MECE-103

ACTUARIAL ECONOMICS:
THEORY AND PRACTICE

School of Social Sciences

Indira Gandhi National Open University
EXPERT COMMITTEE
Prof. B. Kamaiah (retd.) Prof. K. V. Parthasarathy (retd.) Sh. Ashish Prakash
School of Economics, UoH, Madras School of Economics, General Insurance of India,
Hyderabad. Chennai. New Delhi.
Ms. Rajat Arora Prof. Gopinath Pradhan (retd.) Prof. Narayan Prasad
Delhi University, Indira Gandhi National Open Indira Gandhi National Open
Delhi. University, New Delhi. University, New Delhi.
Prof. Kaustuva Barik Prof. B S Prakash Sh. Saugato Sen
Indira Gandhi National Open Indira Gandhi National Open Indira Gandhi National Open
University, New Delhi. University, New Delhi. University, New Delhi.

COURSE PREPARATION TEAM

Block 1 Introduction to Insurance Theory
Unit 1 Interface Between Economics and Insurance Unit Writing
Unit 2 Life and General Insurance Prof. Gopinath Pradhan
Unit 3 Health Insurance and Pension Funds Sh. Ashish Prakash
Sh. P. Sahu
Block 2 Quantitative Techniques for Risk Analysis
Unit 4 Applied Probability Content Format and Editing
Unit 5 Stochastic Process Prof. B.S. Prakash
Unit 6 Financial Markets and Derivatives Sh. B. S. Bagla
Block 3 Interest Theory
Unit 7 Basics of Interest Theory
Unit 8 Equations of Value and Time
Unit 9 Annuities
Block 4 Actuarial Survival Models-I
Unit 10 Age-at-Death Random Variables
Unit 11 Parametric Survival Models
Unit 12 Time-Until-Death Random Variables
Block 5 Actuarial Survival Models-II
Unit 13 Life Table Format
Unit 14 Contingent Payment Models
Unit 15 Benefit Premium and Benefit Reserves
Unit 16 Joint Life Models
Block 6 Risk Management
Unit 17 Valuing Risk Management
Unit 18 Reinsurance
Unit 19 Copulas
Block 7 Risk Models
Unit 20 Theory of Extreme Value
Unit 21 Credibility Theory
Unit 22 Dynamic Financial Analysis

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 CONTENTS
Page No.
BLOCK 1 INTRODUCTION TO INSURANCE THEORY 7
Unit 1 Interface Between Economics and Insurance 9
Unit 2 Life and General Insurance 24
Unit 3 Health Insurance and Pension Funds 38
BLOCK 2 QUANTITATIVE TECHNIQUES FOR RISK ANALYSIS 53
Unit 4 Applied Probability 55
Unit 5 Stochastic Process 72
Unit 6 Financial Markets and Derivatives 90
BLOCK 3 INTEREST THEORY 107
Unit 7 Basics of Interest Theory 109
Unit 8 Equations of Value and Time 126
Unit 9 Annuities 145
BLOCK 4 ACTUARIAL SURVIVAL MODELS-I 167
Unit 10 Age-at-Death Random Variables 169
Unit 11 Parametric Survival Models 187
Unit 12 Time-Until-Death Random Variable 210
BLOCK 5 ACTUARIAL SURVIVAL MODELS-II 231
Unit 13 Life Table Format 233
Unit 14 Contingent Payment Models 246
Unit 15 Benefit Premium and Benefit Reserves 263
Unit 16 Joint Life Models 277
BLOCK 6 RISK MANAGEMENT 295
Unit 17 Valuing Risk Management 297
Unit 18 Reinsurance 314
Unit 19 Copulas 330
BLOCK 7 RISK MODELS 345
Unit 20 Theory of Extreme Value 347
Unit 21 Credibility Theory 367
Unit 22 Dynamic Financial Analysis 388
COURSE INTRODUCTION
This course on ‘Actuarial Economics: Theory and Practice’ is one of the electives
in your two year programme on M. A. in Economics. The course is aimed at
equipping you with the required theoretical background to the area of actuarial
sciences with its interface with the insurance sector. Insurance sector is
important to infuse confidence to investors. The sector’s survival depends upon
the cost effectiveness of policies sold to customers. This means the value of the
number of claims should always be smaller than the aggregate value of premiums
collected. Such an analysis needs the studying of the distribution of clients for
their age and life profiles. This needs a knowledge of random variables,
probability distributions, stochastic processes, life tables, survival and mortality
functions, credibility theory, dynamic financial analysis, etc. With this in view,
the course is aimed at giving you the required theoretical background juxtaposed
with quantitative illustrations. Following these quantitative illustrations,
however, requires the knowledge of obtaining the values of scientific functions.
You must bear in mind this important aspect. The course is distributed over 7
blocks and has 22 units. Brief outline of the block titles and the content of the
units within them are as follows.
The first block (Block 1) of this course is on ‘Introduction to Insurance Theory’.
It has three units. Unit 1 is on Interface Between Economics and Insurance. It
first introduces you to the relationship between ‘financial economics’ and
‘actuarial science’. It then presents an account of the concept of ‘insurance’ and
‘actuarial valuation’. The unit concludes with a note on ‘risk management’.
Unit 2 is on ‘Life and General Insurance’. This unit covers two important issues
viz. (i) life insurance contracts and (ii) general insurance. Unit 3 is on Health
Insurance and Pension. The unit discusses (i) health insurance contracts, (ii)
pension schemes and (iii) pension funds.
Block 2 is on ‘Quantitative Techniques for Risk Analysis’. The block covers
three major areas viz. Applied Probability (Unit 4), Stochastic Process (Unit 5),
and Financial Markets and Derivatives (Unit 6). Unit 4 discusses two major
themes viz. (i) Mean Deviation and (ii) Random Walks and Gambler’s Ruin.
Unit 5 discusses three themes viz. (i) Stochastic Models, (ii) Markov Chain and
(iii) Geometric Brownian Motion. Unit 6 discusses issues like: (i) pricing of a
forward contract, (ii) Black-Scholes Model and (iii) Optimal Portfolios.
Block 3 is on ‘Interest Theory’. It has three units: Basics of Interest Theory (Unit
7), Equations of Value and Time (Unit 8) and Annuities (Unit 9). Unit 7
discusses the concept of Accumulation Function. The unit discusses two types of
accumulation functions viz. ‘linear accumulation functions’ and ‘exponential
accumulation functions’. Unit 8 is on Equations of Value and Time. This unit
explains the concepts of (i) present value and discount factor, (ii) effective rate of
discount, (iii) force of interest and (iv) solving equations for interest rate. Unit 9
is on Annuities. It explains: (i) types of annuities, (ii) increasing and decreasing
annuities and (iii) perpetuity.
Block 4 is on Actuarial Models I. It has three units. Unit 10 is on Age at Death
Random Variables. This unit explains the concept in terms of two functions viz.
(i) cumulative distribution function and (ii) hazard function. Unit 11 is on
Parametric Survival Models. This section covers (i) one parameter model, (ii)
two parameter models, (iii) three parameter models and (iv) extended parametric
survival models. Unit 12 is on Time Until Death Random Variable. This unit
discusses concepts like (i) survival function, (ii) distribution function and (iii)
mean and variance of distribution function.
Block 5 is on Actuarial Survival Models II. This block has four units. Unit 13 is
on Life Tables. The unit first introduces the features of a Basic Life Table. It
then explains the ‘types of life Tables’. The concept of ‘mortality function’ is
then explained. Unit 14 is on Contingent Payment Models. Beginning with the
meaning of the term ‘contingent payment’, the other concepts explained in the
unit are: (i) endowment insurance, (ii) discrete premiums and (iii) variable
insurance benefit. Unit 15 is on Benefit Premium and Benefit Reserves. This
unit discusses the concept of ‘loss function and benefit premium’ and ‘benefit
reserves’. The block concludes with Unit 16 on Joint Life Models. This is
discussed in terms of (i) joint life functions and (ii) last survival status.
Block 6 is on Risk Management. This block has three units. Unit 17 is on
Valuing Risk management. The unit first outlines the concept of ‘risk’. This is
followed by two sections: one on ‘risk management’ and the other on ‘valuation
of risk (VaR)’. Unit 18 is on Reinsurance. The unit first explains the ‘types of
reinsurance’. The steps needed to be followed for the calculation of reinsurance
and pricing of reinsurance are then explained. Unit 19 is on ‘Copulas’ which
basically refer to ‘multivariate probability distributions’ with their marginal
probability distributions as ‘uniform’. Relationship of such copulas with ‘risk
variables’ is explained in the unit.
Block 7 is on Risk Models. This block has three units. Unit 20 is on Theory of
Extreme Value. Beginning with an outline of the concept of ‘extreme value
theory (EVT)’, the unit explains the ‘steps in applying the EVT’. The
requirements for the estimation of parameters is also discussed. Unit 21 is on
Credibility Theory. It first explains the concept of ‘classical credibility’. It then
discusses different ‘types of credibility measures’. A discussion on estimators
and comparative profile of different credibility measures is then given. The last
unit of the course, Unit 22, is on Dynamic Financial Analysis. This unit covers
three important concepts viz. (i) stochastic simulations, (ii) stochastic variables
and (iii) corporate model.
 BLOCK 1
INTRODUCTION TO INSURANCE THEORY
INTRODUCTION TO BLOCK 1

Block 1 is on Introduction to Insurance Theory. It has three units. Unit 1 is on

Interface Between Economics and Insurance. The unit first distinguishes between
‘financial economics’ and ‘actuarial science’. It then explains two aspects of
insurance viz. discounting technique and insurance regulation. The three
important stages of Actuarial Valuation viz. (i) discounted cash flow valuation,
(ii) enterprise valuation and equity valuation and (iii) financial valuation and
actuarial valuation are subsequently discussed. A section on ‘risk management’
and ‘actuarial modelling’ concludes the unit.
Unit 2 is on Life and General Insurance. This unit discusses five types of
insurance contracts viz. (i) endowment assurance, (ii) whole life assurance, (iii)
term insurance, (iv) annuity and (v) unit-linked insurance.
Unit 3 is on Health Insurance and Pension. It explains four types of ‘health
insurance contracts’ viz. (i) income protection insurance, (ii) critical illness
insurance, (iii) long term care insurance and (iv) private medical insurance.
Under ‘pension schemes’, the unit discusses different ‘types of pension schemes’
and ‘characteristics of pension funds’. An account on ‘financing of pension
funds’ is also given.
UNIT 1 INTERFACE BETWEEN Interface Between
Economics and

ECONOMICS AND INSURANCE Insurance

Structure
1.0 Objectives
1.1 Introduction
1.2 Financial Economics and Actuarial Science
1.2.1 Key Concepts of Finance Applied in Actuarial Analysis
1.3 Insurance
1.3.1 Discounting Technique
1.3.2 Insurance Regulation
1.4 Actuarial Valuation
1.4.1 Discounted Cash Flow Valuation
1.4.2 Enterprise Valuation and Equity Valuation
1.4.3 Financial Valuation and Actuarial Valuation
1.5 Risk Management
1.5.1 Actuarial Modelling
1.6 Let Us Sum Up
1.7 Key Words
1.8 Suggested Books for Further Reading
1.9 Answers/Hints to Check Your Progress Exercises

1.0 OBJECTIVES
After reading this unit, you will be able to:
• outline the scope of ‘actuarial science’ and ‘financial economics’;
• identify the concepts of ‘financial economics’ applied in ‘actuarial
analysis’ with a brief outline of each;
• describe the concept of ‘insurance’ with an illustration of ‘discounting
technique’ as applied in it;
• argue why there is need for ‘insurance regulation’;
• state the approaches to ‘actuarial valuation’;
• discuss the approach of ‘discounted cash flow evaluation’ with an
illustration;
• distinguish between ‘enterprise valuation’ and ‘equity valuation’;
• differentiate between ‘financial valuation’ and ‘actuarial valuation’;
• indicate the ‘types of risk’ and the methods employed for their
management; and
• explain the two broad types of ‘actuarial models’. 9
Introduction to
Insurance Theory 1.1 INTRODUCTION
Actuarial science (AS) evaluates statistics of ‘past and present’ in the field of
insurance. Its objective is to evaluate the future risk. Money remains a key
variable in the process. Consequently, dealing with ‘speculation and risk’
remain its areas of core concern. Financial economics (FE), on the other
hand, studies finance to help make policies. Options pricing, portfolio
optimisation and credit risk are important areas studied under FE. Thus, both
the disciplines (AS and FE) deal with monetary operations and are related
with the common variable of money. For instance, consider property
investment. It requires a large amount of capital outlay followed by insurance
to protect the investment. One would not like to spend vast sum of money on
a venture without some protection against possible damage. Notwithstanding
the close work related to finance in both the disciplines, their approach to
find solutions to problems differ. Actuarial science traditionally focuses
on estimation of joint probabilities using real data while FE dwells on
valuation of contracts under an arbitrary distribution.

