually returned) and requests an Attending Physicians Statement if necessary. The examiners decision to deny a claim or accept particularly large claims is checked by a supervisor before cheques are issued. 7.4.2 Disability Claims Disability claims require research for compliance with the policy form, which often contains more exclusions than the credit life form. They are also more subjective as an examiner must assess the validity and severity of the claim on an on-going basis throughout the period of the claimed disablement. The following processes are particular to disability claims: Open files are maintained for continued disability claims in the

payment status or pending claims still under investigation. Closed files are made up after a period of inactivity. In the examination process, four questions are uppermost in the examiners mind: Is the claimant disabled? Has the disability occurred during the policy term? Have all policy conditions been met? Are any policy exclusions applicable? The most demanding part of claims examinations is checking the nature of the disability against pre-existing conditions. Provision needs to be made for disability claims involving more than one payment (some claims extend over several years). For severe cases, the insurer may require a periodic certification of continued disability, in which case it may be requested to pay the loan off rather than continue the monthly benefit payments. The treatment of claims is monitored by the insurer. Audits are performed in terms of client service turn-around times, samples of individual claim files, and complaint handling. The personnel also undergo continuous training.

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SECTION

Eight Distribution
8.1 Distribution Channels 8.1.1 Bancassurance Of late, banks have expanded into life assurance markets, not only traditionally through credit life assurance but also by selling a variety of bundled or unbundled products which are designed to suit an individuals risk and return requirements. The marketing of life assurance by banking institutions has been dubbed bancassurance. The appeal of bancassurance is that it represents a leveraging of the existing activities of a bank. A retail bank typically has an established distribution network and customer base. Furthermore, the volume of face-to-face transactions between a bank and its customers is usually quite high. Face-to-face transactions, particularly those involving the purchase of a bank product, provide the greatest leveraging opportunities. When selling to referred banking customers, bancassurance sales intermediaries often typically achieve sales productivity three or four times higher than the life assurance industry average. Hence the use of these existing distribution capabilities has advantages which can ultimately translate into enhanced profits and extra value added. It is not uncommon for the banks to set up separate affiliates that specialise in financing. These financing institutions now make up the majority of credit transactions. 8.1.2 Providers of Goods Recent developments have seen an increase in the selling of credit protection by stores and dealers. These types of credit plans will typically include protection on vehicle financing and protection for departmental stores cardholders. It must be noted that the sale of credit protection is open to abuse by merchants dealing in furniture and other consumer goods since there are currently no rules or legislation governing this type of business. 8.1.3 Direct Marketing Solicitation via direct marketing involves contacting potential customers without the use of a sales person. Although direct response marketing is growing rapidly, it is still a very small percentage of new life assurance premiums. Direct Mail Direct mail campaigns are targeted at the lending institutions clients and make use of their customer data bases. Telesales Telesales are a follow-up service that may be introduced to those who have not taken up the insurance at the point of sale. The process involves having a list of all credit transactions that have not been matched with a credit policy and contacting these individuals within approximately ten days. These operations are sometimes sub-contracted to specialists.

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8.2 Remuneration 8.2.1 Head Office Sales Staff and General Agents The main difference between head office sales staff and general agents is remuneration. Most South African companies employ sales staff (as opposed to procuring the services of general agents), to promote their product and handle the interface between institution and underwriter. They are normally remunerated by means of a basic salary together with an over-rider incentive based on production. Compensation to general agents is commission driven and depends on the volume of business produced and possibly the profitability of the business. Compensation could also be in the form of over-rider commission. 8.2.2 Credit Provider/Lending Institution Compensation to the credit provider could be one or more of: Up-front commission commission paid to the provider based on net written premium. Service fees - reimbursement of the actual cost of offering the products. Experience refund 8.3 Problem of Conditional Selling Often, when large loans are involved (for example for luxury cars or for specialist medical equipment), the financier makes life assurance a condition for the granting of a loan. In such a situation, it is in the

financiers interest to obtain the insurance for its clients as soon as possible. Therefore a life assurer may find itself pressurised by the financier to issue the required contract. The time constraint will also put pressure on the administrative resources of the insurer. 8.4 Support Function In the credit assurance business, the sales area plays a critical role and often extends beyond the usual responsibilities found in other lines of insurance. In addition to soliciting new accounts, the sales force performs many service functions. Sales people often train the credit providers personnel, work with the provider when problems arise and implement rate changes and product modifications. The sales force frequently monitors the financial experience of the business and initiates corrective action. A separate sales administration area often handles the administrative functions and maintains contact with the accounts on day-to-day operational matters. This permits the sales force to concentrate on personal contact and new sales.

