AN EXCESS SPREAD APPROACH TO NONPARTICIPATING INSURANCE PRODUCTS

In the past two decades many North American life insurance companies have sold primarily nonparticipating and investment-oriented products such as single-premium deferred annuities (SPDAs), universal life, single-pre- mium immediate annuities, single-premium whole life, flexible-premium annuities, guaranteed investment contracts, and pension plan termination annuity contracts. Actuaries have sought to measure the true economic prof- itability of these products by comparing the market value of the offsetting asset portfolios with the market value of the liabilities. The difficulty of this approach is identifying a cred~le market value of the liabilities. The excess spread approach introduced in this paper addresses this prob- lem by measuring expected profitability in terms of a spread between the earnings rate on the assets and the rate required to be earned on the assets to satisfy the liabilities. For many insurance products, an important part of the liability cost is the value of interest rate options embedded in the policies. The excess spread approach incorporates an option-pricing technique that is flexible enough to allow actuaries to study the effect of policyholder (and insurance company) behavior patterns in different interest rate environments. In addition to ongoing profitability analysis, the excess spread approach can be used in product pricing and design and in risk analysis. The SPDA is chosen to demonstrate the technique because it provides the best example of the flexibility of the technique and the importance of be- havior modeling. The SPDA involves an option of the policyholder--the surrender option--and an option of the insurance company--the ability to reset credited rates.