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Published by: Secretary General, Insurance Institute of India, G- Block, Plot C-46,
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 PREFACE
Life insura nce is very di fferent fro m ot her fo rms of insu ranc e cov er,
like f ire i ns uranc e or m ot or insurance. While the latter pro vi des
indemni ty ag ainst actual l osses suffered in t he wake o f specified
perils, lif e insurance contract s ar e know n as co ntract s o f as suran ce.
T hey give an ass ured sum on the ha pp eni ng of a sp eci fied event like
deat h or dis abili ty. Fu rther, unlike g eneral ins urance cont ract s t hat
are ty picall y s ho rt term, l ife insu ra nce is lo ng t erm in cha racter.
T he abo ve t wo dis ti nctions als o mean tha t li fe insuran ce p rodu cts,
by t hei r very nat ure and struct ure, invol ve a combinat ion of
prot ect ion [the t erm el ement ] and s avi ng s [ cash value el em en t]. I n
th e co urse of t heir evolu tio n, life insurance pro ducts wo rld o ver,
hav e b een sol d as protection cum i nvestment vehicles, maki ng t hem
int o financial pro ducts that compete with o ther vehi cles of savings
and i nvestment in the financi al ma rk etplace.

T hi s boo k s eeks to pres ent t he va rious nuan ces of life insura nce as
a financial pro duct t hat plays a definite role in the financi al market.
Beginning with the natu re a nd charact eristics of p ro ducts in
ge neral, it pro c ee ds to out line t he fundam ental pri nciples and
co ncep ts that se rve as t he founda tio ns of l ife insu rance. It the n
makes a deta il ed revi ew of c ert ain co re questions and issues in
marketing like wh y people buy products in g ene ral and the issues
th at aris e w hen co ns idering t he purchas e of lif e insurance and other
fin anci al pro ducts . This is followed by a detailed ex pl o ration of the
personal fi na ncial plann ing process an d t he rol e of lif e insurance i n
an indi vidual ’s financial po rt folio. This book also attempts to mak e
a co mpa riso n b etween v ario us kinds of life ins urance prod ucts an d
ot her financial p ro duc ts , incl udi ng t hei r invest men t a nd financial
manag eme nt im pl icat ions. T he l ast t wo chapters deal with th e
pro cess of pro duct developmen t in L ife I ns urance and also a tour of
on e s pecific form of life ins urance, namel y Takafu l I nsurance, whi ch
has bee n po pula r i n Isla mi c count ries.

T hi s wo rk is inte nded as a t ext bo ok for the Fell owship level of the

Insurance I nsti tute of Indi a. It is hoped t hat th e co nte nts wo ul d be
releva nt and enable t he st ud ents to g et a co mp rehensive
unders tanding of the various di mensions of lif e insura nce pro d u cts
available t od ay.

iii
 CONTENTS

CHAPTER PAGE
TITLE
NO. NO.
1 Pro du cts – An Overview 1

T he U nde rlying Concept s In Life

2 16
Insurance Products

Actu arial a nd t echnica l asp ect s o f

3 38
Life Insura nce Products

4 Why people bu y 68

5 Fina ncial Pl anning And Life I nsurance 107

6 Em erging C onting encies And Pro ducts 147

Life Insura nce Vs . Other Fi na nci al

7 184
Pro du cts

8 Life Insura nce Product D evelopment 209

9 Tak aful (I sl amic I nsuran ce) 224

iv
 CHAPTER 1
PRODUCTS – AN OVERVIEW
Chapter Introduction:
The purpose of this chapter is to provide an overview of how to look at the
concept of product as it has evolved over the years. We shall also present a bird’s
eye view of some of the categories of life insurance. Every life insurance company
needs to have a right set of products in its product line or portfolio. Every person
engaged in marketing these products must have a clear idea about what they are
and what they can do.

Learning Outcomes: at the end of this chapter you will

A. Defining ‘Product’ and its constituents

B. What do life insurance products do at the core?

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 1
A. Defining ‘Product’ and its constituents
Defining Products
Life insurers, like other business entities, have to adapt to the needs and
challenges of a competitive and constantly changing market environment. One
of the most critical factors that determines how business enterprises grow and
thrive is their capacity to create value for customers, in a way that makes them
different and unique in the market.
Take for instance, a brand like Parachute Hair oil [MARICOs] or Asian Paints. Or
you may look at the Apple I-Phone or Google’s Search Engine or Nike’s shoes.
There are many such brands, from India and elsewhere, which caught the public
imagination and became household names in the Indian and global markets. What
was it that made these companies and their products stand out? The answer lies
in the fact that each of them added value to customers in a way that made them
different from other players in the market.
The above cases could give us some ideas with regard to how to look at products.
Today, when many leading companies speak about their product offerings, what
they mean is a ‘Product value proposition’ which describes the sum total of
value that is added to a customer.
Product as a Commodity
To begin with, it is necessary to distinguish between ‘product’ as used in
economics, and as viewed from a marketing perspective. When we use the term
in economics, it is as an Object that is bought and sold in the marketplace, in the
form of a good or services. Generally speaking, products have been treated as
synonymous with commodities – A commodity is a product that is
undifferentiated. There is only one version of it available in the market. This
means that each unit of a commodity is exactly like the other.
The term has a similar meaning in popular parlance – where it is commonly used
to refer to a good or a service in the market-place, which is the end result of a
process. The meaning of the word ‘product’ can be brought out more lucidly in
the context of the term -‘reproduce’ which means ‘to bring forth’ or ‘to create’.
In other words, a product is the output or result of certain labour or efforts.
Thus, for example, salt, sugar, motor cars and all other things would be called as
products. In economics, one may use the generic term ‘toothpaste’ or ‘soap’,
without being concerned about the distinctive features of different types of
toothpastes or soaps.
This characterisation of products as commodities corresponds to the early period
of the Industrial revolution which saw the birth of mass production of
commodities to satisfy core human needs. The appeal of a commodity lies solely
in its functionality [what it does], from which its utility in satisfying a human
want is derived. An example is Henry Ford’s T Model car, about which he quipped,
‘any car is fine so long as it is black’. The thrust of industries and companies in
this early period of industrialisation was to produce and make available various

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 2
kinds of goods and services, to meet a range of hitherto unmet human needs, at
an affordable price.
Product as a Bundle of Features
The decades after the Second World War witnessed a new era when commodities
metamorphosed into products. The difference between a product and a
commodity is that the latter consists of a bundle of attributes [or features] which
help to differentiate one kind of product offering from another. For instance,
the simple T Model [which one may call as a Vanilla Product] gave way to
automobiles of various sizes, shapes, colours, and fuel consumption capacities. A
number of automobile companies like General Motors and Honda entered the
scene with their differentiated offerings. This shift from commodity to product
features was a result of competition from multiple players vying with one another
for dominance and increased market share through designing and offering
products, whose appeal now lay in their differentiating features. On the other
hand, customers who were now offered various kinds of choices, became more
aware and discerning about what they chose to buy.
The Differentiation of Products on the basis of their underlying features led to
the Marketing Perspective. As distinct from the economic view, the Marketing
approach defines a product as a Bundle of Features. The difference between a
commodity and a product, as used in the marketing sense, is that a product can
be differentiated. A commodity cannot. When there are hardly any features to
differentiate between one brand of an industry’s product and another, the brands
become clones of one another. The products then approximate towards becoming
commodities.
A number of marketing gurus, like Theodore Levitt, pointed to the dangers of
adopting a “Product Concept” – a one sided emphasis on product features, with
lesser emphasis being given to the value they actually added to customers.
Theodore Levitt termed this approach as “Marketing Myopia”, while another great
writer, Philip Kotler pointed out that such an approach could lead to what was
termed as the “better mousetrap fallacy” – the belief that a better mousetrap
would lead people to beat a path to its door. The marketing perspective thus
viewed the product not as an end in itself but as a means to satisfy other ends.
Theodore Levitt summed it beautifully when he stated, People don't want to buy
a quarter-inch drill. They want a quarter-inch hole!”
In this sense products were seen as problem solving tools. A Product served as a
need or wants satisfier. Products could be tangible or intangible. A tangible
product is a physical object that can be directly perceived, having physical
features that can be directly experienced by touch, examples being a building, a
vehicle, a gadget, or clothing. An intangible product is a product that can only be
perceived indirectly. Intangible products may include a service, a function, an
idea or a methodology or some data and information that a seller offers to a buyer
in exchange of a value. Examples include an insurance policy or hospitality etc.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 3
Product as Gateway to an Experience
The last few decades have witnessed dramatic changes in the way businesses and
marketers viewed their product offerings. The digital revolution and other
technological innovations, coupled with globalisation and intense competition
among companies and products led to a new era in which the customer became
the centre of all concern. As companies jostled with one another to build a
footprint in customer mind space, many of them shifted their focus from branding
around a product towards building a brand [establishing and emphasising their
uniqueness] around the connect they built with customers. Concepts that
emerged in the nineties, like ‘a million markets of one,’ ‘Customer Intimacy’ as
a marketing discipline, and ‘Customer Lifetime Value’ – reflected this shift. A
strong impetus towards this direction came from the realisation that it would be
difficult to win and retain customer loyalty merely by satisfying their needs
through product functionality [what the product does]. The total experience that
they aspired for, went much beyond this. This would include, for instance, the
feelings and emotions that were aroused as a result of the services offered by the
company and further, by the way the company related with and engaged with the
customer, at the level of the head as well as the heart.

The Dimension of Meaning

More recently, it has been realised that the products which people buy reflect
who they are or who they want to be. Most individuals have a sense of self-
identity, which is given by one’s image of oneself as generally experienced in
relation to both oneself and others - in spheres like the family, workplace, and
community. Individuals have notions and beliefs about who they should be [their
ideal sense of self] and often find it to be different from who they really are
[their real selves]. Purchase and Possession of products helps to fill this gap.
During the industrial era, this self-identity [sense of being] was equated with
‘having more’ things. It led to the penchant for opulent living and focus on
accumulation of wealth, status and power. The consumerist culture that
dominated many societies across the world was based on a premise that happiness
and fulfilment were derived from the pursuit of pleasure which came from the
acquisition and possession of ‘all kinds of material objects.’ However, a strong
counter current is also gaining ascendance. More and more people, in India and
elsewhere in the world, have come to realize the hazards of an untrammelled
pursuit of the above. As a result of the Information and Communication evolution,
individuals have been also exposed to many other dimensions that go beyond
pleasure and ‘acquisition.’ More and more, they are concerned with who they
are and what they believe in rather than what they have. Concerns about Quality
of life issues –like Freedom and greater control over one’s life and relationships;
gender equality and diversity; concern about physical and mental health;
harmonization of material and spiritual aspects of being; search for the ultimate
meaning and purpose of life – have come to the fore.
This has led to a realisation among marketers that their brands need to not only
define their functional goals [what the brand would specifically do] but a higher

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 4
purpose, reflecting a set of social, emotional and spiritual values that would flow
from the brand. Philip Kotler expressed it succinctly when he suggested that
brands in future would need to go beyond [product and service] differentiation
and identity - they must deliver what he termed as ‘brand beneficence’ - how
the brand can serve the [whole] person and society. In other words, products
need to target not only the minds of customers, but also their hearts and spirit
and contribute to total wellbeing.
To conclude, products are commercially distributed goods and services arising as
the result of a process [manufacturing or other operations] and are consumed.
Contemporary marketing perspectives look at Products as Customer Value
Propositions that companies design and deliver to customers with a view to gain
competitive advantage and higher share of the customer wallet. A holistic
approach to such value propositions would contain three dimensions:
Product Functionality: the attributes which define the essential functions of the
product – what it does and how. Functionality would differ from one product
category to another. For instance, in the case of a motor car, the functionality
attributes may be speed and pick up; mileage, cost of vehicle etc. For a
toothpaste or travel in an airline, the attributes would be different.
The Experience it creates for the customer: such experiences are feelings and
emotions that are generated through its purchase and consumption – they may
arise partly from the functional attributes, but also are a result of the services
and support systems that the company provides to the customer. In recent years,
it has been more and more linked to the way in which the company connects with
and engages its customers.
The sense of Meaning and self-identity it creates: here the focus is on certain
values espoused by the company and reflected in its product offerings, which
resonate with values and beliefs that customers cherish. Examples are ‘Green
Products,’ associated with building a sustainable environment, or value
propositions that promote health and wellness
In marketing, one is concerned with the bundle of attributes embodied in the
product which enables it to meet the requirements/ aspirations of a particular
market or segment and thus yields enough profit to justify its continued
existence.
On the basis of its attributes or features [including functionality, creation of an
experience and how it contributes to meaning] one may define any product at
three levels :
Level 1: The Core Product
It consists of a set of core features that are necessary in order for the product to
qualify being in the market. It is a sort of minimum stake that one needs to have
in order to enter the game.
The core product is given by two aspects – the end purposes which customers
actually seek to achieve when buying the product and the minimum features they
look for in order to meet these end purposes.
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 5
For instance: when buying a television set, a customer would look for a set that
works, that has a minimum picture quality and sound...

Level 2: The Expected Product

It represents the set of features that customers would expect a product to have
when considering it in competition with other products.
For instance: when deciding on which hotel to dine, a customer may choose
between hotels that have a certain acceptable level of service, food quality,
ambience etc. Hotels that do not conform to these expectations would not be
considered at all, even though they may possess the core features that a hotel
should have.
Level 3: The Augmented Product
The third level of the product is the augmented product: It consists of attributes
or features that are not present in other products and are not normally expected.
It is these unexpected offerings that actually delight the customer and contribute
to make the ‘Wow’ experience. One of the key concerns of any marketer is to
discover and deliver these augmentation features/benefits that differentiate the
product from all others in the marketplace and make it a winner.
The three levels can be illustrated below for a highly competitive and less
competitive market situation

In the current course, our focus would be largely on the functional attributes of
Life Insurance Products, which correspond to the contractual features of the
products that life insurers design and distribute in the market. Life insurers,
Insurance intermediaries and other players in the life insurance market may also
develop and usher in other features to enhance the attractiveness and appeal of
their value offerings, but they are not the focus of the current course.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 6
B. What do life insurance products do at the core?
We live in an environment in which there are multiple events, like fires, floods,
earthquakes and thefts that can result in serious loss consequences. Death and
disease are two events that can directly impact on human life. We are uncertain
about these events, in the sense that we cannot say for sure whether these would
occur or not and/or when they would occur. However, we humans seek to predict
the probability of their occurrence; to master or at least understand these ‘risk
events’, so that they can control or be prepared for them. This instinct and the
desire of creating security against risk must be one of the prime reasons behind
the creation of the concept of insurance.
Policies of insurance are products that are offered for sale by the insurance
company, which creates the contract and offers a promise to indemnify and / or
mollify should such an event occur. In a General insurance policy, the loss of a
property (the extent and timing of which is uncertain) is sought to be indemnified
for a consideration paid by the policy-buyer. General Insurance policies are called
indemnity contracts because they usually compensate the policy holder for the
exact value of the loss which is suffered. This is easier in case of property losses
since measurement of the loss, post-event, is possible. This is difficult in the case
of life insurance, as one cannot measure the loss of value of a life like one
measures the value of a house or a car. Life insurance policies have hence been
termed as Policies of Assurance’, in which the amount to be paid in the event of
loss by death is fixed at the time of writing the contract and is assured.
Life insurance products offer protection against the loss of economic value of an
individual’s productive abilities, which is available to his dependents or to the
self. The very word ‘insurance’ in ‘life insurance’ signifies that we need to
protect our loved ones and self against financial loss upon death or permanent
disability.
There are other functions such as savings and investment, but death or dread
disease coverage is the most common reason for taking out life insurance. This
feature of insurance cover arises as a result of the ‘Immediate Estate’ which gets
created, once the life assured pays the first premium. For instance, by paying a
premium amount of say Rs.400, an individual may be able to create a potential
estate of Rs.100000, which becomes available in the event of occurrence of an
event like death or disability or a dread disease. This immediate estate can
replace or compensate the loved ones or the self, should the income generating
ability of the insured person be damaged or destroyed during the period of the
contract.
So, a life insurance policy, at its core, provides peace of mind and protection
to the near and dear ones of the individual in case something unfortunate
happens to him or her.
Since the advent of private life insurance companies in the Indian market,
following the opening up of the sector, for participation by foreign companies, in
year 2000, the numbers of policies, of agents and of distribution channels has
rapidly risen multifold. A variety of standard and unique products have been
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 7
introduced in the market during the last two decades. Many people have begun
to realize the importance and benefits of having a properly purchased life
insurance policy.
The cost [or premium] of life insurance is based on our health, age, gender, and
type of policy that we opt for. In this book we will discuss different life insurance
products, their advent and evolution, issues in their design, their relevance and
some ideas about choosing the right life insurance product that is suitable to the
financial profile or life-stage situation of an earning individual.
Life insurance products – a preliminary idea
In marketing parlance the term ‘product’ has been defined in terms of its
attributes and the benefits that flow from its possession and use. As we have
seen, current approaches to marketing however hold that what is important is
not the product per se, but value, as perceived by the customer. Every product
may thus be described as a value proposition. The benefits and attributes
embodied in it constitute the building blocks of such a proposition. As a
proposition, its value would depend on how it is perceived as a solution – which
is given by a set of customer needs or wants or aspirations. Does it provide the
right solution or “Is it effective?” What does it cost or “Is it efficient?”
In this work we shall approach each life insurance product as a value proposition.
Each product represents a particular combination of various attributes like yield,
risk, liquidity and flexibility, which are forged by information processing activities
like actuarial pricing and fund management. We shall also see how each of the
products add value to a portfolio through providing cover against a specific life
contingent risk – the protection role; and also serving as a vehicle for wealth
accumulation and investment.
Basically, there have been three broad categories of life insurance products:
Term Insurance
Permanent life Insurance plans like Whole Life
Endowment Assurance plans.
We can also add Pension and Immediate Annuity products in the list, though in
the case of these products, members of the pool who die early pay for those who
live longer –the exact opposite of what happens in Term or Endowment assurance
plans. In life insurance products those who live longer contribute to those who
die prematurely. .
All insurance products offer their owner some protection from a variety of risks
which he anticipates. Insurance pools the risk of uncertain future events. In
assurance models -typical of life insurance, the events typically are death or
unduly long old age, either of which would definitely happen and the risk being
pooled is the timing of their occurrence.
The product being sold, at least at present, has only intangible attributes, which
are in the nature of a promise to pay in future, on the likelihood of a claim
occurring. The product is often viewed as a ‘grudge’ purchase and is definitely
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 8
not a ‘want’. Its fundamental value lies in mollifying the impact of loss on
occurrence of the insured event. This is achieved through creating a fund that is
made from small individual contributions – in the form of premiums - made by
various individuals who have purchased the policies. Its immediate value is
assumed to be the peace of mind it offers to the purchaser.
Life Insurance industry has seen enormous innovations in product offerings over
the last two decades. The journey began with death benefit products, but over
the period, multiple living benefits like endowment, disability benefits, dread
disease cover and so on kept getting added to it.
Similarly from a ‘participating in profit’ traditional product, the innovations
created ‘market linked’ policies where the insured was invited to participate in
choosing and managing his investment assets. Another dimension was added,
where life insurance products evolved from being a fixed bundle (of defined
benefits) to highly flexible unbundled products, wherein different benefits as well
as cost components could be varied by the policy holder as per changing needs,
affordability and life-stages.
Within Endowment Assurance products which have both savings and investment
components, we have
Traditional Products &
Market Linked Products
Within Term Insurance we have mortgage redemption plans or monthly income
replacement plans or basic HLV covers. In Endowment Assurance or even Market
Linked products (which have dominant savings element) we have variants like
Money Back plans, Child Education plans or other life-stage covering plans which
are mostly catered to on chosen maturity dates.
Term Insurance plans
Term insurance is only valid over a certain time period. A term life insurance
fulfils the main and basic idea behind life insurance, that is, if the life insured
dies prematurely there will be a sum of money available to take care of his/her
family. This lump sum money represents the insured’s human life value for his
loved ones –either chosen arbitrarily by self or calculated scientifically.
When taken as mortgage redemption to cover loans, the cover amount of the
Term Insurance policy reduces along with reduction in the outstanding loan
amount due to repayments during the loan duration.
A term insurance policy also comes as an Income replacement plan under which,
in the event of an unfortunate death during the term of the policy, instead of
paying a lump-sum amount to the dependents, a series of monthly, quarterly or
similar periodical pay outs are provided to the dependent beneficiaries, for a pre-
defined duration.
Disability Protection riders
Normally a term insurance policy covers only death, but when it is purchased with
a disability protection rider on the main policy and if someone were to suffer such
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 9
a catastrophe during the period of term insurance, the insurance company will
provide a payout to the beneficiaries/insured person. If the insured dies after the
term ends, there are no benefits available as the deal is over as soon as the term
expires.
Term insurance can be purchased typically for 5 to 30 years depending upon one’s
age at entry. The premiums are generally charged at a fixed annual rate for the
whole duration of term insurance. Some plans have an option to renew at the end
of the term duration; however, in these products the premium will be
recalculated based on one’s age and health at that stage. The Unique Selling
Proposition [USP] of Term Assurance is its low price, enabling one to buy relatively
large amounts of life insurance on a limited budget. It thus makes a good plan
for the main income earner, who wishes to protect his/her loved ones from
financial insecurity in case of premature death, and who has a limited budget for
making insurance premium payments.
For instance: a life insurance prospect wishes to have a cover of Rs.25 Lakhs,
which is about eight times his annual income of Rs.3 lakhs. Consider his choice
between an Endowment policy wherein the premium is say, about Rs.40 per
thousand and a Term Insurance plan where the premium is about Rs.5 per
thousand. If he buys the Endowment plan, his premium would be Rs.100000,
which is one third of his annual income. If he buys Term Insurance, the premium
would be around Rs.12500. Which would you recommend?

Endowment Life Insurance

This type of life insurance policy combines the features of a Term Life Insurance
and those of a long-term savings account. An Endowment Insurance plan specifies
a maturity date, provides stable returns and grows in value over time for the
premiums paid. In addition, in the event of the death of the insured party, during
the period of the policy, the agreed sum assured is paid out to the beneficiaries.
The effective interest rates are normally more generous than the fixed deposit
rates one gets from banks because of longer duration of the deposit and softer
tax treatment.
This kind of life insurance is a form of savings for whatever purpose one has in
mind, be it buying property or paying for one’s children’s college education. If
the insured person dies or becomes permanently disabled before the maturity
date, the beneficiaries will receive the sum assured. Premiums for endowment
policies are normally higher than for Term Insurance or Whole Life insurance and
are also available as With Profit plans, which is the most popular type of
Endowment life insurance plans. This also means that a share of the company’s
profits (in India it has been as high as 95% of the surplus in traditional endowment
products) is added to the policy annually.
A Without Profits plan means that only the basic sum insured is available on
maturity or death. When someone is planning to save money for a specific period
and for a specific purpose such as kid’s educational fund or retirement fund and
wants peace of mind and the assurance that the required money would be
available, regardless of whether or not one will be able to live to the end of the
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 10
chosen number of years, he or she may find Endowment Insurance a suitable
product.
Whole Life Insurance
Whole life insurance offers to pay the agreed upon death benefit when the insured
dies, no matter whenever the death might occur. There is no fixed term for cover
of death. The premiums can be paid throughout one’s life or for a specified
limited period which is less than one’s lifetime. Since a cash value accrues and
accumulates in this policy the premiums are significantly higher than a term cover
policy. After the insurance company takes the amount of money it needs from
the premium, to meet the cost of term insurance, the balance money is invested
on behalf of the policy holder. This is called cash-value. One can withdraw cash
in the form of a policy loan should he require emergency funds, or he can redeem
by surrendering the policy for its cash value.
In case of outstanding loans the amount gets deducted from the payout that is
made to the designated beneficiaries upon death.
A whole life policy may be a good plan for an individual, who is the main income
earner for his/ her loved ones and wishes to protect them loved ones from any
financial insecurity whenever he or she dies; and further, he/she wishes to avail
of an option to use the cash value of the whole life insurance policy for retirement
needs, if required.
We can thus see that there are three specific kind of functional benefits that can
be provided by a whole life policy:
Like other temporary term insurance policies, it can provide protection to one’s
loved ones in the event of one’s premature and untimely demise in the early years
of one’s life. The immense power of the ‘Immediate Estate feature’ comes into
full play in this situation.
In the event of death in later years, the proceeds from the policy could help to
preserve the wealth that has been generated by the policy holder during his/ her
productive years, from being eroded on account of terminal expenses arising
when he/she dies – for instance, the costs of health care in the case of a dread
terminal illness, or settlement of liabilities.
It can also help meet the requirements of income during one’s post retirement
period – such income coming from the cash value that has accrued in the policy
during its term.
There is of course the condition that the individual must be able to afford the
higher premiums of a whole life insurance policy on a consistent and long-term
basis
Universal Life Insurance
This plan provides flexibility in the death benefits and the premium payments.
The main feature of a universal life insurance policy is that after certain money
has accumulated in the cash value account, one will also have the option of
reducing the premium payments as long as there is enough money in the cash
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 11
value account to cover the costs. This becomes a very useful feature when one’s
economic situation has suddenly deteriorated.
The death benefit may no longer be available if the cash value or premium
payments are not enough to cover the cost of insurance. Sometimes there can be
guarantees wherein, provided certain premium payments are made for a given
period, the policy will remain in force even if the cash value drops to zero. One
can borrow or withdraw money and the policies normally guarantee a minimum
interest rate on your returns.
A universal life insurance policy is a good choice if someone is looking for a whole
life insurance policy but wants the flexibility in premium payments to cope with
any sudden changes in his/her financial situation.
Investment-Linked Life Insurance
This plan offers life insurance protection as well as investment opportunity to the
policy owner. When one takes out such a policy, he is given a choice of funds to
invest in. As long as the premiums are paid, one can also switch funds while the
policy is active.
The benefits of an investment-linked life insurance plan are directly linked to the
performance of the funds that are chosen by customers in accordance with their
risk preference. Essentially, it’s a Whole Life insurance policy with some variants
also allowing for fixed duration like traditional endowment plans that allows one
to invest the cash value of the policy in one of the investment funds. Because of
the variety of funds available, the value of the insurance policy depends on the
performance of the funds. If the insured person dies or is permanently disabled
his loved ones or beneficiaries are paid the sum assured. The protection aspect
of this policy remains firmly in place.
An investment-linked insurance policy can be either single-premium, in which
case the premium is paid in one lump sum, or it may be a regular-premium, which
involve on-going periodical premium payments. The insurer’s fund managers
gather the premiums of Investment-linked plans of all policy-holders and invest
them in various asset portfolios. Investment-linked life insurance policies are a
better fit for people who believe they can generate better returns on the cash
value accounts, by investing in the available funds, than the interest rate offered
by the insurance companies.
So far, we discussed individual life insurance products. There is also Group
Insurance products which provide similar benefits standardized across all
members of a Group, at much lower price points by passing on the benefit of
lower per member service cost of a group policy to the insured group member.
Groups are a collectivity of similarly exposed persons –it can be a formal
employer-employee type group; or it also can be affinity groups of professionals,
borrowers, club, workers or such informal group members and so on. Mostly the
plans for groups are ‘One Year Renewable Group Term Assurances’ or ‘Annuity
Funds’ or ‘Group Savings Linked Insurance’ or ‘Employee Deposit Linked
Insurance’ products.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 12
Chapter Summary
This chapter introduces the concept of product as it has evolved in marketing
literature and also offers a preliminary glimpse of life insurance product which is
seen as an object or thing that is produced for sale – it is seen largely as a
commodity. In marketing, products are seen as bundles of attributes. The
concept has been expanded beyond functional features [what the product does]
and includes various dimensions – functionality; as a doorway to an experience;
and the dimension of meaning. Products also have different levels – like the core,
the expected and the augmented products. The challenge for providers of goods
and services is to go beyond the core and even beyond the expected levels and
to design and deliver augmentation attributes that can exceed the customers’
expectations, leading to customer delight and loyal customers.
The concept of product, as it is understood in marketing, is quite different from
its popular usage. In economics and other popular parlance, a product is
commonly used to refer to a good or a service in the market-place, which is the
end result of a process
Life insurance industry has made enormous strides in the area of product and
service offerings and significantly contributed in making human lives, the
community and the society much better. Every life insurance company needs to
have a right set of products in its product line or portfolio. Every person engaged
in marketing these products must have a clear idea about what they are and what
they can do.
Life insurance policy, at its core, provides peace of mind and protection to the
near and dear ones of the individual in case something unfortunate happens to
him.
In further chapters, we will be discussing the contribution of Life Insurance to
life-stage planning, and in pursuing this aspiration, the evolutionary journey that
Life Insurance products had gone through so far, emerging as fairly differentiated
from regular financial products.
Life Insurance industry has seen enormous innovations in product offerings over
the last two centuries. The journey had begun with death benefit products but
over the period, multiple living benefits like endowment, disability benefits,
dread disease cover and so on kept getting added to it.
Important Concepts Covered:
 Differentiation between Economic & Marketing Perspective of Product
 Dimensions of the concept of product
 3 levels of a Product on basis of its attributes
 Life Insurance Product at its core level
 Types of Life Insurance Plans

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 13
Self-Examinat ion Q ues tions
Question 1
On the basis of its attributes one may define ______levels of any product
A. Two
B. Three
C. Four
D. Five
E. None of the above

Question 2
Types of products discussed in the chapter are
A. Term
B. Endowment
C. Whole Life
D. Unit Linked
E. All of the above

Question 3
Which of the following is not a Tangible product
(1) Building (2) Vehicle (3) Gadget (4) Insurance policy (5) Hospitality
A. Only 1
B. Only 2
C. 2&3
D. 3&4
E. 4&5

Question 4
The level of product that consists of attributes those are not present in other
products which are not normally expected and creates a “wow” effect to
customer.
A. Core
B. Tangible
C. Expected
D. Augmented
E. None of the above

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 14
Question 5
Investment-linked life insurance policies are a better fit for people
A. Who need stable fixed income
B. Who are not very active investor to market securities
C. Who are very conservative
D. Who invest in debt instruments
E. Who believe they can generate better returns by investing in the available
funds, than the interest rate offered by the insurance companies.

Answer s to Self -Examina tio n Questi ons:

Answer to SEQ 1
T he co rrect opti on B.
Answer to SEQ 2
T he co rrect opti on E.
Answer to SEQ 3
T he co rrect opti on E.
Answer to SEQ 4
T he co rrect opti on D.
Answer to SEQ 5
T he co rrect opti on E.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 15
 CHAPTER 2
THE UNDERLYING CONCEPTS IN LIFE INSURANCE
PRODUCTS
C hap ter I nt rod uction:

In this chapter you will be introduced to certain core concepts and principles that
help to define financial products and to also distinguish between various types of
financial products in the marketplace. The chapter further seeks to delve into
life insurance products and distinguish these from other financial products
available in the marketplace. Our objective in the present chapter is to critically
examine certain underlying concepts which go into the creation and
conceptualization of financial and life insurance products

Learning Outcomes: at the end of this chapter you will learn

A. What is a Financial Product and Financial Institution?

B. How are Financial Products distinguished from one another?
C. How is the Pooling Principle applied in Life Insurance ?
D. What is the process of Exchange of Values and how does it occur in
Life insurance?
E. What are the standard approaches and concepts for determining
how much life insurance one needs?
F. What are the implications of Life Insurance as a long term
contract?
G. What has been the Principal source of Appeal of Life Insurance?

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 16
A. What is a Financial Product and Financial Institution?
To finance means in effect to transfer purchasing power through creation of a
debt. Financial products are the means through which such transfer gets
affected, from one economic unit to another. The units may be households, firms
or government. The borrower [typically an institution] creates a claim against
itself, which it exchanges for liquidity (ready purchasing power) now. A fixed
deposit for instance represents a claim on a bank while a corporate bond
represents a claim on the corporation issuing it and a treasury bill represents a
claim on the government.
This process of transfer is critical to modern society. Our societies have millions
of households who earn more money than they spend. They are called the surplus
units. Meanwhile there are other units, like business Enterprises and
Government, who need funds for making Investment in real capital goods like
plant and machinery. As these requirements are much more than what these
units have at hand, they are known as the deficit units. Ultimately it is real
capital [produced means of production] that get created through deployment of
these surplus funds [the savings of the public] that enhances the productive power
of a society, leading to output and economic growth. Finance enables deficit
units to realise their investment intentions through making surplus resources
available from the savers of the community.
There are two ways of making these surplus funds resources available
They may be provided directly. The deficit units issue claims against themselves
and offer them to the surplus units [e.g. households] who have the savings. These
are termed as primary claims. The equity and bonds issued by a corporate house
to members of the public are instances of such primary claims.
The second avenue is indirect, via the process of intermediation. Here, we have
various kinds of financial institutions like Banks, Mutual Funds and Insurance
companies who engage in the process of ‘coming between’ the ultimate lenders
and users of funds.
Every Bank or Insurance Company is thus a Financial Intermediary. Financial
intermediaries provide funds to deficit units in exchange for primary claims that
they purchase from the latter. For instance, when banks give loans to companies
for financing their working capital needs or an insurance company invests in a
government treasury bill, the bank lays a claim on the assets of the company it
has loaned to, just as the Treasury bill is a claim on the government.
To raise these funds however the intermediary creates a claim against itself,
against which it borrows funds from the surplus units. These claims may be
termed as secondary claims, as they are derived from the primary claims that
they purchase from the deficit units. The fixed Deposit issued by a Bank to a
householder or an Insurance policy issued by an insurance company or a Mutual
Fund product issued by an Investment company are all examples of such
secondary claims.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 17
Financial intermediaries thus operate on both sides of the spectrum – they both
mobilise purchasing power and also allocate it to those who need it.
The process of finance is illustrated in a simple way as below:
THE CYCLE OF THE FINANCIAL MARKETPLACE

Pu rch a s in g Po wer
(Fu n d s)
Sur plus Deficit
Units Units
(Savers) Pri ma ry C lai m s (Investors)

Financial
Intermediaries
 Co m m erc ia l b an ks
Fu n d s  Li fe In su r ers Fu n d s
 No n B an k
Se con d a ry Fin an c ia l Pri ma ry
cla i m compani es cla i m

The above Intermediaries are also known as Financial Institutions which

intermediate between ultimate owners and users of funds. These institutions are
rightly known as the blood vessels of the financial system. They help to reduce
the time, costs and risks associated with borrowing, lending and other financial
transactions. By bundling and pooling the funds obtained from numerous
investors, they are able to achieve significant economies of scale and scope. This
is achieved through spreading the costs of information search, analysis and
expertise among diverse units. Finally, these institutions are able to reduce risk
through specialized risk appraisal, risk diversification and risk pooling.
To sum up, Financial Products may include Primary claims that are issued by the
end users of funds – like equity stocks [ownership shares] and bonds that are
issued by corporate organisations, currency and treasury bills that are issued by
government. They may also be products that are created by financial institutions
like banks and insurance companies and sold to households and other surplus units
as Secondary claims.
It is the products of financial institutions that are our focus of concern, since life
insurance products are an example of the same.
Financial Institutions/ Intermediaries are broadly of three types
Depository Institutions
The first and most common type of institutions is the Depository. As the name
suggests, these are institutions that accept deposits and make loans. They may
include commercial banks and certain non-bank financial institutions like thrifts,
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 18
housing finance companies, chit funds and savings and loan associations. The
specific forms of these institutions vary from country to country but they have
some common distinguishing factors.
Firstly, the fact that they create and issue deposits. A deposit is distinguished by
its easy convertibility into cash without much loss of value. It is more liquid than
other kinds of financial assets, like bonds or mutual funds or insurance policies.
Their services are generally utilised by households, firms and governments in
order to carry out day to day transactions that involve payments for goods and
services. They also offer deposit accounts that provide both liquidity and
interest.
Contractual Financial Institutions:
The second type of financial institution is known as the Contractual financial
institution. These derive their name from the fact that they obtain their funds
under some form of contract. This aspect – viz., contractually determined
sources of funds – influences the nature of the product and the investment
behaviour of the institution significantly. For instance, there is an element of
contractual guarantee that is assumed when these institutions issue their claims.
This makes the products of these institutions projected and viewed as ideal
instruments for ensuring financial security. Typical examples of contractual
financial institutions are Provident and Pension Funds and Insurance Companies.
These institutions typically cater to the need for long-term post retirement
savings of individuals. Their liability and asset structures are likely to be longer
term in character. They are not as worried about short-term liquidity as
depositories may be. Rather the safety of funds becomes the critical
consideration when investing funds with these institutions. The funds are likely
to be invested in long term assets like stocks, bonds and mortgages.
Investment intermediaries
An investment is made with a view to enhance one’s stock of wealth or net worth.
Investment intermediaries are financial institutions catering to this need. They
include finance companies, mutual funds, investment trusts, and more recently,
money market mutual funds.
The primary focus of these institutions is to provide the investor with a high yield
consistent with varying degrees of safety. Investment intermediaries are
essentially portfolio managers who seek to create an optimal portfolio (high yield
coupled with lower risk) of investments. Some, like the money market Mutual
Funds, also try and provide an investment avenue, which is liquid at the same
time.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 19
B. How are Financial Products distinguished from one another?
To get to the core distinctions between different financial products, it would be
appropriate to first of all see how the business of financial services differs
fundamentally from that of real goods.
The first point to be noted is that all financial instruments essentially involve a
Promise to pay in future – the FD receipt of a bank or an insurance policy of an
Insurance company are all evidences of claims that are created on the respective
issuing institution on itself – promises they create.
The production of a financial product differs fundamentally from that of a real
product. To understand the distinctions, let us look at the difference between a
Birthday cake that you buy from a cake shop and a Bank Deposit.
In case of the cake, the raw materials are fairly simple to know – you may need
flour and sugar and other items that go into baking it. Coming to the technology,
it is a set of machines [including one’s hands] that are used to bake the cake /add
the cream/ decorate it…. At the end of the process, you have a clear tangible
product known as the cake, which one can see, touch, taste and feel. It is also
obvious that the raw materials; the technology and machines; and the end
product in case of a cake, is very different from what is present when designing
a refrigerator or a welding machine.
Let us now consider a Bank Deposit. Reflect a little on what the raw material is.
It would be seen that bankers ultimately work with only one kind of stuff -
information. They gather information about depositors as well as those who
borrow from them. Information processing enables one to predict the time and
pattern of funds withdrawal by customers, while on the other hand, rating the
credit worthiness of the borrower. In case of mutual funds, it is information on
the investment needs, aspirations and habits of unit purchasers that may be
processed, while on the other hand, one also makes careful studies of different
kinds of debt and equity securities in the market, in a bid to decide the right
place to invest. Life Insurers work on the probabilities related to various life
contingencies like mortality [death], morbidity [disease] and longevity [aging],
and also process information related to the investment market where they need
to deploy their funds. In each case they work with the same thing – information.
The technology and machines that are used in a bank or insurance company is
ultimately made up of some pulp of flesh and other mass, occupying a few inches
of space - it is called the human brain. Computers and other similar devices are
mere extensions of the brain, helping to make its task easier. Note that unlike
baking machines and armament factories, there is no reason why the same brain
cannot produce a range of financial services.
Finally. Consider the end output of the process. We get a promise etched on a
paper parchment. In the [paperless] dematerialised world of today, it is more
likely available as a set of electronic blips. Prospective buyers typically assess the
value of the promise on two bases: firstly the content of the promise (e.g. the
benefit structure of a protection or investment plan of insurance), which is
compared with the opportunity cost of committing funds in a certain direction.
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 20
This opportunity cost is the utility forgone by not spending on immediate
consumption or placing the funds elsewhere. Secondly one would consider the
credibility of the promise – the confidence that it would be fulfilled in a real
rather than a literal sense.
It could be seen that the Business of Financial Services essentially has involved
two sets of activities – Information Processing and Relationship Building. While
the first process created the content, the second process helped to make the
promise more tangible and credibility
This raises a key question: If all financial products essentially involve similar
processes and the same ingredients [information], what is it that differentiates
the structure of a bank deposit from an insurance policy or a mutual fund?
The structure and processes that define each kind of financial product is given by
the use and application of a set of mathematical principles while engaging in
information processing and designing the product.
Banking
Let us first consider Banking and other Depository Institutions. Their main
purpose is to create / make liquidity available with relative ease and efficiency.
The core principle which enables this function is that of Maturity Transformation.
Consider a Bank customer who opens a savings deposit, from which she expects
to withdraw funds once a week. The bank allows her to do so, even while using
the same funds to make five to ten year loans or invest in bonds whose term to
maturity may be much longer than a week. One might say that the time horizons
of lenders of funds (surplus units) – which form part of the bank’s ‘liabilities,’
may not correspond to the period for which borrowers (deficit units) need the
funds [which are part of the bank’s assets]. Maturity transformation is the
principle that enables the matching of these varying time horizons (or maturities).
The principle enables the transformation of a short term liability into a long term
asset and vice versa.
The bank achieves this by collecting and pooling the deposits of thousands of such
customers and operating on the assumption that only a fraction of these funds
(say 5 %) is needed at a point in time. A bank remains technically solvent and
can meet its depositors’ demands for funds so long as cash inflows from its assets
(proceeds from principal and interest payments on loans) are coterminous and
matched with cash outflows (withdrawal from deposits) with respect to their
timing and amount. To ensure such solvency, banks and other depository
institutions also maintain liquid reserves and also buy and sell securities in the
money market when they need funds to overcome shortfalls that arise due to such
mismatch.
Mutual Funds and other Investment Intermediaries:
Many decades ago, an individual who invested in stock markets would have been
named as a gambler/speculator – not considered a wise thing to do. Today, if one
is not present in equities market, either directly or indirectly, she is not viewed
as being very smart and astute. What made the difference was a paper by [Nobel
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 21
laureate] Harry Markowitz in the early fifties, the concept of Portfolio
Diversification that he popularised has become the foundation on which the
modern science of Investment, more specifically, Asset Allocation is based. The
principle of Diversification calls for spreading one’s eggs among different baskets,
so that even if one or a few of them are rotten, it would not affect the entire lot.
As applied to financial and capital markets, Diversification generally addresses a
specific kind of risk, namely that of volatility in the returns of an asset. The
work of Markowitz and others established that while the prices and returns of
individual assets may be volatile, making the assets risky in themselves, when
they become part of a diversified portfolio [collection], made of different kinds
of assets, they contribute to reduce the overall risk of the portfolio. Capital
market institutions like Mutual Funds are essentially Portfolio Management
companies, who reduce the risk of capital market investment and provide a
measure of security with high returns to investors.
Insurance
Let us now turn to Insurance. While Diversification is the central principle for
reducing risk in capital markets, in the case of Insurance, it is exactly the opposite
– The principle is known as Risk Pooling, or putting the eggs into one basket
[combining all risk exposures into one pool], as the means to reduce risk.
One might well ask how it is possible that two diametrically opposite principles
[spreading the risks and pooling the risks] lead to the same outcome, namely
reduction of risk. The answer to that calls for specifying what type of risk one is
referring to. In case of capital markets, the risk arises due to volatility [multiple
values being assumed] in the price of the asset. Such risk is known as Statistical
or Stochastic risk, and Diversification is the appropriate tool for addressing them.
In the case of life contingencies [risk events like mortality or morbidity], which
are related to life, it is not multiple but only two outcomes [present or absent,
or up and down..]. In these risk situations, one of the outcomes can lead to
economic loss to an individual. When such risks [loss exposures] are pooled or
put into one basket, the ‘nays’ [those who do not suffer from an outcome like
death or disease] comes to the aid of the ‘ayes’ [those who do suffer]. Insurance
may thus be defined very succinctly as ‘Risk Transfer through Risk Pooling”. The
risk of loss that may be suffered by an individual is transferred to a community
of similar by pooling their individual contributions to create a pooled fund.
One must note that in Life Insurance, it is not only life contingent risks like
Mortality that are addressed through Pooling, but Investment Risks as well. In
the financial market this is achieved through combining various cash inflows
arising from investment - irrespective of their source, timing, magnitude or other
individual characteristics - into one pooled fund that is then accorded an
undifferentiated treatment. Pooling involves an element of cross-subsidisation -
you take from Peter to pay Paul. It is this application of pooling that enables life
insurers to reduce Investment risks along with life contingent risks, thus making
life insurance an appropriate instrument of Financial Security.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 22
Both in the case of Banking and Insurance, we may observe that the mechanism
of Maturity Transformation and Pooling is effective only when there is a regularity
and predictability of events. The withdrawal of money by a single depositor is a
random event, just as is the death of an insured person. In each case it is a matter
of chance. But when we however observe withdrawals by thousands of depositors
– an event repeated over a large number of trials, we would observe a pattern of
regularity and hence predictability, which increases with the number of deposits
and withdrawals. Similarly, in the case of insurance, we would observe a pattern
of regularity and predictability, which increases as a larger and larger number of
insured persons join the pool. This brings us to a fundamental principle of nature
which makes both Pooling and Maturity Transformation possible – the law of Large
Numbers. It states that as the number of units that are exposed rise, the actual
outcome tends to get closer to the expected outcome. Students of probability
would be familiar with this. For instance, what is the chance that the toss of a
coin would yield a head fifty percent of the times? One can only say that this
becomes more likely as the is To give an oft quoted example, the toss of a coin
is more and more likely to yield heads 50% of the time as the number of tosses
moves from one to infinity.

C. How is the Pooling Principle applied in Life Insurance?

It would be very relevant to look at some of the ways in which the principles of
Pooling and averaging was applied in life insurance contracts.
Firstly premiums were loaded at the pricing stage. While fixing the premiums,
insurers typically would assume that the experience of mortality, interest and
expenses would turn out to be more adverse than expected. Loading meant
charging a higher premium to policyholders to cover the losses from such
adversity. Insurers adopted what might be termed as an “adequate pricing”
mechanism – marking up prices over actual costs, to cover unforeseen
contingencies.
Secondly, life insurers would ‘Zillmerise’ their expenses and reserves [the term
is named after the German actuary, Zillmer, who developed it]. Life Insurance
companies typically incur high initial expenses, related to procurement costs, and
also need to build contingency reserves upfront. Zillmerisation helps to spread
out and average these initial costs and reserves over the term of the contract. It
is the way through which life insurers manage what they term as their ‘New
Business Strain.’
The proceeds of premiums are again, placed in a single pooled life fund. The
investment performance of the fund as a whole is reflected in the returns that
policyholders enjoy. Operations of the life fund are strongly guided by the need
to minimize income and capital value risk. Many countries including India have
strictly regulated the pattern of investment, specifying the assets in which the

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 23
funds are to be invested, including the proportions to be kept with respect to
each.
Yet another application is via creating margins as buffers against unforeseen
mismatches of assets with liabilities. Life Insurers create both assets [premiums
they can invest] and liabilities [claims against themselves] with every fresh
infusion of new business. If the liabilities turn out to be higher than the assets in
future, it may render the company insolvent and unable to honour its contractual
commitments. While loading of premiums may help to fend against this
eventuality, the creation of margins like the solvency margin, is an explicit way
to achieve this purpose. It implies that capital has to be brought to the table –
either in the form of owner’s/ shareholder’s capital or undistributed profits that
should otherwise accrue to policy holders/shareholders.
Finally, when life insurers declare their bonuses to participating policy holders,
they may apply what has been termed as the Uniform Reversionary Bonus
Mechanism or other similar methods. This implies that life insurers average and
smooth out the benefits of investment [returns] earned in individual years, so as
to smooth out the unevenness of stochastic yields over time. In simple terms this
means that life insurers do not immediately distribute all that they have
harvested during their good years [when investment environment was very
favourable] but spare a part of it for the lean years. This means that savings held
in the form of life insurance assets enjoy the benefits of capital protection as
well as relative constancy of returns in good as well as bad years. This is what
enables life insurance to qualify as an appropriate instrument for financial
security, helping to protect against both death and financial [investment] risk.
Application of the Pooling principle was well exemplified in products like
Conventional With Profits Endowment and Whole Life policies. These were
bundled contracts whose risk and savings elements were wrapped in an
amorphous package – with each element being accorded the same principles of
treatment. This enabled these products to acquire a relative sense of security,
which was offered through the pooling and averaging mechanism. It was an
attribute that could not be replicated in the case of Investment products like
Mutual Funds. It has been the traditional forte of life insurers – their source of
uniqueness and strength.
We have so far, looked at some of the concepts and principles that are relevant
in the supply side of life insurance products. Let us now look at some concepts
on the demand side.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 24
D. What is the process of Exchange of Values and how does it occur in
Life insurance?
Value for Customers
The concept of “value for customers” is quite old and appears in many marketing
and managerial publications (Drucker 1954, Porter 1980, Payne and Holt 2001).
The concept has served as a premise while creating models on delivering values
to customers (Szymura-Tyc 2005; Kordupleski and Simpson 2003; Baker 2003).
The concept of creating values for customers has also been raised in Peppers’ and
Roger’s publication, in which they stressed the need for individualized and co-
operation-based dimensions in the relationship (1997). The element of customer
relationships in a value exchange figures both in classical (Bagozzi 1975, McCarthy
and Brogowicz 1981), and more recent marketing approaches (Miller and Lewis
1991, Jackson 2007, Cheng 2009). It has also been argued that Co-operation and
engagement with customers during the process of co-creating values could serve
as a basis for competitive advantage (Prahalad, Ramaswamy 2004, Tapscott,
Williams 2006)
In the process of a value exchange, companies provide customers with values,
while receiving other values in return, from customers. Simply put, a value
exchange is deemed to have happened during an interaction between two or more
parties, when they mutually exchange their respective possessions that results in
each receiving better value than what he was already possessing.
Fundamentally, the exchange occurs between a seller and a buyer. The seller
provides a product of value to the buyer and the buyer provides money. Both
participants perceive an increase in value: the product must obviously be more
valuable to the buyer than the money he pays for it, and the money received in
return is more valuable than the product to the seller.
Let us see how value in exchange happens in Life Insurance.
Value in Exchange and Life Insurance
Consider a Term Insurance policy which offers pure protection to the insured
against loss of economic value. Let us say that the probability of death is about 3
out of 1000 for the insured’s age and a sum of Rs. 50,000 is being offered.
Strictly speaking, the ‘fair actuarial value’ of the Term Insurance cover should be
Rs. 150. [= 3/1000 X 50000], In reality the insurer would charge a much higher
premium [say Rs. 200] after loading for expenses and contingencies and a margin
for profits. The insurer thus gets more from the policy than its pure term cost.
Look at it from the insured’s standpoint. Why should he be prepared to pay Rs.
200 instead of Rs 150, which is the fair actuarial value of the contract? The reason
lies in the Utility that is purchased by paying Rs. 200.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 25
Even though the expected value of the contract [in fair actuarial terms] is only
Rs. 150[= 3/1000 x 50000], the disutility of not having insurance is more than the
disutility of paying the premium [including the loading of Rs. 50].
The above can be represented in a formal mathematical form as follows:
Representation of the Expected Utility Hypothesis for Insurance

Let us assume a target level of wealth w. Let x be the loss, in money terms,
suffered as a result of death. The loss is a random variable with a density given
by f(x). The distribution of this function may be considered related to age and
its probabilities estimated by a mortality table. The expected (dis)utility from
the situation of loss of wealth is given by
u ( w - x ) f(x) dx.
The individual has a choice to be completely relieved from the risk of loss x by
paying an insurance premium ‘ p .’ The (dis) utility of the certain loss is given
by
u ( w - p).
Since the individual is expected to choose the option which would give the
higher utility (lower disutility) we get:
u (w - p) >u (w - x) f (x) d(x)
as the condition for the purchase of insurance from the standpoint of the buyer.

The idea represented above derives from Bernoulli who provided a famous
solution to what has come to be known as the St Petersburg paradox - people
seek to maximise expected utility rather than expected monetary value.
They generally do not like to take risks because the disutility of losing is more
than the utility of winning. This phenomenon has been known in finance as the
principle of Risk Aversion. It is the behavioural foundation of life insurance. The
individual demonstrates risk averse behaviour when he or she is prepared to pay
more than the expected value of loss in an insurance contract. The life insurer
also demonstrates risk aversion in loading margins into the premium (against
contingencies etc.).
In Life Insurance, an agent/ sales person provides value through right advice in
return of premium. He identifies a prospect, collects facts about him/her from
all available sources, recognizes his needs and priorities by gathering enough
credible information, prepares a tentative proposition, fixes an appointment,
helps him visualize the needs during interview creates his/her interest in the
proposition, builds his/her desire to own the proposition, presents his proposition
to address identified need/s of the prospect and on his/her
acceptance/confirmation sale is made. One of the critical roles that the sales
person plays is to highlight the disutility of not having life insurance. His or her
task is to enable the prospect to come out as a winner, who has gained freedom

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 26
from anxiety, and can carefully plan and work out his or her future with peace of
mind.
Prospect Theory
The expected Utility Hypothesis that was discussed above assumes that
individuals adopt a rational approach when they seek to maximise expected
utility rather than expected monetary value in an insurance exchange of values.
This assumption is questioned by studies on how the human brain ordinarily
evaluates the risk of an event that is unlikely to happen in future. It is seen that
people put off purchase of insurance until they know they need it. They ask why
they should invest in something now for a risk that may never happen in the
future’.
Behavioural economists Amos Tversky and Daniel Kahneman [both Nobel
Laureates] developed a model which they named as ‘prospect theory,’ to explain
how people decided between risky alternatives based on what they perceived as
‘gains’ or ‘losses,’ rather than absolute outcomes. The authors described ‘loss
aversion’ as a disposition in which people feel that ‘losses make them more
miserable than gains make them happy.’ This leads to a rationalisation process in
which when considering events with low probability [like a flood or a major fire],
they tend to round its probability of happening down to zero. This arises from a
psychological state that makes it difficult to accept that something like this may
happen. Conversely, for an event that is perceived as having high probability of
occurrence [for instance, being severely afflicted by Covid], they tend to round
off its probability to one – in other words, they exaggerate its likelihood to a
certainty.
Prospect Theory explains why people tend to view purchase of insurance as a loss
[no value for money] until the event actually happens in the neighbourhood. One
sees a low probable event unravelling and the odds seem to be suddenly much
higher than they actually are. This is when people may rush to buy insurance.
Ironically, this is also the point when insurers may be more reluctant to offer
insurance on the same terms as earlier. The same loss aversion syndrome may hit
them as well.
This is one of the factors that make it quite difficult to convince people about
the need for insurance, particularly in General Insurance, where we have pure
insurance contracts. The situation could be a little different in life insurance
where the business has been largely built on the sale of Savings / Investment
contracts, and the insurance element only forms a small part of the premium
outlay.

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E. What are the standard approaches and concepts for determining
how much life insurance one needs?
There are two standard approaches for assessing the need for life insurance. The
first is known as the Human Life Value [HLV] approach and the second is known
as the Needs Analysis Approach.
Human Life Value
Human Life Value (HLV) was recognized since very early days as is apparent in
Anglo Saxon law of 8th-9th century Europe, where they adopted some objective
set of methods to determine the compensation to be allowed to relatives in case
of an individual dying at the hands of a third party wrongfully. Even Courts also
adopt certain method to objectively evaluate estimated loss to legal heirs in suits
to determine compensation against accidental death of a person.
However, in early 20th century, the Late S. S. Huebner - emeritus professor of
insurance, Wharton Business School, Univ. of Pennsylvania, propounded a
philosophical framework to define Human Life Value. The concept of HLV is based
upon the fact that every person who earns more than what is required for his own
maintenance has a monetary value to those dependent upon him.
Theodore W. Schultz (Nobel laureate 1979, in Economics) wrote a series of
articles on the role of human capital - education, talent, energy, will etc. - in
economic development. Investment in and returns from human capital is the
wellspring of society’s development - and is the only genuine solution to the
problem of poverty. From his writings 5 key perspectives emerge:
That, individuals have become capitalists from the acquisition of knowledge and
skills (mostly through investments in oneself), which have economic value;
Human value is the key towards turning property into a productive force;
Family is an economic unit organized around the HLV of its members and need to
be operated, managed and liquidated also like a business enterprise;
HLV is the link between succeeding generations and hence must be protected;
Values that are applied to property - viz. appraisal, conservation, depreciation,
indemnity, etc. are also applicable to HLV in view of above.
In other words, an individual through various investments in oneself acquires an
estate value. In addition, he also has a potential estate value which exists in
possibility and this is the person’s insurable value.
This value stems from his ability to earn more than what he requires and to
accumulate the surplus earnings in estates. Both acquired estate value and
potential estate value are a function of Good character, Good health,
Industry/willingness to work, Investment in intellect, Creativity, ability and
judgement, and Patience and ambition and taken together they determine
his/her insurable value.

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So, HLV is the capitalized value of the net earnings of an individual for the rest
of his normal working span, which need to be indemnified since it can be lost due
to :Premature death, Temporary disability, Permanent disability, Loss of
employment or slip-down, etc.
The method of calculating HLV and thus the insurable value of a person can be
broken into following simple steps:
Step 1: Determine the present income of the individual
Step 2: Reduce his personal expense from above income to determine the net
income available to the family
Step 3: Similarly net income for each balance year of working span is computed
(which may also include a realistic growth rate of say.10% p.a.)
Balance working span is = Retirement Age - Current age
Step 4: From the above total, net earnings of remaining working span is
computed,
Present value of above amount is arrived at by discounting future earnings at a
reasonable rate (say, 6 - 8 %)
The amount so arrived at is the HLV of the individual which needs to be insured.
HLV method, no doubt, is the best way to accurately compute the insurance value
of human life. However certain paradoxes emerge at the point of sale or value-
exchange. Thus HLV is highest when premium paying capacity of the individual is
not very high. For example, the HLV of a 20 year old person would be quite high
- his remaining working span being 40 yrs. But, his current income after meeting
his obligations may not be sufficient to support the required premium.
At advanced ages, the cost of insurance increases substantially. Insurance
becomes unaffordable even if outstanding liabilities become lesser. Because of
this conflicting situation, need analysis method is used effectively, wherein the
projected need of the prospect and his current affordability are matched and
provided through an ‘assured insurance cover’ rather than seeking to provide full
‘indemnity cover’.
Need Analysis Approach
In need analysis method, the present and the future needs of the family are
analysed, thereafter the monetary value of these needs are calculated, then the
difference between funds so needed and the fund available with the family at
present is ascertained, and this is taken to be the required amount of risk cover.
Needs method takes cognizance of pressing needs of the family, wherein
insurance can be added later on as well, as needs increase and income also
improves. However the potential estate of the insured is ignored, affecting the
indemnification philosophy of insurance although selling effort becomes more
rewarding.

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F. What are the implications of Life Insurance as a long term
contract?
The Long Term Relationship Aspect of Life Insurance
In normal products -tangible or intangible, the seller’s involvement after the sale
is made is not very high. Of course there would be warranty, service contracts or
even redemption support occasions when we buy products like white goods, or
FMCG or say banking or mutual funds. Nevertheless the expectation of the
purchaser from the seller is fairly defined and limited.
In life insurance the nature of the product and value-offerings in the product/s
entail a continuous long term series of service transactions between the insurance
company and the insured. This also makes it obligatory on part of the salesperson
that he remains committed throughout the tenure of the life insurance policy.
The tenure of life insurance policies does range from short term to the whole of
life – the average span being about 15-20 years. The need of a buyer of a life
insurance policy changes with changes in his/her life-stage.
When one joins a job he/she may require a normal wealth-accumulation product;
when he/she marries he may need an income-replacement solution from life
insurance products; when one starts getting fat bonuses or such windfall gains
he/she may require wealth-enhancement solutions; when purchasing a house one
may require a good mortgage redemption policy; on becoming a father or mother
a child-education plan or a marriage provisioning plan would be required; while
nearing 40-45 he/she may start looking for a retirement solution; to plan a
dignified retired life or for similar such mid-term goals, one may require
endowment type plans. Not only for self but the existing and newly added family
members also become ready reference for suggesting insurance / savings
solutions.
Nature of the product also demands that timely remission of renewal premiums
are ensured so that the benefits of the product remain continuously available to
the buyer.
The long term relationship aspect also has another implication. Since the
insured’s funds [in the form of cash value of premiums] are locked up for long
periods of time under traditional policies, the insured is getting into a contractual
transaction from which he or she cannot easily get out. The surrender values
being low for such policies the exit cost is high. This creates a sense of uncertainty
and incompleteness [of information] for the insured.
One of the principal tasks for the insurance sales person and the company is to
provide assurance to the insured that the latter’s money is in safe hands and the
investment in insurance is worthwhile. In fact, the inability to assure is one of
the principal reasons why a life insurance company and its sales people are unable
to sell insurance.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 30
The Post-Sales Service Obligation
A life insurance policy, which is truly long term in nature, needs to be maintained
and serviced at regular intervals, post-purchase by the buyer. As mentioned
earlier, timely remission of all modal renewal premiums is mandatory to keep the
contract going and for ensuring that the life-insurance cover remains constantly
available. Buyers need assistance by way of being reminded of the same at
periodic intervals by the insurance salesperson who is a more organized party as
far as the vocation of insurance is concerned.
Again, to ensure timely and effective value delivery, during the life time of a
policy, there may be a need to affect more than one address change or alterations
in mode of payments or nomination changes and so forth. In anticipated
endowment products there may be multiple pay outs to the buyers while there
may be occasions when a policy loan is required. Sometimes policy-owners also
pledge their insurance policies as collateral security in case of large mortgages
like housing-loans or business loans. In all such cases there will be post sale
service requirements of assisting in assignment, registering assignment with
insurer and, in case of re-assignment, even fresh nominations.
The nature of a life insurance product obligates the life insurance salesman to
render post-sale service as and when it is required by the policy-holder. This
commitment separates a true professional life-insurance salesperson from the
crowd as it helps him do repeat multiple sales to his existing policy-holder and
also to his family members, loved ones and professional acquaintances.

