How does DARMA determine the discount rates used in the calculation of the Present Values of all of an insurance contract's projected cash events?
Context
In the Strategies/Discounting - for Discount-Rate-Related Questions, the software requires answers to the following:
(1). What is Policyholder's Risk Tolerance?
Choices are: (A) Low
(B) Below-Average
(C) Average,
(D) Above-Average
(E) High
(F) Answer a Questionnaire that picks one of (A) thru (E)
(G) User-Entered Portfolio
(H) This contract's Portfolio
(I) CPI-paying Bond
(2). What is the policyholder's Personal Capital Gains Rate?
(3). Use Alternate Mutual Fund Annual Fee or Fees from Contract?
To arrive at the discount rates we need to ask the question: If the policyholder had to match the projected stream of cash events in any scenario what amount of investment would they need today based on a portfolio reflecting their choice of one of (A) thru (I), in order to exactly finance the future stream of the contract's cash events in any of the software generated Economic Scenarios?
The app will assign a Portfolio of Asset Classes' Percentages for (A) thru (E) as follows::
Percentages Invested in the theoretical AMF
Risk Tolerance A B C D E
Money Market/Short-Term 25 12.5
U.S. Intermediate Term Gov’t Bonds 50 25
Diversified Fixed Income 25 12.5
U.S. Long Term Corporate Bonds 12.5 25 12.5
Diversified Balanced Allocation 25 50 25
Diversified Large Cap. U.S. Equity 12.5 25 12.5
Diversified International Equity 12.5 25
Intermediate Risk Equity 25 50
Aggressive or Specialized/Exotic Equity 12.5 25
The Non-Insurance Alternate Mutual Fund (AMF) Bank Assumption
In order to answer this question, we assume that the policyholder invests in an Alternate Mutual Fund Bank, instead of the Insurance Contract.
So, how would this initial investment grow?
We assume that this investment is based on the policyholder's risk tolerance for distribution among the various asset classes and that it would grow at their corresponding scenario-based growth rates less fees and taxes. Next we assume that all payments generated by the insurance contract would be simulated through withdrawals from the AMF Bank.
For qualified contracts, the taxes would be income taxes on any withdrawals from the AMF Bank and for non-qualified there would be no tax-deferral and capital gains would continuously apply to the AMF Bank in all years. Unlike the qualified, there would be no income tax effects on the simulated withdrawals from the AMF Bank as the growth rates applied (discount rates used in the app) are net of the capital gains taxes.
This is how we gauge the worth of the contract to the policyholder because it's based on how the policyholder would invest in this parallel investment world represented by the non-insurance AMF bank.
The Non-Insurance AMF Bank Mechanics
The software makes the simple assumption that, in the AMF Bank, earnings are based on the Policyholder's risk appetite e.g. if (1)(A) above was selected then same investments that they have in the contract would be invested in the AMF Bank. Alternatively, they can choose (B) Conservative, (C) Moderate or (D) Aggressive investments.
The assumption is that this investment is deposited in the AMF Bank and we project the fund using the same growth rates used for the contract, less any AMF Bank fees ( see (3) above - Select Current Contract Fees or some other Mutual Fund that policyholder would likely invest in ), as credited earnings. Withdrawals from the AMF Bank by the policyholder would exactly equal the cash payments on the Insurance side and are deducted from the AMF Bank Balance. Any future scheduled premiums are assumed to be deposited in the AMF Bank.
This continues right up to the very last withdrawal, when the balance in the AMF Bank will be exactly equal to the last withdrawal and its balance would reduce to exactly zero and the policy would then terminate.
Non-Qualified:
In the AMF Bank world, there will be taxes. If the policy is non-qualified then there will be plus or minus capital gains in each year so we would first deduct the fee, then apply the capital gains tax; because of this, no income tax would be applied to any withdrawals from the AMF Bank.
Qualified:
If the contract is qualified, the AMF is also qualified. We assume that any fees entered by the user for the AMF are deducted from the growth rates, but taxes would only apply when actual withdrawals are made and we would use the policyholder's income tax rates for those events to determine the tax payments. For qualified contracts, because tax events only occur when money is actually paid out of the contract, all insurance contract payments are marked up by the income tax rate in that year in order to emulate the fact that a gross amount would need to be withdrawn from the AMF, that would then have income taxes deducted. This is needed in order to match the net payment on the insurance side.
How does Discounting the Cash Events simulate the AMF?
Rather than project the AMF from the current date to the end of the policy, we simply discount the cash transactions produced in the insurance contract side using the same rates that were used in the AMF Bank. We can then simply discount all the cash events back to the current date and this will solve for the necessary initial investment required to fund the contract's cash flows, that are represented by withdrawals and deposits in the theoretical AMF Bank.
This is our present value of the policy and it's used as the numerator in the AV-ITM© calculations.
Simply put, this solved-for initial investment (the Present Value of future payments less future premiums), is the exact amount that along with future premiums will fund all future cash events generated by the app for the insurance contract.
