By Ranjit Kulkarni
Why is it that the insurer cannot offer a higher surrender value to the policyholder who is withdrawing? Let’s delve into some of the logical aspects behind this. When the life insurance products are sold, the policy is priced considering the possible claims to be paid in the future. For example, the life insurance company collects premiums for ten years for a given block of policies and continues to invest this amount. The value of this premiums collected during these ten years by the insurer plus the investment earnings, should be sufficient to fund the value of outgo for that block of policies. This outgo is the value of claims and benefit payments promised by the insurer. This calculation becomes complex because all these values need to be estimated, adjusting for the timings of inflows and outflows.
Surrender results into two forces working in opposite directions on the insurer’s profit:
- Lower future claim liability. The expected number of benefits to be paid in future is less, while the surrender value has to be paid now.
- The present and future premium collection decrease, due to discontinuation of surrendered policies, thereby lowering investment earnings compared to earlier estimates. The net effect of these on the insurer is difficult to ascertain. So, the insurer maintains a balance between sufficient liquidity for early claims and surrender values on one hand and earning enough surplus to meet the future liabilities on the other hand.
Typically, any life insurance policy starts generating returns for the life insurer only after some years. For the first few years , earnings are always lower than the expenses of procuring, underwriting and handling the policy. The insurance company actually incurs loss on policies that are discontinued during the early period, and thus the policyholders can surrender their policies only after 3-5 years of premium payments.
Another reason why the surrender value is lower than what the policyholder has paid is that the policyholder is withdrawing earlier than originally promised. For example, if the life insurance policy term is 15 years with 10 years of premium payment, then that means the policyholder has entered into a contract with the life insurer to pay the premiums for ten years to receive the specified benefits and claims. If the policyholder chooses to surrender the policy earlier, for instance, after 5 years of paying the premiums, then it is a breach of the contract. This impacts the estimated cash flows and the out go calculations.
Good life surrenders-bad life continues-From the life insurance perspective the ‘good lives’ are the policies that have minimum possibility of generating claims during the term of the policy. From the policyholder perspective those individuals who believe that they do not need a life insurance, tend to surrender their policy while those who have a health risk of some kind tend to continue the life insurance. This typical trend, though logical at the individual level, affects the profitability of the insurance firm when considering a large pool of policies. The high surrender value will discourage good lives from continuing the policies and the insurance firms’ profits will be affected.
Another reason why the insurer cannot offer higher surrender values is related to the premiums charged for some types of policies For example, endowment insurance products are highly popular in India because they offer an attractive return to all policyholders. However, policyholders have varying risk profiles. If premiums were adjusted according to the riskiness of each policyholder, the returns on endowment products might no longer be appealing. Therefore, the mortality charge for endowment products is standardized and levelled across policyholders with different risk profiles.
The higher surrender values offered to the withdrawing policyholders may not be supported in this case as policyholders with higher mortality risk are cross subsidised in premium calculation. Thus, the level premiums do not support higher the surrender values. When an insurance company pays a surrender value to a discontinuing policyholder, it has to keep in mind it’s financial feasibility as well as the interest of the continuing policyholders.
Finally, we need to understand that people don’t buy life insurance with the purpose of surrender, still the data shows that surrender of a life insurance is an inevitable phenomenon due to the long term nature of the contract. The paradox of the life insurance market is that the policyholders need to liquidate the life insurance while the insurers are unable to pay the high surrender values. Can an entry of a third party resolve this dilemma? Can we re-imagine the life insurance market with a new entity stepping in this situation to offer a solution to this dilemma?
(The author is Research and Strategic Acquisition Head Of ACESO)