G. What has been the Principal source of Appeal of Life Insurance?

We have already seen that life insurance has been positioned in the financial
marketplace as an instrument that offers financial security. We have also seen
that this stems from the power of the risk pooling principle as applied in life
insurance contracts, for pooling mortality and other life contingent risks as also
investment risks. Let us now see how this leads to certain specific features and
benefits for end customers.
The Immediate Estate Feature
The purchase of a life insurance policy, particularly with reference to addressing
mortality risk, in effect results in the immediate creation of an asset equal to the
face value of the policy which, as per the Terms and Conditions [T& C] of the
product, is to be made available to dependants/inheritors in case of untimely
death of the life insured.
In insurance, risk transfer is achieved through risk pooling. A life insurance
product involves an element of pooling and transfer of risk. The term ‘life’
implies that the risks, which are subject to pooling and transfer, are life
contingent. Due to participation in this pooling, an immediate estate in notional

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 31
terms gets created– whether it is due to death or illness or income discontinuity.
The contributions of the many go to meet the needs of the few.
The Immediate estate feature is what distinctively separates life insurance from
all other financial assets. In case of a Bank Deposit or a Mutual fund or a share
certificate, if an individual dies at the end of say two years, the value payable
would be whatever has been earned by the asset in the course of those two years.
An investment of say Rs. 1000 held for these two years, and earning a
[compounded] interest of 20% would still be worth only Rs. 1440. Now consider
a term insurance policy with a term premium of Rs. 14 per 1000 sum assured. If
the individual pays a premium of Rs. 140 and buys a policy worth one lakh, he is
able to create an estate worth one lakh, which is available to his dependents,
even though he has invested just Rs. 280 [two premiums] for the purpose. In other
words, the dependents get almost seventy times more from life insurance
[10000/1440] by investing just 28% of the outlay of 1000. This immense power of
the immediate estate feature arises because insurance through the application of
its pooling and mutuality principles, places the power of the community at the
disposal of the unfortunate dependents of the deceased.
The Safety of Investment Aspect:
This arises as a result of the application of mutuality principle to investment risk.
The pooling and averaging of funds of numerous life insurance policies, creates a
relatively riskless financial asset which contributes to reduce portfolio risk over
the long run.
As a financial product, a traditional life insurance policy thus contributes to
optimal inter-temporal allocation of resources for an individual facing two
sources of income discontinuity during his/ her economic life time - death and
retirement. Life insurance policies have been positioned to meet these
uncertainties. Other features which have made the product attractive include its
tax saving aspects and its role as a compulsory form of savings.
Savings is often treated as a residual of income, which is left after consumption.
In reality, both savings and consumption must be considered as active decision
making behaviours which are performed with the purpose of meeting present
needs and also making provision for the long term future. The life cycle
framework assumes stable expected future Income and consumption streams;
efficient capital markets are assumed with free borrowing and lending at given
rates and no credit rationing. This also implies an absence of liquidity constraints
in meeting short term needs as and when they arise.
Life Insurance, like mutual funds and other instruments have been seen as
vehicles for mopping up the (residual) surplus available with households. A major
concern has been with regard to arriving at an appropriate yield-risk trade-off.
This has been particularly evinced in the debate on "reasonable expectations of
customers" where the smoothing mechanism of the uniform reversionary bonus
system (of traditional contracts) has been compared with the individual
treatment of risk, which is seen in unit linked and other variable contracts.

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In the above sense life insurance has been an attractive proposition for middle
class members of the formal organised sector who earn regular incomes and
salaries and who consider financial security of their savings as paramount. .
The situation may be quite different when it comes to the unorganised and
informal sectors of the economy, like rural farmers and unorganised workers.
Many of them face fluctuating income streams. It is seen that these people have
an increasing marginal propensity to save than even members of the organised
formal sector middle classes. However the purpose of their savings (building net
worth) is related to the need to shield consumption against the vagaries of
income, with assets being selected to serve as buffers in this regard. Many of
them invest in landed property and real assets, including gold and silver, which
they believe they can sell in the event of a financial crisis. Even when they
consider financial assets, it is Liquidity preference which rules in this domain and
assets which build protective liquidity crowd out others from the portfolio. Life
insurance contracts with their low liquidity quotients obviously are at a
disadvantage, compared to bank deposits and other more liquid instruments.
It is one reason why life insurance has been largely a product of the formal sector
middle class. The informal sector and rural masses who make up a large chunk
of the populations in countries like India, have limited preference for it.
If the above elements [immediate estate feature and safety of investment] are
not present in some measure we cannot call it a life insurance product. This
distinction is very important. It clearly separates life insurance from investment
schemes being offered as life insurance. Insurance may no doubt involve
elements of investment like diversification, security selection and market timing.
But an investment scheme can be classified as insurance only when if it involves
the pooling element and if its purpose is, in some part, to address a life contingent
risk
Chapter Summary
This chapter begins with a brief discussion on the nature of finance and financial
products. Financial products involve a transfer of purchasing power via creation
of a debt/claim on the issuing institution. There are three types of financial
institutions – depositories, contractual financial institutions and investment
intermediaries. The distinctions between different institutions is underscored by
certain key principles like Maturity Transformation and Pooling.
The chapter also defines and distinguish life insurance products from other
financial products available in the marketplace. Firstly, it has a Value exchange
that results in each receiving a better value than what he had already. Due to
principle of Risk Aversion, the individual is prepared to pay more than the
expected value of loss in an insurance contract.
The amount of Insurance cover required or that can be given is based on concept
of Human Life Value. Every person who earns more than what is required for his
own maintenance has a monetary value to those dependent upon him. HLV is the
present capitalized value of the net earnings of an individual for the rest of his
normal working span, which needs to be indemnified since it can be lost due to:
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 33
premature death, Temporary disability, Permanent disability, Loss of
employment, etc.
In Need Analysis Approach method, the present and the future needs of the
family are analysed, thereafter the monetary value is calculated, deducting
available funds to ascertain shortfall as the required amount of risk cover.
Life Insurance has a Contract of Assurance rather than Indemnification, which
means in case of occurrence of loss, the cover amount agreed at the time of
formation of the contract is to be paid in full to the beneficiaries. In life
insurance, the nature of the product and value-offerings in the product entail a
continuous long-term series of service transactions between the insurance
company and the insured making it obligatory for the salesperson to remain
committed to render post-sale service throughout the tenure of the policy.
The pooling and averaging of funds of numerous life insurance policies, creates a
relatively riskless financial asset which contributes to reduce portfolio risk over
the long run indicating Safety of Investment aspect in Life Insurance.
The purchase of a life Insurance policy in effect results in the immediate creation
of an asset equal to the face value of the policy made available as legacy or the
estate of the policyholder free from encumbrances as well as taxation.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 34
Important Concepts Covered:
 Nature of finance
 Type of financial institutions
 Life Insurance as a Financial product
 The Value Exchange between Insurer and Insured
 Human Life Value concept and its calculation
 Need Analysis Approach concept
 Creation of Immediate Estate
 Safety of investment aspect

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 35
Self-Examination Questions
Question 1
Life Insurance is seen as
A. Not a constituent of a portfolio of financial Assets
B. One among many constituent of a portfolio of financial Assets
C. The main constituent of a portfolio of financial Assets
D. Unique stand-alone product
E. None of the above

Question 2
In a Value Exchange
A. The product must be more valuable to the buyer than the money he pays for
it
B. The money is more valuable than the product to the seller
C. Both of the above two statements are correct
D. Neither of the above statements are correct
E. Only statement a is correct

Question 3
Risk Aversion happens when the individual is prepared to pay
A. Less than the expected value of loss in an insurance contract
B. More than the expected value of loss in an insurance contract
C. Equal to the expected value of loss in an insurance contract
D. All the statements are correct
E. Neither of the statements are correct

Question 4
In Life Insurance, The Agent has the critical role of
A. Providing value through right advice in return of premium
B. Offering peace of mind and freedom from anxiety
C. Highlighting the disutility of not having adequate life cover
D. Doing thorough fact-finding before recommending a solution
E. Assuring the money in safe hands and investment is worthwhile

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 36
Question 5
An Assurance is the promise by the insurer to
A. Indemnify to a pre-loss situation
B. Compensate a defined loss
C. Compensate up to the actual economic loss
D. All the statements are correct
E. Neither of the statements are correct

Answers to Self -Examination Ques tions:

Answer to SEQ 1
The c orrect option B .
Answer to SEQ 2
The c orrect option C.
Answer to SEQ 3
The c orrect option B .
Answer to SEQ 4
The c orrect option C.
Answer to SEQ 5
The c orrect option B .

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 37
 CHAPTER 3
ACTUARIAL AND TECHNICAL ASPECTS OF LIFE
INSURANCE PRODUCTS
Chapter Introduction:
In the previous chapter we examined some of the core concepts involved in
financial products and life insurance, and also discussed how the Pooling principle
is applied in life insurance products. In this chapter we shall consider the actuarial
aspects involved in the design and pricing of life insurance products, including
some of its technical implications and related processes
Learning Outcomes: at the end of this chapter you will

A. Understand the structure of a Life Insurance Contract

B. What is involved in the design and pricing of life insurance
C. How is Mortality Rate determined from a Mortality Table?
D. Discuss the role of the Interest element in Premiums
E. Understand how net premiums are derived
F. How are Gross Premiums derived?
G. Discuss how Profits or Surplus are determined
H. Understand how Profits are distributed in Traditional Policies

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 38
A. Understand the structure of a Life Insurance Contract

To begin with, it would be instructive to note some of the key differences

between life and general insurance products.

Firstly, General insurance contracts are contracts of loss indemnity [which

restores the insured to his or her original position before occurrence of the loss
event]. In case of life, the loss in the event of death or permanent disability
cannot be measured. Life insurance contracts are termed as contracts of
assurance [life assurance] and the insured typically buys units or packets of
assurance, which may have little relation to the worth of his or her life.

Secondly, unlike other property and casualty perils, there is no doubt about
whether death would occur or not. What is uncertain is the ‘when’ [time of
death].

Thirdly, mortality and even morbidity risks are fairly predictable, being stable
functions of age. In other words, as the age increases, the probability of dying
also increases in some stable proportion. This relation between age and mortality
arises from the fact that human beings, like other living organisms, have an expiry
date – they grow, wither and die, in accordance with the laws of senescence.

One of the key implications of the third feature was that insuring human lives
through one year term assurance contracts written afresh every year [as in
General insurance] would result in premiums that grew with age. Life insurers
found that such increases in premiums led to selection against insurers – those
who were in good health at older ages deciding to opt out, rather than pay the
high premiums, while others who were not in such good health being ready to
join. Life insurers soon found this practice to be quite untenable. The solution
was to create long term life insurance contracts with a level premium feature.
Level premiums entail collection of extra premiums in early years of the contract
which, after payment of current claims, are accumulated and held in trust by the
life insurance company for the benefit and to the credit of policyholders. The
accumulation is termed as a ‘RESERVE’ from the liabilities side, and as a pooled
‘LIFE FUND’ from the assets side

Level Premiums and Life Insurance plans

Every level premium life insurance plan involves by definition a combination of

two elements – an insurance element consisting of an amount set up to meet
current death claims and a cash value element that accumulates over time to
meet claims, which arise in future. The two amounts are so computed that at any
point of time, their sum is equal to the face amount of the policy. One type of
contract differs from another only in the proportion in which the two elements
are combined. While One-year term insurance is all protection and no cash value,

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 39
a Single premium endowment plan would veer towards the other end of the
spectrum, with highest cash values and lowest proportion of sum at risk.

Corresponding to the above we can find two components in the premium as well
- the pure risk premium, which is the price of buying protection and an excess
premium, which comprises the savings element. The latter represents the
individual’s accumulated wealth lying with the insurer. The upshot is that every
level premium plan [except One Year Term Insurance] is in effect, a Savings
plan - a vehicle for holding one’s wealth.

One of the implications of the level premium principle has been that life
insurance contracts have typically been long term contracts – indeed they have
been termed as long term insurance, to distinguish them from other General
Insurance contracts, which are typically of one year duration. Long term level
premium contracts enable policy holders to lock in a regular premium for a
number of years [which might extend till the end of life] without being priced
out of the contract. This also means that, especially for savings contracts with
a large cash value element, a large sum of money [with attendant opportunity
costs] gets locked in for the long haul.

The premium - benefit structures of these contracts can take one of two forms:
Under life insurance, a series of [one or more] premium payments create a Capital
Sum that is typically paid as a lump sum benefit. Alternatively, it may be made
out as a series of periodic [Annuity] payments that last until the policy holder
dies [as in life annuities] or as per the terms of the contract. The latter is
characteristic of pension and annuity contracts that are designed to provide
replacement income [after retirement] during one’s twilight years.

The Long term feature of contracts also mean that the benefits to be paid in
future also create liabilities which are generally more complex to model, and
involve higher risk. Indeed, the longer the period, the more uncertain the
outcomes. Again, multi-period contracts [extending for many years] would make
it necessary to bring in financial considerations [like Time value of Money] into
the picture. Probability models of mortality, combined with financial models of
compound interest enabled life insurers to develop the framework for actuarial
pricing of long term contracts.

The pricing process involves a Cost plus model - the benefits to be provided are
fixed. The models are based on assumptions about the future. Pricing consists of
firstly determining the liabilities that correspond to various benefits [with
respective probabilities assigned to them] and other payments that may arise in
future, and discounting to arrive at their present value. The guiding percept
in premium determination is the principle of equivalence - premiums must be
equivalent to benefits payable and expenses of the insurer. It must also
contribute to profits and the capital of the insurer. Let us examine this process
in some detail.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 40
The chapter is divided into two sections. In the first section, we shall discuss the
elements and factors that go into the premium determination process of life
insurance. In the second section we shall consider the elements that go into
determining solvency and profits in life insurance business.

Section I: Technical Design of Life Insurance Products

B. What is involved in the design and pricing of life insurance

The individual responsible for technical design is known as the actuary. What he
does is to construct a model in which a number of variables are considered and
studied. These include demographic variables like mortality and life expectancy
rates; financial market variables like interest rates on bonds and stock market
returns; inflation and prices. Actuaries also make a number of assumptions about
the likely environment that may emerge in future. Policy holder benefits and
premiums are derived from these assumptions. The model also results in
determining other outcomes like reserves and solvency margins that need to be
maintained and finally the profits expected to be earned. Note that a model is
only a representation of the real world as it is expected to be. One can only
construct different kinds of possible scenarios and predict how different
outcomes may arise under each of them.
Actuaries use two disciplines that form the core of actuarial technology. The
first is the science of probability. It helps to predict various life contingency
outcomes like death and disability. The second discipline is the principle of
compounding / discounting. It gives the present value of money received in
future or alternatively shows how money multiplies over a given time period.
Models are of two types. Models where only one future scenario is considered are
called Deterministic. Models that consider multiple scenarios and simulate many
different results for multiple variables are termed as Stochastic Models. A
deterministic model may work in a stable environment where tomorrow can safely
be predicted to be a repetition of yesterday. As the market environment becomes
more and more dynamic and uncertain, stochastic models become more relevant.
Premiums and Price of Life Insurance: Price has often been equated with
premium. A little reflection would however reveal that the two are not the same.
Premium only represents the outlay which the consumer makes, on purchase of
life insurance. Price on the other hand reflects the relationship that premium
outlay has with the benefits. It may be seen that higher the benefits in relation
to premium, higher the rate of return on the life insurance policy. It also follows
that higher the rate of return, lower the price. It would be also significant to note
that while premium is fixed at the beginning of a life insurance contract, the
actual value of benefits that are paid can be known only at the end of the contract
when the policy has run its full course. It is only at the stage of final payout that
one could know if the purchase of the policy was a cheap or an expensive
proposition.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 41
Elements in determining the Premium
Let us now look at the elements in Premium determination for ordinary life
insurance policies. Broadly there are five elements to be considered:
Mortality - the rate at which people die over different ages
Interest - which the insurer is likely to earn from investment of premiums
Loading for management expenses and other contingencies of the insurer
Loading for various reserves that the insurer has to maintain
Bonus loading: for being entitled to a share in the profits of the insurer.
Mortality and Interest are components which go into determining the Net
Premium. The Net Premium, when combined with provision for expenses and
contingencies, bonus loading and reserves, gives us the Gross Premiums, also
known as Office Premiums.

C. How is Mortality Rate determined from a Mortality Table?

Mortality risk is the primary risk that life insurers are concerned about. This risk
can be measured by applying the theory of probability. The event being measured
is death at a certain age. Let us Suppose l represents the number of persons in
a group who are alive and exposed to the risk of death at a certain age, say age
35: while d is the number of those exposures that are expected to actually die in
the succeeding year after being exposed to the risk, then the probability that a
person from such group would die is given d/l.
To cite an example, out of 690000 persons alive at age 41 about 1400 are
expected to die before achieving age 42. This gives a ratio of
d/l= 1400/ 690000 = 0.002029. This value (0.00203) represents the probability of
death for a given population of age 41 that has been exposed.
The operation of the probability principle depends on two important conditions.
Firstly the events must be independent or random – the occurrence of one death
is independent of another. The second condition is given by the operation of law
of large numbers. It states that as the number of exposures n gets larger, An
Important implication of the above principle is that life insurers can be surer of
their predictions about mortality as the number of people insured by them
increases.
The Mortality Table
Mortality risk is typically estimated by using a Mortality Table. The table provides
rates of mortality or the number of deaths per unit of population during a
particular time interval. Each such unit of population is clearly defined and
consists of a specified age and sometimes a specified gender. A Mortality rate

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 42
thus expresses the rate at which death occurs among members of such group
during a particular time interval – typically a year
Mortality rates have various uses. They can help to determine:
The Cost of providing death benefits [mortality cost] under life insurance policies,
thus indicating the Premium rates to be charged.
Cost of providing periodic income payments or annuities. Mortality rates also lead
us to survival rates, which can help us determine the cost of a periodic income or
annuity payment.
For example, if out of 1 million people aged 35, about 1500 are expected to die
during age 35 –36, it means that 998500 are expected to live at the end of this
interval.
The table is also used for determining the contractual Reserves that have to be
maintained for life insurance and pension products. If we know, for instance, that
2 persons out of 1000, for a certain age, were to die, it indicates that sufficient
reserves need to be maintained for meeting the claims expected to arise for these
two.

Standard Mortality tables

The kind of table used for determining mortality risk by life insurers are known
as Standard Mortality Tables. They project the death rates and related statistics
only of those who are insured, thus reflecting the experience of ordinary or
average policy holders in an insurer’s portfolio. These rates are different from
and typically lower than the crude death rate of the general population of a
country, such as we would get from a census report. These rates are also different
from that likely to hold for other population groups exposed to specific risks – say
a population made of heavy smokers. Consequently, the lives covered by the
standard mortality table are known as Standard Lives.
The construction of a mortality table involves a number of steps. Firstly,
sample(s) are selected representing the population group to be insured. Such
samples are typically drawn from assured lives whose records are with the
insurer. The next step is to observe the mortality experience of the selected
sample groups over a period of time. The observation period should be as recent
as possible - it would make little sense to look at mortality experience of 1970 or
even 1990 in 2023. It must also be sufficiently long and free from non-
representative events like war or epidemics, to ensure the data is adequate and
relevant. Mortality rates may be computed on the basis of such observation over
a period of say five years. Rates thus derived are the ratios of number of deaths
occurring at each age during the 5 years to the total exposure at that age.
The observations made would provide only raw mortality rates for different age
groups. To convert these into a usable mortality table, a number of adjustments
have to be made. They include: [1] Smoothing: a process undertaken to ensure
that mortality is measured as a smooth and continuous function of age with no
kinks – this is necessary to arrive at premiums and reserves grow in a regular
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 43
pattern with age. Actuaries use what are termed as Graduation Techniques for
the purpose; [2] Modification: of the tabular mortality rates to ensure that the
mortality tables, which are often based on historical mortality data, would reflect
recent increases in human life spans as well as to address future improvements
in mortality; [2] Use Safety Margins: this is done to help the insurer meet its
benefit obligations even if actual mortality rates turn out to be less favorable
than mortality assumptions. Such margins are built by setting an assumed
mortality rate that is higher than expected mortality rate.
Mortality Costs are arrived at from the Standard Mortality table used for the
purpose. The formula for life insurance is given by:
Mortality cost = Number of claims X Amount of claims = Probability of death X
Face Amount. Payable. For face amount of 1000 we get a rate of premium per
Thousand Sum Assured.
For Life Annuity it is:
Cost of Annuity = Number of claims X Amount of claims = Probability of living X
Annual income payment
Actuaries everywhere use some common notations for various measures:
Notations used in Mortality table
lx: Number living at age x at the beginning of age interval x to x+1. For example,
l35 implies number of persons living as on age 35
dx: Number dying during the age interval x to x+1
qx: Proportion of persons alive at beginning of age interval (x) who die during the
interval x+1.
The mortality rate for the interval x to x+1 is denoted by qx. The mortality rate
qx represents the probability that a life aged x will die between x and x+1. It is
given by the following expression:
qx = (lx - lx+1 ) / lx Or more simply as dx / lx
Similarly the probability that a life aged x will survive n years to age x+n is given
by lx+ n / lx
For instance, suppose a Mortality table shows that the mortality rate for age 45
or q45 is 0.0038. If the face amount is 1000, the mortality cost would be 3.80 per
thousand [0.0038 x 1000].
An annuity table shows that out of every 1200 persons alive as on age 60, only
320 would be alive as on age 70. The probability of living between age 60 and 71
is thus 0.267 The cost of paying an annuity of Rs. 1000 after 10 years [at age 70]
would be Rs. 267 per thousand [0.267x 1000].

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 44
D. Discuss the role of the Interest element in Premiums
Interest represents the truth that money has a time value - It multiplies with
time. The value of a rupee held today is worth more than what it will be after
one year. Life insurers assume an interest rate for discounting the value of future
benefits (liabilities) they have to pay. Discounting enables them to find out the
present value of future payments
Interest rate represents investment earnings and the rate of discount applied is
based on the insurer’s expected rate of return on investments. When we speak of
interest here, it implies rate of return on invested principal. Note that life
insurers’ investment earnings can take other forms than interest on debt
instruments. It is also important to note that the discount rate that is used is an
assumed rate – it may typically be lower than the rate of return that insurers
actually expect to earn on their investments. Life insurers are typically cautious
and conservative in their approach to interest. For example even while expecting
to earn 8 to 10 % on their investments they would assume an interest rate of only
4 to 6% when determining the premium. Lower, the interest rate that is assumed
and used for discounting, higher would be the present value of future benefits to
be paid. We must remember that life insurers incur liabilities whenever they
have to pay a future benefits, these liabilities have to be funded by collecting
premiums from policyholders. This means that lower the interest rate assumed,
higher would be the premiums to be charged. This also means that larger the
spread between the assumed and actually earned rate, the stronger is the positon
of the life insurer. At the same time, larger spreads mean higher premiums and
this could erode the competitiveness of the life insurer in the marketplace. The
challenge facing life insurers is thus to find the right balance between being
financially sound and being competitive. They must be conservative and assume
a lower rate of interest but not so conservative that they end up pricing the
product out of the market.
We have seen that interest rates are used to determine the present values of
payments that life insurers have to make in future, as also the basis for deciding
the premiums. However the premiums are collected in the form of level annual
premiums. The more relevant concept for measuring the role of interest in the
case of a series of premium payments is that of annuity.
An annuity may be defined as a stream of (annual) payments. Level premiums
are usually paid to an insurer in the form of annuity payments. There are two
types of annuities. An annuity with payments at the beginning of the period (year)
is termed an Annuity Due while an annuity with payments at the end of each
period is termed as an Ordinary Annuity. Since premiums of life insurance
companies are typically paid at the beginning of the period, we would be
concerned with annuity due.
The present value of an ordinary annuity is represented by the symbol an‫ר‬. The
formula for finding present value of an ordinary annuity of P per year, payable
for n years is:

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 45
an‫ = ר‬P V + P V2 + P V3 +…….+P Vn ;
Where the values of V, V2…. represent the present value of 1 paid at the end of
first, second and subsequent years respectively
One can directly compute these present values in a MS Office – Excel [or similar
software], or alternatively, one can obtain it directly from the present value
compound interest table for an ordinary annuity.
For example: The present value of an ordinary annuity of Rs. 1000 for 10 years
@5% interest is
a10‫ = ר‬1000 x 7.7217 = 7721.70
The value 7.7217 is the factor for 10 years @5%, as obtained from the Present
value compound interest table for an ordinary annuity.
To convert the above example into an annuity due (payment at beginning of
the year), we find the present value of Re. 1 per annum for 9 years (which is
7.1078) in the above table and then add 1 to the factor obtained. We get:
ä10‫ = ר‬1000 x 8.1078 = 8107.80

E. Understand how net premiums are derived

The basic principle that informs premium determination is ensuring that a
product’s estimated total premiums with investment earnings are sufficient to at
least meet, and generally to exceed the product’s expected total costs of benefits
and expenses.
The Net Premium is that amount sufficient to provide for all benefits owed under
the contract, whether payable on death or survival. Net premium is different
from the Gross or Office Premium that is actually charged. The latter is obtained
by adding a Loading to the Net Premium. The loading may have three components
(1) A loading to cover expenses of management (2) A margin for contingencies
and (3) A margin to provide for profit.
The calculation of the Net Level Annual Premium involves two steps.
The first step is finding the Net Single Premium. It is the sum of the present values
of all expected benefits. In calculating the present value the insurer uses an
assumed interest rate that represents rate of future investment earnings on
premiums
The second step is to find the Net Level Annual premium which is determined
such that the sum of present values of the set of level premium payments payable
is equal to the net single premium. The method used for the purpose is to divide
the Net Single Premium by the present value of a life annuity of 1 for the premium
paying period.
Let us briefly look at these methods
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 46
Net single Premium: its estimation involves three factors:
The Face amount: or sum assured payable as death / on survival of the term
benefit. Let us call it [S]
Probability of payment: which is given by mortality rate [qx ] in mortality table
The discount factor which gives Present Value [denoted by Vn ] @ rate of interest
n which is assumed.
The first step is to multiply the above three factors and find their product for
each year of the term. Summing these products gives net Single premium.
Net Single Premium =(S x q30 x V61 ) + (S x q31 x V62 ) …. + (S x q54 x V625 )
Where the values of qx [ x = 31, 32…54] represent the probability that the person
who was alive at age 30 dies by age x ; V6x represents the present value for the
period of x years; S represents the sum assured.
Example: Assume that Sum Assured (S) is Rs 1000); mortality factor (qx) =
0.00183 and discount factor (V5 ) is 0.9524 (at @5%) for age x The net single
premium for a one year term insurance policy is
Px = S x qx x V5 = 1000 x 0.00183 x 0.9524 = 1.743
It is assumed that premiums are paid at beginning of the year and all benefits
accrue at its end. We can similarly get the product of S, V, q and r for a term
assurance policy which runs for n years. Adding these, we get the Net Single
Premium.
Net Level Annual Premium: Deriving this premium is the next step. While an
insurer may be quite happy to collect all premiums upfront, in the form of a Single
Premium, customers may prefer to pay in installments.
A net level annual premium cannot be correctly derived by dividing Net Single
Premium by number of years in the term of the contract. This is because of two
reasons: firstly, The Net Single Premium, received upfront would be much higher
and earns interest for a much longer period, than when paid in periodic
installments. This difference in interest earnings must be accounted for.
Secondly, while e net single premium is paid by all those, living at the beginning
of the contract. The level premiums would be paid only by those who survive each
successive year of the policy term.
To take care of the above factors we apply a simple rule to derive the net level
annual premium: We divide the Net Single Premium by the present value of a
Temporary Life Annuity Due of Re 1 for the premium paying period. The formula
for deriving the present value is as follows:
äx:n‫ = ר‬1 + 1 / lx (V lx+1 + V2 lx+2 + V3 lx+3 …….. + Vn-1 lx+n-1 )
We begin with probability of surviving each year starting with age x+1. The
probabilities are given by [lx+1/ lx, lx+2/lx.. and so on] Multiplying these probabilities
with the respective discount factor and adding the results will give us the required
value.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 47
F. How are Gross Premiums derived?
Gross Premium is the Net Premium plus an amount called loading. Life insurers
are guided by three considerations in such loading:
Adequacy: The total loading from all policies must be sufficient to cover the
company’s total operating expenses; provide a margin of safety; and contribute
to some profits or surplus.
Equity: Expenses of the insurer and safety margins should be apportioned
equitably among various types of policies. Each class of policy should pay for its
own costs.
Competitiveness: The resulting Gross Premiums should enable the company to
improve its competitive position.
There are various purposes for which premiums are loaded. There is first of all
the need to Meet Acquisition Costs. The largest expenses are indeed associated
with sale of new policies. They include commissions to agents, incentives for
Business Development; Fees for medical examination and others. These New
Business expenses could account for 90% of new business premiums. If loaded into
the premium for the year incurred, acquisition expenses would make the first
premium much higher than subsequent ones. Life Insurers typically spread these
excess acquisition costs over the total premium paying period, adding a level
amount to the net level premium every year. The second reason for loadings is
to meet the General Overheads of the life insurer. These would include many
items of expenditure like salaries, rents and rates, furniture and fixtures etc.
Thirdly there is a loading for Contingencies. Life insurers cannot normally
change the premiums of their traditional contracts even if unforeseen events
make their rates inadequate. They need to meet these through contingency
reserves, which are funded through premium loadings. Fourthly there are costs
arising from Lapse of Policies. A lapse is a termination of the policy prior to the
insured’s death or maturity. When lapse occurs in the initial policy years, before
acquisition costs are recovered from premium payments the unfunded costs must
be apportioned to other policy holders.
Loading for Expenses
A life insurance company incurs expenses for both investment and insurance
operations. The former includes costs incurred in order to make service and
safeguard the company’s investments. They are generally paid out of the
company’s investment income and are not loaded on premiums.
Insurance expenses are those which are incurred for acquiring and keeping the
company’s business in force. They may be accordingly classified into New Business
and Renewal Expenses. New Business Expenses are generally those which are
incurred as acquisition costs while renewal expenses are incurred for the year to
year servicing of the policy.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 48
Expenses may also be classified into:
Those that vary with the premium – examples are Commission to agents; taxes
on premiums; other agency expenses and incentives for new business
procurement. These are typically expressed as a percentage of premium
Those that vary with amount of insurance: - like Medical fees and Policy stamps.
These are treated as a constant amount for each ‘ooo sum assured’ [or face
amount] to be added to net premium
Those that vary with the number of policies but remain same for all policies,
regardless of premium or policy size. Most overhead expenses like salaries,
postage, stationary, rents etc., fall under this category. They are charged as a
constant amount per policy
Using all three elements produces a premium rate ‘per Rs Thousand Sum Assured’
that decreases as the face amount increases. This is because per policy expenses
are, by definition, the same for all levels of sum assured. Insurers would seek to
pass on the benefits derived from higher sum assured policies to their respective
\policy holders. One way to pass on the benefits of such reduction is via a rebate
on higher sum assured policies. Alternatively, they may offer differentiated
service and other benefits.
Example: A life insurance company decides to consider those policy holders
who have purchased over Rs. 50 lakhs worth of life Insurance as ‘special or
premium customers’ and have a Dedicated Relationship Manager’ to address
their needs. .

Loading for Contingencies

While net premium and loading for expenses is designed to cover the estimated
cost of benefits and expense charges expected to be incurred during the policy
term, there is also the risk that actual experience may belie the assumptions
made in the contract design.
One source of risk is that of lapses and withdrawals. A lapse means that the
policyholder discontinues payment of premiums. In case of withdrawals, the
policyholder surrenders the policy and receives an amount from the policy’s
acquired cash value. Life insurers incorporate a loading in anticipation of both
situations
Lapses can pose a serious problem especially when they happen, as is often the
case, within the first three years with highest incidence being typically in the
very first year of the contract.
We have already seen that Life Insurers incur high initial expenses by way of
procurement costs. They are also required by the law to set up reserves upfront
at the beginning of each contract, to ensure that the company can meet its
obligations to policyholders and remain solvent.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 49
These commitments [including high expenses and reserves statutorily required to
meet contingencies] far exceed the premium in initial years and it is only from
future premiums that the excess can be gradually recovered. One result is that
the cash flow from a policy (which is given by premium less costs and charges)
would be very low or even negative in the early years of the contract, the
contribution of the policy to the assets of the company may be negative in the
earlier years and would grow positive only over a period. The heavy strain, which
thus arises in the early years of the policy, has been termed as New Business
Strain. Life insurers thus incur heavy New Business Strain.
Lapses can seriously erode a life insurer’s financial position
An early lapse would mean there would no longer be any future premiums under
the policy from which to recover the initial costs. Secondly, lapses and
withdrawals imply an element of self-selection – it is lives that are healthy who
would typically seek to exit from the books while unhealthy lives remain. Thirdly,
lapses and withdrawals have the result of increasing unit (per policy) fixed costs.
These costs, like salaries and rent, are now spread over fewer policies producing
higher per policy expenses than was assumed while setting the premiums
When policies are withdrawn and surrendered, the policy holder is eligible to get
a portion of the cash value accumulated under the policy in the form of surrender
value. If these surrenders are pursued when market interest rates high and rising,
life insurers may be forced to sell their assets at a loss to pay such Surrender
Values.
It hence becomes very critical at the stage of selling a policy to ensure that the
sales force introduces only quality business that will stay in the books of the
company. A high lapse ratio generally implies that the business has somehow been
introduced. Not only does it financially drain the insurer but it also results in loss
of credibility. A lot of policy holders who withdraw are likely to be dissatisfied
customers.
Bonus Loading: a number of life insurance policies are participating policies. In
other words, they participate in the profits of the life insurer and are eligible to
receive the benefits of such participation in the form of a Bonus. The actuary,
Brian Corby described the origins of bonus as under:
“Some two hundred years ago, at the beginning of life insurance, the major
uncertainty was the rate of mortality. The solution adopted was to charge
excessive premiums - Of course they did not know that they were excessive in
advance - so that solvency was assumed, and then, when sufficient experience
was accumulated to assess what the premiums should have been, to return the
excess - or some of it - to policy holders by way of bonus additions. This was the
origin of the traditional With Profit policies we issue today…”
Participation in profits ushered an element called “Bonus Loading” into
premiums. The idea was to provide a margin for profits within the premium, such
that it served as an added cushion against unforeseen contingencies and also paid
for the policy’s share of surplus distributed (as bonus).

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 50
The bonus loading feature is one reason why life insurers are confident about
their long term solvency and capital adequacy. It serves as a large additional
buffer over and above the other margins already set up.
Section II: Solvency and Profits in Life Insurance
In the previous section, we discussed one aspect of price, namely the
determination of premiums. However, as stated earlier, premium is only the
outlay for life insurance. Price is determined by the relationship of benefits
accrued to the outlay that is made. This brings us to the second factor which
impacts on price – the enhancement of benefits, which is tantamount to a
reduction in the price and thus enhances the efficiency and attractiveness of life
insurance products. In this section, we shall explore how life insurers work on
price from the benefits standpoint. We shall take up two situations which arise.
The first is where Life Insurers enhance the benefits via sharing the profits they
make under traditional With Profits policies. The second is where the benefits
are directly linked to the performance of a Life Insurer’s investment. This is done
in Unit Linked Insurance Policies. We shall deal with the first situation in this
chapter.

G. Discuss how Profits or Surplus are determined

To begin with, it is necessary to note that the way life insurers view profits is
quite different from the way other business firms treat the term. In case of an
ordinary firm, Profit is typically defined as the excess of income over outgo during
a given accounting period - it forms part of the profit and loss account. It also
forms part of the firm’s balance sheet, where it is a synonym for the firm’s net
worth [excess of its assets over its liabilities]. The above approach is in
accordance with accounting standards and does not give credit to profit from
future performance. It applies an ex post approach to recognition of profits. Thus
if a firm has a profit of Rs. 15 crores at the end of March 2023, this amount is
available for use by the firm as it deems fit.
In case of a life insurer however, the books, as at end of March 2023, would show
a large incidence of liabilities of varying durations, corresponding to benefits and
other payouts that have to be made, just as they show assets derived from
premiums and investment proceeds on those premiums. One cannot place an
exact value on these liabilities as one cannot precisely predict what will happen
in the future. Value of the liabilities depends on the assumptions that are made
(about mortality, interest, expenses and persistency etc.) in determining them.
It is for this reason that in life insurance we use the term Surplus instead of
Profits. It is an ex ante approach to profits. Let us examine in some detail how
surplus arises under traditional life insurance contracts
The Actuarial Control Cycle
This is a concept that helps to illustrate how premiums, reserves and profits can
be viewed from a holistic perspective. The Actuarial Control Cycle [developed by
actuary Goford, 1985] represents an ongoing process by which a life office seeks
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 51
to review and monitor its experience, vis-à-vis it’s pricing and reserving
assumptions, while also, in the process, updating and revising the latter.
The cycle is illustrated below. It indicates how the life office actuary may
proceed, step by step, to review, monitor and manage the divergence between
assumptions and actual experience. It involves building models, testing them in
the light of practice and continuously updating the models.

The Actuarial Control Cycle

Profit Test

Initial
Model Office
Assumptions

Updating of Appraisal
Assumptions Values

Analysis of
Monitoring
Surplus

One begins by outlining the Initial Assumptions with respect to mortality,

interest, expenses, persistency rates etc. These depended on assumptions about
future demographic and financial market experiences.
Actuaries may then carry out a Profit Test, employing Cash Flow Techniques to
project cash flows that would increase or decrease as one varies the assumptions
of mortality, interest and expenses. Accordingly the profits of the insurer would
also vary. Actuaries normally project the expected profits that may be generated
for a single block [or tranche] of business, given a set of premium rate
assumptions. By fixing a target measure of profit (a profit criterion) to be
achieved, one can determine the rate of premium or charges, which would
generate the profit criterion under given assumptions.
A profit test involving a single tranche of business may not always be an
appropriate pricing tool. This is because certain elements of price, like expenses,
are related to not just one block of business but to the total business spread
across all products and tranches. Actuaries may seek to apply cash flow
projections for the entire office in order to determine likely profits. The model
used for the purpose has been termed as “Model Office“. It is obviously much
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 52
more complex than conducting a simple Profit Test. However it may prove useful
for projecting and trying to understand the future financial condition of a life
office, especially when one has to deal with complex and uncertain situations
entailing simulation of several variables.
Analysis of surplus is the next step. Surplus is simply the excess of Assets over
Liabilities of the Life Insurer. Surplus arises from the difference between actual
experience and assumptions made with regard to mortality, interest earnings,
expenses and other areas. Analysis of surplus would help to indicate how far the
Life Insurer has been accurate and on target with regard to assumptions, and the
areas where assumptions need to be revised and results monitored. Obviously it
is those areas in which profits of the life office were most sensitive that needs
close attention.
Finally in the light of its experience, which is continuously monitored, the life
office has to decide whether it needs to change its assumption for the next year
of the control cycle and the implications of such change on premium rates and
product design etc.
The first two steps form part of premium determination. In this section, we shall
concern ourselves with issues arising after premiums are set.
Actuaries typically carry out a periodic valuation of their assets and liabilities to
determine whether they have sufficient amount of assets to cover their liabilities
[in other words, their solvency] and further, to ascertain the difference between
the value of their assets and liabilities. The extent to which assets are higher
than the liabilities would decide the level of surplus. Before we get into this
process, it is worthwhile to consider two other important concepts, namely that
of reserves and asset shares under a life insurance policy.
Reserves
One of the principal outcomes of the level premium principle is the creation of
reserves on the liabilities side and a life fund on the assets side.
A reserve can be defined as the assets that need to be maintained by a life insurer
to meet liabilities of future benefit payments as they fall due. A reserve can be
viewed from two angles: Prospective and Retrospective
The Prospective approach, as the term connotes, looks at reserves from the
standpoint of the future. The reserve thus represents the difference between
present value of future benefits that are p.lololi9likayable and present value of
future premiums expected to be received. Such reserve, along with future net
premiums receivable, should be sufficient to pay the benefits.
Reserves may also be viewed on a Retrospective basis. In this sense it is derived
entirely with reference to past experience. The reserve may be thus defined as
premiums collected by the company for a particular class of products plus interest
at assumed rate less claims and other payouts.
The prospective approach is deemed as the appropriate one to use for contracts
with a fixed premium and guaranteed benefits. The Retrospective reserve may
be appropriate when we deal with flexible premium contracts - where premiums
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 53
are readjusted to subsequent mortality and interest experience. Both approaches
are mathematically sound. Indeed, if one uses the same assumptions while
computing them, the reserves produced at the end of a given period for both
would be identical
In India we have generally used the Prospective method, following British
practice. We shall confine ourselves here to this approach. The reserve for an
ordinary endowment policy on a prospective basis can be calculated as follows,
using standard actuarial formula:

tVx:n = Ax+t :n-t - P x: n x äx +t:n–t

where tVx:n represents Policy value or reserve built up at end of t years of an

endowment policy of term n years for an individual aged x years at entry.

Ax+t :n-t : Present value of benefits expected at age x+t

P x: n x äx + t : n – t represents present value of future premiums payable at rate

P for age x and term n years.
At the inception stage of the policy, the present value of future benefits expected
to be paid during the term (x+n) and present value of future net premiums
receivable are equal and in balance. This is obvious. The Life Insurer has to ensure
that Net Premiums match the benefits.
As the policy moves through its term the balance begins to change. The present
value of benefits increases as the date of maturity draws nearer. The present
value of future premiums on the other hand declines, since there are fewer
premiums to be received. The reserve, which represents the difference between
the two, would steadily increase with the term of the policy. It becomes equal to
the face amount of the policy at the end of the term
The Reserves of a life insurance company are typically determined through
conducting a periodic valuation of its assets and liabilities. The present value of
benefits payable in future and of premiums yet to be received is obviously not
known. They have to be estimated based on assumptions made for the purpose.
The value of a reserve is thus not actual but only an expected value. It would
depend on the Valuation Basis, which is given by assumptions made about future
mortality, interest and expenses, while conducting the valuation investigation.
Generally, the reserves are computed using the same mortality and interest
assumptions as were used in computing the premiums. A Company could also
make its assumptions more, or less stringent. It would result in adding or reducing
the safety margins built into the reserve.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 54
Reserves may again be valued in two ways, giving us two types of reserves - Net
and Gross Premium Reserves. The difference between these two types is defined
by whether it is Net or Gross Premiums that are used for the purposes of
considering future premiums, while arriving at the reserve. Reserves may thus
be calculated on a Net or Gross Premium basis.
In the Net Premium method, one takes into account only the contractual
liabilities payable, as per mortality and interest rate assumptions It does not take
into account either future expenses or bonuses payable by the life insurer. With
respect to future premiums to be received, it is net premium rather than the
office or gross premium that is considered. The method is appropriate for
demonstrating life insurer’s solvency and ability to honour its policy holder
contractual obligations, and is often sought by regulators.

Net Premium reserve = Present Value of expected future outgoes - Present

Value of future net premiums

Under Gross Premium basis, the loading element is also taken into consideration
while computing the reserve. We thus get a prospective reserve defined as:

Gross Premium Reserve = Present Value of Future Claims + Present Value of

Future Expenses - Present Value of Future Gross Premiums

Viewed retrospectively we can define the reserve as

Gross Premium Reserve = Gross Premiums collected in Past + Interest (at

assumed rate) on premium - Claims Paid and Expenses incurred

The Gross Premium Reserve may be more suitable if the life office wants to have
an accurate estimate of its actuarial reserves.
In case of With Profit policies, once life Insurer declare what they term as
‘Reversionary bonuses, they need to ensure it is paid. For this purpose, once it
declares a bonus, tries to maintain that bonus. In such a case, the future bonuses
payable also form part of liabilities, which need to be explicitly provided for, in
the reserves. The approach of establishing reserves that include future bonuses
is known as Bonus Reserve Valuation. If a Life Insurer, for example, proposes to
declare a bonus of at least Rs. 60 per thousand sum assured in future, a provision
is made in the reserves for this bonus addition
Asset Shares and Surrenders
Reserves are only half the story. The other half is given by how the assets of an
insurer emerge under given scenarios of mortality, investment, expenses and
withdrawals. This brings us to the concept of asset shares.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 55
An Asset Share may be defined as the individual policy’s pro rata share of assets
that are accumulated for a block of policies. It is analogous to an income - outgo
account. Each year, premiums and interest earnings are credited to the account
as income. Death claims, surrenders, expenses and other payments are charged
against the account. The balance at year end is divided by the number of
surviving and persisting policyholders to obtain the pro rata share of each policy.
An Asset Share is thus different from the Reserve on a policy. A Reserve tells us
how much money should be maintained in respect of a policy while its Asset Share
tells us how much has actually been accumulated.
Let us compare the asset share on the policy with its reserve and see how they
both emerge in the course of the term of the policy.
A Policy’s Asset Share is likely to be negative at the end of the first year,
reflecting the relatively high first year expenses involved in marketing,
underwriting and issue of new business policies. This is likely to be even truer for
new companies that have to incur heavy expenditure for setting up the business
from scratch. The Policy Reserve, on the other hand, would be positive and
relatively high, reflecting the need to meet the company’s obligations to its
policyholders and maintain required solvency margins.
During the initial years, the pro rata asset share would thus be less than the
reserves to be maintained. The time it takes for an asset share to equal the
reserve is a function of management’s decision about how soon to recoup
acquisition costs. It may extend from five to ten years.
After the asset share equals the reserve, both continue to increase but the asset
share would tend to rise at a faster rate than the reserve. Finally, when the
policy has run its full term the asset share is likely to be considerably higher than
the reserve. The difference between the asset share and the reserve
constitutes the profits that are earned on the individual policy, to be shared
between the company and the policyholder.
Consider what would happen if the policy’s asset share was not allowed to grow
but got nipped in the bud or while in the course of its growth? This can happen
in the event of a lapse or withdrawal. If these events happen early in the policy’s
life [say, within the first one to two years of the policy] the asset share would be
negative. It would be a dead loss for the company.
There ae two situations under which this can arise. The first is where premium
payments cease. Here, the company no longer needs to pay full sum assured to
the lapsed policy holder. If the policy premiums have been paid for a minimum
period, building a positive asset share, it may become a paid up contract. The
policy holder is eligible to receive the accumulated asset share in the form of a
paid up value, which is paid only at the end of the policy term (on maturity or
death). The second scenario is where the policyholder surrenders the policy. In
this case the accumulated asset share is payable to the policy holder before the
end of the term, and the life insurer no longer needs to maintain a reserve on
this policy.

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The Surrender Value is related to the policy’s asset share. It is always less than
the asset share. Since asset share would be nil or negligible in the early years of
the policy, it implies that surrender values may also be nil or negligible in the
earlier years, reflecting the slow growth of asset share. It starts becoming
significant only after a significant term has elapsed.
Let us see why surrender values are less than the asset share. There are four
reasons
Adverse Mortality Selection: Those who surrender their policies are on average
likely to be in better health and expected to live longer than those who do not
surrender. Lower surrender values provide an implicit margin for higher mortality
rates that might prevail among those who remain.
Adverse Financial Selection: Many terminations typically occur during economic
crisis and depressions and also when market interest rates are higher than the
returns provided by the insurer. Life Insurers would be adversely affected since
fewer funds are in hand to invest at higher rates of interest. The insurer may
also be forced to liquidate its already invested assets at depressed prices, to pay
the surrender amounts
Contribution to Profits: Every policy involves a commitment of capital and the
stockholders (owners of capital) are entitled to compensation for the risk borne
by their capital funds. This compensation comes from the profits earned by each
policy. Surrender of a policy would bring its contribution to such profits to an
end. An adjustment for the above is in order
Cost of Surrender: Finally, some amount of expenses are incurred in processing
a surrender and need to be recouped.
Ultimately the determination of surrender value calls for balancing of company’s
financial soundness and its competitive consideration
Valuation and Surplus
Surplus is the excess of the value of assets over the value of liabilities. If it is
negative, it is known as a strain. As we have seen earlier, surplus depends on the
assumptions used in valuation and is a function of the method and basis we choose
to use in valuing assets and liabilities. When an actuary uses a very conservative
basis in valuation the surplus would correspondingly reduce. This would mean
lesser bonuses available for distribution among current policy holders. But it
would contribute to financial soundness of the insurer and benefit future policy
holders. A liberal valuation basis has the opposite result. It would benefit current
policy holders but there would be lesser provision retained for the future.
The actuary faces an important question here, of maintaining what is termed as
inter - generational equity. Various generations of its policy holders, who have
taken policies at different times in the past and present, have contributed to the
Life Insurer’s fund. The issue is about how to allocate the surplus so that each
generation of policy holders would get a share of surplus in proportion to the
contribution they have made to it.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 57
Analysis of Surplus
We have already defined Surplus as the excess of assets over liabilities of a Life
Insurer. We saw how the value of liabilities was given by present value of future
benefits and other expected payouts less present value of premiums receivable
on a block of policies
Let us now look at how assets may be valued. This may be done in one of the
following three ways:
At Book Value: This is the value at which the life insurer has purchased or
acquired its assets. It is also known as ‘historic cost.’ Since capital assets like
stocks or real estate appreciate (or depreciate) in value, it may not be considered
realistic to value assets in this way. An alternative is to make adjustments in the
book value and thus arrive at a written up book value to reflect such
appreciation.
At Market value: This represents the worth of the company’s assets in the market
place. It involves discovering the price at which buyers would be willing to buy
the same or similar assets. The problem with this method is that market values
can be volatile. There is no guarantee that today’s values will prevail. This can
pose problems in case of traditional life insurance contracts whose guaranteed
benefits require their assets to be adequate to meet liabilities, not just in the
present but in the future as well.
Discounted present value: Here we estimate the future income stream from
various assets and discount the same to the present. This method has the merit
of reflecting the asset’s intrinsic worth as different from its market price – the
latter can be volatile. However it is not easy to estimate the present value,
especially when we have a massive amount of assets to be so valued. The method
is also sensitive to the assumptions used for estimating future streams of
payments and the rate of discount. For instance if you are conservative in your
assumptions, the value of assets would reduce and vice versa.
Sources of Surplus
Surplus in any year is a result of increase in the value of assets less the increase
in the value of liabilities. When we speak of sources of surplus, we are actually
comparing actual with expected experience. On reflection we would see that
surplus in a valuation can emerge through two sources:
Any favourable divergence of actual experience from the assumptions made in
the valuation basis.
Changes made in the valuation basis itself viz., the assumptions;
Let us see how Surplus arises when there is a divergence of experience from
assumptions. The sources are;
Interest: This is the source from which largest portion of insurer gains arises. It
emerges because actual interest earnings are higher than the rate assumed while
deciding the premiums and reserves. Profits can also be made from appreciation

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 58
in the value of investments (capital gains). Such gains arise from sale of assets
for value that is higher than book value.
Mortality: Life insurers’ actual mortality experience is generally not as heavy as
indicated in the mortality table used for calculating premiums and reserves.
Mortality also improves over time. Both factors can result in favourable
divergences
Loading : Insurers load the net premium to cover expenses, based on assumptions
about future expense levels (including anticipated inflation). If actual expenses
remain lower than assumed level, the resultant savings will contribute to surplus.
Finally, with profit policies also include a loading for the bonus /dividend
element. So long as other unforeseen contingencies do not eat into the provision
thus made, it would contribute to the surplus.
Gains from surrenders: in cases of policies terminated by surrender, there is a
payout of surrender value and simultaneous release of reserves held under these
policies. If the paid surrender value is less than the released liability (reserve),
the difference between the released reserves and surrender values allowed
constitutes another source of surplus. Note that creation of such surplus does
not imply that termination of a policy is financially beneficial to the insurer. First
of all, such gains only represent amounts earlier taken, in whole or in part, in
order to establish reserves. These are now returned to surplus. The gains are also
offset by unfavourable mortality experience, attributable to adverse selection.
The issue gets more serious when policyholders replace existing surrendered
policies with new ones. This process, known as Churning of policies, can result
in the company incurring heavy initial expenses and new business strain for a
second time.

H. Understand how Profits are distributed in Traditional Policies

We have examined above, how Reserves, Asset Shares and Surplus gets
determined when a valuation is conducted. Let us now consider the issues dealing
with allocation of the surplus among various constituents and finally their
distribution among policy holders.
Determining the divisible surplus
The first step is to decide the level of surplus to be distributed. Under With Profit
contracts, the life insurer is obliged to pass the benefits of favourable divergences
between actual and expected experiences, to participating policy holders. But
Surplus is also the source for enhancing the company’s basic capital (its equity or
net worth) from within. It is thus akin to a company’s undistributed profits
(retained earnings), and contributes to its financial soundness. Two issues arise
whilst determining the divisible surplus.
The first issue is deciding the quantum of surplus to declare for a given year.
Surplus is a function of the valuation assumptions. It is possible, by jacking up
the value of liabilities or undervaluing the assets, to reduce the surplus declared,

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 59
thus creating implicit or hidden reserves, which contribute to the company’s
financial solidity.
The next issue is to decide how much surplus to retain with the company and
how much to allocate as divisible surplus (for distribution among policy holders).
The allocation of a life insurers’ divisible surplus is similar to the dividend policy
of any other business corporation. In a corporation, the net profits (after interest
and tax) is either used to pay dividends to shareholders or retained as a reserve.
Here reserves are undistributed profits and would form part of the assets in a
firm. They contribute to the capital and net worth.
In a similar way a part of the surplus of the life insurer may be added to the
capital. While reserves form part of assets in a firm, the term ‘reserve’ as used
by actuaries is akin to the ‘provision’ as used by accountants.
Factors influencing retention of surplus
There are broadly two factors which influence the amount of surplus to be
retained by an insurer.
The first is Solvency Requirements: Life insurers need to demonstrate their
solvency to the regulator and other authorities. This means that they must not
only have an excess of assets over liabilities but also sufficiently higher assets to
ensure that an additional layer is there to protect policy holders in the event of
unforeseen adversities in future.
The Solvency margin may be defined as that portion of surplus assets over
liabilities specifically set aside as a cushion for addressing any unforeseen
deviations between expected and actual experience
There are two ways of building such a cushion. One way is to assume higher
margins while making pricing and reserving assumptions, so that the resultant
increase in loading would automatically lead to an increase in and create an
implicit margin within the reserves. The problem is that it could lead to
increasing the premium burden and rendering the insurer quite uncompetitive.
Again, insurers may also need to take risks and engage in riskier investments in
order to earn a higher rate of return on funds. In such a case, there could be
depreciation in the value of assets or a fall in investment income.
This brings us to the second way. In general, supervisory authorities may require
a substantial amount of assets to be set-aside as an explicit solvency margin.
These margin requirements would have the first claim on any surplus that is
arrived at.
Free Assets
Another purpose for maintaining unallocated surplus is to increase the level of
free assets. Free assets are unencumbered - they are not required for meeting
any liabilities. The life insurer is thus free to use them. Life insurers need to have
such free assets for two reasons.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 60
Firstly companies need capital to write new business. These Free Assets can be
made available to meet the capital requirements for financing new business
strain.
Free assets also offer the life insurer with greater leverage and freedom in
choosing its investment strategies. This becomes vital for companies who need to
generate and provide higher and competitive returns to their policy holders and
shareholders.
Distribution of surplus
Once the divisible surplus is declared, it needs to be distributed among
participating policyholders. Broadly three approaches to profits distribution have
been followed by life insurance companies worldwide: they are the Bonus
Mechanism; Revalorisation; and the Contribution Method.
The Bonus mechanism This system is popular in the United Kingdom, India and
many other countries. As the name suggests, surplus is distributed in the form of
a bonus. Bonus is an addition to the basic benefit payable under a contract.
Typically it may appear as an addition to basic sum assured or basic pension per
annum.
The most common form of bonus is the Reversionary bonus. It is so called,
because the policyholder only receives them at the end of the contract period,
usually by death or maturity. The company is expected to declare such bonus
additions each year of the contract term. Once declared, they get attached and
cannot be taken away, forming part of the liabilities. Bonuses may also be payable
on surrender, provided the contract has run for a minimum term to become
eligible.

