Assumptions used in pricing contracts: factors for consideration

Question 1

Margins

Answer 1

▪ By including margins somewhere in the basis, the risk from adverse future
experience is reduced
▪ Where the cashflow model is used to price products , the risk to the
provider from adverse future experience could be allowed for by :
o The adjusting the risk element of the risk discount rate
o Using stochastic discount rate
o Applying margins to expected rates

Question 2

Profit margins

Answer 2

In pricing, a profit requirement is incorporated
▪ This is because owners of the provider want returns from their investments

Question 3

Risk discount rates

Answer 3

▪ Not all products are equally risky , and riskiness of product changes
▪ Rate used to discount the pricing cashflows may be set as sum of
o Expected rate of return
- Could be the risk free rate of return used for statutory or funding
valuations , where a prudent ( risk free ) approach Is needed or
- The shareholder’s required rate of return , more market based and
includes allowance for investment risk
o Risk margin ( risk premium)
- Reflects the inherent risk within the cashflows of the product that is
priced

Question 4

Features that can increase the risks in product design

Answer 4

➢ lack of historical data
➢ high guarantees
➢ policy options
➢ overhead costs
➢ complexity of design
➢ untested market

Question 5

Profit criterion

Answer 5

➢ normally a single figure that tries to summarise the relative efficiency of contracts
➢ it helps in determining contracts that make most efficient use of company’s capital
➢ methods of quantifying profitability include :
o Net present value
o Internal rate of return
o Discounted payback period
➢ Profit criterion for insurer is that the net present value of profits emerging from each
of its product lines is a predetermined proportion of the distribution costs
➢ Distribution costs : cost incurred by a producer incident to activities connected with
placing a finished product in the hands of a customer (as the expense of selling,
advertising, shipping)
➢ Distribution systems – the way of selling
o Brokers – independent intermediaries
o Owns sales people
o A distribution may wrongly favour products that pay a higher commission
over those with low commission