Capitalisation factors for group life insurance explained
Chris Morgan has 12 years working in the group protection industry so knows a thing or two about group insurance. Here he explains what capitalisation factors are, how they’re used and the AIG way.
Author: Chris Morgan, Head of Group Distribution, Group Protection.
What are capitalisation factors?
A calculation used by insurance companies to work out how much money to set aside to pay a death in service pension for the lifetime of the beneficiary. This amount is known as the reserve and is a multiple of the pension insured. The multiple used is called the capitalisation factor.
How is a capitalisation factor calculated?
Capitalisation factors are calculated by actuaries. They take into account three things:
- The expected length of payment of the pension
- The escalation rate (an increase in the pension in line with agreed factors, such as inflation) specified when the policy was set up
- Long-term interest rates.
As capitalisation factors depend on the length of payment of the pension, they will vary by age and sex. For ease, insurers will usually select one capitalisation factor per escalation rate across the whole group life policy.
As an example...
a quote has been completed and the capitalisation factor is 30. An employee’s death in service pension is 25% of their £20,000 salary.
The calculation the insurer would make to estimate how much they need to reserve is:
£5,000 (25% of salary) x 30 = £150,000.
Long term interest rates change over time, so it’s expected that capitalisation factors will also vary. Generally, when interest rates go down, insurers have to increase their reserves. That’s because with a lower interest rate, an insurer’s reserves take longer to accumulate interest. So lower interest rates generally mean higher capitalisation factors.
Since the financial crisis in 2008, long-term interest rates have reduced and have stayed low. As a result, there have been increases in capitalisation factors set by insurers in the group protection market.
AIG’s approach to capitalisation factors
Capitalisation factors will vary depending on the insurer. Here at AIG, we use two sets of capitalisation factors:
- One to calculate the capitalised benefit for event limit purposes and
- One to calculate the capitalised benefit for individual assessment purposes.
The event limit capitalisation factor will be the higher factor of the two and is the one that reflects the ‘true cost’ of the pension and we need this to understand our liabilities properly. However, if we used the event limit capitalisation factor to calculate if a member’s benefit exceeds the automatic acceptance limit (AAL), it would result in us individually assessing a relatively large number of employees.
Group protection insurers are keen to reduce the number of employees who need individual assessment, as this can be expensive and time consuming, so we use individual assessment capitalisation factors (which are lower than the event limit capitalisation factors) for this calculation. For individual assessment, the purpose of having a capitalised benefit is to see which cover exceeds the AAL. This helps us to identify employees with high benefits, or disproportionately high benefits, in comparison to other members in the policy, otherwise known as peak risks.
Insurers use the capitalised value of the pension to calculate a benefit. The capitalised value of the pension is the sum of the pension insured multiplied by the capitalisation factor.
By doing this, we can see if a member is over the AAL – the AAL is expressed as a benefit figure (and not a pension figure). For a death in service pension policy, the calculation to identify if a member’s total benefit exceeds the AAL is: salary x benefit basis x capitalisation factor.
The higher the escalation, and therefore the capitalisation factor, the more likely the benefit is to exceed the AAL.
Say the selected basis was 50% of salary and an employee had a salary of £50,000. The DISP benefit would be £25,000. If the escalation rate was 3% we would use a capitalisation factor of 30, but if the escalation was 5% we would use a capitalisation factor of 46.
The total benefit, if the escalation is 3%, would be £25,000 x 30 = £750,000
The total benefit, if the escalation is 5%, would be £25,000 x 46 = £1,150,000
So if the AAL is £1,000,000 there would be no need for individual assessment if the escalation is 3%, however if the escalation is 5% then £150,000 would need to be individually assessed.
Get in touch
If you’d like to talk to one of our team get in touch with us today by emailing email@example.com or calling us on 020 3003 6262. Or visit our website to find out more about our group life product.