What are capitalisation factors and how are they calculated?
Sometimes tricky to understand, we explain how we use capitalisation factors for death in service pensions.
A death in service pension is an annual pension which is paid to the dependent of a deceased employee. The insurance company needs to calculate how much money it needs to set aside to pay the pension for the lifetime of the dependent. This is known as the reserve and is usually a multiple of the pension insured. The multiple used is called the capitalisation factor.
Capitalisation factors are calculated by actuaries and take into account the expected length of payment of the pension, the escalation rate specified when the policy was set up and long-term interest rates.
As capitalisation factors are dependent on the length of payment of the pension to the dependent, the capitalisation factors calculated by the actuaries will vary by age and gender. For ease, insurers will usually select one capitalisation factor per escalation rate across the whole policy, meaning it won’t be calculated on an individual basis.
This calculation also helps insurers to determine their exposure for event limit [link to event limits article] purposes.
As an example, a quote has been completed and the capitalisation factor is 30 (calculated using the data given). An employee’s death in service pension is 25% of their £20,000 salary. The calculation the insurer would make to work out how much they need to reserve is:
£5,000 (25% of salary) x 30 = £150,000.
The higher the escalation rate and/or the lower the long term interest rate (meaning an insurer’s reserves take longer to accumulate interest), the higher the capitalisation factor will be.
Long term interest rates change over time. Therefore it is expected that capitalisation factors will also vary. Generally, when interest rates go down insurers have to increase their reserves and as explained above, this results in higher capitalisation factors. Since the financial crisis in 2008, long-term interest rates reduced and have stayed low. As a result, there have been increases in capitalisation factors set by insurers in the group risk market, which in turn increases the sums assured.
Insurers also use the capitalised value of the pension (the sum of the pension insured multiplied by the capitalisation factor) to calculate a benefit in order to see if a member is over the automatic acceptance limit (AAL).
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.
Using the same example above, if the AAL was £500,000 the employee would be accepted without having to be individually assessed. However, if the AAL was £100,000 they would need to be individually assessed for the extra £50,000 benefit.
So the higher the capitalisation factor, the more likely the benefit is to exceed the AAL threshold. Group risk insurers are keen to reduce the amount of employees who need individual assessment, as this can be an expensive and time consuming activity. Therefore they try to keep capitalisation factors as low as possible, but have to balance this with the need to have capitalisation factors that accurately reflect how much they need to reserve.
At AIG Life Group Protection
Capitalisation factors will vary depending on the insurer. Here at AIG Life Group Protection we use two sets of capitalisation factors:
- one to calculate the capitalised benefit for claim and event limit purposes and
- one to calculate the capitalised benefit for individual assessment purposes.
The claim/event limit capitalisation factor will be the higher factor of the two and is the one that reflects the “true cost” of the pension.
For individual assessment, the purpose of having a capitalised benefit is to see which cover exceeds the automatic acceptance limit (AAL). This would help to identify employees with high benefits or disproportionately high benefits in comparison to other members in the policy, otherwise known as peak risks.