1.2 FINANCIAL ECONOMICS AND

ACTUARIAL SCIENCE
Much of the foundation of actuarial science predates the development of
modern financial theory. In the early twentieth century, actuaries relied on
assumptions as opposed to the risk-neutral valuation approach employed in
modern finance. As a result, suggested solutions went in divergent paths. For
instance, one traditional actuarial method suggests that changing the ‘asset
allocation of a mix of investments’ can change the ‘value of liabilities and
assets’. In essence, this meant changing the discount rate assumption. This
concept is inconsistent with the principles of FE which logically analyse
issues related to finance by employing methods of ‘quantitative techniques’.
Further, they use their knowledge to develop financial instruments to be used
by investment firms and banks. Actuarial experts also analyse data and
determine related risks using mathematical tools. But they work on ‘risk
management’ by designing ‘models for insurance’. Their work span areas of
benefits and risks in areas of health, life, property, casualty and enterprise.

Economists do not accept that high discount rate is justified in ‘equity

allocation’ as an asset management policy. They argue that higher equity
returns might or might not materialise and hence should not be recognised
before time. Another area of disagreement is on the concern for valuation
since the active liabilities do not sometimes reflect the market-value. For
instance, in pension plans, economists would not like using the normal ‘entry
age method’. Instead, they insist on making use of ‘unit credit method’.
Despite these differences, in recent years, the potential of modern financial
economics theory to complement the actuarial methods has gained wide
acceptance.
10
1.2.1 Key Concepts of Finance Applied in Actuarial Analysis Interface Between
Economics and
Insurance
The following are the key concepts of finance applied in ‘actuarial analysis’.

1) No-Arbitrage Premium: The principle that ‘two identical cash flows

must have the same price’ has become a common ground between
financial economics and actuarial science. Though it has many
equivalent formulations in actuarial valuations, doubts on its
applicability persists. This is because no arbitrage premium tells us
anything about the real premiums required by insurance companies.

2) Irrelevance of Capital Structure: An ideal capital structure of a firm

(i.e. optimum debt-equity mix), does not exist even under many
assumptions. This theoretical insight (due to Modigliani–Miller) is
responsible for a debate on ‘investment in pension funds’. The
irrelevance result of capital structure is considered as a way to identify
the factors that makes it relevant.

3) Mean–Variance Portfolio Selection: The theory behind this tells us that

if ‘investment reward’ is the ‘expected return’ and ‘investment risk’ is
the standard deviation of such returns, and we know these values along
with the correlation between them, then the portfolio selection is an
optimisation problem.

4) Capital Asset Pricing Model (CAPM): This theory describes the

relationship between ‘risk’ and ‘expected return’ used in the pricing of
risky securities. The theory suffers from limited applicability since it
cannot be applied to construct portfolios as its parameters cannot be
precisely estimated.

5) Equilibrium: This is defined as the expected return of a risky asset

which is a function of many other risky assets. The assumptions of
arriving at the point of equilibrium (by treating that all investors have
same expectations and same attitude to risk) are considered unrealistic as
it precludes trading.

6) Black–Scholes–Merton Option Pricing Formula: This gives us a

theoretical estimate of the price of options. There are objections to the
formula due to its inadequacy to capture the reality.

7) Portfolio Selection in Continuous Time: This refers to an inter-

temporal portfolio choice where an investor decides how much to invest.
Based on this, he allocates between stocks and a risk-free asset so as to
maximise his expected utility.

Check Your Progress 1 [answer within the space given in about 50-100
words]

1) Define the term ‘actuarial science’?

…………………………………………………………………………… 11
Introduction to ……………………………………………………………………………
Insurance Theory
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
2) Distinguish between the ‘actuarial approach’ and the ‘financial
economics approach’ in solving a problem of finance.
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
3) State the crux of the debate between economists and actuaries on
valuation of liabilities.
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
4) What are the key concepts of ‘finance’ that are also applied in ‘actuarial
analysis’?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

1.3 INSURANCE
Insurance system is a mechanism for reducing the adverse financial impact of
random events. Such events prevent the fulfilment of reasonable
expectations. There are many type of insurances. For instance, life insurance
offers protection against monetary loss due to an untimely death; health
insurance covers the cost of medical care; bank deposits are insured by the
government, etc. In each case, the insured pays a premium to receive benefits
in the event of the occurrence of an unlikely high-cost event. To understand
insurance, it is necessary to assess risk. This needs the analysis of variation in
possible outcomes of a situation. For instance, shipment of goods from India
to Australia might arrive safely or be lost in transit, one may incur zero
12
medical expenses in a good year, but in the event of a sudden road accident Interface Between
Economics and
one may have to incur unexpected high cost, etc. In short, we cannot Insurance
eliminate risk from life. We can only provision for it by insurance.

The focal point of ‘risk theory’ is the ‘probability of ruin’. While insurance
company makes it certain that the probability of ruin does not exceed a
certain number �, there is no mechanism to show how the number is decided.
The insurer offers protection against financial loss by pooling the risks from a
large group of similarly situated individuals or firms. The laws of probability
ensures that the insurance company gives out only a fraction of the total
insured as compensation. The law of large numbers assures that when a large
number of people face a low-probability event, the proportion experiencing
the event will be close to the expected proportion. In many cases, however,
the risks to different individuals are not independent. For instance, in a
hurricane or airplane crash or epidemic, many would suffer at the same time.
Insurance companies spread such risks both across individuals and time i.e.
across good years and bad year. They build up reserves in good years to deal
with heavy claims in bad ones. For further protection, they diversify.

1.3.1 Discounting Technique

Discount rates are used to calculate the present value of future cash flows.
The technique of estimating the ‘present values’ of ‘discounted cash flows
(DCF)’ summarises a series of future cash flows into a summary value in
today’s monetary terms. For instance, using the formula for present value i.e.

PV = CF/(1 + r)� (1.1)

we can calculate the DCF by adding up the present values over different time
t (t = 1, 2, ...., n). Hence:

DCF = Σ CF� /(1 + r)� (1.2)

where CFt stands for cash flow in time ‘t’, r is the periodic rate of return or
interest (also called as the ‘discount rate’ or the required rate of return) and n
is the number of periods in which we get the requisite number. Let us take an
example. Assume that you would like to deposit your money in an account
today to make sure that your child has enough money in 10 years to celebrate
her 17th birth day. If you would like to give your child Rs. 10,000 in 10 years,
and you know that you can get 5% interest per year from a savings account
during that time, how much should you deposit today? The present value
formula tells us that it is:
�����
�� = ��, ���/(� + . ��)�� = �.���
= �, ���. Thus, Rs. 6,142 will be
worth Rs. 10,000 in 10 years if you can earn 5% each year. In other words,
the present value of Rs. 10,000 ten years from now is Rs. 6,142. Thus, the
three most influential components of present value are: (i) time, (ii) expected
rate of return and (iii) the size of the future cash flow. To account for
inflation in the calculation, investors use ‘real interest rate’ i.e. [nominal 13
Introduction to interest rate – inflation rate]. If given enough time, small changes in these
Insurance Theory
components can have significant effects. Actuarial calculations that require
discount rates to be determined for placing values on cash flows include the
following factors. (a) Solvency: used to assess the assets that would be
required to meet the ‘liability cash flows’ in the absence of any other
supporting financial entity; (b) Transactions: used to assess a (fair) value of
assets to be transacted in exchange for the liability cash flows; and (c)
Funding: needed for the purpose of assessing the required accumulation of
assets to meet the ‘liability cash flows’ when they fall due i.e. the likely
sufficiency of the assets to meet the future cash flows.

1.3.2 Insurance Regulation

Regulation of insurance industry basically aims at protecting the consumer.
There are two main reasons for it. Firstly, long term nature of contracts
require that the insurer continues to be in business without becoming
insolvent. This is because the date of claim would be spread over many years
into the future. Even if we assume that the customers could reasonably assess
the financial soundness of an insurer (which itself is unlikely), there would be
no safeguard to protect the policyholder from a company that becomes
insolvent. When the insolvent firm exits from the market, the ultimate loss of
benefit befalls the policyholders. Secondly, customers often have imperfect
knowledge of products available. Many do not even understand the benefits
provided and the charges associated with the products offered for sale. Thus,
in many cases, policyholders are unable to assess a product’s value for
money. Keeping such considerations in view, actuaries provision to keep two
areas for regulation: (i) solvency assessment and (ii) control to ensure that
claims will be paid.

A basic objective of regulation is to ensure that the ‘probability of ruin’ of

insurance companies is below some ‘acceptable’ value. It is assumed that the
main tool available to the regulator to reach such a goal is to set a ‘mandatory
solvency margin’. This refers to the minimum amount of a firm’s own equity
that could be used as a buffer. While this approach is traditional and classic in
the insurance industry, it is interesting to note that a similar view has recently
become influential in banking. This is with the rise of ‘value at risk’ methods
to manage market and credit risks. In sum, therefore, information asymmetry,
unequal bargaining power and externalities (e.g. fraudulent claims) require
that there should be an insurance regulator to protect the interest of
consumers or policy holders.

1.4 ACTUARIAL VALUATION

Actuarial valuation is a kind of appraisal. It requires making economic and
demographic assumptions to estimate future liabilities. For this purpose, use
is typically made of a mix of statistical analysis and experienced judgement.
Broadly speaking, there are four approaches to valuation. First is, ‘discounted
14
cash flow valuation’. This relates the ‘present value of an asset’ to its value at Interface Between
Economics and
a future time point by an accumulation of the ‘expected future cash flows on Insurance
that asset’. Second is, ‘liquidation and accounting valuation’. This is built
around valuing the existing assets of a firm based on their ‘book value’. Third
is ‘relative valuation’. This estimates the value of an asset by looking at the
pricing of ‘comparable assets’ relative to a common variable like earnings,
cash flows, book value or sales. The fourth method is the ‘contingent claim
valuation’. This uses ‘option pricing models’ to measure the value of assets
which share option characteristics. These methods are applied either at
‘enterprise level’ or at ‘equity level’. They are further based either on
‘financial methods’ or the ‘actuarial methods’ of valuation. We shall now
study some of these methods in this section.

1.4.1 Discounted Cash Flow Valuation

In this method, the value of an asset is the present value of the expected cash
flows on the asset. It is discounted at a rate that reflects the riskiness of the
cash flows. For instance, suppose the cash flow in an investment for year one
is projected to be Rs. 1,000 which is assumed to grow by 3% per annum i.e.
to Rs. 1,030 in the following year. Likewise, if the discount rate is assumed
to be 6%, then the discounted cash flow at the end of 2nd year would be:
���� ����
(���.��)�
+ (���.��)� = 1860. There are four variants of the discounted cash
flow model. In the first, we discount the expected cash flows on an asset by a
‘risk-adjusted discount rate’. The rate is established by adding an
expected ‘risk premium’ to the ‘risk-free rate’ to determine the present
value of a risky investment. We can write this as:

Risk Adjusted Discount Rate (RADR) = Risk free rate + Risk premium
(1.3)

Thus, if the risk free rate is 10% and compensation of investment risk is 5%,
then a rate of 15% will be used for calculating the ‘discounted cash flow’.

In the second method, we adjust the ‘expected cash flows’ for risk to arrive at
‘risk-adjusted equivalent cash flow’. We again discount the ‘expected cash
flows’ by a ‘risk free rate’ to arrive at an estimate of the ‘value of a risky
asset’. For instance, suppose there is a project having a useful life of 15 years
for which the ‘risk free rate’ is assumed to be 5%. Let us also assume a ‘risk-
adjusted rate of return’ of 13% to yield an expected annual net cash flow of
Rs. 0.23 crore. Then, from Equation (1.3) we get: Risk Premium = Risk
Adjusted Rate of Return − Risk Free Rate = 13% − 5% = 8%. Hence, ‘risk-
adjusted equivalent cash flow’ becomes equal to: 0.23 ÷ (1 + 8%) = 0.23 ÷
1.08 = 0.213 crore. Thus, the project is expected to generate Rs. 0.213 crore
in a ‘certainty equivalent cash flow manner’ per year for 15 years with the
assumed ‘risk premium’ and RADR as applied.