There are different types of Reversionary Bonuses. Simple Reversionary Bonus

is expressed as a percentage of the basic cash benefit under the contract. In India
for example, it is declared as Amount per Thousand Sum assured. The second
type is Compound Bonus, which the company expresses as a percentage of basic
benefit and already attached bonuses. It is thus a bonus on a bonus. A way to
express it may be as @ 5% of basic sum assured plus attached bonus. Finally there
is Super Compound Bonus, which may be applied in terms of two percentages.
The first applies to the basic benefit while the other, usually higher, applies to
already attached bonus. This may be expressed as 8 % of basic Sum Assured + 10%
of attached bonus.
An advantage of the last two types of bonus is that the company may start with
a smaller bonus as bonus emerges at a slower pace in early stages. This enables
the company to enhance its free reserves. Ultimately, it may contribute to a much
higher level of bonuses.
An important feature of reversionary bonuses is that they are regular. Bonus rates
would ideally tend to increase smoothly and gradually over the years, but not
decline, as far as is possible.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 61
Terminal Bonuses:
As the name suggests, this bonus attaches to the contract only on its contractual
termination (by death or maturity). Again such a bonus is declared only for claims
of the ensuing year without any commitment about subsequent years (as in the
case of reversionary bonuses). Finally, terminal bonuses depend on the time
duration of the contract, increasing with it.
Terminal bonuses emerged in the United Kingdom and elsewhere as a solution to
the problem of how to treat large unrealised gains that were accrued through
increasing life insurers’ investments in shares and property. By giving these as
one off payments and also relating them to time, the company solved two
problems. They did not have to sustain these bonuses. Further those who
contributed more to these profits received more, proportionately. For instance,
policies with longer duration, which had contributed in larger measure to the
gains, were eligible for a higher proportion of the surplus under this method. Life
Insurers were thus able to achieve equity among policy holders in the matter of
bonus distribution.
Cardinal principles in bonus distribution
The Reversionary Bonus distribution system is based on certain cardinal
principles:
Equity: It implies that With Profits policy holders who exit the fund at maturity
should receive total benefits which are fair. Each group of policy holders should,
to the extent possible, get benefits that are in due proportion to their
contribution to the profits.
Reasonable Expectations: Policy holders are assumed to “reasonably expect”
that the company would not depart significantly from its recent practice with
respect to bonus distribution. Thus if Bonus for a certain year has been declared
at Rs. 54 per thousand sum assured, policy holders would reasonably expect that
this bonus rate should at least be maintained by the company.
Smoothing Mechanism: The expectation that bonus rates will not significantly
change from year to year is sought to be addressed through a Smoothing
Mechanism. As the name suggests the life insurer would try to smooth out the
bonus yields so that it does not fluctuate from year to year but ideally grows in a
smooth or uniform and graduated manner over the years. It simply means that
the company does not share its gains with policy holders in proportion to their
contribution to the same. Instead they seek to spread the gains over time and
across contracts.
Essentially this implies a pooled system - while strict equity would imply that
each maturing contract should be allocated a bonus on the basis of its own
contribution to surplus, the pooling mechanism does the opposite. It does not
individualise the gains and the risks but pools them. This leads to smoothing out
of volatility in returns that may arise, ideally resulting in a Uniform Reversionary
Bonus that gradually increases over time.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 62
Re-Valorisation :
This method of surplus distribution has been popular in France. Surplus is
expressed as an increase in guaranteed sum assured and as a percentage increase
in the policy reserve. In some cases the increase in reserves entails increase in
premiums while in others the premiums may remain unaltered.
Let us suppose the company earns an interest rate of r1 on its assets as against
the valuation interest rate of r that has been assumed. The increase in reserves
may be expressed as :

(r1 - r) X ( t+1V ) where t+1V represents reserve at the end of the year

The above type of expression is also known as the savings profit since it reflects
only the gains in interest earnings of the policy. The company may similarly have
an insurance profit which represents the gains arising from mortality and expense
experience being better than expected. The difference between actual and
expected profits may be similarly reflected in an increase in reserves.
In actual practice, the life insurer may not provide for the entire gains to be
added to the reserve but only a proportion of such gain. We could thus say that
reserves would increase by k (r1 - r), where k represents the proportion of (r1 -
r), by which the reserves are increased.
The Method is quite simple to apply and exactly spells out how gains from
investment and other sources is to be added to the benefits payable to the policy
holder. These may be codified and prescribed by the supervisory authorities.
The disadvantage is that there may be little discretion for the company. It may
be inappropriate for dealing with investment earnings that arise from volatile
instruments like stocks.
The Contribution Method
The Contribution method is extensively used, and is the dominant one, in North
America. It is based on an analysis of the sources of surplus and leads to dividends
that vary with the plan of insurance, age at issue and duration of the policy. The
idea is to ensure that surplus distributed to each policy contract must be directly
related to the amount it has itself generated.
The method essentially considers three sources of surplus - excess interest,
mortality savings and savings derived from loadings. The surplus is thus given by
the difference between what was expected to happen and what actually
happened over the year with respect to mortality, interest and expenses. The
formula is given below

Cn= ( Vo + Pv) (ra - r) +(q - q”) (S - V1) + (P- Pv - e) (1 + ra )

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Where VO, V1 represent value of contract at year beginning and year end as
measured on valuation basis
Pv = valuation premium; P = office premium;
ra = actual rate of interest earned; r = valuation basis rate of interest.
q” = actual rate of mortality experienced; q = valuation basis rate of mortality
S = sum assured ; and e represents actual expenses experienced under contract

The first term on the right represents the excess of actual interest over that
assumed earned on the valuation reserve plus the valuation premium.
The second term is the saving in mortality cost due to experienced mortality being
less than that assumed in the valuation. It can be seen that the percentage
declining factor of mortality is applied to the net amount at risk, which grows
steadily smaller and thus constitutes a smaller cost of insurance.
The third term represents the difference between the gross premium and the
valuation net premium (the expense loading) less actual expenses.
An important point to note above is that in North America, the premium does not
contain an explicit loading for bonuses. Surplus arises only due to the margins
gained vis-a-vis the assumptions.
The dividends that are declared may be used in one of four ways:
As payment of dividends in cash
As an adjustment to and reduction in future premiums
Purchase of non - forfeitable paid up additions to the policy
As dividends that are allowed to accumulate at interest to the credit of the policy.
It may be withdrawn at the option of policy holder or only at the end of the
contract.
Chapter Summary
This chapter deals with the actuarial aspects of designing and pricing life
insurance products. It is divided into two sections. The first section deals with
the determination of premiums while the second deals with the issue of profits
and returns in life insurance.
The critical feature in the design of life insurance products was given by the level
premium concept which in effect made these products long term products having
both a protection and savings element.
The premium in life insurance is determined by four factors. The first two are
Mortality, whose rate is determined through a morality table; and interest rate,
which is used to discount future benefits to their present values. They together
enable to arrive at the net premium. This premium is then loaded for two other
factors, namely expenses of the insurer; and loading for contingencies and profits
[bonus loading], which yield the Gross or office premiums.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 64
The solvency and profitability of life insurance policies needs to be continuously
examined, for which the Actuarial control cycle may serve as a relevant approach.
Actuaries typically conduct a periodic valuation of the assets and liabilities of a
life insurer, in which they review the reserves [liabilities] created and the assets
of the insurer. The excess of assets over liabilities yields the surplus. Once
determined it has to be allocated for maintaining solvency margins and building
free assets, and the remaining part is the surplus available for distribution among
policy holders and shareholders.
Distribution of surplus or profits may take different forms like the Bonus
mechanism, Re-valorisation and the Contribution method that is adopted in North
America.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 65
Self-Examination Questions
Question 1
Which of the following statements is incorrect
A. General insurance contracts are contracts of indemnity
B. What is uncertain about mortality is its timing
C. Morbidity and mortality are fairly stable functions of age
D. A Level premium contract has premiums increasing every year with age
E. Life insurance contracts are a bundle of protection and cash value element

Question 2
The guiding percept in premium determination for life insurance is
A. The principle of discounting
B. The principle of costs pooling
C. The Principle of Equivalence
D. The principle of mutual obligations
E. The principle of Uberrima fidei

Question 3
Two disciplines form the core of Actuarial Technology. They are
A. Cost Focus and Investment management
B. The science of probability and the principles of compounding/discounting
C. Financial Management and Budgeting
D. Mathematical Reasoning and Probabilistic approximation
E. Statistics and Calculus

Question 4
Four factors that go into determination of Premiums of conventional life products
are
A. Mortality, Cash Values, Expenses and profitability Rates
B. Claim, Underwriting ratings, Reinsurance rate and Investment earnings
C. Mortality, Interest, Loading for expenses – contingencies, and Bonus loading
D. Mortality losses, Solvency Margins, Capital Reserves and Profits
E. Mortality rates, Unit values, Expense rates and Reserves

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 66
Question 5
A policy’s contribution to the insurer’s assets is negative in early years due to
A. High Mortality rates
B. Low interest rates
C. New Business Strain
D. Huge Lapsation
E. Reinsurance requirements

Question 6
One factor that does not make surrender values less than a policy’s asset share is
A. Adverse Mortality Selection
B. Adverse Financial Selection
C. Reinsurance
D. Cost of surrender
E. Policy’s contribution to profits

Answers to Self -Examination Ques tions:

Answer to SEQ 1
The c orrec t option D.
Answer to SEQ 2
The c orrect option C.
Answer to SEQ 3
The c orrect option B.
Answer to SEQ 4
The c orrect option C.
Answer to SEQ 5
The c orrect option C.
Answer to SEQ 6
The c orrect option C.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 67
 CHAPTER 4
WHY PEOPLE BUY
Chapter Introduction:

This chapter focuses on the question of why people buy different kinds of
products, including the needs, wants and aspirations that drive them and various
other factors that impact their buying decisions. We also explore the process by
which people take such decisions. This knowledge is important in order to
understand the role and significance of different kinds of products like Fast
Moving Consumer Durables, Financial Products and Life Insurance products.
Learning Outcomes: at the end of this chapter you will

A. What is involved in the Purchase of a Good or Service?

B. Explain the concepts of Need, Want, Necessity and Drives
C. Discuss Maslow’s Hierarchy of needs and other approaches
D. Who is the Customer?
E. What is the role of various products like FMCGs, Durables,
Financial Products and life insurance in meeting needs
F. Discuss some of the needs, faced by individuals, met by Death
Benefit products and Living Benefit Products

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A. What is involved in the Purchase of a Good or Service?
A purchase decision arises as a response to a problem, which the buyer has
experienced. The problem arises because there is a significant perceived
difference between one’s current state and some desired or ideal state, giving
rise to a need to move towards the latter. The buyer or consumer (we use the
terms interchangeably) then goes through a sequence of successive stages to
arrive at the final decision. These stages are:
Problem recognition:
It is the phase of arousal in which the idea of the purchase is triggered. The
arousal occurs when one begins to feel or recognise that there is a gap between
one’s current state and an ideal state. This gap creates what is popularly termed
as a need, which has been defined as a felt state of deprivation. We shall discuss
the concepts of needs, wants and necessities a little later in this chapter. The
gap has to be sufficiently strong and compelling to rouse its recipient to action.
This gap can arise in two ways. In the first case, an individual’s actual state
deteriorates and he / she is worse than before. Instances of this are when you
feel hungry or thirsty or ill and need to eat and drink and take medicines. In the
second instance, one’s existing state has not changed but his/ her ideal state is
enhanced and there is a yearning to get to a better state than the present. For
instance, when one sees a mobile being used by one’s neighbour, there is an urge
to buy a similar gadget. Observe that the yearning [felt deprivation] to have a
phone that one can carry around may be latent in one’s mind, or it may or even
be present, until the opportunity to have it arises and is recognised.
Insurance and, to some extent, other financial services clearly belong to the
second category. In insurance, one is offered a promise of compensation [a better
future] in the event of a calamitous loss event in exchange for a premium [a
deprivation of current resources]. The benefits are intangible and the need itself
[sense of deprivation] is not actual but imagined. The consumer would need to
have a compelling reason to buy. The persuasive role of an insurance agent/
advisor becomes significant here.
Information search:
The next stage is when a prospective buyer conducts a search for information in
his / her environment, looking for data that may be appropriate for taking a
decision. The impetus for a detailed search for and processing of information is
given by the degree to which one engages in ‘rational behaviour’. By this we
mean, a disposition to carefully collect all available information about the
problem/situation and various solutions/responses to it, and integrate this with
one’s own knowledge and experience. Note that consumer may not engage in
such detailed search and information processing in all products. Buying a kilo of
sugar or picking a bottle of coconut oil off the shelf may be much more habitual
and entail less information search compared to purchase of a laptop or a four
wheeler.
How far a consumer would be motivated to process information and engage in
information processing for extended problem solving depends on the ‘degree of
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involvement’ of a consumer in the purchase decision. It is possible to place both
products and consumers along a continuum, which stretches from low to high
involvement. We thus get High Involvement Products [HIPs] and Low Involvement
Products [LIPs]. Involvement in turn depends on two factors: [1] the personal
meaning or relevance of the product category for the buyer: a lady choosing a
wedding sari or party wear may spend hours in a showroom looking for the right
apparel to wear. Dressing right is critically important for making the right
impression on this occasion. [2] The perceived risk from making a wrong choice
and the probability of making a poor purchase: this would be especially seen in
cases of high price products which also have many substitutes. For instance, the
opportunity cost involved in making a large outlay for purchase of a mutual fund
[Opportunity cost = returns forgone by not buying alternative investments]. More
competitive the market, higher the perceived risk.
In Insurance, we have two terms that are often used in connection with the above
two stages [problem recognition and information search] – Insurance awareness
and insurance literacy.
Insurance Awareness:
This term is used to refer to the process by which an individual begins to
consciously recognize the existence of one or more risks to which he / she has an
exposure and also recognizes the possibility of addressing such risks through the
mechanism of insurance. This should ideally lead to specific action of purchase
of an insurance product.
The building of Insurance awareness, it may be seen, involves certain issues:
Unearthing of the need: from the day one is born, one is exposed to risks like
mortality, morbidity and longevity. These may sometimes cause a sense of
apprehension or foreboding in the sub conscious mind. The task here is to bring
this sense of anxiety [or risk aversion] into cognitive mind space. If this is not
done, the need for insurance protection may not even be considered.
Addressing cognitive dissonance: there are many instances where the need for
and the very idea of insurance may be unacceptable, because it is disagreeable
or in conflict with a value or belief that one holds. For instance, one may hold
that buying insurance entails mortgaging or gambling on one’s life or property in
exchange for money. Quite often, dissonance and disenchantment may be a result
of the way the insurance has been positioned and sold, sometimes it may be a
result of one’s own or someone’s bad previous experience that one is aware
about.
Finally Trust Building: Paying attention and giving consideration to a
communication about the benefits of insurance are the result of a decision which
is ultimately taken in the individual’s animal or limbic brain. This ‘seat of
emotions’ needs to be won over before rational information processing can even
begin. Many sales persons and companies, even while having a strong argument
for buying their products, fail to get their prospects’ attention because they have
been unable to make ‘the connect’ and build trust and acceptance. The sense of
dissonance and trust deficit becomes even more pronounced due to the
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perceptions of prospective customers about hassles they may face in their
transactions with the insurer.
It is obvious that awareness building in large measure is a matter of removing
deep misgivings that people have.
Insurance Literacy
‘Literacy’ in popular parlance means ability to read and write. When used in
insurance, Literacy consists of Knowledge and Skills that are required to buy /
adopt and use insurance optimally towards achieving well - being.
In an interesting study by Weeding Sampath Sanjeewa and Ouyang Hongbing. The
term is defined as follows
“Insurance Literacy is a term that may be used to “measure the level of
knowledge, skills and confidence of an individual to select the insurance
mechanism among other personal risk management strategy; decide appropriate
insurance products with right cover to handle the potential risk; evaluate such
cover with terms and conditions involved therein; understand rights and duties
when using the insurance product, and awareness of necessary information
sources, to make sound insurance decision”.
There are six knowledge dimensions suggested by the authors
Understanding of Potential risk exposure: to various kinds of risk including life
contingent risks like mortality and morbidity
Understanding Risk Mitigation Strategies: Corporate risk management literature
suggests three main ways – [1} reduce the risk, by reducing either its likelihood
(incidence) or severity (financial impact); [2] Transfer the risk, using a
mechanism like insurance; or [3] finance the risk via creating funds through
precautionary saving. These methods need to be understood and compared
Understanding Insurance concept and its benefits: this includes knowledge about
the principles of risk pooling, probability and the law of large numbers, and how
these work. Such knowledge can create competence and confidence in the
insurance process. Understanding various types of insurance products and the
perils covered – including perils that impact on property, liability and there are
multiple types of perils that have an impact on property, liability and person.
Understanding the rights and duties of insured: including the obligatory
requirements that must be fulfilled by policy holders during the policy period
Awareness about the right information sources for insurance: This may be difficult
to gain, even for those who are educated and financially literate if there is a lack
of transparency, and requisite knowledge is not easily available and accessible.
Apart from knowledge and awareness, one also needs to have various kinds of
skills – like mathematical computational skills to more accurately assess risk
exposure and its impact. Another skill set is analytical skills in order to make
tradeoff between different features of insurance products and their benefits

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Generation of Alternatives
On the basis of information gathered, a number of alternative solutions to the
problem are generated. Some of these may call for buying a specific kind of
product while in other cases, an alternative course of action may be suggested.
Generation of alternatives is a rather difficult and time consuming task which
may involve much effort and a certain degree of skill and expertise in collecting
and gathering information. Its performance depends on a few factors.
First of all, such generation becomes important only when one is considering high
involvement products. In many cases, like the purchase of a bar of soap or
toothpaste, one is likely to go by habit – a Close Up or Colgate toothpaste pack
may be picked up without a second’s thought.
Again, a lot depends on the exposure that consumers have to information on
various kinds of products. Until the advent of internet and social media, the only
source of information and awareness about any product would often be the sales
person of that product [e.g. the life insurance agent] or some advertisement. The
time honoured practices of aggressive selling of life insurance products to passive
customers has been the way the industry has been built for many decades. Today
that process of ‘push sales’ is becoming more difficult because of the exposure
that prospects and customers are getting as a result of being present in the
information age.
One of the serious limitations in generating alternatives comes from ‘Information
asymmetries.’ This is where one party in a transaction does not have the same
information that another has. In life insurance, for instance, the agent, who is
mainly concerned with closing a sale, provides selective information that is
incomplete and sometimes even inaccurate about a product or alternative
products and pushes the prospect to close the sale. Another source of limitation
may be the lack of transparency of various life insurers – when product structures
are opaque and cannot be easily understood without the help of a company
representative, it would be difficult to make an objective assessment and
comparison among alternatives.
Yet again, there may be cases where the purchase of a life insurance policy is
linked to another non – insurance benefit. For instance the provision of a student
loan by a bank may be tacitly linked to purchase of a life insurance policy from
the bank [acting as a banc assurer].
We thus find that consumers in life insurance and other markets too, may face
limitations in engaging in such activity. These limitations may get weaker in days
to come as information and communications technology opens new vistas in the
markets. For instance, the launch of Bima Sugam by the Indian regulator [IRDAI]
promises the availability of a platform where prospective customers may be able
to easily access and assess the features and benefits of various kinds of insurance
products of different companies and get a measure of the alternatives available
to them

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Evaluation of and selection among the various alternative solutions
In this step the prospective buyer may apply various criteria to reject or weed
out various alternatives and short list a few for final selection. It is the heart of
the purchase decision. This involves two steps – firstly one may narrow down the
alternatives to be considered into a more acceptable number. Secondly, one may
adopt a criteria for evaluation and apply this to choose one or more alternatives
over others.
There are broadly two kinds of approaches by which consumers may engage in
the above tasks. The first is categorisation and the other is via piecemeal
evaluation
Categorisation: under this approach, people may assign each product alternative
to a certain category and make an evaluation based on its comparison with other
alternatives within the category. The categories are
The evoked set: made of all alternatives that are actively considered,
The Inert set: which the consumer is aware but would not consider buying.
Inept set: which the consumer does not consider at all
For instance, a prospective investor may begin by grouping various product that
are avenues of savings, providing favourable returns. Then, he/she may narrow
down to considering only a set of alternatives among savings products that have
much in common with each other – say ULIPs as long term investment plans as
compared to other similar long term investment vehicles. At a still narrower level,
the investor may now consider and compare between a set of selected brands of
ULIPs – say SBI Life, HDFC and ICICI.
The task for a marketer is to have a product that fits into the evoked category
and yet is unusual and unique within it, so that it attracts attention and a
favourable decision.
In Piecemeal Evaluation: a prospective buyer considers the advantages and
disadvantages of each alternative along important product dimensions. There are
three steps here–
Firstly one has to determine the criteria/product dimensions for evaluation – for
instance, in selection of a ULIP, one may choose the criteria of size of returns as
reflected in NAVs; charges at the purchase and redemption stages; and comfort
with the insurer.
Secondly, one evaluate strengths or weaknesses of each alternative along the
particular criteria that has been chosen. The three brands that are being
considered may be evaluated according to the above criteria
Finally one may make judgments about performance on the above counts to form
an overall evaluation
Selection of Product Alternative
Finally, there is the choice of the product alternative. Buyers may arrive at this
decision on the basis of certain decision rules that they adopt. Quite often, they
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simply follow heuristics or simple mental rules of thumb that lead to speedy
decisions. Instances may include General Rules [e.g. Made in Japan = best
quality], or Specific {the soap my best friend uses]. But they may also be more
deliberative.
Deliberative rules may be of two types : compensatory and non-compensatory.
In non-compensatory rules, the buyer may consider just one or two attributes
and reject all alternatives that do not meet a certain minimum standard on these,
then going on to select the brad alternative that scores best on the most
important attribute(s] selected. This means that a product with a low standing
on one attribute cannot make up for this position by being better on another
attribute. Under Compensatory Decision Rules on the other hand, the buyer give
a product a chance to make up for its shortcomings in one dimension by features
in another. Thus would obviously involve careful comparison and making of trade-
offs both among attributes and among products.
The process of making a purchase extends even after the decision is taken as one
learns about the quality of the decision through post purchase evaluation of the
results.

B. Explain the concepts of Need, Want, Necessity and Drives

The primary factor that drives the entire process of purchase is the existence of
certain needs and wants. The genesis of this process lies in a gap that exists
between one’s current state and an ideal state. This gap creates what is
popularly termed as a need, which has been defined as a felt state of
deprivation. The gap has to be sufficiently potent to rouse its recipient to action.
It can be widened in two ways.
The first way is when the individual’s actual state deteriorates and he / she is
worse than before. A number of physiological needs would fall in this category.
For example, when you are thirsty you need to drink. When you are sick you need
treatment and medicines.
In the second instance, the individual’s existing state has not changed but his/
her ideal state is enhanced and there is a yearning to get to a better state than
the present. This yearning (felt need) to reach a better state may be latent in
the mind or it may not even be present until an opportunity to achieve it arises
and is recognised.
An example of the latter is the need for internet. A couple of decades ago, such
a need did not exist, or at least did not form a part of the lives of most individuals.
However, with the creation of this ‘information highway’, it is difficult today for
many people to conduct their day to day lives and work without it. Many a
business enterprise has found its purpose and prosperity through unearthing
opportunity and enabling people to dream. Marketing itself has been a process

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of selling dreams. In a sense, this is what Peter Drucker meant when he said that
the purpose of a business is to create a customer.
Insurance and financial services clearly belong to the latter category of needs. In
both cases the promise of a better future (an opportunity) is offered in exchange
for current purchasing power [cash or other liquid assets which the buyer has to
forgo. Given the intangible and contingent nature of benefits, the consumer for
life insurance needs to have a compelling reason to buy. The persuasive role of
an insurance agent/ advisor becomes significant here.
While a need is something that one must have and cannot do without, a want is
something that one would like to have. Needs and wants often operate together
in many instances of purchase. To give an example, thirst is a need that has to
be quenched by drinking water. Many people however would want to buy a
specific brand of bottled water, even though their thirst could have been met by
drinking ordinary tap water.
One must also note that in many cases, the mere presence of a need is not
sufficient enough to motivate purchase of a product. One must also want to buy.
This is especially evident in the case of the second kind of needs, which are
prompted by yearning to reach a better state. Life insurance is again, a classic
case in point. Even though the need for insurance protection is universal and
could lead to a greater sense of security, the fact remains that the insurance
industry in many countries, including India, has not been able to convert that
need into a want. This is evidenced by the massive protection gap that still exists.
Quite often, the need gets converted in to a want only when the solution [product
or service] becomes attractive and irresistible.
We may also note that very often, what starts as a product or service that it is
good to possess or avail [a want], may get converted into something that the
buyers [individuals or entire communities] cannot do without. When the want
[nice to have] becomes urgent and insistent [cannot do without], it becomes a
necessity. The Television sets that we have in our homes, the mobiles that we
carry in our hands and the Facebook account that we visit frequently, all began
as wants, a couple of years ago, but have become necessities today, without
which life might seem inconceivable for many.
Human needs in turn arise from certain fundamental drives that exist in all human
beings. Every product, including life insurance, must address one or more of these
drives. They include the following:
The need to acquire and achieve: is perhaps one of the most critical drives that
underlies the need to acquire various kinds of things including wealth
accumulation. It is the dominant need that has been fueled by our consumerist
society.
The need to bond: and have relationships based on love of others, is what
creates the sense of one’s role and responsibilities. It is from this sense of
responsibility and consciousness of one’s role that the need for insurance
protection and savings is derived

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The need to learn: creates a continuous thirst for information and knowledge.
This varies from individual to individual. It has also increased multifold in the
knowledge society of today where all the information we would like to have is
available at our fingertips.
The need for meaning and fulfillment: is a central theme that drives human
behaviour – it has especially become central today
The need to protect and defend what one has: is closely linked to the need for
security – one of the key value promises of life insurance.
The need to have new experiences and novelty: has emerged as a key drive
today, in the contemporary context. Indeed, it is often said that the emerging
era is one where a needs economy is being replaced by an experience economy
The need to contribute: and make a difference to the lives of others. It is
closely associated with the need to bond and find fulfilment in action.
The key to growth and prosperity for any business enterprise is its ability to
identify, unearth and address one or more core drives, as indicated above, in a
powerful way. The more needs and drives one can address, the better.
Chemicals in the Brain
A key reason for any kind of behaviour, including purchase behaviour, is the
pursuit of happiness. Note that happiness is a fundamental emotion which is
associated with various kinds of situations - like possession of something or
achievement or connection with someone, or realisation of an ideal…One of the
major contributions of modern neuroscience has been to establish the importance
of physiological and biological factors in kindling this emotion – in particular we
have the role of certain chemicals, also known as hormones or neurotransmitters
which are produced in the human body and which play a critical role in regulating
our moods and emotions. These chemicals play a key role as the emotional drivers
of various behaviours, including buying. There are four fundamental chemicals or
hormones we shall consider – Endorphins, Dopamine, Serotonin and Oxytocin.
Endorphins are known as the runner’s hormone. They not only block pain signals
but also can induce a sense of euphoria, which may explain how people get
hooked to running or other strenuous sports or adventures.
The chemical that is associated with a wide range of activities that we perform
is Dopamine – the motivational molecule. This chemical is part of the brain’s
reward system, which gives you the pleasurable sensations and keeps you coming
back for more. One may feel a rush of Dopamine inside oneself, when driving a
Ferrari or getting a huge applause or making love or taking intoxicating substances
[alcohol or drugs]. When people want to accumulate various kinds of wealth or
seek to gamble or gets power hungry and even sadistic, it is the rush of Dopamine
that drives them. It is obvious that Dopamine is the active neurotransmitter in
various kinds of addictions and can lead to irresponsible and extreme behaviours
that can cause harm to self and others.
The balance is struck when one has a release of Serotonin, the neurotransmitter
that carries messages to the body, telling it how to work. Serotonin plays a critical
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role in promoting a sense of stability and balance – it regulates a number of body
functions like temperature, sleep, hunger and sexual behaviour. When Serotonin
is at normal levels, one feels you feel more focused, emotionally stable, happier
and calmer; while low levels are associated with anxiety and depression.
The final chemical to consider is that of Oxytocin, also known as the ‘cuddle
hormone’. It is the chemical associated with bonding and trust, and other
emotions like love, generosity, caring and a feeling of responsibility.
A little reflection would reveal that a balance between all the above chemicals
are vital for maintaining our emotional balance and wellbeing. It is also apparent
that the purchase of different kinds of products and services promote emotional
experiences within us by triggering production / release of one or the other of
the above chemicals. For instance, a great deal of obsession with speculative
investments arises from the release of Dopamine that it generates. The purchase
of life insurance on the other hand may be more prompted by release of Serotonin
and Oxytocin.

C. Discuss Maslow’s Hierarchy of needs and other approaches

Maslow’s Hierarchy of needs
Abraham H. Maslow in 1943 proposed a theory of human behaviour called
“hierarchy of needs”. Maslow asserts that people are motivated to action by
unsatisfied needs and that certain lower needs are the initial focus and requires
satisfaction before higher needs can be addressed or achieved. There are five
sets of needs and each set does have relative priority which can be arranged in a
hierarchy. They are:
Physiological needs: Basic amenities - air, water, food, clothing and Shelter
Safety needs: Physical, environmental and emotional safety and protection
Social needs: Need for love, affection, care, belongingness, and friendship;
Esteem needs: Two types of esteem needs
Internal esteem needs: self- respect, confidence, competence, achievement and
freedom;
External esteem needs: recognition, power, status, attention and admiration
Self-actualization need- This include the urge to become what one is capable
of becoming through more knowledge, social- service, creative, being aesthetic
etc. The self- actualization needs are never fully satiable.
The concept is most often demonstrated with a pyramid that illustrates each need
and its relative importance. The base of the pyramid consists of the most basic
needs, while more complex human needs make up the top of the structure.

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At the bottom are physiological needs that must be satisfied first, else it would
monopolize consciousness. When this level of need gets satisfied the next ‘higher’
need emerges. In short, when people get food and other bodily necessities, they
are then concerned about safety. After safety comes the need for belongingness
or love, then esteem or achievement, and finally, at the top of the triangle,
comes the need for self-actualization, which he defined as “the individual is doing
what he is fitted for”.
For example, a hungry man will be more motivated by a desire to eat than by a
desire to remain safe or maintain social status. Higher needs include, in order,
Love, Self Esteem and Self Actualization. When each of these needs in turn is
satisfied, from lower to higher, new (and still higher) needs emerge, and so on.
As each need is met, personal achievement rises and purpose is fulfilled.
The above theory has important implications for marketers. The five needs are
grouped into two categories – a) higher-order needs; and b) lower-order needs.
While physiological and the safety needs constitute the lower-order needs, that
are mainly satisfied externally, the higher order social, esteem, and self-
actualization needs are generally satisfied internally, i.e., within an individual.
Different products may be designed and positioned to address different order
needs. For instance, while some shirts or wrist watches may be positioned to
satisfy fundamental needs of covering the body or telling the time correctly,
others may be targeted towards higher needs like social and self-esteem, and
may include expensive apparel designed for party wear or some other formal
occasion. We find that even nations and societies follow this trend. A very poor
subsistence economy may thus be more concerned with lower order physiological
and safety needs of member citizens [like food, clothing, shelter basic health
care and minimum standard of living items]. On the other hand, as one looks at
more developed economies, the concerns shift to vacations, hobbies, quality of
work life and novel experiences.

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Limitations of Maslow’s Theory
While Maslow’s hierarchy seems intuitively and logically correct, in real life it
does not work in such an orderly manner. Different individuals may be driven by
different needs at same point of time. For instance, even when a starving artist’s
basic needs are not satisfied, he will aspire for recognition and admiration. The
latter is a more powerful unsatisfied need that motivates him.
Michael Maccoby argues in his book “Why Work?” argues that “what we choose to
do depends more on our ethics than on satisfying needs”. Apparently our
motivations are not driven solely by our innate needs. Again, Wahba and Bridwell
in their extensive review titled “Maslow Reconsidered: A Review of Research on
the Need Hierarchy Theory” state that ‘there is no clear evidence that human
needs are classified in five distinct categories, or that these categories are
structured in a special hierarchy.’
Dutch social psychologist and anthropologist Geert Hofstede argued that the
social and intellectual needs of people who have grown in individualistic societies
and of those who have grown in collectivist societies are different. While
Maslow’s is an individualistic perspective, in collectivist societies the needs of
acceptance and community outweigh the needs for freedom and individuality.
Chilean Economist and philosopher Manfred Max-Neef argued that fundamental
human needs were non-hierarchical as they all formed part of the universal
condition of being human. He proposed a set of Fundamental Human Needs from
the perspective of Economics, in which he segregated nine needs into four
categories for each need. A look at his scheme could help us in understanding
needs in greater perspective.
Max - Neef’s Fundamental Human Needs:
Need Being Having Doing Interacting
(Qualities) (Things) (Actions) (Settings)
Feed, Living
Physical and Food,
Subsistence clothe, environment,
mental health shelter, work
rest, work social setting
Social
Co-operate,
Care, security, Social
plan, take
Protection adaptability, health environment,
care of,
autonomy systems, dwelling
help
work
Share,
Respect,
Friendships, take care Privacy,
sense of
family, of, make intimate
Affection humour,
relationships love, spaces of
generosity,
with nature express togetherness
sensuality
emotions

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 Critical Literature, Analyse, Schools,
capacity, teachers, study, families,
Understanding
curiosity, policies, meditate, universities,
intuition educational investigate, communities,
Associations,
Receptiveness Cooperate,
Responsibiliti parties,
dedication, dissent,
Participation es, duties, churches,
sense of express
work, rights neighbourhood
humour opinions
s
Games, Day-dream, Landscapes,
Imagination,
parties, remember, intimate
Leisure tranquillity,
peace of relax, have spaces, places
spontaneity
mind fun to be alone
Invent,
Imagination, build, Spaces for
Abilities,
boldness, design, expression,
Creation skills, work,
inventiveness, work, workshops,
techniques
curiosity compose, audiences
interpret
Language,
Get to know
Sense of religions, Places one
oneself,
belonging, work, belongs to,
Identity grow,
self-esteem, customs, everyday
commit
consistency values, settings
oneself
norms
Autonomy, Dissent,
passion, choose, run
Freedom self-esteem, Equal rights risks, Anywhere
open- develop
mindedness awareness

Clayton Alderfer, an American psychologist, redefined Maslow’s need hierarchy

theory of motivation in his own terms to bring it in synchronization with empirical
research. He further developed Maslow's hierarchy of needs by categorizing the
hierarchy into his ERG theory (Existence, Relatedness and Growth). The “‘E’ of
ERG” or ‘existence group’ is concerned with providing for basic material
existence requirements. They include the items that Maslow considered to be
physiological and safety needs. The second group of needs “‘R’ of ERG” is
‘relatedness’- the desire we have for maintaining important interpersonal
relationships. These ‘social and status desires’ require interaction with others if
they are to be satisfied, and they align with Maslow's social need and the external
component of Maslow's esteem classification. Finally, Alderfer isolates ‘growth
needs' or the “’G’ of ERG,” as an intrinsic desire for personal development. These

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include the intrinsic component from Maslow's esteem category and the
characteristics included under self-actualization.
ERG Theory states that at a given point of time, more than one need may be
operational. ERG Theory also shows that if the fulfilment of a higher-level need
is subdued, there is an increase in desire for satisfying a lower-level need.
Alderfer also suggests a ‘regression’ theory in which, when higher category needs
are not met, individuals redouble the efforts they have invested in a lower need.
For example if self-actualization or self-esteem is not met then individuals will
invest more effort in the relatedness category in the hopes of achieving the higher
need. This is also called the frustration- regression aspect of ERG theory. For
instance, aggravation of growth need might motivate an individual to seek
accomplishment of the relatedness need and so on.
In his model, ERG Theory of motivation is very flexible as Alderfer perceived the
needs as having a wide range/variety rather than dubbing them as a hierarchy.
According to him, an individual can work on growth needs even if his existence
or relatedness needs remain unsatisfied. Thus, he gives explanation to the issue
of “starving artist” who can struggle for growth even if he is hungry.

D. Who is the Customer?

Needs and wants are, no doubt, the springboards from which purchase decisions
regarding different products emerge. One mistake that many manufacturing and
service companies make however is to assume that a product will sell just because
there is a generic need for the same. It would be absolutely foolish, for instance,
to believe that a person would want to buy a Mac Donald burger just because he
is hungry or even wants to eat a burger, or visit Starbucks because he or she wants
to drink a cup of coffee. Remember what we learnt in a previous lesson – that
Products are bundles of Attributes – it is not just the need but also whether
an individual’s preferences for certain attributes possessed by a particular
brand of product, that determines whether that individual would seek out and
buy that brand.
When any enterprise, including a life insurance company, sets out to create
products and services, it needs to be sure about who are the customers it should
approach and target with those products. In fact, the very process of design and
development of a product should be conducted, keeping the needs and
preferences of a certain set of customers in mind.
Jobs to be done Framework
One of the most significant works in current [21st century] marketing literature is
the ‘Jobs to be done’ framework which was developed by Clayton Christensen
and others. This model argues that Customers do not buy products and services.
They rather pull them into their lives in order to make progress in terms of getting
a certain job done. These writers define a job as the progress that a person is

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trying to make in a particular circumstance- in terms of moving towards a goal or
an aspiration. A job may thus imply fulfilment of a need, or resolving a problem
or realising an aspiration or getting rid of a certain hassle or obstacle on the way.
It is also obvious that a job can only be understood with respect to the specific
context in which it arises – for instance, one’s income or family status or role or
stage in the life cycle. It is also related to certain values, attitudes and beliefs
that one holds and has functional, emotional and social dimensions. Jobs need
to be understood not only in the context in which they need to be performed but
also the pain areas – the problems, pains, hassles and risks that people face in
getting the job done today; and the gains – specific outcomes and benefits that
they seek to attain through its performance. A product is like a candidate being
hired to do the job. The question to consider is whether the candidate has the
right qualifications, capacities and can be trusted to do the job well.
Segmenting and Profiling the Customer
The fact that jobs to be done are related to certain contexts in which they need
to be performed means that there is no one all-inclusive amorphous group of
customers. Instead, customers may need to be divided into various groups or
segments, based on the specific kind of job they are trying to get done by ‘hiring’
a particular product. For instance, in the case of life insurance, we may find that
pure Term Protection products are purchased by a particular class of customers
who want to get the job of ‘Premature Death Protection’ done. Another category
of customers may be those who want to do the job of preserving their capital in
the later stages of their life or wish to leave a bequest for their grandchildren.
Whole life products may be prospective candidates to do the job. ULIPs may be
sought out and considered by those interested in making more money or getting
their money to work for them more efficiently. In each case, the product is
considered and may be evaluated with respect to whether it is an appropriate
and ideal candidate to do the particular job.
Once the customers are categorised based on the kind of job they want to get
done through a product [it may be a four wheeler or a life insurance policy], the
various segments that are formed may need to be profiled. For instance, it is
necessary to know what is the profile of a buyer of Term Insurance or a Pension.
Segment classification and Profiling is the process by which the differentiating
characteristics of various customer segments are set out on the basis of certain
bases, known as bases of segmentation. Broadly, these ca be divided into two
types – Demographic and Psychographic factors.
Demographic Factors refer to objective aspects of a given population that can
be observed and even measured. Among the more important demographic factors
that are relevant for life insurance and financial products we have
Occupation and Income: which decides one’s class and social standing in the
community. It plays a major role in deciding both willingness to buy and ability
to pay the premiums.

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Education and level of literacy : It decides how much an individual would be able
to understand and appreciate the significance of intangible concepts like
insurance and be ready to buy them
Age structure: Human beings generally go through a life cycle with various stages
like youth, middle age, and old age. They play distinct roles, depending on the
age group they belong to – like that of a learner [student], till say age 18 to 25;
partner [after getting married]; and retired [after entering the twilight years].
The needs of each group of individuals may be quite different.
Gender: this is a factor that has acquired newfound importance with the
emergence of women as a distinctive market segment with immense potential,
and
Family structure: it is a key determinant of spending priorities including life
insurance and other assets.
Demographic variables are very useful in understanding the objective context in
which people perceive and interpret various stimuli. For example the life
contingency needs and preferences of a business executive differs from that of a
farmer. Similarly a young parent would have different need from a retired old
man. However, human beings are not just categories divided by some
characteristics like their income and occupation. They are thinking and feeling
entities with a sense of being that is derived based on what they identify with in
the world around then. Michael Solomon thus argues that consumer behaviour
goes beyond just buying. It is closely related to their sense of who they are. Thus
our purchases are based on and in turn influences our sense of how we feel about
ourselves and others and also what we want to be.
Self - Identity: This brings us to another dimension of the customer profile –
one’s sense of self-identity. This identity is often given by how one relates to
others, and the role that one plays in the context of the family, the workplace,
and the community. In each of these spheres, one may have a role identity
[father, executive, ‘samaj sevak’…etc.] Individuals also hold beliefs about the
attributes/qualities of what they possesses in relation to these roles. This would
often determine, for example, the type of houses they live in, the clothes they
wear and the consumer durables they own. These evaluations go to make up what
we call one’s self-concept. Note that there is often a gap between one’s concept
of an ideal self and real self – products are purchased precisely because their
possession helps to fill this gap.
A key concept in marketing literature is the ‘means – ends chain’ model.
Products are valued as means to an end. Attributes and benefits like death
protection and investment returns make sense only to the extent that they lead
to outcomes that consumers want to see attained [or jobs they would like to see
done] - like ensuring that one’s children are settled in life whatever happens to
oneself.
Psychographics: The above notion of self - identity or self-concept is in turn
linked to certain personality traits one has, values one cherishes, attitudes and
beliefs one holds vis-à-vis many things and one’s lifestyle preferences. All these
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have a strong influence on how individuals look at and make choices about what
to buy or reject. They are together classified as Psychographics – the subjective
and psychological factors that go into individual purchases.
Personality: Personality refers to one’s unique psychological makeup, which
influences how an individual responds to his/ her environment. The term comes
from ‘persona’ which implies donning a mask or a guise. There are many studies
on Personality in psychological literature, one of the most important is “Trait
theory’ which states that each individual possesses a combination of certain
psychological predispositions or traits. One may thus be an extrovert or introvert;
She may be thinking/ reason oriented or alternatively feeling oriented. Again
some people; largely rely on empirical data (sensing) for understanding the world,
while others are more driven by intuition. Yet another distinction may be made
between risk taking and innovating persons versus risk averse and conservative
individuals. Finally we may find some people who are extroversive and outgoing
while others are introverts and withdrawn. Combinations of these various traits
yield distinctive temperaments. The type of personality one is dealing with has
a lot to do with what kind of product features would attract which kind of
individual.
Values: constitutes another dimension. A value is a belief that a certain condition
or state of affairs is preferable to its opposite. In general they represent beliefs
about how life should be lived and what kind of behaviours should be upheld. For
instance, if a person holds that freedom is a value, he would seek to live and work
in an environment where freedom of thought and expression is allowed, he would
himself be expected to reflect and allow such freedom in his dealing with others.
Values are universal in nature. What makes one culture different from another is
the relative importance it gives to these universal values. They make up the
value system of that culture. For example western cultures are believed to give
high importance to values related to individualism: like self-reliance, self-
improvement and achievement of personal goals; freedom of expression and
personal freedom. Asian societies in contrast are believed to give more
importance to the collective; they emphasize values like family, community life
and appropriate social behavior.
Lifestyles: tell us who we are in terms of what we do and how we live. More
specifically it speaks about one makes choices about spending one’s time and
money. Products are the building blocks of lifestyles. They define what kind of
life one leads, how one relates to others and how one conducts life in general.
Attitudes: all the above aspects that we discussed have a bearing on how how
individuals in various objective and subjective contexts relate to products and to
predict whether they will buy. The intention of various groups of customers are
closely determined by their attitudes. An attitude describes how people relate
to a product – whether they like or dislike it and where it ranks in their order of
preferences among various products.
An interesting model on Attitudes is the ‘ABC model’. It states that attitudes have
three components. The first is Affect. It describes how an individual feels about

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an attitude object like insurance. The second is Behaviour. It expresses an
intention to do something with regard to the attitude object – like purchasing it.
The third component is Cognition or the belief that one has about the object. It
represents the evaluation or judgement that one makes about the object. The
sequence in which these three appear in attitude formation may be a matter of
debate. One approach is that feelings lead to behavior and this in turn leads to
realization or cognition, which may reinforce or alter the feeling. In the case of
life insurance purchase, one may argue that attitude building should begin with
cognition [creating the right belief and knowledge] which in turn should result in
affect [favourable feelings] which leads to behavior.
Gestalt: finally, we must note that people do not view life insurance or other
products in isolation but rather as part of a totality. The term “Gestalt” means
whole pattern or configuration - the idea is best summed up by the adage that
“the whole is greater than the sum of its parts.” For instance, life insurance has
meaning and relevance on as part of a broader dimension – which may include the
role of financial security; managing wealth and other spheres in the lives of
individuals and households. When life insurers speak of product design and
positioning they have to determine where they would want their offerings to fit
within this wider context.

E. What is the role of various products like FMCGs, Durables, Financial

Products and life insurance in meeting needs
In our day to day living we consume many products and services –tangible and
intangible, each catering to myriad needs of our existence as discussed above and
which depend upon one’s life stage, affordability, access and exposure. Let us
see how consumers view and respond to different types of products that they
encounter in the market
Fast-moving consumer goods (FMCG)
FMCG are products that are sold quickly and at relatively low cost. They are non-
durable in nature. Examples of FMCG generally include a wide range of frequently
purchased consumer products which are non-durables such as toiletries, soap,
cosmetics, tooth pastes, shaving products and detergents; it also includes light
bulbs, glassware, batteries, paper products and plastic goods. FMCG may also
include pharmaceuticals, consumer electronics, packaged food products and
drinks, although these are often categorized separately.
Perishables like meat, fruits and vegetables, dairy products and baked goods also
fall in FMCG product category. FMCG products turnover rates are very high - either
because they are consumed quickly by the users or because they deteriorate in a
short period of time. FMCG products like alcohol, toiletries, pre-packaged foods,
soft drinks and cleaning products do have high turnover rates while meat, milk,
fruits, vegetables etc., go bad very rapidly.

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The Margin of profit on FMCG products is normally small but since they sell in
large quantities, the cumulative profit on such products can be substantial. FMCG
products are also called consumer packaged goods (CPG). These products are
generally replaced or fully used up over a short period of days, weeks, or months,
and within one year. This contrasts with durable goods or major appliances such
as kitchen appliances, which are generally replaced over a period of several
years.
Consumers purchase these products more frequently. These are low involvement
products requiring little or no effort to choose the item (opposite of life insurance
products which demand very high involvement on part of the purchaser in
choosing the type and size of the product) and are normally low priced. These
products are sold in high volumes, with low contribution margins through a
widespread distribution networks since the stock turnover is reasonably high.
Durables:
Durable goods are the opposite of nondurable goods. They may be defined as a
hard good that does not quickly wear out, or more specifically, one that yields
utility over time rather than being completely consumed in one use. Items like
refrigerators, cars, or mobile phones usually continue to be useful for multiple
years of use, so durable goods are typically characterized by long periods between
successive purchases.

Examples of consumer durable goods include cars, household goods (home

appliances, consumer electronics, furniture, etc.), sports equipment, and toys.
Examples of nondurable goods include fast moving consumer goods such as
cosmetics and cleaning products, food, fuel, beer, cigarettes, medication, office
supplies, packaging and containers, paper and paper products, personal products,
rubber, plastics, textiles, clothing and footwear.
While durable goods can usually be rented as well as bought, nondurable goods
generally are not rented. While buying durable goods comes under the category
of Investment demand of Goods, buying Non-Durables comes under the category
of Consumption demand of Goods.
We can classify durable goods into
Major appliances, or White goods
Small appliances, or Brown goods
Consumer electronics, or Shiny goods
This division is also noticeable in the service area of these kinds of products.
Brown goods usually require high technical knowledge and skills (which get more
complex with time, such as going from a soldering iron to a hot-air soldering
station), while white goods need more practical skills and "brute force" to
manipulate the devices and heavy tools required to repair them.
Fundamental Financial Products:

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Money is the most basic form of finance. It represents ready purchasing power
and is considered the most liquid of assets. Liquid is that which can be converted
into ready cash with least cost and time. There are degrees and degrees of
liquidity
Currency and coins are the most liquid form of money. A bank demand deposit
(C/A or S/B) is slightly less liquid. You can draw a cheque on it. A time deposit
in a bank or a non-bank financial company (an FD) is even less liquid. But it pays
a higher rate of interest than a demand deposit. Idle cash earns nothing. These
products are maintained and used largely in [order to facilitate various kinds of
buy- sell transactions in the marketplace.
Debt: a large number of financial products are debt instruments. A debt
instrument (bond, mortgage) is a contractual agreement by the borrower to make
interest and principal payments to the holder of the instrument or lender by a
specified (maturity) date. A borrower (like a firm or government) may incur a
debt in two ways:
By taking a loan from a bank or financial institution – here there is a personal
relationship between the borrower and lender. It entails a personal obligation;
or
By raising debt, the borrowing institution floats a claim against itself in the
market in the form of marketable debt (e.g. bond or debt certificate) which can
be purchased by the lender. The latter are popularly known as debt securities.
They can be converted to cash either through redemption with the borrower or
sale in the market.eg. ICICI bonds, NSC etc. Debt instruments are used by their
creators [borrowers] to acquire large amounts of capital that they can utilize to
create various kinds of productive resources like machines and other forms of real
capital. The lender or investor in a debt instrument uses the instrument as a way
of storing one’s wealth in a relatively safer form in which one’s money starts
working for the owner [earning interest].
Equity: unlike debt, equity [shares in a company’s stock] represents claims to a
share in the net income and assets of a firm’s business. While debt holders are
creditors of a firm, equity or shareholders own a piece of the firm. Firms usually
share the profits they earn in the form of periodic payments (bonuses) to their
shareholders. Often they may reinvest the profits back in the business. In this
case the shareholder gets a share of the enhanced earning power that the firm
enjoys as a result.
Equity involves long term holdings with no maturity date. An equity share can
only be redeemed into cash through selling it. The Main disadvantage of equities
is that the equity holder is a residual claimant after debt holder and gets paid
after the debt holder has got his due. The Advantage is that the equity holder
benefits directly from an appreciation in firm’s profitability or asset value since
equities confer ownership rights on the holder.
These forms of holding wealth in the market are issued in the form of various
other kinds of financial products, which are instruments that help one save,
invest, get insurance or get a mortgage. These are issued by various banks,
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financial institutions, stock brokerages, insurance providers, credit card agencies
and the government sponsored entities.
Mutual Funds: these are pools of money invested by an investment company in a
number of securities like stocks, bonds, or government securities. Because most
mutual funds invest in a large number of securities, they offer investors the
benefit of diversification, which can help reduce market risk.
Stocks are financial instruments that signify an ownership position-referred to as
equity-in a corporation.
Bonds are debt instruments, which is in the form of a loan, that an investor makes
to a corporation, government, federal agency, or other organization in which the
bond holder typically receives the amount of the face value of the bond on a
future date, and regular interest payments. The difference between a loan and
a bond is that the latter arises as a result of a ‘promise to redeem in future’ which
is purchased in the market. It is in other words a form of “marketised debt” and
is also hence known as a debt security’. A bank who has lent to a company, for
instance, cannot sell that loan to another entity. But when the same bank buys a
bond of a corporate organisataion in the market, the bank can buy or sell that
bond in the secondary market.
Systematic Investment Plans are an increasingly popular set of products that allow
you to accumulate shares of a mutual fund indirectly by making small regular
monthly payments, but with high first-year costs. These are of significance to
consumers who want to invest their money in the capital market but are able to
invest only small amounts of money at a time. These plans also enable an investor
to tide over volatility that is present in the market. They follow a principle called
‘Dollar cost averaging’ in which by buying regularly and investing the same sum
in up and down markets, investors buy more shares at lower prices [when the
share price falls lower] and fewer shares at higher prices [when he price of the
share goes up].
Annuities are contracts between investor and the insurance company in which
company promises to make periodic payments to the investor, starting
immediately or at some future time. If the payments are delayed so as to begin
at a future date, you have a deferred annuity. If the payments start immediately,
you have an immediate annuity. Annuities come in three types: fixed, variable
and equity indexed. Annuities are a way for investors to get a steady and assured
amount of income for long periods of time, regardless of market fluctuations and
other uncertainties, this enables them to meet the needs of longevity [long life]
post their retirement.
Certificates of Deposits are deposits of a fixed sum of money for fixed period of
time - six months, one year, five years, or more - and, in exchange, the issuing
bank pays you interest, typically at regular intervals. They are a form of debt
instrument with similar features.
Typical Life Insurance Needs
Let us now turn to the reasons why people buy life insurance – what are their
typical life insurance needs and how life insurance products address these.
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Life Insurance products seek to provide compensation to the named loved ones -
through an assured amount rather than precise indemnification- who are
legitimate and legal dependants/heirs to the buyer (the Insured Life). This can
happen in case of premature death of the life-assured, when the projected flow
of sustenance support from his earnings to the loved dependants get stopped
suddenly, or when his projected earning potential gets adversely affected due
to some disabling event like accident, serious illness, old age etc. Life insurance
products also enable their owners to preserve the capital that has been
accumulated during the lifetime of the buyer/assured life, from being depleted
on account of expenses incurred during a terminal disease [before death] or other
huge expenses that arise in the wake of an individual’s demise, which have to be
incurred or borne by one’s loved ones. One’s capital can thus be passed on
smoothly in the form of a bequest to one’s dependents or heirs these two
functions, namely of premature death protection and leaving behind of a bequest
constitute the two major features and benefits and sources of appeal of all life
insurance products.
An array of life insurance products are available –ranging from simple protection
to endowment assurance, income-replacement or retirement benefits, education
for child or enhancement of one-time gain, etc. each catering to a full assortment
of needs, wants and necessity so typical of a productive social individual’s life.
Typical Life Insurance needs, for which provisions need to be created through
different life insurance products are Children’s Education, Creating & Enhancing
Wealth, Retirement, Family Care in case of Premature Death, Serious Illness,
Protecting Goals & Objectives and so on.
For an individual in the family across most societies, the following major reasons
can be cited to describe their life insurance buying behaviour:
To ensure that the income that the buyer provides to the family gets restored or
remains around similar level even in case of unfortunate premature death of the
life insurance buyer.
To support children education or such major event like his/her marriage or
business set-up when they come of age by tapping the thrift feature of the
product.
To ensure protection of living standards of self and family in case of disabling
diseases when the person (bread-winner) lives but his/her income stops or
diminishes severely. The product needs to provide continuity of sustenance
support to requirements of daily living like grocers’/water/electricity bills or such
other needs.
For accumulating a target sum in a regular manner through disciplined regular
savings for other life-cycle goals definable at the time of purchase like building a
house or purchasing a farm-house or similar such aspirations or for even undefined
events which keep unfolding as one traverses the journey of life.
Sometimes, particularly when one gets a one-time big income like bonus or prizes
–as in cases of sports star, cine artists, etc. this money needs to be invested in
such a manner that it grows in real-terms –negotiating the degenerative impact
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of inflation, over a period of time. Life Insurance products, because of their value
to society and community get state support in most countries by way of tax
exemptions. Taking advantage of this and also the expertise of life-insurance
fund-managers in handling long term funds, the wealth-enhancement needs of a
prospective buyer get fulfilled
Last but not least, one more major reason to buy life insurance for an individual
is to build a large enough corpus through the discipline of regular savings as
required by a life insurance policy during the earning span of his life which can
be used post-retirement to ensure a dignified old age. Pensions and annuities may
fall in this bracket also.
Similarly, for individuals who are business owners or are in corporate context,
their need of business continuity or of effective passing on to the next generation
gets addressed through insurance arrangements like employer-employee
schemes, partnership-insurance or key-person insurance as the case may be.
A point to note here is that while products like Child Education or Wealth
Accumulation for various life stage needs and aspirations or Single Premium
Commitment products for Wealth Enhancement and Dread Disease Cover are
mostly asked for by the prospective purchasers, indemnity oriented products like
term assurance or business-continuity plans or income replacement or even
retirement planning need a particular level of expertise on part of the seller to
canvass, convince and sell.
When the main bread-winner dies prematurely, the family may need:
readjustment income: enough income for permitting time to smoothly shift to
required adjustment in living conditions;
income for family till children are self-supporting;
life income for spouse after children become independent;
Clean-up funds: for medical expenses, funeral expenses, succession/inheritance
expenses, outstanding loan etc. and/or
Special needs like mortgage redemption, emergency medical needs, marriage of
daughter, and higher education of children and so on.
The above broadly covers all the foreseeable needs and substantially defines the
ambit that an insurance salesperson can address.

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F. Discuss some of the needs, faced by individuals, met by Death
Benefit products and Living Benefit Products
Life Insurance products are created to provide assured compensatory pay-out
both in situations of death (of the insured) to the loved near and dear ones so as
to meet liabilities or aspirations created and left behind by the insured as well as
in situations of living while severe illness, disability or old age impairs his
(insured’s) ability to create income which he was capable of creating when in full
and good health. There are pure protection products that address the problems
arising from two sources of risk: mortality or death and morbidity or health
impairment.
Death is of concern to us in insurance for two reasons:
(1) Its timing - when it is premature or out of turn; and
(2) The way one dies – whether one goes with a bang, leaving a gaping hole in
the bank (balance).
In the first situation, the property being insured is one’s lifetime labour earning
power. The beneficiary may be one’s dependents (legal heirs) or one’s creditor
(where life insurance serves as collateral) or one’s employer (key man insurance)
or business partner (partnership insurance).
In the second situation, the property being protected is one’s estate or
accumulated wealth, which is being preserved against the bills (of treating
terminal illness) or the taxman (where estate duty is applicable). The first
situation is typical when one is in the accumulation stage. The second may be
relevant in the consolidation or still later stages.
Term Assurance: The product that ideally meets the need for pure protection
against dying early is Term assurance. Here is a policy that provides coverage for
a specified period of time called the policy term. The benefit is payable only if
the insured dies during the specified term and the policy is in force (the premiums
stand paid) at that time. The term can range from as short as it takes to complete
an airplane trip to as long as forty years. Protection may extend up to age 65 or
70. One-year term policies are quite similar to property and casualty insurance
contracts. All premiums received under such a policy may be treated as earned
towards the cost of mortality risk by the company. There is no savings or cash
value element accruing to the insured.
The premium for term assurance is typically very low, even though it may contain
a relatively high expense loading and an allowance for adverse selection. The
reasons are simple. The term contract only covers a probable event (death during
the term) and not a certainty of getting the benefit, as in other life insurance
contracts like whole life or endowment. Secondly, most term contracts only give
cover when one is relatively young. They do not extend to older ages when death
is more likely to occur, and when the cost of insurance is high. The contracts are
carefully underwritten, for obvious reasons, and restrictions are often imposed
on the amount of insurance one can buy or age up to which one can renew the
policy.
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Protection under term life is usually provided as a stand-alone policy but it could
also be provided through a rider in a policy. For example, a pension plan may
contain provision for a death benefit payable in case one dies before the date
when pension is to start. A rider is a provision typically added through an
endorsement, which then becomes part of the contract. Riders are commonly
used to provide some sort of supplementary benefit or to increase the amount of
death benefit provided by a policy.
Renewability: Many term life policies with short terms of five to ten years or
less contain an option to renew such policies for limited numbers of additional
periods of protection. While the premium is level for a given term, it increases
with each renewal. The new renewal premium would depend on the age attained
on date of renewal and the new term for which the policy is being renewed.
Convertibility: Convertible term insurance policies allow a policyholder to
change or convert a term insurance policy into a permanent plan without
providing fresh evidence of insurability. This privilege helps those who wish to
have permanent cash value insurance but are temporarily unable to afford its
high premiums. When the term policy is converted into permanent insurance the
new premium rate would be higher. One method of conversion has been referred
to as the attained age method. Here the renewal premium is based on the
insured’s age when the coverage is converted. The other approach is to affect
conversion as on the original date of purchasing the term policy. Attained age
conversion is much more common than original age conversion (despite premium
being higher due to high age at the time of conversion) as it does not require the
policyholder to make a large cash outlay at the time of conversion. Level term
assurance has been the most common form of term insurance. It provides the
same amount of death benefit during the entire term of the policy.
A number of other variants are also possible.
Decreasing term assurance plans provide a death benefit that decreases in
amount with term of coverage. A seven-year decreasing term policy may thus
offer a benefit of 70000 for death in the first year, with the amount decreasing
by 10000 on each policy anniversary, to come to nought at the end of the seventh
year. The premium payable each year however remains level.
Decreasing Term Assurance has also been aggressively marketed as mortgage
redemption and credit insurance.
Mortgage redemption is a plan of decreasing term insurance designed to provide
a death amount that corresponds to the decreasing amount owed on a mortgage
loan. Typically in such loans, each equated monthly instalment (EMI) payment
leads to a reduction of the outstanding principal amount. The insurance may be
arranged such that the amount of death benefit at any given time equals the
balance of principal owed. Term of the policy would correspond to length of the
mortgage. The renewal premiums are generally level throughout the term.
Purchase of mortgage redemption is often a condition of the mortgage loan. The
borrower is the life assured and is required to maintain the coverage.

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Credit life insurance: is a type of term insurance plan designed to pay the
balance due on a loan, if the borrower dies before the loan is repaid. Like
mortgage redemption it is usually decreasing term assurance. It is more popularly
sold to lending institutions as group insurance to cover the lives of the borrowers
of these institutions. It may be also available for automobile and other personal
loans. The benefit under these policies is often paid directly to the lender or
creditor if the insured borrower dies during the policy term.
Family Income schemes: Here is a decreasing term insurance plan that provides
a stated monthly income benefit to the surviving spouse if the insured dies during
the term. The monthly payments would continue until the end of the specified
term. Thus if A purchased the plan for a term of fifteen years and died after five
years, the spouse would get an income for the remaining period of ten years. It
is deemed as decreasing term since the period of payment of benefit to the
spouse would reduce the longer the insured is alive during the tem. The plan has
been commonly purchased as a rider to a permanent life insurance policy like
whole life.
Increasing Term Assurance: As the name suggests, the plan provides a death
benefit, which increases with the term of the policy. The sum may increase by a
specified amount or by a percentage at stated intervals over the policy term.
Alternatively the face amount may increase according to rise in the cost of living
index. Premium generally increases as the amount of coverage increases. The
plan has been written both as a stand-alone policy and more commonly as a policy
rider.
Term Insurance with return of premiums: Yet another type of policy (quite
popular in India) has been that of term assurance with return of premiums. The
plan leaves the policyholder with the satisfaction that he / she has not lost
anything in case he / she survives the term. Obviously the premium paid would
be much higher than that applicable for an equivalent term assurance without
return of premiums.
Viewed in retrospect, term insurance has been perceived to hold much relevance
in the following situations:
Where the need for insurance protection is purely temporary, as in case of
mortgage redemption or for protection of a speculative investment.
As an additional supplement to a savings plan: e.g. a young parent buying
decreasing term assurance to provide additional protection for dependents in the
growing years. Convertible term assurance may be suggested as an option where
a permanent plan is non-affordable.
As part of a “buy term and Invest the rest “philosophy, where the buyer wishes
to buy only cheap term insurance protection from the insurance company and to
invest the resultant difference of premiums in a more attractive investment
option elsewhere. The policyholder must of course bear the risks involved in such
investment.
Price is in sum the primary basis of competitive advantage in term assurance
plans. This is particularly seen in case of yearly renewable term policies that are
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cheaper than their level premium counterparts. The problem with such one-year
term plans is that mortality costs rise with age. They are thus attractive only for
those with a short period insurance planning horizon.
At the same time one must be aware of the limitations of Term assurance plans.
The major problem arises when the purpose of taking insurance cover is more
permanent and the need for life insurance protection extends beyond the policy
period. The policy owner may be uninsurable after the term expires and hence
unable to obtain a new policy at say age 65 or 70. Individuals would seek more
permanent plans for the purpose of preserving their wealth against erosion from
terminal illness, or to leave a bequest behind. Term assurance may not work in
such situations.
Living Benefit Products:
Life Insurance also saw a set of innovations to meet the need of catastrophically
high costs of treating certain major diseases. Known by various names like Living
Benefits and Accelerated Benefits policies, they have emerged as a popular
category within life insurance only during the last two decades.
Essentially these policies form part of life insurance proper in the sense that they
all include a death benefit. They differ from other life insurance plans in the
sense that they provide for pre-payment of a part of the death benefit if the
insured is stricken with a catastrophic or terminal illness. They also differ from
other medical expense insurance contracts in that payments made to
policyholders under living benefits policies are at the expense of the death
benefit. The latter would be accordingly reduced.
The idea of living (accelerated) benefits originated in South Africa in 1983 when
Crusader Insurance launched the first living benefits product. It was introduced
in the UK market in 1985 and the US market in 1987. Today, a large number of
life insurers in these countries offer some form of living benefits, either in the
form of a separate policy or as rider to an existing life insurance contract. Living
Benefits policies are also popular in India and other countries.
These policies are broadly of two types: the first is termed as Terminal illness
policies under which the payment is made if the life assured suffers from a
terminal illness and has a life expectancy of say twelve months or less; the second
type is called Dread Disease (DD) cover which provides for payment if the insured
suffers from any one of certain pre-defined dread diseases or conditions such as
heart attack, bypass surgery, strokes, certain types of cancers etc.
Terminal illness: Terminal illness benefits are supplementary to the basic death
benefit under a life insurance policy. The percentage of face amount that can
be accelerated may typically range from 50 % to 100%, depending on how the
terminal illness is defined. In many cases it is common to place an absolute limit
on the amount of death benefit, which can be accelerated. The cost of the benefit
may be recovered either through the front or a back end approach. In the first
case the benefit is pre-funded through charging an extra premium for all
policyholders or for those opting for such coverage or an adjustment can be made
at the time of claim. The advantage of back ended pricing is that no premium
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 94
increase is needed and only those policyholders who actually claim the benefit
have to pay for it.
Dread disease policies: Dread disease policies were designed in the form of riders
providing for pre-payment of part of the sum assured in the event of specified
dread diseases. Newer policies provide for pre-payment of the full sum assured
or even additional sum in the event of the disease, thus leaving the death benefit
unaffected. The amount thus paid is usually expressed as a percentage (say 25
to 50%) of sum assured and limited to a certain maximum. It is payable only once,
in full and final settlement of the company’s liability under the rules. The
maximum age limit at entry and maturity age may also be fixed. Medical
technology has made it possible to recover today from illnesses that were once
considered fatal. The policy is of value since it also helps in meeting readjustment
cost due to reduced capability to earn post illness that may arise in the wake of
a dread disease. The monetary cost of recovery could however be prohibitive.
The policy makes it possible to consider going for such quality treatment.
Living benefits products are still evolving. In years to come we can expect life
insurers to create new variations and improvements on the basic concept. This
may include extending the scope of cover to include more diseases and enhancing
the percentage of the accelerated benefits component. Additional benefits may
also be provided to dependents via riders. An important issue that needs mention
is the need for consumer awareness about the concept. This calls for training the
field force with more detailed sales procedures. The latter, who are used to
selling life insurance, often find it difficult to position and sell a product that
incorporates a health benefit. In spite of these constraints, the concept has the
potential to break new ground in the life insurance market.
Life insurance for capital preservation and as a bequest
A life-cycle model of life insurance demand, saving, and portfolio choice
intuitively indicates strong bequest motives that arise from events like being
married, having children, and other subjective measures, while considering
purchase of life insurance products. Life insurance obviously has to be an
effective tool for estate planning. An appropriate form of life insurance for the
purpose is what is termed as a Permanent life insurance plan.
Whole Life Policies: these plans are characterised by permanent protection
[coverage for whole of life], and the build-up of a cash value, which makes it a
savings instrument. The premiums may be paid for the whole period of an
insured’s lifetime [termed as Ordinary Whole Life] or for a limited period [which
is termed as Limited Payment Life]. While whole life plans have not been as
popular in the Indian sub-continent [where it has been secondary to Endowment
plans], they are the dominant form of life insurance in many other markets,
especially in North America.
The plan comes in various forms.
Ordinary whole life is typically a level premium term policy that ends at age
100. The annual premium required is lower than that under any other payment
schedule, since premiums have to be paid throughout one’s life. It thus offers
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permanent protection for the lowest premium outlay. The permanent feature
means that the term never expires and the policy does not need to be converted
or renewed. Protection is guaranteed regardless of one’s state of health. It could
thus be an appropriate foundation for a lifelong savings programme extending
until death. This feature is invaluable for those who may need protection against
terminal illness or other contingencies late in life.
A Limited premium Whole Life, as the name indicates, entails only limited
premium payments – say 5, 10 or 20 annual payments; or annual premiums to
cease at say age 65. The idea here is to provide for a lifetime of protection
through payments made during one’s working lifetime. The premiums payable
would obviously be higher than for ordinary whole life. This also implies higher
cash and surrender values, enabling a larger fund available for use in case of
emergencies and other long-term savings needs like retirement income.
There are also versions of Whole life which permit modification of the amount
of premium or the face amount during the life of the policy. In the first case
the premiums are redistributed so that they are lower in the initial years and
increase in scale after a specified period. This enables purchase a larger amount
of insurance for younger cohorts who seek higher amount of protection but lack
the income to buy it. Modification of face amount helps those who may feel that
their need for large amounts of life insurance cover is likely to diminish as the
insured grows older. The sum assured in these policies thus decrease by specified
percentages or amounts either on attainment of certain ages by the insured or at
the end of stated time periods
Joint Whole Life is similar to individual whole life insurance except that it insures
two lives under the same policy. It is often referred to as first to die life insurance
as upon the death of one of the insureds the death benefit is paid to the surviving
insured. A variant of the above is called Last Survivor Life Insurance, also known
as second to die life insurance. The policy benefit in this policy is payable only
after both people insured by the policy have died. Premiums may be payable
until first insured dies or both. In either case the annual premium cost is less
than that of either two individual whole life policies or a joint whole life insurance
policy. These policies could be designed to insure married couples. They have
also been popular due to their handiness in other specific situations. Business
partners for example, may take out a joint life policy on the lives of all partners
where the amount written is equal to the largest interest involved. On death of
a partner, the surviving partners receive funds with which to purchase the
deceased's partnership interest. Stockholders in a closely held firm may follow a
similar practice.
A family policy is a whole life plan that provides additional term insurance
coverage on the insured’s spouse and children, provided of course, that the
applicant provides evidence of insurability for all family members. Once issued,
the policy automatically covers ay extra child that is born or adopted by the
family thereafter is automatically covered by the policy. An additional premium
may be payable for such added cover.

