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'll vary by age and sex. For ease, insurers will usually select one capitalisation factor per escalation rate across the whole group life policy.

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, 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'd 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.

Individual assessment

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.  In this example we're going to say that the capitalisation factor for 3% escalation is 30 and for 5% it's 50. 

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 50 = £1,250,000

So if the AAL is £1,000,000 there'd be no need for individual assessment if the escalation is 3%, however if the escalation is 5% then £250,000 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 groupquotes@aiglife.co.uk or calling us on 020 3003 6262. Or visit our website to find out more about our group life product.

 

Examples used in this blog are for illustrative purposes only.