Note that the ‘adjusted present value’ is an ‘investment appraisal technique’

similar to the ‘net present value method’. However, instead of using the 15
Introduction to weighted average cost of capital as the discount rate, we use the ‘ungeared
Insurance Theory
cost of equity’ to discount the cash flows from a project. The ‘ungeared cost
of equity’ is the ‘required rate of return’ for a firm that is financed by equity.
It is calculated by the formula:

Ungeared Cost of Equity = Risk Free Rate + β (Market Return –

Risk Free Return) (1.4)

where β is the ‘coefficient of volatility’ or systematic risk. Note that ‘interest

cost’, if allowed for tax deduction while calculating the taxable income,
provides ‘tax savings’ (or tax shield). The ‘tax savings’ should then be
discounted from the ‘gross cost of debt’. To illustrate, let us assume that a
project costing Rs. 50 crore is expected to generate an ‘after tax cash flows’
of Rs.10 crore a year for many years to come, ‘risk free rate’ is 3%, asset beta
is 1.5%, required return on market is 12%, cost of debt is 8%, tax rate is 40%
and ‘annual interest costs’ related to project is Rs. 2 crore. Given these, we
can calculate the ‘adjusted present value of the project’ as:

Adjusted Present Value = Present Value of Cash Flows + Present

Value of Tax Savings (1.5)

From (1.4) the ‘ungeared cost of equity’ is calculated as: 3 + 1.5 (12 − 3) =
16.5%. Using this rate, the present value of cash flows become: 10 ÷ 16.5% =
10 ÷ 0.165 = 60.61 (Rs. crore). Since the initial investment is Rs. 50 crore,
the ‘net present value of future cash flows’ (after applying the ungeared cost
of equity) is obtained as: (60.61 – 50) = 10.61 (Rs. crore). Thus, the present
value of tax savings is:

[Annual Interest Cost Relating to Project] * [Tax Rate ÷ Cost of Debt]

Hence, the ‘tax savings’ in our example considered is: 2 * (0.4 ÷ 0.08) = 10
(Rs. crore). Therefore, the adjusted present value is:

present value of cash flows + present value of tax savings

= 10.61 + 10 = 20.61 (Rs. crore).

1.4.2 Enterprise Valuation and Equity Valuation

Of all the approaches to adjusting for risk in discounted cash flow valuation,
the most common method used is the ‘risk adjusted discount rate approach’.
Under this, we consider here two types of valuations viz. ‘enterprise
valuation’ and ‘equity valuation’. Note that we use higher discount rates to
discount expected cash flows when valuing riskier assets and lower discount
rates when valuing safer assets.

There are two ways in which we can approach the discounted cash flow
valuation. The first is to value the entire business with both ‘assets-in-place’
and ‘growth assets’ (i.e. assets with growth potential) taken into account.
This approach is termed as the firm or the ‘enterprise valuation’. Cash flows
16
considered are cash flow from assets prior to any debt repayment but after the Interface Between
Economics and
firm has invested to create growth assets. Discount rate reflects the cost of Insurance
raising both debt and equity financing (proportion to their use).

In ‘equity valuation’, the cash flows before debt payments and after
reinvestment needs are termed as ‘free cash flows to the firm’. The cash
flows after debt payments and reinvestment needs are called ‘free cash flows
to equity’. The discount rate that reflects just the cost of equity financing is
taken as the ‘cost of equity’. The discount rate that reflects the composite
‘cost of financing’ from all sources of capital is the ‘cost of capital’.

1.4.3 Financial Valuation and Actuarial Valuation

In recent years, the major focus in ‘financial evaluation’ has been on making
risks tradable in financial markets. This attempt at risk securitisation has
resulted in the emergence of financial products that takes into account
insurance related risks. Examples of such products are: catastrophe insurance
derivatives, index-linked life insurance contracts, index-linked debt, funded
pension schemes, etc.

The overlap of insurance and financial markets has led to developments in

‘risk valuation’. Prior to the convergence of capital and insurance markets,
either financial contracts exclusively based on financial risk or insurance
contracts based on insurance risk were studied. With the convergence of the
two markets, stochastic models for analysing the underlying risk processes
and methods for the valuation of the contracts are separately developed. This
has resulted in contracts like: equity-linked life insurance contracts. In such
contracts, the benefits of the insurance policies depend on the performance of
a reference portfolio traded in the capital market. Such insurance contracts
are based both on financial and insurance risks by way of ‘policyholders
mortality risk’.

Hence, the basic difference between financial valuation and actuarial

valuation is in terms of their underlying principles. Financial valuation
principles are formulated in a framework that allows for the trading of assets.
In contrast, the actuarial valuation principles are based on considerations of
the ‘law of large numbers’. From this standpoint, financial valuation
principles are based relatively more on the concept of ‘dynamic trading’.

Check Your Progress 2 [answer within the space given in about 50-100
words]

1) State the four approaches to ‘actuarial evaluation’

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Introduction to 2) Distinguish between ‘enterprise valuation’ and ‘equity valuation’.
Insurance Theory
……………………………………………………………………………

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3) Differentiate between ‘financial valuation’ and ‘actuarial valuation’

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1.5 RISK MANAGEMENT

Economic models (called economic capital modelling) are used for risk
assessment and capital management. They are also used for regulatory
reporting. For instance, banking and insurance regulators evaluate the
additional capital requirement to ensure that the liabilities could be covered
after an extreme event. Actuaries use the results of ‘risk modelling’ for risk
mitigation, capital management and capital allocation for the insurance
industry. Economic models can suggest ‘strategic actions and pricing’
(including mergers and acquisitions). Risks commonly fall into four
categories. Market risks are those that arise from changes in the value of
assets such as equity and property due to changes in interest rates, inflation
and credit spreads. Life insurance risks relate to mortality or longevity,
expenses and persistency. General insurance risks are those which cover
catastrophic claims and premium adequacy. Operational risks are those
which a company faces when it attempts to operate within a given field. This
is a type of risk which is not inherent in financial, systematic or market-wide
risk. Financial and systematic risks are ‘residual risks’ which includes
breakdowns in internal procedures, people and systems. Examples of this are:
IT failure, fraud, legal, strategic and group risks (e.g. contagion from one
business unit to elsewhere in a group).

Calibration of the dependencies between each pair of risks is an important

step in ‘economic capital modelling’. To account for dependencies, a
correlation matrix (or a copula) is used. Other techniques commonly used in
conjunction with ‘economic capital modelling’ are the following.

18
• Sensitivity Testing: This is a technique used to determine the impact of Interface Between
Economics and
different values of an independent variable on a particular dependent Insurance
variable under a given set of assumptions. The technique is used to
assess the effect of changes in interest rates on the price of a ‘bond’.

• Scenario Testing: This uses scenarios (i.e. hypothetical situations) to

help the tester work through a complex problem. The idea behind the test
is to develop a credible, complex, compelling scenario, the outcome of
which can be evaluated. The recent Euro zone crisis is an example for
this type of testing. Here, one considers factors like: interest rates,
inflation, equity and property prices, credit spreads, etc. on government
and corporate bonds. Such variables are considered to move
simultaneously so as to affect the counterparty’s credit risk, business
levels, expense levels and operational risk like fraud.

• Reverse Stress Testing: These are tests that help assess scenarios and
circumstances which could render a business become unviable. They
help in identifying potential business vulnerabilities.

1.5.1 Actuarial Modelling

A ‘model’ is a simplified mathematical description of a certain task.
Actuarial models are meant to suggest an opinion and in its light recommend
a ‘course of action’ on uncertain future events. For instance, life insurance
use models to arrive at the likely ‘mortality rates’ of their customers, car
insurance use models to work out claim probabilities, pension fund models
estimate the contributions and investments needed to meet the future
liabilities, etc. Actuarial models are broadly classified into two categories:
deterministic models and stochastic models. Deterministic models are those
that produce a unique set of outputs for a given set of inputs (e.g. the future
value of a deposit in a savings account). In these models, the inputs and
outputs do not have associated probability weightings. Another example of a
deterministic model is calculation to determine the return on an investment
with a higher annual interest rate than in a bank’s savings account. One of the
purposes of such type of models is to make predictions in ‘what if’ scenarios.
We can change the inputs and recalculate the model to get a new answer. In
contrast, ‘stochastic or probabilistic models’ are models which have their
outputs and/or inputs appearing as ‘random variables’. Examples of
stochastic models are asset model, claims model, frequency-severity model,
etc. The list of such models, indicating its growing application, can be seen in
terms of the following.

Expected Utility Model: Here, assuming that an insured is a risk averse and
rational decision maker, it is projected to know when she is ready to pay
more than the expected value of her claims to be in a secure financial
position. Such a decision is taken under uncertainty, on the basis of the
expected utilities associated with the pay-off.
19
Introduction to Individual Risk Model: Here, the total claim on a portfolio of insurance
Insurance Theory
contract is a random variable modelled as ‘the sum of all claims on the
individual policies’ which are assumed to be independent.

Collective Risk Models: These are models often used to approximate the
‘individual risk models. In this, an insurance portfolio is viewed as a process
that produces claims over time. The size of these claims are taken to be
‘independent and identically distributed’ (IID) random variables. They are
also independent of the number of claims generated. This makes the total
claims the ‘sum of a random number of IID individual claim amounts’.

The Ruin Model: In this, the stability of an insurer is studied. Starting with
an amount of capital, it is assumed to increase linearly in time by fixed
annual premiums. However, it decreases with a jump whenever a claim
occurs. Ruin occurs when the capital is negative at some point of time. It is
based on the probability that such an event occurs under the assumption that
‘the annual premium as well as the claim generating process remain
unchanged’. It therefore indicates whether the insurer’s assets are matched to
her liabilities.

Premium Principles: This is a function that assigns a ‘normally loaded

premium’ to any distribution of claims. Such a function is termed as
‘premium principle’. Note that risk premiums are studied disregarding costs
incurred by the insurance company. By the law of large numbers, to avoid an
eventual ruin, the total premium should be at least equal to the expected total
claims. However, additional amount is included with the premium to
compensate the insurer for being in a less safe position so as to avoid getting
ruined.

Bonus Systems: With some types of insurance, notably car insurance,

charging a premium based exclusively on factors known a priori is
insufficient. To incorporate the effect of risk factors, additional data such as
race or the gender of the policy holder, state of health, reflexes and accident
proneness, etc. are added. Premiums are then based on a priori factors like
‘type of coverage’, ‘catalogue price’, etc. They assign ‘weight for the asset’
with some bonus system. With such a bonus, one gets more discount after a
claim-free year but pays a higher premium after filing one or more claims.
Thus, premiums are fixed according to the driving capabilities of the insured.
Such situations are modelled as Markov Chain models.

Credibility Theory: The claims experience on a policy may vary by two

different causes. The first is the quality of the risk, expressed through a risk
parameter. This represents the average annual claims in the hypothetical
situation that the policy is monitored without change over a long period of
time. The other is the ‘purely random good’ and ‘bad luck’ of the
policyholder that results in yearly deviations from the risk parameter.
Credibility theory assumes that the risk quality is drawn from a given
structure of a distribution. The risk quality, conditional to the actual claims
20
experience, is a sample from a distribution with the risk quality as its mean Interface Between
Economics and
value. The next years’ experience is predicted as a linear function of the Insurance
claims experience. It is optimal in the sense of ‘least squares’ (which is a
weighted average of the claims experience of the individual contract) and the
experience of the ‘whole portfolio’. The weight factor is the credibility
attached to the individual experience.

Generalised Linear Models (GLM): The GLM is a flexible generalisation

of ordinary linear regression. It permits response variables that have error
distribution models other than a normal distribution. The GLM generalises
linear regression by allowing the linear model to be related to the response
variable through a link function. The magnitude of the variance of each
measurement is also a function of its predicted value.

IBNR Techniques: To forecast the total of the claims that are ‘incurred but
not reported’ (IBNR) or not fully settled, the method used is of ‘run-off
triangles’. Under this, claim totals are grouped by year of origin and
development year.

Ordering of Risks: A risk (i.e. a non-negative random variable), can be

preferable to another for two reasons. First, the other risk is larger. Second, it
is thicker-tailed i.e. the probability of large values is high. It makes a risk
with equal mean less attractive because it is more spread and hence less
predictable.

Check Your Progress 3 [answer within the space given in about 50-100
words]

1) State the uses of ‘actuarial models’.

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2) Differentiate between ‘probabilistic and deterministic’ models.

