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FIELD NOTES Lapse Supported Insurance

What exactly does it mean when we say a product is lapse supported? Every product
design has a persistency assumption built into the pricing. Generally if lapses are
less than assumed, profitability improves because present value of the income
stream increases more that the present value of the future benefits plus the
acquisition cost. If instead profitability is reduced, the product is technically lapse
supported. I say "technically" because whether this will become a problem for the
company is a function of the sensitivity of the lapse assumption, and, of course, just how far off the
assumption is. A more operational definition for the manager is that a product is lapse supported when
there is a possible lower lapse rate that will create a problem for the company. If the profit margin built
into the pricing is adequate, such that the lower lapse will still leave the product profitable, the issue of
lapse support is unlikely to ever come up.

A tolerable degree of lapse support can be viewed as a positive, as it tends to reverse the more usual
situation where the policyholders who persist are subsidizing those that lapse. Lapse support shifts the
benefit pattern in favor of those that stay over those that lapse. The problem is that with any degree of
lapse support the lapse rate becomes a moving target, and it moves in the opposite direction from your
aim. Most companies have a stated profit target and interest rate assumption for product design, so with
a lapse supported product the higher the lapse rate assumed, the lower the premium, and the lower the
tendency to lapse. Lower the assumption and the rate goes up.

Notes Discussion

A good way to size up whether a How do reserves figure in here? The short answer is that they
lapse support problem exists is to don't determine lapse support, they just determine when you are
ask the actuary to give you the likely to find out about it. Profitability is measured at issue, when
profitability test with a zero lapse the reserve is zero. The function of the reserve is to take up the
rate, or, with the assumptions difference as the PV of the future premiums decreases and the PV
mandated by the life illustration of the future benefits increases. In other words, the reserve
rules for determining disqualifying controls the incidence of profit, or apparent profit. If the reserve
lapse support. These allow actual accumulates too slowly, you may be reporting a profit right up until
lapse experience for the first five the day it is discovered the reserve is inadequate.
years, and zero lapse thereafter. If
the product is still profitable under The lapse assumption used for the reserve technically doesn't
those conditions, you are unlikely have to be the same as the one used in the product design and
to ever have a problem, and can profit test, but it would sure look funny if they were very different.
just enjoy the higher profit if As a result, the inadequate reserve accumulation is the henchman
lapses are up to design. of the lapse supported design. You can't have one without the
other, because you wouldn't start with a product if you knew it was
a loser.

The degree to which a lapse When life products are specifically designed to work around the
supported product is sensitive to non forfeiture laws in order to eliminate or reduce cash values,
the lapse rate is a function of (increasing the lapse support) low lapses are more likely to
when most of the benefits are paid. become a problem. The classic example is the term to 100
If there if a level premium and the available in Canada, which is essentially level premium whole life
bulk of the payments are late in with no values for those that lapse. The inherent lapse support
the product cycle, then the lapse became a huge problem for the industry. The U.S. has its own set
rate defines the number of people of gimmicks to eliminate cash values, such as the 40 year level
who pay premiums but do not last term that has low premiums the first 20 years and very high the
long enough to collect any second, and the rates are so low it would be surprising if it did not
benefits. become a problem.

With most life insurance it is the Most level premium A&H policies are lapse supported to some
cash values (which are benefits degree, since morbidity increases with age. Most do pay enough
paid early) that eliminate problem early benefits to reduce dangerous sensitivity to lower than
lapse support. Some term expected lapse, with the notable exception of long term care
insurance has some degree of policies, where there are no "early" claims. Pricing has already
lapse support, but on the longer become a problem for the early entrants.
terms and older ages there is
enough cash value to keep Both life and A&H can become dangerously lapse supported when
profitability from being overly they provide a refund of the premiums paid after some time.
sensitive to lapsation. Generally the pricing on such products assume a lapse rate that
will keep the premiums reasonable. The risk is that the refund
feature will virtually eliminate lapse at the point where it becomes
obvious to the policyholder that there is little or no cost to finishing
out the period.

Lapse supported products have a Consider the interaction between marketing and actuarial in
bad reputation because they have dealing with a product that is either inherently heavily lapse
resulted in disasters for so many supported, like long term care, or has been designed to be lapse
companies. Why is that? As a supported.
practical matter, the forces are all
against allowing a correct lapse Since the goal is to have the cheapest premium that can be
assumption. The higher the lapse justified with the established profit goals, everyone becomes very
assumed, the lower the price of pessimistic about persistency, and the lapse assumption is set as
the product. The lower the price of high as anyone can rationalize. While this contributes to lower
the product the greater the lapse rates, it will be several years before the actual lapse
perceived value is likely to be, statistics become credible, during which period the company is
and thus the lower the probable building a shortfall in the reserve. This comes due all at once.
lapse rate.

