Unit 8: Surplus management

1.1 Introduction to surplus/profit

As we know, Profit = revenue – expenditure
Because of the long-term nature of financial services contracts, the final profit from a
scheme or tranche of policies cannot be determined until all have gone off the books.

Waiting until this happens before the terms under which the next tranche of policies are
written can be determined is clearly impractical. In particular, if a company is selling long
term contracts on terms that are not profitable, it needs to realise this as early as possible,
not at the end of the life of the contract.

Surplus = value of assets – value of liabilities

Surpluses (or deficits) may appear and disappear as the contract’s experience unfolds. The
size of the surpluses also depend on the basis and methodology used to value the assets
and liabilities.

The surplus arising over any time period is the change in the surplus over the time period.
So, using the notation At for the value of assets at time t and Lt for the value of liabilities at
time t, the surplus arising from time t to time t+1 will be:
𝑆𝑢𝑟𝑝𝑙𝑢𝑠 𝑎𝑟𝑖𝑠𝑖𝑛𝑔 = (𝐴𝑡+1 − 𝐿𝑡+1 ) − (𝐴𝑡 − 𝐿𝑡 )
or equivalently:
(𝐴𝑡+1 − 𝐴𝑡 ) − (𝐿𝑡+1 − 𝐿𝑡 )

Surplus arising is equivalent to profit.

The choice of valuation basis will not affect the total amount of surplus arising over the life
of a contract, which will depend solely on the differences between the actual experience
and that assumed in pricing the contract. However, it will affect the timing of the emergence
of the surpluses during the life of the contract.

An analysis of surplus (or profit) is a breakdown of the surplus (or profit) arising over a year
into its constituent parts. A provider will want to analyse the change in any surplus arising
over a year or a longer period of time in order to:
• show the financial effect of divergences between the valuation assumptions and the
actual experience
• determine the assumptions that are the most financially significant
• show the financial effect of writing new business
• validate the calculations and assumptions used
• provide a check on the valuation data and process, if carried out independently
• identify non-recurring components of surplus, thus enabling appropriate decisions to be
made about the distribution of surplus
• reconcile the values for successive years
• provide management information
• provide data for use in executive remuneration schemes provide detailed information for
publication in the provider’s accounts
• demonstrate that the variance in the financial effect of the individual sources is a
complete description of the variance in the total financial effect
• give information on trends in the experience of the provider to feed back into the
actuarial control cycle.

Possible sources of such surplus / profit (deficit / loss) include:

• mortality
• morbidity
• claim frequency
• claim amounts
• withdrawal / lapses
• investment income and gains
• expenses
• commission
• salary growth
• inflation
• taxation
• premiums / contributions paid
• new business levels.

A change to valuation methods or assumptions may also lead to surplus (or deficit). The
impact of assumption changes depends on the extent to which assets and liabilities are
matched.
For example, management can try to:
• reduce the likelihood of claims through:
– good underwriting of new business
– good underwriting at the claim stage
– providing customer incentives not to claim: A general insurer can control claims
and expense costs by offering discounted premiums in future years to
policyholders who do not make claims. In other words, it can offer a ‘no claims
discount’.
• reduce the cost of claims through:
– cost-effective claims management procedures
– eg by periodically reviewing ongoing claims
– using reinsurance to limit the volatility of claims or to protect from the risk of
large claims
– reducing future benefit payments
– keeping guaranteed benefits to a minimum: A benefit scheme can control costs
by not guaranteeing regular benefit increases but only giving discretionary
increases as and when they can be afforded.
 – introducing / increasing excesses
• control expenses:
– periodically reviewing expenses
– keeping charges / premiums flexible: If a provider can change any expense
charge it makes to the customer within the product design then costs can be
passed on in this way.
– ensuring that claims expenses are commensurate with the claim size
• reduce the number of contracts that lapse or that do not renew at the renewal date
• follow an investment policy that increases investment returns (subject to an acceptable
level of risk)
• adopt an effective tax management policy.

1.2 Distribution of any surplus / profit arising

For with-profit life assurance business some or all of the distributable surplus is allocated to
policyholders in the form of bonuses. The structure of the bonus and the manner in which it
is paid is determined by the terms of the policies and the constitution of the company. The
constitution of the company may also determine the maximum proportion of the
distributed surplus that can be paid to shareholders. In some jurisdictions this is determined
by legislation. For example, a very common approach for proprietary companies in the UK is
for 90% of all with-profit surpluses (from whatever source) to go to policyholders and 10%
to shareholders. A mutual insurance company has no shareholders and thus all the
distributable surplus belongs to the policyholders.

