Insurer’s Lapse Rate Assumption Debate: Which is the Right Choice?

A recent discussion in the insurance industry has garnered significant attention as some non-life insurance company is reportedly considering applying an exceptional model in its lapse rate assumption guidelines for no-surrender-value insurance. This move comes despite financial regulators recommending the "log-linear" method as the standard model, as the company seeks to reflect its unique circumstances by adopting an alternative approach, such as a "linear-log" or "log-log" model. The debate has expanded into a broader issue of balancing insurers' financial stability with regulatory compliance.

Regulatory Guidelines and Industry Choices

In the 4th Insurance Reform Meeting of 2024, financial authorities announced guidelines for lapse rate assumptions for no-surrender-value insurance. These measures aim to address the issue of some insurers inflating their financial statements by overly optimistic lapse rate assumptions. The regulators proposed the "log-linear model" as the principle method, which assumes a steep initial decline in lapse rates that eventually stabilizes. However, they also allowed exceptions for insurers to adopt "linear-log" or "log-log" models in consideration of their unique circumstances. These exceptional models assume a more gradual decline in lapse rates, reducing the increase in Best Estimate Liabilities (BEL) on financial statements and minimizing the decrease in future expected profits, such as the Contractual Service Margin (CSM).

Comparing Principle and Exceptional Models

Principle Model (Log-Linear)

The principle model, recommended by financial authorities, assumes a steep decline in lapse rates during the early stages of premium payments, followed by stabilization, forming an "L-shaped" curve. This approach ensures transparency and reliability by applying uniform standards across all insurers.

Advantages:

• Prevents the inflation of financial results through conservative lapse rate assumptions.

• Builds trust with financial regulators and investors.

• Enhances comparability across insurers through consistent application.

Limitations:

• Fails to fully reflect company-specific circumstances.

• Increases financial burden on insurers with a high proportion of no-surrender-value insurance policies.

Exceptional Models (Linear-Log or Log-Log)

Exceptional models consider the unique characteristics of individual insurers by assuming a more gradual decline in lapse rates. These models are evaluated as a more realistic approach as they reflect past contractual characteristics and customer behavior patterns.

Advantages:

• Reduces financial strain on insurers with a high proportion of no-surrender-value insurance.

• Better reflects historical contract characteristics and customer traits.

• Minimizes the impact of BEL and CSM reductions on financial statements.

Limitations:

• Risk of overly optimistic financial projections.

• Greater scrutiny and regulatory oversight, such as shareholder interviews and regular reporting requirements.

• Potential negative perception compared to peers adopting the principle model.

For insurers with a high proportion of no-surrender-value insurance, many past contracts are based on optimistic lapse rate assumptions. Applying the principle model could significantly strain financial statements due to the steep initial decline in lapse rates. Conversely, exceptional models offer an alternative that maintains financial stability by reflecting such specificities.

However, financial regulators have warned that adopting exceptional models will trigger stricter regulatory measures, such as mandatory shareholder interviews, focused inspections, and regular reporting requirements. These measures could result in additional audit costs and potentially erode trust among investors and the market.

Strategic Implications for the Insurance Industry

The choice between principle and exceptional models will serve as a pivotal case for determining the future direction of the entire insurance industry. While the principle model offers transparency and trust, it lacks the flexibility to accommodate company-specific conditions. In contrast, exceptional models may be better suited to certain situations but require cautious application due to their optimistic assumptions and associated regulatory risks.

One industry expert commented, “The final decision of the non-life insurer currently under discussion will hinge on a strategic balance between financial strategies and market credibility. This decision could shape the evolution of guidelines for no-surrender-value insurance lapse rate assumptions in the future. Allowing exceptional models as an option is desirable for fostering autonomy in insurance accounting, and if their validity is demonstrated through experience-to-actual variance analysis, this could serve as a significant milestone for the growth of the insurance industry.”

Seoul Tribune (c)

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