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21
Introduction to
Insurance Theory 1.6 LET US SUM UP
Professionals of actuarial and financial economics work on a common theme
centred around money. Working with problems in the presence of risk,
actuaries provide services to mainly the insurance sector. Despite the similar
techniques used in both the fields, for solution on core issues, different
platforms are adopted in their approaches. Actuaries largely go for ‘risk
management’. Theoretical developments in modern financial economics
offers many results in ‘portfolio investment’. Insurance system is a
mechanism for reducing adverse financial impact of random events. In view
of the variation in the possible outcomes of a situation, the insurance industry
is compelled to ensure that the ‘probability of ruin’ does not exceed a certain
number. To deal with this, actuaries use stochastic modelling for ‘risk
mitigation’. It also helps them in ‘capital management’ and ‘capital
allocation’ for the insurance industry.

1.7 KEY WORDS

Capital Asset : It describes the relationship between risk and

Pricing Model ‘expected return’ used in the pricing of risky
securities.
Collective Risk : It refers to the ‘aggregate claims’ generated by the
Model portfolio for the period under study.
Discount Rate : This is the interest rate used in discounted cash
flow (DCF) analysis to determine the present value
of future cash flows.

Insurance Risk : It is the likelihood that an insured event will occur,

requiring the insurer to pay a claim.
Law of Large : It states that as a sample size increases, its mean
Numbers will get closer and closer to the average of the
whole population.
Market : Refers to the cash flows that are valued consistently
Consistent with the prices of similarly traded cash flows in the
Discount Rate capital market.
Probability of : This is the percentile of the probability distribution
Ruin corresponding to the point at which capital is
exhausted.
Risk Adjusted : This is the rate determined by adding an ‘expected
Discount Rate risk premium’ to the ‘risk-free rate’ in order to
work out the ‘present value of a risky investment’.
Risk-neutral : This is a situation in which an investor effectively
Valuation ignores risk in making investment decisions.

22
1.8 SUGGESTED BOOKS FOR FURTHER Interface Between
Economics and
READING Insurance

1) Arrow Kenneth J (1985). The Economics of Agency, In John W. Pratt

and Richard J. Zeckhauser (eds.), Principals and Agents: The Structure
of Business. Boston: Harvard Business School Press, 1985.
2) Black F and Scholes M (1973). The Pricing of Options and Corporate
Liabilities, The Journal of Political Economy, Vol. 81, No. 3 (May-June,
1973), pp. 637-654.

1.9 ANSWERS/HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Actuarial science is the discipline that applies mathematical and
statistical methods to assess risk in insurance and finance.
2) Actuarial approach focuses on ‘estimation of joint probabilities’ using
real data. Financial economics focuses on valuation of contracts under an
arbitrary distribution.
3) The active liabilities sometimes do not reflect the market value.
Economists prefer to valuate using the ‘entry age normal method’ and
‘unit credit method’.
4) No arbitrage premiums, irrelevance of capital structure, etc.
Check Your Progress 2
1) (i) Discounted cash flow valuation (ii) liquidity and accounting
valuation, (iii) relative valuation and (iv) contingent claim valuation.
2) ‘Enterprise valuation’ takes the entire business with both ‘assets in place’
and ‘assets with growth potential’ into account. ‘Equity valuation’
applies the ‘discount rate’ to work out the ‘cost of equity financing’ and
‘cost of capital’. The latter reflects the composite cost whereas the
former reflects only the ‘cost of equity’.
3) ‘Financial valuation’ considers risk as tradable in ‘financial markets’. In
contrast, ‘actuarial valuation’ is based on the principle of ‘law of large
numbers’.
Check Your Progress 3
1) Actuarial models are useful in dealing with ‘uncertain future events’.
They are used in the insurance sector like life insurance, car insurance,
health insurance, pension funds, etc.
2) ‘Deterministic models’ calculate the return on an investment which yield
higher than the interest rate in ‘savings account’. They predict scenarios
in ‘what if’ type of situations. They permit changing of inputs to
recalculate the return on an investment. In contrast, stochastic or
probabilistic models treat their inputs/outputs as ‘random variables’.
23
Introduction to
Insurance Theory UNIT 2 LIFE AND GENERAL INSURANCE

Structure
2.0 Objectives
2.1 Introduction
2.2 Life Insurance Contracts
2.2.1 Endowment Assurance
2.2.2 Whole Life Assurance
2.2.3 Term Insurance
2.2.4 Annuity
2.2.5 Unit-Linked
2.3 General Insurance
2.3.1 Liability Insurance
2.3.2 Property Insurance
2.3.3 Financial Loss Insurance
2.4 Let Us Sum Up
2.5 Key Words
2.6 Suggested Books for Further Reading
2.7 Answers/Hints to Check Your Progress Exercises

2.0 OBJECTIVES
After reading this unit, you will be able to:

• distinguish between ‘life insurance’ and ‘general insurance’;

• indicate the need for ‘life insurance’;
• specify the design of an ‘endowment assurance’ life insurance contract;
• delineate the features of ‘whole life assurance’ and ‘term insurance’
contracts;
• outline the concept of ‘benefits’ in an ‘annuity contract’;
• list the ‘key features’ of a unit-linked life insurance contract;
• define the terms ‘bid value of unit-fund’ and ‘non-unit fund’;
• state the need for ‘general insurance’ along with its ‘key features’; and
• discuss the types of ‘general insurance products’.

2.1 INTRODUCTION
Life insurance is a contract between an insured (insurance policy holder) and
an insurer (or assurer). In this, the ‘insurer’ promises to pay the ‘beneficiary’
(policy holder) a sum of money (called ‘benefits’) in exchange for a
24 premium. The benefit is payable upon the maturity of the contract or the
death of the insured person, whichever is earlier. Depending on the contract, Life and General
Insurance
other events such as terminal illness or critical illness can also be covered for
payment. The policy holder pays a premium, either periodically or in one
lump sum. Expenses like funeral expenses can also be included in the
benefits. Life insurance policies are legal contracts. The terms of the contract
describe the limitations of the insured events. Specific exclusions are written
into the contract to limit the liability of the insurer. Common examples of
such exclusions relate to suicide, fraud, war, riot and civil commotion. Life-
based contracts fall into two major categories: protection policies and
investment policies. The former is designed to provide a benefit, typically a
lump sum payment, in the event of a specified event. A common form of a
‘protection policy design’ is ‘term insurance’. Investment policies are
designed with the main objective of facilitating the growth of capital by
regular premiums. Common forms of ‘investment policy’ are whole life,
endowment insurance, etc. Insurance contracts that do not come under the
ambit of life insurance are called ‘general insurance’. They go by the names
of property insurance, casualty insurance (in U.S. and Canada) and non-life
insurance (in Europe and India). The products of ‘general insurance’ are
divided in two groups: personal and commercial.

Over time, with changes in lifestyles, standard of living, education and

technology, the need for ‘life insurance’ have undergone changes. With
increasing awareness and better financial position, people are buying life
insurance as a ‘savings product’ rather than a protection policy. Such a trend
has led to innovation in life insurance market to cater to the changing needs
of people. Thus, individuals’ life style over a lifetime has a strong bearing to
influence the kind of life insurance products sold in the market. Further, the
‘need for life insurance’ changes with age. For instance, in the age group of
16-25, one finds the need for financing higher education. Likewise, for those
in the age group of 25-35, there would be need to plan for a house, those in
the age-group of 35-60 would be willing to make provision for the higher
cost of sickness or disability, those in the age group of over 60 years for old
age care, etc. These needs warrant saving for future financial requirements.

2.2 LIFE INSURANCE CONTRACTS

In this section, we shall discuss the following types of life insurance
contracts: (i) endowment assurance, (ii) whole life assurances, (iii) term
insurance, (iv) annuity and (v) unit/index-linked contracts.

2.2.1 Endowment Assurance

An endowment assurance is a life insurance contract designed to pay a ‘lump
sum’ after a specific term on its ‘maturity’ or the death of the insured. This is
thus a savings product. It can be used to: (i) provide a lump sum at the time
of retirement or (ii) provide money on death before maturity. Or, it can also
be used to convert the contract into a ‘paid-up policy’ in case of need of the
25
Introduction to insured to stop paying the premium. The sum-insured is then reduced to the
Insurance Theory
number of premium fully paid. An endowment assurance policy could come
in without-profits, with-profits or in a unit-linked form. Each has
significantly different characteristics to meet the varying needs of consumers.

A contract without-profit offers a guaranteed amount of money (the sum

assured) at the end of the contract. This can be either in exchange for a single
premium at the start of the contract or a series of regular premiums paid
throughout the contract. If the policy holder dies before the contract term
ends, then the sum assured is paid to the nominee. The contract should be so
structured than an ‘assured sum’ is payable on the death of the insured. A
contract with-profit is also known as ‘participating contract’. It is a contract
in which the insurance company distributes part of its profit to the policy
holder in the form of bonus or dividend. The rate of bonus is decided after
considering a variety of factors such as the return on underlying assets, the
level of bonuses declared in previous years and other actuarial assumptions
like future liabilities, anticipated investment returns and marketing
considerations.

The ‘basic sum assured’ in ‘with profit contracts’ is the ‘minimum amount of
life assurance payable on death’ or the ‘minimum lump sum payable at
maturity’. A ‘reversionary bonus’ is awarded during the term of the insurance
contract and guaranteed to be paid at maturity. It cannot be taken away after
declaration. Besides this, the annual bonus consists of two parts. One is a
‘guaranteed bonus’. This is an amount expressed as ‘per Rs. 1,000 sum
assured’. This is set at the outset of the policy and is not altered. The second
is a ‘terminal bonus’ paid at maturity. This is sometimes paid even to a
surrendered policy. The quantum of ‘terminal bonus’ depends on the
‘investment return achieved’ by the fund. The basic sum assured may earn
‘reversionary bonuses’ which are based on profits earned. These are usually
applied in unit-linked contracts (discussed later in sub-section 2.2.5) in which
the premiums paid by the policy holders is lumped into a ‘pooled investment
fund’. Here, the benefit payable at maturity depends on the performance of
the underlying assets and the level of ‘charges’ levied by the insurance
company.

2.2.2 Whole Life Assurance

Whole life assurance is a life insurance contract guaranteed to remain in force
for the insured’s entire lifetime. The contract is valid as long as the premiums
are paid or till the maturity date. Based on the age of issue, premiums are
fixed i.e. premiums do not increase with age. The insured pays premiums
until death, except for limited payment policies which may be paid for 10
years or 20 years or till retirement date. For the insured, this contract is useful
as a means of providing for funeral expenses or for meeting any liability tax
(e.g. inheritance tax or death duties, arising on the death of the life assured).
It is also a general purpose contract providing for long-term protection to
26 dependents. In this sense, it is useful as a means of protecting the dependents
the expected transfer of wealth from a parent to one’s children will take place Life and General
Insurance
either when the term of the policy expires or upon the insurer’s death.

2.2.3 Term Insurance

The ‘term insurance’ contract pays benefit on the death of the life insured.
The benefit is paid within the terms of the contract to be chosen at the outset.
Generally, no benefit is paid on surrender of the policy. The benefit on death
is usually a lump sum. The term of the contract can range from one year to
twenty-five years or more. The lump sum remains a fixed amount throughout
the policy term. The policy is also referred to as ‘level term assurance’. Like
‘endowment assurance contracts’, ‘term insurance’ can also be on without-
profit, with profits or on unit-linked basis. They can further be level-
decreasing, level-increasing, renewable or convertible.

The ‘level term decreasing policies’ are useful to provide income to children
until such time as they become independent. The ‘level term increasing term
assurance’ policies are also referred to as ‘index-linked life insurance’. This
is because the sum assured increases each year in line with the ‘retail price
index’ (RPI). The main advantage of ‘increasing term assurance’ policies are
that a policy will not be affected by inflation. The renewal term insurance
contracts allow the policyholder to renew or extend their policy for additional
terms without medical examination. This is useful when a policy holder
wishes to continue their insurance as they get older or find themselves in
poorer health. A convertible term assurance allows the policyholder to
convert one type of contract into another type of contract. At what point
conversion is allowed depends on the policy conditions. This ‘hybrid’ nature
of conversion proves useful in situations of ill health when a policyholder has
difficulty in making payments to secure the coverage.

