5 February 1998

Review of "Report on Payment for Interest Rate Guarantees"

1. INTRODUCTION

The insurances that a life assurance company or a pension fund (hereinafter called companies) offers are typically covered by a benefit guarantee calculated on the basis of the assumptions relating to interest rates (technical rate of interest), risk and administration which are included in the company's technical basis. The guarantee applies to the whole period in which the insurance is in force.

The choice of a given technical rate of interest means that the company's investments of premiums/single premiums must on average over the guarantee period produce a yield equal to at least the technical rate of interest chosen in order that the company can meet the guarantees given without incurring any loss.

The company assumes a risk when it grants a guarantee to customers. Therefore, the technical rate of interest fixed must be fair and adequate, cf. section 31 of the Danish Insurance Business Act (IBA)¹ , like the assumptions relating to future mortality, disability, administrative costs, etc.

In recent years there has been a decline in the expectations of the companies as regards the future investment yield, due in part to the relatively low rates of interest and inflation in society. After 1 July 1994, as a result of the requirements of the third life assurance directive concerning prudential determination of the technical rate of interest, (the greater part of) the companies have had to accept new business at a lower technical rate of interest than the one applied so far. Today, therefore, many companies have written insurances with two different technical rates of interest. Usually, the companies have a portfolio of insurances on which they have promised a future yield of 4.5% (technical basis G 82 5%) and a portfolio of insurances on which they have promised a future yield of 2.5% (technical basis G 82 3%), but there are also insurances which include both technical rates of interest.

The assets covering commitments are owned by the life assurance company and are normally not distributed on the individual policy-holder but are treated as a total volume of assets whose yield is shared by everyone² . This means that the provision for the commitment vis-ŕ-vis the individual policy-holder carries interest at an average rate based on the yield on the company's total investments. Against this background, questions have been raised as to whether more detailed demands should be made on the companies as regards the policy-holders' payments for the various guarantees given.

In the autumn of 1996, the Danish Financial Supervisory Authority set up a committee with the object of evaluating the need for explicit payment for the interest rate guarantees given by the companies to the policy-holders. In that connection also the consumer protection element following from the Danish Financial Supervisory Authority's supervision of the fairness of the rules in the life assurance field should be included as some life policy-holders should not be unfairly favoured at the expense of others.

The committee included representatives from the Danish Financial Supervisory Authority, the Danish Insurance Association and the Danish Society of Actuaries and has submitted the "Report on payment for interest rate guarantees".

2. REPORT ON PAYMENT FOR INTEREST RATE GUARANTEES

The report shows that the calculation of the price of a given interest rate guarantee can be modelled in several different ways depending on the approach adopted. All the described models are based on an actuarial determination of the price of the interest rate guarantee, i.e. the price ensures that premiums and benefits balance on average.

The price could also be determined according to a financial method so that the interest rate risk is covered completely. One might compare it with a kind of hedging. This possibility arises to the extent the yield profile of the investments is adapted to or can be adapted to the expected disbursement pattern of the insurance. However, the committee has found it inappropriate to base the calculation of the interest rate guarantee price on a financial price determination because it is not found to be possible to cover completely all interest rate guarantees given in the existing market.

Thus, in practice, it is not possible to point to one correct payment model for interest rate guarantees, but there will be a number of models reflecting the underlying approaches. The models described cannot be regarded as an exhaustive list of the possibilities but can only be used as a catalogue of ideas for some fundamental methods of calculating the payment for interest rate guarantees.

However, the model calculations all show that particularly a continuing low rate of inflation must cause the companies to evaluate whether the various groups of customers are adequately ensured a fair treatment in the current situation where no distinction is made between groups of customers with different technical rates of interest.

A company's technical basis must be adequate at the time of writing the insurance. Thus, from a security point of view, it is not necessary to consider supplementary payment for interest rate guarantees given for insurances written on the existing basis for new business (2.5%). However, the principle of supervision of the fairness of the rules in the life assurance field makes it necessary to consider a form of payment from the policy-holders who have a higher guarantee so that they pay for the extra risk that they represent for the company compared with the policy-holders with the lower guarantee.

Incidentally, the model calculations lead to fairly uniform price differences between the price of interest rate guarantees of 2.5% and 4.5% respectively. With an inflation rate of 2% the models show a price difference of the order of 1.5 - 3% of the premiums. The payment for the interest rate guarantee can be calculated as a percentage of the premium or as a percentage of the company's technical life assurance provisions.

3. QUESTIONS FOR CONSIDERATION

The question of payment for an interest rate guarantee concerns the requirements laid down by law concerning the choice of an adequate and fair technical basis. Thus, according to the provisions of section 31 of the IBA, the individual companies must decide whether payment should be demanded explicitly from the individual policy-holder to cover the guarantee given with respect to the future yield, and the Danish Financial Supervisory Authority has power to intervene if the basis notified in that connection is not found to be adequate and fair.

As a company's technical basis must be adequate at the time of writing the insurance, there will be no need for collection of payment for an interest rate guarantee in a situation with one technical rate of interest. Already now the companies are making an implicit charge for interest rate guarantees through the solvency margin rules, in principle independently of the size of the technical rate of interest.

When there is more than one technical rate of interest, the degree to which they are adequate differs, and it will then be necessary to consider supplementary payment for interest rate guarantees from the groups of policy-holders who receive a higher guarantee than the others so that it is ensured that the requirements laid down by law concerning fair treatment of all groups of policy-holders are also met in the new situation with more than one technical rate of interest in the same company. This payment can, for example, be made through a bonus reduction. In that case, this solution must be applied in relation to insurances already written.

The investigations made by the committee have confirmed that there is a need for relatively stronger consolidation the higher the technical rate of interest applied is. This is due to the fact that there is a greater risk that the yield will be lower than the technical rate of interest. Further, the developed models have quantified the need for relatively stronger consolidation in those situations where the company has relatively large share investments which have a greater variation in the yield than bond investments.

To the extent an implicit payment is made for the difference in the interest rate guarantee in the form of a bonus reduction and/or different bonus equalisation provisions, it might be appropriate to divide these according to the various sub-portfolios.

The methods developed for the determination of the interest rate guarantee payment show how the size of the interest rate guarantee payment depends on the composition of the portfolio, inflation and interest rate levels and the current taxation of yields and on the assumptions chosen - also as regards the variation in the investment yield. Therefore, it will be necessary to monitor the size of the interest rate guarantee payment on a continuous basis.

Klaus Grünbaum, Director
Heidi Jensen, Deputy Financial Inspector

Notes:

1. Danish Ministry of Business and Industry's Consolidated Act No. 746 of 6 August 1996 on Insurance Business as amended by Act No. 475 of 10 June 1997.
2. The fact that pension savings from the period before 1983 are exempt from real interest rate tax is ignored here.