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Finally we have Preferred risk whole life policies that are offered with reduced
premiums to lives that exhibit better than normal mortality standards. They may
be offered for a large minimum face amount [say 5 lakhs] and only to preferred
risks. Stringent selection processes are laid out to ensure better mortality
experience at least in the initial years.
Whole life has been often positioned as a package of options. As the term extends
till death and cash value accumulates at a slower pace than any other cash value
plan like endowment, its protection element is much higher than for endowment,
though lower than for term policies. The cash value feature enables the policy to
serve as a protection cum savings package that provides various options:
The first of these is the Policy loan option – it offers a substantial part of the
cash value as a loan on the policy. Interest can be charged on the loan at a fixed
rate [specified in the policy]; or at a variable rate [tied by a formula to a specified
index]. The latter provision arose because it was found that fixed rates
encouraged policyholders to withdraw the money from the policy and invest the
proceeds elsewhere, if market rates exceeded the rate charged on the loan.
There are multiple repayment options for the loan.
The second type of option is called Non Forfeiture or Surrender option, which
form a part of the standard contract provisions. Surrender values have emerged
in one of three forms. The first is as Cash Value, where the policyholder gets the
surrender proceeds as cash and the policy gets terminated. The second option
permits the insured to take a reduced amount of paid up whole life insurance,
wherein protection continues in the reduced form until the death of the insured
or unless the policy is surrendered for cash. The third type of option provides a
paid up term assurance which equals the original face amount of the policy and
any bonus / dividend additions and deposits that may have accrued less any policy
indebtedness (loan plus interest charges). It is purchased with the net cash value
being applied as a single premium.
Finally one may also use cash and surrender value to purchase an annuity or
retirement income.
Whole life has thus been positioned as a plan for purchasing life insurance
protection for one’s family during one’s working life and for using the accrued
cash value to add to replacement income after one’s own retirement. It serves
as a useful supplement to other retirement benefits like occupational pension and
provident funds.
Conversion is the third option. Whole Life policies can be converted into other
forms of insurance so long as the new contracts call for a larger premium.
Companies may however not permit exchange from a higher to a lower premium
contract without evidence of insurability. Such an exchange, apart from reducing
future premiums, also increases the net amount a risk and may give rise to the
element of adverse selection.
A final feature of whole life is the provision for participation in profits. With
profits policies have a higher premium than others. Profits are payable as bonuses
or dividends. Bonuses, as we have seen, are normally paid as reversionary
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bonuses. While bonuses are not guaranteed in advance, once a bonus is credited,
it is guaranteed. Bonuses are often a significant portion of the actual
performance of the policy over time.
Profits are shared in certain markets like the US in the form of dividends. There
have been two approaches to dividend crediting. The traditional approach was
the Portfolio Method. Here the total investment return on the portfolio held by
the company was determined and all policyholders were credited their share of
the divisible surplus. No attempt was made to distinguish the rate of return
earned on monies invested with the company in previous years from that
deposited recently. The portfolio method thus homogenized rates of return and
made them stable over time. The portfolio method thus applies the principle of
pooling of risks over time and is quite similar in this respect to the uniform
reversionary bonus mechanism. The second approach is the Current Money
Method. Here the return depends on when the investment was made and the rate
that was secured at the time of investment. It has also been called segmented or
investment block method as different investment blocks gets different returns.
In sum, Whole life serves as an ideal vehicle for someone who needs and seeks
for life insurance protection for the entire period of his/her life cycle. Term
insurance or other forms like Endowment Assurance, which are temporary in
nature, cannot provide this protection beyond a certain age. Its uniqueness lies
in that it serves not only as a hedge against loss due to premature death but also
as a preserver of accumulated wealth, during the twilight ages of one’s life. It is
the ideal way to bequeath wealth to one’s heirs and descendants. It plays a role
in ensuring that certain philanthropic projects that one may have initiated [say,
a home for orphaned children or shelter for the aged] do not fold up for lack of
funds after one’s demise. It can also be a vehicle for providing a supplementary
income in the later post retirement years of one’s life.
Endowment Assurance Plans
An Endowment Assurance contract is actually a combination of two plans - a term
Assurance plan which pays the full sum assured in case of death of the insured
during the term; and a Pure Endowment plan which pays this amount if the
insured survives at the end of the term. The product thus has both a death and
a survival benefit component. From an economic point of view, the contract is a
combination of decreasing term insurance and an increasing investment element.
Shorter the policy term, larger is the investment element.
The combination of term and investment elements is also present in whole life
and other cash value contracts. It is however much more pronounced in the case
of Endowment Assurance contracts. This makes it an effective vehicle to
accumulate a specific sum of money over a period of time. Endowment is
primarily a savings programme, which is protected by insurance against the
contingency of premature death. It has been positioned as an instrument that
lends certainty to one’s personal financial plans by linking insurance to one’s
savings programme. Endowment also offers a safe and compulsory method of
savings accumulation. While prudent investment and asset liability management

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lends safety, the semi-compulsory nature of premiums provides the incentive to
save.
People buy Endowment plans as a sure method of providing against old age or
specific purposes like an Education Fund at the end of say 15 years; or a fund for
meeting marriage expenses of one’s daughters. There can be no playing around
with these objectives. They have to be met with certainty. It has also served as
an ideal way to pay for a mortgage (housing) loan. Not only is the loan protected
against the uncertainty of repayment on account of death but the endowment
proceeds could suffice to pay the principal. The policy has also been promoted
as a means for thrift savings. Endowment can serve as a worthwhile proposition
when one is looking for an avenue to set aside a surplus from income every
month/quarter/year and commit it to the future. The plan is also rendered
attractive because of the deduction of premiums for tax purpose. Yet another
proposition in the Indian context has been the facility to place the policy in a
trust created under the MWPA [married women’s property act] - the policy
beneficiary is protected against all creditors’ claims on the property of the
insured. Finally many Endowment policies mature at ages 55-65, when the insured
is planning for his/her retirement and such policies may be a useful supplement
to other sources of retirement savings.
We have highlighted a few of the axes along which traditional endowment
assurance plans have been positioned. It is also necessary to note the limitations
of these plans. In general the plan may not be appropriate when death protection
is the dominant need. Premiums paid are the highest but provide for the least
amount of protection per rupee of premium among all life insurance plans. The
high savings component of premiums eats into the limited surplus funds available
for savings with most families. There is an opportunity cost in terms of earnings
forgone from not investing these funds in alternative avenues. Endowment
insurance policies thus have been competing with other investment vehicles.
Their higher transaction costs and conservative investment policies have however
often resulted in returns being lower than for other instruments. The positioning
was ‘Die or live- you win both ways’.
Money Back policies
A popular variant of endowment plans in India has been the Money Back policy.
It is typically an endowment plan with the provision for return of a part of the
sum assured in periodic instalments during the term and balance of sum assured
at the end of the term. Thus a Money Back policy for 20 years may provide for
20% of the sum assured to be paid as a survival benefit at the end of 5, 10 and 15
years and the balance 40% to be paid at the end of the full term of 20 years. If
the life assured dies at the end of say 18 years, the full sum assured and bonuses
accrued are paid, regardless of the fact that the insurer has already paid a benefit
of 60% of the face value. These plans have been very popular because of their
liquidity [cash back] element, which renders them good vehicles for meeting short
and medium term needs. Full death protection is meanwhile available when the
individual dies at any point during the term of the policy.

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Flexible Endowment
This is another variant of the Endowment policy, developed by UK companies in
response to changing market needs. These contracts were basically With Profit
Endowment Assurances. However at any point of time after an initial period (say,
ten years), it was possible to surrender the contract (in whole or in part) for a
value proportionate to the sum assured and reversionary bonuses already
declared. The contracts thus introduced more flexibility into endowment
assurances.
Dynamic life insurance
Dynamic Life Insurance plans were developed as a way to address inflation that
has been ushered in markets like the United Kingdom since the seventies. Both,
the benefits as well as premiums under these plans could be altered and enhanced
to keep pace with inflation. The Value of insurance in real terms could thus be
preserved without offering further evidence of insurability.
These plans found some popularity in Germany, which thus had a large portfolio
of dynamic endowment policies. Similarly the Family Income policy of UK
allowed policyholders to increase benefits in line with cost of living, by paying a
proportionately higher premium. Yet another variant was the Cost of living rider,
available in the USA, which automatically increased the coverage of the basic
policy along with rise in consumer price Index (CPI). No evidence of insurability
was needed as long as the insured accepted additional protection each time it
was offered.
Index linked products could be divided into two categories. In the first case, the
inflation risk was borne by the policyholder with the company merely undertaking
to provide additional insurance at the policyholder’s expense. In the second
instance, the company would bear the risk, with a provision that it would be
covered under the overall premium paid by the policyholder.
Family oriented policies
One of the problems facing those who are dependent on a bread winner, who is
no more, is the need for a regular income for long periods of time. Family oriented
policies fill this void. These products principally provide an income to the family
on death of one of its members, typically the breadwinner. They may also be
designed to specifically address certain perceived insurance needs that are
associated with family life through additional cover.
For instance in a family income policy, the beneficiary may be paid a fixed
monthly income upon the death of the insured. The income is in addition to
payment of the face amount.
Example: if a person aged 30 purchases a 20 year family income policy and dies
at age 35, the beneficiaries would receive a monthly income for the balance 15
years.
The purpose of the plan is to provide an income for the family to help it tide over
a specific period-like when the children are maturing. The policy is a combination
of a permanent whole life plan and a decreasing term assurance plan.
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Another variant is the Family Maintenance Policy. It is similar to the family income
policy except that here the income payments are made for a full period (15 or 20
years as specified) regardless of when the insured dies within the specific period.
It thus overcomes a disability of the family income policy.
Example: take the instance where a thirty year old takes a 25 year old family
maintenance policy and dies at age 40. The payment of income would continue
for 25 years.
The above contract is a combination of permanent insurance and a level term
plan. In recent years, riders attached to the main policy have supplanted these
plans. Typically this could take the form of a term insurance rider attached to a
permanent insurance contract.
Yet another variant is the Family Policy. It is a plan that seeks to cover all family
members in one package. It is primarily written on the breadwinner's life with
supplementary coverage provided to the spouse and children. Thus all members
are covered, though primary focus is on breadwinner’s protection. The question
here is whether it is worth spending money, for insuring other family members,
when one could use it better by buying additional cover on the breadwinner’s
life.
Juvenile Insurance
The term ‘Juvenile Policy’ or Children's Assurance plan refers to contracts written
on the life of minors - typically children under age 15. Since the life assured is a
minor and hence incapable to contract, the applicant (proposer) for insurance is
different from the assured. Normally the proposer has to be a parent or legal
guardian of the child.
Control of the policy is in the hands of the proposer, who also pays the premiums
during the deferment period .These plans are also known as children's Deferred
Assurance [CDA] since control over the policy passes onto the assured on attaining
majority age. Some of these plans cover mortality risk right from the beginning
while others may cover the risk only on attainment of a certain age.
Companies often restricted the amount of juvenile insurance because of the
limited insurable value of a child. It was felt that indiscriminate insurance on
minors’ lives could lead to speculation on their lives, leading to moral hazard.
Companies thus would insist that the family should have an insurance culture.
This implies that an adequate programme of insurance should be already in place,
covering the parent or guardian.
The objectives of buying Juvenile Policies are various. One reason is to start a
permanent insurance programme at a very young age, for low premiums. This also
ensures that the child would have some life insurance even if he or she later
became uninsurable. It could also provide some protection to parents against loss
in the event of the child’s death. The dominant appeal of these policies lies in
their being a means to build an insured savings fund that finances the child’s
higher education or marriage. If the proposer dies, future premiums may be
waived until the child reaches a fixed age, say 21. This ensures that the fund

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 10 1
would not be affected by premature death of the proposer. Such application for
waiver would obviously require the proposer to furnish evidence of insurability.
Juvenile plans have become popular in many markets, including India. Their
popularity stems from the facility to build an estate right from the childhood
stage and the motive it gives for promoting savings habit at a very young age.
Riders
We have so far discussed various kinds of life insurance policies. Let us now look
at riders, which are not part of the main life insurance contract but
supplementary to it.
Some very popular riders in vogue in India are: ADR or Accidental Death Rider,
which has been made available on payment of an extra rupee per thousand sum
assured. Here, in the event of death due to accident, an additional sum equal to
the original amount of cover is paid to the beneficiary on death of the insured.
Normally the Accident Death Cover amount cannot exceed the main sum assured
under the basic policy.
Similarly TPDBR or Total and Permanent Disability Benefit Rider provides for a
living benefit pay-out – either as standalone or as accelerated payment from the
basic policy, in case a policy-holder having such cover, becomes totally and
permanently disabled due to an accident. To be eligible for this benefit, the
policy holder would have to survive for at least 30 or a given number of days, as
specified in the policy, post the trauma.
We have discussed critical illness rider in detail earlier where, in the event of
diagnosis of the same, the life assured becomes eligible to either accelerated or
additional cover amount. In Hospital Cover, for a specified number of days during
the policy term, a person becomes eligible for a benefit pay-out in the event of
him/her being admitted into a hospital. This amount can be a percentage of SA
or a fixed amount.
Similarly, a Waiver of Premium rider is also available under which, in case of
premature death of a policy-holder (who is different from the life assured under
the policy) all future premiums up to maturity date are waived.

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Chapter Summary
The process of purchase of a product involves various steps like awareness of a
need or want; search for and generation of alternative solutions to address the
need or want; selection of the appropriate alternative and finally the decision to
purchase.
It is important that we understand needs and its range and relatedness to our
existence and growth as it would enable us to better appreciate different types
of products and the purpose they serve. Necessity is urgent and insistent e.g. food
for hunger. Necessities are essential & indispensable –like time and money are
necessary for a vacation. Want is something which is necessary but lacking. When
the customer wants a service or a product, the salesperson has to respond to the
customer’s wants as immediate service is important in this case.
Both need and want imply a condition that requires relief. But there is a
difference between the two while a need is something one has to have, something
one can’t do without.eg food. However, a want is something one likes to have. A
good example is music. In some categories, it can be both needs and wants. For
instance, food could be a need or a want. Basic kinds of foods are needs while
exotic ones can be wants.
Purchase decisions are driven by more than just needs. The profile of the
customer and what he or she seeks to do with the product [Jobs to be done], also
plays a critical role in impacting the decisions. Customers are different from one
another and need to be segmented. The bases of segmentation include
demographic, psychographic, personality and other factors.
In the case of insurance, needs are to be “introduced” to a prospective customer
by a Sales person and also calls for requirement of after sales service. Effective
sales people design their strategies after learning that which needs of the
customer can be best met by their products. The same applies to Organizations.
Keeping the needs in mind, we consume many products and services which can
be FMCG, Durable, Financial Products and services.
Fundamental financial Products: Money is the most basic form of Finance,
however the degree of liquidity varies from instrument to instrument e.g.
Currency & Coins, a fixed deposit, (a debt instrument). Equity represents a share
in the firm. The financial products are categorized in terms of their type, asset
class, volatility, risk and return e.g. Mutual funds, Stocks, Bonds, SIP, Annuities,
Certificates of deposit.
Life Insurance needs are taken care of by various products, keeping in mind the
needs, wants or necessities of individual and take scare of insured in various
situations e.g. death, disability, Children’s education or life cycle-goals.
Accordingly Life insurance products are created like Death benefit products,
Living Benefit products, Term assurance and Money back policies, Flexible and
Dynamic insurance plans; Family Income policies and Juvenile or Childrens’
Policies. Apart from these policies there are also a number of riders that may be
added to life insurance policies.

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Important Concepts Covered:
 The purchase decision and its steps
 Customer segmentation
 Demographics and psychographics
 Need, Want and Necessity
 Maslow Hierarchy of needs
 ERG theory
 FMCG ,Durable ,Financial Products
 Compounding and Discounting

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Self-Examination Questions
Question 1
Tick which one is the correct option:
A. Necessity is something urgent and insistent, needed for a desired result
B. Want is something which is necessary but lacking
C. Both need and want imply a condition that requires relief
D. 1st and 3rd are true
E. All the above statements are correct

Question 2
As per Maslow Hierarchy of needs, the bottom of pyramid is composed of
A. Safety needs
B. Physiological needs
C. Social needs
D. Esteem needs
E. Self-actualization needs

Question 3
FMCG products are also called Consumer packaged goods.
A. True
B. false

Question 4
Which one of the following is an example of Fundamental Financial Products?
A. White goods
B. Debt & Equity
C. Safety and Security needs
D. Relatedness
E. None of the above

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Question 5
Which one of the following is example of Life Insurance Products?
A. Death benefit Products
B. Living Benefit Products
C. Term Assurance Products
D. Money Back Policies
E. All of the above

Answers to Self -Examination Ques tions:

Answer to SEQ 1
The c orrect option E.
Answer to SEQ 2
The c orrect option B .
Answer to SEQ 3
The c orrect option A.
Answer to SEQ 4
The c orrect option B .
Answer to SEQ 5
The c orrect option E.

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 CHAPTER 5
FINANCIAL PLANNING AND LIFE INSURANCE
Chapter Introduction:
This chapter discusses the concept to financial planning for different stages of an
individual’s life cycle and some of its elements. It also focuses on the
requirements for different life stages. Each of the stages of an individual’s life
involves a set of events and opportunities, along with liabilities, expectation of
future liabilities, roles vis-à-vis dependents, financial goals, and life style
requirements. Financial planning is the process of anticipating the liabilities and
fund requirements that may arise in different life stages and preparing for them
through appropriate savings, investment, insurance and other strategies. Life
Insurance products play a critical role in meeting some of the contingent needs
that arise in the course of the life cycle and the chapter focuses on these.

Learning Outcomes: at the end of this chapter you will

A. What is Financial Planning?

B. Meeting Needs at Different stages of life cycle
C. Life Cycle needs and the demand for Life Insurance
D. Life Insurance Products for life stages
E. Health Cover – Stand-alone and Riders
F. Savings for a need or aspiration
G. Estate Planning
H. Retirement Planning – the Role of Pensions and Annuities
I. Life Insurance and Business Financial Planning for Corporates

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A. What is Financial Planning?
Life insurance as a financial product constitutes one element in an individual’s
portfolio of outlays which he or she makes towards meeting various needs that
may arise in the course of his/ her life cycle. The role of life insurance products
must thus be examined in the context of financial planning – they need to be
designed and positioned so as to be able to appropriately fulfil certain needs that
arise in the course of the life cycle.
Financial Planning has indeed emerged as a discipline in its own right, consonant
with the rise of financial planning professionals [e.g. Certified Financial
Planners.] Efforts to meet client needs have led to the development of two types
of financial plans – segmented and comprehensive. While Segmented plans
enable practitioners to review one aspect of a client’s life, such as insurance,
investments or retirement, a comprehensive plan would entail the development
of a more detailed and complete approach, which factors in a range of financial
concerns that affect people today - such as steady cash flow, education needs,
insurance, retirement, investments, income tax and estate issues.
In sum the process of Financial planning may be described as one that entails
identifying one’s life’s goals, translating them into financial goals and charting a
roadmap to meet expected and unforeseen needs in one’s life as a part of
reaching these goals. The process calls for assessing one’s income and net worth,
estimating future financial needs, assessing one’s risk profile and working towards
meeting those needs through proper management of finances. It is a scientific
way to act for converting goals and desires into reality.
An important aspect of financial planning is the view and strategies one adopts
towards investment of funds. In the early years, when one is young and has a lot
of years to look forward to, one may tend to be quite aggressive and willing to
take risks in order to accumulate as much wealth as possible. As the years pass
however, one may become more prudent and careful about investing, the purpose
now being to secure and consolidate one’s investments. Finally, as one nears
retirement years, one may tend to be quite conservative. The focus shifts to
having a corpus from which to spend in the post retirement years, and also make
bequests for one’s progeny or gift to charity etc.
The change in investment style, in relation to the risk profile is shown below
Risk Profile and Investment Style
Risk Profile Investment Style

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Financial Planning or life cycle planning involves a number of core disciplines that
are given below
Cash flow management: the process of planning and budgeting for one’s regular
income and outgoes, so as to meet liquidity needs on a regular basis
Insurance planning: to meet one’s various life and other contingency needs
through insurance
Investment planning: done with a view to accumulate capital over one’s life time
in an efficient way to meet various future needs.
Education planning: to set up funds for meeting childrens’ educational needs
Income tax planning: to meet one’s tax liabilities in an efficient and effective
manner
Retirement planning: to meet one’s post retirement needs for income and
wealth
Estate planning: to meet the needs that arise after one’s demise and leave a
bequest behind.

B. Meeting Needs at Different stages of life cycle

It was William Shakespeare who said that the world was a stage. From the day a
person is born till the day of his / her death, he / she goes through various life
stages in which he / she is expected to play distinct roles
We can easily identify the following seven roles and related needs linked directly
to the seven stages of a person’s life cycle.
Stages Roles
Childhood Stage Learner
Young Unmarried Stage Earner
Young Married Stage Partner
Married with Young Children Stage Parent
Married with Older Children Stage Provider
Post Family/Pre-Retirement Stage Empty Nester
Retirement Stage Dignified or Destitute

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These stages are illustrated below

Con su m p t ion

In com e

The above diagram indicates the different stages in the life cycle. We can see
that income increases over time and becomes higher than consumption, resulting
in a savings surplus. As an individual grows old however, he or she retires and
moves out of employment, in which case, income from such employment earnings
comes to an end, but life continues. Meanwhile, as an individual moves through
the various stages of life and roles, there are a number of needs for funds that
also emerge at each of these life stages. We can see in the diagram above that
while an individual’s consumption needs are felt from birth to the end of life,
income begins to earned, typically when he/she reaches a certain age and begins
to work. When Income is higher than consumption during a good part of one’s
working life, there is a surplus which is saved and invested. At the later stage of
one’s life, income stops or declines but consumption continues. Savings and
investment, along with earning of income, becomes the means through which
funds for different needs that arise during the life cycle are allocated.
In economics, we have the familiar identity: Y – C = S
[Y is income; C represents consumption; and S savings].
The above identity can be taken to imply that savings is a surplus (residual of
income) after consumption. One thus talks about the role of financial institutions
in ‘mopping up’ the surplus. This residual identity has often been interpreted to
mean residual behaviour – it assumes that people first decide how much to
consume and savings automatically follows as a result.
A more relevant way may be to look at savings as an active (as against residual)
decision by individuals to capitalise their income streams and create capital
assets. The decision to save cannot be separated from the decision to hold real
or financial assets. It is a composite of two interrelated simultaneous decisions:
• To postpone consumption;
• To part with liquidity (ready purchasing power) in exchange for less liquid
assets.
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There are two major theories of consumption and savings in economic literature,
which sought to explain savings behaviour over the individual’s lifetime. The first
one was known as the Permanent Income Hypothesis [PIH] which was developed
by Milton Freidman. He defined [1957] Permanent Income as s a measure of the
discounted present value of expected streams of future income. Friedman’s
significant insight was to make a distinction between permanent and transitory
components of income. For instance let us assume that Mr Rakesh expects to earn
a regular salary that increases at say 5% per annum over the next twenty years.
When he plans his expenditure (standard of living) it is not based just on what he
gets at hand at present but bears a stable relationship with the income streams
he expects to earn over her economic lifetime. This can be borne out from the
fact that he may invest in buying a flat for which the total expenditure is many
times his annual income – he expects to pay them through EMI s drawn from
expected income streams in future. We may say, taking a cue from Friedman,
that his her permanent consumption is a stable function of his permanent income.
On the other hand, if Rakesh were to receive a windfall gain from a local lottery
or gets a bonus, this is a transitory (non-permanent) component of income.
Rakesh normally would not plan his consumption in anticipation of such transitory
income streams. Such earnings are thus likely to be saved.
Yet a theory, pioneered by Modigliani and Brumberg [1954], was slightly different
from Freidman’s model. Known as the Life Cycle Hypothesis {LCH], this model
explicitly took into account the fact that one’s economic life is finite and
structured. One’s income and consumption reflects a pre- working; a working
and a retirement or post work phase. In Modigliani’s work, the proportion of
income (given by life time resources) used for consumption was considered to
depend on the interest rate that discounts future time; tastes and preferences
and age of the Household.
The PIH – LCH models provide us with an important perspective in which
consumption and savings are seen as an allocation of scarce resources (wealth)
to optimise utility [welfare one derives] from consumption over the individual’s
lifetime. The model suggests that savings represents an Intertemporal allocation
[allocation of income over multiple time periods] of income resources.
Investment is the choice of specific financial instruments or vehicles through
which one chooses to hold one’s funds.
The needs or purposes for which funds may be saved are various. J.M. Keynes
[1936] furnished a whole list of motives for savings:
1. To provide for anticipated future relation between income and needs of the
individual - the Life Cycle motive.
2. To build up reserves against unforeseen contingencies - the precautionary
motive
3. To enjoy interest and appreciation - the inter temporal substitution motive
4. To enjoy a gradually increasing expenditure - the improvement motive.
5. To enjoy a sense of independence and the power to do things though without
a clear idea or definite intention of specific action - the independence motive.
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6. To secure a masse de man oeuvre to carry out speculative or business projects
- the enterprise motive.
7. To bequeath a fortune after one has passed away - the bequest motive
8. To satisfy pure miserliness - the avarice motive
9. To accumulate deposits to buy houses, cars and other durables - the down
payment motive.
In general we can broadly classify the above under three broad end purposes for
savings:
To enable future transactions: with regard to two types of needs.
• Specific transaction needs: made up of specific life events which call for a
commitment of resources – instances are provision for higher education /
marriage of dependents; buying a house or consumer durables; saving for a
vacation etc. These events may arise in the long or short run and sometimes
require more funds than are available or can be accumulated during the
interim period. One then needs to borrow. The payment of interest and
(repayment of) principal in equated monthly instalments (EMI) becomes a
form of compulsory savings.
• General transaction needs: represent amounts set aside from current
consumption without being earmarked for any specific purpose. They achieve
the archetype purpose of savings - smoothing out income streams over one’s
lifetime.
To meet Contingencies:
Contingencies are unforeseen events that may arise during the life cycle, which
require large commitment of funds, which cannot be paid out of one’s current
income, hence needs to be pre-funded. Some of these events, like death and
disability or unemployment, lead to a loss of income while others, like a fire, may
result in a loss of wealth. Where these events have a low probability of
occurrence but entail high cost, they may be addressed through insurance.
Alternatively one may have to build a reserve as a provision to meet such
contingencies.
Wealth Accumulation:
One may also withdraw from current consumption and commit funds to ventures
for wealth accumulation. All savings and investments indeed lead to capitalisation
of income and wealth creation. The wealth accumulation motive refers to one’s
drive to take advantage and reap the benefits of favourable market opportunities.
Examples of this process are Speculation and Arbitrage activities. The first refers
to investment of funds in an asset whose value is going upwards and withdrawal
of funds from an asset when the value is going down, with a view to earn profits
from such buy- sell transactions.
The needs discussed above are, in general, linked to specific purposes for which
financial assets may be held. In case of transactions needs, having adequate
purchasing power (liquidity) at the right time and quantum is the prime concern
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for holding assets. When people purchase insurance or seek other ways to meet
unforeseen contingencies, they are essentially concerned with ways to reduce
uncertainty and its costs. Coming to wealth accumulation, its name suggests
people committing money to make more money.
Obviously all the above needs do not arise with the same intensity. Since
resources are scarce, a person who is rational and discerning in his or her
approach may undertake a ‘preference ordering’ of needs [arrange needs in order
of priority], searching for appropriate assets to address them. An individual who
is not interested in buying life insurance is not necessarily unconcerned about
his/ her demise, rather it may just indicate that other needs are deemed to rank
higher in relative importance.
Corresponding to the above we may classify financial products, according to the
core purposes they address, as belonging to three generic categories:
Transactional products: held to provide for anticipated transaction purposes.
Examples are liquid funds in a savings bank, from which children’ fees are paid,
or funds placed in an FD to meet a daughters’ marriage expenses.
Contingency Products: held for a rainy day. They are typically unanticipated
events whose occurrence entails emergency funds – like death or disability.
Insurance contracts typically address such needs
Accumulation products: serve as a vehicle for accumulating wealth. They are
held primarily to earn a high return, their appeal being in the yield they promise.
Shares of companies are held typically for such purposes.
A look at the illustration of life cycle stages also reveals that there are three kinds
of objectives that one may have for investment. In the earlier life stages, when
one has a longer span of time for investment and the needs for funds are far in
the future, the principal objective would be accumulation of funds. One may thus
invest in growth funds/ vehicles with the potential for high growth of values over
time. As one crosses the middle years of one’s life and moves towards the ‘empty
nester’ stage, the focus may shift from accumulation towards consolidation of
one’s wealth. The preferences may move towards bonds and other debt
instruments that offer a safe avenue of investment and steady income. In the
Post – Retirement stage, the focus shifts towards withdrawal of income and
capital for meeting needs in the twilight years of one’s life. Pensions and other
forms of income earning assets become important. Other solutions for such
period may include products like ‘Reverse Mortgages’, in which one’s living
premises can be leveraged [through a system of mortgage] to earn a regular
income for a specified period of years, while one continues to reside there.

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C. Life Cycle needs and the demand for Life Insurance
It would be instructive to look at the various academic works that have sought to
explain the demand for life insurance within the life cycle framework. We have
already seen (chapter 1) how the life cycle hypothesis) views savings as an inter-
temporal allocation of resources. Its purpose is to optimise one’s lifetime (as
opposed to current) utility of consumption. The archetype individual who plans
and allocates her wealth faces two sources of uncertainty with regard to the
continuity of her income and consumption – one contingency which can affect her
plan is premature death and the other is surviving beyond what her resources can
provide. Life insurance policies with a savings element may be positioned to
meet both these kinds of uncertainty. Life Insurance fits into the individual’s
scheme of things as a transaction that helps to add certainty to the consumption
pattern. A number of writers espoused the role of life insurance in this
framework.
 Yaari
Among the pioneers in the field of insurance economics, we have Yaari’s (1965)
work in which he showed, in the context of a model with uncertain lifetime, that
a consumer purchased life insurance to increase his expected lifetime utility. The
utility function was given by
V(c) =  (t) g [c (t)] d t
Where  was the subjective discount function with respect to time t, and g the
utility associated with consumption c at every moment of time. The introduction
of insurance in the model was seen equivalent to removal of uncertainty from the
allocation problem. In particular, by expanding the set of feasible consumption
- savings plans, life insurance was shown to have significant effects on the optimal
allocation of consumption over time. Yaari introduced a concept known as “the
Actuarial note”. This note represented a kind of contingent claim, which would
get redeemed in case the individual who issued it died before redemption date.
The purchase of a life insurance policy in effect represented the simultaneous
issue of Rs.X1 of actuarial notes in exchange of Rs.X2 worth of regular notes. An
annuity represented a transaction in the opposite direction – purchase of Rs X1 of
regular notes and simultaneous sale of Rs X2 of actuarial notes.
Yaari suggested two models for analysing the effects of life insurance. In the first
case known as the “Fisherine model”, the emphasis was on the collateral function
– an individual wanting to maintain levels of consumption in excess of income, at
early periods of his life time, could do so only by issuing actuarial notes. In the
second instance, known as the Marshallian model, we have the presence of a in
the utility function, which is represented by a need to bequeath (leave a legacy)
for one’s descendents. This means that one could not consume as much as one
wants or accumulate a debt – as that would mean leaving a negative legacy
behind. The presence of a bequest thus imposes a natural penalty on
consumption and accumulation of debt. Life insurance serves as a means to
overcome this disability.

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 Stanley Fischer
Another pioneer in the field was Stanley Fischer (1973) who developed a single
period term assurance model in the life cycle framework. He concluded that
demand for life insurance was an increasing function of labour income next
period, and the relative weight of the bequest function. An individual might thus
buy life insurance, which was loaded (priced more than its fair value) against him,
if the weighting on the bequest function was sufficiently large. On the other hand
he could well reject fair or even favourable insurance if the weighting on bequest
function was small. An individual was likely to increase his present consumption
when facing an increased probability of death, if there was a lower weighting on
the bequest function. Fischer also suggested that an individual receiving labour
income was more likely to purchase insurance than one who lived off his wealth.
Further an individual with labour income was likely to purchase life insurance
early in life and tend to sell it late in life.
 Hakansson
Nils Hakansson (1969) considered a model having individual’s lifetime as a random
variable with a known probability distribution, and a utility function that was
introduced to represent the individual’s bequest motive. Each individual was
postulated to have an initial capital position [his wealth] and a non-capital
income stream [expected earnings from work], the latter terminating with
certainty on death. The individual sought to maximise expected utility from
consumption during his lifetime and from bequest after his death. The
introduction of an uncertain lifetime was seen to have two effects. Firstly the
person would tend to be averse towards postponing consumption to an uncertain
morrow. Secondly it reduced the individual’s borrowing power, given that he had
a non- - capital income stream extending beyond the current period. Life
insurance implicitly helped to overcome the limitations arising out of such
uncertainty and enable achievement of a more optimal solution. The optimal
amount of insurance in the model was seen to depend on the present value of
non- - capital income stream in any period [a proxy for his human life value] and
on the strength of the bequest motive
 Richard Scott
Richard Scott (1975) argued, in his model, that each investor had a human capital
component of wealth, which was independent of his preferences and risky market
opportunities. This was the certainty equivalent of the investor’s future (wage)
earnings stream, assumed to be sure if the investor were alive. This human capital
was calculated by discounting the future earnings stream until the maximum time
of his death, at a discount rate equal to the sum of the risk free rate and the cost
rate of insurance, available at the time. Life insurance premium was paid here
to protect against the loss of his main asset - his future.
 Pissarides

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Pissarides (1980) argued, to start with, that under general conditions, a life cycle
model with uncertain age of death would yield two motives for saving - saving for
retirement and saving to leave a bequest. In the individual’s allocation without
life insurance, the bequest arising from death was equal to the wealth he
happened to have in hand when he died. Both consumption and bequests would
be affected by the timing of income receipts. The existence of life insurance
removed this dependence and implied that the individual was free to more
optimally structure both his consumption and wealth in relation to his age profile.
 Ritchie campbell
Ritchie Campbell (1980) argued for labour income uncertainty as the basis of life
insurance purchase. As he put it, “the spirit of the life insurance problem is
contained in the simple environment where the sole source of uncertainty is the
age at death of the household’s primary wage earner and household choice is
limited to the insurance consumption decision.” According to him the optimal
amount of life insurance would be given by a factor of proportionality (b), which
was determined by the level of risk aversion and the intensity for bequest of the
household as also its perceptions about the insurance firm’s loading charges.
Another insight was that households would tend to view some proportion of their
accumulated marketable assets as perfect substitutes for human capital
insurance. This portion could then be self-insured. Again, the household’s
composition of total resources (accumulated marketable assets and human
capital) had a major influence on life insurance demand. As households got older,
the proportion of human capital, which was insured, would probably decrease
even as the level of risk aversion stayed constant.
In the paragraphs above we have only presented a few of the numerous academic
studies that have been conducted with respect to the demand for life. Insurance.
A review of these models indicates that they highlighted the role of life insurance
in the allocation of resources to maximise expected lifetime utility of
consumption. Life insurance helps to increase this utility through meeting the
impact of uncertain lifetime on the maximisation process. As Osterville (1996)
put it, “In general the models thus imply that a demand function for life insurance
should depend, among others, on wealth, expected income streams over life
time, a vector of interest rates and prices including insurance premium rates, and
the consumer’s subjective utility function for consumption and wealth
Let us now look at some of the specific factors and considerations that impinge
on purchase of life insurance
There are three factors that are clearly discernible when we examine the demand
for life insurance protection - risk aversion; the bequest motive and the
immediate estate feature of life insurance. These factors need to be present in
order for making someone ready to be a buyer of life insurance.
Risk Aversion: The level of risk aversion indicates the propensity of an individual
to avoid risk. We have already seen
We have already seen (chapter 1) how the Expected Utility Hypothesis provides a
measure of the fair actuarial value of insurance. The hypothesis also explains
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 11 6
why individuals are prepared to pay more than this value (the loading). Risk
aversion tells us how much more a rational individual would be prepared to pay,
as a certainty equivalence (a price for having certainty).
There are a number of points to remember when discussing the role of risk
aversion in prompting life insurance purchase.
Firstly there is the impact of wealth on the degree of risk aversion. An
individual’s readiness to buy life insurance protection by pay the amount of
loading would depend on two factors – her/her level of wealth and the extent to
which this wealth is not directly related to one’s human capital. It is seen that as
the level of one’s wealth increases, the inclination to pay a higher price (the
loading) to protect this wealth decreases. Again, since death primarily only
diminishes one’s personal earning power (human capital) and not that of other
assets (like real estate or financial assets), the aversion towards death risk would
be reduced for those who have a higher proportion of wealth that is not human
capital. For example, the head of a farming household may be less worried about
the impact of his death than of a household whose head is a wage or salary earner.
Another very critical aspect of risk aversion to be considered is the individual’s
preference ordering of the loss event (death). Without a doubt, everyone may
be expected to have a little anxiety and concern about what could happen if he/
she were to die suddenly. But this concern varies from person to person and
situation to situation. Again, death is not necessarily the only or even the most
important of one’s concerns at any point of time. There are other risk events
(which we may call life contingencies) in the individual’s life continuum. Aversion
towards mortality risk thus competes with aversion towards other life contingent
risks. Indeed an important insight [made by Karni,1996] was that that an
individual’s subjective beliefs and expectations about his/her mortality had to be
derived and constructed from his/her actual choice behaviour (purchase of life
insurance for given price). It is seen that individuals would make their own
subjective evaluation of the loss event (death), quite independent of the
consequences. In other words, Individuals are not likely to be swayed towards
greater anxiety about their death, just by highlighting its consequences
Let us examine this a little further. A little reflection would show how an
individual’s subjective evaluation of mortality could arise.
[1] Firstly there is me frame or planning horizon over which one is considering the
operation of risk aversion. The longer the time expected (in subjective terms) to
elapse before occurrence of the event, the lower the level of risk aversion. This
is illustrated below:

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Risk
Aversion

TIME

Quite simply, the longer the time one expects to elapse, before death strikes,
the less urgently it is felt in the present. In a world where life expectancy has
considerably increased and longevity has become a well-recognised reality, it
would not be surprising to find that other life considerations weigh far more in
the mind than one’s likely demise.
[2] Secondly the intensity of the aversion towards (mortality) risk might also
depend on household demographic; socio-economic and psychographics
characteristics.
There are various studies [e.g. by Hammond (1967), Katona (1964)..] that
examined the impact on life insurance demand of demographic variables like age
and stage of life cycle; education; household size; income and total assets;
number of income earners in household etc. They found these to be significant
explanatory variables. A study by Burner and Palmer (1984) similarly considered
how psychographics variables like religious salience, work ethic, self-esteem,
community involvement, child orientation etc. impacted purchase behaviour of
life insurance. An important finding was that purchase of life insurance was not
a matter of believing or not believing in life insurance. Rather, life insurance
appeared as a product associated with specific needs and personality traits.
Again, culture and religion have been studied as variables that might significantly
impact on the population’s risk aversion. Zelizer (1979) thus noted that religion
has historically been a strong source of cultural opposition to life insurance.
[3] Thirdly, when the event (death) appears as one among a spectrum of
individuals’ lifetime contingencies, choice behaviour would involve exercising a
trade-off among these.
In a pioneering study, Doherty and Schlesinger (1983) showed that an increase in
risk aversion of the insured, ceteris paribus, did not guarantee that purchase of
insurance coverage would be higher. The reason is that these markets are
incomplete. The authors define insurance markets to be incomplete if contingent
claims (insurance policies) cannot be written to cover all possible loss situations.
The presence of incomplete markets implies that various needs for risk cover may
have to be met through diversification among commodities (assets).

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 11 8
Another study by David Mayers and Clifford W.Smith (1983) also brought out the
issue vividly. The authors analysed the individual’s demand for insurance as a
special case of general portfolio hedging activity. The demand for insurance
contracts was found to be determined simultaneously with demand for other
assets in the portfolio. The authors attacked erstwhile approaches which have
assumed that there is only one source of uncertainty (death) in the individual’s
opportunity set and that a life insurance contract is the only available asset for
hedging risk.
The Bequest Motive: while anxiety about one’s death may be a prime condition
in motivating life insurance purchase, it is not a sufficient condition. . All life
insurance contracts have a beneficiary who is different from the life assured
(usually the policy holder). One would normally not purchase life insurance if
there were no beneficiary. This brings us to the second factor in life insurance
purchase – the role of bequest. The Bequest motive refers to the individual’s
desire to leave an estate behind to his or her dependants.
It might be relevant to make a distinction here between two types of Bequests.
The first kind consists of accumulated wealth (savings) that is naturally
bequeathed to heirs after one’s demise. Modigliani (1954) suggested that was
the result of a ‘precautionary’ response to uncertainty as regards the time of
death. With a view to control the risk of outliving their resources, risk averse
consumers would pursue a strategy that, with high probability, would result in
their leaving behind some positive bequest. The second type of bequest is in the
form of a specific kind of estate, which becomes real only after one’s demise.
Life insurance fits into the latter category
Bequest in the former sense has been a part of man’s history for long. In the latter
sense however it emerged as relevant mainly with the breakdown of the extended
family system and the formation of nuclear families. The strength of the bequest
motive for life insurance may be said to depend mainly on the extent to which
the individual feels responsible for taking care of his dependants and the sense
of unease suffered (or dis-utility) as a result of not making such a provision. This
in turn is contingent on a number of factors like degree of family attachment;
prevailing socio-cultural mores and the value attached to such a form of bequest;
alternative arrangements for taking care of dependants, like state social security
or community action
Quite often, when we speak of Bequests in life insurance, it is seen as a means to
hedge against the losses that dependents might suffer as a result of probable loss
of wage earners’ future non – capital earnings in the wake of premature death.
Typically a young individual with a family of dependants would be expected to be
concerned with such bequests. There is also the possibility that life insurance
can serve as an instrument for preservation of capital, that one earns during
his/her lifetime. An estate could thus be created to protect one’s accumulated
lifetime savings from depletion or forfeiture, consequent on one’s demise. Such
depletion can arise especially as a result of high medical treatment costs; taxes;
other settlement expenses that may arise as charges on the estate of the
deceased.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 11 9
Life insurance plays the role of a wealth preserver, ensuring that dependents do
not suffer unduly as a result of such depletion. Life insurance can also be
purchased to form an additional estate (apart from one’s savings), which is
bequeathed to descendants. In this sense, it can also be purchased at a later
stage in the life cycle. Indeed, given the phenomenon of ageing population and
the changing profile of inter-generational relationships, the latter type of bequest
has acquired some significance.
A significant argument that has emerged with regard to the role of bequest is that
they might take the form of implicit contracts whereby parents secure services
from their children in exchange for some inheritance [e.g. suggested by Kotlikoff
and Spivak (1981); Horioka (1984); Bernheim, Schleifer and Summers (1985)]. In
this avatar, bequest may represent an instrument that satisfies both the altruistic
utility of leaving behind an inheritance (true bequest) and also serves as a reward
for taking care of the aged cohorts in society. A study by Zweifel and Struwe
(1996) thus compared Long Term Care (a form of insurance that provides care for
the old and infirm) with bequests as alternative instruments for shaping
intergenerational relationships. The authors argued that while bequests and long-
term care could be combined, they do not go very well together. The balance is
seen to be undermined by long term care insurance – indeed the greater the risk
reduction achieved through such insurance (LTC), the more it may disturb the
balance. The very effectiveness of LTC may thus contribute to its conspicuous
lack of market access.
Non - Substitutability: we come now to the crowing argument of the life
insurance industry – that it is a unique product, which has no substitutes in the
financial marketplace. What exactly is the basis of this uniqueness? We can see
that it rests on two cornerstones. The first is irreplaceability of human
capital as an asset. Ask the simple question – what gets lost when a person is no
more - and you will realise what we mean. Simply stated, one cannot arrive at a
precise certainty equivalent of the uncertainty with regard to loss of one’s life.
The need for life insurance cannot, in other words, be compared to any other.
Secondly we have the distinctive feature of life insurance – the creation of an
immediate estate –, which can compensate for loss of human life value on death.
No other asset has payoffs that can match the size of this estate in the short run.
By paying a premium of Rs. 5000 for instance, an individual is able to purchase
[assuming a term premium rate of 10 per 1000 SA] an immediate estate of about
half a million rupees [5000/10 X 1000 = 500000]. This gives a yield which is ninety
nine times more or 9900% [5000/10 – 1]. Can any other asset offer such a payoff!
One could make the obvious observation – the chance of earning this amount is
slim. This brings us to the expected value of the payoff. If the objective
probability of dying (the mortality table rate) is three out of thousand, we get an
expected return of about 30 % [9900 X 0.003]. If the individual believes that
his/her chances of dying are more than the objective probability (say 0.005), the
expected rate of yield would be about 50%. The issue of substitutability is all

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 12 0
about the efficiency of the life insurance mechanism vis-à-vis other mechanisms
for managing contingencies like death.
An interesting study by Mayers and Smith (1983) suggested that a necessary
condition for the specific demand for insurance was that the costs of eliminating
risks through diversification must exceed costs of hedging them with insurance.
In other words, the extent to which protection could be obtained through what
the authors termed as “home-made insurance” (i.e. a substitute for a standard
insurance policy) would depend both on the availability of marketable assets to
provide such a hedge, and on the relative costs of the standard insurance policy
vis-à-vis such home-made insurance. They suggested that the key to separating
life insurance demand from other portfolio decisions was that the losses covered
by life insurance are independent of [not correlated with] payoffs of other
marketable assets. Another work by Buser and Smith (1987) showed that amount
of insurance and level of risky securities were both related to the risk tolerance
of portfolio holders. An increase in the ‘ risk tolerance of holders would, ceteris
paribus, lead to an increase in the level of risky securities and a decrease in the
amount of insurance if the premiums exceeded the actuarially fair amount. Yet
another study by Cook and graham (1977) argued that the individual’s demand
for insurance coverage or protection of an asset depended on his personal
valuation of the asset. Its market (sale) value was relevant only insofar as it
influenced his personal valuation. An asset like Human life [or Human capital],
whose utility was derived from sources like good health and well-being, could
not, in an individual’s personal valuation, be tied to any market price.
While the studies cited above, examined the role of accumulabIe capital assets
as substitutes to life insurance, another argument has been raised by some
authors [e.g. Art Goldsmith] It was thus hypothesised that the wife’s human
capital - i.e. a highly educated wife with considerable marketable skills – served
as a substitute for pure insurance on the husband. Goldsmith’s empirical results
showed that (i) Greater wife education decreased the likelihood of term
insurance purchased on husband (ii) Employment of the wife reduced likelihood
of purchase of term insurance. (iii) Household asset accumulation appeared to
reduce likelihood of insurance purchase.
In sum, the non-substitutability premise is to be evaluated with respect to the
extent to which individuals would exercise a preference for the immediate estate
feature of life insurance vis-à-vis alternative assets.
Risk aversion, bequest and non - substitutability are the three crucial planks on
which the demand for pure life insurance protection may be seen to rest. Anyone
seeking to position life insurance as a vehicle of death protection needs to
understand their dynamics.
In the marketplace, life insurance is today pitched with reference to addressing
a range of life cycle needs that individuals may face. This range varies at each of
the different life-cycle stages. At the childhood stage, one would need support
for continuing education, or at a young unmarried earning life stage one may
want to spend more but also feel peaceful that his near and dear ones are
properly provided for. At the young married stage or as parents of young children,
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 12 1
the commitment to provide and protect the beloved dependents is top priority.
Post these stages, accumulation or wealth enhancement needs and the need for
creating a regular income stream for old age become most important.
One service that a buyer is seen to look for, In the Life Insurance domain, is ‘right
advice’ – akin to the ‘advice’ of a lawyer or of a doctor. Once the need area (or
maybe necessity or wants) are identified and established the Life Insurance
product(s), which is primarily a financial instrument, is offered as a solution or
answer to that need. So a range of life insurance products exist, which in effect
cater to every life stage need. The needs also depend on factors like the life
stage at which the individual is, one’s current liabilities, expectation of future
liabilities, and number of dependents, financial goals, and life style
requirements. It is argued that life insurance ensures peace of mind, at times, it
can also enable an individual to be more enterprising and take risks.
The prominent needs of an earning individual are - to ensure child's education or
marriage; purchase of a house, car, vacations and so on; provisions for his/her
own old age; providing for adequate income till children become self-dependent;
providing for spouse’s income after children grow up and become self-sufficient;
finally there is a need to ensure that clean-up funds are available at hand – these
provide for terminal stage medical expenses, funeral expenses and settling
outstanding loans – these clean up funds need to be adequate to meet needs
arising in the wake of premature death, a re-adjustment fund in case of a
calamitous exigency, and so on.

D. Life Insurance Products for life stages

Insurance products also serve as a long term savings and wealth creation tool by
promoting the habit of thrift and regular savings. These products allow the
individual to systematically save over the long run and generate returns to create
a corpus that can be used to fund different milestones such as child's education,
marriage or retirement.
Protection
A portfolio that includes insurance cover for various life contingencies can be
considered superior to one that consists only of investment assets. Focus on pure
protection can offer life insurers a source of competitive advantage.
Term Assurance is a life insurance product that ideally meets the need for pure
protection against dying early. One-year term policies are quite similar to
property and casualty insurance contracts. Premium for term assurance is
typically very low, even though it may contain a relatively high expense loading
and an allowance for adverse selection. Numerous variants of Term Assurance
have been already discussed in the previous chapter – like Level, decreasing and
increasing Term Assurance; Mortgage Assurance and Credit Life plans; Family

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 12 2
income schemes and Term insurance with return of premiums on survival to the
end of the term
Developments in Term Assurance
Term assurance has seen much change in recent decades. One result of price
competition was to spur life insurers to come out with more aggressive pricing
models. A significant development in this regard was the emergence of
differential pricing. It offered clear advantages for those companies, having rich
mortality / morbidity data and experience, on which they could base their
pricing. Under differential pricing the standard mortality table is a reference
point, which determines the base rates. One may then go on to set up select and
preferential rates for preferred lives.
An example of such differential premiums is the provision to charge varying
premiums when people renew their policies. This kind of product, known as re-
entry term insurance, has different premium schedules. A lower premium is
charged based on select mortality rates – these are applicable to those who give
recent evidence of insurability. A higher premium based on ultimate mortality
rates is charged for those who do not provide such evidence. Higher premiums
may also be charged to those in poor health when they renew their policies.
Another example of differential premium is the granting of preferred status to
non-smokers over smokers and non-drinkers over drinkers.
With the new developments in medical technology, like genetic testing, it is
possible today to determine ‘pre-dispositions to particular diseases or group of
diseases.’ This would enable prediction of mortality risks to be fine-tuned even
further, making it possible to usher greater and greater degrees of price
differentiation in this area.
Appeal of Term Assurance
One year Term Assurance has been the simplest and cheapest form of life
insurance. Historically the industry moved away from it towards complex products
with a mix of protection and savings. The re-emergence and popularity of term
assurance in recent decades reflects consumer disenchantment with cash value
contracts and their willingness to look at life insurers only for pure protection.
The main point of contention with bundled level premium plans has been that
they overcharged the policyholders. For one thing the premium outlay under a
plan like whole life or endowment would be considerably higher than term
assurance for one who dies early. A more serious issue has been the relatively
low returns that insurers offered on the substantial savings elements in these
bundled plans. It was argued that the individual would be better off buying only
protection from the insurer since his/her surplus funds could be more wisely and
profitably invested than if given to the life insurer.
The promise of being able to protect one’s wealth portfolio from the loss
prospects of premature death and capital erosion in later years enhanced the
appeal of term assurance as a portfolio protection instrument. However term
assurance, which is unavailable except for a limited term, loses its relevance
when the purpose of taking insurance cover is more permanent and the need for
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 12 3
life insurance protection extends beyond the policy period. The policy owner
may be uninsurable after the term expires and hence unable to obtain a new
policy at say age 65 or 70. Even if a plan was available, the increases in renewal
premium would become prohibitive in later years.
We have already seen that individuals would seek more permanent plans for the
purpose of preserving their wealth against erosion from terminal illness, or to
leave a bequest behind. Term assurance may not work in such situations.
Finally, a product portfolio, which has a high incidence of term insurance policies,
can pose some hazards for the insurer. Cash value policies play a vital role in
providing an extra (savings) cushion for insurers to tide against higher than
warranted mortality risks. Insurers need to strike the right balance between
savings and term components in their product mix

E. Health Cover – Stand-alone and Riders

These are also in the nature of protection plans but they provide cover against
debilitating illnesses should the buyer live after exhausting his/her savings and
end up with reduced income-creation capabilities post illness. In fact, such
disease can be far more terrible in its impact. Death comes visiting only once in
one’s life. It leaves pain behind for loved ones but the pain recedes and reduces
into a dull ache as one moves on (out of sight, out of mind). Health impairments
on the other hand come visiting far more often and lingers, especially when they
are chronic and degenerative. What is worse, the pain is not in memory but
present before the eye.
Another difference from death is that disease may not only lead to loss of income
earnings but also can result in astronomical costs. Little wonder that morbidity is
a far greater source of concern for many cohorts today. In this section we shall
discuss the contingencies associated with morbidity and the products that have
been developed to address them.
The more popular form of providing health care protection has been through
medical expenses insurance which are sold in India by General Insurance and
Standalone health insurance companies.
Medical expenses insurance contracts are typically monthly or annually
renewable & reimburse various kinds of expenses up to a limit like:
 In-patient hospitalisation charges;
 In-patient surgical and medical charges;
 Outpatient charges;
 Home nursing charges;
 Other extra expenses, which are specified.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 12 4
The above covers are not generally sold by life insurers as they are typically sold
as short term rather than long contracts. However life insurers typically cover
two types major of ailments under the life insurance side of health cover. The
first is Terminal illness policies covering situations where the life assured suffers
from a terminal illness with expectancy of less than a year; and the second is
Dread Disease (DD) policies that cover a range of pre-defined dread diseases or
conditions such as heart attack, bypass surgery, strokes, certain types of cancers
etc. The features of these policies have been discussed in the previous chapter.
Rising Health costs and Financial Planning
One of the critical challenges facing individuals in the current era is the
desperation arising from living a long life that is marked by health impairments.
A significant issue here is that the impact of morbidity related costs has rocketed
on account of escalation of costs involved in detection [cost of various tests
entailed] and treatment of various geriatric and chronic diseases that arise in the
later stages of life. Indeed, many of these costs are borne at the terminal stages
of life when one is no longer covered by occupational health schemes. Many of
the costs of nursing and home treatment in such cases fall outside the purview of
hospital treatment and thus of medical expenses insurance covers. Again, the
incidence may extend for long periods of time.
One conclusion that may be drawn on reflection is that the challenges of
addressing chronic and degenerative diseases that are long tailed in their duration
and whose effects are humped towards the end, cannot be easily addressed
through traditional medical expenses insurance schemes [like the medi-claim
variant in the Indian market] that adopt a short term model. A long term
perspective is needed and this implies a role for life insurers. Products that
emerged in the eighties and nineties, like dread disease policies and long term
care insurance, were are responses in this direction.
Developing countries particularly face serious challenges with respect to efficient
and effective allocation and utilisation of scarce public funds for optimally
promoting the health of the community. Funds are needed to conduct public
health programmes like immunisation, eradication of diseases like malaria and
healthy awareness. There is also a need for providing a package of essential
health clinical services to the population at large via primary health care centres.
Subsidising secondary and tertiary care in the form of various kinds of
hospitalisation and other treatments is the third requirement. While a Universal
Health Care programme which provides free medical care and treatment at all
levels [primary, secondary and tertiary care] would be an ideal one, and it is
found in many advanced western markets, it is not easy for a developing
economy. This is where the availability of various health insurance products at
affordable prices would be crucial in reducing the need for subsidising the
financing of health care, but also reduce the impact of out of pocket expenses
that drive many families into ruin and penury. Providing for such schemes would
call for a closer look at how health risks could be pooled
There are indeed, two ways of pooling health risks. One is on cross – sectional
basis across individuals and families in a single year. The other is via inter-
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 12 5
temporal pooling, for a single individual or family. The first approach is adopted
today in traditional (one-year) medical insurance. It leaves insurers hard pressed
to meet the escalated costs of degenerative and geriatric ailments, which
typically get pronounced in an individual’s twilight years. An alternative to this
could be to consider a variant that combines the features of both cross sectional
and inter temporal pooling.
Medical Savings plans are an instance. Here, one typically makes contributions
to a tax-exempt savings account [similar to individual retirement accounts].
However, this fund is dedicated to meet future medical expenses. It may
accumulate at the individual’s discretion and earn both interest and capital gain.
At the same time, a low cost high deductible insurance policy serves as a “back
up firing mechanism” (Nichols et al., 1997). The high deductible ensures that
one would not small amounts below a minimum level. We thus get insurance
cover to meet large or even catastrophically high medical costs that may arise
during interim periods in the life cycle, without exhaust the medical savings fund.

