Cashflow Profiles and Reserves: Actuarial Terminology I – Calc with Dec 🧮 🤓

This post is especially intended for interested non-actuaries, and it’s simplified.

Feel free to send me feedback, suggestions, and to share!

Life insurance

In this post I aim to briefly illustrate some basic actuarial terminology for life insurance.

Some usual important features of life insurance business are:

Risk
Long durations and, often:
Recurring payments

Many actuarial things are relatable to other industries - especially other industries involving recurring payments (like SaaS or subscription businesses), and those that involve risk.

The simplest life insurance contracts include two main cashflows that I’ll focus on here; from the insurance company perspective:

Premiums are the main income and
Claims: paid out on death of the life insured, are the main outgo

I’ll be considering a 20-year term insurance contract, which pays out a fixed amount if the life insured dies during the 20-year term, and otherwise pays out nothing (no surrender value).

Claims

For this type of contract, we expect claims to be higher later: when policy holders are older and therefore have a higher risk of mortality.

Premiums

We expect premiums on the other hand stay relatively flat:

This premium pattern is reducing: not flat. It’s reducing because of ‘decrements’ reducing the number of customers expected to continue paying premiums.

Decrements are mainly due to cancellations here but also due to deaths.

In insurance we tend to refer to cancellations as ‘lapses’; in other industries the same thing is known as ‘churn’.

Lapse or churn risk is often a key risk for life insurance companies, as is mortality risk in a product such as this.

More about decrements: modelling and monitoring them, another time. Actuaries look at these very closely!

Premiums - Claims

Combining premiums and claims gives us the following:

This is a stacked bar chart where bars represent cashflows: premiums are positive, and claims are negative.

Circle symbols represent their sum, which indicates a profit profile for the contract.

symbols indicate profitable years: where premiums are higher than claims
symbols indicate loss-making years: where premiums are too low to cover claim payments

Notice that there are large expected losses in the later stages of the contract: occuring after some sustained profitability

This is a very common cashflow profile in life insurance contracts. And points to some reasons why trust is important when it comes to buying life insurance.

Reserves

It’s bad to expect to lose: especially if doing so means you can’t make payments you can be held accountable to - which puts you out of business.

Because of this (and because of regulation), insurance companies create reserves: they set aside money so they can pay for or cover future losses.

Here we set aside money in profitable years, that we can ‘release’ in later years to cover losses.

The new profit profile is much less wild (it’s much more smooth) - but notice in particular, expected losses are covered ✅

symbols: indicating large expected loses, are no more. 🦺

Prudence

Insurance companies accept risk as a routine, so that merely preparing to pay expected claims - as above, is bound to be disastrous in the ordinary course of time.

They must also be prepared for higher than expected claims: amongst other risks.

So, their reserve calculations will often add some level of prudence.

Insurance companies will consider a lot of things in their calculation and presentation of reserves: especially regulatory rules.

In the EU, Solvency II regulation talks about a 1-in-200-year-event calibration; but that’s a different blog post!

Now you can add a new reserve calculated as some proportion of all expected future claims:

Reserve calculations might be ‘notional’ and money set aside by the insurance company might get returned to the insurance company, but this still serves a purpose.

By adding prudence in reserve calculations, money is available to cover some worse-than-expected experience, until some associated risk passes. 🦺

In this post and others I’m using calculang: a language for calculations I develop that helps provide structure for calculations and numbers. To find out more about calculang, you can check calculang.dev.

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New Business Strain

Above we saw that reserves can (and usually do) result in capital being needed at outset: that is, capital being needed just to be able to make a sale and continue meeting regulatory requirements.

Insurance companies will therefore measure this “New Business Strain” and monitor their sales and sales strategies according to available capital.

There are lots of ways to manage capital requirements: for example reinsurance: where the insurance company insures some part of it’s risk with reinsurance companies. Good planning about capital utilization (including it’s release) is also important.

The profit profile I outlined above goes a long way to explain patterns in my [linked visuals] blog post.