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SECTION

Nine Reserving
A reserve is an estimate of the amount of money an insurer must hold for future claim payments. It is an accounting timing mechanism, meaning that it serves to allocate profits appropriately between different accounting periods. The method of calculating reserves depends on whether the cover is yearly renewable (e.g. group life cover), or priced on a long-term basis (e.g. individual cover for a 5 year term). 9.1 Long Term Pricing When premiums are priced on a longterm basis, the usual net or gross premium valuation methods used in life assurance are applied, adjusted for the specific nature and experience of the business. 9.2 Yearly Renewable Business The following types of reserves are common when premiums are renewable on an annual basis, such as is common under group credit assurance: Unearned Premium Reserve (UPR) t Notified Outstanding Claims Reserve (NOCR) Incurred But Not Reported Claims Reserve (IBNR) 9.2.1 Unearned Premium Reserve (UPR) The UPR is based on the assumption that a portion of the original premium (commensurate with the remaining term and sum assured) must be put aside to pay future claims. Certain assumptions regarding the incidence of risk over the term of the cover are needed. The UPR is calculated by = number of full months remaining from the valuation date to the expiration of the policy multiplying the original gross premium by an unearned premium factor. The unearned premium factor is further adjusted for acquisition costs. Single Premium Decreasing Cover For single premium gross pay off cover and net pay off cover, the Rule of 78 unearned premium factor is used. The Rule of 78 assumes an arithmetic progression in successive capital repayments as opposed to the geometric progression used in compound interest loan schedules (i.e. it is assumed that the difference between each consecutive capital repayment is constant).

Rule of 78 factor = (1 acq) x

t(t + 1) n(n + 1)

where n = the original term in months

acq = acquisition expenses For single premium level cover, the Pro rata unearned premium factor is used. This assumes that the single premium can be applied uniformly over the term of the assurance.

Pro Rata factor =

t x (1 acq) n

27

where n t = the original term in months = the number of full months remaining from the valuation date to the expiration of the policy

The following table depicts such a continuing claim.

Date of Treatment Oct 2 Accident Reported Nov 5 Dec 15 Dec 31 Claim payment Jan 15

Time Feb 15

acq = acquisition expenses In general, the average of the Rule of 78 and the Pro rata method are used to calculate unearned premium reserves for credit disability assurance. Recurring Premium Business The same methods are applied to recurring premium business, the reserve being the unearned portion of the premiums already received. 9.2.2 Notified Outstanding Claims Reserves (NOCR) A NOCR is a reserve for claims that arose, and were reported to the insurance company prior to the accounting date, but for which payment was not issued by the accounting date.

9.2.3 Incurred But Not Reported Reserves (IBNR) An IBNR claim is a claim arising from an event occurring prior to the accounting date, but which will only be reported to the insurance company after the accounting date. For example, assuming the accounting date to be 31 December, the contingent event could have occurred on 2 October but the claim will only be reported on 8 January.

Date of Treatment Oct 2 Dec 31

Accident Reported Jan 8

Claim payment Time Feb 1

Date of Treatment Oct 2

Accident Reported Dec 4 Dec 31

Claim payment Time Jan 15

The IBNR can be calculated using run-off triangles that make use of the run-off patterns of the past to project the expected number of IBNR claims in the future. Other methods include a percentage of earned premiums or incurred claims. 9.2.4 Alternative Methods The loss ratio method is occasionally used when insufficient data is available to apply one of the other methods, or as a quick check. The loss ratio is equal to incurred claims as a proportion of earned premium, which is total premium less unearned premium. Subtracting paid claims from incurred claims gives the total claim reserves.

In disability assurance the claimant may receive multiple payments at different points in time. The NOCR in this instance will be an estimate of the benefits that will be earned and paid after the accounting date for disabilities that occurred prior to the accounting date.

