Some life insurance policies do not just protect against death; they are heavy financial investments. If an insurance contract behaves like a stock option or is linked to a real estate fund (REIT), the normal GMM fails. We should utilize the Variable Fee Approach (VFA) for this.
A big number of life insurers market “unit-linked” policies. A premium of $100,000 is paid by a customer. The insurance firm takes that money, puts it into a specific pool of underlying assets (like a mutual fund of tech stocks) and manages it. As the stock market rises, the customer's payout grows accordingly. The payout declines if the market experiences a downturn. The insurance company operates more like a Wall Street investment manager, taking a percentage “fee” from the fund performance to account for the life insurance risk and profit.
Because the payout is directly participating in the market, we call these Direct Participating Contracts.
To use the VFA, the contract must meet three strict criteria:
If it satisfies all three criteria, the VFA is absolutely mandatory. It isn't something that you can do instead of the PAA.
In chapter 3, we have studied a contract which is called the Contractual Service Margin or CSM. Further, CSM refers to the unearned profit of the company.
According to standard GMM, a sudden drop in the world’s stock market would mean an immediate financial loss of the insurance company, reflected in the Company’s Income Statement and making profits look exceptionally volatile and messy.
The CSM’s behaviour (how it works) is changed by the VFA. Under the Variable Fee Approach, the profit of the insurer (the CSM) is viewed as a “variable fee” for managing the policyholder’s investments. During a stock market crash, the company’s fee also drops.
The variable fee approach (VFA) allows the cost of the market issue to be absorbed in the CSM instead of the income statement.
By allowing the CSM to function as a financial shock absorber, the company’s official Income Statement does not reflect this volatility in performance but rather the real performance of the company.
The VFA works as a brilliant accounting mechanism. In simple terms, the company is earning a variable fee for asset management in respect of investment-linked insurance. It shields investors from panic by allowing CSM to absorb market shocks. We have three engines as of now. How do we choose?