2.2.4 Annuity
An ‘annuity’ is a contract which pays out amounts at regular time intervals
(e.g. monthly). The policyholder can buy annuity either by paying a single
premium or buy an endowment policy which provides a lump sum at
maturity. The main purpose of this type of contract is to convert capital into
lifetime income. It removes the uncertainty of how carefully the capital
should be spent to provide income over the annuitant’s remaining life time.
Annuity can be of two types: immediate and deferred. An ‘immediate
annuity’ pays out regular amounts of benefit during the life time of the
insured. The word ‘immediate’ indicates that the contract starts payments
immediately without a deferred period. Such contracts are purchased in
advance by a single premium. Such a premium may itself be the proceeds of
another regular periodic premium contract. Immediate annuities may be
purchased on single or joint life basis. In case of joint life policies, it can be
on ‘first death or last survivor’ basis. A last survivor annuity is used to
provide income for dependents following the death of the main life. On the
other hand, a deferred annuity is a contract to pay out regular amounts of 27
Introduction to benefit at the end of the deferred period (called the ‘vesting date’). Such
Insurance Theory
payments are made when the insured is alive ‘from the beginning to the end
point of the policy period’. Due to the ‘deferred period’, regular or single
premiums can be paid up to the ‘vesting date’. Under individual contracts, a
single premium is payable at the beginning of the contract. An insurer may
also prefer the flexibility of buying a ‘new single premium policy’ each year
(until a chosen age like the retirement age) rather than be committed to
paying a fixed level of premium each year (as would be required under a
regular premium contract). Deferred annuities may be without-profits or
with-profits. A with-profit deferred annuity provides a guaranteed level of
regular income with bonus as additions. The additional benefit of bonus
income may also be made while the policy is in deferment.

2.2.5 Unit-Linked
A unit-linked contract enables consumers either to obtain a ‘higher expected
level of benefit’ for a given premium or pay a ‘lower expected level of
premium’ for a given level of benefit. The key features of a unit-linked
contract are the following.

a) The premium is paid into an investment fund. At the time of buying, a

certain ‘number of units’ representing a share of that fund is allotted to
the policy holder. The value of the fund depends directly on the ‘value of
the assets’ underlying the investment fund. The value of one unit (i.e. the
‘unit price’) will be calculated on a daily basis. This is because, being an
investment fund in the market, the value of the assets change at short
intervals. However, the policyholder’s share (i.e. the number of units)
remains unchanged until some ‘cash flow’ occurs. This could occur for
reasons like: (i) payment of a premium, (ii) deduction of a charge, (iii) a
switch over of units from one fund to another, (iv) payment of a claim
(like partial withdrawals), etc. The total value of an individual
policyholder’s fund at any time is the ‘number of units’ multiplied by the
‘unit price’.

b) The insurance company will deduct its charges from the policyholder’s
fund. These are generally deducted from the premiums before they are
invested. This could take various forms like: (i) allocation of units worth
less than 100 percent of premium paid, (ii) application of a bid-offer
spread i.e. a difference between the price at which the insurance
company sells the units (i.e. the ‘offer price’) and that at which it will
buy them back (i.e. the ‘bid price’), (iii) a fixed amount may be deducted
from each premium paid [which may be in the form of a percentage of
the fund value taken on a regular basis, called as the ‘regular fund
charge’ (or a fund management charge)].

c) Another form of recovering the charges is to issue ‘special units’ called

‘capital units’. These are subject to higher fund charge than normal units.
28 A ‘supplementary penalty’ can be levied for policies closed prematurely.
 Such charges by the insurer are meant to balance expenses and risk Life and General
Insurance
benefits in order that the insurance company can remain afloat i.e.
remain solvent.

Bid-Value of Unit Fund and Non-Unit Fund: The ‘bid value’ of a

policyholder’s ‘unit fund’, at any point of time, is the amount of money that
the company would have to pay to the policyholder on a claim under
contract. This might be upon the death of the insurer or the maturity of an
endowment or on the surrender of a contract. The ‘non-unit fund’ refers to
the ‘balance of money’ with the company. It is the accumulated value of all
the charges the company has levied on its unit-linked policies minus
expenses. The expenses would be on account of (i) the actual costs incurred
on behalf of the contracts, (ii) distribution of profits to creditors i.e. providers
of capital, (iii) any capital injections paid-in (e.g. payment towards the cost of
setting up of reserves), etc. The ‘actual costs’ will include all expenses plus
any ‘additional claim costs’ over and above the amounts of unit fund paid-
out. Such ‘additional claim costs’ could be the additional amounts required to
make up the ‘total guaranteed sum assured’ of all the policyholders.

Check Your Progress 1 [answer within the space given in about 50-100
words]

1) Distinguish between life insurance and general insurance.

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2) Indicate the need for ‘life insurance’.

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3) Give examples of ‘protection policies’ and ‘investment policies’.

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29
Introduction to 4) What are the types of bonuses paid in an ‘endowment assurance’ life
Insurance Theory
insurance contract? Under which category of life insurance policy is this
paid?

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5) What is meant by ‘bid value of a unit fund’?

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

2.3 GENERAL INSURANCE

The Need of General Insurance was felt Centuries ago. The merchants had a
common interest in their ventures. They were required to make a contribution
to take care of one’s loss or the cumulative loss of all the ventures. Hence, as
early as in the fourteenth and fifteenth centuries, the practice of insurance
contract gained currency throughout the maritime states of Europe. The
contract protected the merchants from any maritime risk or disaster leading to
bankruptcy. The same social concern or advantage is behind the concept of
‘general insurance’ in the modern society now. Today, the ability to insure
against perils enables the individuals and companies to take on risks that they
would otherwise not take. It is this ability and willingness to make a small,
known outlay as ‘insurance’ against the risk of a potentially large loss is what
is behind the theory of general insurance. People pay more for ‘insurance’
than the ‘expected recovery from insurance’ (i.e. the ‘risk premium’) because
they are risk-averse and prefer a more ‘certain outcome’. The key features of
general insurance contract are: (i) it is not a life insurance, (ii) in most cases it
is a contract of indemnity, (iii) they are for short term (i.e. most general
insurance policies are for one year except some engineering projects, and
property insurance, which are of more than one year duration), (iv) an insured
can make multiple claims over the policy year, (v) claim amounts are
generally unknown and (vi) there can be delays in reporting and settling
claims. The basis of indemnity is to restore the insured to the same financial
position ‘after a loss’ as ‘before the loss’.
30
General insurance contracts can be split into: personal or individual contracts Life and General
Insurance
and commercial contracts (e.g. residential buildings and contents insurance).
Commercial contracts are sold to businesses for their commercial property,
employers’ liability and business interruption. Different businesses are
classified into ‘short-tailed’ or ‘long-tailed’ claims. A short-tailed claim is
reported and settled quickly by the insurer. A long-tailed claim implies that
there is a sizeable proportion of total claim that takes a long time to report or
it would take a long time for the insurer to settle. The types of general
insurance products can be classified under the following main headings. (i)
liability insurance, (ii) property insurance and (iii) financial loss insurance.
The ‘financial loss insurance’ itself is sub-classified into: (a) fidelity
guarantee insurance, (b) credit insurance, (c) creditor insurance, (d) business
interruption insurance and (e) personal accident insurance. General Insurance
policies may comprise elements of one or more of these types of cover.

2.3.1 Liability Insurance

Liability insurance provides indemnity to the insured. It applies where, owing
to some form of negligence, the insured is legally liable to pay compensation
to a third party. Any legal expense relating to such liability are also usually
covered. An illegal act of negligence will invalidate the cover (e.g. injury or
death in a state of drunken driving). Most liability insurance is compulsory
by law. The benefit provided by ‘liability insurance’ is an amount to
compensate a financial loss. The benefit could be restricted by a maximum
specified amount per claim or per event. It can also be restricted by an
aggregate maximum per year in case of more than one claim. The main types
of liability insurance are: (i) employers’ liability/workers compensation, (ii)
motor third party liability, (iii) marine and aviation liability, (iv) public
liability (often linked to other types of insurance such as property and
marine), (v) product liability, (vi) professional indemnity, (vii) Director’s and
Officers (D&O) liability and (viii) environmental liability.

Employers are liable if they are negligent in providing their employees with
safe working conditions. The liability covers accidents and perils like
exposure to harmful substances and working conditions. ‘Employers liability’
indemnifies the insured from compensating an employee (for bodily injury,
disease or death suffered), owing to the negligence of the employer in the
course of employment. Loss of or damage to employees’ property is also
usually covered. The benefit can be in the form of regular payments to
compensate for disabilities that reduce the employee’s ability to work. It can
be a lump sum payment to compensate for permanent injuries to the
employee. ‘Motor third party liability’ indemnifies the owner of a motor
vehicle against compensation payable to third parties for personal injury or
damage to their property. Such benefits include compensation for loss of
earnings, hospital costs and damage to property costs. In most countries, such
a cover is compulsory. In the ‘marine and aviation liability’, the insured is
indemnified against paying compensation to a third party for damages arising
31
Introduction to out of operation of the vessel or aircraft. The third parties include passengers
Insurance Theory
and crew. In ‘public liability’, the insured is indemnified against paying
compensation to a third party for damage to property or person. Likewise, in
a ‘product liability’, indemnity is provided to the insured against paying
compensation to a third party resulting from a product’s fault. Here, the perils
depend on the nature of the product like faulty design, faulty manufacture,
faulty packaging, incorrect or misleading instructions, etc. ‘Professional
indemnity’ covers the insured for the losses resulting from negligence in the
provision of a service (i.e. unsatisfactory medical treatment or incorrect
advice from an actuary or solicitor). Likewise, ‘directors and officers
liability’ indemnifies the insured against payment of compensation to third
parties owing to any wrongful act of the insured (in their capacity as a
director or officer of a company). The insurance is personal to the director or
officer but is usually bought by the company. Deliberate fraud by directors
and officers will not be covered by such insurance. Environmental liability
indemnifies payment of compensation to third parties to property by
unintentional pollution for which the insured is deemed responsible. The
costs of cleaning up the pollution and regulatory fines are also covered in
such policies. Gradual and sudden environmental pollution are both covered.

2.3.2 Property Insurance

The main purpose of ‘property damage insurance’ is to indemnify the
policyholder. Here, the indemnity is against loss of or damage to
policyholder’s own material property. The main types of property that are
subject to such insurance against damage are: (i) residential buildings (e.g.
house), (ii) commercial and industrial buildings (e.g. offices, shops and
factories), (iii) moveable property (e.g. contents of a home or of commercial
premises), (iv) land vehicles (e.g. cars, buses, taxis), (v) marine craft, (vi)
aircraft, (vii) goods in transit, (viii) engineering plant and machinery and (ix)
crops. Land vehicles can be further divided into: (i) private motor, (ii)
commercial vehicle, (iii) two wheelers and (iv) motor fleet. A motor fleet
policy provides insurance cover for different vehicles belonging to an
individual owner like a company. A small fleet might have five vehicles in it.
A large fleet could have 500 or more.

Insurance contracts may combine more than one of the above. For instance, a
combined household policy may cover both building and its contents. The
benefit is an amount up to which the insured is compensated for the value of
the loss or damage. In respect of household and commercial buildings, fire is
the principal peril against which it is insured. But policies can cover many
other perils such as explosion, lightning, theft, storm and flood. A policy on
‘moveable property’ will be defined precisely to identify which moveable
property is covered by the insurance. For instance, under a household
contents policy, the definition may include the insured’s household goods
and personal possessions plus visitors’ personal effects. Theft is the major
peril for moveable property. The amount paid on a claim can be: (i) the
32
replacement value, which is the cost of a new item reduced to allow for the Life and General
Insurance
depreciation on the lost item, or (ii) on a ‘new for old’ basis. Under the latter
the cost of an equivalent brand new item is provided. For ‘motor vehicles’,
the perils include accidental or malicious damage to the insured vehicle, fire
and theft. In many countries, including India, this cover is typically provided
together with ‘third party cover’ within a single policy. For ‘marine
property’, the perils covered relate to marine hull cover, marine cargo and
marine freight. Damages through perils of the seas (or other navigable
waters), fire, explosion, jettison, piracy etc. are also covered. ‘Goods in
Transit’ is a commercial insurance cover against loss or damage to goods
while being transported in vehicles specified in the policy (e.g. the
company’s vehicles or by a carrier). The periods of loading and unloading are
also covered in addition to the journey. The sum insured is closer to the value
of the goods. Construction and engineering projects can take several years
and hence the associated policies will last until the end of the project. There
can be an ‘extended warranty’ to cover losses arising from the need to replace
or repair faulty parts in a product (e.g. electrical goods, furniture or motor
vehicles). Such coverage is usually beyond the manufacturer’s normal
warranty period. Policies may have a term of several years.