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9.3 AIDS Reserves With the increasing incidence of death and disability caused by AIDS, insurers have made appropriate adjustments within their reserving formulae. Most AIDS deaths arise between the ages 20 to 40. Under long-term pricing, the mortality factors for lives falling in this age range should therefore be adjusted upward to account for the increased mortality. AIDS is obviously less of a problem for annual renewable contracts, as rates can be adjusted when needed. 9.4 Catastrophe Reserves Rare occurrences and natural disasters could result in ruinous claims. It is therefore necessary to set up a reserve for this contingency. An indication of the risk involved can be found by examining the geographical and occupational spread of the portfolio. As an alternative to setting up the reserve, reinsurance could also be used to manage the risk. 9.5 Reserving Methods for Credit Disability Claims Since disability claim reserves are more subjective and tend to fluctuate more widely from year to year, (due to economic cycles, unemployment and claim underwriting), reserving tends to be more uncertain and daunting. Various methods or combinations of methods are used to set claim reserves. In the case of the lag method, prior experience is studied to estimate the average remaining period of disability after the accounting date. Factors are developed based on the time the insured has already been disabled at the accounting date.

The total factor method recognises that the total claim reserve is the key value, thereby including a provision for IBNR. A total claim reserve is developed initially from a factor method and subsequent subsidiary calculations are made to separate the total claim reserve into its subdivisions. For the case reserve method, a knowledgeable claims underwriter reviews each reported claim and estimates the remaining time of disability. The reserve is then the expected product of the remaining months of disability and the claimants monthly benefit. This method is impractical for large volumes of claims.

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SECTION

Ten
business being drawn up. The larger the group of lives, the greater the credibility that can be attached to the experience of the specific group of business. The claims experience of a small account fluctuates significantly from quarter to quarter. 10.3 Analysis of Surplus 10.3.1 Loss Ratios The basic concept involved in the measurement of profitability is to match the premiums of the period with the claims of the same period. Unearned premium reserves and claim reserves provide the accounting mechanisms to accurately determine earned premium and incurred claims. To accurately measure experience over short time periods, the premium must be earned throughout the term of the policy. The solution is to earn the premiums in proportion to the claims that are occurring. This can be achieved using the Pro Rata method or Rule of 78. The general formula for earned premiums is: Written premiums for the period + Unearned premiums at the beginning of the period Unearned premiums at the end of the period Incurred claims is the proportion of the original premiums (the earned premiums) associated with claims that occurred prior to the accounting date.

Control Cycle for Profitable Credit Life

10.1 Concept of the Control Cycle All well-managed companies utilise a planning and control cycle made up of four stages; strategic planning, tactical planning, performance monitoring, and control and readjustment. Strategic planning defines the target market, products and distribution systems that are co-ordinated to achieve the companys profitability and solvency objectives. Tactical planning provides the implementation of the strategic plan. The tactical plan involves the development and maintenance of all the managerial and distribution components that are required to carry out the strategic plan. The third stage, performance monitoring, is used to determine whether the insurers strategic and tactical plans are being carried out so as to meet the profitability and solvency objectives. Effective performance permits control and readjustment, the fourth stage of the control cycle. This involves the continuous readjustment of tactics to achieve the strategic plan. 10.2 Measuring Profitability Successful operation in the credit assurance business requires that the financial results be measured and monitored periodically. Accounts should be reviewed regularly, with the financial statements containing the information on the profitability of the book of

30

The general formula for incurred claims is: Paid Claims Claim reserves at the beginning of the period + Claim reserves at the end of the period The loss ratio (the incurred loss ratio) can be calculated by dividing incurred claims by earned premiums. Of course, the true loss ratio is not known until the block of business goes off the books. Various other methods exist for calculating loss ratios. Paid loss ratios (paid claims divided by written premium) and paidearned loss ratios (paid claims divided by earned premium) tend to understate the loss experience of a block of business in its early history. This can be seen in Figure 2:

10.3.2 Commission and Stamp Duty Just as premium is earned during the term of the policy, the charge to earnings for expenses must be spread over the policy term by developing unearned expense amounts. These are assets, as cash has been paid out for expenses that have a future value. The formula for earned commissions and stamp duty is: Commissions and stamp duty paid + Unearned commission and stamp duty at the beginning of the period Unearned commissions and premium taxes at the end of the period 10.3.3 Expenses A detailed expense analysis involves the allocation of total general expenses to individual accounts. The study takes the total corporate expenses, allocates the expenses by line of business, and then subdivides the line expenses by function. The resulting percentages can be incorporated into the assessment of future profitability and can also be used for future pricing. Common function evaluated for an analysis are: groups expense

