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Profit Testing

This document discusses profit testing of unit-linked insurance contracts. Profit testing involves projecting cash flows and revenues to determine expected profitability. For unit-linked contracts, the unit fund and non-unit fund must be projected separately. Projected revenue accounts are constructed for each year showing premiums, investment income, expenses, benefits paid, reserve increases, taxes, and profit. Profit vectors and signatures can then be calculated to analyze expected profits per policy in force each year and at inception. Examples are provided to demonstrate calculating expected profits for different years of a sample unit-linked endowment policy.

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Brian Kipngeno
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315 views16 pages

Profit Testing

This document discusses profit testing of unit-linked insurance contracts. Profit testing involves projecting cash flows and revenues to determine expected profitability. For unit-linked contracts, the unit fund and non-unit fund must be projected separately. Projected revenue accounts are constructed for each year showing premiums, investment income, expenses, benefits paid, reserve increases, taxes, and profit. Profit vectors and signatures can then be calculated to analyze expected profits per policy in force each year and at inception. Examples are provided to demonstrate calculating expected profits for different years of a sample unit-linked endowment policy.

Uploaded by

Brian Kipngeno
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Profit testing

This is the process of projecting the income and outgo emerging from a policy, and discounting
the results.
The results can then be used for various different purposes, such as setting the premium
for a life policy that will give us our required level of profitability.
we can also use profit tests to set reserves.

Before discussing profit tests in detail, we describe the structure of unit-linked


contracts, and how profit emerges from them.

Unit-linked policies can have a minimum guaranteed sum assured payable on survival
to a specified date, on death, or both. Death benefit guarantees are generally more
common than survival (or maturity) guarantees.
In order to price and value unit-linked contracts, details of allocation percentages (usually
specified in the policy) and an assumption about the future growth in the price of the units
purchased are needed.
Note that contracts that are non-unit-linked are normally called conventional
Projecting expected cashflows for various contract
types
The expected cashflows are used to construct a projected revenue account (per
contract in force at the start of the period) for each time period. For some
contracts, eg life assurance, there is only one way in which a contract remains in
force and so only one projected revenue account is needed.
The revenue account for a life company is:
(+) premiums
(+) investment income
(–) expenses
(–) benefit payouts (claims, maturity, surrender values)
(–) increase in reserves
= profit gross of tax
(–) tax
= profit net of tax
If we are doing this for a unit-linked contract then our projections get more complicated as, we
shall need to project the unit fund and the non-unit fund separately.

together with the different probabilities of the various events leading to the
payment of particular cash amounts.
Exercise
A life insurance company is studying the profitability of a 5-year unit-linked endowment
assurance contract. Details are as follows:
Note:
The bid-offer spread is simply the difference between the price at which you can buy a share
and the price at which you can sell it. ... The offer price is what you have to pay to buy shares
from them. The offer price is usually higher than the bid price so that the market maker can
make a profit.

Calculate the expected profit or loss on the non-unit fund in each year, per policy in
force at the start of each year
Solution
We first need to project the size of the unit fund over the term of the policy
We can do the same for every year of the contract, to give the profit in each year per
policy in force at the start of that year.
One area where we need to be slightly careful is in calculating the cost of death cover,
because if the value of the units goes above the guaranteed sum insured then the death
cost will be zero.
Profit tests for annual premium contracts
Having now considered how to project the revenue accounts for a policy, we see how to
use that projection.
The first step in the profit testing of a contract is the construction of the projected revenue
accounts for the non-unit (cash) fund for each policy year .
For some contracts other funds, eg unit fund for unit-linked assurances, reserve fund for
traditional assurances, provide cashflows to the non-unit fund.

For instance an endowment assurance policy gave the following profit vector:
(–803.99, 186.97, 178.12, 206.47, 215.23)

Note
Summarising the above, we have the very important distinction:
 profit vector = profits per policy in force at the start of each year
 profit signature = profits per policy in force at inception
So all of the work we did earlier went to determining the profit vector of contracts, that is, the
profits for each year per policy in force at the start of the relevant year.
For the profit signature, we wish to calculate (for each year) the expected amount of profit
emerging in that year, per policy in force at inception.
For example, for the endowment assurance policy example, we found the second element of the
profit vector to be £186.97.
For which policies in force do we expect a profit of £186.97?
£186.97 will be the profit expected by the end of the coming year (Year 2), from a policy that was
in force at exact time 1.

Using the dependent decrement probability table below.


Summary measures of profit

Example
Calculate the net present value of the endowment assurance policy provided earlier, using a risk
discount rate of 7%.
Calculate the profit margin of the endowment assurance policy using a risk discount rate of
7%.
WHAT IS IRR.CALCULATE IRR

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