2.3.3 Financial Loss Insurance

Financial loss insurance can be categorised as follows: (i) fidelity guarantee
insurance, (ii) credit insurance, (iii) creditor insurance, (iv) business
interruption cover (also known as consequential loss) and (v) personal
accident insurance. Fidelity guarantee insurance covers the insured against
financial losses caused by dishonest actions of its employees (fraud or
embezzlement). These will include loss of money or goods owned by the
insured or for which the insured is responsible. It will also include reasonable
fees incurred in establishing the size of the loss i.e. what is paid to auditors or
accountants. Fraud is wrongful or criminal deception intended to result in
financial or personal gain. Embezzlement is stealing or misappropriating
funds placed in one’s trust or under one’s control. ‘Credit insurance’ covers a
creditor against the risk that the debtors will not pay their due obligations. Its
principal types are: (i) trade credit and (ii) mortgage indemnity. Trade credit
covers uncollectible debts which can be sold on an annual basis. Such a cover
may also be for the length of a project. For instance, an aircraft built for a
customer who does not pay for it at the end of construction. Mortgage
indemnity covers the lender (mortgagee) in a mortgage loan against the risk
of the borrower’s (mortgagor’s) default. It provides coverage for the value of
the property on which the loan is secured. Creditor insurance provides cover
to all the insured who are subject to obligations to repay credit advances or
debt. Most of such policies are made to individuals to cover ‘personal loans,
mortgage loans or credit card debts’. The cover is usually against disability
and unemployment on the ground that these perils may prevent the insured
from earning an income. The policy will pay for the loan payments until the
borrower has recovered or obtains new employment or until the loan is fully 33
Introduction to repaid. ‘Business interruption cover’ indemnifies the insured against losses
Insurance Theory
made as a result of not being able to conduct business for various reasons
specified in the policy. For instance, fire at the insured’s or in a neighbouring
property where the financial consequences can be substantial. Another
example is where the company’s production lines are hit and income from
customers will be much reduced. If such income stream was being used to
pay off loans from a bank, the accumulating interest charges can put further
financial strain on the company. ‘Personal accident insurance’ gives benefits
by way of ‘specified fixed amounts’ to cover for the loss that an insured party
may suffer on account of losing one or more limbs or other specified injury.
This may also include the policyholder’s family. This is not an indemnity
insurance because it is not possible to quantify the value of the loss of a limb.

Check Your Progress 2 [answer within space given in about 50-100 words]

1) List the features of ‘general insurance’.

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.....................................................................................................................

2) Specify the types/classification of ‘general insurance’.

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3) State the types of ‘liability insurance’.

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4) What are the categories of ‘financial loss insurance’?

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34 .....................................................................................................................
5) What is meant by ‘credit insurance’? What are its two principal types? Life and General
Insurance
.....................................................................................................................

.....................................................................................................................

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2.4 LET US SUM UP

The unit has discussed the need and types of the life and general insurance. It
looks at the way in which insurance is provided as security to the policy
holders. Different kinds of product provided by the life and general insurance
are covered. In particular, it covers five types of life insurance viz.
endowment assurance, whole life assurance, term insurance, annuity and
unit-linked insurance. Under general insurance, the unit covers four specific
types of insurance viz. liability insurance, property insurance, financial loss
insurance and personal accident insurance.

2.5 KEY WORDS

Endowment : An ‘endowment assurance’ is a life insurance

Assurance contract designed to pay a lump sum after a
specific term (on its 'maturity') or on death.
Term Assurance : A ‘term assurance’ is a contract to pay a benefit
on the death of the life insured within the term of
the contract (chosen at outset). No benefit is
given on surrender of the policy.
Convertible (or : These contracts combine a term assurance with
Renewable Term the certainty of being able to either convert to a
Assurance) permanent form of contract (i.e.an endowment or
whole life assurance) or to renew the original
contract for a further period without requiring
evidence of health (unless the benefit level is
increased).
Annuity : An annuity is a contract that pays out regular
amounts of benefit. The policyholder can buy
annuity either paying single premium or buy an
endowment policy which provides a lump sum at
maturity.
Unit-linked : Unit-linked contracts operate by paying the
Contracts premiums of the policyholders into pooled
investment funds. The benefit payable at
35
Introduction to maturity depends on the performance of the
Insurance Theory
underlying assets and the level of charges levied
by the insurance company.
Liability Insurance : Liability insurance provides indemnity where the
insured, owing to some form of negligence, is
legally liable to pay compensation to a third
party. Any legal expenses relating to such
liability are also usually covered.
Property Insurance : The main characteristic of property damage
insurance is that it indemnifies the policyholder.
The indemnity is against loss of or damage to
policyholder’s own material property.
Financial Loss : This is an insurance against financial losses
Insurance arising from a peril covered by the policy.

2.6 SUGGESTED BOOKS FOR FURTHER

READING
1) Dorlan H. Francis (1999). Life Insurance, Aprilee Publishers.

2) Willey Nathan (1972). Principles and Practice of Life Insurance, Arkose

Press.

3) R Haridas (2011). Life Insurance in India, Neha Publishers &

Distributors.

2.7 ANSWERS/HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1

1) Life insurance is a contract between an individual and an insurance

company. The insured is covered for life as well as critical health needs.
Expenses like funeral expenditures are also covered under life insurance.
General insurance, on the other hand, relates to property insurance,
liability insurance, etc. In general, whatever is not covered under the
ambit of life insurance, is covered under ‘general insurance’.

2) With changes in lifestyles, standard of living, education and technology,

the need for ‘life insurance’ too have undergone changes. Parents often
plan for the higher educational needs of their children in advance. Young
people in the age-group of 35-45 plan for investing in their own house.
In short, life insurance products have graduated from being mere
‘protection policies’ to serve as ‘investment policies’. The latter
facilitates the growth of capital by regular payment of premiums.

36
3) Term insurance and annuity are examples of protection policies. Life and General
Insurance
Endowment assurance, whole life assurance and unit-linked policies are
examples of investment policies.

4) Bonuses are paid in the with-profit endowment assurance contract.

Bonuses are of two types: guaranteed bonus and terminal bonus. The
former is a sum expressed as ‘per 1000 sum assured’. The latter depends
on the ‘investment return achieved’.

5) The ‘bid value’ of a policyholder’s ‘unit fund’, at any point of time, is

the amount of money that the company would have to pay to the
policyholder on a claim under contract.

Check Your Progress 2

1) It is not a life insurance, it is a contract of indemnity, it is for short term,

there can be multiple claim over the policy year, claim amounts are
unknown and there is usually delay in reporting and settling claims.

2) A broad classification is: individual or personal insurance and

commercial insurance. A second type of classification based on claims
is: short tailed claim and long tailed claim. Former is reported and settled
quickly, latter is its opposite. A third type of classification is based on the
main head viz. liability insurance, property insurance and financial loss
insurance.

3) Employer’s liability/workers compensation, motor third party liability,

marine and aviation liability, public liability, product liability,
professional indemnity, etc.

4) Fidelity guarantee insurance, credit insurance, creditor insurance,

business interruption cover and personal accident insurance.

5) It covers a creditor against the risk that the debtors will not pay their due
obligations. Its two principal types are: (i) trade credit and (ii) mortgage
indemnity. Trade credit covers uncollectible debts e.g. an aircraft ordered
but not collected later. Mortgage indemnity covers the lender in a
mortgage loan against the risk of the borrower’s default.

37
Introduction to
Insurance Theory UNIT 3 HEALTH INSURANCE AND
PENSION FUNDS

Structure
3.0 Objectives
3.1 Introduction
3.2 Health Insurance Contracts
3.2.1 Income Protection Insurance
3.2.2 Critical Illness Insurance
3.2.3 Long Term Care Insurance
3.2.4 Private Medical Insurance
3.3 Pension Schemes
3.3.1 Types of Pension Schemes
3.4 Pension Funds
3.4.1 Characteristics of Pension Funds
3.4.2 Financing of Pension Funds
3.4.3 Role of Actuaries in Pension Funds
3.5 Let Us Sum Up
3.6 Key Words
3.7 Suggested Books for Further Reading
3.8 Answers/Hints to Check Your Progress Exercises

3.0 OBJECTIVES
After reading this unit, you will be able to:
• differentiate between ‘health insurance contract’ and ‘pension plan’;
• state the need for ‘health insurance’;
• discuss the classification of health insurance ‘contracts’ and ‘benefits’;
• outline the working of the different types of ‘health insurance contracts’
under PMI (private medical insurance)’;
• enumerate the features of a ‘pension scheme’;
• describe the three main types of ‘pension scheme’;
• identify the characteristics of ‘pension funds’;
• explain the methods of financing the ‘pension funds’; and
• explicate the ‘role of actuaries’ in managing the ‘health insurance
contracts’ and ‘pension funds’.

3.1 INTRODUCTION
Health Insurance is a contract between an ‘insured’ and an ‘insurer’. In this,
38 the ‘insurer’ undertakes to indemnify or pay a fixed benefit to the insured.
The benefit becomes applicable when the ‘insured’ falls sick or suffers bodily Health Insurance and
Pension Funds
injury. Such suffering may require hospitalisation, surgery, doctor’s visit with
other medical expenses, etc. ‘Health insurance’ also provides a monthly
income to the insured’ when they fall sick or gets injured. The payment will
be a percentage of their monthly income subject to a limit. Health insurance
also provides for ‘long-term care facility’ to elderly people.
A pension, on the other hand, is a ‘fixed sum’ paid regularly to a person. It is
usually following the retirement from service or a certain age like 60 years or
so. There are many types of pensions. Broadly, they represent two types:
‘benefit defined plans’ and ‘contribution defined plans’. A pension created by
an employer for the benefit of an employee is referred to as an ‘employer
pension’. Such pensions are also called as ‘occupational pension’. Labour
unions, government, or other organisations, fund such pensions. Occupational
pensions are a form of deferred compensation. They are beneficial to both the
employee and the employer for tax purposes. Many pensions contain an
additional insurance aspect. The insurance gives benefits to survivors or
disabled beneficiaries. Pension funds draw on the ‘pooled contributions from
pension plans’. The pooling gives it the advantage of ‘size’ and ‘risk bearing’
characteristic. In most countries, they are large investment blocks invested in
‘stock markets’. Pension funds are in ‘national public interest’ and are backed
by legislative provisions.

3.2 HEALTH INSURANCE CONTRACTS

Poverty remains a prominent cause of ‘poor healthcare’ in India. In addition,
for even those who are above the poverty line and well off, due to lack of
awareness of health insurance, thousands of families suffer with no health
cover. Researchers from the Harvard Medical School have linked lack of
health insurance with an increased risk of death. Having health insurance
therefore, is important for both health and personal wellness needs.
The need of health care varies with the age of the individuals. Health needs of
children between 0 to 5 years may require regular visit to doctor. Sometimes,
they may even require hospitalisation. But after the age of 5, health tends to
get stabilised and the visit to doctors reduce. Between the ages of 16-25,
health needs change to need for health cover against injuries (e.g. young and
active people with minor or sporting injuries). Between the age of 25-60
years, factors like dependants care determines the healthcare needs. In this
age group, with one nearing 50 years, long term healthcare needs start taking
priority. Based on such differing healthcare needs, broadly four type of
‘health insurance contracts’ are designed in the health insurance sector. These
are: (i) income protection (IP), (ii) critical illness, (iii) long term care
insurance and (iv) private medical insurance.

3.2.1 Income Protection Insurance

Income protection (IP) is an insurance that provides the insured with regular,
short term or long term payments during periods of incapacity (or disability).
39
Introduction to Incapacity means being unable to work due to illness or injury. The IP
Insurance Theory
benefits are in the form of a temporary ‘annuity’. They are regular periodic
payments which continues until the insured recovers, dies or the annuity term
ends (whichever event occurs first). The aim of an IP product is to replace
part of the income that the insured would have earned when one is unable to
work due to accident or illness. IP therefore pays a benefit in the form of a
regular income.

3.2.2 Critical Illness Insurance

This insurance product is known by many different names (e.g. dread disease
insurance, serious illness insurance, crisis cash, living assurance, critical
illness cover, etc.). The benefit under a ‘critical illness policy’ is a lump sum.
This is paid when the policy holder suffers one of the defined conditions. The
product may also be structured to provide regular income. In the latter case,
the lump sum benefit is used to buy a ‘life time annuity’. The annuity then
provides a regular income to the insured from the date of a valid claim until
death.