For other corporate institutions, eg life insurers with only non-participating (ie unit-linked or
without-profit) policyholders, general insurers, banks, the surplus belongs entirely to the
shareholders, and the only decision the directors of the company have to make is the extent
to which it is retained in the business or distributed as dividends to shareholders.

For benefit schemes any surplus is usually retained within the scheme, and may be used to:
• enhance the benefits of members, or
• reduce future contributions of members and/or the employer.
Because it is usually difficult to remove benefit enhancements once awarded, changes in
contribution rate are normally the first choice. In some jurisdictions it is possible for surplus
to be repaid to the scheme sponsor, and in others it is not.

For a life insurance company the key factors that will affect the amount of surplus
distributed are:
• provision of capital
• margins for future adverse experience
• business objectives of the company
• policyholder expectations
• shareholder expectations
• other stakeholder (including staff) expectations.

For a benefit schemd, factors influencing the decision about the application of a surplus or
deficit are:
• legislation
• tax treatment
• scheme rules
• discretion of the sponsor or fund managers.
In the latter case, the following may also be taken into account:
• risk exposure of the various parties
• the source of the surplus
• industrial relations.
A decision also has to be made about the:
• speed of corrective action.
1.3 Monitoring of experience
Monitoring the experience is a fundamental part of the actuarial control cycle. The actual
experience of a provider should be monitored to check whether the method and assumptions
adopted for financing the benefits continue to be appropriate and, if not, what changes should
be made in order to achieve the desired level of profit. The experience will be monitored so as
to:
• update the methods and assumptions adopted so they reflect expected future
experience more closely
• monitor any trends in experience, particularly adverse trends, so as to take corrective
actions
• provide information to management and other key stakeholders.
The basic requirement is that there is a reasonable volume of stable, consistent data, from
which future experience and trends can be deduced. Consistent here means that, when
comparing the experience of one group with another, the data used as a basis for the
calculations for each group should be:
• in a similar form
• preferably extracted from the same source
• grouped according to the same criteria
• equal in terms of reliability.
The data ideally needs to be divided into sufficiently homogeneous risk groups, according to the
relevant risk factors.
However, this ideal must be balanced against the danger of creating data cells that have too
little data in them to be credible. For example, for benefit schemes with a small number of
members, it may not be appropriate to carry out any analysis or at least the results should be
recognised as being very crude.
This may also be true when events are infrequent and volatile. For example, a benefit scheme
with only young members may have many members but few deaths in service and so an
analysis of the mortality rate may lack credibility.
The analysis of data for actuarial work can be divided into the following:
 • Statistical factors: Statistical factors include mortality rates, morbidity rates (inception
and transition) and withdrawal rates. These are generally calculated as the number of
events divided by the number exposed to the risks. The results can then be compared
with the assumptions adopted to determine whether there is a significant difference
and also with other relevant standard tables to determine if they appear to be more
appropriate.
• Economic factors: Economic factors generally include interest rates, inflation (both
earnings and price inflation). They usually have the greatest impact on the result for a
company or scheme, but are also generally outside the management’s control.
The results of an analysis of experience should not be used blindly. Consideration should be
given to whether the period under investigation was typical and whether the experience is
likely to be representative of future experience. For example, the period under investigation
may have been affected by abnormal events or by significant random fluctuations – many
elements of experience are affected by economic cycles.
When considering whether the past experience is likely to be representative of future
experience,
the actuary should attempt to separate the effects of:
• trends – a trend is a long-term underlying increase or decrease over time
• cycles – a cycle causes higher or lower values with a frequency of several years
• random variation.
If it had not been possible to split the analysis into sufficiently homogeneous groups, it is
important to consider whether the individuals to whom the investigation related are relatively
homogeneous with the individuals whose benefits will be affected by future experience.
Subject to these considerations, the results of the analysis may be adopted as assumptions
when calculating values. However, depending upon the purpose of the assumptions, it may first
be appropriate to make an adjustment in these assumptions to allow for data and modelling
risk. This will allow for any uncertainty as to the validity of the results of the analysis.

In summary, Monitoring investigations typically involve the following stages:

 • the division of data into suitable groups that are homogeneous by risk – need to
consider:
– the volume of data in each cell (its credibility)
– the risk factors for the investigation (eg age, gender)
– changes that have occurred that will reduce the relevance of old data
• identification of any past trends, cycles and anomalies and random variation in the past
• data
• using the results to revise models and assumptions used – need to consider:
– the purpose, and hence the need for accuracy and margins for prudence
– allowance for future trends
– likely differences in future experience from past experience.

Thank you to your batch! It was great being around you and my experience of teaching you
has been very pleasant.
I hope I have added at least some value to your life and career (as actuaries or as any other
kind of professionals).