Context
In the Strategies/Discounting - for Discount-Rate-Related Questions, the software requires answers to the following:
(1). What is Policyholder's Risk Tolerance?
Choices are: (A) Low
(B) Below-Average
(C) Average,
(D) Above-Average
(E) High
(F) Answer a Questionnaire that picks one of (A) thru (E)
(G) User-Entered Portfolio
(H) This contract's Portfolio
(I) CPI-paying Bond
(2). What is the policyholder's Personal Capital Gains Rate?
(3). Use Alternate Mutual Fund Annual Fee or Fees from Contract?
To arrive at the discount rates we need to ask the question: If the policyholder had to match the projected stream of cash events in any scenario what amount of investment would they need today based on a portfolio reflecting their choice of one of (A) thru (I), in order to exactly finance the future stream of the contract's cash events in any of the software generated Economic Scenarios?
The app will assign a Portfolio of Asset Classes' Percentages for (A) thru (E) as follows::
Percentages Invested in the theoretical AMF
Risk Tolerance A B C D E
Money Market/Short-Term 25 12.5
U.S. Intermediate Term Gov’t Bonds 50 25
Diversified Fixed Income 25 12.5
U.S. Long Term Corporate Bonds 12.5 25 12.5
Diversified Balanced Allocation 25 50 25
Diversified Large Cap. U.S. Equity 12.5 25 12.5
Diversified International Equity 12.5 25
Intermediate Risk Equity 25 50
Aggressive or Specialized/Exotic Equity 12.5 25
The Non-Insurance Alternate Mutual Fund (AMF) Bank Assumption
In order to answer this question, we assume that the policyholder invests in an Alternate Mutual Fund Bank, instead of the Insurance Contract.
So, how would this initial investment grow?
We assume that this investment is based on the policyholder's risk tolerance for distribution among the various asset classes and that it would grow at their corresponding scenario-based growth rates less fees and taxes. Next we assume that all payments generated by the insurance contract would be simulated through withdrawals from the AMF Bank.
For qualified contracts, the taxes would be income taxes on any withdrawals from the AMF Bank and for non-qualified there would be no tax-deferral and capital gains would continuously apply to the AMF Bank in all years. Unlike the qualified, there would be no income tax effects on the simulated withdrawals from the AMF Bank as the growth rates applied (discount rates used in the app) are net of the capital gains taxes.
This is how we gauge the worth of the contract to the policyholder because it's based on how the policyholder would invest in this parallel investment world represented by the non-insurance AMF bank.
The Non-Insurance AMF Bank Mechanics
The software makes the simple assumption that, in the AMF Bank, earnings are based on the Policyholder's risk appetite e.g. if (1)(A) above was selected then same investments that they have in the contract would be invested in the AMF Bank. Alternatively, they can choose (B) Conservative, (C) Moderate or (D) Aggressive investments.
The assumption is that this investment is deposited in the AMF Bank and we project the fund using the same growth rates used for the contract, less any AMF Bank fees ( see (3) above - Select Current Contract Fees or some other Mutual Fund that policyholder would likely invest in ), as credited earnings. Withdrawals from the AMF Bank by the policyholder would exactly equal the cash payments on the Insurance side and are deducted from the AMF Bank Balance. Any future scheduled premiums are assumed to be deposited in the AMF Bank.
This continues right up to the very last withdrawal, when the balance in the AMF Bank will be exactly equal to the last withdrawal and its balance would reduce to exactly zero and the policy would then terminate.
Non-Qualified:
In the AMF Bank world, there will be taxes. If the policy is non-qualified then there will be plus or minus capital gains in each year so we would first deduct the fee, then apply the capital gains tax; because of this, no income tax would be applied to any withdrawals from the AMF Bank.
Qualified:
If the contract is qualified, the AMF is also qualified. We assume that any fees entered by the user for the AMF are deducted from the growth rates, but taxes would only apply when actual withdrawals are made and we would use the policyholder's income tax rates for those events to determine the tax payments. For qualified contracts, because tax events only occur when money is actually paid out of the contract, all insurance contract payments are marked up by the income tax rate in that year in order to emulate the fact that a gross amount would need to be withdrawn from the AMF, that would then have income taxes deducted. This is needed in order to match the net payment on the insurance side.
How does Discounting the Cash Events simulate the AMF?
Rather than project the AMF from the current date to the end of the policy, we simply discount the cash transactions produced in the insurance contract side using the same rates that were used in the AMF Bank. We can then simply discount all the cash events back to the current date and this will solve for the necessary initial investment required to fund the contract's cash flows, that are represented by withdrawals and deposits in the theoretical AMF Bank.
This is our present value of the policy and it's used as the numerator in the AV-ITM© calculations.
Simply put, this solved-for initial investment (the Present Value of future payments less future premiums), is the exact amount that along with future premiums will fund all future cash events generated by the app for the insurance contract.