100

80 Less Ratio (%)

60

40

20

0 78 Paid 79 80 81 Years Paid-Earned Incurred-Earned 82 83 84

Operating Departments Claims Administration Commission Accounting

Figure 2: Various Loss Ratios Policy Issue

31

 Premium Booking Sales Sales Administration Underwriting Service Departments

10.3.5 Tax This is required if the insurer wishes to determine profitability after tax. The level of tax incurred under this class of business is usually calculated using approximate methods. 10.3.6 Profit Criterion

Corporate Overheads Some expenses (especially start up costs) will need to be spread over the expected volume of business in the medium term future. Sometimes the administration is provided outside the life office, in which case the cost as a percentage of premium is easy to derive. 10.3.4 Investment Income Income depends primarily on the level of commissions paid and the nature of any deposit arrangement. For example, automobile dealer business generally involves regular cash flow without any deposit arrangement. Income is calculated as premiums, less commissions and premium taxes (e.g. stamp duty). A cash flow analysis is performed reflecting each element of paid expense against the premium income flow. An assumed rate is applied to the flow of funds, generally using representative short-term interest rates, in order to estimate the level of investment income. The profit criterion can be set as a proportion of any statistic relevant to the book of business. Examples include expressing it as a percentage of the premium (e.g. 10% of premium), or as a percentage of the capital required to finance the business (e.g. 15% of capital). 10.4 Controls Given that the principal quantitative objectives relate to growth and profit, it follows that the factors to be controlled are the revenue and expenditure items, such as new business premium, renewal premium, investment income, claims and expenses. New business and renewal premiums are controlled by managing the elements of the marketing mix. The potential for acquiring new business and retaining existing business is higher when products and services are designed to meet customers expectations, the price is lower than the price offered by competitors, and customers perceive that the products and services will meet their expectations at a price which is favourable. Control can be exercised over investments by establishing an investment committee to review current investment philosophy by considering, in particular, the asset/liability profile of the group portfolio, the target asset mixes and liquidity requirements.

32

The claim administration cycle provides the control mechanism for the claims item. Expense control is largely a matter of controlling the number of staff and their salaries and wages which usually makes up more than half of total expenses. The effective use of technology, productivity improvements and partnership arrangements between management and staff should all contribute to minimising expenses. Other factors include unsuccessful quoting, stamp duty and inefficient distribution channels.

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SECTION

Eleven

Conclusion
Credit assurance emerged to meet the specific needs associated with loan transactions. This publication serves to illustrate key aspects of successful and profitable credit life assurance. As with any industry, an insurer involved in the credit life industry should first develop a sound knowledge of the prevailing competitive and legislative environment before proceeding to his own product development. The types of credit life assurance products in the market are best introduced by exploring various credit transactions. Another aspect for consideration is whether to issue group or individual insurance plans. Based on these findings the insurer can begin the process of designing a suitable credit assurance scheme. Like other insurance products, the pricing of credit assurance schemes is also based on the expected values of the risks involved. Various actuarial techniques can be employed to assess these risks as well as to attach suitable values to the reserves necessary for future claim payments. Alongside the design and pricing issues lie those of marketing and administration. Naturally, there are policy administration processes and successful distribution techniques that are particular to credit life assurance. Continuing control and monitoring is facilitated through the introduction of a control cycle to suitably readjust the companys initial strategic plan. Profitability measures and analyses are all useful tools that can be used at each stage of the credit assurance process. In conclusion, a strong technical and strategic approach towards managing credit assurance business as advocated in this publication will provide the foundation for a profitable operation.

