By Jay Vadiveloo
Conservation or policy retention is not a new idea for life insurers. However, it has always taken a distant second place to the sales process as seen from the very design and structure of life insurance product development:
- The commission structure favors first-year sales with significantly lower commissions for renewal business.
- Rewards and recognition are generally awarded to agents with the highest level of sales, with no such corresponding attention given for agents who have the lowest rates of lapses for their inforce block of business.
- Life insurance management generally publicizes quarterly sales figures and whether the company exceeds goals, seldom announcing policy persistency figures and whether they are in line with persistency goals—which may not be established in the first place.
While lack of attention to conservation has been embedded in the organizational structure and culture of many life insurers, it is in my opinion an economically unsound strategy because for any established life insurance company, I believe its true economic value lies in the value of its inforce block and not new business. The nature of life insurance pricing is such that upon the sale of an insurance policy, the company loses money, ranging from 1.5 to 2 times the premiums received due to high acquisition costs. In renewal years however, the insurance company starts to make money because renewal and maintenance costs are low relative to renewal premiums and generally the longer a policy stays on the books, the more profitable it is for an insurer.
Despite this economic mismatch between the first year and renewal years, insurance companies continue to downplay the emphasis on conservation relative to new sales. There are some reasons for this:
- The agent and commission-based distribution system that insurers employ does not easily permit the leveling of commissions because agents want to maximize commissions up front.
- While sales are easily measurable in terms of first-year premiums or first-year commissions, it is not the case for measuring gain from conservation. In fact, from a statutory accounting perspective, the year a lapse occurs generates a statutory gain for a company because the reserves released from surrender or lapse are larger than the surrender benefit.
- Besides the problem of measurability, the gain from conservation is a long-term financial gain and company management is generally more sensitive to short-term gains and losses.
- Even if gain from conservation can be measured and quantified, it is not obvious what actions are needed to prevent a policy from lapsing. In addition, it is not clear how to identify policies that show a greater risk of lapsing compared to others.
Impact of COVID-19 Pandemic on Conservation Strategies
One of the key outcomes of COVID-19 is that any industry that relies on direct, personal contact to sell products and services has been massively affected. Life insurance is no exception. Since the lockdown started, there have been many posts on professional social networks from life insurers saying as much.
The immediate impact of COVID-19 on the insurance industry would seem likely to be a drop in new sales. This is to be anticipated by all businesses in general because of the loss in consumer purchasing power and lower consumer confidence resulting from high levels of unemployment. Unlike other industries, the loss in sales has less of a financial impact on life insurance because of the embedded economic value of the inforce block. It is therefore imperative, in my view, under these difficult financial circumstances that life insurers focus their attention and resources on conserving their inforce block of business using proactive customer retention strategies so as to not erode their embedded economic value.
Quantifying the Gain From Conservation
The gain from conservation is a relative measure that compares the economic gain of a policy with a 0% lapse rate and the same policy with its current lapse rate. It is given by the formula:
Economic gain from conservation = economic gain under a 0% lapse rate – economic gain from current lapse rate
For a policy at a given duration and underlying lapse rate, economic gain is defined as:
Accumulated value of past premiums – accumulated value of acquisition costs + actuarial present value of future premiums – actuarial present value of future death benefits – actuarial present value of future surrender benefits
The following should be noted about the definition of economic gain:
- It can be calculated on a policy-by-policy basis;
- It varies by duration, policy face amount, and policyholder characteristics like gender, underwriting class, etc.;
- Past premiums and acquisition costs are accumulated by interest only, while future premiums and benefits are discounted by interest and survivorship;
- The economic gain from conservation captures the increase in economic gain realized by eliminating the risk of lapse; and
- For an inforce block of policies, the total economic gain from conservation is simply the sum of all positive individual economic gains from conservation.
How Much Is a Retention Strategy Worth to a Company?
I have reviewed the work that a team of students at the Goldenson Center at the University of Connecticut did to estimate the gain from conservation at varying durations for a whole life insurance policy of $100,000 issued to a 45-year-old non-smoker. Assuming an underlying 10% lapse rate and reasonable assumptions on mortality and pricing, for an inforce of 100,000 such policies equally distributed over the first 5 durations, the total gain estimated from conservation is in excess of $300 million.Some comments about this result.
- The magnitude of this amount was certainly an eye-opener. The cost of any reasonable conservative strategy that a life insurer may choose to implement will only be a small fraction of this potential gain.
- While the modeling results apply to a whole life insurance policy, it should be applicable to other lifetime insurance coverages like Universal Life and Variable Universal Life.
- The results are linear by face amounts, so for an average face amount of $200,000, the potential total gain from conservation for an inforce of 100,000 policies would be in excess of $600 million.
- The gain from conservation is very impacted by plan of insurance, policyholder characteristics, and duration:
- Whole life insurance shows the highest gain from conservation across all durations.
- Longer-term insurance coverages show larger gains from conservation compared to shorter-term coverages.
- Gains from conservation decreases by duration, with new issues showing the highest gain.
- Beyond a certain duration, which varies by plan of insurance and other policyholder characteristics, no gain from conservation may be realized.
How to Implement a Conservation Strategy
For a given policy inforce, the gain from conservation can be calculated on a policy-by-policy basis and ranked from highest to lowest gain. This will allow an insurer to target the economically most viable policies in which to implement a conservation strategy. It will also allow an insurer to eliminate a subset of the inforce (e.g., late-duration policies, policies with small face amounts) from their conservation strategy because there is little economic gain to be realized.
In any major implementation of a conservation strategy, I believe it is important to ensure the following:
- The inforce economic gain model should be run regularly, preferably every quarter, to recognize the influx of new sales and changes in policyholder characteristics.
- A tracking and monitoring system should be developed at the same time to ensure that the conservation strategy is effectively implemented and meeting expectations.
Using Artificial Intelligence Techniques in a Conservation Strategy
There are also developing technology companies that use machine learning to predict the risk of a policy lapsing based on behavior and other characteristics of individual policyholders that may be useful to some insurance companies.
In the era of the COVID-19 pandemic, a conservation or retention strategy is perhaps the only viable and economically sound option for a life insurer to offset the anticipated drop in new life insurance sales. Given the magnitude of the potential economic gain of a conservation strategy, this is always a viable option, even in the absence of a pandemic crisis. It is also an option that is unique to life insurers versus other industries because of the significant embedded economic value in an insurer’s inforce.
While the need for implementing a conservation strategy is self-evident, this article outlines what I think is an actuarially sound and systematic approach to doing it. By incorporating machine learning techniques to assess the risk of lapses for policies, the insurer can maximize the gain from conservation by targeting policies that have both high economic gain and a high risk of lapsing as well.
JAY VADIVELOO, MAAA, FSA, is the director of the Goldenson Center for Actuarial Research at the University of Connecticut.