Chapter 19 - Models (2) Flashcards
What are the main uses of models
- Costing and reserving options
- Model office - new business projections, embedded values, solvency, takeovers
- Reserves - statutory and management accounting
- Pricing - Profit, premium rates
Cashflow approach to pricing
Many Elephants Prefer Apples, It’s Definitely A Favorite Until Pears Disappear
- Choose MODEL points to represent expected new business.
- For an EXISITING product, modify the profile of the existing business to obtain the model points; for a new product, use the profile of any similar existing product with advice from the marketing department.
- PROJECT cashflows for each model point, including typical elements of cashflow (e.g., premiums, expenses, claims)
- ALLOWANCE could be made for lapses, premium holidays, reinsurance, etc for long term products
- INVESTIGATE net cashflows for negative flows and the need for additional reserves.
- DISCOUNT net projected cashflows at a risk discount rate.
- ANALYSE the net cashflow to assess the adequacy of the premium in producing the desired return.
- FINE-tune calculations for required premium levels by focusing on particular model points.
- If certain model points are UNPROFITABLE, aggregate profitability is exposed to changes in mix and volumes of contracts sold.
- PERFORM sensitivity tests by varying assumptions.
- DETERMINE acceptable premiums for model points, then use them to determine premiums for all contract variations
What is a profit criteria
It is a single figure that tries to summarise the relative efficiency of contracts with different profit signatures
What are the different profit criteria
NPV
IRR
DPP
What is the NPV
It is discounting the profit signature at the risk discount rate
What is the IRR
It is the rate of return at which the discounted value of the cashflows is zero.
A company should prefer a contract that has a higher IRR.
however, the IRR does not always agree with the NPV
Why is NPV more reliable than IRR
- If there is more than one change of sign in the stream of profits in the profit signature, there is no unique IRR
- the NPV can be related to useful indicators of the policys’ worth to the company, in terms of sales effort or market share. There is no way to do this with the IRR
- If a policy makes profit from the outset then the IRR may not even exist. The NPV always exists
What is DPP
It is the policy duration at which the profits that have emerged so far have a present value of zero.
I.e it is the time it takes for the company to recover its initial investment with interest at the risk discount rate
The DPP ignores completely all the cashflows after the DPP
What might a company reconsider to make the premiums charged more marketable
- The DESIGN of the product, either remove features that increase the riskiness of the net cashflows, or to include features that will differentiate the product from those of competing companies.
- The DISTRIBUTION channel used, if that would permit either a revision of the assumptions to be used in the model, or a higher premium to be used without loss of marketability
- The company’s PROFIT requirement
- Whether to PROCEED with marketing the product
What is the embedded value of a company
It is the value of the future profit stream from the company’s existing business together with the value of any net assets separately attributable to shareholders
Cashflow approach to profitability
Fishing may require some patience, especially during tough-times
- The FULL policy data set can be used to model individual policies.
- Alternatively, MODEL points can represent the business. Previous assessments may form a starting point for the model points, with adjustments for new business and business going off the books.
- It is common to REDO the model generation process based on the current policy portfolio.
- Check the SUITABILITY of any model points used.
- To check the PROFITABILITY of the business, use model points to determine supervisory reserves and compare with the published value.
- For EACH policy or model point, obtain the present value of projected cashflows using the cashflow approach to pricing.
- DISCOUNT cashflows using an appropriate risk discount rate.
- TOTAL the present value of projected cashflows across all policies or scale up the results of each model point to determine the expected profit from the existing business
How does a company measure solvency at a point in time
It can be measured by comparing the value of its liabilities with the value of its assets
There are two main ways in which the value of assets and liabilities can be determined:
- Supervisory values - These would be the values as determined for supervisory reporting purposes
- Economic values - These would be the values calculated on the basis of the expected experience of the company or on a ‘Market-consistent’ basis
Capital needs for financial providers
ABCD FOG SIP
- achieve strategic AIMS
- meet BENEFITS before sufficient premiums / contributions received
- hold CUSHION against unexpected events (adverse claim experience)
- meet DEVELOPMENT expenses ( product development, R&D, marketing)
- demonstrate FINANCIAL strength to customers and advisors
- OPPORTUNITIES such as new ventures ( M&A)
- sell products with GUARANTEES
- meet STATUTORY capital requirements ( fund new business strain )
- INVEST more freely
- PROFIT smoothing, smoothing discretionary benefits, smoothing dividends
What is sensitivity analysis
- It involves assessing the effect on the output of the model of varying each of the parameter values