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APPENDIX

One SAMPLE POLICY APPLICATION FORM

Loan Balance Protection Insurance Proposal Schedule Name of Creditor: Branch Name: Account Number: Name of Debtor: Date of Birth: Occupation: Address: ________________________________________________________ ________________________________________________________ ________________________________________________________ ________________________________________________________ ________________________________________________________ ________________________________________________________ ________________________________________________________

Particulars of Loan Amount of debt (VAT inclusive): Period of Cover (Months): Premium Payable: Frequency of Premium Payments: _______________________ _______________________ _______________________ _______________________

Declaration I, name of the life assured, declare that to the best of my knowledge and belief: I am in good health and free from disease or disability or symptoms thereof and I am not receiving any regular medical treatment and have not done so in the last 12 months and the assurance does not replace any other existing assurance with any life assurer. This policy has been effected by me voluntarily and has not been made a condition of granting credit by the Institution. I agree that if the above declaration is not true, this assurance shall be null and void. Signed at on the day of 20

SIGNATURE OF THE ASSURED

SIGNATURE OF OFFICIAL OF INSTITUTION

35

APPENDIX

Two
before the expiry of the term of the credit agreement an amount equal to the death benefit shall be payable by the Insurer. Temporary Total Disability If, before the policy anniversary preceding the life assureds 65th birthday and the expiry of the term of this policy, the life assured is prevented, as a result of illness or bodily injury, from earning his normal income following any occupation for which the individual is suited, taking education, training and experience into consideration, the Insurer shall pay, after the deferment of 30 days, the monthly instalment agreed upon under the credit agreement referred to in the proposal schedule. The Insurers liability in terms of this policy shall not, under any circumstances: Extend beyond the 65th birthday of the life assured named in the proposal schedule. Extend beyond the early termination or the settlement date of the credit agreement. The insurer shall not be obliged to make any payment in respect of any event arising directly or indirectly from or traceable to intentional selfinflicted injury, suicide or suicide attempt.

SAMPLE POLICY DOCUMENT

The insurer undertakes in favour of the life assured named in the Proposal Schedule to pay the benefits described in this policy subject to: The receipt by the Insurer of the correct premium(s); The terms and conditions contained herein or endorsed hereon. DEFINITIONS Creditor The institution as named in the proposal schedule. A natural person named in the proposal schedule who is indebted to the Creditor.

Debtor

Insured Debt The gross invoice value, together with agreed or legal interest thereon, of goods sold and delivered or services rendered on credit owed by the insured debtor to the insured in terms of a valid contract that specifies credit terms not more favourable to the insured debtor than those specified in the relevant credit limit and which does not exceed the relevant credit limit of such insured debtor. Credit Limit The maximum aggregate amount due at any one time by a particular insured which is indemnified under the policy.

Provisions and Conditions

BENEFITS Death Benefit An amount equal to but not exceeding the balance of the indebtedness as herein defined. In the event of the total and permanent disablement of the life assured occurring prior to the attainment of age 65 and

Total and Permanent Disability

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Premiums

In the event that the premium or premiums actually paid to the Insurer are incorrectly calculated so that they are in fact insufficient to pay for the benefits in the proposal schedule then written notification thereof shall be sent by the Insurer to the creditor as well as to the life assured. If the error is corrected within the grace period, the full sum assured will be maintained.

Claims

A claim shall be lodged in the form specified by the Insurer together with all supporting documentation required by the Insurer. Once the Insurer has satisfied itself as to the occurrence of the insured event and the validity of the claim the Insurer shall notify the insured in writing of its basis for settlement of the claim and shall pay the claim on that basis. The Insurer shall not be liable in respect of any event arising directly or indirectly from or traceable to any of the following events: War, whether war be declared or not, from warlike action, civil war, insurrection, riot, civil commotion or other acts of violence originating from any political or civil unrest. Engaging in aviation other than as a fare-paying passenger on a regular route of a recognised airline. Intake of illegal drugs or the presence of alcohol exceeding the legal limit.

Exclusions Grace Period Where premiums are payable by means of other than a single premium the life cover of the policy as set out in the proposal schedule will be maintained by the Insurer for a period of grace of 30 days beyond the due date of any outstanding premium. Should this period of grace be exceeded without the outstanding premiums being received by the Insurer the cover will lapse and the Insurers liability under this proposal schedule will cease. Termination The Insurers liability in terms of of Insurance the policy shall cease in the event the indebtedness in respect of which the policy was issued has been paid in full or when it would have been paid in full had the life assured complied with his obligation to the creditor as originally undertaken whichever event shall happen first.

37

NOTES

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