Critical illness is unlike income protection (or private medical insurance)

where the product is specifically designed to meet either a defined loss in
income or meet the direct medical costs incurred. A ‘critical illness policy’ is
a pure ‘protection product’. As such, the insured is not going to make a claim.
This is because the insured may survive to the end of the policy term without
any of the insured events occurring. Thus, like in the case of term insurance,
the policy will not acquire a ‘surrender value’ at any time. There will be no
maturity benefit. The policy will end when the first event occurs. However, in
some cases, the insurer may allow the policy to be reinstated without further
evidence of health. The major critical illnesses covered under such a policy
are: (i) cancer, (ii) coronary artery by-pass surgery, (iii) heart attack, (iv)
kidney failure, (v) major organ transplant, (vi) multiple sclerosis and (vii)
stroke. Such ‘terminal illnesses’ are often added to complete the overall
cover. It does not relate to a specific disease. Instead, its definition covers the
severity of a condition and its effect on life expectancy. Terminal illness
cover ensures that all conditions that significantly reduce life expectancy are
covered.

3.2.3 Long Term Care Insurance

The ‘average life expectancy’ is increasing throughout the world. With this,
the ‘ageing population’ requires care for chronic illnesses, disabilities or
other conditions needing healthcare on a daily basis over a long period of
time. The type of help needed can range from assistance with simple
activities (such as bathing, dressing and eating) to skilled care that is
provided by nurses, therapists or other professionals. Apart from the elderly
people, other people such as disabled from birth and those disabled as a result
of an accident may also require regular care. The family and the State are
40 usually seen as the providers of care for those disabled from birth. To cater to
the need of ageing population and others, ‘long term care insurance’ is Health Insurance and
Pension Funds
designed by the insurer. ‘Long term care insurance’ is defined as ‘an
insurance product which provides all forms of continuing personal or nursing
care and associated domestic services for people who are unable to look after
themselves without some degree of support, whether provided in their own
homes, at a day centre, or in a State-sponsored or care-home setting’. The
insurance cover for this type of care generally covers homecare, assisted
living, adult day care, respite care, nursing home and Alzheimer’s facilities.
The costs of care is divided between living costs, housing costs and personal
care. These are defined to include: (i) living costs – food, clothing, heating
amenities, etc., (ii) housing costs – rent, mortgage payments and council tax,
etc. and (iii) personal care – additional costs of being looked after, arising
from frailty or disability.

3.2.4 Private Medical Insurance

‘Private medical insurance’ (PMI), for individuals or group of persons, is an
indemnity product. It provides compensation for the cost of private medical
treatment. It focuses on acute treatments rather than chronic or incurable
conditions. An individual PMI is a short-term insurance contract, renewable
annually. At each renewal, though the premium payable does not depend on
the claims experience, insurers usually provide a ‘no claims discount’ to the
individual policy holders. Since it is a short-term policy, cover is not
guaranteed from one year to the next. PMI covers specialist consultations,
out-patient treatment and in-patient treatment. It covers diagnostic tests and
surgery. In case of in-patient stays, room costs, drugs, dressings, theatre fees,
etc. are covered. There are three type of private ‘health insurance contracts’:
(i) individual mediclaim, (ii) family floater and (iii) group mediclaim. An
‘individual mediclaim policy’ is one in which each individual member of the
family has an independent cover for himself. For instance, each member may
be covered for Rs. 5 lakh. A ‘family floater’ is a health insurance plan tailor-
made for families. It is similar to the individual health plan with an add-on
benefit of providing health coverage for the entire family. An insured has the
option to get a ‘full family medical insurance coverage’ which includes self,
spouse, children and parents. A ‘family floater’ is the best insurance plan
when it comes to safeguarding the health of dependents. Since it is a single
policy for the entire family, it relieves one from the task of buying and
maintaining several health insurance policies for each family member.
Another benefit from a ‘family floater’ health insurance plan is that, in
case one of the family members gets seriously sick and has to be hospitalised,
the total sum insured of the policy of the entire family for treatment can be
utilised by the un-well member. ‘Group mediclaim’ is a health insurance plan
that provides healthcare coverage to a select group of people. Such plans are
offered by ‘employers’. These plans are uniform in nature i.e. they offer the
same benefits to all employees or members of the group. They cost less than
individual plans and offer the same benefits. The rationale for this is that the
risk is spread over the entire group, rather than one person. 41
Introduction to Actuarial Implications: The financial strains of the healthcare insurance
Insurance Theory
system have many actuarial implications. They exist at both the macro and
micro level. At a macro (profession-wide) level, actuarial leadership is
needed to add value while designing the ‘structure of healthcare financing
system’. Such a task needs to integrate itself with healthcare delivery experts
to improve its effectiveness. The integration of the ‘practice of medicine’
with the ‘practice of actuarial science’ needs expertise in problem solving.
Such actuarial needs must take into account the different healthcare ‘costs
and utilisation drivers’ along with their impact on ‘trends in healthcare
services’. An emerging health care crisis requires both short-term and long-
term solutions. It requires a clear understanding of likely short- and long-term
healthcare outcomes. In view of these, health actuaries need to get involved
in the development of ‘financial modelling’ by adopting latest approaches for
efficient healthcare financing. Such actuaries need to keep themselves abreast
with complex technical issues associated with selection bias, risk assessment,
predictive modelling, medical management, etc.

Check Your Progress 1 [answer within the space given in about 50-100
words]

1) Differentiate between a ‘health insurance contract’ and ‘pension’.

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2) State the need for ‘health insurance’.

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3) Distinguish between ‘income protection insurance’ and ‘critical illness

insurance’.

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42 ……………………………………………………………………………
4) What are the three types of ‘private health insurance contracts’? How is a Health Insurance and
Pension Funds
‘family floater’ beneficial?

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3.3 PENSION SCHEMES

One needs to plan for the financial needs of their retirement period to manage
a decent standard of living. They may also need to support a partner or other
people in the family. With increase in life expectancy, people are living
longer than before. This means, due to their healthcare costs, they need more
finances to meet their requirement as they grow older. Many old people live
in poverty because of their low savings and no pension of any kind. Pension
schemes play a vital role in savings and providing for retirement benefits to
people. The pension providers are mainly three: (i) the State, (ii) the
employer and (iii) the individuals themselves. The State has a major role in
the provision of pensions. This may be through direct provision or through
the regulation of pensions provided by others. In countries where life
expectancy extends well beyond working age, retirement benefits have great
financial significance. In deciding the type of benefits, the State has the
greatest role to play. This is particularly important in case of pension for low
earners. The political, economic and fiscal situations of the State determines
the precise roles that the state will play. The role of the government in
providing pension to the population includes the following:

• ensure that the largest section of the population receive the benefits of
pension;
• educate the population on the importance of planning for pension; and
• set up and regulate the working of the pension providers.

Like the State, employers (i.e. employing organisations) too play a role in
compelling their employees to plan for their pension provision. The most
significant role played by employers is in financing the pension funds of their
employees. Likewise, the main role that individuals play in provisioning for
their pension is in its ‘self-financing’. This needs to stem from either an
encouragement by the State or a personal desire by the individuals for their
dependants. The main features of a pension scheme are the following:

• They are a means of income in retirement for an individual and his

dependants.

43
Introduction to • They provide a lump sum payment to dependants if the individual dies
Insurance Theory
before retirement.
• They may have options to change the form or timing of the benefit (e.g.
option at retirement to exchange a proportion of the pension payments
for lump sum cash payment).
• They are long-term arrangements.

3.3.1 Types of Pension Schemes

Pension scheme members can be divided into three types: (i) active members
i.e. those still earning for future pension benefits (i.e. current employees of a
sponsoring company whose contributions are going to the pension fund); (ii)
deferred members i.e. those members who have stopped earning but who
have a existing benefit entitlement that will come into payment in the future
(i.e. an employee who has left one work for another company) and (iii)
current pensioners i.e. members who are receiving their benefit entitlement.
Broadly, the pension schemes can be divided into three types: (i) benefit
defined schemes, (ii) contribution defined schemes and (iii) hybrid schemes.

Benefit Defined Schemes: These are plans in which the benefit on retirement
is determined by a set formula, rather than on investment returns. This is a
traditional pension plan. In this, the benefit is worked out by incorporating
factors like: employee’s pay, years of employment, age at retirement, etc. A
simple example is a company X that provides a certain amount like Rs. 1000
a month per year of service. For a person retiring with 30 years of service, the
company would provide Rs. 30000 per month as pension. This type of plan is
popular among unionised workers. In an yet another variety of this type of
pension plan, the ‘final average pay’ (FAP) remains the most common
principle of a ‘benefit defined plan’ or scheme. In the FAP plans, the average
salary over the final years of an employee’s career determines the benefit
amount. Averaging the salary over a number of years means that the
calculation is made after making adjustment for reduction in the value of
money. For instance, if salary is averaged over five years, and retirement is in
2015, the present values of salary for each year starting from 2011 will be
calculated by applying suitable inflation adjustments. Thus, inflation in the
salary of averaging years has a considerable impact on purchasing power and
cost, both being reduced equally by inflation. The effect of inflation can be
eliminated by converting salaries in the averaging years to first year of
retirement equivalent and then averaged.

Contribution Defined Schemes: A ‘defined contribution’ (DC) scheme is an

occupational pension scheme where ‘employee’s own contributions and the
employer’s contributions’ are both invested in the market and the proceeds
are used to ‘buy a pension’ and/or other benefits at retirement. The value of
the ultimate benefits payable from the DC scheme depends on the amount of
contributions paid, the investment return achieved less any fees and charges.
A DC scheme has a set contribution for the employee and a set contribution
44
for the employer. For instance, in some DC schemes, the employer and the Health Insurance and
Pension Funds
employee each contribute 10% of the member’s earnings, or 20% in total.
Some DC schemes allow members to choose the level of contribution they
wish to pay with a related employer contribution. Contributions are invested
on behalf of each member. Money invested can either be from employee’s
salary or from employer contributions or both. In a contribution defined plan,
investment risk and investment rewards are assumed by each individual and
not by the employer. The risks may be substantial. In addition, participants
do not necessarily purchase annuities with their savings upon retirement. This
means, they may bear the risk of outliving their assets.

Hybrid Schemes: A hybrid pension scheme is one which is neither a fully

‘benefit defined scheme’ nor a fully ‘contribution defined scheme’. It has
some characteristics of both these types of schemes. In a contribution defined
scheme, the member generally bears the full risk of paying higher costs or
receiving reduced benefits. This is if the investment on pension funds are not
as good as expected. In a benefit defined scheme, the employer takes that risk
and pays higher contributions in order to maintain the agreed level of
benefits. In hybrid schemes, the risk can be shared between the employer and
employees. There are many possible types of hybrid schemes. For instance, a
member may be accumulating two types of benefit simultaneously. This
could be a ‘benefit defined element’ for one portion of income and a
‘contribution defined element’ over another portion of income. Such a
situation arises when one changes jobs where the earlier employer had
‘benefit defined scheme’ and the later employer had ‘contribution defined
scheme’ for pension.

In the ‘contribution defined’ and ‘hybrid plans’, benefits are given out based
on certain schemes. These may be: (i) self-annuitising or (ii) final salary lump
sum based or (iii) underpin schemes. In the self-annuitising ‘direct
contribution’ (DC) schemes, when a member retires, the accumulated fund is
converted to a pension income. This is done in accordance with a process
which is set out in the rules of the scheme. The pension is then paid from the
scheme. In the ‘final salary lump sum’ scheme, the rules of the scheme
provides for a lump sum at retirement. For instance, it may be 20% of final
salary for each year of service. Thus, if a member retires with 40 years'
service, a lump sum of 20% of 40 i.e. 800% (or 8 times) the final earnings
would be used to buy a pension for that member at the market cost on that
date. In the ‘underpin scheme’, on retirement, the member receives a benefit
based on whichever calculation provides the better result. For instance, a
scheme may have an employer and employee contribution rate of 6% each,
with a guarantee that at retirement, a pension of at least 1% of earnings per
year of service would be paid as a minimum.

Check Your Progress 2 [answer within the space given in about 50-100
words]

45
Introduction to 1) Mention the importance of ‘State’ in the matter of ‘pensions’. Which
Insurance Theory
factors determine the capacity of the State to provide pension
effectively?

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

2) How does the principle of FAP (final average pay) works in determining
the pension? To which category of pension plans does the FAP belong?
In what way is this method beneficial to the employee?

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

3) How does a ‘contribution defined scheme’ fundamentally differ from

that of ‘benefit defined scheme’ in the matter of pension?