Timing is everything on lapse When you say agent persistency is poor, or the lapse on a product
support. A CEO once told me that is high, almost inevitably you are talking about the first year or two.
the sale of a heavily lapse Most executives get their persistency information from the agency
supported product would cause system, and generally those systems only give data for the first 13
no problem because "the agent or 25 months. After that it is generally assumed that the effects of
selling it has always had very how the sale was made wear off, and the product approaches its
poor persistency". That doesn't ultimate lapse rate, which depends more on the market than the
work. You not only have to have agent.
the projected lapse, you have to
have it WHEN it is projected. Lapse support becomes relevant well after acquisition costs are
recovered. Before that, you lose regardless of the ultimate lapse
rate. After that there is usually a number of years where low
lapsation increases profit, before the claims accelerate. It is clearly
not fair to adjust your policies and procedures to discourage early
lapse and encourage late lapse, although companies that cancel
blocks of business or raise premiums disproportionately in later
years are in effect doing exactly that.
Lapse supported products are Term to 100 was designed assuming an ultimate lapse rate of
very likely to create adverse around 6%, and the actual rate turned out to be 2%. The
results. The Canadian experience difference in Canada is that the companies guaranteed the
with term to 100 has been premiums and will pay the price. In the U.S. on most of these
disastrous to the industry. Term to devices there is a current rate and a significantly higher
100 is whole life at less than guaranteed rate, so the company can raise the premium.
whole life premiums due to the Therefore the policyholder bears the risk. Consequences to the
elimination of non forfeiture company depend whether premiums can be raised enough, how
values. soon premiums are increased, and the reaction to the premium
increase.

Lapse supported products can Long term care and term to 100 products are pretty obvious, since
be created by their structure, or the lapse support is created by pricing assumptions and the future
created in normal structures by is difficult to estimate. Since no one can prove conservative
inadequate pricing assumptions. assumptions, the "everyone is doing it" test is likely to prevail.
The fundamental problem with Perhaps less obvious are the universal life products where
lapse support is that the higher charges do not immediately affect premiums, and the class of
the assumed lapse rate, the lower "whole life" at half the cost, whether created by artificially low early
the premium, the better the cash values, or by the combination of non guaranteed annual
perceived bargain, and the lower renewable term with something that is supposed to increase, such
the resultant lapse rate. as paid up additions or permanent dividends, to keep premiums
and face level, like the product that caused the insolvency of Mid-
Continent Life.

For a closer look at the Mid- Mid-Continent began aggressively selling the extra-life policies, a
Continent Life insolvency, seized blend of traditional whole life and term insurance, outside the
by the insurance commissioner in Southwest after its sale to Florida Progress. The majority of the
1997, put "Mid-Continent policy was made up of term coverage that decreased in value
Life"+"Extra Life" in Google. The every year. But the dividends were used to buy add-ons to the
product was supposed to have term insurance to guarantee a fixed level of protection -- a big
level premiums and level face for selling point. Mid-Continent heavily promoted the policy as having
life, thus making it function as a "level" premiums, suggesting the annual cost of a policy would not
whole life product. The premium change over the years.
was less than half the cost of an
equivalent whole life policy, Former Oklahoma Insurance Commissioner John Crawford seized Mid-Continent
in 1997 after determining the company was insolvent because of a huge shortfall
something made possible (to in reserves. Florida Progress fought the move, saying the company could raise
calculate) by a very high lapse premiums to cover future liabilities.
assumption coupled with high © St. Petersburg Times, published September 28, 2000
projected dividends on the small
par whole life portion of the Note that the argument that the company could raise premiums did not forestall
coverage. The reserves were the seizure of the company, and that the commissioner sued the parent company,
a utility, claiming it had control of the board and should be held responsible for the
based upon that lapse deficiency in the reserve. That suit was dropped by the next commissioner, and
assumption and fell short when the issue never resolved.
the lapse did not materialize.

Lapse supported products that The essential nature of a level premium is that policyholders pay
perform as projected, i.e. have a excess premiums early to support deficient premiums later. The
lapse rate such that the expected reserve is posted to sop up the excess so it will be available later
number of premium payers is not to support earnings when premiums are insufficient to pay
around to collect benefits, still benefits. Management needs to be sure that not only is the
need to be reserved carefully so product lapsing at the rate designed, but that the reserve
that too much of the lifetime profit assumptions match the product design assumptions. There tends
is not reported in the early to be no complaint when reported earnings appear to be higher
durations. While this is true of all than expected on a given product or line of business, but it is pay
products, ones with significant me now or pay me later. Earnings emerging higher than expected
lapse support are the most difficult warrant just as much concern as earnings that appear too low.
to gauge. You need to identify why. Failure to do that can create disclosure
problems, at the very least.