F. Savings for a need or aspiration

In the previous section we were concerned with life insurance as a protection
vehicle. By this we mean that the risk pooling mechanism leads to the creation
of a large immediate potential estate, which is larger than what one could
normally accumulate through personal savings. Let us now consider life
contingent savings plans. By this we mean products that involve accumulation of
funds over time. Savings may broadly be classified into two types - General
savings and Specific savings. The former refers to amounts set aside from current
consumption without earmarking for any specific purposes – in other words, set
aside for “future provision”. Specific Savings are held to meet particular
liquidity needs that may arise in future, whether foreseen or unforeseen. They
may be governed by transactional or precautionary motives. Examples are money
set aside as provision for daughter’s marriage or son’s education.
Corresponding to the above needs, individuals may be expected to divide their
portfolios into two portions. While assets related to the general savings
component may have attributes, which contribute to general enhancement of net
worth, the second portion would consist of dedicated assets, whose attributes
depend on the specific purpose for which they are held. Short-term liquidity
needs for example, would call for more liquid and short-term instruments like
bank deposits or money market instruments. One may invest in certain types of
bonds to provide for medium or longer-term needs like education of children. In
each case, the key question is - what combination of assets would be the most
efficient one, given the objectives of investment and its constraints.
Life Insurance in the Financial Portfolio
All savings and investment lead to capitalising of income and creation of wealth.
Investment enables one to not only achieve an intertemporal allocation of
financial resources [purchasing power] across the life cycle but also to take

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 12 6
advantage of market opportunities and secure capital gains [in equity markets]
and/or reap the benefits of compounding [in debt markets]. In the latter sense,
investment enables one to put money to work for making more money. While the
first objective is driven by considerations of maintaining funds dedicated towards
meeting specific needs, the second is prompted by the need to multiply wealth
in a more efficient manner. Whether for specific or general needs, the efficiency
with which financial wealth gets accumulated would depend on two factors – the
rate of return, which defines the rate of such accumulation; and risk, which is
given by the volatility or variance of returns. While returns measures the pace of
the wealth accumulation process, Risk measures the consistency with which it
occurs.
Life insurance, as a savings asset, has been designed and positioned as one of the
vehicles of investment. In this sense, it is one among other financial products that
may be considered as instruments for wealth accumulation. This raises an obvious
question – how does life insurance compare vis-à-vis other financial products with
regard to meeting various financial planning needs.

The role of traditional life insurance as savings has been given by a set of standard
arguments that have been advanced in its favour. They include:
 Historically it has been proven safe
 Involves compulsory planning of one’s savings and provides the discipline
savers require
 Insurer takes care of investment management, so insured is free of this
responsibility
 In some measure it provides liquidity- the ability to realise cash without
loss of value
 Cash value type life insurance and annuities may enjoy some income tax
advantages
 As wealth, it may be safe from creditors’ claims, generally in the event of
the bankruptcy or death of the insured
 Provision of a stable yield over the long run future.
What we see in the above arguments is a focus on the role of life insurance as a
product in itself, positioned as a unique bundle - that contains both death
protection and savings benefits – to serve as a substitute to other products (like
mutual funds) in the financial marketplace. However one needs to examine how
tenable is such a positioning.
There are two reasons that prompt such a re-examination. Firstly, there is the
increasingly complex and dynamic character of the individual’s life cycle. The
concerns of individuals extended beyond death to other (life) contingent needs.
These needs arise under different kinds of situations (states of the world)
including inflation, unemployment, capital market uncertainty etc… No asset,

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 12 7
including life insurance, can completely address all the above needs for which
people save and hold money.
Secondly, a number of deep-rooted structural changes have been ushered into
erstwhile financial markets. Two of these are particularly relevant to us – the
emergence of alternative investment vehicles as substitutes to life insurance and
the convergence of financial markets. The latter trend is especially notable, as
it has spawned a range of hybrid products that combine different principles.
Within life insurance itself we have seen the emergence of products with such
combinations - for example, the combination of mortality risk with the principle
of the unit trust has led to the design of unit linked insurance.
The convergence of markets raises another point – there is a difference between
life insurance as a product in itself (as in conventional life insurance) and life
insurance cover as an attribute of a financial product. One cannot entirely rule
out a future with various hybrid products, each having an element of life
insurance cover, competing with one another.
It would hence be more appropriate to understand the demand for life insurance
in a portfolio setting – as one among other assets in a financial portfolio. The
idea of life insurance as a portfolio asset intuitively suggests a trade-off in
relation to other assets, in which the portfolio share of life insurance depends on
its relative contribution to portfolio utility. This share in turn determines the
optimal amount of life insurance to be purchased.
The Mean - Variance Model of Portfolio Behaviour
The most versatile form of the portfolio approach was the Mean – Variance model
developed by Markowitz, Sharpe and others. It postulated that the fundamental
determinant in choice of assets was the expected mean and variability of their
future returns. Portfolio Utility could thus be represented by the simple function
Up = f (rp, p)
As expressed above the utility of the portfolio depends on the portfolio’s mean
return (rp) and portfolio variance (p) of return. The typical investor in modern
portfolio theory is a risk averse individual who seeks to maximize the return on
the portfolio of assets held by him/her while trying to minimize the risk of the
portfolio as a whole. His /Her choice of assets thus depends on the average
return she expects to receive from each asset, relative to others and the riskiness
of the asset. This riskiness is assumed to be adequately measured by the
volatility, i.e. the variance of the rate of return. The higher the rate of return
and the lower the fluctuation in the rate of return the more desirable the asset
becomes to the investor. Portfolio theory however involves consideration of a
third factor - the correlation of the returns of the asset with other assets. It has
been established that the lower the correlation, the more beneficial it becomes
to diversify among various assets. The critical concept to grasp here is that
inclusion of an asset whose returns are not correlated with returns of other assets
results in reduction of the overall riskiness of the portfolio. The great merit
of the Mean – Variance model is that it can enable to precisely measure and

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 12 8
evaluate the relative contribution of any financial asset vis-à-vis others, via use
of a common numeraire, namely their mean and variability of returns.
Let us consider some implications of considering life insurance as a product in a
financial portfolio. While traditional life insurance products like Whole life and
Endowment may offer a reasonable level of returns, it is the role that they can
play in reducing the overall riskiness of the finance portfolio that can form a
paramount factor in positioning them.
We have already seen that the raison de’ etre of life insurance has been given by
the application of the pooling (mutuality) principle for reducing both mortality
and investment risks. The smoothing of returns that is achieved by the uniform
reversionary bonus system results in the returns to life insurance products having
almost zero correlation with other capital market products like Stocks or Mutual
funds that have market linked returns. During periods of bearish downswings,
when the latter turns out to be negative, the stable positive returns of life
insurance can even result in a negative relationship between the returns of life
insurance and that of other capital market assets which suffer from such
downswing – in other words they have a negative covariance with market returns.
It is this feature which makes more conventional life insurance plans (with their
element of guarantee of returns] attractive vis-à-vis other investments like
mutual funds. In the case of a portfolio made only of capital market instruments
[like stocks and mutual funds], it may be possible to reduce un-systematic risk
[arising from volatility of individual assets in the portfolio] through
diversification. But diversification in itself, may not be of much help when the
market as a whole is in a downswing. It cannot overcome what is termed as
systematic market risk. A life insurance plan, having zero or negative correlation
with market returns, may be among the few avenues for protecting one’s
portfolio under such a situation.
This is one of the major reasons why it makes sound sense to have some life
insurance in a financial portfolio, not as a substitute, but rather as a
complementary part of the portfolio. This is especially important when such
portfolios are maintained to meet various kinds of specific and general needs
where dedicated funds need to be maintained.

G. Estate Planning
We have already seen the role of the Bequest motive in the purchase of life
insurance. Bequest is closely related to another key element of financial
planning, namely Estate Planning. This process is especially important for
individuals and households that have large amount of assets and property,
including both Property [in the form of real and financial assets] and ownership
rights in business enterprises. Imagine, for instance, the head of a family
enterprise worth crores of rupees. The family not only owns the enterprise but
may also have a large amount of various assets. A key question is that of ensuring
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 12 9
that ownership and enjoyment of these assets actually passes down to the heirs
and also that they are appropriately and fairly distributed. Such planning is not
only necessary to ensure the future wealth and welfare of descendants but also
to ensure that the family legacy is continued.
A Life Insurance policy, by definition, creates a potential estate the moment it is
purchased. While in case of a term Insurance policy, the policy benefits become
available to one’s dependents only on death during the term; in a Whole Life
policy the insurance company guarantees a level death-benefit thus creating an
estate that is certain, for the next generation. Permanent life insurance policies
like whole life also often provide increasing guaranteed cash values; in case they
are policies which participate in profits [termed as ‘Par Policies’ in India today]
they provide bonus which, once credited, are guaranteed. In certain markets like
India, it is possible to provide for making the proceeds of these policies part of a
trust [formed in India under the Married Women’s Property Act 1874]. Policy
monies under such a trust are protected from any creditor or other claims on the
assets of the policy holder.
Estate Planning is in fact a key factor in prompting the purchase of conventional
life insurance policies among many households, including high net worth [HNW]
families, who are concerned with the legacy they leave behind.

H. Retirement Planning – the Role of Pensions and Annuities

Let us now ally look at Pensions and retirement income provisions
The concept of Pensions
Pensions represent the opposite of life insurance. While life insurance was
designed to protect the individual against the financial consequences of death,
pensions seek to protect against the risk of living too long and thus outliving one’s
financial resources, creating what may be termed as post retirement income
discontinuity. They also differ with regard to their basic structure.
In the case of life insurance, a stream of premium (income) payments is paid to
the insurer, who capitalises and converts them into an (lump sum) estate
available to the nominee/beneficiary on the insured’s death. In the case of
pensions, a capital sum (the corpus or total consideration) gets exchanged for a
stream of regular income payments (annuities).
The considerations surrounding them are also quite different. Death may be
horrifying and sordid but is still is a relatively simple affair, involving just one
state of being (stillness). Life is much more complex. It throws up problems that
need to be addressed with a sensitivity going beyond simple calculations, and
requiring an affirmation of living values. This has implications for the way we
design pension products and position them amongst different market segments.

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The primary objective of any pension is to provide members of the work force
with an income during their old age. There are three types of pension schemes
in existence today
Three types of Pensions
“Public Pensions” or state sponsored Social Security schemes are publicly
managed with mandatory membership and typically funded on a ‘Pay As You Go’
(PAYG) basis. They involve financing of current pension payments through
withdrawal (via social security contributions) from current income of the work
force. Many developed countries provide a minimum guaranteed pension, which
may alleviate poverty but are not sufficient to maintain even a modest life style.
This raises the need for additional layers of provision to supplement the basic
state pension.
“Occupational Pension schemes” are set up by employers. They may be
mandatory or voluntary. Employers may run these as independent funded
schemes. Alternatively they may have an arrangement with life insurers, who
may then manage the fund and discharge obligations on the employers’ behalf.
“Personal Pensions” are offered by life insurance companies, banks, mutual
funds or other financial institutions. There are different types of Personal
Pensions or annuities as follows:
An Immediate Annuity is one where the annuities are scheduled to begin
immediately – within one annuity period of 12 months after its purchase. It is
typically purchased with a single premium and is known as a single premium
immediate annuity.
A Deferred Annuity is where periodic benefits are scheduled to begin more than
one annuity period (12 months) after the date of purchase of the annuity. Every
deferred annuity has two periods – an accumulation period that extends between
the points in time when the annuity is purchased and the annuity date, and a pay-
out or liquidation period during which the insurer makes the annuity payments.
In case of deferred annuities the corpus is accumulated during the accumulation
period and consists of premium contributions plus investment earnings less
amount of withdrawals made by the annuitant. Typically the contract holder may
be allowed to withdraw a specified proportion of the corpus by way of
commutation of the pension. There is also a provision to surrender the policy for
cash surrender value, as in case of other life insurance contracts.
Finally, deferred schemes also provide for life insurance cover against the death
of the annuitant before the deferment or due date of annuity. The amount of
insurance would typically bear a relation to the expected accumulation amount.
It would be payable to a beneficiary who is nominated by the annuity contract
holder. All these provisions like surrender and life insurance cover would cease
to operate once the pay-out period begins. The terms of the pay-out option would
determine the rights of the annuitant thereafter.

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Pensions as Retirement Vehicles
While life insurance was designed to protect the individual against the financial
consequences of death, an individual is also required to protect against the risk
of living too long and thus outliving one’s financial resources, creating what may
be termed as post retirement income discontinuity. These plans, called pension,
differ with regard to their basic structure. (
In the case of life insurance, a stream of premium payments is paid to the insurer
who capitalises and converts them into an (lump sum) estate, which is made
available to the nominee/beneficiary on the insured’s death. In the case of
pensions, a capital sum (the corpus or total consideration) gets exchanged for a
stream of regular income payments (annuities). The considerations surrounding
them are also quite different.
Death may be horrifying and sordid but still is a relatively simple affair, involving
just one state of being (stillness). Life is much more complex. It throws up
problems that need to be addressed with a sensitivity going beyond simple
calculations, and requiring an affirmation of living values. This has implications
for the way we design pension products and position them amongst different
market segments.
The primary objective of any pension is to provide members of the work force
with an income during their old age. Pension involves payment of an annuity
whose purpose is to provide for income after retirement. Present day financial
markets also have other investments that purport to meet the same purpose.
However all such annuities may not qualify as pensions. The defining
characteristic of a pension (as an insurance product) lies in the application of the
mutuality principle for addressing contingencies associated with living in the post
retirement stage of the life cycle. Every pension is an annuity in the sense that
it involves a regular stream of income payments. But every annuity is not a
pension. To qualify as a pension it must possess the characteristic discussed
above. The question to be answered is why buy a pension annuity and not any
other annuity.
The classical argument for a pension has been as a vehicle for addressing longevity
risk – the chance that one may live too long and outlive one’s resources. The
dilemma of the old age retiree is twofold – how much old age provision one must
make and where the fund must be invested. Let us consider the first. Ideally an
individual should, on the point of death, have enjoyed his/her funds in full, just
leaving a target bequest as one desires. The problem is that one does not know
when one will die and how long the funds will be needed. If one builds a huge
nest egg by restricting his or her living standards, there is the chance of dying
excessively rich without having enjoyed one’s resources. On the other hand there
is the spectre of resources proving to be inadequate if one lives too long.
The second issue boils down to finding a vehicle that both provides a large enough
annuity income and also has a term to maturity that exactly corresponds to one’s
lifetime. The pension annuity solves both kinds of problems. The problem of
finding a vehicle whose term neither ends too soon nor is too long is solved, since
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 13 2
the pension can be made payable exactly as long as one’s lifetime. This also
means that the insurer takes on the risk of pension inadequacy. Again, the
pension annuity can enable the most optimal conversion of capital into income.
To illustrate, a fixed deposit of Rupees Ten lakhs, invested at 10%, gives a monthly
income of only about Rs. 8334(the interest payment). The principal (Ten lakhs)
is of no use to one after one’s death. On the other hand the pension annuity
provides for scientific liquidation of the principal in such a way that both principal
plus interest is timed so as to be exhausted during one’s (actuarially estimated)
lifetime. As a result the corpus of Rs ten lakhs can yield a pension, which is much
larger than the interest that one earns on a fixed deposit of ten lakhs.
While longevity is the problem that pensions were traditionally designed to
address, retirement income uncertainty has today come to be associated with a
lot of other risk outcomes, which has made the world of pensions more complex.
Let us examine some of these.
Replacement rate risk: This is the risk of the individual not having a post
retirement income sufficient to replace the income or standard of living enjoyed
while in service. This risk can emanate from the following sources:
Post retirement incomes must bear some relation to final salary levels, since
one’s living standards are normally linked to these. Consider an individual aged
40 earning a salary of Rs 10000 a month. Given that income rises @ 5% per year,
the final salary at age 60 would be Rs 26533(10000 x (1.05)20). The replacement
income at age 60 would thus amount to about two and half times of that earned
at age 40. The individual has two types of concerns – firstly how to fund this rising
liability and secondly, the unpredictability of the rate at which income and living
standards would rise in future.
Inflation risk: Inflation can reduce post retirement living standards in real terms.
Real incomes are protected while one is in active service through suitable wage
indexing. Would such a provision be available after retirement?
Social Security risk: This is the possibility that Social Security and other
retirement benefits may prove to be lower than what the individual had
anticipated and planned for. Individuals have, in anticipation of this contingency,
turned to Personal Pensions in recent years to recoup shortfall in expected
earnings.
Longevity Risk: it is the possibility that the individual might live too long after
retirement and thus outlive his resources. We have already discussed it earlier.
Investment risk — the possibility of retirement funds being rendered inadequate
or even wiped out because the underlying investments performed badly vis-à-vis
expectations, on account of default by debtors and / or a fall in the market value
of investments.
Insurers and other pension providers have sought to design the basic content of
the pension so as to provide adequate replacement income in the context of the
above contingencies. In many occupational pension schemes for example, such

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 13 3
risks were addressed through a system of sharing and distribution (risk pooling)
among employees and pension providers (employers and life insurers).
Under defined benefit schemes, employers undertook the provision of a pension
with linkage to final salary. Success of these plans depended on the employers’
ability to accurately estimate current and future earnings and to build an
appropriate funding system. It also meant that employers had to be prepared to
bear some of the replacement risk and make good the loss out of company profits.
Investment risks were normally borne, under an insured scheme, by the insurance
company who managed the funds. Inflation risk had to be met through some form
of index linking. This often called for investing the assets of the pension funds in
securities whose value rose in relation to the general level of prices (e.g.
equities). Longevity risk called for establishing a pace of funding such that the
individual lived just long enough for principal and interest payments to exhaust
the accumulated corpus. Under Money purchase schemes (e.g. Personal Pensions)
the contributions were defined and the benefits depended on fund performance.
Where pensions were guaranteed, the insurer would set the price accordingly and
aim for a target performance. When pensions were index-linked to performance,
investment risks along with the gains passed on to the pensioner. This also meant
that a share of the replacement risk devolved on the pension recipient. A possible
solution has been to develop Dynamic Pension Plans in which both the benefits
and the consideration amount could be varied from year to year, so as to be linked
to future rise in income.
The key to managing the future of pensions may perhaps lie in recognising that
when individuals think about future financial security, they are concerned with
more than longevity and replacement income (as specified above). The question
of living after retirement is associated with certain other contingencies as well.
Other contingencies
One of these is the prospect of discontinuity in income before the expected
normal retirement date. This is on account of early job exits and declining
participation rates among older employees, which has become more common in
many developed countries. Beleaguered by industrial recession and the need to
cut flab, employers have both reduced retirement ages and also affected layoffs
of older employees, even before they reached the end of their full expected
tenure of service.
Many workers too have opted for early retirement, both voluntarily and due to
redundancy and recession. An early retiree is often young enough to be
productive. Many such retirees re-enter the labour force (let us call this phase as
Para employment) after their premature retirement, in the form of part time or
self-employed or temporary contract workers. They may seek supplementary
sources of income to replace any shortfalls in earnings arising on account of these
changes.
Individuals who face and expect such job adjustments / changes that could lead
to a decline in work earnings typically respond in two ways. Firstly, they would
seek a high rate of accumulation, which can generate a substantial corpus within
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a much shorter period. Secondly they may seek a strategy of phased dis-savings
without undue depletion of assets. The idea is to supplement one’s income during
the Para-employment phase while at the same time leaving enough provision for
the period when one is no longer able to work and earn. Could pension plans have
the built in flexibility required for this purpose?
The second set of problems stem from large health care expenses that cause a
huge dent in one’s income during old age. The major incidence, as we have seen,
falls at the terminal stages. The state‘s health provision may not easily be able
to take this burden. Quality of treatment offered under state auspices may also
be found wanting. Superior care and treatment can often be had only at a
premium through private sources. Occupational schemes have been designed
mainly to take care of medical expenses incurred by individuals while in
employment. They may not normally apply to other individuals who are not in
such employment.
Private medical expenses insurance is largely written on a short-term basis,
typically as a monthly or annually renewable contract, covering expenses up to a
certain limit. They are inadequate or even unavailable to those needing them
most. Many old age retirees face the dreadful prospect that treatment costs may
dissipate their lifetime savings and even cause a burden to fall on their loved ones
– this is a prospect one would die rather than face.
Meanwhile the breakdown of the traditional family framework, where care and
protection of the elderly were provided on an informal basis, has compounded
the concerns. In short, financial uncertainty constitutes only a part of the
problems that accompany the process of aging. Other concerns plague the aged,
like - fear of being a burden on others; lack of independence; reduced sense of
self-worth; a sense of being a cause of friction in the household; loneliness and a
sense of meaninglessness regarding one's own existence.
Pension Providers face a challenge as well as opportunity. Concern about a larger
set of contingencies has led individuals to seek not only for income but also
continued accumulation of wealth in old age. This largely explains the demand
for annuity products that served both as income and accumulation vehicles.
Another driving factor was the need for liquidity to meet income discontinuities.
It called for products that enabled a shift from scheduled to unscheduled cash
flows, achievable through partial withdrawals.
These changes ushered a new generation of annuity products. One such was the
flexible annuity. It allowed individuals to vary their drawings, to suit their
changing individual circumstances, while enabling them to also participate in
equity type capital growth after retirement. The provision for income withdrawal
was designed to allow individuals desiring early retirement to go for part time
employment. They could make good the shortfall in earnings, through such partial
annuity drawings.
The nineties witnessed a surge in variable annuities in countries like the US. A
popular version of the plan had a general account and a separate (variable)
account. While the former provided a guaranteed return, the variable account

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 13 5
offered a variety of sub-accounts that comprised stocks, bonds and other
instruments. The latter had the potential to yield a much higher rate of return
but carried higher risk. The annuitant could determine the proportion of premium
to be allocated to each type of account. Along with control over investment, the
annuity holder also had to assume some risk. Yet a third possibility for
augmenting pensions could be its linkage with a medical savings account.

I. Life Insurance and Business Financial Planning for Corporates

Individual Life Insurance plans are taken by people for protection of their family
members or of self during old age. Similarly, Life Insurance plans are taken by
corporate institutions to protect their interest in case of loss of a highly valuable
human asset.
There are three ways in which it works.
Key Man Insurance
Corporate organisations need to protect themselves from loss of physical assets,
due to a catastrophe or calamity like fire, flood, earthquake etc. for sake of their
business continuity, by overcoming such interruptions through recovery from
insurance. The same applies to their valuable human assets which they also need
to protect.
Key Man Insurance is taken to protect the Company against the risk of financial
loss that can arise as a result of death or critical illness of its key employee(s).
These contingencies can cause severe loss of specialist skills, loss of customers,
loss of sales, loss of market-share, and loss of credit standing for the company,
loss of Business Confidence and future expansion of the company getting delayed.
Every employee is not key man. It is only that employee who has some specialist
skills or particular responsibilities and who contributes substantially to the profits
of the company that we consider as a ‘Keyman’. Indeed, every employee in the
business is important; however, certain key employees may be vital to the future
of any business. It is essential that the key employees are identified and the
business is protected against their loss as a result of death or illness. The benefit
of a key employee or key man to the business cannot be measured by the benefits
package alone.
Some examples of Key Men can be Managing Director / CEO, CFO / Head – Finance,
Sales Director / Head – Sales, Technical Director, R & D Head, Key Project
Manager and so forth.
The following are not key men and Key man insurance cannot be granted in such
cases:
Sole proprietor (the business is not independent of the sole proprietor and hence
key man insurance cannot be granted)

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Partner in a partnership firm who is not active.
An ordinary employee doing normal jobs and who can be easily replaced.
A majority shareholder in a company.
There are several possible losses a company may face due to the death or
disability of a key man. They are:
Loss of customers or sales attracted by his ability.
Loss of his specialized skills.
Cost of recruiting and training a suitable person in his place.
The delay or cancellation of any project upon which he is working.
The loss of Opportunities for future expansion.
The loss of stable management & relations
The reduction of credit standing of the company.
Normally, only term insurance policies are offered under Key man Insurance.
There are certain norms to calculate the sum assured on a key man. Logically,
the maximum amount of insurance that can be granted on the life of the key man
depends on the financial loss suffered by the business on the death of the key
man. The sum assured depends on case to case basis. The following are some of
the criteria the insurer would use to determine the sum assured under the key
man insurance.
Three times the average gross profit of the company/firm in the immediately
preceding three financial years.
Five times of the average net profit of the company/firm in the immediately
preceding three financial years.
Ten times of the annual compensation package of the key man.
Key Man Insurance policies are granted to companies limited by shares (both
public limited and private limited) and to partnership firms.
Key Man Insurance – Restrictions
Key insurance cannot be granted to a proprietorship concern.
The Key man should not be a major shareholder in the company proposing the
key man insurance.
Normally key man insurance will not be allowed in case the key man holds more
than 25% of the share capital of the company.
Key man insurance cannot be granted in case the key man together with the
family members holds more than 50% of the shares of the company.
Family members for this purpose are defined as spouse &children only.
Normally key man insurance will not be granted to the partnership firm on the
life of a partner, unless it is established that the partner is active in the business
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 13 7
of the firm and in case of death or illness of the partner the other partners may
not be able to continue the business of the firm, since a key man insurance is not
offered to replace the partnership capital of the firm, but to protect the firm
against business losses due to the death or illness of the key man.
Key man insurance cannot be granted to loss making companies/firms.
In case of venture capital companies/firms, key man insurance will be granted on
merit. In such cases, in addition to the key man questionnaire, the company/firm
may be required to submit the following:
The key man’s CV and credentials
Copy of the business plan
Copy of the financial agreements (loans) agreed with the bankers
If the company/firm is not part of a wider group, details of the various cross
shareholdings and relationships
Note:
There can be more than one key man in a company. The insurance will be granted
taking into account all the existing Key man Insurances. The company would be
granted key man insurance taking the total insurance granted on the lives of all
the key men taken together.
A key man insurance policy cannot be assigned to any person other than the key
man himself. In view of the above the Company would not be able to raise any
policy loans or assign the policy as a security.
Partnership Insurance:
Partnership is a relation between two or more persons who have agreed to share
the profits of a business, carried on by all or any of them acting for all. Persons
who have entered into partnership with one another are individually called
partners. Partnership is a business jointly owned by several partners, but is not a
corporate entity.
The partners run the partnership in a largely personal way. This can create
problems if one of the partners dies, as his successors may not wish to take up
his role in the business or may withdraw his stake in the business. On the other
hand, the co-partners may not have sufficient funds to buy out the heir’s share.
This may result in selling the share to an outsider. The value of the share might
have grown manifold after the partnership came into existence. The remaining
partners may not like to have an outsider and instead of selling the share to an
outsider the remaining partners would like to buy out the share from the heir of
the deceased partner.
In certain cases the death of a partner poses an undesirable situation. The legal
heirs of the deceased partner may not co-operate with the other partners
resulting in a hindrance to the smooth running of the business or sometimes in
litigation. To avoid such a situation, it is advisable to provide in the partnership
agreement that, in the event of the death of a partner the remaining partners

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 13 8
will have the option to purchase his share upon terms and conditions as specified
in the partnership deed. If such a provision is there in the partnership deed the
remaining partners have to pay to the legal heir of the deceased partner the
purchase price However, for this purpose the partners should have sufficient cash
available and hence partnership insurance.
Partnership insurance is allowed on the lives of the partners.
All the partners are to be insured in this arrangement.
Partnership insurance makes an amount of money available to the firm in the
event of death of any of the partners.
The amount should be sufficient to purchase the share of the deceased partner.
The amount of insurance on respective partners depend on the share capital of
each partner, share of the profits, goodwill etc.
The firm should be a viable and profit making concern and should not have
incurred any loss, at least in the preceding three years.
All the partners in the firm should be insured simultaneously. No one should be
left out of the partnership insurance.
Only exception can be in case of a partner who is uninsurable.
The firm will be the proposer and owner. So in this case nomination is not
allowed.
Since the purpose is to buy out the share, any assignment to a third party, except
in case of assignment in favour of the partner himself, is not allowed.
The maximum amount of insurance that can be granted on the life of a partner
depends on the capital brought by the partner and his share in the goodwill of
the firm or the business that would be lost on the death of the partner.
The sum assured offered would thus depend on a case-to-case basis. The sum
assured on a partner’s life under partnership insurance would depend on his share
payable in case of his death.
In order to ascertain the individual partner’s share, it is necessary to value the
whole partnership. This will include the invested capital, undrawn profit and
goodwill.
When looking at a partner’s share, any agreements made between the partners
should be taken into account. Some partners would have invested a large
percentage of the capital whilst others may not have invested any.
There will be a split of the undrawn profits allocated to each partner and
frequently the percentages will not be equal.
Goodwill has been defined as: - “The whole advantage attaching to an established
business, by reason of name and reputation, personality of individuals,
connection, rights and contracts, introductions to old customers and agreed
absence from competition”. While the definition presents little problem, placing
a financial value on it does.
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 13 9
Goodwill varies depending on factors such as the type of business carried out,
how established it is, length of the outstanding lease on the main partnership
property, extent of personal relationship etc. Often past profits are used as a
basis for assessing goodwill. However, more important are the trends of the
profits and the amount of business risk involved. The sum assured is likely to be
fixed as a total of the following:
The amount equal to the average outstanding in the partner’s capital account
over a period of the immediately preceding three financial years.
The share in the goodwill. The goodwill can be calculated as three times of the
average gross profit of the firm over the immediately preceding three financial
years.
Partnership Insurance - Restrictions
All the partners should be insured under partnership insurance unless one is
uninsurable due to ill health or higher age.
The partnership insurance is restricted to the amount of the partner’s share in
the capital and his share in the goodwill of the firm.
The partnership insurance policy is issued in the name of the partnership firm
only.
Employer Employee Insurance:
Interplay of current economic forces has made it necessary for progressive and
forward looking employers to retain the services of their experienced executives
and employees.
Employers can, therefore, take life insurance policies on the lives of their
designated employees, where the benefits are payable either (a) to the members
on retirement or (b) to their families in the event of their death while in service.
No benefit accrues to the employers under this policy. The Insurance Act, 1938
under Section 2(11) recognizes that an employer has an insurable interest in the
life of an employee. The right of an employer to take out policies on the lives of
their designated/selected executives and employees is therefore legally valid.
There are two ways in which an employer can proceed with the plan of an
employer-employee insurance scheme. Depending on the requirement and
convenience, anyone can be adopted.
Scheme A
Employer is the proposer of the policy and retains with itself the right to assign
the benefits of the policies to respective employees, the time and manner of
which is defined at the introduction of the scheme.
Premiums paid by the employer are held as deductible business expenses. The
employee pays no tax in this case because he does not enjoy any rights until the
policy is assigned to him or his family.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 14 0
Scheme B
Employee is the proposer himself and retains control over the policy as owner of
the policy.
The premiums paid by the employers are treated as deductible business expenses.
However in the hands of the employee it is treated as perquisites and hence tax
is paid by him (employee).
Benefits
To the Employer:
Employer’s contribution towards the premiums is tax free as business expenses
under section 37(1) of the Income Tax Act, 1961
Loyalty of the employees is ensured.
Fewer turnovers of employees
To the Employees
Income Tax free death benefit to the family
Income Tax free benefits on retirement or maturity of the policy
Supplements to existing retirement benefits
Disability may induce the employer for early transfer of the policy benefits to the
employees.
Group Insurance:
These contracts may include life insurance, health care indemnity, pensions,
savings, disability income and personal accident benefits. The major category of
group insurance plans is employee benefit plans, which are typically sponsored
by employers. Generous pension and protection schemes are as much a
constituent of a competitive benefits package as are basic pay and incentives.
There are tax advantages, which the employer can avail of. These plans also help
to reduce turnover since benefits like pension and gratuity typically accrue and
increase only with length of service with the employer. These benefits again
form an important part of collective bargaining between employers and labour
unions.
Group insurance is among the younger branches of the life insurance business. It
came into its own only in the early part of the twentieth century. Let us look at
some of its key features.
The most significant is of course the substitution of the group for the individual.
Group insurance implies one contract covering a group of lives. The terms of
insurance depend on the characteristics of the group as a whole rather than any
of the individuals constituting the group. This means that the underwriter of a
group insurance policy is not concerned with the health or other insurability
aspects of any individual member. The idea is that if the group is large enough to
be homogenous, or if there are a large number of similar groups, which can be
aggregated together, the risks can be pooled to yield a predictable mortality rate.
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 14 1
The group must have some general characteristics to qualify for insurance. These
are necessary to ensure predictability and lack of bias.
The group must be reasonably homogenous by nature of occupation so that its
members can be treated as a single unit for underwriting.
Insurance must be incidental. The group must have been formed for a purpose
other than purchase of insurance
The Group must have single central machinery, which must be able and willing to
act on behalf of all its members.
There must be a steady stream of new entrants from to year to year to match
outflows of older members from the group. This is required to ensure that an
undue proportion of group members are not aged or impaired
There must be minimum participation in the group and a large proportion of
eligible members must enter the scheme to prevent adverse selection. Group
schemes may be contributory or non-contributory. In the latter case, where the
employer foots the bill [pays the premiums entirely] it is compulsory for 100% of
the workforce to be included in the scheme. Where it is contributory [employee
contributes in part to the premium] it is generally stipulated that a large
proportion, say 75%, should join the scheme. Minimum participation is be insisted
in order to prevent the risk of anti-selection.
A Minimum size is generally prescribed for the group.
Let us look at different types of groups that would be eligible for insurance. The
most common are Employer – employee groups. Another type is the Creditor –
debtor group. Here a master policy is taken out by the creditor to cover the
outstanding amount of loans granted to debtors. A third category consists of
Associations of professionals, who may contract with the insurer to provide
protection to their member professionals. Then there may be many
miscellaneous groups like co-operative societies, welfare funds etc.
The second major feature is the issue of a master policy by the insurer to the
group policyholder. The persons whose lives are actually insured are, strictly
speaking not parties to the contract. They may get a certificate of evidence of
insurance. They are eligible to however enforce their rights as beneficiaries of
the contract.
The third major feature is the availability of low cost protection at a premium
far below what would have been payable for individual insurance. This is on
account of low distribution costs and economies of scale in administration. The
commission for group business as a percentage of total premium is much lower
than that for individual contracts. In many cases the department may directly
deal with the employer or group representative, thus eliminating the middleman.
Again, the costs of administration are considerably reduced.
Finally group premiums are not standard as in the case of traditional individual
contracts but are adjusted periodically on the basis of experience. Group
premiums thus involve Experience Rating. The premium structure may thus be
flexible and may depend on the character of the group. A major reason for using
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 14 2
experience rating is to promote competitiveness and equity. The Latter demands
that groups which have a better experience of mortality or other life
contingencies should be charged less.
Generally, the larger and more reliable the experience of the group the more
weightage would be attached to its own experience. For smaller groups, on the
other hand, the insurer may use pooled rates under which a number of such small
groups are combined and a uniform rate is applied to all such groups. Experience
rating enables the insurer to share the gains from favourable experience with the
group by reducing subsequent premiums.

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Chapter Summary
Life insurance, as part of a portfolio of financial assets, must be seen in the
context of an individual’s financial plan towards meeting various kinds of needs
that arise in the life cycle. These needs arise in the course of seven stages and
are classified into transactional, precautionary and wealth accumulation needs.
They call for having transactional, precautionary and wealth accumulation
products. Individuals also differ with respect to their risk profile and this is
impacted by the stage of the life cycle in which one is. The process of financial
planning, which is the scientific way of meeting one’s various goals and related
needs through proper planning for the future, consists of various disciplines like
cash planning, insurance planning, investment and tax planning, and retirement
and estate planning
As apparent from above, the need-range with respect to life insurance varies at
different life-cycle stages. The advice in this case that a buyer looks from the
financial adviser is as critical as the advice of a lawyer or a doctor. Right advice
can give the buyer of a life Insurance Product, peace of mind as it can meet his
various needs, wants or necessities. Hence it is important to make a plan to
protect oneself from risks of premature death to keep the family from suffering
due to a fall in the standard of living.
Insurance products also serve as long term savings and wealth creation tools.
Death is certain but its timings are uncertain, hence it is important to protect the
family against any contingency, therefore a portfolio that includes insurance
cover for various life contingencies can be considered superior to one that
consists only of investment assets.
A life insurance policy creates a potential estate the moment it is purchased and
a whole life policy also has a cash surrender value which can be accessed during
the life-time of the insured. Life Insurance plans are also taken by corporate
institutions to protect their interests in case of loss arising from death of highly
valuable human assets; the three ways in which it works are Key Man Insurance,
Partnership insurance, Employer-employee Insurance, Group Insurance.
Important Concepts Covered:
 Financial planning and its core disciplines
 Life cycle stages and needs
 Transactional, precautionary and wealth accumulation products
 Investment styles and risk profiles
 Term Assurance and its Variants
 Health Cover: Stand alone and its Riders
 Terminal illness
 Dread Disease policies
 Medical Savings Plans
 Retirement planning
 Retirement Planning Risks
 Estate Planning

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  Insurance Plans for Corporates
Self-Examination Questions
Question 1
Which one of the following are the life-cycle stages of a Person
A. Childhood stage
B. Young Married stage
C. Married with older Children
D. Retirement stage
E. All of the above

Question 2
Which one of the following are prominent needs of an earning individual
A. Child’s Education
B. Child’s Marriage
C. House
D. Provision for Old –age
E. All of the above

Question 3
Which one of the following is Variant of a Term Insurance Plan?
A. Level Term Insurance
B. Endowment Plan
C. ULIP Plan
D. Principle of Insurability
E. Health Plan

Question 4
Which one of the following are not taken care by Retirement Planning
A. Replacement rate risk
B. Disability income risk
C. Social Security risk
D. Longevity Risk
E. All of the above

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Question 5
Which ones of the following are Insurance Plans for the Corporates?
A. Key man insurance
B. Employer-Employee Insurance
C. Partnership Insurance
D. Group Insurance
E. All of the above

Answers to Self -Examination Ques tions:

Answer to SEQ 1
The c orrect option E.
Answer to SEQ 2
The c orrect option E.
Answer to SEQ 3
The c orrect option A.
Answer to SEQ 4
The c orrect option B .
Answer to SEQ 5
The c orrect option E.

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 CHAPTER 6
EMERGING CONTINGENCIES AND PRODUCTS
Chapter Introduction:
In the last two chapters we have considered a number of contingencies that arose
in the course of an individual’s life cycle and discussed how various life insurance
products provided solutions to their loss implications. The products that we
considered are fairly popular and known in Indian and other developing country
markets.
In this chapter we shall consider certain other contingent situations that have
been emerging during the last few decades and issues related to these. We shall
also see how the industry has offered solutions to them. Some of the products we
discuss are not part of the Indian market as yet, but may join the product line as
Indian market gets more integrated with the global marketplace and is subjected
to its influences.

Learning Outcomes: at the end of this chapter you will

A. Emerging realities and risks in the global environment

B. Insurance Protection plans and Disability
C. Other Savings linked Life Insurance Plans
D. Bundled and Unbundled plans
E. Unbundled and Customised Contracts
F. Variable Life Insurance plans
G. Unit Linked Insurance

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A. Emerging realities and risks in the global environment
Life insurers, like other businesses, faces customers who have multiple life cycle
needs and concerns. The industry has sought to address some of these, especially
the needs, which are related to state of nature [life contingent] events - like
Mortality, Morbidity and Longevity – through various traditional products, that we
discussed in the previous chapter. But there are many other needs and
imperatives that have emerged as a result of demographic changes, especially
the challenges posed by population aging. Still other issues have emerged as a
result of changes in the socio – economic and cultural context: in areas like work,
careers, relationships, issues like alienation and lack of meaning. There are also
a number of new aspirations that have emerged, which are linked to the desire
for a higher quality of life – these include the quest for self- approbation,
learning; creativity and contribution; finding meaning and connecting with a
‘higher self’…
These yearnings or aspirations are not separate stand alone, but are closely linked
and inter-permeate with one another. The actors who feel and confront them
are people who meet, talk, share, trust, transact, collaborate and work together
in both physical and digital space – in short they connect and exchange
information and feelings with one another in a world that is accessible with the
touch of a finger. .… The question facing life insurers is whether and how far they
are ready for these challenges.
Let us begin by exploring some of the changes that have been ushered in the
global environment of risks during the last decades of the twentieth century and
the first two decades of the twenty-first.
The world of work: The twentieth century was largely dominated by the smoke
stack industrial order which focused largely on efficient mechanical work
processes. They were manned by a stable labour force that stayed loyal with a
company for years. The twenty first century post - industrial economy has ushered
a different milieu. Work outputs of yesterday can now be delivered by machines
at a fraction of the time and cost they once entailed. The onset of artificial and
the new developments in Information and Communication Technology are set to
disrupt the work setting still further.
One of the fundamental implications of the change is the shift in the nature of
the employment contract - from permanent or continuous employment to focus
on employability. An employee, in yesteryears, began on a lower scale of
emoluments, even below their productivity or potential, and later rose to higher
and higher scales. Their employment was for life with a single company, and on
retirement, they enjoyed pension and superannuation benefits. Commitment to
a long term association between employer and employee was not written down
but was implicit.
The picture began to change by the closing years of the twentieth century.
Company managements facing competition and technology changes were no
longer in a mood to consider their earlier commitment to ensuring job security.
Meanwhile, as labour markets became tight and demand for certain type of skills
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and competencies escalated in the knowledge economy, many young age
professionals with relevant skills / qualifications [like IT engineers and
Management professionals] were no longer ready to commit to a single employer.
These individuals demanded and were paid full value as per their productivity/
contribution but could no longer expect any long term commitment [of job
security] from their employers. Further, as privatisation and liberalisation
became the new mantra around the globe, labour markets became more open
and diversified. A new generation of labour market cohorts emerged, who were
more concerned with their self, than in earlier years, and ready as well as able
to move to distant corners of the world. Meanwhile, as the logic of ‘perform or
perish’ and chronic recessionary cycles gripped corporate life, many companies
began to lay off their employees in times of slack, hoping to rehire them when
times were better. Others were influenced by various mantras and prescriptions,
or prompted by necessity, to downsize, delayer and dismantle their erstwhile
bureaucratic and hierarchical organisations and replace them with lean and
meaner structures. One result of all this is a sense of fear and job uncertainty
that has gripped employees in many organisations. These have come hand in
hand with enormous work pressure – as twelve to sixteen hour days and seemingly
impossible deadlines became the norm. Even where pay packets have risen, the
price is a tremendous amount of stress and burnout in a few years.
One result of all this is a massive sense of ‘dis-engagement’. People go through
life and relationships in a mindless, robotic and reactive manner, with little
ownership or commitment. They are scarcely inclined to respond with awareness
and proactivity to events in the work environment. The problem is, this
disengagement extends to home and relationships, often leading to the wrecking
of personal lives. Both at home and in the work place, it leads to toxic
behaviours, including neurotic, abusive and bullying actions
The issues discussed above are seen in the Indian market in ample measure, as
the studies below would reveal
Some Findings on Indian Corporate health
1. Study by Apollo Hospitals : In 2000, when Apollo Hospitals first compiled the
health status of corporate India from 15,000 executive checks in the six
metros, the findings were dismal. Over 56 per cent were found to be prone
to heart attacks, over 30 per cent had cancer risk and 30 per cent were on
daily medication.
Their latest study, concluded in 2011, covering 250,000 employees from 32
cities and towns, however, shows improvement in overall health:
Degenerative and chronic ailments have come down by 36 per cent over the
decade. But stress has zoomed. “Overall stress among corporate executives
has gone up from 39 per cent in 2000 to 50 per cent now, while daily
pressures are up from 9 to 17 per cent among the same group,” says Dr
Adrian Kennedy, head of Lifetime Wellness Rx International, an Apollo
Hospitals group company. The immediate impact is behaviour change. No
wonder, domestic stress among them is up from 2 to 19 per cent, levels of

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 smoking from 14 to 24 per cent and alcohol consumption from 6 to 16 per
cent.
2. Survey by ASOCHAM : A Survey Report by the associated chamber of
commerce and industry of India (ASSOCHAM) on “Preventive Healthcare:
Impact on Corporate sector,” April 2012 : revealed that depression was the
first hard hit disease that was observed among the respondents, with 42.5
per cent of the corporate employees suffering from this lifestyle disease.
The study showed that rate of emotional problems such as anxiety and
depression had increased by 45-50% among corporate employees in the last
eight years. Obesity was the second hard hit disease that was observed
among the respondents, with 23% of the sample. High blood pressure (B.P)
and diabetes formed the third and fourth largest disease with a share of 9
per cent and 8 per cent respectively as suffered among the corporate
employees. Spondolysis (5.5 per cent), heart disease (4 per cent), cervical
(3.0 per cent), asthma (2.5 per cent), slip disk (1 per cent) and arthritis (1.5
per cent) were other diseases that were mostly suffered by corporate
employees.
3. Study by Optum: A high 46% of the workforce in organisations in India
suffers from some or the other form of stress, according to the latest data
from Optum, a top provider of employee assistance programmes to
corporates. Optum's study had a sample size of 200,000 employees (over
30 large employers) who took an online Health Risk Assessment during the
first quarter of 2016.

Social Relationships
People everywhere are also impacted by the relationships they build with other
people and the social institutions of which they become a part. One of the most
critical of these is the family. Indeed, the entire argument for life insurance has
been often built around its core function, namely that of protection of the family
in the event of death of its principal earner.
The institution of marriage and family has seen tremendous changes in recent
decades. A study by James P. Cunningham [2004] revealed that the entire period
from mid19th Century had the probability of a marriage ending in divorce (or
annulment) hovering below 10 percent. By 1974, one had reached a point where
divorce had emerged as the most common endpoint of marriage. By 1985, the
divorce rate had steadily increased to over 55 percent. Over the past 20 years, it
has remained level at about 50 percent’. There has been a steady decline
worldwide, in the Crude Marriage Rate [Number of marriages in a year /
population, multiplied by 100]. Meanwhile, live in relationships outside of
marriage have seen a large increase, as has postponement of marriage. One
result is that today, over half the households in almost all OECD countries have
no children. The number of children born outside marriage tripled, from 11% in
1980 to almost 33% in 2007. Almost 10% of all children now live in reconstituted
households, and nearly 15% in single-parent households. One in 15 children lives
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with their grandparents”. Predictions for the future in OECD countries suggest
a large incidence of single person and single parent families as well as a projected
rise in households without children, among the developed markets. These trends
are also felt, in varying degrees, in other countries. The increase in childless-
couple households, divorce rates, re-marriages and step - families [step fathers
or step mothers] has considerably weakened family ties with older children, thus
eroding the fabric of informal family care
Environmental, Social and Governance [ESG] Risks
Let us now consider another set of risks and contingencies that have emerged in
the last two decades or more and threaten the very future of the planet and
mankind. These have come to be popularly known as ESG risks. The number of
such risks could be immense and we have only listed a few categories below,
largely drawn from the UNEDPI ‘s [2009] own findings [UNEPFI, The Global state
of Sustainable insurance - a report by the insurance working group of UNEPFI, Oct
2009] They are as follows:
A. Environmental risks: these include
 Climate change: including global warming
 Biodiversity loss: in the quantity and variability of living organisms
 Ecosystem degradation: of forests, coral reefs, soils, wetlands.
Environmental risks named above affect the dynamic and complex interaction of
plant, animal, and micro-organism communities and their non-living
environment, including the services they provide us
 Water management issues ; arising when water resources are depleted
or contaminated and unable to meet ever-increasing demands, like
sanitation and drinking water
 Pollution: arising from discharge/release of toxic materials/ pollutants
B. Social Risks: that include
 Lack of inclusiveness in economic/human development
 Crime and Terrorism: a result and reflection of lack of inclusiveness
 Human rights: issues arising from abusive workplace conditions, gender or
racial discrimination, child or forced labour in supply chains, forced
relocation of communities, and governments that are perceived to commit
human rights abuses.
 Health risks arising from lifestyles and other man-made risk factors: like
those posed by nano – particles and genetically modified organisms,
pandemics, electromagnetic fields, endocrine disruptors, and obesity.
Covid was a classic example of this risk

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 15 1
C. Governance related risks:
These are also related to lapses in regulations and disclosure requirements or
arising from lack of ethics and principles - they include corruption, bribery and
extortion, excessive profiteering, exploitation of nature and society and
alignment of vested interests to undermine social interests.
Any of these risks have emerged as a result of what Thomas Freidman termed as
a ‘Situational’ rather than a ‘Sustainable ‘mode of living – a myopic view of life
which suggests ‘Make hay for the moment and devil take care of the morrow.. .’
This may refer to many things – like the penchant for opulent living and spending
[often far beyond one’s means], fuelled by the credit card and easy money; and
an obsessive pre-occupation with the self [self- centeredness]; a focus on
accumulating and acquiring wealth, often at high personal cost; and a cynical
approach to values that promote [inner and outer] balance and sustainability.
The Personal dimension – Aging and other issues
The insurance industry’s approach to human life, including its underwriting
process, has generally been founded on the Bio-Medical model which looks at the
human body and mind as machines: Mortality implied complete stoppage of the
machine, requiring replacement for its earnings capacity, while morbidity implied
the machine was out of order, calling for its repair. However in recent years, a
different model has begun to emerge, which looks at the human body life as an
organism – a system of energy and information.
Human beings, like other life forms, go through a process of ‘growth,
development, maturity and senescence’ [Robert Arking 2006]. The last of these,
which is also known as ‘biological aging’, results in gradual deterioration of
faculties and abilities to perform activities.
There are two terms associated with human longevity. The first, Life expectancy,
is defined as the average total number of years that a human expects to live. The
other term is Life Span, which is given by the maximum number of years, a human
being can live. While the human life span has substantially remained unchanged
for the past 100,000 years at ~125 years, life expectancy has steadily been
increasing, particularly in developed western markets, but also elsewhere in the
world. This has been in part due to the dramatic reduction of infectious diseases,
which, in turn, significantly reduced both infant mortality and mortality in adult
age. In the last few decades, medical advancements have also led to improved
medical assistance in case of age-related diseases, like Cardiovascular Disease
and Cancer. While this may extended the life span of many people, it has not
necessarily led to a healthy life.
All this has called for a relook at concepts related to aging [longevity], mortality
and morbidity.
Let us begin with aging. It has more than one meaning and dimension. One ages
chronologically when putting more years to one’s life. Biological aging happens
when the signs of senescence – like reduced ability to respond to environmental
stress factors, degeneration of cellular structures, increasing homeostatic
imbalance, failing immunity and greater susceptibility to disease – begin to be
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visible. One ages in a psychological sense when he / she begins to believe that
old age has set in, feels a sense of learned helplessness and inability to cope with
things, feels loss of control and gets disengaged. As Adi Shankaracharya
said, ’People grow old and die because they see other people grow old and die’
Consider mortality. Strictly speaking, it means a state of rigor mortis, which is
certified as ‘clinical death’ by a competent authority. Yet, as we can see all
around us, one can be clinically alive, even while having a vegetable existence.
Again, there are various levels of ‘vegetating’, liked to one’s state of aliveness
and vitality. While clinical death is stable function of age, the loss of vitality [the
life force within oneself] is not necessarily age dependent.
Coming to morbidity, the key concern today is with factors that impact one’s
healthy life span [also termed as health-span]. It is observed that this is impacted
both by genetic background and lifestyle. Factors like diet restriction and reduced
caloric intake, quality of nutrients play a key role here, as does exercise and
sleep. Further, a great deal of risk arises from proneness to Inflammation, which
is given by the normal defence reaction of body parts to physiological and non-
physiological stressors. Health is also impacted by the role of ‘Free Radicals’,
which can attack and damage cells, proteins and DNA, if they are not limited
through anti - oxidants and other counter forces. Finally, it has been observed
that aging and health depend on the degree of control exercised by a network of
cellular and molecular defence mechanisms, which limit the negative effects of
various physical, chemical, and biological stressors.
In sum, the entire universe of Mortality, Morbidity and longevity are influenced
by how one perceives them and chooses to live his or her life. Mainstream
Allopathic medicine [on which life and health insurer perspectives on health are
based] has been largely concerned with treating diseases. Body and mind were
seen as two separate systems [machines] and treated through different clinical
procedures. In recent years however, the onset of advances in mind – body
medicine has begun to show that serious imbalances in the body - mind framework
can have seriously deleterious results for one’s health and wellness.
The Shastras of ancient India tell us that as we grow older, our physical body
[Sthoola-Shareeram’ or gross body] withers and gets weaker and more feeble,
so that one is less able to actively work and do all that one would like to do.
Meanwhile the mind [‘Sookshma-Shareeram’ or subtle body] gets more active,
even hyperactive and begins to hyper ventilate. The result is panic and anxiety
attacks, conjuring up of demons, crankiness and withdrawal.

Note that imbalance and its outcomes are not associated only with aging, but can
be triggered even during the prime of one’s life, by factors ranging from natural
onset of arthritis to a mental breakdown after a relationship breakup, to
something as trivial as non-receipt/ receipt of messages on Face-book. When we
combine these inner complexities and frailties with a social environment replete
with unhealthy life styles, family ruptures, alienation and meaninglessness,
boredom, loss of self – identity, job uncertainty and a nameless sense of fear…

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we get a classic recipe for what Thoreau described over one and a half centuries
earlier as ago as leading lives of ‘quiet desperation’
The life insurance industry still needs a long way to go towards these new
imperatives. Some of the developments and concerns which have emerged within
the industry during recent decades, are discussed below.

B. Insurance Protection plans and Disability

In the previous chapters we considered two types of life contingencies, namely
death and disease; the first involves loss of human life while the latter results in
erosion of wealth on account of high costs of treatment and hospitalisation. We
have seen the role of the immediate estate feature in enabling life insurance
products to serve as instruments of protection.
Disease or morbidity can also result in two other life contingent situations with
serious loss implications. The first is physical or mental disability which can result
in the inability to earn a regular income. The other is the inability to perform
normal human functions as one grows older, as a result of acute impairment of
normal human faculties like sight, hearing, use of limb and memory. While the
first kind of situation is addressed through Disability Income insurance, the latter
is addressed through a product popularly known as Long Term Care [LTC].
Disability and its solutions
Disability can be a rather elusive concept. Unlike death, which is clear and
unambiguous, disability is a relative condition that involves intermediate states.
It can be severe or mild, total or partial, temporary or permanent, depending
from case to case. The subjectivity involved in determining the nature and
severity of the risk renders it difficult for an insurer to provide feasible and
profitable solutions.
Yet, disability can be as much a cause of concern as death. Its seriousness can be
gauged from the fact that disability is a major consequence of disease in the
productive age groups from 15 to 59 both worldwide and among individual regions
of the world. In the established market economies, for instance, its incidence
has been observed to even exceed loss from premature death for age group 15-
59.
To cite US experience, a person aged 25 has a 24% chance of dying during the
next forty years [before age 65]. It has however been long established that the
chances of getting disabled during the earlier stages of the life cycle are much
higher than that of premature dying. For instance, it was found that there was a
54% chance that he may get disabled for at least 90days during the same forty
year period (Commissioner’s Table, 1985). The same data also indicates that
there is only a ten percentage point’s rise in cumulative probability of being
disabled between ages 25 to 45 while the remaining 44 percentage point’s rise
comes between age 45 and 65.
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We may also note that the probability of recovery from a temporary spell of
disability is far higher during the early years of one’s working life, than in late
years. This is because in younger ages, the reasons for being disabled are likely
to be arising from acute diseases [like Malaria or Typhoid] where one gets cured
after a limited period of treatment, unlike chronic and degenerative diseases,
whose effects can be more permanent. The motivation to return to work is also
much higher at younger ages, when the recipient is embarking on a career and
starting a family. As age advances, both the causes are more chronic and
motivation levels are reduced. This implies that as populations grow older, we
would expect a scenario of marked rise in duration of disability and reduced
recovery rates.
Disability income insurance
Disability income insurance seeks to protect the insured against the prospect of
discontinuity of income on account of a loss event, typically disease or accident.
In the past, this product was in the backseat, relative to life insurance, even in
the developed markets. Insurer’s generally provided additional benefits
consisting of lump sum payments in the event of accidental dismemberment.
Equally common was the waiver of premiums in case of disablement, usually
provided in conjunction with a life policy.
In India, for instance, permanent disability benefit for disability, arising as a
result of accident, was available via payment of an extra premium of Re 1 per
thousand sum assured. In some countries, a disability pension was also offered,
as a rider to the life insurance contract. Only a few countries like the USA
offered separate disability income policies. Among the third world markets the
disability benefit has been available, if at all, in a very restrictive sense.
Disability Pension, in the event of a health related disablement, has been virtually
absent. Even in developed countries, the lack of experience data and paucity of
technical studies has posed limitations in providing such cover. Nevertheless,
disability income insurance has begun to come of age in the developed markets.
A variety of contracts have emerged under this head. Let us look at some of these
in the global context.
United Kingdom: In UK disability income insurance comes in the form of
‘Permanent Health Insurance’ (PHI) policies. These are designed to provide a
weekly or monthly income to an individual who is unable to work as a result of
sickness or injury. The benefit is related to the individual’s normal income and is
payable after a deferment period (ranging from say 4 to 26 weeks) after onset of
injury or sickness. Policies are usually for a fixed term, ceasing at age 65 for
males and 60 for females.
A feature of these contracts is that once written, they cannot be cancelled by
the company so long as the policyholder fulfils the policy conditions. The benefit
will be paid until the policyholder recovers or dies or attains the specified age
when the policy’s term ends. The benefit may again, be a level amount or
indexed to inflation or cost of living. Sometimes the benefit level may reduce as

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 15 5
duration of the claim increases. This measure is to overcome moral hazard and
encourage a return to work.
PHI Policies in UK have been designed in a number of ways: They may be
conventional policies with cover guaranteed throughout the lifetime of the policy
or may be short term renewable policies. They may also be unit-linked. A fourth
type consists of key-man policies, covering disability of key employees of
companies.
United States: Disability Policies in the US are similar to the UK though their
nomenclature may differ. Disability Income benefits for specified periods are
provided to those unable to work because of illness or accidental injury. Earlier,
the definition of total disability implied that the insured was unable to perform
duties involved in any occupation. Only those individuals who did not work at all
could qualify. Current definitions are more liberal. They provide that the insured
be considered totally disabled if he or she is unable to perform the essential
duties of his or her regular occupation.
After a specified period of say 2 to 5 years, one may be considered totally disabled
if still unable to work at any occupation for which one was reasonably fitted by
education, training or experience. The insured would not be considered as totally
disabled if engaged in any other gainful occupation. An even more liberal
definition provides for the Insured being considered totally disabled if unable to
perform essential duties of his / her own previous occupation. Here the benefits
are paid even when the insured is gainfully engaged in another occupation.
Companies also have income protection policies that are popular with higher
income professionals. It provides for two types of income benefits – a maximum
benefit amount payable if one is completely unable to work, and a lesser amount,
related to lost income, when the individual works for a lower income than earned
prior to the disability. Insurers also have a presumptive disability condition,
which, if present, automatically makes one eligible for total disability benefits.
For instance, in the event of total and permanent blindness or total loss of
hearing, the individual receives full income benefit even on resuming full time
employment in the occupation earlier pursued.
Policies in the US are mainly offered on a stand - alone basis rather than as riders
to other long term insurance policies. They are issued both on individual and
group basis, as in the UK.
In Germany and Switzerland, disability covers are offered both as riders and on
stand-alone basis. Disability is defined as the “inability to practice one’s own
occupation or to carry out another job which can be performed on the basis of
the insured’s training and experience and which reasonably corresponds to the
previous social standing”. Indeed, disability plans in Germany are sold as
“inability to earn income insurance” – the claims payment does not depend only
on medical conditions but also takes economic factors into account.
While disability income insurance fulfils a vital life cycle need, its development
has been hampered by certain key problems and issues.

