Finance Expansion

In an established company, the "free" reserves are also used to finance expansion. Life insurance companies need to expand (that is, to generate more new premium income each year than they lose through claims or surrenders on existing policies) for two reasons. First, if they sell no new policies then their investment policy will become increasingly restricted because of the need to match future liabilities with greater exactitude. Secondly, at any point in time a life insurance company has a large amount of relatively fixed expenses - rent, rates, equipment, salaries, administration - which are necessary to serve existing policyholders. It is virtually impossible to reduce these expenses in proportion to the number of policyholders diminishing through claims and surrenders, and so the ratio of expenses to income in a static company would rise and the benefits for policyholders would be reduced.

On the other hand, given these relatively fixed expenses, if the company can achieve a growth in income from the sale of new policies larger than any consequent increase in its expenses, then the ratio of expenses to premium income will fall (or at least remain static) and there will be more benefits to be shared among policyholders.

However, this incentive to expansion is checked by a number of other factors. The most important is "new business strain", that is the relationship between money flowing in, money flowing out and the setting up of appropriate actuarial liabilities.

The sale of new policies creates a substantial new business strain because the bulk of the commission paid on new policies has to be paid in the first year of the policy, and on many regular premium policies it is over 50% of the first year's premiums. Thus if a company in any year sells a number of new policies that is substantial in relation to the amount it has "on its websites", a large proportion of its total income will be flowing out in commissions, leaving little to allocate to meet the actuarial liabilities requirement. An established company can use its free reserves or shareholders' funds to fund this gap, but a new company may not be able to; it will have to rely mainly on its shareholders' funds (which may be limited) to finance such growth.

And if it expands too quickly it will use up all its shareholders' funds before the policies it has sold have started to contribute significantly to its free reserves, and could end up in a technically insolvent position.

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Policyholders Protection Act

Though the Act does provide a safety net for policyholders, nobody would want to insure with a company that failed, and, even with the Act's provisions, anyone who does so will suffer some loss he could have avoided with a safe and sound insurer.

A significant number of the managements of the established life offices indeed expressed the view when the Act was introduced that it was undesirable because it reduced the incentive for the individual to choose his insurer with care and because it might encourage irresponsible management of smaller companies. However, thanks to increasingly strict... see: Policyholders Protection Act

Of interest