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Actuarial funding in unit linked insurance products

There was a recent news item in financial papers that the Insurance Regulatory and Development Authority had banned "actuarially funded" unit linked insurance products. This has puzzled many as the concept of actuarial funding is not widely known. Before explaining this concept, one can look at the basic structure of unit linked products as available in India.

In traditional policies, the sum assured and bonuses (already declared) are guaranteed even if the investment conditions turn adverse. This means that the insurer covers both mortality and investment related risks. If investment conditions are favourable, the policyholder gets not less than 90 per cent of the resulting profits, after tax.

The value of a unit linked policy is the product of the number of units under the policy and market value of the unit (known as net asset value or NAV). It can show an impressive gain when the market is bullish but can touch the bottom when bearish. The risk is to be borne entirely by the policyholder. Though investment related risks are not covered, these policies are attractive because of the chance they provide to secure high returns.

Let us consider a typical unit linked plan marketed by the Life Insurance corporation. The charge towards marketing expenses is 26.5 per cent of the premium in the first year and 2.5 per cent in subsequent years. If the annual premium is Rs. 5,000, a sum of Rs. 1,325 will be deducted from the first premium towards marketing expenses and the balance (known as allocation rate) of Rs. 3,675 will be allocated in the form of units.

The face value of each unit will be Rs. 10 while the real value — the NAV — can be higher or lower, depending on market conditions. If the NAV is Rs.12.50 on the day the premium is received, 294 units will be allotted. If it is Rs.7.50, then 490 units will be allotted. From the second year onwards, the allocation rate is 97.5 per cent.

In addition to marketing expenses, there is a deduction of Rs. 60 per month in the first year and Rs. 20 per month in subsequent years towards administrative expenses. Apart from this, 1.5 per cent of the value of the fund pertaining to the policy will be deducted per year towards fund management expenses. Charges towards risk cover will depend on the age of the life assured and the nature of risk covered. Dividend and interest income from investments will be credited to the fund. When the market value of the assets increases, the NAV and along with it the value of the fund will increase. The position will be the reverse when the market value decreases.

If the actual expenses of the company are less than the deductions made, a profit emerges. Else, the company sustains a loss. The real profit for the company flows from the deductions towards fund management expenses, which is a percentage of the value of the fund. As the fund size increases year after year, the amount deducted will also increase and be substantial after five years.

To make its product attractive, a company may waive the deduction towards marketing expenses in the first year, allowing the allocation rate to go up to 100 per cent or even higher. How then can it meet the high initial expenses in the first year?

A company offering 100 per cent allocation in the first year compensates itself by charging higher administrative and fund management expenses. For example, a fund management charge of, say, three per cent will be made instead of the usual 1-1.5 per cent. As actual expenses will be below one per cent, it can take advance credit for future profits arising from the additional charge. Since such advance credits are not allowed as per Accounting Standards, it is done indirectly through a technique known as ‘actuarial funding’. What is this technique?

Depending on the age at entry, policy term and excess fund management charge available, certain actuarial factors can be determined. For age at entry of 35 years, term 15 years and excess available fund management charge of 2 per cent, the factors corresponding to the beginning of first, second, … etc. years are, say, 75 per cent, 76 per cent, 77 per cent, 78.5 per cent, …etc and 100 per cent at the end of the 15th year.

Though the statement to the policyholder will show that units corresponding to the full premium have been allocated, the actual assets purchased will be only for 75 per cent of the premium. The balance 25 per cent will be used for meeting the first year marketing expenses. The proportion of the assets held to that shown in the statement to the policyholder will increase year after year and, at the end of the policy term, will become 100 per cent.

Consider a similar hypothetical procedure in the banking industry. A bank collects Rs. 100,000 towards a five year fixed deposit with 8 per cent interest. It is confident of earning not less than 12 per cent from its lending and investments. If it is permitted to adopt actuarial funding, it can indirectly take advance credit for 50 per cent of the additional investment income and purchase assets for only Rs. 90,000 and use the balance Rs.10,000 to meet current expenses. This proportion can gradually increase to 100 per cent at the end of five years. Will this be permitted? If not, how can it be permitted under unit linked insurance?

In this system, a substantial portion of profits emerging in future will go towards making up for the initial deficiency in assets. As long as investment conditions and rate of growth of new business remain good, the company will not face any problem. If the conditions become adverse, the company will face a problem.

Actuarial funding is a new concept as far as the Indian insurance industry is concerned. It has become necessary for the accounting profession to take a close look and offer its considered views.

R. RAMAKRISHNAN

(Actuary)

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