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Firstly there has been a problem in defining disability. Should one limit its scope
to just inability to pursue only one’s “own occupation” or should the definition
extend to “any gainful occupation”. The first definition is more generous than
the second, but would entail much higher outflows and would be difficult to
control.
Secondly, what should be the elimination or waiting period after onset of disease,
before any benefits become payable? How long should one be disabled in order
to be eligible to receive the policy benefits? The length of the elimination period
may range from one to six months. Such elimination period not only cuts the
general cost of coverage but also cuts expenses involved for processing and paying
claims, when the disabilities last for only a few days. In fact this would exclude
thousands of small duration episodes when people have to stay at home for a few
days and recuperate.
The third issue is the benefit period, or for how long the benefits may be payable
under the contract. The coverage is classified as short or long term depending on
the length of the benefit period. Short term policies for individuals may thus
provide a maximum benefit period of 2 to 5 years. Long term policies may allow
benefits for at least five years and extending until age 65 or 70.
The fourth issue is the amount of benefit to be paid – should it be just
indemnifying actual loss of income, or be a fixed amount payable every month.
In the first case, disability amount would be a specified percentage of the
insured’s pre-disability earnings. In the case of fixed amount, a sum is fixed,
which is related to the insured’s income at the time of policy purchase. It is paid
regardless of other benefits received during disability.
There is also the question on supplemental benefits that may be provided. These
may automatically form a part of basic cover or extended on optional basis for an
additional premium account. For instance, a policy may provide for partial
disability benefits, wherein one becomes eligible for an income if deemed unable
to perform duties of one’s usual occupation on a full time basis. Another
supplementary benefit may allow one to purchase additional benefit amounts in
accordance with an increase in earnings. The insured has of course to prove
evidence of insurability. Finally one may have a cost of living adjustment [COLA]
wherein the benefit amount increases with a rise in the cost of living.
Challenges likely to be involved in introducing disability income policies in
markets like India:
Firstly there is a lack of experience data and technical studies for developing and
pricing such products appropriately. The problem is compounded because of the
difficulty in assessing disability risk. This is because disability, unlike death, is
an intermediate rather than an absolute (either or) state. Its degree can vary.
While death comes once, disability claims can arise again and again during any
given time period.
Secondly there is moral hazard. It is difficult to determine if one is actually
disabled and its cause, especially in case of persons suffering from chronic
degenerative ailments. Again one’s reasons for continued absence from work may
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not be physical, but also reflect factors like negative attitude to work; lack of
confidence about being able to perform; work "redundancy" or "lack of job
opportunities." One may prefer being "disabled" rather than being termed
"jobless". Moral hazard is a situation where in the insured files a claim for
disability income or continues to remain "disabled " and claims insurance even
when able to return to work.
Life insurers have responded to these problems in different ways like:
Prescribing an elimination period before one can claim.
Placing restrictions and narrowing the meaning of the term "disabled" so that it
excludes many
Reducing the maximum benefit payable, so as to reduce the incentive to stay
away from work.
Setting restrictions on the amount payable when disability is for a longer
duration.
Is there a case for having such products in India? What should be its scale and
scope? These are questions the insurance industry needs to answer.
Long Term Care
‘Every man desires to live long; but no man would be old’
- Jonathan Swift.
The above quote quite succinctly brings out the fears and worries facing millions
of people world- wide and especially in the developed markets. The greatest
worry about growing old is that one may be unable to take care of oneself and
hence may need to depend on others for support in conducting the daily activities
of one’s life. In the past, particularly in Joint and well-knit nuclear families and
communities, family members and well-wishers have provided the care and
support required by older persons informally.
Two significant changes have however dramatically impacted the prospects of old
aged cohorts. Firstly, there is a marked incidence of very aged people suffering
from chronic ailments that have affected their basic faculties. Secondly, family
support structures have broken down on account of factors like geographic
division among family units, as younger members move away from elders.
Secondly there are breakdowns in relationships [e.g. divorce] which have resulted
in single person families.
While developing markets like India have yet to face the full impact of the above,
they are not immune to these currents which are fast getting globalised.
Long Term Care has emerged as the insurance industry’s response to this problem.
It consists of services provided to those people in need of assistance for
performing daily activities at home or in a nursing home or some other facility.
Recipients of such care would include people suffering from chronic disabilities
arising as a result of stroke, cancer, arthritis, Alzheimer’s disease and dementia.

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The situation may arise suddenly as a result of traumatic events or illnesses [e.g.
an accident followed by coma or paralytic stroke]. More commonly it may be a
gradual development arising as a result of degenerative processes within the body
system [e.g. Arthritis]. The point to note is that care is needed on a long term
basis, generally until death, with severity often increasing with age. Long-term
care would thus not include the short-term convalescence one has to go through
after a bout of acute illness [like being bed ridden after suffering from Typhoid]
or an operation.
This raises the question of determining when one should be considered eligible
for long term care benefits. – When is the claim payable?
We clearly need an objective measure for the purpose. An example of such
measure is the ‘Barthel Index,’ which is commonly used by health care
professionals in UK. It measures the ability to perform ten activities of daily living
(ADL). These include bowel and bladder functioning; grooming and personal care
activities like combing hair or shaving; use of the toilet; feeding; transferring;
mobility; dressing; using stairs and bathing. Different levels of ability involved in
performing each of the above are measured and the overall score gives an
indication of the total care requirements of each individual. Similar measures
are required for ascertaining mental health status as well.
There are two ways of providing for Insurance against the above contingency.
Firstly there is the annuity approach: one can buy an annuity by making a single
payment at the point when a person needs such care. The insurer then pays an
annuity benefit at a specific rate that is payable during the lifetime of the
annuitant.
For instance: Harry and Helen are old and infirm couple in their seventies,
whose children have moved away. They are no longer able to take care of
themselves. So they decide to purchase an annuity, which then pays for
specific home care services that they avail. They may move into a nursing
home or aged persons’ home and have the annuity pay for monthly charges
incurred for the support services they enjoy
In such instances, the individual has to often dip into his or her past financial
savings or sell one’s house or other assets to get the capital required.
The other approach is to pre-fund the care by paying an insurance premium
[single or regular]. This is a kind of insurance plan under which one pays single or
regular premiums at a stage when such care is not needed. At this point the
benefit is contingent on an event that may or may not happen. It is paid only
when the need [claim] is triggered by a specified event [such as one’s inability to
conduct certain prescribed activities as seen above]. The advantage of the second
version is that the cost of care is pooled and hence reduced considerably. One
does not need to dip into one’s lifetime savings. Such insurance could be
purchased as a rider to a life insurance policy or as an augmented pension plan.
Long Term Care (LTC) policies have been around for more than two decades.
Initially they were designed and marketed as insurance for care in nursing homes.

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Subsequently their scope has been extended to include coverage for alternative
care services like home health care. Today, we have fifth and sixth generation
LTC policies.
There are three levels of care, which may be covered:
Custodial Care: nursing care of a non-medical nature. It may be 24-hour care as
ordered by a physician and provided by a registered and licensed nurse, as an
alternative to hospital confinement.
Intermediate Nursing care: is similar to skilled nursing care, except that the
patient neither receives nor needs 24 hours attention.
Home Care: which is provided by a visiting nurse or therapist at home. These may
take various forms like visits to a drugstore / hot meals on wheels / cheer visits.
These services are periodical and less expensive than the other two.
Long Term Care services may be conducted under different circumstances. The
insured may be living alone or even part of a household with access to informal
care providers (like spouse, family or friends).
For instance: a typical situation in India is where the aged father or mother
stays at home with son or daughter and his or her family, but still has a nurse
coming home to take care of various needs.

Another situation is that of a cohort staying in a residential house or confined to

a nursing home run by public, private or voluntary agencies.
The dramatic rise of LTC policies has been a result of response to problems thrown
up by aging and chronic disability. Demand has also been driven by the failure of
alternative systems in providing such care. For instance, among the developed
countries, it was the state which primarily provided for formal long-term care,
while the family traditionally provided the bulk of informal care. As governments
found themselves unable to finance the cost of such care, the onus began to shift
to the market and private insurers. Again, as more and more women began
working outside the home, the role of the informal care provider has begun to
reduce.
The US has one of the largest markets in the world for these policies. Other
countries like France and UK also have sizeable numbers. In Japan, the range of
LTC products available (since their first introduction in 1984) have expanded to
include costs of bedridden patients (1985), long term care expenses (1989) and
more complex accumulation products. (Gaten by 1997).
Long Term Care is set to emerge as one of the key products of the life insurance
market place in the twenty first century. No doubt, an aged person may ideally
prefer to have a home and family rather than the market providing such care.
However, many kinds of nursing care needs call for the services of a professional,
and cannot be fulfilled by family members, who may be amateurs in this regard.
Initially, long term care products laid emphasis only on nursing costs. There was
no coverage for services provided to the insured at home. Today, a great deal of
long term care in the US and elsewhere concentrates on home care elements.
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One issue that may be considered, particularly in markets like India, where family
attachments are still strong, is whether LTC policies could accommodate an
individual’s preferences for informal providers (one’s own spouse and family) –
could sufficient incentives be created in the system to make their services
available. One way perhaps, may be to consider a benefit payment for the
informal care provider [say daughter or daughter in law] that compensates for
loss of earnings forgone as one does not take alternative employment.
Another issue that one may consider is whether care could extend beyond mere
physical disability to include support with respect to the individual’s emotional
and mental makeup as well. For instance, old age also brings forth inner demons
like sense of loneliness and loss of self-worth, a sense of meaninglessness etc.
Could the industry look beyond financial provision (the benefit payment) to other
kinds of services and supports that are aimed at enhancing well-being and quality
of life of the aged?

C. Other Savings linked Life Insurance Plans

Capital Accumulation and Traditional plans
We have already seen that one of the principal purposes of saving and investing
has been to achieve inter- temporal allocation of resources, which is both
efficient and effective. The term Effective here implies that sufficient funds are
available to successfully satisfy various needs as they arise in different stages of
the life cycle. Efficient allocation on the other hand implies a faster rate of
accumulation and more funds available in future.
Higher the return for a given level of risk, the more efficient would the
investment be. A critical point of concern with respect to life insurance policies
has been the issue of giving a competitive rate of return which is comparable to
that of other assets in the financial marketplace. Life insurers have responded in
two ways – one stand continues to stress on the benefits of traditional plans
which, they argue, offer a safe avenue of savings while also providing a rate of
return, which many life insurers [and actuarial professionals] have described as
meeting the ‘reasonable expectations’ of customers’.
Under Traditional Plans, the pooled life funds are invested under tight regulatory
supervision, as per prescribed norms, and policy holders are either guaranteed a
part of growth or get a share of the surpluses that are generated by the insurer,
under what are termed as With Profit Plans. All plans which are not market linked
(also called unit linked) fall under this category.
With profit plans
Unlike without profit or guaranteed plans, these plans have a provision for
participation in profits. With profits policies have a higher premium than others.
Profits are payable as bonuses or dividends.

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Bonuses, as we have seen, are normally paid as reversionary bonuses. They are
declared as a proportion of the Sum Assured [e.g. Rs70 per thousand Sum Assured]
and are payable as additional benefits on a reversionary basis [at the end of the
tenure of the policy, by death or maturity or surrender]. Apart from reversionary
bonuses which, once attached, are guaranteed, the life insurer may also declare
Terminal Bonuses. These are contingent upon the life insurer earning some
windfall gains and are not guaranteed. Bonuses have been the way of sharing
profits in the United Kingdom. They have also been followed in India and many
other developing markets.
Profits are shared in certain markets like the US in the form of dividends. There
have been two approaches to dividend crediting. The traditional approach was
the Portfolio Method. Here the total investment return on the portfolio held by
the company was determined and all policyholders were credited their share of
the divisible surplus. No attempt was made to distinguish the rate of return
earned on monies invested with the company in previous years from that
deposited recently.
The portfolio method thus homogenized rates of return and made them stable
over time. It favoured new policy holders in times of interest rate decline as they
were able to invest in a portfolio of securities with higher rates than that
available in the market. By the same token, long-term policyholders would lose
out in times of interest rate decreases since they had to share their returns with
new policyholders. It however proved advantageous to them in times of interest
rate increases.
New policyholders would provide new funds that could be invested at higher rates
of return, thus improving overall portfolio return. The portfolio method thus
applies the principle of pooling of risks over time and is quite analogous in this
respect to the uniform reversionary bonus mechanism.
The second approach is the Current Money Method. Here the return depends on
when the investment was made and the rate that was secured at the time of
investment. It has also been called segmented or investment block method as
different investment blocks gets different returns.
Conventional with Profits [participating] policies thus have been said to offer
some linkage to the life office’s investment performance. The linkage however
is not direct. What the policyholder gains by way of bonus depends on the
periodic (usually annual) valuation of the fund’s assets and liabilities. The surplus
declared in the valuation depends on the assumptions made and factors taken
into consideration by the valuation actuary.
In determining the surplus the valuation process makes due allowance for the
guarantees provided under the contract. The result of the above is that the bonus
structure does not directly reflect the value of the underlying assets of the
insurer. Even after the surplus is declared, its allocation among policyholders
would depend on the decision of the company’s management. Because of all this,
the bonuses added to policies only follow investment performance in a very
cushioned and distant manner.

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The basic logic underlying the approach is the smoothing out of investment
returns over time. It is true that terminal bonuses and compound bonuses have
enabled the policyholder to enjoy a larger slice of the benefits derived from
equity investments. Nevertheless they still depend on the discretion of the life
office who declares these bonuses. Finally, bonuses under a valuation are
generally only declared once a year. They obviously cannot reflect the daily
fluctuations in the value of assets.
Traditional with Profit plans thus represent a genre of products in which the life
insurance company decides what is the structure of the product or plan, including
the benefits [sum assured and bonuses] and premiums. Even when the Life
insurance Company earns high returns in the investment market, it is not
necessary that its bonuses or dividends be directly linked with these returns.
Profits that are declared under traditional with profits plans may reflect market
returns only in an indirect way. The great advantage to the policy holder or
insured has been that the certainty of investment makes these plans quite
appropriate vehicles for meeting those needs that may require definite and
dedicated funds. They also help to reduce the overall portfolio risk of an
individual’s investment portfolio.

Let us now consider some of the inadequacies perceived in these products and
the responses to them from the life insurance industry.

D. Bundled and Unbundled plans

Let us firstly examine the underlying structure of conventional bundled cash value
plans. A little reflection would reveal a few serious issues:
Firstly, the Savings or cash value Component in such policies is not well defined.
It depends on the amount of Actuarial Reserve that in turn is determined by
assumptions about mortality, interest rates, expenses and other parameters that
are set by the life insurer. These can be quite arbitrary.
Secondly it is not easy to know what would be rate of return. This is because
firstly, the value of the benefits under With Profit policies would be known for
sure, only when the contract comes to an end. Again, the exact costs of the
insurer are not disclosed. As the rates of return of life insurance products are
not clearly known, it becomes difficult to compare them with other instruments
of savings. We must note that when individuals consider investing in any asset
including life insurance, they would like to compare its returns with its
opportunity costs. The return on alternative assets is the opportunity cost of
investing in life insurance. Obviously one cannot know how efficient life
insurance is as a savings instrument unless one can compare its payoffs with its
opportunity cost.

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A third problem is with regard to the cash and surrender values (at any point of
time) under these contracts. These depend on the amount of actuarial reserve
set up vis-à-vis the policy and it’s pro rata asset share, both of which may be
quite arbitrarily arrived at. The method of arriving at surrender value is not
visible, nor is surrender values that would be available in the event of premature
withdrawal, generally disclosed at the point of sale.
Finally the issue of the size and competitiveness of the yield on these policies.
As the limitations of conventional life insurance plans became obvious, many
shifts occurred in the product profiles of life insurers. The basic shifts that have
taken place in conventional life insurance are summarised below:
Unbundling: This trend involved separation of the protection and savings
elements and consequently the development of products, which either
emphasized protection or savings, but no longer an amorphous mix of both.
While in markets like the United States, these led to a rediscovery of term
insurance and new products like Universal Assurance and Variable Assurance, the
United Kingdom and other markets witnessed the rise of Unit linked insurance.
These products stress on Unbundling and individualisation of risk.
Investment Linkage: The second trend was the shift towards Investment linked
products, which linked benefits to policyholders with an index of investment
performance. There was consequently a shift in the way life insurance was
products like Unit linked implied that life insurers had a new role to play –they
were now efficient fund managers with the mandate of providing a high
competitive rate of yield, rather than as providers of financial security (including
life insurance protection). In more recent years, the ups and downs of the stock
markets have resulted in marked declines in the yields of investment linked
insurance. Consequently investment risk has emerged as a critical factor as life
insurance buyers began to seek more guarantees of yields. Life insurers are
increasingly rated by agencies like Moody and Standard & Poor.
Transparency: Unbundling also ushered greater visibility in the rate of return and
in the charges made by the companies for their services (like expenses etc.)
Non Standardisation: The fourth major shift has been from rigid to flexible
product structures, which is also seen as a move towards non-standard and
customised products. Non - Standardisation may be defined as given by the
degree of choice exercised by a customer with regard to determining the
structure and outcomes of the contract. There are two areas where customers
may actively participate in this regard – while fixing and altering the structure of
premiums and benefits; and while choosing how to invest premium proceeds.

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E. Unbundled and Customised Contracts
The principal characteristic of unbundled products is the flexibility provided to
the customer in choosing how the product and its benefits should be structured
including its likely pattern of yields. These Yields could differ from customer to
customer. Unbundled products also allowed both guarantee and non-guaranteed
elements in product design.
For instance the death benefit and part of the survival benefit could be
guaranteed. Again, one may vary a part of the survival benefit and link it to
investment performance. In effect this implied a mix of both mutuality and
individualization of risk. The important point here is that premiums collected
towards funding the above benefits receive separate treatment depending on the
degree of guarantee of the benefit.
Let us now examine how the above trends were reflected in products that came
to prominence and even dominated the product landscape in some leading
markets.
Universal Life
Universal Life Insurance was introduced in USA in 1979 as a variation of whole life
insurance, offering truly flexible premiums. Economic conditions of the early
eighties prompted its rise. High inflation rates and soaring returns on investments
had led to investors avoiding long-term fixed income investments. As short term
investment returns and inflation soared to nearly 20%, policy holders pulled out
of funds locked in traditional Whole Life policies through policy loans or
surrenders, meanwhile investing the proceeds elsewhere in newer high yielding
securities. This was a process popularly known as dis-intermediation. Life
insurance companies were forced to liquidate their long-term investments in
order to make benefit pay-outs. They began to respond to the new challenges
through investing in new money market portfolios that earned very high short-
term investment yields, which were very large, when compared with yields on
traditional Whole Life long-term investment portfolios. These high short run
yields enabled the design of Universal Policies with their flexible structures.
Universal life insurance is a form of permanent life insurance characterized by its
flexible premiums, flexible face amount and death benefit amounts, and the
unbundling of its pricing factors. While traditional cash value policies require
payment of a specific gross or office premium to be paid periodically in order to
keep the contract in force, Universal life policies allow the policy holder, within
limits, to decide the amount of premiums he or she wants to pay for the coverage.
Larger the size of the premium, greater the coverage provided and greater the
policy‘s cash value. The contract specifies the interest rate to be credited to the
cash value and mortality and expense charges that will apply.
Mortality: This charge is based on the insured’s age and risk class and represents
the cost of life insurance coverage. Universal life policies normally guarantee
that mortality charges will never exceed a stated maximum amount. They also
provide that mortality charges would be less than a specified maximum if the
company’s mortality experience proved to be more favourable than expected.
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The policies express the mortality charge as a cost per thousand dollars of net
amount at risk. The net amount at risk is equal to the difference between the
amount of death benefit and the policy’s cash value. It is the amount that has to
be contributed from the rest of the insurer’s pool.
Interest: A universal life insurance policy guarantees that the insurer would pay
at least a stated minimum interest rate on the policy’s cash value each year. A
higher interest rate would be paid if economic conditions allowed it.
Expenses: The policy also lists the expense charges imposed by the company to
cover policy administration costs. Expenses would include a flat charge in the
first policy year to cover sales and policy issue costs and a percentage of
subsequent annual premiums to cover renewal expenses. If actual expenses
incurred by the company proved to be less than the assumptions made, it would
constitute savings that would serve to enhance policy cash values.
The upshot is that the Cash Values on a Whole Life policy would depend on the
actual experience of Mortality, Interest and Expenses vis-à-vis that assumed in
the premiums, and the savings generated on each of these elements. Higher the
cash value available in the policy, more the policy holder has leeway in deciding
its structure and greater the scope for flexibility.
Flexible premiums: The major innovation of Universal Life Insurance was the
introduction of completely flexible premiums after the first policy year. One
had only to ensure that premiums, as a whole, were enough to cover the costs of
maintaining the policy. What this implied is that the policy could be deemed to
be in force, so long as its cash value was sufficient to pay the mortality charges
and expenses. There was usually a target premium to be paid on a level basis
throughout the policy duration. This target premium was more of a suggestion
and carried no obligation.
Premium flexibility allowed the policyholder to make additional premiums above
the target amount. It also allowed one to skip premium payments or make
payments that were lower than the target amount. In each case the policyholder
could do so without prior negotiation or agreement with the insurance company.
However if non-payment of premiums resulted in policy cash value dropping so
low, as to be inadequate to cover expense and mortality charges, the policy would
lapse. Cover could be restarted without needing a formal reinstatement [revival]
process, through payment of additional premiums.
One implication of such flexibility was that minimum premiums payable would
depend significantly on the interest rates earned on the policy. Thus even a half
per cent increase in returns would allow a significant lowering of gross premiums.
By the same token, a decline in investment earnings would have a negative
impact. The policyholder might not be able to predict these premiums and may
not even be aware that the cash value has declined to negative levels and the
policy has consequently lapsed.
Pre-funding: flexible premiums were an outcome of the facility given to the
policyholder to determine the manner in which the policy liability could be pre-
funded. At one extreme, one could pay a minimum amount of premium that was
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barely enough to cover mortality and expense charges. This would mean nil or
negligible pre funding and the policy would lapse if the premiums were not
continued. Such a contract would be like an annual renewal term insurance. As
the amount of pre-funding increased, it would result in higher cash values and
their investment earnings thereof, that could be utilised to cover policy charges.
This enabled policy holders to create an adequate fund [cash value] through
paying just one or a few premium instalments [say five or six] to cover all future
costs.
The more the pre-funding that was achieved, the more leeway the company had
to grant premium reduction or other concessions against future premiums. This
would also provide the life insurer with sufficient funds on hand to cover even
worst case scenarios in future. However, with intense competition, it was
difficult to affect large upfront collection of premiums. It was more common to
have a level premium structure in which partial prefunding led to creating ever-
increasing cash values and investment returns that offset mortality and
administrative costs.
Transparency: High prefunding and increase in cash values under traditional
Whole Life policies would generally result in larger dividends being credited to
policy holders. A similar process of accumulations from prefunding being credited
to the policy cash value happens in Universal Life as well. The difference is that
under the latter, the process is conducted in a manner that is clearly visible to
the policyholder. This open disclosure feature eliminates doubts about fairness
and equity, which have been often raised with regard to conventional life
policies. This also put life insurers under great pressure to perform, since higher
visibility would lead to greater expectations.
Withdrawal: Yet another result of having flexibility of structures is that Universal
life policies provided the facility to make partial withdrawals from the Cash value
that was available. There was no obligation to repay what was withdrawn, nor
did one need to pay any interest on the amount that was withdrawn. The cash
value was simply reduced to that extent. Withdrawal would of course affect the
policy’s ability to generate future earnings, since a lower level of fund was
available for investment. In other words, one could withdraw only at the expense
of forgoing what one could have earned in future.
Universal Life also provided facilities for availing loans on the policies. However
once the policyholder borrowed from the cash value, the insurance company
would usually credit a rate lower than the current interest rate or earnings rate,
to the portion of cash value associated with the policy loan. This was done to
curb disintermediation.
Death Benefits: the policy offered a choice between two kinds of death benefits-
level death benefits and increasing death benefits. Design of the first was similar
to traditional whole life – a constant death benefit meant that higher cash value
would result in reducing the amount at risk or the protection element. Increasing
death benefit design on the other hand kept a constant amount at risk, which was
superimposed over the policy’s cash value. When the cash value increased, it also

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enhanced the total death benefit payable under the contract. A reduction in cash
value on the other hand would reduce the death benefit.
The effect, on death benefit, of a partial withdrawal would differ under the above
two types of design. In case of level death benefits, a withdrawal would not
affect the death benefit amount. It would however reduce the cash value
element in the policy and consequently increase its amount at risk. As a result
one would have to pay a higher mortality charge [premium] to meet the increased
cost of mortality. In the case of increasing death benefits, partial withdrawal
would reduce the death benefit payable. The amount at risk and the mortality
charge would however remain constant. The cash value would not fall as in the
first case.
Expense loading: Most first generation Universal Life policies were heavily front
end loaded and allotted a significant proportion of initial premiums for
administrative expenses. This meant that the policy cash value was reduced to
that extent. Cash value amounts were reduced by mortality charges based on
amount at risk. As Universal life policies evolved, many of them moved towards
loading at the back end. This meant that while reducing or removing up-front
loading charges on premium, they imposed new or increased the surrender value
charges, which were especially applicable to the contract’s earlier years.
Surrender charges were usually maximum during the first policy year and
decreased on a straight lines basis over the remaining years, until the first year
expenses were completely recouped. Some companies have also combined
moderate front end loading with moderate surrender charges. Ideally, companies
would prefer higher surrender charges and lesser front end loading.
In sum, one can see that the flexibility of premiums coupled with flexible
withdrawal features and adjustable death benefits made Universal Life quite
popular and capable of accommodating policyholder’s needs. Universal life
emerged in the late seventies and early eighties, in an era of high current yields,
when life insurers moved shifted from long-term bonds and mortgages to short
term money market investments that yielded high returns. Universal life
structures provided the means to pass on the benefits of high current interest
rates returns very quickly to policyholders. They could redeem these benefits
either through purchasing higher life insurance cover or paying lower premiums
in future. Universal Life also brought total disclosure to the life insurance
business. The specific charges, expenses and credits were all itemised and made
available to the policyholder. Transparency of the policy made information
available, for the purpose of evaluating and comparison of policies.
Flexibility of premiums and face amount also helped the policyholder to adjust
premium payments to suit his or her particular situation. At the same time it
ushered a serious syndrome of “Vanishing premiums”. Typically life insurance
sales persons would sell Universal Life by alluding to its provision of “Paying just
a few premiums in the beginning and the policy would take care of itself”. What
they did not disclose was that cash values could maintain and keep the policy in
force only if investment returns were adequate for the purpose. The decline of
investment returns during latter half of the eighties led to erosion of cash values.

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Policy holders who failed to continue premium payments were shocked to find
that their policies had lapsed and they no longer had any life insurance
protection. In fact companies in the United States faced a flurry of litigations as
a result.
Universal life, at least as it was positioned in the US, was attractive to those who
preferred investments offering high current market rates of interest as opposed
to long term bond/mortgage rates. It would also appeal to one who sought its
flexibility features. Universal life would not be a very attractive option if short
run market rates were to tumble and one was worried about longer run stability.
Again, policyholders buying Universal life would need to be clearly aware about
the risks involved.
Does Universal Life have relevance for a market like India? The product, probably
in a modified form, could hold considerable relevance for individuals facing
income – expenditure uncertainties and requiring a flexible premium – benefit
schedule that could match their cash inflows and outflows. For instance, many
well to do cohorts in the informal and unorganised sector may be outside the
ambit of life insurance today precisely because they have not been offered such
options.
One challenge of having such flexible design is that it calls for extensive use of
the computer. Tailoring of the product to suit individual customer requirements
would obviously require unbundling and re-bundling to be done at the front end
level. Again, the complexity of the product implies that customers need to be
given specialist advice and information, which in turn calls for special training of
field force personnel who sell these products. For these reasons the product is
not very easy to develop in a new market.

F. Variable Life Insurance plans

This policy was first introduced in the United States by Equitable Life Assurance
Society in 1977. Variable life insurance is a kind of Whole Life policy where the
death benefit and cash value of the policy fluctuates according to the investment
performance of a special investment account into which premiums are credited.
The policy thus provides no guarantees with respect to either the interest rate or
minimum cash value. Theoretically the cash value can go down to zero, in which
case the policy would terminate.
The difference with traditional cash value policies is obvious. A traditional cash
value policy has a face amount that remains level throughout the policy term.
The cash value grows with premiums and interest earnings at a specified rate.
Assets backing the policy reserves form part of a general investment account in
which the insurer maintains the funds of its guaranteed products. These assets
are placed in a portfolio of secured investments. The insurer can thus expect to
earn a sturdy rate of return on the assets in this account.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 16 9
In contrast, assets representing the policy reserves of a variable life insurance
policy are placed in a separate fund that do not form part of its general
investment account. In the US this was termed as a separate account while in
Canada it was termed as a segregated account. Most variable policies permitted
policyholders to select from among several separate accounts and to change their
selection at least once a year.
First-generation variable life policies often gave the purchaser three kinds of
investment options for placing the funds - a bond fund, a stock fund and either a
treasury fund or money market fund. A policyholder could select one of these
choices or choose various proportions for investment among the three options.
Over the years, the number of options has increased, including a variety of stock
funds like growth stocks, income stocks, balanced stocks and international stock
funds. Similarly a number of bond funds of different duration and types of issuers
are also available. Investors also have the option to place their funds in a
managed portfolio fund. In this case, professional portfolio managers working for
the insurance company make the investment allocation decisions.
The policyholder could choose the investment option at the time of purchase and
also switch funds from one account to another, with some limits placed on the
number of times it can be done during a given calendar year. This provides the
policy owner with some control over his or her portfolio, though he/she cannot
exercise control over actual assets to be purchased and sold within the overall
selected portfolio framework. This portion of the investment decision process is
still in the hands of the insurance company’s portfolio managers.
The insurer follows a different investment strategy, depending on the desired risk
return trade-off for each separate account. Thus one account may be held in the
form of high growth stocks with higher risk while another account may be held in
the form of high investment - quality bonds where both risk and returns are
relatively lower.
Variable Insurance policies are essentially investment vehicles, and thus fall
within then ambit of the Securities and Exchange Commission (SEC) in US. Only
agents who are registered with the SEC and licensed to sell both life insurance
and capital market securities, can sell them. As per the SEC requirements,
Variable life policies cannot be sold without an accompanying prospectus, giving
full disclosure of various aspects like expenses, investment options, and
policyholder’s rights under the contract. The prospectus contains very thorough
information about all expense charges levied by the insurer, including
commissions, administrative charges and other expenses. The administrative
charges are higher during the first year and much lower in the renewal years.
The prospectus also outlines how charges are made against the asset account to
cover the Cost of Insurance [mortality costs]. It specifies what rate will be used
to determine cost of insurance charges and also if there is any maximum rate
above the intended rate.
Another charge levied against the separate accounts is the fees for managing the
various mutual fund types of accounts from which the policy owner can choose.
The prospectus also outlines the investment objectives of each available fund
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 17 0
option and a record of its historical performance as also a projection of future
performance. Finally the prospectus gives the surrender charge applicable on
surrenders. In most cases this is set forth in a tabular form, giving the policy year
and the applicable Surrender Value charge.
A prime condition for purchasing Variable Life Insurance is that the purchaser
must be able and willing to bear the investment risk on the policy. This implies
that Variable Life policies are typically bought by people who are knowledgeable
and quite comfortable with equity / debt investments and market volatility.
Obviously, its popularity would depend on investment market conditions – thriving
in market booms and declining when stock and bond prices plummet. This
volatility has to be kept in mind while marketing Variable Life.
Although seen as investment vehicles, Variable Life policies also have an
insurance element which is significantly attached to investment performance.
These contracts thus have a benchmark level of investment performance against
which actual performance may be measured. If the performance exceeds the
target level, the excess would be used to fund incremental increases in the death
benefit. On the other hand if performance falls below the target level it may lead
to downward adjustments in the death benefits, to make up the deficit. Most
variable life contracts of course guarantee a minimum face amount at the time
of purchase, regardless of investment performance.
Policy cash values under variable policies are given by premiums less the
administrative charges. The actual cash value is determined by the net asset
value (NAV) of the separate account funds constituting the policy portfolio. The
value is diminished by mortality charges to support death benefits. The cash
values are accessible via loans. Variable life policies also provide the same range
of non-forfeiture options as traditional whole life policies. They also contain the
usual reinstatement provision.
In sum Variable life insurance is a policy in which the cash values are funded by
separate accounts of the life insurance company, and death benefits and cash
values vary to reflect investment experience. The policy also provides a minimum
death benefit guarantee for which the mortality and expense risks are borne by
the insurance company. The premiums are fixed as under traditional whole life.
The principal difference with traditional whole life policies is thus in the
investment factor.
Variable life becomes the preferred option if one would like one’s assets to be
invested in an assortment of funds rather than in a long-term bond and mortgage
portfolio as has been typical of traditional whole life. The other advantage is that
one is enabled to direct one’s account value to an investment of choice from the
menu offered.
Universal Variable Life plans
Universal variable life insurance [VUL] has been one of the fastest growing
products in the US life insurance market. As the name suggests it is a form of
Whole life, which combines the features of both Universal life and Variable life.
As Whole life insurance, VUL has a cash value component that is payable to the
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 17 1
policyholder on death or as surrender value on cancellation of the policy.
However while cash values under traditional whole life contracts grow at a
specified rate that is generally guaranteed, the cash value in a VUL policy need
not. The difference from traditional Whole life policies reflects the universal life
and variable life aspects of VUL policies. Let us now see how the elements of the
above two types of product design are combined under Universal Variable Life.
The Universal life aspects: Universal Life has three distinctive features – an
unbundled price structure that lists charges separately, flexible premiums and
flexible benefit amounts.
Separate charges: unlike traditional policies where the policyholder only knows
the gross or office premium and not their separate components, universal variable
has mortality and expense charges separately shown. In addition the insurer also
describes the amount to be credited to the policy’s cash value and the investment
earnings that will be added. But while many Universal life policies may guarantee
a specified interest rate for a limited period and investment earnings would not
fall below this guarantee specified minimum, Variable Universal policies may not
offer such a guarantee. Indeed they apply a different approach to crediting
investment earnings.
Both Universal and Variable Universal products also allow the policyholder to pay
flexible premiums, whose amount and frequency can be varied within given
boundaries set up by the insurer.
The third provision is that of flexible benefits. Unlike traditional contracts where
face amount [sum assured] is fixed at the purchase stage and is not easily
changeable thereafter, both Universal and variable Universal products allow the
policyholder to change the face amount after the policy has run for some time.
This is of course subject to furnishing evidence of further insurability, if the
request is for higher face amount. One may also change the amount in the
policy’s cash value. This can be done by choosing one of two options.
The first option fixes that the total benefit payable as being equal to the face
amount or Sum Assured under the policy. Since the Net amount at risk [the pure
insurance component] is the Face Amount less the Cash Value, an increase in
benefits leads to increasing the cash value which results in a decrease in the net
amount at risk and consequently in a fall in mortality charges.
Under the second option, the life insurance benefit under the policy is specified
as equal to the policy’s face amount plus the cash value of the policy. Here the
Net amount at risk remains always equal to the face amount and the mortality
charge remains constant. An increase in benefits results in higher cash value
which in turn leads to a higher amount payable as death benefit [face amount +
increased cash value].
In sum while one option enables the policy holder to reduce the premiums payable
the other increases the final benefits that would be received by him.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 17 2
Variable Universal policies – the Variable Life aspects:
Variable life insurance has fixed premiums but allows the death benefits and
other values to vary, reflecting investment experience. The policyholder decides,
within limits, how cash values are to be invested and must accept the investment
gains and losses that are associated with the performance of a chosen investment.
It is possible to transfer funds from one investment to another. The better the
investment performance the higher the cash value of the policy. We have also
seen that the assets under Variable life policies are kept in a separate account
that is segregated from the general account fund in which the proceeds of the
insurer’s other life insurance products are maintained. The separate account may
in turn be subdivided into sub accounts, each representing a smaller portfolio of
securities. The above provisions, which apply to Variable life policies, are also
incorporated into Variable Universal life.
In sum, the distinctive hallmark of Variable Universal life consists in allowing
policyholders to exercise greater control over investment returns, premium
payments and benefits amounts; making full disclosure of various charges
and credited returns and providing policyholders with the opportunity to
earn higher return by taking more risks. This combination of flexibility with
regard to the premium- benefit structure along with choice of investment has
resulted in a highly non-standardised product with immense possibilities. While
flexibility and freedom of choice are its hallmarks, its flip side is the passing of
investment risk to the customer.

G. Unit Linked Insurance

Let us now consider Unit Linked Plans, also known as ULIP s, which emerged as
one of the most popular and significant products, supplanting conventional plans
in many markets. These plans were introduced in UK, in the wake of substantial
investments that life insurance companies made in ordinary equity shares and the
capital profits they made as a result.
A need was felt for having both greater investment in equities and also passing
the benefits to policy holders in a more efficient and equitable manner.
Conventional with Profit [participating] policies offers some linkage to the life
office’s investment performance. The linkage however is not direct. The
policyholder’s bonus depends on periodic (usually annual) valuation of assets and
liabilities and resultant surplus declared, which in turn depends on assumptions
and factors considered by the valuation actuary.
Critical to the valuation process is the allowance for guarantees provided under
the contract. As a result the bonus does not directly reflect the value of the
underlying assets of the insurer. Even after the surplus is declared, the life
insurer may still not allocate it to bonus but may decide to build free assets which

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 17 3
can be used for growth and expansion. Because of all this, bonus additions to
policies follow investment performance in a very cushioned and distant manner.
The basic logic of conventional policies are to smooth investment returns over
time. While terminal bonuses and compound bonuses have enabled policyholders
to enjoy a larger slice of benefits of equity investments, they are still dependent
on the discretion of the life office who declares these bonuses. Again, bonuses
are generally only declared once a year since the valuation is done only on annual
basis. Returns would thus not reflect the daily fluctuations in the value of assets.
Unit linked policies help to overcome both the above limitations. The benefits
under these contracts are wholly or partially determined by the value of units
credited to the policyholder’s account at the date when payment is due.
Unit linked policies thus provide the means for directly and immediately cashing
on the benefits of a life insurer’s investment performance. The units are usually
those of a specified authorized unit trust or a segregated (internal) fund managed
by the company. Units may be purchased by payment of a single premium or via
regular premium payments.
In the United Kingdom and other markets these policies were developed and
positioned as investment vehicles with an attached insurance component. Their
structure differs significantly from that of conventional cash value contracts. The
latter, as we have said, are bundled. They are opaque with regard to their term,
expenses and savings components. Unit Linked contracts, in contrast, are
unbundled. Their structure is transparent with the charges to pay for the
insurance and expenses component being clearly specified. Once these charges
are deducted from the premium the balance of the account and income from it
is invested in units. The value of these units is fixed with reference to some pre-
determined index of performance. The key point is that this value is defined by
a rule or formula, which is outlined in advance. Typically the value of the
units is given by the Net asset Value, which reflects the market value of assets
in which the fund is invested. Two independent persons could arrive at the same
benefits payable by following the formula. Policyholder benefits thus do not
depend on the assumptions and discretion of the life insurance company.
An endearing feature of Unit Linked policies is its facility of choosing between
different kinds of funds, which the unit holder can exercise. Each fund has a
different portfolio mix of assets. The investor thus gets to choose between a
broad option of debt, balanced and equity funds. A debt fund implies investment
of most of one’s premiums in debt securities like gilts and bonds. An equity fund
would imply that units are predominantly in equity form. Even within these broad
categories there may be other types of options.
One may choose between a growth fund, predominantly invested in growth
stocks, or a balanced fund, which balances need for income with capital gain.
One may also choose sectorial funds, which invest only in certain sectors and
industries. Each option selected must reflect one’s risk profile and investment
need. There is also provision to switch from one kind of fund to another if
performance of one or more funds is not perceived to be up to the mark.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 17 4
All these choices also carry a caveat. The life office, while being expected to
manage an efficient portfolio, does not give any guarantee about unit values. It
is thus relieved here of the greater part of the investment risk. The latter is
borne by the unit holder. The life insurer may however bear the mortality and
expense risk.
Again, unlike conventional plans, unit linked policies work on a minimum premium
basis and not on sum assured. The insured decides on amount of premium to
contribute at regular intervals. Insurance cover is a multiple of the premiums
paid. The insured has a choice between higher and lower cover. The premium
may consist of two components – the term component may be placed in a
guaranteed fund (termed as the sterling fund in UK) that would yield a minimum
amount of cover on death. The balance of premium is used to purchase units that
are invested in the capital market, particularly the stock market, by the insurer.
In case of death the death benefit would be the higher of the sum assured or the
fund value standing to one’s account. The fund value is simply the unit price
multiplied by the number of units in the individual’s account.
Unit linked vs. Traditional life insurance plans
In the Indian market, the last two decades have witnessed a major divide
between two types of policies – traditional savings policies, represented by a
guaranteed increase in sum assured or participation [in profits] policies on the
one hand and Unit linked policies on the other. It is thus relevant to examine
the differences between the two in some detail
Nature of returns:
Market-linked in the case of Unit-linked policies.
Determined by assumptions of the insurer in case of traditional policies

Risk profile:
Both risk and return are individualized for Unit- linked plans and hence higher
return and risk possible

Traditional policies are bundled products where the mutuality principle is

applied to both mortality and investment risk. Both returns and risks are thus
pooled rather than borne by the individual.

Flexibility:
Unit-linked policies are essentially unbundled contracts. Their pricing
elements can be varied. The premiums as well as benefits can be customized.

Traditional policies are essentially bundled and standardised. There is little

scope for flexibility.

Transparency:
Unit-linked policies are transparent. Being unbundled.
Traditional policies are highly opaque, being bundled
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 17 5
 Premium structure:
In Unit-linked plans, the term component generally consists of renewable one-
year premiums, which increases with age.
Traditional contracts are level premium contacts, which may extend for life

Expense loading:
Unit-linked plans may involve high front-end loading.
In traditional plans, expenses are amortised and spread over the policy term.

Value of the policy:

Value of the policy in traditional contracts depends principally on Value of the
liabilities, as determined typically by the process of a valuation.
Value, in the case of Unit-linked contracts, is primarily given by value of Assets.

Withdrawal:
Since in traditional contracts the cash value gets gradually accumulated only
towards the end of the contract period, any withdrawal in the earlier years can
only be at a loss.

Under Unit-linked contracts on the other hand the loss in case of withdrawal is
defined by the withdrawal charges set out at the beginning.

Unit Linked Insurance and Mutual Funds

Differences between ULIP s and Mutual Funds
A major concern for life insurers stems from the comparison of unit linked
insurance products with mutual funds. Both have common characteristics, except
for the death cover [insurance protection] feature available in unit linked
insurance plans. Both provide market-linked returns and offer a menu of
investment choice options – like balanced, growth and equity and debt funds
both provide facilities to switch from fund to fund. They offer the benefits of
professional portfolio management and diversification while individualising
investment risk.
A major difference between the two is the higher cost structures perceived in
case of unit linked insurance plans. This is on account of high initial administrative
charges, whose ratio to total value of units reduces as the term increases. The
higher charges results in a unit-linked policy, in its earlier years, comparing poorly
with a mutual fund even as the investment performance of both are alike. In
recent years, as a result of interventions by the regulator, some limits have been
imposed on these charges, thus bringing them more in line with Mutual Funds.
All this raises a question of how a Unit Linked plan is to be positioned vis-à-vis a
mutual fund. Quite often these plans have been positioned solely on the basis of
their returns and investment flexibility. A unit linked plan could also be seen as
a customised insurance cum investment vehicle for meeting various long term
needs like son’s or daughter’s higher education or marriage or increased
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 17 6
replacement income in retirement. Or it could be simply a way of enhancing
general net worth. In each case, enhanced returns are a means to more efficiently
meet target needs through faster wealth accumulation.
The essential logic of the unit linked product is that investment in a carefully
selected and well diversified portfolio of equities and other securities can yield
high and consistent returns in the longer run. This is because in the longer run,
companies with strong fundamentals are likely to enjoy high-sustained earnings,
resulting in long-term stock value appreciation.
A mutual fund asset manager on the other hand is expected to beat the market –
build an asset portfolio that gives higher returns than the market [reflected by
BSE or NSE or some other index]. A unit-linked policy is not designed to beat the
market. Its purpose is to meet life contingency needs more efficiently. If
presented and sold in the right manner the product has much potential of turning
out a winner in both the short and long run.
In sum the unit linked policy marked a fundamental transformation in product
design. There was no longer any question of excess premiums, surpluses and
profit distribution via the bonus mechanism. The notion of pooling the premium
proceeds into a single fund also vanished, to be replaced by numerous funds, each
with different yield / risk characteristics. The insurer in effect now took on the
role of an investment manager for a fee. A result of the above was that
investment risk was no longer assumed by the insurer but passed on to the
policyholder. This marked a retreat from the principle of mutuality.
Unitised With Profit Policy
The major disadvantage of Unit linked policies is that it unitises [individualises]
and passes investment risk entirely to the customer. The product can be a winner
so long as market conditions are buoyant and the returns were good. The product
would come out as a terrible loser if market values of assets tumble and NAV s
crash, especially if the product has been positioned purely on its returns. One
way to overcome this contingency of crash in investment returns has been to
introduce a product called as Unitised with Profits policies, which are actually a
cross between unit-linked and traditional policies.
Under Unit linked plans, the benefits under these policies are defined in terms of
value of units allocated. However, unlike other ULIP s, the value of unitised with
profit policies do not automatically rise or fall with the value of the underlying
assets with which the units are linked. Instead, as in traditional contracts, the
company exercises discretion in determining the value of the units and decides
the extent to which the gains or losses in NAV should be reflected in the price of
the units. The method of achieving this is to set unit values to rise more gradually
than ordinary unit linked policies. Once the values are determined they are locked
and guaranteed like the reversionary bonuses of traditional products. This
reduces the volatility of returns of these policies vis-à-vis other conventional
ULIPs.
The concept of Unitised With Profits policies has emerged as a response to the
life insurers’ need to meet rising policyholders’ expectations of yield while not
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 17 7
compromising unduly on the safety of investment objective. It offers both
investment linkage and a margin of protection to policyholders.
The price in these contracts normally has two components – there is a guaranteed
rate of increase, which is usually less, and a bonus rate of increase, which is
actually declared each year. The product was quite popular in markets like
United Kingdom, which operated in a unit-linked environment.
Other Kinds of Products
Let us now look at some other kinds of product concepts that have found
application in Insurance industry in recent years, with some relevance also for
life insurance.
Parametric Products :
These are also known as index-based insurance and represent a specific type of
insurance products that offer a pre-determined payout when a specific parameter
or index is triggered. Unlike in the case of traditional insurance, where the actual
loss incurred can be identified, measured and compensated accordingly, under
parametric insurance, payment is made, based on the occurrence of a predefined
event, such as a natural disaster, without the need for a loss assessment12.

Some of the features of this category of products thus include:

 The fact that they have Trigger-Based Payouts, made when a specific
event, like an earthquake of a certain magnitude, occurs.
 They enable speedy and Efficient payment of claims, without needing
specific and individual loss assessment. There is also an element of
flexibility that is enabled in the use of funds – they can be used for any
purpose, not just for repairing damage.
 Finally, they enable coverage of risks that are hard to model or quantify.
Parametric insurance is slowly gaining popularity and traction in India,
particularly in sectors like agriculture and disaster management. Some examples
include weather-based crop insurance schemes (WBCIS) in crop insurance, that
provide payouts based on parameters like rainfall, temperature, and humidity;
Disaster Risk Insurance policies that cover natural disasters like cyclones,
earthquakes, and floods – here the payouts are triggered by specific parameters
like wind speed or seismic activity. Another area is Livestock Insurance, in which
payouts are made, based on parameters like disease outbreaks or extreme
weather conditions.
Parametric insurance is more commonly associated with non-life sectors. Yet
there may be some potential applications in life insurance as well. One instance
is that of Health-related products - parametric triggers could be used to provide
quick financial succor to policyholders in the event of health situations, like the
outbreak of a pandemic or specific disease outbreaks. The Covid pandemic was
an instance. Similar applications may also be considered in the area of
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 17 8
Microinsurance for low-income populations, where quick and affordable payouts
could be made for life events like death or disability, based on predefined
triggers. Parametric triggers could also be used in case of Catastrophic Bonds that
are relevant in managing risks associated with large-scale events like pandemics.

Regulatory Sandbox Scheme

The scheme was introduced by the Insurance Regulatory and Development
Authority of India (IRDAI) to foster innovation in the insurance sector. The basic
idea and purpose underlying the scheme is to have a controlled environment
where insurers and insure-tech companies are able to test new products, services
and business models under a framework of relaxed regulatory requirements.
Companies, under the scheme, can experiment with innovative solutions for a
fixed period, typically up to six months. The period can be extended, based on
the project’s pr0ogress and impact.
The process, to be followed under the scheme, involves a number of steps:
1. Submission of Applications [or proposals] by companies for trying out
innovative products or services.
2. The IRDAI evaluates these proposals based on criteria like innovation,
potential benefits, and risk management.
3. After due evaluation, some of the projects are granted a temporary
relaxation of certain regulatory requirements.
4. This is followed by a stage of testing, where the companies introduce their
innovations in the market under controlled conditions, and test them
under close supervision.
5. Finally, after making a review of outcomes, IRDAI may decide whether to
allow the product to be launched commercially.
The Regulatory Sandbox Scheme thus provides for a Controlled Environment - a
safe space for testing without entailing full regulatory burden. The temporary
relaxation of specific regulatory requirements allows a measure of flexibility,
encouraging innovation and development of new value offerings. At the same
time, sufficient care is taken to ensure that policyholders’ interests are
safeguarded during the testing phase.
A number of innovative life insurance products have been introduced under the
scheme in the Indian market. They include Health and Wellness Products
[sometimes also referred as Vitality Products] that offer lower premiums for
individuals who maintain a healthy life style. These are monitored through
wearable [Internet of things sensor] devices. Another instance is that of Usage-
Based products, in which premiums are adjusted, based on the actual usage of
the insured item. An example is ‘Pay - as -you - drive’ motor insurance. There are
also a slew of Microinsurance products that are tailored for low income
populations – these provide coverage for specific risks like life and health events.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 17 9
There is little doubt that the scheme has been quite successful in promoting
innovation and enhancing the insurance sector’s responsiveness to market needs.
Over thirty non-life insurance products have been approved, that offered a range
of innovative solutions. They include personalized and flexible coverage options
benefitting consumers. One remarkable feature is that the scheme has
encouraged collaboration between traditional insurance companies and Insure
tech companies, driving growth and modernization of the sector.
The Scheme has also provided a ground for introduction of innovative products in
life insurance. Examples include ICICI’s Dynamic Term Insurance, where sum
assured dynamically adjusts, based on the life assured’s life stage and needs;
HDFC’s Health India account that allows policyholders to save and use funds for
medical purposes; India First’s Life insurance Loyalty Programme, that rewards
policyholders with loyalty benefits, encouraging long-term retention and
customer engagement; and Health insurance schemes like ICICI’s Disease
Management Product, which focuses on managing chronic diseases by providing
coverage for regular checkups, medications and other necessary treatments.
In sum, the IRDAI’s Regulatory Sandbox scheme has played a pivotal role in
bringing about some changes in the Indian insurance landscape. Its success
underscores the importance of regulatory support in fostering a dynamic and
resilient insurance industry.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 18 0
Chapter Summary
During the last few decades, there have been marked changes in the nature of
the external environment and related risks. The demographic transition coupled
with the changes in the work environment and the changes in family structures
and social relationships led to an era of populations that live longer but with
impairment and reduced social and familial networks of support. In addition,
there is the rise of ESG Risks, arising as a result of a ‘Situational’ rather than a
‘Sustainable’ mode of living. The financial market has meanwhile witnessed the
rise of various financial products as competitors to life insurance. Life insurers
have had to respond to these imperatives.
In this chapter we have seen how the insurance industry has offered solutions to
face certain contingent situations that arise in the course of an individual’s life
cycle other than death and disease. Some of the products we discussed are not
part of the Indian market as yet, but may join the product line as Indian market
gets more integrated with the global marketplace and is subjected to its
influences.
A need was felt for having both greater investment in equities and also passing
the benefits to policy holders in a more efficient and equitable manner, hence
Unit linked policies came into existence. This chapter also distinguishes between
Unit Linked Insurance Plans and Traditional Insurance plans as well as a
comparison with Mutual Fund. Unit linked insurance plans are transparent and
offer more flexibility to the customers are per the required needs.
Important Concepts Covered:
 Emerging risks and contingencies in the last few decades
 ESG Risks
 Disability Income Insurance
 Long Term Care
 Custodial Care
 Intermediate Nursing Care
 Home Care
 Family Maintenance Plan
 Family Policy
 Juvenile Insurance
 With Profit Plans
 Bundled and Unbundled Plans
 Unit Linked Insurance Plans
 Mutual Fund
 Vanishing Premium
 Immediate Annuity
 Deferred Annuity

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 18 1
Self-Examination Questions
Question 1
------------ is a situation where in the insured files a claim for disability income or
continues to remain “disabled” and claims insurance even when able to return to
work.
A. Physical hazard
B. Moral hazard
C. Disability hazard
D. Long term hazard
E. None of the above

Question 2
If the patient does not need 24 hours attention, which Long Term Care will cover
it?
A. Custodial Care
B. Home Care
C. Intermediate Nursing Care
D. Hospital Care

Question 3
In case of ----------------- death benefit, partial withdrawal would not affect the
death benefit amount.
A. Level
B. Increasing
C. Guaranteed
D. Both (A) and (B)

Question 4
PAYG abbreviates ------------------
A. Pay and Go
B. Pension Aayog
C. Pension As You Get
D. Pay As You Go

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 18 2
Question 5
If the policyholder has pulled out funds locked in traditional Whole Life Policy
through policy loans and surrenders and invests the proceeds in high yielding
securities, what is this process popularly known as?
A. De – tariffication
B. Dis– intermediation
C. De freezing
D. Unbundling
E. None of the above

Answers to Self -Examination Ques tions:

Answer to SEQ 1
The c orrect option B .
Answer to SEQ 2
The c orrect option C.
Answer to SEQ 3
The c orrect option A.
Answer to SEQ 4
The c orrect option D.
Answer to SEQ 5
The c orrect option B .

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 18 3
 CHAPTER 7
LIFE INSURANCE VS. OTHER FINANCIAL PRODUCTS
Chapter Introduction:
In the earlier chapters we have discussed the various types of life insurance
products and their features. Let us now consider life insurance products as
financial products and examine where they stand vis-à-vis other types of financial
instruments.
We begin with a brief look at some of the key principles that govern financial
products in general – particularly those which govern secondary instruments that
have been issued by various kinds of financial instruments and examine their
implications for life insurance.
As stated earlier, every product is a bundle of attributes and financial products
are no exception. The basic attributes of a financial product are yield, risk and
liquidity. There are other features like convenience in holding it as a financial
asset, tax benefits, life contingencies cover etc. This chapter explores these
features and how they are mixed or packaged in different types of financial
products. We shall also examine how these features and benefits make each
product appropriate for meeting various kinds of needs along the human life
cycle.

Learning Outcomes: at the end of this chapter you will

A. Product Structures – some guiding principles

B. Financial products – Needs and attribute preferences
C. Financial Product Attributes – a brief look
D. Financial Products – a Comparison
E. Financial Management in Financial Institutions and life insurance

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 18 4
A. Product Structures – some guiding principles
At the outset it would be instructive to note some guiding principles which have
helped to forge the technology of the financial marketplace.These principles are
quite well known and have for long served as the conceptual tools underlying
finance as a formal discipline. Their creative application to solve problems in
finance forms the core of product development whether in banking or insurance
or capital markets.
The Time Value of Money:
This is probably the most fundamental of all the principles of finance. It tells us
that time has a value and that a rupee in hand today is worth more than a rupee
received tomorrow. One would not be ready to forgo the present in exchange for
the future unless he / she is compensated for it. Interest is the price
(compensation) of parting with the present in exchange for the future.
The time value of money is expressed through the principle of discounting cash
flows received in future to their present value. To discount cash flows we need
an appropriate discount rate, which is also termed alternatively as interest rate
or the rate of return.
For instance, the present value of a sum of Rs100 receivable after one year,
discounted at 10% rate of interest (expressed as 0.10) would be given by Rs90.90
PV = 100 / (1+0.10) 1 = 100/ 1.1 = 90.9.
If invested for two years at the same rate of discount would be worth only Rs
82.64. The expression is: PV = 100 / (1.1) 2 = 100 / 1.21 = 82.64
This means that the further away is receipt of a cash flow, the lower its present
worth. Similarly, the higher the rate at which a cash flow is discounted, the lower
its value would be today.
Another principle, which is a companion to discounting, is that of compounding.
It refers to the frequency with which interest is compounded and adds to
principal. The principle implies that money can and should be reinvested again
and again. Both discounting and compounding essentially reflect the pace at
which an investment and, by extension, the wealth of the investor multiplies.
The reason lies both in the demand and supply side. On the one hand financial
assets are needed to purchase real capital assets that have productive power, or
to create other utilities that would not have been possible otherwise. On the
other hand, time involves waiting (sacrifice of present consumption). It also
brings uncertainty in its wake.
This principle is applied in all financial assets. The deposit rate [SB or FD] that a
bank offers is an example. In Insurance, the rate of discount [interest] is assumed
when considering the present value of liabilities [for death and other payouts]
that may arise in future. It reduces the premium rates. In bond markets, it is the
rate of interest that reflects this principle while in equity markets, it may be
reflected in the returns that arise as a result of both dividend and capital
appreciation of the shares.
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 18 5
Risk Aversion
There is a popular saying - ‘a bird in hand is worth two in the bush.’ The second
principle reflects this simple home truth - investors are by nature risk averse.
They would rather have a safe rupee than a risky one. This does not mean they
will not take a risk. It means that they will take a risk only if they expect to be
rewarded for it. People have different degrees of risk aversion. Higher the
degree, greater the reward expected. The yield of a plantation company is thus
much greater than that of a bank.
The concept of risk aversion arises from the principle of diminishing marginal
utility of wealth, which holds that each rupee added to wealth increases utility
(satisfaction) of that wealth but at a lesser rate than the previous rupee. A
rational individual would be less prepared to sacrifice certainty (take a risk) to
gain more wealth since the additional utility is less, in relation to the sacrifice
one has to make.
The risk aversion principle implies a trade-off between the return and riskiness
of an asset. People may not think about the trade-off in specific terms but tend
to do so innately. The differences in their perception about risk and return
provide the rationale for designing financial instruments that price and allocate
risk.
Risk aversion is reflected all financial products. The returns of a life insurance
product are, for example, lower than that of a Mutual fund or share because the
latter also carries with it a certain level of riskiness, which is not there in life
insurance, where the sum to be paid, including bonuses, are guaranteed. The
death protection cum safety of investment feature of a life insurance policy
makes it attractive for those who have a high degree of risk aversion [are anxious
about] vis-à-vis mortality and investment risk.
Information Asymmetry
Information asymmetry, as the term suggests, refers to a situation where one
party to a transaction has insufficient knowledge and must take decisions with
inadequate information vis-à-vis another. For instance, a creditor may not have
the information about a debtor that the later has about himself/herself. An
applicant for life insurance may have more knowledge about his /her financial
and other circumstances, health, habits etc. that the life insurer would not know.
Similarly, an investor in a bond or a share certificate may not know about the
company he/ she invests in, as much as the management of the company.
This can lead to two kinds of problems:
Adverse selection: the tendency for those persons with highest possibility of
experiencing financial problems (of repayment) to seek out and obtain loans/
insurance cover/ investments, without revealing their actual state of affairs. This
is a sort of asymmetric situation that arises at the stage when an investment is
being made.

