Risks involved in securitising life premia

Chennai: Though life insurance premiums are payable in equated instalments (monthly, quarterly, yearly) and spread over several years (like housing loan repayments), insurers and investors are wary about securitising the same. The reason? Uncertainty hangs over its continued payment by policyholders.

Why is it so? Says Standard and Poors director (insurance ratings) Earl Lancaster: "The securitisation of future premiums beyond the contractual term of the insurance policy [like renewal premiums for non-life business or annually reviewable life business] will involve the transfer of: [a] the persistency risk [the risk that there are fewer renewals than anticipated]; and [b] the rate revision risk [the risk that the premium rates per unit of exposure will be lower than expected because of competitive or other considerations]."

Both the risks, he says, are dependent on future market conditions and the future way in which the insurer conducts its business. "The risks are typically not very easy to predict."

Similarly, securitisation of future premiums due up to the end of the contractual term of the policy will still be a persistency risk, though, depending on the contract design, this risk will be partially mitigated (and therefore more predictable) by surrender penalties, market value adjustors and encashment deferral rights all of which will reduce policyholders propensity to terminate insurance contracts prior to the end of the contractual terms, says Lancaster.

He says the premium consists of contributions towards expenses, mortality and (hopefully) profits. "The securitisation of future premiums will also, therefore, necessitate the establishment of higher actuarial reserves [for life] or un-expired risk reserves [non-life] plus reserves for future administrative expenses."

Therefore much of the capital raised from securitising future premiums should be used to set up higher reserves. Equally, higher actuarial reserves will attract an increased solvency requirement. It is even possible that prudent reserving requirements may utilise all the capital raised. There may also be tax implications as with any securitisation.

For investment-orientated life contracts, it will be imprudent to securitise future premiums, as the policyholders expected return and the operation of the policy may depend on the timing of the payment of the contractual premium, says Lancaster. "It should be remembered that most of the premium assets belong to the policyholder and are therefore unsuitable to be securitised."

A contrary view is also available. Says Birla Sun Life Insurance actuary K S Gopalakrishnan: "In life insurance the product is different. If a policyholder fails to pay future premiums the insurer protects himself by paying only a surrender value, or nothing. Also, a lapsing policy need not result in a loss to the insurer; instead, it could actually improve the profits."

Lapses can, however, result in a loss to the insurer if the policy is of a smaller size and the lapse happens at early durations, say within the first three years, despite a nil surrender value. Gopalakrishnan says even if a life insurer wants to securitise, it need not securitise future premiums totally, or all the future premium payments, under the policy.  "Financially, the insurer only has to securitise that part of the premium in such a way that the targeted profits are made even under a lapsed policy."

But determining this can be a messy exercise. Thus, instead of securitisation, life insurers are managing this risk through product design. Unit-linked products are a good example. Actuaries are thus developing products that are lapse-supported on the whole, even though there is a certain amount of cross subsidy between smaller and bigger policies.