In looking at the term market, you have probably wondered how a handful of price leaders can offer such competitive rates and still make a profit. The short answer is – assuming they are achieving acceptable return targets – these companies price with aggressive assumptions and then manage the performance drivers effectively.
As a leader and innovator in the term market, Transamerica Reinsurance is committed to being at the forefront of the market and sharing our insight with clients. This means…
- Close monitoring of market trends
- Ongoing study of mortality and lapse risks and their impact on product returns
- Providing value-added product development services
- Investing in technology that supports risk management strategies
- Developing financing structures and tax advantages that improve capital efficiencies
Current Trends
The most recent LIMRA report on U.S. Individual Life Insurance Sales (1Q08) shows term life down slightly, but the decline is not across the board. While some companies had double digit decreases in sales, others had double digit increases.
Price leaders continue to push term rates to new lows, but the decreases are generally modest (a few cents per $1,000 here and there) and reflect a jockeying of position among the top tier vs. the game changing rate cuts of recent years. However, middle tier and smaller term writers feel pressure to get their rates closer to the price leaders, and it is within these tiers that we see companies striving to make more dramatic changes in their rates.
As we have pointed out in previous articles, term players have good reasons to strive for rates that are within 10 percent of the top tier. (See Observations on Term Life from the June 2006 Messenger.) The top tier companies experience higher growth and more favorable mortality experience than the rest of the market. Moreover, when term rates exceed 10-15 percent of the price leaders, it increases the risk of anti-selection.
So, how do you get to top tier price points with reasonable returns?
Scenario Testing
As part of our ongoing analysis of the term market, we periodically perform scenario tests to compare the impact that different assumptions can have on premium rate and rate of return. We calibrate the best economics that a portfolio can achieve, match this with the most competitive term rates in the market and see if the premium rates and returns are sustainable.
We recently performed extensive scenario testing on a base line portfolio that reflected “as good as it gets” experience. In addition to insurance assumptions (premium, mortality, lapse, end of level period shocks, future mortality) we modeled the impact that changes to capital requirements, tax jurisdictions or capital financing structures can have on premium and return rates. We tested single assumptions scenarios and a combination of assumptions.
Our findings suggest that to be a price leader, or even to get within 10 percent of the top tier players, and get six to eight percent returns, companies need to use aggressive insurance assumptions, reasonably efficient capital strategies, and then manage the portfolio closely to ensure that experience and assumptions are in alignment. In order to achieve returns in the 11-12 percent range, companies need the additional benefits of very efficient capital and tax structures.
Considerations in Setting Assumptions
Assumptions and experience need to align in order to make the math work. Miscalculations in mortality and lapse assumptions can quickly drain the profits out of a term portfolio.
Minimum Return on Investment (ROI)
While we see companies moving to other measures to gauge the profitability of their term portfolios, for this article we will use ROI. Depending on how expenses are allocated (marginally or fully), ROI expectations can vary greatly from company to company with some targeting a seven percent to eight percent return while others expect 15 percent.
Mortality
Mortality is the most potent factor in determining term life results, comprising 60-70 percent of the premium dollar. The following points deserve close attention.
Initial Mortality Level. Our data shows that early duration mortality results vary a great deal among companies that appear to execute similar underwriting and business procedures. We see ranges as wide as 28-42 percent of the 1975-80 SOA S&U Mortality Tables. Even a modest miscalculation of the initial mortality level can have a significant impact on ultimate profits. For example, a combination of underwriting exceptions and oversights on 10 percent of your business with an average impact equal to two classes would increase mortality by five percent, from an expectation of 30 to 31.5 percent of 1975-80 SOA S&U. This additional five percent of mortality would reduce ROI on our hypothetical term portfolio from 11 percent to eight percent.
Mortality Management Technology. New rules based underwriting systems are helping companies improve their mortality experience as well as business processes and policy acceptance rates. (See New Tools for an Evolving Term Market from the October 2007 Forecaster.) The value of these mortality management systems is growing as companies retain more risk, work with new financing partners, and prepare for principles-based reserves and capital – which will be more sensitive to mortality volatility.
Mortality by Band. Our research indicates that mortality experience is higher for face amounts of less than $250,000; satisfactory for the $250,000 to $1 million band; and favorable for face amounts of more than $1 million. (See Observations on Mortality by Band in the October 2007 Messenger.) At a minimum, companies should review mortality experience by face amount band. Once the relationship is understood, a company can opt to subsidize the low band, reflect the cost differential, or pursue a new product strategy for low band (middle market). (See Helping Clients Tap into the Middle Market in the March 2007 Messenger.)
Mortality Improvement. How much mortality improvement to factor into term pricing assumptions varies significantly, with companies using zero to 1.4 percent and higher in their models. Adding a 0.5 percent annual mortality improvement for 25 years to our hypothetical term models increased the ROI from eight percent to11 percent. A big question, however, is whether or not long term mortality improvement will be a dependable source of profitability.
Older Age Mortality. While the impact of older age mortality is minimized for term life products, recent trends – older individuals buying larger term policies – increase the pricing and underwriting risks. Evidence is mounting that companies need to review previous speculations about the effects of underwriting at issue ages over 70. Research by Transamerica Reinsurance shows that for older age issues, the initial selection effects fade fast. (See Older Age Issues: Initial Selection Effects Fade Fast in the December 2007 issue of the Messenger.) These findings (corroborated by a recent SOA study) indicate that actual mortality may be higher than expected for this business.
Lapse Rates
For term life, lapse rates typically receive less attention than mortality in most modeling exercises. In our recent scenario testing, we looked closely at lapse rate assumptions as our data shows that level period term lapse rates are grading to lower levels at earlier durations. Pricing assumptions which do not reflect this can have a big impact on profitability down the road.
Lapse rates that previously leveled out around four to five percent by duration six or seven are now starting to dip into the two to three percent range for some companies. Incorporating a two percent annual decrease in the level period lapse rates decreases the ROI on our hypothetical term portfolio by roughly two percent, from eight to six percent.
In addition to the level premium period lapse, there is a wide range of assumptions being used for the “shock” lapse at the end of the level premium period. Experience is now emerging on the 10 year level premium products sold in the mid 90s. Our data shows the mean duration 10 lapse rate on these products is roughly 50 percent, consistent with the SOA 2007 Survey. A reduction from this survey average from 75 percent used in pricing to the mean experience of 50 percent could have a positive impact of as much as 10 percent on the 10 year term ROI.
Capital Management
Term writers that want 11 percent to 12 percent returns need to look to more effective Triple X reserve financing programs. Earlier this year
Transamerica Reinsurance introduced a Term Notes Program (see New Options in Reserve Financing in the March 2008 Messenger) that leverages our expertise in both mortality risk management and capital markets financing. The new program compares highly favorably to other reserve financing options, and it unlocks value not available to clients in a traditional coinsurance transaction.
Once a product is designed to achieve an eight percent or higher return, adding the latest capital and tax strategies can provide a strong uplift to the ROI (i.e., eight percent leveraging up to 11 percent). However, if the product’s ROI is not above a mid single-digit return, these capital and tax strategies will likely not provide any improvement in returns.
Room for Improving Performance
Marketing a term life portfolio that is both competitively priced and profitable poses a challenge for everyone in this business. But our experience in the term market shows that a number of companies can still find ways to improve performance. We look forward to sharing information on our most recent term life research and how our value added solutions can help companies grow their business and achieve target returns.