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Moral Hazard: arises because the loan agreement /writing of the insurance
contract etc. creates an incentive for the borrower or insured to take
unwarranted risks only creates an obligation to make certain fixed payments and
allows the that are not consistent with the best interests of the lender. In banking
and in bond/stock markets, you may thus find companies who have obtained such
borrowed money/ capital investments, squandering away money in a fit of
undisciplined spending and resulting in high NPAs [non-performing assets] or
failed stocks. Similarly in health insurance, one would find a classic case of
hospitals inflating the bills for medical treatment for those who patients who are
insured.
Information asymmetry is the reason why financial institutions including life
insurers exercise due diligence [e.g. underwriting] when deciding whether or not
to offer insurance, or impose conditions stipulating when a claim may be
rejected. Similar safeguards are also exercised by other financial institutions as
well. In a sense, the superior ability of banks, insurance companies and mutual
fund companies to collect information and assess the riskiness of their debtors/
insureds/ companies in which they invest, that enable these financial institutions
to play their role of financial intermediation effectively. They act like a delegated
monitor for their clients, assessing and monitoring the value and security of their
deposits/ investments.
Economy
Economy in a broad sense means leveraging on scale to achieve more for less. In
financial markets the economy principle is applied in many forms. One way is
packaging of numerous cash contributions by small investors into large
denominations, which can then be used to purchase lumpy assets [Mutual funds].
The share of a blue chip company may be well beyond the reach of a small
investor, but when his contribution is combined with hundreds of others, it
becomes easily possible. Bankers are able to implement the principle of maturity
transformation more effectively when they combine the deposits of millions of
depositors. Life Insurers similarly become more sound and robust as the size of
their customer base increases.
There is another kind of economy, which is not achieved by enhancement but
rather by extension. This is known as economy of scope. It refers to the extension
and use of one’s endowments or competencies in new areas. Banc assurance is
an instance. A bank’s familiarity and closeness with customers may be leveraged
to develop wealth management solutions, including the recommendation and sale
of life insurance solutions. Similarly, the expertise in money markets is extended
to create interest yielding sweep accounts. This principle is today reflected in
many of the leading financial institutions in India and elsewhere emerging as giant
financial conglomerates [e.g. HDFC, ICICI, SBI, LICI ..] who have operations in
multiple financial markets, where they leverage their strengths in one or other
markets for cross selling and expanding their market reach and share of the
customer wallet.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 18 7
Expectations
The value of a financial asset is realised in the future. In the here and the now
all that one has is an expectation about how things would shape up. It is the
differences in expectations that make financial transactions happen. A bullish
person buys a share expecting its price to go up while another, more bearish,
person sells his shares because he expects the price to go down. One buys life
insurance because one is not quite sure about what to expect – when would his
or her death come. A life insurer on the other hand, can be surer about the
probability that a person of a certain age would die. The insurer need not be
concerned about which particular individual would die – it is enough to predict
fairly accurately that 2 out of every 1000 persons of a certain age is expected to
die in the following year. The expectation of death can in other words be more
precisely measured [using a Mortality table] and priced. It is this difference in the
level of expectation between the insured and the insurer that have brought the
life insurance contract into existence.
In earlier decades, economists generally considered expectations as being formed
from past experience only. This view, known as “Adaptive Expectations”
suggested that changes in expectations would occur slowly over time as people
responded to changes in past data. This view has been faulted on the ground that
people use more information than just past data or data about just one variable
when forming expectations about that variable [e.g. assessment about the price
of a certain stock]. It has also been argued that people often change their
expectations quickly in the light of new information. These arguments led to
development of the Rational Expectations Hypothesis.
A Rational expectation is formed by people when they use all available
information and result in optimal forecasts (best guesses of the future). Even if
these forecasts are not perfectly accurate but correct on average [the best
estimate one can make given the available information], it is rational.
A tenet that is closely related to the concept of Rational Expectations is the
Efficient Markets Hypothesis. It states that in a market where there are a large
number of buyers and sellers who operate on the basis of complete and up to
date market information and make decisions based on rational expectations, such
a market would settle into a state of equilibrium in which the price of the asset
is in tandem with the intrinsic worth of the product. For instance, in an efficient
market, the price of a share [at which it is traded] would more or less correspond
to the actual value of the underlying share – it would neither be over priced nor
under-priced. Similarly, in an insurance market where buyers of insurance take
rational purchase decisions based on more complete information about the
underlying risk, it may be difficult to overprice the product and remain
competitive. It is difficult to make super normal [higher than normal] profits
through engaging in transactions in such markets.
These above conditions may however be belied when people may be aware about
all available information but not ready to exert in order to make an optimal
forecast. Again, people are unaware about some of the available information, so
that their prediction is not accurate. In both cases there is a gap between some
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 18 8
people who have the necessary relevant information and act on it and others who
may not have that information or do not act on it. It is the presence of these gaps
that create opportunities for engaging in profitable transactions in the financial
market place.
Two specific processes reflect the application of the expectations principle
financial markets– speculation and arbitrage.
Speculation involves divining about what future prices are likely to be and taking
positions (buying or selling) in order to profit. An example is buying a financial
asset whose price is low and selling it when its price goes up. In essence it implies
that if one expects prices to rise in future, one would buy now and sell later at
the increased price. Alternatively if one expected prices to fall, one would sell
now and buy at a lowered price later. In either case one would make a gain.
Arbitrage on the other hand involves a simultaneous taking of long and short
positions (buying and selling) in two or more different markets in order to exploit
the opportunities arising from discrepancies in their valuation and pricing.
While speculation arises from changes in the price of the same asset, arbitrage
arises from discrepancies in the prices of different assets. An example of
arbitrage is the case where life insurance policies were found to yield a return
that was less than that offered by money market mutual funds. As a result,
policyholders withdrew (took loans) funds from their policy cash values and
invested them in money markets mutual funds.

B. Financial products – Needs and attribute preferences

Let us look at the attributes and the preferences that individuals have for these
attributes. A number of points may be made in this regard, as given below:
The Tradeoff: Every financial product involves a tradeoff between Yield, Risk
and Liquidity. Ideally, one would like to have a financial instrument that gives a
very high rate of yield, with nil or lowest risk [high guarantees] and redeemable
instantly with nil or negligible cost. The problem is that such a product only
exists in utopia. In general, higher the rate of yield, higher would be the risk
and lower the liquidity quotient [ease with which it can be redeemed for cash].
Attribute Preferences: Individuals have varying dispositions with respect to the
tradeoff they make between yield, risk and liquidity. Those individuals who are
strongly concerned about risk and are prepared to accept a lower rate of yield to
ensure security of their investments are known as risk averse individuals, while
others who are willing to take extra risk in order to earn a higher rate of yield,
can be said to have a yield preferring disposition. Similarly, individual may have
a strong preference for liquidity and would be willing to let go of their cash and
liquid assets only for a high rate of yield.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 18 9
Individual preferences for various features depend on their wealth endowments.
Those with very high levels of wealth may be expected to have lesser risk aversion
since the marginal utility of their wealth may be expected to be less, relative to
those who have a lesser level of wealth.
Risk dispositions are also related to age. Those who are young and have a long
time to go before retirement may be relatively less risk averse and more yield
preferring than those in mid-life, who are nearing retirement. The latter need to
consolidate their wealth and cannot afford to risk it away, since the time at their
disposal, to earn more wealth, is limited.
Again, those who have uncertain income streams and relatively limited access to
low cost credit would tend to display high liquidity preferences and would not be
very comfortable with assets that are long term or prone to risk. This is the
source of the challenges that life insurers face in rural and informal markets.
Saving Needs, Attribute Preferences and Assets: Individual preferences for
various kinds of asset features [yield/ risk/ liquidity] are also closely related to
the purpose of savings and investment. For instance, one could hardly expect a
prudent investor to hold his retirement savings or a fund designed for his
daughter’s marriage, in a junk bond, whatever yield he may expect to earn.
One can in general relate expectations with respect to yield, risk and liquidity to
the three motives for holding financial assets – transaction, precautionary and
speculative needs.
Assets held to meet various kinds of anticipated transaction needs [ranging from
monthly expenditures to purchase of durable goods or children’s education
expenses] would be driven by the concern to have adequate purchasing power at
the time when it is needed. The focus would be on a reasonable yield, consistent
with safety that would enable one to have a definite sum accumulated and set
up for the given purpose. Assets held for the above are driven by the Transactions
Motive.
Assets held to meet unexpected contingencies like unforeseen medical expenses
or sudden death or disability, are driven by the objective of reduction of
uncertainty. Here the focus would be to have liquid cash available at the critical
moment when it is most needed. For instance there are only two ways to meet
a medical emergency needing hospitalization. One must either have ready cash
or enough liquid assets in hand or one must have insurance to indemnify the costs.
These asset holdings are driven by the Precautionary Motive.
Finally there are assets held with a view to enhance one’s net worth in general,
through taking advantage of market opportunities. The purpose here is simply to
maximize one’s wealth [make as much money as one can] and one may have a
long term horizon while doing so. In fact, the desire for long term capital
accumulation is what distinguishes a typical investor from a market speculator.
As the name suggests, the latter is one who saves and invests money with a view
to make quick gains from rise and falls in the prices of stocks and other securities.
One may thus speculate in the stock market or in Gold or in Real Estate.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 19 0
Individuals who generally save and invest with a view of maximizing their wealth
may be said to be driven by the Wealth Accumulation Motive.
Some of them, who seek to maximize their capital gains through active market
[buy – sell] transactions, may be said to be driven by the Speculative Motive.
Keynes termed those who are driven by these motives as being moved by Animal
Spirits. Thus individuals who are optimistic about market trends and in a hurry to
buy, expecting prices to rise in future, are known as Bulls, while those who are
pessimists and seek to sell their holdings, expecting prices to fall, are known as
Bears.
Each of these motives is present in some measure while purchasing life insurance
or another financial asset. The individual’s preferences with respect to various
risk – return; and return – liquidity tradeoffs may be represented along a
continuum that is linked to the relative mix of the above motives. In general the
relation is likely to be as illustrated below

As the graph shows, individuals are expected to have least risk tolerance or high
risk aversion / Liquidity preference when guided by the precautionary motive.
Their risk tolerance - yield preference would be relatively higher, to the extent
they are guided by the Speculative motive, while they would be somewhere
between these two positions, in so far as their transaction needs are concerned
Mathematical principles and Attributes: as already seen in a previous chapter,
the attributes of a financial product are linked to and a result of the
mathematical principle(s) that are applied in creating the product.

For instance
A bank deposit is created by applying the principle of Maturity
Transformation, in which the banks borrow short and lend long – creating
liabilities of short duration and assets of long duration. Transforming of
maturities requires holding liquid assets in hand [in the form of CRR and SLR],

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 19 1
 which consequently reduces the scope for generating high interest margins
from loans and investments in their balance sheet.

A Mutual Fund is created by firstly creating a pool of funds and then investing
it in a diversified portfolio of typically variable income securities. Portfolio
Diversification is the dominant principle here. It enables the Mutual fund to
yield higher return than a deposit.

At the same time, a Mutual fund may not earn as much return as investment
in a single stock. The dominant principle in the latter is Security Selection
and Market Timing [where one may apply fundamental and technical analysis].
The stock instrument may however be much more risky, as it is subject to
unsystematic risks which are reduced through diversification.

An Insurance policy is created by applying the principle of Mutuality or Risk

Pooling. Pooling makes it possible to create immediate estates that are
available to those who need it to cover their risks. It also enables one to
smoothen out investment returns over time, thus reducing both risk and
return. At the same time, it would reduce liquidity, as the funds are no longer
individualized and any withdrawal would affect the pool. Pooling rather than
individual treatment of the life fund [made of contributions of thousands of
policy holders] reduces both the returns and riskiness of policyholder funds
risks.

Let us now enunciate the last principle. Individuals purchase financial products
which have the attribute mix that matches their preferences, which are in turn
linked to the end purposes for which they are buying these products.
There is thus a clear linkage between Products; their Mix of Attributes and the
End Needs / Motives for saving. Understanding this linkage and advising the
client on this basis is what Personal Finance is all about.

C. Financial Product Attributes – a brief look

It would also be worthwhile to have a brief look at the various attributes that go
to make a financial product.
Attributes - a closer look
Yield: or Rate of Return: is probably the most important attribute of a financial
instrument. Yield (also termed as Yield to Maturity or YTM) is the rate of discount
that equates the value of expected future cash flows from a financial instrument
with its Present value. Yield is a measure of the rate at which one’s investment
multiplies or increases in its value.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 19 2
Such increase in value of the investment is a result of two kinds of cash flows
which may be earned – income flows [in the form of dividends or interest coupon
payments or interest installment payments etc.] and capital gains /losses arising
as a result of a change in the price of the asset.
A key question is why different financial instruments have different rates of
return and correspondingly, what is the appropriate rate of return one should
expect to earn from an instrument. The key point to note here is that Yield or
Return is a price that an investor is paid for investing in a security. This price is
a component of four prices:
R1: the rate of time preference – it is the price that must be paid as a
compensation for waiting (sacrificing current consumption for later).
R2: the inflation component - Inflation reduces purchasing power, so that the
real value of one’s wealth is diminished over time. An investment must at the
very least, compensate for the loss of value that one would suffer as a result.
Obviously when prices rise in general, financial assets must offer yields that have
kept pace with this increase. They would find few takers otherwise.
R3: the liquidity premium–it is the price paid for parting with liquidity –
sacrificing cash in exchange for less liquid assets. Longer the term to maturity,
more uncertain the investment becomes and hence a higher liquidity premium
(price for parting with liquidity) must be paid to compensate for bearing extra
risk. The relation between return and term to maturity is normally represented
by the concept of ‘Term Structure of Interest Rates.’ It is normally given by an
upward sloping Yield curve as shown below

Yield

Term to Maturity

While the above relationship may be expected to hold in general, there are
situations where yields on short term instruments may be higher than for long
term ones. This is typically found when market conditions may create a strong
demand for short term liquidity, jacking up the returns, or where interest rates
are currently high but are expected to fall in future. Such situations may result
in what is termed as a Reverse Yield Curve.
R4: Risk premium – the last component is the premium one is paid for bearing
risk. The principle of risk aversion tells us that rational individuals would not
take extra risk unless they are adequately compensated for it. Risk is defined as
the variability of outcomes [or volatility] of a financial instrument. An equity
share is considered more risky and hence should give more return than a Bank
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 19 3
Deposit. A Junk Bond [low grade investment] should yield more than a bond with
Triple A rating.
The rate of return, R of a financial instrument should compensate adequately for
its time preference, inflation, term to maturity, risk and other components
[R = R1 + R2 + R3 + R4].
For instance suppose that
R1 = Rate of Time Preference = 1 ½ %
R2 = Expected rate of inflation = 4%
R3 = Liquidity premium applicable to long term assets = 1 ½ %
The nominal risk free rate of yield (Rf) for a short dated instrument, like a one
year gilt may then be
Rf = R1 + R2 = 1 ½ % + 4% = 5 ½ %
The nominal risk free rate of yield (Rf) for a long dated instrument like a ten year
bond would include a term structure premium for term. If this is assumed at 1 ½
%, we have
Rf = R1 + R2 + R3 = 1 ½ + 4% + 1 ½ = 7%
What about a financial instrument that carries some risk. Obviously the
instrument should provide a rate of yield which compensates for the risk. The
rate of return would then be given by Rf + Rp where Rp represents the risk
premium.
Risk
Risk refers to the variability of outcomes of a financial instrument. It must be
understood in relation to return. While the term ‘return’ normally represents a
mean value, risk is measured by the statistical dispersion of returns about the
mean.
We can represent the concepts of [expected] return and risk as follows:
Let ri (i= 1,2,3…. n) represent the returns of a financial instrument over n periods.
Based on past performance, one may assign a probability for each return. This is
represented by Pi (i=1,2,3…).
The expected return R is the mean value of different weighted values of r. It is
given by
R = P1 r1 + P2 r2 + P3 r3 ……. + Pn rn
The risk of the above distribution of returns is measured by its variance [σ2],
which is represented by:
σ2 = P1(r1 - R)2 + P2(r2 - R)2 ….+ Pn(rn - R)2
Risk may also be measured by standard deviation, which is the square root of the
variance.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 19 4
Yet a third measure of risk is Beta, which reflects the volatility of returns of an
investment in response to market volatility. Beta is typically used to measure the
sensitivity or variability of returns of a specific stock’s vis-à-vis variability of
returns of the stock market as a whole. Such returns for the market are typically
represented by an index of stocks like the BSE Index.
What are the sources of risk for a financial asset? They arise from losses of income
or capital value that may be suffered as a result of holding the asset. The risks
are of the following types
Default Risk:
Default risk is the chance that a borrower will default, due to inability or
unwillingness to pay either interest or principal [face value] when an instrument
matures. Default includes both non-payment and late payment – in both cases,
the lender suffers a loss. Default risk is principally applicable to Debt
instruments, which may have varying degrees of such risk.
For instance, Gilt edge securities issued by Government are considered to carry
negligible or nil default risk since government normally has authority and ability
to meet its debt obligations by printing money or other means. Other instruments
like corporate bonds may include those with high default risk [like Junk bonds]
and others that are low risk grade.
Interest Rate Risk:
Interest rate risk is the chance that the holder of a financial instrumental
[typically a fixed income instrument] would suffer a loss due to a change in
interest rates.
For Instance
If someone buys a bond priced at Rs 100 with a yield rate (YTM) of 10% and
market interest rates rise a week later to say 12%, the price of the bond would
fall to below 100.

This happens because investors who are risk averse would prefer a higher yield
for a given level of risk. Newly issued bonds which are equally risky will have a
higher rate of yield after the rise in the interest rate rise. Older bonds, as a
result, can be prematurely redeemed or repurchased only at a price below the
purchase price.
Reinvestment Risk: arises when the owner of a financial instrument, say a bond,
needs to keep funds invested for a period which is longer than the instrument’s
term to maturity. In this case, the investor would be hurt if interest rates were
to fall.
For instance
A father wants to hold funds for his daughter’s marriage expected after twenty
years. At YTM of 8%, he can expect that an investment of Rs. 100000 would
amount to Rs.466095 after twenty years. Unfortunately only bonds of ten years

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 19 5
 duration are available. A ten-year bond at eight percent rate fetches him a
maturity value of Rs.215892 at the end of the ten year period. Suppose that
interest rates have in the meanwhile reduced to 6%. If the father reinvests the
maturity value he received at the new market rate of 6% for another ten years,
he would end up receiving only Rs. 386630 at the end of the twentieth year. A
reduction in interest rates in other words has led to a loss of Rs. 79464.
Reinvestment risk thus represents the chance of loss arising because of the need
to reinvest the proceeds of a financial instrument at a reduced future rate.
Marketability Risk refers to the difficulty of selling a financial instrument, like a
share of stock, because it is not actively traded in the secondary market.
Liquidity
Liquidity has been defined as the ease with which a financial instrument can be
converted into cash. An instrument is liquid if it can firstly be redeemed into cash
without loss of time. The second condition is that its transaction cost be low.
Transaction cost refers to the monetary outflow involved in converting less liquid
assets into cash. We may observe that there are different degrees of liquidity –
a bank deposit stands at one point on the liquidity spectrum while an insurance
policy stands at another.
Instances of Liquidity are various
In case of a bank deposit, liquidity cost can be measured by the reduction in
rate of interest that one must accept in order to close the deposit prematurely.
In case of an equity share, the cost is given by the brokerage fee that one has
to pay in order to sell it.
For a life insurance policy, liquidity would be given by the reduction in cash
value or Net asset value [after surrender charges] that one gets on surrendering
the policy.
We have discussed the primary three features of a financial product or
instrument. Other attributes may be linked to the above three in terms of their
impact on them.
For instance, tax benefits are reflected in the form of higher yields being
available when investing in tax savings instruments.
Similarly convenience in holding a financial asset is given by the ease with which
one can invest in the asset, maintain it and redeem it on maturity. Convenience
is typically reflected in the form of higher liquidity that it lends to the asset.
Finally let us consider the sense of fiduciary responsibility demonstrated by the
financial institution which has placed the financial instrument in the market.
Whatever the product in the financial marketplace, it is ultimately only a
promise. The credentials of the institutions making the promise determine the
worth of the product.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 19 6
D. Financial Products – a Comparison
Let us now examine various financial products in comparative perspective.
Types of financial products
Money or cash [currency and coins] is the most basic form of finance. It
represents ready purchasing power and is obviously the most liquid of assets. It
is also the safest way of holding wealth as none of the risks that we referred to
above, are present. Money would be needed for meeting transaction needs,
expected to arise in the immediate future [like monthly or weekly expenses].
One also needs to hold cash for meeting unforeseen precautionary needs that may
suddenly rise. The flip side is that cash in hand is idle and does not earn any
return. It is thus a very inefficient way of holding wealth to meet future needs.
Savings Bank Deposits: Current Account or Savings Bank (C/ A or S / B) comes a
close second. It is slightly less liquid. One can draw a cheque on it. Savings
Accounts offer a small rate of return while also offering near instant liquidity. In
recent years banks have started offering innovative kinds of deposit accounts like
Sweep accounts, in which they provide for a minimum balance to be held in the
form of a savings deposit while sweeping the excess over then balance, into a
fixed deposit. In case the deposit holder withdraws funds above the minimum
balance, the latter gets replenished through a reverse transfer of funds. In effect
these deposits provide the returns of a Time [or fixed] deposit while enabling one
to avail the liquidity of a Savings Deposit.
Fixed Deposits: The largest component of financial assets, held for future
provision, of typical Indian households continues to be in Bank Fixed Deposits.
The growth of capital markets has not been able to dislodge the role of the FD.
The reasons are not difficult to find. A large proportion of households which are
in the informal and rural sector, with uncertain and fluctuating income streams,
typically seek an asset with high liquidity, easy to invest and hold and offering a
reasonable rate of return that is also safe. Bank FD s fit the bill. Banks are also
easily accessible, with their branch network spread out to reach near to most
villages and towns in India.
There are however certain disadvantages with Bank Deposits. Their tenure is
short, with normally not many deposits over five years. Those seeking to hold
assets for long term future provision may face the problem of reinvestment risk,
since there is no guarantee that present interest rates on FD s will continue and
not decline in future. If we look at the experience of other countries like the USA
or Japan, FD s have negligible yields. Banks in many countries themselves don’t
encourage deposits but are turning towards fee based income through selling
insurance, mutual funds and other services. Another issue, in the present Indian
context at least, is that Bank FD s do not offer any tax benefits. Their interest
income is in fact taxable. As a result the post-tax yields on bank fixed deposits
may not be very attractive, at least for those who fall in higher tax brackets.
Finally, deposits in certain banks can be subject to default risk, especially those
who have a high level of NPAs. It would be prudent to check out the credentials
and financial strength of a bank before committing large funds to it.
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 19 7
Government Small Savings: these are a set of savings instruments that have been
largely promoted and sold through the Post Office network. They include Public
Provident funds, National Savings Certificates, Monthly Income schemes. The
great advantage is that they offer a guaranteed rate of yield and can be
considered gilt edged, being issued by government. The rate of yield is
comparable to bank FD s and perhaps one may consider the FD - NSC rate as a
sort of benchmark riskless rate. They are good vehicles for holding wealth
towards meeting medium term requirements. For instance an NSC certificate has
a term of around 5 years while a KVP [Kisan Vikas Patra] has a term of 9 years 7
months. They may not be very suitable for meeting long term fund requirements.
Equity Shares: Equity markets have emerged as one of the fastest growing
segments of the financial marketplace, with many individuals participating in it
either directly or indirectly through institutional investments. Direct
participation in equity markets can be and has been a thrilling and highly
rewarding engagement for many individuals, especially for those who understand
markets. There are two ways in which one can access these markets – There is
firstly the longer term investor who carefully selects the stock, which he or she
wants to buy, after conducting detailed analysis of the company’s fundamentals.
The stock is then held with a view to secure longer term capital appreciation.
This is typically a passive investment strategy. It has paid great dividends to
those who selected winners after due diligence and had the patience to hold on
to them.
For Instance
Consider an investor who would have invested say Rs 100000 in the early
nineties in a then little known company named Infosys. What would be the
value of his stock today?

The other approach is where one looks for stocks that are apparently underpriced
[before the rest of the market finds out] and whose prices are likely to rise, only
to make a profit by selling it when the price is high. The reverse is to sell a stock
that is seemingly overpriced, and buy it back when its price falls. In both
instances, the strategy involves timing the market – buying a stock when it is low
and likely to rise, and selling it when it is high and likely to fall. This process,
known as speculation, can be a means to make quick money and is very alluring
especially when markets are buoyant. However, in a market that is efficient
[where complete information about market trends is freely available and used by
large number of buyers and sellers in taking their decisions] the scope for ‘making
a quick killing’ may be limited. One may only end up with small gains which one
has to pay to the brokers.
The problem with direct investment in equities is that one may not have the
resources to invest in a basket of shares, so as to have a diversified portfolio. It
is not often you can find an individual who had the fortune to pick out a variety

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 19 8
of relatively unknown companies [with low priced shares], all of whom turn out
to be winners in later years.
Consider an individual with say Rs 25000. Let us suppose a blue chip stock is
priced at Rs 750 to Rs 1000. At Rs 750 per share he can at the most buy around
33 shares of a single stock. Would it be possible, with this amount, to invest
in a portfolio of 5 to 6 stocks?

The risk with having one’s investments limited to just one or two companies is
that there is no guarantee; the companies may come out as winners, in a volatile
and uncertain market environment. Would it make sense to invest all of one’s
savings and link one’s future well-being to the fortunes of a few corporate units?
Mutual Funds: emerged precisely owing to the difficulties of having a diversified
portfolio of investments. Many individuals, who could not access the capital
markets due to resource limitations as discussed above, found an outlet for the
purpose in Mutual Funds. In some of the western markets like USA, Mutual Funds
have emerged as one of the principal means for holding personal savings. In the
United Kingdom they are known as Unit Trusts.
Typically, a Mutual Fund pools the contributions of several thousand investors to
create a large enough fund that enables it to buy into a portfolio of securities –
which may be a combination of stocks, bonds, government gilts and other
instruments. The fund thus seeks to enable one to achieve an efficient asset
allocation that helps to maximize portfolio return for given level of risk.
Typically the returns of a mutual fund investment would be related to the capital
market Index – does it give superior returns vis-à-vis the market index? Many fund
managers seek to and are assessed by their performance with regard to ‘beating
the market.’ Mutual funds have the potential to give much higher yields than
fixed income instruments like bank deposits, as their member investors can enjoy
the benefits of growth and profits earned by companies the fund invests in.
Especially when a fund is investing in Blue Chip and /or growth companies, its
investors can hope to earn a large consistent return, which makes it a winner in
the longer run. However diversification can only help to overcome unsystematic
risks [one or a few stocks turning out to be losers]. It cannot help much when
the capital market is characterized by systematic risks – economic downturns and
other forces that lead to decline in the market index as a whole. During the last
few years, this situation has led to Mutual Funds and ULIP s as well, losing some
of their popularity in the Indian market.
One of the variants of mutual funds, that have become quite popular, is the SIP
or Systematic Investment Plan. This type of plan has two great advantages.
Firstly, it enables the investor to build an asset portfolio through placing one’s
small savings in a regular and systematic way, to build a large portfolio over time.
The other great advantage comes from what has been termed as Rupee [or dollar]
Cost Averaging.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 19 9
Since the contributions are made after scheduled intervals [typically monthly]
rather than at one go, each contribution buys units of the fund at the price then
prevalent. If the market index goes down and fund values decline as a result, the
individual’s monthly contribution actually buys more units of the fund at the
lower price. Later as the fund value goes up, the units can be redeemed at a
much higher capital gain.
To Illustrate
Consider Mr. Thomas who makes a regular contribution of Rs 10000 every month
into an SIP. During August 2010, the value per unit of the fund was Rs 60 and
so his contribution was able to purchase 166.66 units. During September of the
same year, the value declined to Rs 48 per unit. His new contribution of Rs
10000 was now able to buy 208.33 units, with the result that he now had 375
units. Suppose now the value per unit was to rise to Rs 58 per unit. If he were
to sell his units at this value, he would get Rs 21750 – a clear gain of Rs 1750
[21750 – 20000].

Bonds: are debt instruments. They involve a contractual agreement by the

borrower to make interest and principal payments to the holder of the instrument
after a specified (maturity) date. Bonds thus represent a form of marketable debt
- they can be converted to cash either through redemption with the borrower on
maturity or by sale in the market. Such marketable debt instruments are also
called securities.
Generally the return on a bond is fixed and one can know what one is going to get
at the end of the period, with certainty. The major form of risk is default risk –
whether the borrower will pay the principal and interest in time. Generally bonds
are graded by rating agencies with respect to their default risk and ability to pay
their holders. A bond with an ‘AAA’ rating may thus be a welcome addition to a
portfolio of stable assets. The yields on a bond would normally depend on the
riskiness of the bond. A bond with Triple Rating would obviously have to give a
much higher rate of yield than a bond of low investment grade.
Let us now briefly look at the products of life insurance companies. We shall only
consider life insurance and pensions.
Life Insurance: as we have seen earlier, the fundamental distinguishing feature
of all insurance products including life and health insurance is the creation of an
immediate estate, which is achieved by paying a small amount of premium. The
rate of return available potentially through such an estate is enormous, and
unimaginable for any other kind of financial asset. The reason is simple. The
Mutuality or Pooling principle enables an individual to avail of the entire [insured]
community’s contributions, at his or her time of crucial need. It thus goes without
saying that there is no substitute to the Immediate Estate feature of life
insurance.
Both life and health insurance [including other covers like critical illness, accident
insurance, disability income insurance etc.] thus act as necessary and critical

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 20 0
components of an individual’s portfolio. They are the most effective way to meet
one’s precautionary needs and have peace of mind while planning for the future.
With respect to meeting other savings needs, the relevance of a life insurance
plan would depend on the kind of need being funded and the asset attributes one
prefers. Historically, the industry’s conventional With Profit plans served as a
means to build secure long term savings for one’s future. The smoothing out of
returns over time and gradually increasing bonuses, sought to be achieved
through the Uniform Reversionary Bonus Mechanism, made these products
valuable as vehicles for consistently saving to build a safe and sizeable nest egg
over a life time.
The product was especially useful for meeting needs that arise in middle and later
years of life – like funding of marriage and higher education of children or as an
addition to provident and other terminal benefits after retirement. Conventional
plans like Whole Life also serve as a powerful way to make a bequest. Is there a
more efficient way, for instance, to leave a legacy for one’s just born
granddaughter? Yet another role it plays is in preserving capital [built up over the
years] from getting eroded on account of huge costs entailed in treatment of
diseases during one’s twilight years.
For those who seek a rapid accumulation of wealth and are prepared to bear the
risk, investment linked insurance products have much to offer. They may be seen
as vehicles for building a large corpus, thus enhancing general net worth over the
years. As one’s wealth [net worth] increases for instance, one can think of earlier
retirement and have more time for leisure; one gets a greater sense of freedom;
one can plan better vacations and enjoy better quality of life, at least in economic
terms.
Annuities and Pensions: have yet to really take off in the Indian market, though
the foundations for their widespread growth and sale are being laid. These are
contracts between investors and an insurance company in which the company
promises to make periodic payments to the investor, starting immediately or at
some future time. If the payments are delayed so as to be made at a future date,
you have a deferred annuity. If the payments start immediately, you have an
immediate annuity. Annuities come in three types: fixed, variable and equity
indexed.
An annuity, it must be noted only implies a regular and periodic payment. All
pensions are annuities but all annuities are not necessarily pensions. To qualify
for being called a pension [which is an insurance product], an annuity must have
the characteristics of insurance - it must involve the element of risk pooling and
transfer of longevity risk to the insurer or pension provider. The central principle
of a pension annuity is that liquidation of a corpus results in payment of a defined
sum during the lifetime of the pensioner or annuitant. The pension ideally helps
to replace the gap in income one suffers after retirement and contributes to
peaceful enjoyment of one’s life savings in the twilight years.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 20 1
E. Financial Management in Financial Institutions and life insurance
We have already seen that financial institutions like banks and life insurers
operate in two different markets – the retail market where they collect funds,
and the loan or investment markets, where they disburse their funds. These
operations create a set of liabilities and assets for each kind of institution and
managing these assets and liabilities so as to ensure solvency and profitability is
a critical task of management of these institutions.
The central purpose of financial management is to maximise the value of an
enterprise. Financial managers seek to achieve this by taking measures to both
increase and speed up the cash flows of the enterprise and reduce their riskiness.
Their decisions for the purpose are made in three critical areas: How to raise
funds to finance the firm – the mix of debt and equity to be used and the specific
types of debt and equity securities to be issued for the purpose; Investment
decisions for allocation of funds – what goods and services to produce and how
they will be produced and delivered; and Dividend policy decisions – the
percentage of current earnings to pay out as dividends and what proportion to
retain and invest.
The financial management of a financial institution, like a bank or a life insurance
company, differs quite significantly from corporate financial management of
companies [manufacturing or service enterprises] that deal with real assets.
Financial institutions deal with financial rather than real assets. Since financial
assets are created via contracts that promise to pay in future, borrowing money
by creating claims against itself is thus the main business of a financial
institution. Here it differs markedly from a manufacturing firm [which borrows as
a means to an end]. Again, unlike a non-financial firm, a financial institution
deploys the major part of its funds to buy other financial assets – promises, which
others make to pay in future. For a manufacturing firm, such purchase is
secondary.
This also means that profits in a financial institutions are very different from
other manufacturing /service enterprises. Profits of financial firms arise when
expected benefits on its assets [its investments or loans] yield more cash inflow
than the outflows on its liabilities. A bank, for instance, makes its profits from
the spread between interest rate proceeds on its loans and advances [assets] and
the interest rate paid on its deposits [liabilities]. A financial institution would
typically seek to enhance this spread and also its stability over time. The achieved
through the discipline of Asset Liability Management.
Yet another crucial difference arises from the huge level of financial leverage in
financial institutions. In a typical manufacturing firm, the ratio of debt to equity
in its capital structure may be 40:60 or half. In case of a financial institution the
leverage may be as high as 90 % or even more. This is because raising debt
[creating claims against itself] is what a financial institution basically does. One
implication is that high financial leverage can magnifies the return on equity
[ROE] since stockholders own relatively smaller equity stakes, compared to the
debt of the institution. While they can earn high return, the risk to equity owners

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 20 2
is low since their losses are limited to the low equity stakes they hold. Owners
of financial institutions thus stand to gain a lot if the institutions invest in risky
projects and securities, which promise excessive profits. On the other hand the
customers who have purchased these claims [debt] are left holding the bag if the
institution reneges on its promises. Unlike in manufacturing, there are no real
assets like plant, machinery and inventory on which to lay a claim.
The state and the regulators have to hence step in to protect the interest of the
customers. The managers/executives of financial institutions are required to act
as agents to two principals. On the one hand, while pursuing policies and courses
of action that would make profits and maximise value for the owners [equity
holders], they also have an agent – principal relation with the government and
the respective regulatory authority. They have to comply with norms of asset
liability management set by the regulatory authorities. Banks in India are obliged
to comply with comply with the Reserve Bank of India’s requirements, just as life
insurers have to meet IRDAI’s norms and Mutual Funds must meet SEBI
requirements. In each case there is a clear fiduciary relationship that financial
institutions bear with their customers. The trust that the latter repose on the
institution, cannot be betrayed. Regulation and supervision set the boundary
limits and the criteria to be adopted in various aspects of financial decision
making – like nature and quantum of capital to be raised, capital allocation for
developing various products, pricing and revenue flow, market conduct,
prevention of fraud and misrepresentation in sale of products, expenses and
charges to be provided in pricing of financial products like life insurance, reserves
to be maintained, recognition of various asset and liability items, provision for
liquidity to meet claims, norms for investment of funds, solvency and capital
adequacy norms. In addition the regulator may institute measures to promote
social policies like welfare of the under privileged or capital to build social
infrastructure. Financial institutions have to comply with these requirements.
Coming to Life Insurers, they, like other financial institutions have an inordinately
high degree of financial leverage on the liability side of their balance sheets.
But unlike banks and other financial institutions, risk taking is not just an
incidental part of the business. Assumption of life contingent risks is the
business. In this regard life insurers differ from banks and other financial
institutions. In case of the latter there is little or no uncertainty about whether
and when a debt is to be redeemed. The risk is almost entirely on the asset side
– like fall in market value due to interest rate changes or risk of default on
payments leading to it becoming a non-performing asset. In the case of life
insurance the risk is both on the liability and the asset side. Not only has one
to face the prospect of non -performing assets/assets with declining market
values, but they also face uncertainty about whether and when the debt would
have to be redeemed, the claims being life contingent and not set at
predetermined dates. Again, the contracts of a life insurer being long term, the
liabilities have a long-term character. This makes them all the more uncertain.
Huge amount of capital is thus required for writing any kind of insurance business
– at the start up stage, first is an entry stake, a minimum investment that has to
be made for entering the business. Then there are the fixed costs of setting up
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 20 3
the business, appointing the principal officers and staff, setting up the
infrastructure, distribution networks etc. Capital is also needed to finance new
business strain – arising because sale pf every new policy results in initial
premium inflows being less than the outflows needed: (i) to meet the acquisition
costs [like commissions] which are in excess of the loadings in the first year
premium; and (ii) to meet the reserves, imposed by the regulator, to be
maintained for new policies – resulting in a negative cash flow. This new business
strain has to be met by capital supplied by the owners. Finally, capital is required
to meet solvency and capital adequacy requirements as determined by the
regulatory authorities. These may arise if real outcomes are adverse relative to
the assumptions that life insurers make about the future, when they design and
price their products. In such case the assets of the Insurer may fall short of that
required for meeting the liabilities, resulting these arise in possible insolvency.
Capital requirements may be determined by two approaches : the traditional or
deterministic approach typically prescribes a minimum absolute amount plus a
varying sum that is determined by applying fixed factors [as percentages] to
various items in the insurer’s balance sheet or financial statements [e.g. M % of
mathematical reserves + S % of net sum at risk + A % of assets of insurer]. The
other approach, adopted in the US and elsewhere, is known as the Risk Based
Capital Requirements approach. It seeks to specify capital needs with reference
to the risk profile of its business and the risk appetite of management.
The Society of Actuaries of USA for example had adopted a fourfold
classification of risk depending on its sources: (i) Asset Risk [C –1]: the risk of
assets losing value either because of borrowers of insurer’s funds defaulting on
their obligations to the company or due to a decline in the market value of an
insurer’s investments, other than that caused by interest rate movements; (ii)
Pricing Risk [C –2]: the risk that liabilities will increase in value because the
future operating outcomes turn out to be worse than those assumed when
making the pricing decisions; (iii) Interest Rate Risk [C –3]: the risk that the
value of assets and liabilities will be negatively affected by interest rate
movements in the market. In a rising interest rate environment the value of
both assets and liabilities will decrease. The risk is that the value of assets will
decline at a higher rate than that of liabilities. Similarly when the interest
rates fall, the value of both assets and liabilities will increase. The risk is that
the value of liabilities will increase to a higher extent than that of assets. In
both instances there could be a mismatch leading to insolvency; (iv)
Miscellaneous Risks [C –4]: these are risks associated with social, legal,
political, technological and other changes which are not included in the above
three categories. One may adopt other approaches to classify risks and may
come up with another set of categories.

Assumption of life contingent liability side risks is the core of life insurance
management. It constitutes the life insurer’s business and purpose of being. In
this sense they fundamentally differ from other financial institutions.
On the liability side a life insurer is required to manage a number of risks.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 20 4
Firstly the risk that can arise when the loss on account of the happening of the
contingency [the sum at risk] is in excess of the provision in the pool. This risk is
called Underwriting risk.
The second source of liability risk can come from increase in Costs of operations.
Since life insurance contracts are of long duration and involve a level premium,
the expenses of management have to be projected such that they can be
recouped from the expense loadings in the Gross premiums.
The third source of liability risk may come from surrenders and premature
withdrawals. This risk can arise in two ways: firstly the new business strain in
life insurance policies implies cash outflows that are more than inflows in earlier
years. A large number of policy lapses happen in the first year itself, leading to
a loss situation because the excess cash outflows in the new business stage cannot
be recouped from subsequent premiums. The second kind of risk can arise when
cash outflows by way of loans and surrenders occur in a period of rising market
interest rates. This phenomenon has been termed as dis-intermediation.
Policyholders withdraw from their cash value proceeds to invest the same in
higher yielding securities elsewhere. Since higher interest rates [discount rates]
lead to a fall in market value of the insurer’s existing investments in fixed return
instruments, the life insurer may be able to redeem its investments only by taking
a hit on the asset side of the balance sheet
Coming to the assets side, life insurers often state that their investment portfolios
do not stand on par with other financial institutions’ because of the contractual
and contingent nature of their liabilities. Utmost caution needs to be exercised
to guard against any investment outcome proving to be more adverse than
expected. They have focused on addressing two types of risk. The first was
Capital Value risk - the possibility that value of principal might decline and fall
below the value of expected liabilities. The second was Income risk - the
possibility that market interest rates would change, especially fall, so that funds
available in future (either premium receipts or investment securities that
matured) might have to be reinvested at lower rates.
In general, Portfolio management, which is the approach followed in capital
investments, does not shy away from risk. It seeks to actively manage risk through
diversification and other strategies. Life insurers on the other hand have been
governed by a philosophy of Risk Avoidance. Their asset management practices
have been governed in great measure by the concern to meet contractual
liabilities as they arose. This philosophy has been further reinforced by
regulation. It is one of the factors that impacts on the rate of return available in
traditional life insurance products. In case of investment linked insurance policies
like ULIPs, the considerations are different. In these policies, while the fund
maintained for meeting life contingent risk [mortality] has to be invested, based
on solid safety considerations, the investment component can be placed in
relatively more riskier assets, based on the principles of portfolio management.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 20 5
Chapter Summary
In this chapter we have seen how the life insurance products are considered as
financial products and where they stand with other types of financial instruments.
The chapter begins with a review of some of the key principles that govern the
working of the financial marketplace and the design of all financial products –
like time value of money; risk aversion; information asymmetry; financial market
efficiency and expectations.
Some of the principles in designing the attributes that go into the structure of a
financial product are Trade off of Returns, Risk involved and Liquidity. Higher the
rate of yield, higher would be the risk and lower the liquidity quotient.
Individual’s preferences vary with respect to the tradeoff they make between
yield, risk and liquidity. Individuals who are concerned about risk and prepared
to accept lower yield are known as risk averse individuals and individuals who are
willing to take high risk to earn high returns are said to have a yield preferring
disposition.
An individual preference for various assets depends on the purpose of savings and
investment. Mathematical principles are also applied in creating financial
products; however Individuals purchase those financial products which match
their preferences, which in turn are linked to the end purpose for which they are
buying.
Various Financial Products discussed from the perspective of comparison are
Money, Savings Bank deposits, fixed deposits, Government Small Savings, Equity
shares, Mutual Funds, Bonds, Life Insurance and Pensions.
The financial management of financial institutions are quite different from that
of other manufacturing and service firms, both with respect to the nature of their
liabilities and assets. Life insurance companies face quite a few distinct issues
with regard to their assets and liabilities side, stemming from the fact that risk
assumption is the main business of a life insurer.
Important Concepts Covered:
 Guiding Principles in the structure of any financial product
 Basic attributes of a financial product – Yield, Risk and Liquidity
 Bulls and Bears
 Term Structure of Interest Rates
 Junk Bond
 Default Risk
 Interest Rate Risk
 Reinvestment Risk
 Marketability Risk
 Different Financial Products

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 20 6
Self-Examination Questions
Question 1
Individuals who are optimistic about market trends and in a hurry to buy,
expecting prices to rise in future, are known as ---------------
A. Bears
B. Cats
C. Bulls
D. Dogs
E. None of above

Question 2
A Junk bond should yield ---------- than a bond with Triple A rating.
A. More
B. Less
C. 5 % more
D. 5 % less
E. Equal to 5%

Question 3
There is no substitute to the ------------------ feature of Life Insurance.
A. Deferred Estate
B. Immediate Estate
C. Pooling
D. Law of large number
E. Risk adjusted returns

Question 4
The relation between return and --------------- is represented by the concept of
“ Term Structure of Interest Rates”
A. Risk
B. Liquidity
C. Yield
D. Term to maturity
E. None of the above
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 20 7
Question 5
Portfolio Diversification is the dominant principle in which of the following?
A. Life Insurance
B. Equity Shares
C. Bonds
D. Money Market Fund
E. Mutual Fund

Answers to Self -Examination Ques tions:

Answer to SEQ 1
The c orrect option C.
Answer to SEQ 2
The c orrect option A.
Answer to SEQ 3
The c orrect option B .
Answer to SEQ 4
The c orrect option D.
Answer to SEQ 5
The c orrect option E.

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 20 8
 CHAPTER 8
LIFE INSURANCE PRODUCT DEVELOPMENT
Chapter Introduction:
In previous chapters we examined the concept of product and dealt with various
kinds of generic life insurance products. Every life insurance company may have
some or many of these products. The complete set of all products available with
a life insurer constitutes its product mix or total product portfolio. These may
be broadly divided into three broad classes – life, health and annuities. They offer
security with respect to the three broad kinds of life contingencies viz., mortality,
morbidity and longevity.
Each product itself is a bundle of attributes. It also includes various services and
relationship aspects. Some of them, like the literature provided to the policy
holder, are tangible. Others like the advice which the client receives, the
promptness and care in responding to any client service needs etc. are intangible.
In this chapter we will learn how the products are developed, what are the steps
involved in Product Development right from ideation to Marketing and the Product
Life Cycle.
Learning Outcomes: at the end of this chapter you will

A. Product Development
B. The Steps in Product Development
C. The Product life cycle
D. New Vistas

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 20 9
 A. Product Development
Concept and approaches to product development
Product development involves creation of a new product or modifying an already
existing one. There are various types of Innovation processes. Some of them
result in entirely new product offerings that have not been set out by any other
company. They may also be targeting needs that have not been addressed or
even discovered earlier. Companies who develop these products have the
potential to emerge as brand leaders but also face the risk of every pioneer,
namely that the innovation may be copied and near substitutes may soon arise.
Another kind of new product development that we have largely seen in India is
where products already existing elsewhere are introduced in the home market.
This is an instance of what is known as diffusion of innovations across national
borders and markets and is a source of new product development in case of many
products. For instance Unit linked insurance was a product that was imported
from the United Kingdom to dominate the product line of many Indian life
insurers.
Thirdly a life insurer may also modify an existing product and offer a new bundle
of protection and investment elements. For instance, allowing flexibility of
premium payments could be a modification of a traditional endowment product.
Other modifications could include new benefits like say protection against
diabetes related contingencies, covered through a special rider. Life insurers
may also add to the level of service features and information provided in the
product.
Every life insurance company may have some or many of these products. The
complete set of all products available with a life insurer constitutes its product
mix or total product portfolio. These may be broadly divided into three broad
classes – life, health and annuities. They offer security with respect to the three
broad kinds of life contingencies viz., mortality, morbidity and longevity. The
product mix in turn may be divided into different product lines. Each line
consists of a set of benefit offerings that are similar in character which are
similarly priced and also are distributed through the same or similar channels.
Examples of Product Lines are Term insurance, conventional endowment
products and Unit Linked Insurance

Finally, under each kind of product line one may have a variety of individual plans
of insurance, each representing different combinations of the same features,
which are part of each product line.
For instance a company may have different variants of Endowment, Whole Life,
Term, Immediate and Deferred annuities, Critical Disease plans and investment
linked products.
The width of the product portfolio is given by the number of product lines it
contains. Its depth on the other hand is given by the variety of product forms
that are represented in each product line.
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 B. The Steps in Product Development
Product development is a rigorous process requiring endeavour through a number
of stages. Though companies may have product managers who are responsible
for promoting and overseeing the various tasks involved in bringing a new product
to market, many of its critical activities and decisions would ideally be achieved
through constituting a cross functional team. Such a team may be drawn from
sales, actuarial, underwriting, legal department, claims administration,
investments and management information systems.
Steps in Product Development
Idea Generation
The first step in the process is the scouting for new product ideas. These ideas
can emerge both within and outside the company. The agents and field officers
who are in constant touch with customers would be a critical source since they
know from innumerable interactions, what the latter need and want. The back
office staff can also be an important source of information and ideas – especially
when they are placed in direct touch with customers within a branch office setup.
Yet another source is Market intelligence about competitors’ products. No
company can afford to not have its antennae wide open to capture information
and intelligence on what is happening in the market, what new innovations are
being introduced and how the customers are responding to these. Indeed, in case
of new products it is not always necessary that the earliest bird catches all the
worms. The best results are often an outcome, not of being first in the market,
but coming out a close second, with a much better version of the new product
than the first. Companies who choose to be followers are able to learn from the
mistakes of those who are first in the race and can often develop and position
new products much more efficiently and effectively.
Customer surveys and depth/ focus group interviews are also a source of new
product ideas. While surveys give us information about needs and preferences
drawn from a wide spectrum and large number of individuals, depth interviews
help to provide a deeper perspective and insight into what customers think and
what could drive their buying process. Focus group interviews involve a process
in which groups of individuals are collectively interviewed and the interaction
with and among the group helps to crystallise and draw lessons from the collective
impressions of then group.
Finally one may have specific marketing research projects addressing specific
problems and concerns facing customers. These may throw up unmet needs and
gaps in the customers’ experience which are then addressed through adding new
benefit and service features into the product.
In recent years, a major source of information on buyer habits and patterns of
behaviour is gathered through carefully tracking numerous transactions of
customers not only with respect to life insurance but a range of other products.
Such information can tell a lot about demographic and psychographic profiles of
customers and their drives. Life Insurance companies worldwide have sought to

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develop extensive data warehouses and mine the data to derive meaningful
insights on consumer behaviour, as a part of their CRM initiatives. New Product
innovation is one of the important outcomes of this process
What is important in these above processes is not just capturing what buyers say
but also what they do not say. It is not enough to just get information. One must
be able to use intuition and reflection to delve into the minds of customers and
identify possible needs gaps not yet addressed. Surveys of international product
trends would help to provide an international perspective to this process and
enable us to ask the right kind of questions for the purpose.
It is crucial that the life insurer develop an ongoing formal process, designed to
identify new or better ways to serve the market and add value to customers. New
Ideas will come up if they are considered important and if the company accords
product innovation pride of place in its hierarchy of values that are reinforced in
its governance process.
At this stage it is imperative that every idea should be encouraged however
outlandish it may seem.
Screening of Ideas
The next step is that of screening. Its purpose is to evaluate new product ideas
quickly and efficiently with minimum cost so as to determine which of the ideas
that have come up would merit further investigation. The purpose here is to
separate the grain from the chaff and weed out ideas that would not be worth
pursuing.
There are two types of errors that are possible at the stage of screening:
The first is that a good product idea may be rejected because it looks
impractical on the surface or it has come from a source that does not enjoy
sufficient patronage or for some other reason. Indeed, many companies that are
run on traditional hierarchical lines and governed by mental models that inhibit
the scope for organisational learning are not likely to encourage and consider
ideas that are revolutionary and transformative.
The second error is, pursuing a bad idea that may look deceptively great.
An ideal cross functional team would be one which is able to bring both objectivity
and openness to the table. It is not enough to look at just the skeleton and meat
of an idea. One may also need to explore deeper into its DNA [the underlying
principles]. It is always possible that an idea with suitable modifications can
come out a winner. At the same time, one needs doubting Toms and sceptical
team members who would prevent the team from rushing headlong into a new
product.
The best way to conduct successful screening is to adopt a rigorous process of
passing a new product idea through a series of tests of objective criteria. At this
stage the product is still at the concept stage and the purpose is to decide
whether it is worthwhile to proceed beyond the concept. Some of the questions
that may be asked to check out the idea are listed below:

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Is the product idea in line with overall objectives of the life insurer? Would it
contribute to its market image and corporate identity?
Are there a sufficiently large number of consumers in the market with a need that
can be uniquely met through the product? A large group is obviously needed to
sustain the product in the longer run. This would in fact determine the market
potential
What is its profit potential? This question can be answered through conducting a
preliminary profit test in which the likely net cash flows are estimated [expected
cash inflows from premiums and investment earnings less expected cash out flows
from mortality, expenses and other factors] over the tenure of the product and
one can ascertain the product’s profitability.
Could it be marketed by existing distribution channels or would it require
alternative systems. Can the premiums support a level of commission payment
which would motivate the sales force to sell the product?
What is the level of technology and systems support required to service the
product. An unbundled product like universal life for example would require a
different systems framework from that needed for conventional endowment.
Is it in conformance with the regulatory requirements?
Product concepts that have got the nod are ready for being considered further.
Comprehensive Business Analysis
The next task to be undertaken by the product development team is to prepare
a detailed blueprint that it needs to place before management for deciding
whether or not to go ahead with the product idea. This task involves repeating
some of the things done during the screening stage but now it has to be done in
much greater detail.
The product Development Team needs to prepare a comprehensive business
analysis after conducting research about the feasibility and market potential of
the proposed product.
The analysis would firstly involve scanning the market environment where the
product will be launched – estimating the size of the potential target market;
determining how the product would add value to some or many market segments;
how it is to be positioned; how it would contribute vis-à-vis other products in the
product mix; how it fits with the company’s agenda and image; what are the
competing substitutes that are available and how is the proposed product going
to be different. One also needs to look carefully at the regulatory and legal
aspects – does it meet with regulatory requirements and would it pass through
regulator’s scrutiny or face problems. Again there is the question of how
appealing the product is likely to be to the sales force. Many a life insurance
product has died a quiet death because the agents and other channels simply
refused to promote it.

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Secondly there are the design specifications of the product. This would include
setting out the objectives and setting up the basic premium – benefit structure,
including the actuarial assumptions. The team also needs to establish the related
financial, underwriting and legal considerations. These would serve as guidelines
to be followed during the technical design stage.
The team also needs to make a detailed feasibility report of the product’s
marketability and operational/financial viability. This implies making detailed
Forecasts about likely sales, premium incomes and expenses under different
scenarios including a test of its profit potential.
The final step is to develop a detailed marketing plan, which would outline how
the various activities in the marketing mix – like pricing, promotion and
distribution of the product will be undertaken.
Technical design
The technical design stage of the product begins after management has given the
go ahead. There are two aspects here. Firstly, the actuarial design aspect,
which calls for setting out the schedule of premiums and benefits. This calls for
making assumptions with regard to mortality and morbidity, interest, expenses
and persistency and setting out the premium rate, benefits and underwriting
requirements. Premiums and benefits also determine the assets and liabilities
with respect to the specific product. The second aspect is the legal design which
includes preparation of the policy document, including the various contract
provisions.
The schedule of commission and other compensations for distributors, the
hardware and software requirements, investment implications [which may be
different for Conventional and Unit linked insurance plans] are some other areas
that have to be considered in policy design.
Final Launch
Finally we have the actual launch. An important task at this stage is filing of the
policy with the regulator. Informing the regulator / Supervisory authority is a
requirement for product launch in many markets. The life insurer has to give
relevant details of the technical design of the product. This is a mandatory
requirement since the regulator is the watchdog of the customer and society, and
bears the onus responsibility towards ensuring that the premiums are adequate,
the product meets solvency standards and does not violate market conduct
norms.
While some markets require prior approval of the regulator for launching a
product, others are satisfied with a ‘file and use’ provision. In this kind of
framework, the insurer has to file the policy with the regulator but need not wait
for approval from the latter. If no objection has been received from the regulator
for a period, of say one month after filing, the insurer can go ahead with the
launch. It is deemed that the regulator has approved the product.

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In recent years, the Indian Regulator [IRDAI] has initiated the concept of
‘Regulatory Sandbox’. The system allows for live testing of new products and
services in a controlled regulatory environment. It acts as a safe place for trying
out innovations in a limited sense as the regulators may or may not permit certain
relaxations for the limited purpose of testing. The sandbox allows the players
[insurance companies and insure tech companies..] to conduct field tests and
collect evidence on the benefits and risks of new financial innovations while being
able to limit and contain any of their adverse risk consequences.
Test Marketing
Sometimes a life insurer may decide to conduct a preliminary launch on a much
smaller scale and test market the product before introducing it on a larger scale.
The purpose is to test the waters and have a measure of how the product is being
actually received and how it is likely to fare once it is subject to a full scale
launch. The advantage of having a test marketing done is that in the event of
the product proving to be a failure at this stage, it can be quickly removed, saving
the large costs that would be entailed in having a large scale launch.
The actual launch calls for a number of pre-launch activities like preparation of
publicity literature and training material; conducting orientation training of the
field force and office personnel about the new product. The purpose of these is
to both educate and create buy in for the new venture among those people [the
company’s sales and office personnel] who will ultimately decide its fate. The
systems and MIS also have to be set up.
The actual launch would normally be a public event normally conducted with
some fanfare. After the launch the product development team has to get down
to continuously monitoring and reviewing the feedback on progress.

C. The Product life cycle

“One of the important concepts in marketing literature is that of product life
cycle. It stipulates that every product, including life insurance, passes through
a lifecycle consisting of four stages, namely introduction, growth, maturity
and decline. New Product development takes place in the first stage. In many
cases the product is not a new idea but rather a variation of an old theme [like
endowment or unit linked].
Product life cycle stages
A lot of effort and money may need to be invested to build awareness among
customers and buy in among the intermediaries who would ultimately sell the
product. The greater of these challenges is to get the sales force excited
about the new product and its distinctiveness. As both research and
experience has revealed, a large number of new product launches fail. A
major cause is that what looks great among the corporate echelons is viewed
poorly in the field where it ultimately matters. Once the product has
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successfully crossed the introduction barriers and established its uniqueness
in the market, it may quickly get into the growth trajectory.
Soon enough its very success invites a number of ‘me too’ imitators or
modified versions that draw forth as competitors. The marketing team needs
to have a game plan to reach out to new customers or develop processes and
price / service attributes that may not be easily matched. The maturity stage
is reached when the product has already achieved high market penetration in
its target market. Competition then boils down to price and yield
considerations. As the product nears the end of its life cycle, the marketer
must be able to proactively act to either withdraw it altogether or come out
with a more relevant and current version” –
- “Managing L ife Insurance ” by Dr.
Shashidharan kutty

D. New Vistas
The previous paragraphs highlight the process of product development and the
product life cycle concept as it has been obtained and has been expected it in
the context of a life insurance company. The details of the practice of product
development may vary from company to company.
For instance, designing Stand-Alone products is only one approach to product
development. One could also adopt an alternative approach wherein products
are modular structures. A wide range of broad modules could be thus made
available in a menu and a customer could pick and choose a package most
appropriate to him or her.
This would be a significant milestone in the journey from “one market of a million
to a “million markets of one”. We are far from reaching such a milestone and
have not even begun to fully grasp the implications of customised products but
they may be the wave of the future.
Emerging Expectations
One of the critical factors that are sure to impact the prospects of life insurers in
the next two to three decades is the emergence of the Millennials [those born
after 1980] and Gen Z [born after 2000] generations, who are set to become the
dominant buyers of all products during the next two decades. A lot has been
written about these segments and we shall confine to a few points
BCG Study
The Boston Consulting Group, in an important study [2012], suggested that
millennial expectations are different from those of previous generations, and
companies will need to rethink their brands, business models, and marketing
accordingly. The survey was on the US market, but the findings would be
reflected in many other countries, including India. Some of their key findings are
given below:

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Millennials - some findings
Millennials tended to think of themselves more highly than other generations do
– and more likely to consider themselves hip, tech-savvy, innovative, and fun
while other generations tended to view them as lazy, young, spoiled, and
entitled.
Millennials did not use the internet more, they used it differently – both
millennials and non-millennials were found to spend roughly the same amount of
time online. But millennials viewed the Internet more as a platform for
contributing to the content and to broadcast their thoughts, they were more
likely to upload videos and images, and to have their own blog.
Millennials were found to be all about instant gratification. They wanted it ‘here
and now’, obviously valuing efficiency and speed as much, if not more than
service. They were found to be people in a hurry, and this factor has to be a
critical consideration when trying to connect with them.
Millennials wanted to make a difference: They were concerned about the planet,
and would support brands that they thought had similar causes, even acting as
advocates and encouraging others to join them. The study found that they were
much more receptive to cause marketing and more likely than non-Millennials to
purchase items associated with a particular cause. Millennials expected
companies to care about social issues and would reward those that partnered with
the right causes
They trusted their friends: the explosion of social media has made millennials
connecting with and valuing the opinions of their friends (offline or online), or
any peer who has a first-hand experience, much more than that of the ‘experts’
(whom they considered to be corporate mouthpieces). They avidly read reviews
before a purchase (often on their smart-phones) and were often swayed by
campaigns that “went viral.”
The desire for connection and shared experience was also found to extend offline.
Millennials were much more likely than non-Millennials to engage in group
activities—especially with people outside their immediate family. They dined,
shopped, and travelled with friends and co-workers, to whom they looked for
validation that they’ve made the right decisions.
The above study, along with other works, drives home a couple of core lessons
that innumerable companies from different industries have been forced to
recognise and respond to, if they needed to remain alive and relevant in the last
few years.
 The “Needs Economy,“ where goods and services were produced and sold
with a view to meet the needs of people, is on the way out, and getting
replaced by the “Experience Economy,” where people are no longer satisfied
by their ‘needs being met,’ but look at business enterprises and their
products in terms of the experience they provide. “Meeting a need” may
indeed be only a first step [necessary but grossly insufficient] in getting entry
into the mind of tomorrow’s customer.

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 The era of “Marketing to People,” where brands were sought to be promoted
and products distributed, through multiple channels, is giving way to
‘Marketing with People,” where the vital element is engagement. What this
means is that future generations are no longer willing to be passive
consumers, they demand to participate, co-create and to be partners with
the brands they associate with.
Technology
Meanwhile the onset of the information and communication technology revolution
has led to massive changes in the way companies connected with and understood
customers. Two major trends that have come to dominate marketing are
noteworthy here.
The first is the role of Analytics and Big Data: it may be defined as the process
of examination and study of large and varied data sets –popularly termed as big
data -- to uncover hidden patterns, unknown correlations, market trends,
customer preferences and various other kinds of useful information that can
enable organizations to make more-informed business decisions. The primary role
of Big data [analytics] in life insurance may be to understand and predict needs,
wants, situations and behaviour of multiple stakeholders - primarily, customers,
but may also include other internal and external constituents of the life insurance
ecosystem. The idea is to dig deep and unearth underlying drivers, looking at
both historical and real time data to discern past behaviour patterns, yearnings,
risks and future trends. It can also be used to detect and prevent frauds and cut
down on leakages... Its end outcomes may be in the form of actionable
intelligence which can be applied in marketing, pricing, operations [underwriting,
claims, risk management etc.] and finance… and some more.
Artificial Intelligence: Also known as machine intelligence, MI, it has been
defined [Wikipedia] as ‘intelligence demonstrated by machines, in contrast to the
natural intelligence (NI) displayed by humans and other animals’. Essentially, the
term involves a wide variety of areas where a machine replicates [or mimics] in
various degrees, the different types of cognitive functions that humans engage in
– like pattern recognition, learning, problem solving, reasoning, knowledge
representation, expert [decision making] systems, movement and manipulation
of objects etc. Coined by John McCarthy, an American computer scientist, in
1956, the discipline of AI has evolved considerably. Its scope may embrace simple
[weak AI] systems / machines that are designed and trained for particular tasks,
to more complex [strong AI] systems, with more generalized human cognitive
abilities, so that, when presented with an unfamiliar task, it has enough
intelligence to find a solution. Artificial intelligence, along with analytics, has
provided immense capacity to companies around the globe to create predictive
models of how people would think, behave and respond to various kinds of
interventions that may include a mix of product functionalities [what the product
does, services, relationships and active engagements with customers in multiple
areas.
The Platform: the world of 21st century business has been completely
revolutionised by the platform model, which has emerged as the wave of the
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future. The current business model of the life insurance industry, as for many
other industries, involves a linear chain of value creation and delivery: Customer
Value is assumed to be embedded in a contract which is created by the life
insurance company; then distributed or sold through a marketing channel [most
often a channel intermediary]; to a group of passive customers. The platform
represents a completely different model, where companies create a space
[platform] where individuals and organisations can come together and
collaborate, interact, innovate and create new forms of value, not otherwise
possible when they act/work alone. It is now common knowledge that the most
valuable firms in the planet [over one trillion dollars of market capitalisation] are
mostly platform companies, as are the most well-known unicorns. Products and
services that are household names today – like the personal computer and smart
phone, cloud computing and on line market places, social media and the world’s
largest library [Google] have all been set out by platform companies.
The above trends that have already begun to massively disrupt industries and
companies worldwide. How they are going to impact life insurance companies in
future still remains to be seen. We may summarise their significance in terms of
two very well-known equations that were set out by the late C.K Prahlad [Prahlad
and Krishnan 2008]. They have been called the two pillars of innovation in any
business today:
N =1[it implies that each customer, a single market] &
R = G[implying that Resources are global]
The first equation highlights the fundamental shift that has occurred in the course
of over a century - from creating products and services for meeting the needs of
undifferentiated customers in what was termed as ‘one market of a million;’ to
a new dynamic where the firm addresses a ‘million markets of one’ customer
each.
This is a world where ‘value is determined by one co-created experience at a
time’. Obviously the crafting of interventions that lead to personalized wow
experiences calls for immense dynamism and flexibility in company processes,
matched by strong analytics that would enable managements to uncover hidden
needs and opportunities for creating unique value offerings.
The second equation calls for accessing resources [the wherewithal] from an array
of suppliers, both local and global. The focus here is on securing access, not
ownership, to resources, and savings] placing them in the service of customers.
Perhaps the only way this could be achieved is through erecting and leveraging
the power of collaborative networks.
These emerging trends: [1] The rise of new generations, who demand and expect
far more than needs satisfaction – seeking out the creation of ‘Experiences’; and
[2] The possibilities created by the new technology and the advent of the platform
– portend a future in which Life Insurance may undergo a significant shift from
being a mere contract [offering functionalities like risk protection and savings]
to being a way of life.