Illustrations of non guaranteed The state laws adopting the model regulation do not prohibit the
values in lapse supported life sale of lapse supported life products, they just prohibit showing
products are prohibited by NAIC the prospect any values that are not guaranteed. This can be an
Model Regulation adopted important consideration for management if the field force is
12/4/95 and effective in states on accustomed to using illustrations or the proper presentation of the
or after 1/1/97. Actuarial Standard of product requires an illustration. For example, it is hard to imagine
Practice 24 defines lapse support how universal life can be explained without an illustration, since for
as one that is not self supporting any face amount there is a broad range of premiums that can be
given defined persistency paid. The choice simply determines how long the policy can
assumptions in the first 5 years, remain in force at the premium selected. A given premium at the
and assuming 100% persistency guaranteed internal charges and interest credits might appear to
thereafter. Questions remain as to maintain the policy for only a few years, not a sensible option,
whether the regulation has been while at the current rates might appear to maintain it for life.
effective.

Companies in the high income The company may be looking at lapse experience that is quite
markets, particularly those that high for the market they are in, created largely by substantial
market through brokers, would replacement activity sponsored by agents. If the company relies
seem more likely than most to run on these statistics to issue products with artificially low premiums,
into problems with lapse the product may be replacement proof, and will reveal the inherent
supported designs. Designing lapse rate of the large policy high income prospect, which is
products that avoid cash values almost zero if there is no better value for the agent to switch him
and have unrealistic lapse to.
assumptions may appear to be
the only way to get premiums low
enough to be "competitive". The
market, however, inherently has a
very low lapse rate, that is, in the
absence of replacements
promoted by agents.

Return of premium riders are For an excellent analysis see "Return of Premium Riders Under the
popular with agents, as they make Microscope", SOA Annual Meeting New Orleans, October 2001.
a product look much cheaper, and Focusing on the disability insurance market where ROP is often a
sometimes even "free" on a "net percentage (60% for example) of premiums less claims paid every
cost" basis. A net cost 10 years, the panelists note that the demographics of ROP for the
presentation, of course, compares majority of purchases are the blue collar and gray collar markets.
the total premium outlay with the The presentation includes sensitivity testing of interest rate and
total dollars received, ignoring the lapse rate assumptions on profitability.
time value of the dollars involved.
Since payments under the rider The discussion includes the CSV rider, which has the quite
go only to those who persist to the different effect regarding lapse support. CSV returns a percentage
end of the specified period, it has of premium, grading from 0% to 100% at maturity, when the base
the maximum possible lapse plan is surrendered, i.e., lapses. This has the early benefit effect of
support, and profitability will be the traditional cash value, reducing sensitivity to lapse.
highly sensitive to the lapse rate.

The ROP rider is clearly a tontine, The relevance of the claim offset to the company varies by the
modified by the deduction of any nature of the product. Disability policies produce significant offset
claims paid from the ultimate and enjoy claim deterrence as a result. Cancer policies produce
payout. Everyone pays in, but
only those left at the end receive low incidence high value claims, so the offset is less important to
payment. The payouts are the pricing.
insufficient to make the ROP a
rational investment for the The purest tontine is the ROP available on term life policies, since
policyholder. While the return is the risk of reduction by claim is minor. One example of Zero Cost
positive, usually north of 8%, for Life Insurance states that an extra premium of $14 a month will yield
those staying the course, the risk a "a tax-free check for $26,640 at the end of 30 years". The future
of lapse makes that a bad value of $14 at 6% is $14,000 so they must expect just over half of
investment. The ROP is best the insureds to collect. At 9% the future value would cover the
understood as a sales tool for the entire ROP. Put another way, the yield to the survivors is 9%,
agent. For an considered view, which in most periods is a good yield for a tax free return. On the
and an consideration of the risks other hand, it looks pretty bad if you factor in that each saver
to the company, particularly on apparently has a 50% chance of losing their investment.
level term with ROP, see two
articles in the Transamerica
newsletter, the Messenger. here
and here.

Like all heavily lapse supported While the strength of your niche will define competitive pressure
products, ROP can be profitable, and influence your lapse assumption, certain niches have
even highly profitable, if you can additional pricing advantages. If the lapse rate is influenced by
get the lapse rate right, or better independent events rather than purely individual decision, the
yet, market with a design rate contrary affect of price on lapse may be significantly less, and
lower than you actually therefore easier to forecast accurately. A prime example is work
experience. If your perception of site marketing, or any market where premiums are collected by
competition permits the higher payroll deduction. Employee turnover and the cessation of
premium dictated by the lower premium deduction often results in a lapse, and for each industry,
lapse rate, all of the excess goes highly predictable. The normal rate is unlikely to be influenced by
straight to the bottom line. the relative cost of the policy.

