Report of Commission on Inflation and Insurance Page 25 applied to purchase paid-up additions to the face value in the same way. Unfortunately, additions to the face value financed by surplus generally fall far short of providing protection against inflation. Neither can indexed premiums finance indexed face values without using surplus appropriations as well. In fact, to operate on a completely sound financial basis, indexation of the face values and premiums must be supported by investments which fully maintain their real value in times of inflation. The consequences of the three approaches to financing indexation can be compared by examining the simplified formula for policy reserves in life insurance (for simplicity expenses and other considerations have been deleted): Policy reserve present value of face amount - present value of premiums. To take an example, suppose that for a particular policy: Following this example through, suppose that there was an inflation rate of 10 percent during the year. The effects of the three methods of financing the required 10 percent increase can now be examined. Financing by Premium Increases Alone. In this example, index-linkage requires a 10 percent increase in face amount. The present value of the Report of Commission on Inflation and Insurance Page 26 face amount is therefore also increased by 10 percent, that is, by $1,000. Under this method, no surplus will be used to finance the increase. Therefore, premiums must be raised to provide the additional $1,000 of present value. This requires an increase of 1000/4000 or 25 percent. In practice, premiums increase at a greater rate than the face value because the increases are purchased by the policyholder at an older age than when the policy was originally written. This effect will, in fact, worsen over the term of the policy as the reserve grows and the effect of advancing age becomes more pronounced. Increases Financed by Surplus Funds. Returning to the example, suppose that the funds supporting the policy amounted to $6,600, leaving a surplus of $600. If the premium were left fixed and the surplus of $600 were appropriated to provide an increased face amount, the face amount could be increased to the point where the new policy reserve was $6,600, or the total accumulated reserve fund. The value of the new face amount is therefore: Value of increased face amount = Total accumulated reserve fund + present value of premiums The face amount can therefore be increased by 600/10,000 or 6 percent without increasing the premiums. This falls well short of the required Report of Commission on Inflation and Insurance Page 27 10 percent increase, even though the surplus was about 10 percent of the fund. In other words, even if the real rate of return (i.e., the rate after inflation) is as high as the interest rate assumed in the reserve calculations, the resulting surplus will not provide increases to match inflation. Indexation of Both Face Amount and Premiums. Using the same example, suppose that both the face amount and premiums are increased by the inflation rate of 10 percent. = Present value of increased face amount = 1.1 x $10,000 $11,000 = $ 4,400 New policy reserve present value of increased face amount - present value of increased premiums = $11,000 - $4,400 = $ 6,600 In the example, the total accumulated reserve fund was $6,600, so that a combination of surplus funds plus indexed premiums is sufficient to finance the indexed face amount. The 10 percent surplus figure is no accident. In general, it would be necessary to earn surplus investment yield at the same rate as inflation to maintain an indexing scheme. In other words, investments must retain their real value and, in addition, provide the nominal rate assumed in the reserve calculations. In practice, several other points are important. First, surplus may result Report of Commission on Inflation and Insurance Page 28 from favorable mortality or expense savings as well as from investment yield. Mortality rates have been generally decreasing for many years, and this is therefore a realistic source of surplus. Expenses will, of course, increase with inflation, but, if the gross premium is indexed, the expense loading will increase proportionately. By using modern technology and cost-saving methods, it may be possible to hold increases in expenses to less than the increases in the inflation index being used for indexation. Second, gross premiums usually include a loading for initial expenses and commissions, which are paid in "old" currency at the outset. Any index-linked increase in gross premium will therefore contain a redundant increase in this loading, which can be used to offset the cost of indexation. Third, it may be possible to calculate premiums on an artificially low interest rate to ensure a strong emergence of surplus in the future. For example, the premiums might be calculated on a 4 percent interest basis and, in addition, allow for 10 percent annual increases in both premiums and face amount. This would mean that an effective interest rate of minus 6 percent would be used. This is an extreme example; a less severe loading might well be adequate. It should be noted, however, that the inflation problem is not entirely solved by this approach unless the investments are fully hedged against inflation. Otherwise surplus premiums must be accumulated to help finance future increases, so that to a certain extent old money will still be used to meet inflated benefits. Nevertheless, with good investment yields, and Report of Commission on Inflation and Insurance Page 29 possibly moderate premium loadings, indexing may still be an attractive compromise to both company and policyholder. Finally, there is the possibility of partial index-linking. Under this scheme, premiums and face amounts could be increased by, say, 50 percent of the current inflation rate to provide partial protection against inflation. The level of surplus need not be so high in this case. Indexed permanent policies are currently being issued in Finland. The system can be described as a "conditional and partial" indexing system. Until the latter part of the 1960's, companies in Finland issued policies with a guarantee of 50 percent index-linkage, and voluntarily paid through profit-sharing up to 100 percent during the first policy years. This indexlinking was aided by the opportunity to invest in indexed securities. However, index loans have since been prohibited by law, and indexation is no longer guaranteed. Despite these changes, companies still attempt to maintain 100 percent indexing for newer policies and 50 percent indexed coverage for older policies. Another country where indexed permanent life policies have a long tradition is Israel. Indexation in Israel began in 1958 based on the fact that insurers have the opportunity of investing the policy reserves in indexed state bonds. Life insurers in Chile have also employed such indexation where indexed securities are available. |