Actuarial Notes

Term Conversions: Pricing and Reserves

By Hezhong (Mark) Ma · Society of Actuaries · 2017

Study guide: Exam ILA-101

An article by Hezhong (Mark) Ma in the March 2017 issue of Product Matters, the newsletter of the Society of Actuaries' Product Development Section, appearing on pages 20-26. Most U.S. term products offer policyholders the option to convert to a permanent policy, typically without additional underwriting. The article looks at how insurers account for the cost of that convertibility, in pricing and in reserves, through two hypothetical situations and a worked example.

On the syllabus

  • Exam ILA-101 — Term Conversions: Pricing and Reserves, Product Matters, Mar 2017 (the whole article); outcomes 2b.

Introduction

  • Convertibility of a term contract is, to some extent, similar to a swaption, in that the policyholder has the option to swap premium for the death benefits of permanent life insurance.
  • The conversion decision is generally one of self-selection, and insurers do not have a general consensus on how to account for the cost of convertibility.
  • In a survey of 21 companies, 12 built their conversion costs, explicitly or implicitly, into their term policies, and seven built them into their permanent products.

Situation 1: The Net Cost of Conversion to the Insurer Is Zero

  • If the slope of expected mortality matches that of the gross premium for a permanent policy through conversion, the converted policy is perfectly priced, and there is no need for extra premium or a reserve for the convertibility option.
  • The article calls this situation a bit wishful thinking and not necessarily preferable.

Situation 2: An Insurance Company Has Substantial Experience with Term-to-Permanent Policy Conversions. Its Experience Is Mature and Not Expected to Change

  • For these companies, many think there is no need to institute a separate charge for the conversion option.

Observations

  • With the simplified assumptions used, the higher the base mortality, the bigger the difference in the present value of future benefits between converted term policies and regular permanent policies, and so the higher the cost of convertibility.
  • The convertibility net premium for 54 sample policies, by gender, risk class, smoker status and issue age, ranges from 0.02 per 1,000 of face amount to 0.30 per 1,000.
  • Reserves for convertible term policies build slowly during the first nine years, then are significantly released in duration 10; the cost of convertibility is rear-heaped, which makes it difficult to manage the profit in the term products.
  • If conversions are disallowed in year 10 and beyond, the annual premium for the convertible term product can be reduced by roughly 30 percent, assuming policyholders do not alter their behavior to adapt.
  • Changing the timing of conversions and lapses to the end of each policy year raised the net premium for convertibility by about 25 percent.
  • The article concludes that revenue should match risks, so an insurer should charge and establish reserves specifically for conversions at the issuance of a convertible term policy.

Sources