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

3.4 PENSION FUNDS

In India, there are three main types of pension funds. For those employed in
salaried jobs (in a government or large private sector establishment in India),
there are two schemes. These are: the GPF (general provident fund) and the
CPF (contributory provident fund). The GPF is an example of ‘benefit
defined scheme’ while the CPF is an example of a ‘contribution defined
scheme’. In the CPF, there is a matching contribution by the employer to the
fund. In the GPF, there is no contribution to the fund by the employer.
However, being a benefit defined scheme, the employer takes the
responsibility of meeting the defined amount of pension and other benefits
after the retirement of the employee. In the CPF, there is no obligation for the
46 retiring employee to buy an ‘annuity’ from the lump sum he gets on
retirement. Annuity ensures regular periodic (e.g. monthly) payment. A new Health Insurance and
Pension Funds
scheme called the NPS (National Pension System) is introduced in 2004. This
is a scheme which enables the individual participants in investment decisions.
A person who is not an ‘employee’, or one who is self-employed, can also
become a member of the NPS. For employees of the government, there is a
compulsory need to buy an ‘annuity’ at the time of retirement from the
portion of the fund contributed by the employer. The ‘public provident fund’
(PPF) is another type of savings-cum-tax-saving instrument in India. Like the
NPS, this is applicable for anyone in general i.e. one need not be an
employee. The aim of the PPF scheme is to mobilise small savings by
offering an investment with reasonable returns combined with income tax
benefits. Pension funds are thus accumulated capital by contributions made to
it in one’s active working life. Such a fund, through its investment returns, is
supposed to provide a regular income as pension.

3.4.1 Characteristics of Pension Funds

There are four distinctly identifiable characteristics of a ‘pension fund’.
These are: (i) pooling and diversification, (ii) transfer of economic resources,
(iii) uncertainty and risk control and (iv) comparative advantage. The
characteristic of ‘pooling and diversification’ accrues owing to the large size
of a pension fund with the resultant advantage of ‘economies of scale’. This
is important because the ‘participation costs to market activity’ is a major
determining factor in boosting the demand for services of pension funds.
Pension funds reduce the cost of transacting by negotiating lower transaction
costs and custodial fees. This accrues owing to the sharing of ‘professional
asset management costs’ by all the members. Owing to this, the direct
participation cost to members for acquiring information and knowledge
needed to invest in a range of assets, as well as in undertaking complex risk
of trading and risk management, are reduced. However, the cost of
monitoring the ‘asset manager’ remains.

The basic role of pension funds arises at the time of ‘resource transfer’. This
means at the time of retirement of a person (or persons) there is a need to
‘transfer resources’ for benefit payment. This function does not typically
entail maturity transformation. This is because pension funds do not have
matched assets and liabilities i.e. the portfolios of pension funds vary widely
across its members. Together they hold a greater proportion of ‘uncertain
capital and long term assets’ than the individual members. Hence, pension
funds compensate for the increased risk by pooling assets at a lower cost.
Being pooled, the returns on pension funds are imperfectly correlated.
Pension funds thus provide risk control to members through ‘retirement
income insurance’. To assist in undertaking this risk control function, pension
funds usually diversify their assets. They also indulge in ‘securities and
derivatives markets’ to hedge and control risk. Thus, pension funds afford
‘comparative advantage’ (over individual investments) by virtue of their ‘size
and managerial expertise’.
47
Introduction to 3.4.2 Financing of Pension Funds
Insurance Theory
There are two approaches to financing benefits: unfunded or funded. In the
unfunded approach, the ‘money to pay’ is just paid out whenever the benefit
becomes due. There is no planned way for an accumulated fund to be used
for paying the benefits. The unfunded approach is also called as ‘pay-as-you-
go’. This term is used to describe a situation where the sponsor makes the
necessary payments only at the points that each separate tranche of a benefit
becomes due. In the funded approach, the money to meet the benefit are set
aside before the benefits fall due. Such planned funding for payment of
benefits can be done by different methods like: (i) lump sum in advance, (ii)
terminal funding, (iii) regular contributions, (iv) just-in-time funding and (v)
smoothed pay-as-you-go. In the ‘lump sum in advance’ method, funds that
are expected to be sufficient to meet the benefit (or more appropriately the
cost of the benefit) is set aside as soon as the benefit promise is made. This is
similar to advancing a lump sum as a single premium for future payment. The
lump sum is designed to be sufficient to provide all future benefit outgo. The
entire funding payment is made even though the first benefit payment may
not be expected for some considerable time. In the ‘terminal funding’
method, funds that are expected to be sufficient to meet the series of benefit
tranches are set up as soon the first tranche becomes payable. Thus, here also
a payment is made whenever a benefit becomes due to be paid. The payment
is a capital sum designed to be sufficient to provide all future payments of the
benefit.

In the ‘regular contributions’ method, funds are gradually built up. Such a
build up is taken to reach a level expected to be sufficient to meet the cost of
the benefit. This is done over the period ‘between the promise made’ and the
‘first benefit becoming payable’. In the ‘just-in-time funding’ method, funds
that are expected to be sufficient to meet the benefit is set up as soon as a risk
arises in relation to the ‘future financing of the benefits’ (e.g. bankruptcy or
change in control). Under this method, payment is made at the last possible
moment. What distinguishes this method from ‘terminal funding’ is that
payment is triggered by an external event (not a benefit to be paid out). For a
pension scheme, specific examples include employer insolvency or the
change in the ownership of a company. The latter is the same as change in
control. In the ‘smoothed pay as you go’ method, funds are set up to smooth
the costs so as to allow for the differences in timing between the
contributions and benefits.

3.4.3 Role of Actuaries in Pension Funds

Management of pension schemes is not easy. Various service providers,
including actuaries, are involved in its management. They ensure that
contributions and investments are secured. In this, the role of actuaries is to
evaluate the ‘likelihood of events’ and ‘quantify the outcomes’ so as to
minimise or control financial losses associated with uncertain events.
48 Actuaries have both ‘statutory’ and ‘advisory’ roles in pension fund
management. The ‘Pension Fund (Regulatory and Development) Authority Health Insurance and
Pension Funds
Act’ (2013) provides for the appointment of an actuary. The board of trustees
of the Pension Scheme/Fund appoints the actuary. His function is to make the
valuation of a pension scheme at intervals prescribed in the Act. He is also
required to periodically carry out an actuarial valuation to determine the
sound funding of the Pension Scheme.

Actuaries provide statements or certificates conveying their professional

opinion on the current and likely future financial position of the Pension
Scheme/Fund. The purpose of the actuarial valuation of a pension scheme is
to enable the trustees to meet the legal requirements of pension to the
members. The valuation may be quarterly valuations or a special valuation
because of significant recent or prospective changes to the scheme. In either
event, the first step is to decide on the uses to which the results of the
valuation are to serve. Once they are defined, the actuary will decide the
approach he will adopt, the assumptions to make and the methods to be used
to determine the values of the assets and liabilities.

Check Your Progress 3 [answer within the space given in about 50-100
words]

1) State the three types of ‘pension funds’ in vogue in India with its
distinctive features.

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

2) How is NPS different from the CPF and PPF?

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

3) What are the characteristics of ‘pension funds’?

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………
49
Introduction to 4) How does a ‘contribution defined scheme’ (CDS) fundamentally differ
Insurance Theory
from that of ‘benefit defined scheme’ (BDS) in the matter of pension?

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

3.5 LET US SUM UP

This unit discusses the need for health insurance and pension to cater to a life
free from health problems and old age financial needs. Four health insurance
schemes are discussed. These are: (i) income protection scheme, (ii) critical
illness insurance scheme, (iii) long term care insurance scheme and (iv)
private medical insurance scheme. The unit then makes a distinction between
‘pension schemes’ and ‘pension funds’. Three different type of pension
schemes viz. (i) benefit defined schemes, (ii) contribution defined scheme
and (iii) hybrid schemes are explained. The types of pension funds existing in
India are illustrated. The methods of financing the pension funds are outlined.
The role of actuaries in administering the health insurance contracts and
pension funds is indicated.

3.6 KEY WORDS

Income Protection : IP insurance provides the insured with regular,

(IP) short or long-term payments during periods of
incapacity.
Critical Illness (CI) : This policy gives benefits in a lump sum. The
benefit is payable if the policyholder suffers from
one of the defined conditions. The product can be
structured to provide regular income. In this case,
the lump sum benefit is used to buy an annuity
which provides a regular income. The benefit is
paid from the date of a valid claim till death.
Long Term Care : This is an insurance product which provides
Insurance personal or nursing care with associated domestic
services. The benefit can be provided either in
one’s own home or a day centre or in a state-
sponsored care-home setting.

Private Medical : This is an individual or a group indemnity-based

Insurance product. It provides compensation for the cost of
50
 private medical treatment. It concentrates on acute Health Insurance and
Pension Funds
types of treatments rather than on chronic or
incurable conditions.
Benefits Defined : Defined benefit schemes are pension plans in
Schemes which the benefit is determined by a set formula
rather than on investment returns.
Contribution : These are schemes in which the investments made
Defined Schemes periodically at regular intervals is invested in the
market. They are thus subject to market risks.
Professional fund managers deal with the risks for
which they need to keep themselves abreast of
techniques and developments.

3.7 SUGGESTED BOOKS FOR FURTHER

READING
1) Michelle A. Green (2014). Understanding Health Insurance, 12th Edition,
Delmar Cengage Learning.

3.8 ANSWERS/HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1

1) Health insurance contract is a plan that covers the health expenditure of

the insured (and sometimes the dependents) in case of specified illnesses
and its related expenses. A pension plan, on the other hand, gives cash
benefits upon retirement or a certain age limit. Usually, it is for life and
may also cover spousal benefits upon the death of the main member of
the plan.

2) Research has established conclusive link between ‘lack of health

insurance’ with an ‘increased risk of death’. Its need varies with age. At
higher ages, meeting the ‘critical healthcare expenses of dependents’ and
‘long term health coverage’ becomes major determinants for healthcare
insurance.

3) In the IP insurance, a percentage of income the insured would have

earned, but for the loss of earning capacity due to illness or injury, is
paid in cash. They are thus in the form of ‘temporary annuity’. CI
insurance protects the insured against serious illnesses like cancer. CI
insurance is a ‘protection product’ where the insured does not claim the
benefit. This can be converted into a ‘life time annuity’.

4) Individual mediclaim, family floater and group mediclaim. A family

floater is beneficial for two reasons: (i) it provides coverage for all
dependents stated in the policy and (ii) if any one member becomes 51
Introduction to seriously ill, requiring large amount of payment, that one member can
Insurance Theory
avail benefits up to the ‘total sum insured’ for the whole family.

Check Your Progress 2

1) One reason is, higher proportion of ‘low earners’ in the population. A

second reason is to ensure ‘regulation’ of pension providers. The
political, economic and fiscal situations of the State determines the
precise roles that the state will play.

2) FAP is a ‘benefit defined scheme’. In this, the average of some ‘final

years of service’ is used to work out the amount of pension. It is
beneficial to the employee in two ways: (i) during the final years, the pay
of the employee would be higher than in his initial years; and (ii) it
protects for adjustment to rising prices or inflation.

3) In a ‘contribution defined plan’, investment risk and investment rewards

are assumed by each individual and not by the employer. A ‘benefit
defined plan’, on the other hand, not only does not carry any market
investment risk to the employee, it also gives protection against rising
costs or inflation.

Check Your Progress 3

1) The GPF, the CPF and the PPF are the three types of ‘pension funds’
operational in India. The GPF is a ‘benefit defined scheme’ while the
CPF is a ‘contribution defined scheme’. In the GPF there is no
employer’s contribution to the fund but being a ‘benefit defined scheme’,
the employer takes the burden of meeting the defined benefits of the
employee after retirement both for the employee and upon his death to
the spouse. The PPF, on the other hand is a savings mobilising scheme,
open to all, and offer tax benefits to the investing public.

2) In the CPF, there is no obligation for the employee to buy an ‘annuity’.

In the NPS the employee is committed to buying an annuity from the
employer’s contribution. Buying an annuity, which offers a regular
income, is an option both for the CPF and the PPF members.

3) Pooling and diversification, transfer of economic resources, uncertainty

and risk control and comparative advantage.

4) The returns from the former (CDS) is subject to investment risks making
it variable over time. The latter (BDS) is not subject to variations in
returns due to market fluctuations. Further, with protection from
inflation, pension from BDS is always increasing over time.

52