There are some ROP offerings Perhaps the definition of lapse support, at least with a negative
that do not take the lapse rate connotation, needs further clarification. If a product is sensitive to
(and the resulting windfall) into lapse, and the lapse rate turns out to be significantly different from
consideration in pricing. For that priced into the product, then it is going to be unfortunate for
example, if the assumed long somebody. Either the company takes a lower profit than projected
term new money rate is 7%, and or the policyholder paid a higher premium than necessary to
the premium on the rider, invested produce a "reasonable" profit for the company. And of course,
at 7%, will give a future value overpricing a product in a competitive market will be a negative for
equal to the return of premium, the company as well.
the lapse windfall flows
exclusively to the company. To the With some products the structure makes it is impossible to avoid
same effect is the assumption of a lapse support, and ROP is one of them. The tendency of the lapse
very low lapse rate, like 2%, which rate to move away from any reasonable projection explains the
would be pretty safe for about any bad reputation, but unless design modifications that increase early
product or market. Note that the benefits are possible (such as the CSV rider), all you can do is pay
Canadian disaster with term to close attention to the lapse assumption at time of pricing, and then
100 still had a 2% lapse rate. track it closely.

Any company that suffers from The pricing of ROP also favors companies with less than average
poor persistency in the early persistency. From a purely theoretical standpoint, the worse the
years should certainly consider expected persistency, the less you would charge for ROP. But of
emphasizing ROP. The standard course it doesn't work that way in practice. The rates are fairly
nonforfeiture values are usually uniform, and are kept high by the necessity to keep them
zero for at least the first 5 years, adequate for the more persistent markets. For example, ROP is
and many companies, particularly very popular with the level 20 and 30 year term sold for home
those in the lower income mortgage protection, and the fairly good persistency historically
markets, lose more than half their has supported rates that add 80 to 85% to the base premium.
policies in that period. On those There is no incentive for companies with poorer persistency to
policies the company received charge less than to going rate, so the result has been significant
extra premium and paid no support to the profitability of the sale.
benefits. Poor early persistency
will undercut the profitability of the
base plan, so an ROP rider can
turn a loser into a winner.

What about nonforfeiture values? In most instances ROP nonforfeiture values are not as high as you
Many states now require ROP would expect from a stand alone product. There are several
riders to comply with the standard reasons for this. Many ROP riders were filed as annuities, which
nonforfeiture law, so the profit to they do resemble, and were thus exempt from the nonforfeiture
the company in a lapse will be requirements. Thus the cash values provided tended to be skimpy.
reduced by the cash value. Even Another reason, even in those states that require compliance, is to
for sales in states with no consider the base plan and the ROP rider together, and the base
requirements, market forces and plan, particularly level term the way it is packaged today, often has
standard industry practice has a long expensive tail designed to reduce or eliminate reserves. An
made the provision of cash values example is the "40 year" term with is really 20 year coverage, as
fairly universal. But "fairly" is not the second half is prohibitively expensive (to keep the PV of future
quite the word to use, since the premiums more than the PV of future benefits). Taken together
ROP is still a loser for anyone with a ROP rider, the tail also undercuts the rider CVs, leaving the
lapsing before the bewitching cash values at the mercy of the market.
hour, and hugely profitable for the
company, when compared to the ROP cash values are drawing attention from the SOA, and some
base product sold without ROP. states are looking at such riders on a stand alone basis.

All limited pay policies have a How do you handle reserves on a limited pay policy? To the
degree of lapse support, but most business person it makes sense to accumulate the present value
are purely technical and will not of the reserve during the premium paying period. To do otherwise,
cause problems for the company. for instance, to accumulate the reserve pro rata over the life of the
For example, on a 7 pay 20 year policy, is to seriously front load the profits. If all the profit emerges
term policy the real profit will during the premium paying period, even small loses for the rest of
decline after the 7th year (you the duration can become a problem, particularly on a closed block.
have all the premium, and all you But here we meet our old argument about ROI. The reserve
have left is cost) but the reserve counts, and accumulating the reserve early will significantly
accumulated during the premium reduce ROI, even though there is no effect on the real profitability
paying period should cover the of the product. The actuary may then feel that accumulating the
subsequent mortality. If, however, reserve over the life of the policy is a more accurate presentation
you add an ROP rider to the for management, whom he feels may lack an in depth
policy, you have back loaded the understanding of the process. Adding an ROP rider to this process
pay out and probably converted to will exacerbate not only the ROI problem, but also, if the reserve
a lapse support that needs to be accumulation is deferred, create real problems for the company.
carefully handled.