Have you ever thought about purchasing and owning a lifetime membership of a fitness centre? As an actuary, the first thing that came to mind was to compare the single premium lifetime membership with the present value of my yearly fee, increasing with inflation, until I retire. So, the next question was “How do you protect yourself if the fitness centre doesn’t stay open at least for the next six years?”
This is exactly what would happen if insurers were not regulated and did not have actuaries. Insurers might be able to close without any restrictions, putting their policyholders in a much larger bind than what was experienced by us at the fitness centre. At that moment we simply had no other option than to start over and join somewhere else. Thus, raising the notion that actuarial provisions should be required in fitness centres where there is a prepayment for services.
To take this comparison further, think of a single premium term insurance such as Mortgage Reducing Term (which is popular in Malaysia for both conventional insurers and Takaful operators). The policyholder pays a single premium at policy inception which in turn must pay for benefits and expenses for the lifetime of the policy. Thus the actuary must set up reserves accordingly. The result is that even though the full single premium is considered revenue at policy inception, instead of howing directly as profit to the company which can be taken out by shareholders, we set a reserve aside for all future expenses and benefits, at best estimate plus padding. Thus we analyze the entire company, understand what are the factors affecting the company and model it accordingly. We model future mortality, lapsation, expenses, commissions, inhation, regulatory costs and investment returns. This provides smoothness to the revenue accounts and gives comfort that the insurance policy will be there when needed. The regulators provide a huge service to the industry in ensuring this smoothness and safety. As an aside this is what IFRS 17 is trying to fine tune and brings to the next level (It seems like a nightmare now but in time the beauty of IFRS17 will come out).
Unfortunately, for a fitness centre, there are no such requirements for reserves and smoothness in the revenue accounts. To be precise there surely is some sort of provision for any prepayments, but without an actuarial calculation of how long a lifetime is we will never know how sufficient it is. Without this smoothness and consistency the profitability and viability of the company depends on a steady supply of (lifetime) members, which obviously in this case did not materialize to the extent needed. This points to a need for regulations requiring actuaries to be involved in this type of company, or to be more precise, any company where there is a lifetime prepayment for services being rendered.
The actuary would be able to review the operations of the company and model the prepayments accordingly. For instance, once the lifetime membership fee is received, how would the money be invested? This would be used to determine the discount rate. The actuary would also determine the costs of running the fitness centre, such as the commissions paid to the marketing staff, the salaries of the trainers, the fees paid to the class instructors, and the office staff such as receptionists and finance team.
The actuary would be able to also determine the recurring costs such as replacement and depreciation of equipment and facilities as well as rent.
Of course there is a chance that an existing member might pass away, so the probability of death would need to be taken into account into the modelling, as well as the probability of retirement, moving or shifting far away from the fitness centre , making coming to the fitness centre no longer viable. Furthermore we can also model the ‘new year’s resolution’ effect where people decide to join the gym, pay a lifetime fee with the best of intentions and then get lazy (or just get distracted with all the delicious Malaysian food). If an actuarial reserve had been set up whenever a member prepaid their fees, then perhaps this fitness centre would not have closed down, or to be more precise with these reserves the viability of the fitness centre in the first place could have been known with more precision, allowing shareholders to take a more measured approach as to whether or not to start operations. We haven’t even discussed the usefulness of a Financial Conditions Report to show shareholders not just expected profits over the next five years but also the risks involved. With an understanding of the key risks this can be the focus of attention for the company to maximize profits and reduce surprises.