The idea of gross premium valuations (GPV) is to obtain a best estimate of the amounts required in the future for a particular policy. We do this by making a number of assumptions. This article explores the assumption of future dividend declarations.
The Risk-Free Yield Curve in Sri Lanka versus the Dividends of Universal Life Products
Both assets and liabilities are affected by changes in the risk-free yield curve, which is provided by the regulator every valuation period. For most insurers, the average duration of assets is lower than liabilities, which means that as the yield curve decreases, the value of liabilities will increase faster than the value of assets, and conversely as the yield curve increases the value of liabilities will reduce faster than assets.
For universal lifestyle products, there is a recommendation in the document “Directions for Identification and Treatment of One-off Surplus” released on 20 March 2018, with reference to page 5 item 2.11:
“It is hereby clarified that, under the existing RBC rules, universal life business may be valued using either discounted cash flow method or as policy account value plus general account (non-unit) liabilities. However, the discount rate used should be the risk-free interest rate curve: and the crediting rate assumption should be set consistent with the discount rate.”
Based on this statement, we should link the crediting rate to the level of the yield curve, meaning that as the yield curve increases, the payout to policyholders increases as well. Thus, even though under an increasing yield curve the market value of assets reduces, the value of liabilities for universal life products will increase, which is counter to the entire concept of that if there is a matching asset and liability portfolio that changes in the yield curve should have little effect on financial results (and solvency). This is also counter to the approach by some insurers to make best efforts to hold the declaration rates relatively fixed (i.e., treat the plan more as non-par than par).
As an example, let’s assume:
- 8% yield curve (discount rate)
- 8% coupons on bonds (assets held)
- 8% dividend rate.
Now, the yield curve then changes to 15%. For non-universal life products, the market value of assets drops, along with liabilities, so solvency is not affected. HOWEVER, for universal life products, we need to assume higher dividends due to a recommendation from the regulator, say 15%, BUT coupons (asset backing these liabilities) are still 8% since “the crediting rate assumption should be consistent with the discount rate (i.e., risk free yield curve)”. The crediting rate used in our projections has increased with the risk-free yield, but the actual coupons backing this liability still remains. This will cause distortions to the effect of discount rate changes, which is not how GPV was envisioned (in our opinion).
Adding complexity to this example, as an existing insurer with invested assets, our intention is to still declare 8% as these are our coupons we are receiving from our assets. BUT if there was a new company, they could buy new bonds at 15% coupons and be more competitive. Thus, there is no easy balance between GPV theory and actual practice of insurers.