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This would have immense implications for product development. A quote from
Steve Jobs may be relevant here
“Some people say, "Give the customers what they want." But that's not my
approach. Our job is to figure out what they're going to want before they do. I
think Henry Ford once said, "If I'd asked customers what they wanted, they would
have told me, 'A faster horse!'"
People don't know what they want until you show it to them. That's why I never
rely on market research. Our task is to read things that are not yet on the page.”
- Steve Jobs

Steve Job’s words perhaps rings loud and shrill. Given the framework within
which life insurance and many other industries operate today, it may be difficult
for a customer or other stakeholder to envisage a different set of outcomes or
expectations.
However, as author Herve Mathe [“Living Innovation: Competing in the twenty
first century access economy”, 2015] reminds us: “Technology and the Ubiquity
of social media enables us to deep dive into ‘user environments’.”
Mathe’s concept of ‘living innovation’ makes a case for immersing in the user’s
world and having deep empathy [not only walking in another’s shoe but firstly,
removing one’s own] with his/her situation.
Living innovation elaborates on a number of themes like “open innovation” –
inviting users and other actors in ecosystems to participate actively in the
creativity process; “Design Thinking” - getting close to users and empathising
with them, understanding their emotions and gleaning information for shaping
designs; and “Ethnography” – the observation of customers in their living
environments, making devices and solutions by studying what people actually do..
Secondly let us look at the concept of ‘product’. A relevant term to consider
here is that of ‘Servitization.’ Coined by Vandermerwe and Rada [‘Servitization
of Business: Adding Value by Adding Services’ - 1988] it describes a strategy by
modern corporations to offer fuller market packages or "bundles" of customer-
focused combinations of goods, services, support, self-service, and knowledge.
Clearly, ‘Customer value’ goes far beyond benefits and outcomes of products, as
defined in their traditional sense. It calls for inclusion of a much larger package
including functional features, service, relationships and mutual engagement.
Product development in life insurance is set to witness marked changes as the
trends of the future unfold.

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Chapter Summary
Product development is an integral part of an Insurance company. It is not only
starts or stops at creating a product. A lot of ground work is required even before
designing a product. This can be better understood as life cycle of products,
which stipulates that every product passes through a life cycle consisting of four
stages namely Introduction, growth, maturity and decline.
It first starts with creation of new product - companies who create and have the
potential to emerge as brand leaders also poise the risk of getting their innovation
copied (if it’s a success) in a very short span of time.
The first step in product development is Idea generation which can come from
many sources like agents, customers, field officers, market intelligence,
customer surveys, back office staff especially if they are in direct connect with
the customers. Customer Focus group interviews is yet another source as it gives
insight into what customers think and could drive their buying process and also
help us understand not only what buyers say but also what they do not say.
The next step is screening of ideas to evaluate new product ideas quickly and
efficiently with minimum cost. Next stage is Comprehensive business analysis
where the product development team will present its blue print to management.
The analysis is done based on the company’s agenda and image.
After the management has decided to go ahead with the idea then starts the
Technical design which has again 2 stages actuarial design and legal design
Final launch, where the product will be filed with the regulator and waiting for
its approval. The actual launch is a public event after which the product team
has to continuously monitor and review the feedback of the progress.
The actual practice of product development may be quite different and may vary
from company to company. This will be a significant milestone in the journey
from “one market of a million” to a “million markets of one” Though we are very
far from this milestone and have not begun to fully grasp the implications of
customised products but they may be the wave of the future.
Important Concepts Covered:
 Product development
 Market Intelligence
 Comprehensive business analysis
 Scanning the market environment
 Technical design – Actuarial design and legal design
 Final launch
 Test Marketing

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Self-Examination Questions
Question 1
Life, health and annuities offer security with respect to the 3 broad kinds
Of life contingencies viz:
A. Mortality, Morbidity and longevity respectively
B. Longevity, morbidity and mortality respectively
C. Morbidity and mortality only
D. None of the above
E. All of the above

Question 2
The purpose of screening of ideas
A. Is to pursue a bad idea that may look deceptively great
B. Is to understand the needs of the customer at this stage
C. Is to evaluate new product ideas quickly and efficiently with minimum cost
D. None of the above
E. All of the above

Question 3
Technical design has namely 2 aspects
A. Practical design and virtual design
B. Actuarial design and Legal design
C. Actuarial design and Product design
D. All of the above
E. None of the above

Question 4
There are 4 stages of the product life cycle in the order of
A. Introduction, growth, maturity and design
B. Product development, maturity, design and growth
C. Design, maturity, growth and product development
D. All of the above
E. None of the above

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 22 2
Question 5
Customer surveys and depth/focus group interviews are a part of
A. Idea generation
B. Market intelligence in the stage of Idea generation
C. Final launch
D. Test marketing
E. All of the above

Answers to Self-Examination Ques tions:

Answer to SEQ 1
The c orrect option A.
Answer to SEQ 2
The c orrect option C.
Answer to SEQ 3
The c orrect option B .
Answer to SEQ 4
The c orrect option A.
Answer to SEQ 5
The c orrect option B .

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 CHAPTER 9
TAKAFUL (ISLAMIC INSURANCE)
Chapter Introduction:
All human activities are subject to risk of loss from unforeseen events. To
alleviate this burden to individuals, what we now call insurance has existed since
at least 215BC. Takaful refers to insurance that is offered according to the tenets
of Islam as set out in the Quran. Takaful origins lies in the 6th century with tribal
practices on the Arabian Peninsula including arrangement by merchants of
Mekkah which formed funds called ‘hiff’ to assist victims of natural disasters, or
hazards of long trade journeys as well as placement of surety, called ‘daman
khatr al-tariq’ whereby traders who suffered losses during these journeys caused
by bandit, pirates or natural calamities could be compensated by more fortunate
traders.
Another common tribal practice called ‘aqila’ prevented revenge killings and
bloodshed by extending shared compensation to ransom captives or to settle a
claim from an accidental killing. Therefore, we can conclude that thousands of
years prior to the advent of modern day conventional insurance, Takaful mutual
assistance was common place among Arab tribes.
It resolves around the philosophy of mutual cooperation, where each policy holder
(or contributor) participates in each other’s loss and a Takaful operator facilitates
this, using its expertise. Takaful of course, is insurance like conventional one,
and yet it has distinct differences. It compensated financially for protection
against unforeseen risks just like conventional insurance. It is bound by and based
on same scientific rules and actuarial approaches to mortality rates, morbidity
rates, loss ratios, claims experience and discounted cash flows for calculating
price of risk and evaluation of liabilities. And yet it is different.
Takaful is like conventional mutual insurance as its policyholders conceptually
own the co-operative Takaful pool but Takaful has shareholders to support the
development and expansion plans which is different from mutual companies.
Islamic Insurance is also known differently in different regions. It is commonly
expressed as Takaful or Co-operative insurance. In Sudan the term Takaful is
used for Islamic “life’ insurance, whereas in the Middle East and Far East, Takaful
is a generic word for insurance. The terms General Takaful and Family Takaful
are used to express general insurance and life insurance respectively.
The key difference between Takaful and conventional insurance results in the
way the risk is assessed and handled, as well as how the Takaful fund is managed.
Further difference is also present in the relationship between the operator (under
conventional insurance using term: insurer) and the participants (insured or
assured). Takaful business is also different from the conventional insurance in
which the policyholders, rather than the shareholders, solely benefit from the
profits generated from Takaful and investment assets.

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Learning Outcomes: at the end of this chapter you will

A. Meaning & Concept of Takaful

B. Takaful Development & Markets
C. Life Insurance based Family Takaful Products

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A. Meaning & Concept of Takaful
Meaning of Takaful:
Takaful is an Arabic word means “Guaranteeing each other”. It is an Islamic
system of Insurance based on the principle of Taawun (Cooperation) and Tabaru
(gift, giveaway, and donation) where group voluntarily shares the risk
collectively. Takaful is an Islamic insurance model based on Shariah law (Islamic
law). It dates back more than 1400 years and taken from the Arabic word
‘Kafalah’ which means ‘mutual guarantee’.
Takaful is a pact among a group of members or participants who agree to
guarantee jointly among themselves against loss or damage to any of them as
defined to their risk-hedging needs. The goal of Takaful is community well-being
and self-sustaining operations-not high profits; a growing part of the insurance
that is increasing in geometric proportions in the Gulf and Fat East.
Definition: As per Takaful Act, 1984 (Malaysia) Takaful is- “a scheme based on
brotherhood, solidarity and mutual assistance which provide for mutual financial
assistance to the participants in case of need whereby the participants mutually
agree to contribute for that purpose”
Takaful Business is “business of Takaful whose aim and operations do not involve
any element which is not approved by the Shariah”.
According to Dr.Ajmal Bhatty,* President & CEO, Tokyo Marine Middle East, UAE,
& Actuary, the definition “Takaful is participatory from insurance based on risk
sharing by customers on co-operative principles instead of risk transfer to a third
party, the company. The customers participate in the technical and investment
surplus of insurance and reinsurance funds. The risk pool is managed by the
company and the company is run on a commercial basis with co-operate
responsibilities towards its stakeholders, i.e. Customers, employees and
shareholders. The business operations are strictly focused on aspects of social
goodness with all its monies and funds invested according to Shariah principles
for greater good of society and environment at large benefiting everyone
irrespective of religion”.
Concept of Takaful:
Takaful means shared responsibility of shared guarantee.
Participants mutually bear the risks themselves in the tabarru (gift, donation)
Takaful operator does not bear the risk.
From the economic point of view, it means
Participants are both the insurer as well as insured at the same time.
“Mutual guarantee” is provide by a group living the society against a defined risk
or catastrophe befalling one’s life, property or any form of valuable things. Hence
Takaful is better known as cooperative insurance.
*Dr.Ajmal Bhatty describes himself as ‘an actuary by profession’ and has been in
the Takaful industry for the last 15 years.

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B. Takaful Development & Markets
Takaful Development-A comparatively young industry
Most of the phenomenal growth, to date has, not surprisingly, taken place in
countries with large. Muslim populations, but that is beginning to change. The
world’s 1.5 billion Muslims obviously comprise a very substantial potential
market, but they also represent a younger and evermore affluent society. This
group is becoming increasingly mobile, so the Takaful concept is being exported
to other countries and its ethical concepts are finding support from a growing
number of non-Muslim customers.
There are currently more than 125 dedicated Takaful insures operating in
approximately 30 countries around the world and may of the larger conventional
insurers have added Takaful windows to their organizations.
Muslim Countries and Muslim world wide: Approx one and a half billion people:
Afghanistan, Albania, Algeria, Azerbaijan, Bahrain, Bangladesh, Burkina Faso,
Brunei, Chad, Comoros, Cote d’lvoire, Djibouti, Eritrea, Ethiopia, Egypt, Gambia,
Kazakhstan, Kyrgyzstan, Lebanon, Libya, Maldives, Malaysia, Mali, Mauritania,
Morocco, Niger, Nigeria, Oman, Pakistan, Palestine, Qatar, Saudi Arabia, Senegal,
Sierra Lone, Somalia, Sudan, Syria, Tajikistan, Turkey, Tunisia, Turkmenistan,
Uzbekistan, United Arab Emirates, Yemen.
Takaful company formations – a chronology
1979: Establishment of the first Takaful Company in Sudan
1996: 30 Companies offer Takaful Products
2002: 50 Takaful Companies and 4 Re-Takaful companies
2004: 80 Takaful Companies, 200 “Takaful Windows”
2006: Over 100 Takaful Players around the World
2008: Over 179 Takaful Players around the World.
Since, the Islamic Insurance Company of Sudan was established in 1979 as the
first formalized Takaful provider, soon followed by the countries in the GCC. To
date, around 200 providers, covering 32 countries from the Bahamas to Yemen,
offer Takaful service, free from the concepts of interest, uncertainty and
gambling.
The desire for Muslims and indeed an increasing number of non-Muslims, to
engage with financial products affording benefits is increasingly evident.
Commercially, world Takaful contributions are estimated to be on the rise in
uncertain terms. Dubai-based Salema, the largest Islamic Insurance operator for
the Takaful and re-Takaful in the world, expects substantial growth during the
next five years in the global market.

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The upsurge customer interest in a hitherto sparsely populated Takaful provider
market has created a rush of interest from the big international insurance players
such as Allianz, AIG, Prudential and Axa. There are registered Takaful companies
worldwide writing General Takaful (Commercial Property/liability) and Family
Takaful (Life Insurance) on a direct basis, mostly ASEAN countries and in the Gulf.
In addition, there are 179 more Takaful programmes either as Takaful ‘Windows’
or marketing agencies that place insurance risk with conventional insurers or
with Takaful operators. More Takaful companies are under formation in Sri
Lanka, Singapore, Bahrain, Kuwait, UAE and Egypt. The main spread of Islamic
Finance and Takaful has been in the Middle East and parts of Asia, Africa and
Europe.
Takaful grew at a compound annual growth rate of 39% over 2005-08 in terms of
global Takaful premiums, 45% in the GCC, and 28% in South East Asia. The
comparative growth of global insurance is 7%, for the GCC 20% and for SEA 23.5%.
The estimated size of the global Takaful premium was USD5.3bn in 2008 and
USD8.9bn in 2010. Takaful is still a small subject of the global insurance
premiums which stood at $4.2trillion in 2008, but it is growing fast. There were
some 179 Takaful companies and windows (20%) in 2008, and this number in 2010
could easily be in excess of 200.
Regions(Sept,20008) Takaful Companies & Windows

Middle East 69
Africa 27
Asia Pacific 56
The Rest 27
Total 179

The third edition of Ernst & Young’s World Takaful Report 2010: Managing
performance in a recovery, unveiled at the 5th Annual World Takaful Conference
of 2010, confirms that global Takaful industry is well on course to surpass US$8.8
billion in contributions in 2010. Contributions grew by 29% in 2008 to reach US$5.3
billion.
Selected Takaful Markets:
Sudan:
Sudan is the Takaful pioneer when it started Takaful in 1972. A supervisory law
was issued in 1992 requiring Shariah compliance for all companies; currently the
Insurance Act 2003 applies. Shariah compliance is supervised by the company’s
own Shariah Supervisory Board (HSSB). The HSSB is part of the Insurance
Supervisory Authority of Sudan (ISA) and has final authority in Takaful matters.
Sudan is the most significant market outside of the GCC and SE Asia, with
contributions totalling US$280 million in 2008.

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Malaysia:
The strategy adopted by Malaysia has been to develop a comprehensive Islamic
financial system that operates in parallel with the conventional system. It has
been a gradual and pragmatic evolution over time. Malaysia was the first country
to implement a regulation specific to Takaful (Takaful Act, 1984) and it required
that a Takaful operator has to operate as dedicated subsidiary. The regulator,
Bank Negara Malaysia (BNM), has fairly strict approach towards the legal set-up
of a Takaful as it does not allow window operations. In Malaysia, there are eight
licensed Takaful operations and an international Takaful operator. They are CIMB
Aviva Takaful Berhad, Etiga Takaful Berhad, Hong Leong Tokyo Marine Takaful
Berhad, HSBC Amanah Takaful (Malaysia) Sdn Bhd, MAA Takaful Berhad,
Prudential BSN Takaful Berhad, Syarikat Takaful Malaysia Berhad, Takaful Ikhlas
Sdn. Bhd and AIA Takaful International Bhd, according to the central bank. As at
Dec, 31, 2009, Malaysia's total Takaful fund assets amounted to 12.45 billion
ringgit (US$3.9 billion), up 17.8% from 10.57 billion ringgit in 2008. Net
contributions income from the Takaful sector was 3.52 billion ringgit, up 16.1%
from 3.03 billion ringgit the previous year, according to the central bank.
Lebauan
Lebauan is an island that is located approximately 8km off the coast of the state
of Sabah at the mouth of the Brunei Bay. It comprises of one main island and six
smaller ones, thus covering an area of 92 sq. km. Takaful is embedded within
the existing Offshore Insurance Act 1990 by setting out additional guidelines, such
as Guidelines of Takaful and International ReTakaful Business in IOFC. According
to , Lebauan Offshore Financial Services Authority (LOFSA) there are currently 14
Takaful insurers and reinsurers throughout the world, many of whom are members
of the Global Takaful Group (GTG), a Lebauan-based organization promoting
mutual co-operation among Takaful operators in Malaysia, Indonesia, Brunei,
Singapore and further afield. As of June 2009, the captive market in Lebauan had
a premium value of $100m spread across the oil and gas, shipping, property and
heavy equipment industries.
Pakistan
The Securities Exchange Commission of Pakistan (SECP) has drafted Takaful Rules
in 2005 that stipulate the set-up of dedicated companies, disallowing any kind of
Takaful window until 2010 to give full-fledged Takaful operators a head-start.
Composite companies are not allowed, in line with the regulation for conventional
insurance companies; proposed capital requirements are the same for both
Takaful and conventional companies. The Takaful fund has to operate on Waqf,
wakalah or mudarabah model but does not allow a sharing of the underwriting
surplus.
Bahrain
The Central Bank of Bahrain (CBB) assumed regulatory and supervisory
responsibilities for the supervision of insurance sector and capital market in 2006.
While the insurance sector overall grew by 6 percent, the seven Takaful
companies in the market say their gross contributions rose by 22 percent in 2007,
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totaling BD32.7m ($86.4m). The two re Takaful, or Shariah-compliant reinsurance
firms, posted an even better result, seeing their combined premiums increase
from BD15.9m ($42m) in 2008 to BD50.5m ($133.5m) last year, representing 217
percent growth.
Singapore
The Monetary Authority of Singapore (MAS) has opted to accommodate Takaful
within the existing supervisory framework for insurance companies, as many of
the supervisory processes and prudential measures are common to both
conventional and Islamic Insurance activities. Although sandwiched between the
two giant South East Asian economies of Malaysia and Indonesia, Singapore is
surprising in that it does not have a strong Takaful and re Takaful market. This is
even though the island, which is slightly bigger than Bahrain at 704 square
kilometers, has one of the highest insurance penetration rates in the region. One
of the reasons for the lack of penetration is due to the small number of Muslims
that reside in the multi-ethic and religious country compared to the likes of
Malaysia and Indonesia.
The majority of Singapore's Muslims are Malays and they amount to a little under
500,000, or roughly 13 per cent of the island's total population. There are
currently three companies providing Takaful cover in Singapore. Two of them,
HSBC Insurance and NTUC Income, provide family Takaful products based on the
investment-linked products (ILP) concept. These structures are similar to
conventional ILPs, in that some of their contributions are invested in Shariah
compliant funds worldwide.
Qatar
The Qatar Financial Centre Regulatory Authority (QFCRA) has amended the
Insurance Rulebook to set out Additional Requirements for Takaful Entities under
Chapter 6. It allows the operation Takaful windows, but requires separate books
of accounts to be kept. There is huge growth potential for Qatar’s Takaful market,
with its annual growth estimated at 25%, according to the Qatar University’s
Islamic jurisprudence scholar, Ali Mohayeddin al-Qaradaghi. Al Khaleej Insurance
& Reinsurance Company (Al Khaleej) has converted all its conventional insurance
and reinsurance business to Takaful operations, renaming itself Al Khaleej Takaful
Insurance & Reinsurance.
United Kingdom
The Financial Services Authority (FSA) has adopted a ‘no obstacles, but no special
favours’ approach in handling Takaful business and has only recently approved
the first license to a wholly Islamic General Takaful provider. Like other
regulators in pre-dominantly non-Muslim countries, the FSA will manage Takaful
operators within their current regulatory framework and develop it over time.
Saudi Arabia
The supervisory authority Saudi Arabian Monetary Agency (SAMA) requires that
insurers must operate on a cooperative basis; there is no detailed framework as
to how cooperative insurance is to be conducted. Rather, within the regulatory
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framework the only real restrictions on an insurer’s operations are the
requirement to maintain separate profit and loss accounts for participants.
Takaful premiums in Saudi Arabia totaled $1.7 billion in 2007, according to a
report by Ernst & Young published in 2009, or about half of global Takaful
premiums.
TAKAFUL DEVELOPMENT & MARKET UPDATES

Takaful insurance market: key indicators:

 A relatively new business, takaful insurance, which by the end of 2023

generated a turnover of almost 34 billion USD, offers promising growth
prospects.
 Significantly improved underwriting results, achieved through prudent risk
management, bear witness to the steady improvement in the performance of
this insurance business.
 According to the Islamic Development Bank Group, 77% of takaful operators
were profitable in 2022. Contributions or premiums collected have grown
steadily over the past ten years, mainly in the motor and family (life) lines.
 This growth is driven by:
 the solid financial performances achieved by the main market players,
 the increase in the number of players operating in the market, with the
number of takaful companies having risen from 274 in 2012, to 344 in 2022,
 transparency of operations and good communication of market data,
 a better legislative framework with the promulgation of a specific regulatory
framework in many countries,
 increased policyholder awareness of the need for life and health protection
to mitigate rising healthcare costs,
 improved compliance with capital requirements,
 the introduction of new takaful products to meet customer needs,
 consolidation of the takaful insurance market through mergers and
acquisitions particularly in Saudi Arabia and the United Arab Emirates,
 the development of 100% takaful markets such as Saudi Arabia,
 the increasing integration of technology into takaful services with a view to
improving accessibility and the customer experience,
 the rise of insurtech, which offers innovative digital solutions: mobile
applications and online platforms,
 the widening scope of Islamic insurance markets with the diversification of
products better suited to consumer needs: health, education and investment.

Growth in the number of takaful insurance companies

By 2022, the global market accounted for 344 companies dedicated exclusively to
Takaful and Retakaful.
These companies operate in over sixty-five countries, mainly in the MENA(Middle
East & North Africa) and South-East Asia zones. In 2012, the market counted just
274 operators of this type, that is an increase of 25% in a decade.
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 General - 126
 Composite - 117
 Family - 78
 Retakaful – 23
Takaful insurance market assets: 2012-2022
In Islamic finance, takaful insurance not only meets the expectations of
policyholders, but it is also attracting the interest of investors. Sustainable
development projects with social, ecological and ethical connotations are the
main focus of investments initiated by takaful insurers.
The total value of assets built up over the past decade has tripled, rising from 31
billion USD in 2012 to 90 billion USD in 2022, representing an average annual
growth of 12%. Projections point to 128 billion USD in assets generated by 2026.
Despite this growth, takaful assets account for only a tiny 2% of total Islamic
finance assets, which, according to the Islamic Finance Development Report 2023,
amounted to 4 500 billion USD in 2022.

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Takaful insurance market: country-based assets (2018-2022)
In descending order, the main takaful assets are to be found in the Iranian, Saudi
and Malaysian markets. In 2022, these three countries alone recorded total assets
under management of 74 billion USD, compared to 60 billion USD a year earlier
and 37 billion USD in 2018.
In billions USD

Country 2018 2019 2020 2021 2022

Iran 13 14 20 30 39
Saudi Arabia 15 17 17 18 22
Malaysia 9 10 12 12 13
United Arab Emirates 3 3 3 3 3
Indonesia 3 3 4 3 3
Turkey 1 1 2 2 2
Pakistan 0.5 0.5 1 1 4
Qatar 1 1 1 1 1
Bangladesh 1 1 1 1 0.5
Oman - - - 0.5 0.5
Source: Islamic Financial Services Industry, Stability Report 2023
Source:https://www.atlas -
mag.net /en/category/tags/focus/features - of-the-t akaful-
insurance- market

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Takaful and conventional insurance
Only three markets - Iran, Saudi Arabia and Sudan - fully comply with Islamic
insurance criteria. In many other markets, traditional insurance products rub
shoulders with Sharia-compliant products.
The market shares of takaful insurance range from 100% (Saudi Arabia, Iran,
Sudan) to 1% in Kenya and Nigeria, which have recently adopted the concept.

The takaful insurance market premium

Over the past 20 years, takaful premiums have gone sixteen-fold, rising from 2.1
billion USD in 2022 to 33.6 billion USD in 2023, the year when it accounted for a
12% increase in comparison with 2022.
According to the study "Takaful Market Report: Global Industry Trends, Share,
Size, Growth, Opportunities and Forecast 2024-2032", the size of the global
takaful market is poised to reach 74 billion USD in 2032, assuming an average
annual growth rate of 8.9%.

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Evolution of contributions: 2002-2023

In billions USD

2002 2008 2010 2011 2015 2017 2021 2022 2023 (1)

Takaful Premiums 2.1 5.3 8.9 11 17 20 25.8 30 33.6

(1) Arab Monetary Fund estimates for 2023

Takaful insurance market: turnover by region

 As mentioned in previous developments, the highest takaful premiums in
2022 are found in the Gulf markets, accounting for 55.6% of total business.
In fact, Saudi Arabia remains the growth driver for this industry in the Gulf.
 The MENA(Middle East & North Africa) zone (excluding GCC countries) and
South-East Asia generated premiums of 6 billion USD and 5.9 billion USD
respectively in the same year, each representing a market share of 20%.
 Takaful insurers based in sub-Saharan Africa, Europe and the Americas
account for just 4.4% of premium income in 2022.
 Over the 2021-2022 period, the takaful insurance market as a whole grew by
16.3%. At 33.3%, Africa has the highest growth rate, followed by the GCC zone
at 23.7%.

Premium breakdown by region: 2021-2022

In billions USD
2021-2022
Region 2021 2022
evolution
GCC 14.5 16.7 23.7%
MENA
(excluding 5.7 6 5.3%
GCC)
Southeast Asia 5.5 5.9 7.3%
Africa 0.6 0.8 33.3%
Others 0.5 0.6 20.0%
Total 25.8 30 16.3%

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Source : Islamic Financial Services Industry, Stability Report 2023

Takaful Insurance Market: turnover by country

The three leading takaful insurance markets - Saudi Arabia, Iran and Malaysia -
account for almost 80% of global premiums. Among the top three, Saudi Arabia
alone accounts for 47% of premiums in 2022.
2022 premium breakdown by country
In billions USD

2022 2021-2022
Country 2022 shares
contributions growth
Saudi Arabia 14.2 47.33% 26.90%
Iran 5.4 18.00% 6.00%
Malaysia 4.13 13.77% 9.10%
Turkey 0.647 2.16% 57.10%
Qatar 0.527 1.76% 72.50%
Sudan 0.488 1.63% 78.00%
Egypt 0.278 0.93% 118.10%
Pakistan 0.26 0.87% 9.40%
Jordan 0.116 0.39% 15.00%
Brunei 0.1145 0.38% 6.90%
Palestine 0.06 0.20% 45.00%
Tunisia 0.06 0.20% 12.00%
Bahrain 0.0231 0.08% -4.9%
Maldives 0.0118 0.04% 29.40%
Other
3.6846 12.28% -
countries
Total 30 100% 16.30%

Principles of Islamic Insurance:

According to Wikipedia, the principles of Takaful are as follows:
Policyholders cooperate among themselves for their common good
Every policyholder pays subscription to help those who need assistance

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Losses are divided and liabilities spread according to the community pooling
system
Uncertainty is eliminated with respect to subscription and compensation
No advantage can be derived at the cost of others
The main objective of Takaful is to diversify the risk among members. Takaful
can be visualized as a method of joint guarantee among participants against loss
and damage that may be inflicted upon any of them. Thus, Takaful is a system
based on solidarity, peace of mind and mutual protection which provides mutual
financial and other forms of aid to members (of the group) in case of specific
need, where by members mutually agree to contribute monies to supports this
common goal.
Takaful insurance complies with Islamic law, or Shariah, which derives primarily
from the Holy Quran and the saying and deeds of the Prophet Muhammad (PBUH),
but the conclusions of Muslim scholars are important secondary sources. An
Islamic insurance company will usually appoint a board of recognized scholars
who will monitor the company’s insurance products, investments and
management practices to ensure that they remain compliant with Shariah law.
The growth of Islamic finance has led to a shortage of qualified Shariah scholars
with relevant international experience. The key concept of Islamic law applied
to insurance are:
1. Riba- Payment of interest is forbidden, as money is a medium of exchange,
not a commodity.
2. Gharar-Uncertainty is forbidden in both contracts and transactions.
3. Maysir-Gambling is forbidden
4. Haram-Commodities such as alcohol and pork are forbidden, as are any
associated activities.
Riba i.e. Interest: Riba means an excess or increase. Technically an increase,
which in a loan transaction or in exchange of commodity accrues to the owner
(lender) without giving an equivalent counter value or recompense in return to
the other party. It covers interest both on commercial and consumer loans. In
conventional terms “interest” is the equivalent of Riba. Paying and/or receiving
interest is not permissible; Quran says that “God has permitted trade and
forbidden usury”. Conventional policies promising a contractually-guaranteed
payment, hence offends the riba prohibition. The element of interest in
insurance companies refers to the investment side (e.g. investments in fixed rate
assets like deposits or bonds) as well as to the liability side (e.g. interest on policy
loans). Islamic jurists believe that usury has been prohibited because it admits
the possibility of fraud in transactions.
Some scholars argued that the prohibition was mainly aimed at eliminating the
excesses and exploitation involved in consumption loans when given on interest
and that commercial institutions gave loans mostly for productive purposes, the
prohibition of riba need not cover bank loans. The advocates of these views
neglected the fact the Quran categorically declares any surplus (or excess) over
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 23 7
the principal to be riba and clearly mentioned that creditors are entitled only to
their principal amounts. It was also forgotten that Islam does not make
distinction between loans of consumption and production. Riba applies,
irrespective of the purpose for which loans have been raised.
A resolution was therefore adopted by the Islamic Fiqh Academy of the
Organization of the Islamic Conference at Jeddah and attended by the foremost
Islamic scholars from 45 countries. The resolution stated that bank interest came
under definition of riba and must be replaced in Muslim countries by Islamic
modes of finance.
In traditional life and general insurance, the element of riba is present, in life
insurance, because at the time of claim (death/maturity) the amount payable
under policy is much more than the amount received by way of premium. In
general Insurance and life insurance, the insurance funds are invested which are
interest based structures.
Gharar: Gharar means uncertainty, hazard, and chance of risk. Technical sale
of a thing which is not present at hand; or the sale of a thing whose consequence
or outcome is not known; or a sale involving risk or hazard which one does not
know whether it will come or not, such as fish in water or a bird in the air.
Gharar means that it is not acceptable in contract arrangements to make
payments conditional upon the outcome of a certain event. Instances can include
something like “selling the fish in the water” or “the fruits on the trees at the
beginning of the season”. It may result in the unjustifiable disadvantage/loss of
one party and equally undue enrichment of the other. Gharar is forbidden to
ensure full consent and satisfaction of the parties in a contractual agreement.
This can only be achieved through certainty, full knowledge, disclosure and
transparency. Islamic jurists believe that, when a claim is not made in an
insurance company, one party (insurer) may acquire all the profits (premium)
gained whereas the other party (insured) may not obtain any profit whatsoever.
Unjust because of the forfeiture of premium paid in case of lapse of insurance in
life insurance contract and to so call short period scale used in refund in premium
in general insurance. The prohibition of gharar would require all investment gains
and losses to eventually be apportioned in order to avoid excessive uncertainty
with respect to a return on the policyholder’s investment.
Maisir: Maisir means gambling, a prohibited activity, as it is a zero-sum game of
just transferring wealth not creating new wealth. E.g. term life: small
contributions –large benefit on death. Gambling is a form of Gharar (uncertainty)
and conventional insurance is regarded as a kind of gambling as the insured makes
a bet on the loss occurrence and the same applies for the insurer. It is also
regarded as acquiring wealth on luck or by chance and at the cost of the others.
The element of gambling is believed to be there in traditional insurance for the
following reasons:
In general insurance, if no claim, the policyholder losses the premium paid.
Besides the premium is very less compared to likely claims benefit. Due to this
there may be situations where the insurance company will become insolvent.

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In life insurance, upon happening of the event the insured (or beneficiaries) did
not know how this amount of sum assured was generated from a small premium
paid.
Elements of Takaful:
The Insured: The insured party (the contributor) be it a natural person or a legal
entity.
The Insurance Company: The party in charge of managing the operations of
insurance through remunerated proxy contract, in which the company signs
contract with insured persons on behalf of all the company signs contract with
insured persons on behalf of all the contributors in the mutual insurance on the
base of fixed remuneration proxy.
The Insured risk: It is the potential event in the future
The Insurance Premium: It is the amount donated in full or part by the Insured
according to the contracted rates and prices of insurance hazards which are fixed
by the company.
The Takaful Fund: It is the sum of the insurance operations premiums and the
contractual conventions managed by the company for fixed remuneration.
The Religious Control Body: It is the body responsible for conformity with Shariah
and correspondence of the documents, conventions and operations of the
company. It is considered as the body that ensures the rights and interests of
policyholders.
Takaful Contract: A Takaful contract should embody the following conditions.
a) Specialty Condition
b) Partnership Condition
c) Investment Condition
d) Management Condition
a) The Specialty Condition should confirm that the company functions
according to Islamic co-operative principles. According to Ministry of
Commerce, Islamabad, Pakistan, vide notification dated 03.09.2005, A Takaful
Company may underwrite any or all classes of Takaful business, approval shall
be obtained from the Commission as to the permissibility of underwriting that
class of Takaful business and the types of risks that may be permissible within
each class. The objective of this is to ensure that risks of non-permissible
classes of Takaful business, such as which may not be in accordance with the
principle of indemnification of losses or insurance business of non-permissible
terms, as identified by Shariah Board, may not be included in Takaful
Operations.
b) Partnership Condition should confer upon the participants the right to
participate in surplus profits. In case of deficit in Takaful Fund, the Takaful
operator shall undertake to give Qard-e-Hasna (interest free loan) to the
Takaful fund to make good of the deficit. The Qard-e-Hasna may be recovered
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 23 9
 from future surpluses without any excess on the actual amount given to the
Takaful fund.
c) The investment condition should stipulate that the insurance base funds
are invested through modes approved by regulator and follows identical
procedures for Shareholders fund. Family Takaful Fund (Life Insurance) and
General Takaful Fund (General Insurance), such as
Quoted listed shares and unit trust-only in shares approved by Regulator and
Shariah Committee.
For investments in high rise commercial buildings, tenants are screened to see if
they are Shariah compliant.
Deposits are made only Islamic banks, linked Islamic finance companies and
Islamic financial institutions;
Participating in syndicate financing such as project finance, car finance and
housing finance in proposals initiated by Shariah Committee.
Real Estates.
The following type of investment are haram (activities which are prohibited
according to Islamic Law) under Islamic finance: Products based on animal
testing, production of greenhouse gases, health and safety breaches, abuse of
human rights, ozone-depletion, nuclear power, pornography, pork, alcohol,
gambling and tobacco and interest bases finance etc. For example, HSBC Amnah,
a leading Islamic financial organization has financed their funds in aircraft in UAE,
earthquake free airport in Istanbul, Islamic home finance in the UK, supporting
Hamad Health City in Qatar, Islamic financial project to Harvard University, gas
carriers in Brunei etc.
d) The Management conditions is intended to give corporate objectives
include providing high quality service for both family Takaful and General
Takaful to the participants; attaining profitability sufficient to support the
growth of Takaful provider; continuously encouraging a dynamic management;
uplifting and developing a motivated work force with responsible work ethics;
and striving to protect the interests of participants and shareholders sources of
income and profits from the investment of its shareholders' fund and its share
of profits from management of both the Family Takaful business and General
Takaful business in accordance with the profit-sharing agreement Mudarabah.
The Board of Directors hold monthly scheduled meetings with additional meetings
convened as necessary. The BoD delegates certain responsibilities to five Board
Committee, namely Audit Committee, Nomination Committee, Remuneration
Committee, Risk Management and Compliance Committee; and Employees' share
option scheme (ESOS) Committee. The committees' memberships are based on
Directors' focus and experience as well as their ability to add value to committee.
Takaful Operation: In summary, Takaful Operations are based upon principles
of mutuality where by the participants (insured) makes a donation (tabarru) to a
Takaful fund. Unlike conventional insurance, which is based upon a bilateral
contract between the insurer and insured, Takaful arrangements are based on
IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 24 0
two unilateral contracts where by the participant gifts its contribution to the
Takaful fund and is gifted the amount of its claim in the event of loss.
The Takaful fund is managed by a Takaful operator on behalf of the participants.
However, unlike traditional insurance, the contributions (premiums) are
segregated from the assets of the Takaful operator and the collective participants
retain an ownership interest in the Takaful fund. The Takaful operator is
responsible for the day-to-day operations of Takaful fund, including underwriting,
investment and claims administration. This role is usually undertaken in
accordance with the principles of Al-Wakalah (agency) and/or Al-Mudarabah
(trust financing). The Takaful operator will receive a percentage of the
contributions and/or a percentage of the investment income/surplus by way of
payment its management of the Takaful fund.
It is apparent that a Takaful operation has to be in line with Shariah, in each and
every aspect. For instance, a Takaful also has to avoid interest bearing and
forbidden investments which basically mean that all investments have to be in
Islamic financial instruments. Another aspect is the high degree of disclosure and
transparency required under the Shariah. Hence, every Takaful operator has to
establish a Shariah Advisory Board of qualified Shariah scholars to ensure Shariah
compliancy of the operation at all times.
Takaful operational Models:
As matter of deep faith, Muslims believe that there is unity in diversity. As such,
Takaful models may be separated into three categories.
A. Non-Profit Model: This model includes social-governmental owned
enterprises and programmes operated on a non-profit basis (such as Al Shikhan
Takaful Company-Sudan) which utilize a contribution made of 100% Tabarru
(donation) from participants who willingly give to the less fortune members
of their community.
B. Al-Mudaraba Model : (Profit and loss sharing Model)
A form of business contract in which one party brings capital and the other,
personal effort. The proportionate share in profit is determined by mutual
agreement at the beginning. But the loss, if any, is borne only by the owner of
the capital, in which case the entrepreneur gets nothing for his labor.
Al-Mudaraba is a Model, where by cooperative risk-sharing occurs among
participants yet the Takaful operator shares also in any operating surpluses as a
reward for its careful underwriting on behalf of participants.
Al-Mudaraba essentially involves an investor providing cash to another person,
called Mudarib, who will invest that money in a commercial venture, with the
Mudarib managing that commercial venture. The deal is that if there are losses
in the venture, the investor has to bear the losses. If there are profits in the
venture, as expected, those profits are shared between the mudarib and the
investor as an agree rations ie. 50:50, 60:40 etc.

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C. Al-Wakala Model: (Agency-a fee driven model):
A contract of agency, in which one person appoints someone else to perform a
certain risk on his behalf usually against a certain fee.
Wakalah is an Islamic form of contract, in which an agent is authorized to act on
behalf of a principal and to carry out a predefined business against a fee. This
fee may be pre-agreed as an absolute figure or as a percentage of the turnover,
but usually not as a share of the profits of the venture.
Wakalah model comprising of cooperative risk of occurs among participants where
a Takaful operator earns a fee for services (as a wakeel of agent) and does not
participate or share in any underwriting results as these belong to participants as
surplus or deficit. Under the wakalah model, the operator may also charge a fund
management free and performance incentive fee.
Segregated Funds:
The split of the insurance business into administration/asset management and
risk-carrying function obliges the Takaful operator to maintain strictly segregated
funds. One fund is for the equity of the shareholders of the Takaful operator,
i.e. the shareholders' fund and the other for the contributions of the participants
(policyholders).
Shareholders' Fund
Participants Risk Fund: This fund divided into two categories.(1)Participants' Risk
Fund (PRF) and Participants' Investment Fund (PIA)
Participants' Risk Fund: (PRF)
It works on the basis of mutual help, where all participants sign a contract (aqad)
to participate and to fill their obligation in the form of contribution (tabarru) to
mutually help other participants who suffer a misfortune. The PRF may
sometimes also be referred to as simply Takaful fund. There can be more than
one risk fund, e.g. distinguished by line of business (individual life, group life,
investment linked, annuity etc.). For savings/investment type life Takaful
products there is a need for at least another additional fund.
Participants' Investment Fund (PIF):
The other part of the contribution is placed in funds which are mutual in nature
but is rather the sole and exclusive property of the individual who participates in
a life Takaful contract. The fund is also used for regular or single premium
contracts where the tabarru charges are “dripped” on a regular basis (e.g.
monthly or yearly) to form the PIA to the PRF. One might notice the similarities
to a unit-linked insurance construct.
Operating principles of a Takaful Company:
A Takaful company must have the following operating principles.
a) It must be operated according to Islamic co-operative principles.

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 b) Reinsurance commission may be paid to, or received from, only Islamic
Insurance and reinsurance companies.
c) The insurance company must maintain two funds:
participants/policyholders' fund and shareholders' fund.
The Policyholders' Fund:
a) The assets of the policyholders' fund consist of:
Insurance premiums received
Claims received from re-insurer
Such proportion of the investment profits attributable to policyholders as may be
allocated to them by the Board of Directors
Salvages and recoveries
b) All the claims payable to policyholders, reinsurance costs, technical reserves,
administrative expenses etc. excluding the expenses of the investment
department, shall be met out of the policyholders' fund.
c) The balance standing to the credit of the policyholders' fund at the end of the
year represents their surplus. The General Assembly may allocate the whole
or part of the surplus to the policyholders' special reserves. If a part remains,
the balance will be distributed among the policyholders.
d) When the policyholders' funds are insufficient to meet their expenses, the
deficit is fund from the Shareholders' fund.
e) The shareholders undertake to discharge all the contractual liabilities of the
policyholders’ fund, but this liability does not exceed their equity in the
company.
The Shareholders' Fund:
a) The assets of the shareholders' fund consist of:
Paid up capital and reserve attributable to shareholders.
Profit on the investment of capital and shareholders' reserves.
Such proportion of the investment profit generated by the investment of the
policyholders' fund& technical &other reserves as is attributable to them.
Miscellaneous receipts.
All the administrative expenses of the investment department are deducted from
the Shareholders' Fund.
The balance of the Shareholders' surplus, if any, is distributed among them.
Operating Principles in Takaful Pakistan:
Pakistan: Takaful Draft Rules 2005 at a glance
Country's Insurance Regulator: Securities and Exchange Commission of Pakistan
(SECP)
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Minimum Capital Requirements:
Family Takaful/reTakaful company:PKR 150 million
General Takaful/reTakaful company:PKR 80 million
General rules
Wakalah model adopted for risk management
Mudaraba adopted from the investment company
A Shariah Board to be established for each Takaful operator
Central Shariah Board setup at SECP level
Shariah audits to be carried out
ReTakaful
ReTakaful must be consistent with Takaful principles
The compulsory cession to the Pakistan Reinsurance Company (PRCL) by a Takaful
operator shall not be applicable. However, where a share is offered to a
conventional reinsurance company, in such a case it shall be necessary to first
offer this PRCL.
Agent training
Each Takaful operator shall include in its agent training course, a class room
course on Takaful concepts of minimum eight hours duration.
Every agent intending to sell Takaful business shall be required to attend such
course.
Rural Business
To ensure the steady growth of Takaful business in all parts of Pakistan, the
Takaful operator shall be encouraged to market Takaful products effectively in
rural areas.
Not allowed
SECP shall not grant permission to underwrite and to carry on the businesses both
of family Takaful and general Takaful conjointly.
Window products or Takaful operations by conventional insurers shall not be
permitted. However, SECP may allow window Takaful operations after at least 5
years of the start of Takaful operations in Pakistan.
Administration of a Takaful Company:
Administration is the part of the company where all matters have to do with
employees and business transactions, and other matters concerning a Takaful
company must be reported and recorded. The Administration Department is
known as the Human Resources Department where it classified into three specific
areas branch operation, general administration and personal training. Branch

IC -1 0 4 Pr od u ct s o f L ife I n su ran ce 24 4
operation highlights any matter of problems of a Takaful company's
branch/outlet.
All managers at every outlet must refer to headquarters about problems arising,
especially management problems, before making any changes or decisions.
General Administration acts as the main management office where all
information, problems and any matters do with business are discussed and kept.
For example, information is kept about participants' personal details etc.
A Takaful company needs good trust (amanah) and well-trained people as
operators who will manage entire funds paid in by participants. Therefore a
Takaful company has a special division called the personnel and training division,
which will provide, special training for a new operator to work effectively and
efficiently.
Marketing: A Takaful company needs a marketing department to plan and
promote all the products and services it provides. To make it more effective and
efficient, the marketing department is divided into two areas, using an agency to
help them promote their “product' and corporate marketing for the company
itself. Nowadays, the marketing department of a Takaful company promotes and
its products through Internet.
Product design:
Generally speaking the kinds of products offered under Takaful are comparable
to that of conventional insurers as the insurance needs of both Muslims and non-
Muslims in the same country are very similar. They are Similar but not the same,
as certain features cannot be provided under Takaful, such as policy loans or
guaranteed benefits. Due to the imminent uncertainty in the contract term,
whole life cover would also not be accepted under Shariah.
A Takaful operator will have to provide a similar product spectrum to
conventional insurance not only to with stand the competition from insurers but
also to attract non-Muslim customers in multi-racial countries. It is what he can
offer on top or finding a niche that will make the difference in the long run.
However, it is important to understand that Takaful does not need to be limited
to the Muslim community. The distinctive features of the Takaful product-such
as transparency over product profitability, an element of profit share, limitations
on acceptable investments] e.g. no alcohol, no gambling] -may be attractive to
the growing 'ethical investment' segment. Evidence from existing Takaful markets
support this. One Shariah-based investment-linked fund has been notably
successful even when marketed to an 85% non-Muslim population.
Similarly, in Malaysia, Takaful is popular amongst Muslims and non-Muslims. For
example, over one quarter of the policyholders in one of the Takaful operators in
Malaysia are non-Muslim. With five new Takaful licenses granted in the last six
months, there has been massive provider interest-and the current (10%) share of
the market taken by the Takaful product looks likely to rise shapely. Among the
new licensees were Prudential and HSBC from UK and Tokyo Marine from Japan.
They joined Fortis, whose joint venture with May Bank has been successfully
marketing Takaful products in Malaysia over the last five years.
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As far as the product development process is concerned, the operators strictly
comply with the following guidelines:
Any form of products may be allowed to be developed and marketed by the
operator provided that
Development and marketing mechanism that are adapted by the operators shall
not be contrary to the government policies of the country concerned; and
Product development mechanism, shall be in conformity with the Shariah
principles and be endorsed by the Shariah board of the concerned. Takaful
companies offer coverage for all classes of general insurance, namely, accident,
including personal accident, agricultural, aviation, burglary, cash, contractors all
risks, erection all risks, employees' liability, engineering fidelity guarantee, fire,
liability (both general/and product), livestock, oil, energy, marine (cargo and
hull) and motor.

C. Life Insurance based Family Takaful Products

Types of life Insurance products
1. Protection Takaful, similar to term assurance is available on individual and
group basis. Most of these products have the option to build a small fund available
at the expiry of the policy, unlike conventional term insurance. The policy offers
cost effective cover based on actuarial calculations, incorporating mortality
tables. The proceeds of the policy on death are paid according to Islamic
inheritance laws or in trust to a named beneficiary. These are various types of
protection benefits to suit participant needs. This may be just a provision for the
family to cover liability towards outstanding mortgage or to cover business
interests in a partnership or directorship etc.
2. Savings Takaful have two portions, protection and investment. The protection
part works on donation principles as in protection Takaful. The investment
portion works on a Mudaraba basis where the participant has full rights over this
part of the contribution after administrative expenses. This portion goes into
Savings Funds within participants' funds and is repaid with accrued profits in
proportion to size of the paid contributions for the policy. The policy is sold on
individual or group basis.
3. Education Takaful is similar to Savings Takaful in its structure, but specifically
builds a fund to pay for education fees for the child at target dates in future.
During the build-up period, family protection is provided to the insured parent or
guardian.
4. Medical Takaful, providing both inpatient and out-patient treatment is
available and operates more on general Takaful basis.
Additional benefits are available such as Accident Takaful, Disability Takaful,
contribution waiver and Critical illness Takaful.
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1: Pricing:
Mortality Rating: The actuary and pricing department is responsible to prepare
costing for new products by looking into Mortality and Morbidity rates as a
consideration. The mortality rate refers to the average number of people of
different ages, dying at a certain time and morbidity rate is constructed by
looking to the number of persons falling ill out of a certain given population set.
Such illness or disability may also be related to and on account of the rate of
accidents in a particular country. The morbidity rate is also used for measuring
the crucial illness and medical expenses. The mortality and morbidity rates
should come from the primary sources or originally result from the research which
done by the marketing department in Takaful itself.
In multi-racial countries it is important to separately analyze the expected
mortality of the target group of Muslims and not simply use the existing
conventional mortality table. Muslims may have both a different socio-economic
and genetic background with different mortality experience. For instance, a lot
of diabetes cases have been observed amongst the Muslim community within the
UK. On the other hand it should be considered that overall there positive factors,
e.g. the ban on alcohol. This might cause less motor/road accidents amongst the
younger Muslims that otherwise happen due to alcohol abuse.
The Time Value of Money: Like conventional insurance, Takaful also recognizes
time value of money in order to measure the expected return for the company.
However, the interest rate arising from time value of money is considered as
profit margin in Takaful practices, which is lawful in Islam.
Takaful Benefits: These benefits are paid from the defined funds under joint
indemnity borne by participants.
Expenses of Management:
According to the opinion of Islamic jurists, management expenses may be dealt
with in either of the following ways:
All administrative and management expenses attributable to participants' affairs
shall be debited to the participants' account directly. In practice the Takaful
operation may deduct 5% to 10% of premium for management fund purpose.
Taking the performance of Takaful Malaysia as an example, where participants
have been enjoying a rate of profit averaging at around 35%p.a. for the general
Takaful business, over the last five years, those participating in the scheme, who
have been sticking to Takaful in terms of their insurance needs, would fully
appreciate in the meaning of 'free cover'.
All administrative and management expenses of the company, including these
attributable to participants' affairs, shall be borne by the shareholders in
consideration of receiving a stipulated of the gross premiums by way a
management fee (wakalah fee).
Provision for Profits: Takaful contract specifies from the outset how the profits
from Takaful investments are to be shared between the operator and the
participants. This shall be in accordance with the principle of al-Mudaraba, and
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the share could in the ration of i.e. 5:5 or 6:4 or 7:3 etc. as agreed between the
participant and the operator in the contract regardless of the amount of
investment profit made during the year. Takaful policyholders, pay their
contribution (premium) on a fairly traditional actuarial calculation based on
exposure to pool of policyholders. However, the actual assessment of exposure
does not include a “profit” ingredient, concentrating rather on pure loss cost,
plus operating expenses to cover the cost of maintaining the organization.
Bonus: This will be given by the Takaful operator at the end of maturity.
Basically, this money belongs to Takaful operator. It indicates that the companies
show it appreciation towards customers.
The basic calculation in computing bonus:
Surplus-(General Expenses+ management cost)- Zakat=Net Profit.
Zakat is an obligation on Muslims to pay a prescribed percentage of their wealth
to specified categories in their society, when their wealth exceeds certain limit.
Claims under Family Takaful:
In the event that a participant dies before the maturity of his family Takaful plan;
the following benefits shall be paid to him:
The total amount of the Takaful instalments paid by the participant from the date
of inception of his Takaful plan to the due date of the instalment payment prior
to his death and his Takaful and his share of profits from the investment of the
instalments which have been credited into his participants' account;
The outstanding Takaful instalments which would have been paid by the deceased
participant should he survive. This outstanding amount is calculated from the
date of his death to the date of maturity of his Takaful plan which shall be paid
from the participants' special account as agreed upon by all the participants in
accordance with the Takaful contract.
If a participant survives until the date of maturity of his Takaful plan, the
following Takaful benefits shall be paid to him:
The total amount of Takaful instalments paid by the participant during the period
of his participation plus his share of profits from the investment of the Takaful
instalments credited into his participants' accounts.
The net surplus allocated to his participants' special account as shown in the last
valuation of the participants' special accounts.
In the event that a participant is compelled to surrender or withdraw from the
Takaful plan before the maturity of his Takaful plan, he shall be entitled to the
surrender benefits. The participant is entitled to receive the proportion of his
Takaful instalments that have been credited into the participant's account
including his share of investment profits. However, the amount that has been
relinquished as Tabarru will not be refunded to him.

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 The product scenario involved in pricing procedures - a case
Mr. Rahim wants to buy Insurance policy from authorized agencies. Initially,
he is 30 years old. He indulges in Family Takaful plan and the maturity period
is 30 years. In the contract stated that proportion between Al-Mudarabah fund
and Al-tabarru fund is 91.7:8.3 respectively. His policy amount is RM50000.
The issue raises: What is the monthly premium? How much amount allotted in
Tabarru and Mudarabah funds? At the end of 40 years death occurs what is
total amount payable?
Calculation:
Total fund: RM50000/25YX12Months=RM166.67 per months
Tabarru Fund: RM166.67X8.3%=RM15.00
Mudarabah Fund: RM166.67X91.7%=RM150.02
Rahim died in the age of 40 years, the total amount payable to beneficiary is:
Rahim already contributed the money in the first 10 years.
Mudarabah: RM166.67X10YX12Months=RM20000.4
If the profits in 10 years are RM 2500 and the contribution ratio is 60:40. The
participant will get 40% from the underwritten investment, which is RM1000.
Total fund: 166.67X20 remaining years=RM3333.4
Total amount of claim payable to the beneficiary is
RM20000.4+1000+3333.4=RM24333.8

Distribution of Profits:
Profit sharing under Takaful is simple as any surpluses at the end of the period
are shared between the participant and the Takaful Company. The operating
expenses of the company are paid from the total income of the Takaful, whereas
management and other expenses are paid from the share of the profit of the
Takaful Company. If the Takaful Company makes a loss, this is written off against
the general reserve of the company. If the general reserve is insufficient, the
loss is met by the shareholders general reserve, or from capital in the form of an
interest-free loan that will be recovered from future surpluses.
Takaful works on the basis of an agreement made by the participants of the
insurance scheme. Each agrees that he or she is one of the insured as well as
one of the insurers. Each pays a premium to the scheme which is then invested
by the scheme in an Islamic ally acceptable way. A Takaful company cannot for
example invest in companies that deal in interest, alcohol, gambling or
uncertainty. The profits made from the permitted investments are divided among
the participants in the scheme. However, the participants also agree to give up
a portion of their contributions in the event that a policyholder suffers financial
loss or a catastrophe befalls him.

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There are two models of Takaful that can be adopted, the Wakalah model and
the Mudarabah model. The Wakalah model works on the concept that the
operator of the company is paid a fee, which is deducted from the participant's
contribution. The Mudarabah model is where the operator is entitled to a fixed
percentage of any investment profits or surplus. In this model, management or
operating expenses cannot be charged to Takaful fund. Expenses are borne
entirely by the operator from the shareholder fund.
References:
Developing a Takaful Product in India by Frenz Tobias, Sridharan, Madhu&Iyer,
and Krishna on 10th Global conferences of Actuaries.
A scholarly background to Takaful by Dr.Muhammad Imran Usman.
The growing importance of Takaful insurance by Dr.Ajmal Bhatty.
ICMIF Articles & Islamic Actuarial Science by Dr.Mohd.Masum Billah.
Study course material of IIBI, London-Module IV-Islamic Insurance.
Islamic co-operative insurance-world Takaful conference, Dubai-2006 by
Dr.Ahmed M.Subagh.

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Chapter Summary
Takaful in its simplest term means Islamic Insurance. What is distinct about
Takaful is that it abides by the Islamic insurance model based on Shariah law
(Islamic law) and it is in accordance with the tenets of Islam.
Takaful is an Arabic word means “guaranteeing each other” It is based on the
principle of Taawun (cooperation) and Tabaru (gift, giveaway and donation)
where the group voluntarily shares the risk collectively. Takaful is a pact amongst
the group of members or participants to agree to guarantee jointly against the
loss of damage as defined to their risk hedging needs.
The goal of Takaful is community well-being and by this means the definition of
Takaful is “A scheme based on brotherhood, solidarity and mutual assistance
which provides for mutual financial assistance to the participants in case of
need whereby the participants mutually agree to contribute for that purpose”
It is currently a very young industry. The first Takaful Company was established
in Sudan in the year 1979 and by 2008 there were 179 Takaful players around the
world. As of today selected Takaful markets are in Sudan, Malaysia, Lebauan,
Pakistan, Behrain, Singapore, Qatar, UK and Saudi Arabia.
It is important that Takaful operation has to be in line with Shariah in each and
every aspect.
Takaful model may be separated into 3 categories
Non-profit model
Al-Mudaraba Model (profit and loss sharing model)
Al-Wakala Model (Agency – A fee driven model)
It is also important to understand that Takaful does not need to be limited to
Muslim community as its distinctive features may be attractive to the “growing
ethical” segment.
Important Concepts Covered:
 Takaful
 Principles of Islamic Insurance
 Elements of Takaful
 Takaful contract
 Takaful operational models
 Operating principles of a Takaful company
 Rural business
 Product design
 Family Takaful
 General Takaful

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Self-Examination Questions
Question 1
Establishment of first Takaful Company
A. 1979 in Sudan
B. 1979 in Pakistan
C. 1998 in Singapore
D. None of the above
E. All of the above

Question 2
_____ was the first company to implement the regulation specific to Takaful
(Takaful act 1984)
A. Singapore
B. Saudi Arabia
C. Malaysia
D. None of the above
E. All of the above

Question 3
A Takaful contract should embody the following conditions
A. Speciality condition
B. Partnership Condition
C. Investment condition
D. Management condition
E. All of the above

Question 4
PRF (Participants Risk Fund) works on the basis of
A. Mutual help
B. Self help
C. Community help
D. All of the above
E. None of the above

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Question 5
One of the operating principles of a Takaful company is
A. It must operate according to Islamic cooperative principles
B. Principle of law of Utmost good faith
C. Principle of Indemnity
D. None of the above
E. All of the above

Answers to Self -Examination Ques tions:

Answer to SEQ 1
The c orrect option A.
Answer to SEQ 2
The c orrect option C.
Answer to SEQ 3
The c orrect option E.
Answer to SEQ 4
The c orrect option A.
Answer to SEQ 5
The c orrect option A.

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Extra writings

Features of Financial Products

Financial products are categorized in terms of their type or underlying asset class,
volatility, risk and return. There are certain core principles which govern the
creation and transaction of financial products.
The first concept is generalized as time value of money. “Longer the time,
lesser the value”

Present value (PV) = Future Value (FV) X DF (Discount Factor)

Future value (FV) = Present value (PV) X CF (Compounding Factor)
DF = 1 / (1+R )t ( where t = time in years & R = Interest rate)
CF = (1+R )t

Compounding refers to the frequency with which interest is compounded and adds
to principal.
The second principle is about risk aversion and return. It reflects a home truth
that investors are by nature risk averse. They would rather have a safe rupee than
a risky one. This does not mean they will not take a risk. They will take a risk
only if expected to be rewarded for it. People have different degrees of risk
aversion. Higher the degree, greater the reward expected. There is a tradeoff
between return and risk of an asset. Yield of a plantation company would be much
greater than a bank precisely due to this reason.
Real products and financial products are as different as a biscuit from a bank.
They give an experience rather than a physical possession. They cannot be
separated from the provider since its selling is interactive and production and
consumption are simultaneous. The process by which value is determined is
powerful and related to well-being. One can make or lose money faster and in
much larger magnitude than anywhere else. Their inherent fragility and sensitive
nature makes them vulnerable to financial distress. This is why financial markets
are closely regulated and supervised

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