Chapter 19-Models (2) Flashcards
What is product pricing? (2)
Outline how models are used for product pricing (4)
Pricing is the process of setting the premium/charging structure, for:
new business or
existing business
+continually monitoring validity of premium rates on existing business
+re-examine if expected future experience changed from that used in initial pricing
Choose model points, considering
existing business: profile of similar business, with advice from marketing dependent
new bus: profile of existing bus, adj for exp future changes
For each model point, project cashflows, allowing for reserving + solvency capital requirements, on basis of set of assumptions
Discount cashflows at risk discount rate RDR that allows for:
+return required by company
+level of statistical risk attaching to cashflows (so in theory, separate RDR for each component of cashflows)
Premium/charges for model point set to produce profit required by company
Model points
What is a model point (MP)? (3)
How do model points help in the modelling exercise? (3)
A model point is a
data record fed as input into a model/modelling programme…
…will represent either a policy or group of homogeneous policies
…will contain most important characteristics of the policy
How model points help?
Underlying business comprises wide range of policies
Model points group policies expected to produce similar results, which can then be scaled up, saving time, requiring less power
Number of model points represent whole business
Define the term ‘profit criterion’ and name 3 profit criteria (3)
Single figure that tries to summarise relative efficiency of contracts with different profit signatures
NPV (net present value)
IRR (internal rate of return)
DPP (discounted payback period)
Describe the net present value criterion (2)
List 4 issues regarding the NPV criterion (4)
NVP of profit signature is calculated by discounting at risk discount rate
Economic theory implies NPV is best profit criterion to use
List 4 issues with NPV criterion
However, it’s dependent on assumptions of
+RDR being appropriate for inherent risk
+operating in free and efficient capital market
Means little by itself (e.g. can double NPV by doubling MPs’ premiums), so NPV normally expressed in relative terms such as
+in proportion to initial sales costs (initial commission)
+in proportion to total discounted premium incomes (market share)
Subject to law of diminishing returns, else company could sell unlimited same policy with positive NPVs to increase profits
Says nothing about competitiveness: high NPV bad if can’t sell
Define the internal rate of return profit criterion (2)
State 3 reasons why the NPV may be more reliable than the IRR (3)
Defined as rate of return at which discounted value of cashflows (NVP) is zero
Company will usually prefer contracts with higher IRR
Potentially NPV may be better than IRR:
If more than one change of sign in stream of cashflows, IRR wil not usually be unique
NPV can be related to useful indicators of policy’s worth to company, IRR can’t
NPV always exists. IRR may not exist (e.. if policy makes profits from outset)
Define the discounted payback (DPP) profit criterion and state why it will not usually agree with the NPV (2)
When is the DPP an important criteria? (4)
Policy duration at which the profits that have emerged so far have zero present value i.e. time it takes for company to recover initial investment with interest at risk discount rate
DPP will not usually agree with NPV as it ignores cashflows after the DPP
When is the DPP criteria important:
+Limited capital available=> sell policies with short DPP
+Long term policies
+Large initial capital strain
+Greater variation in DPP
List 5 possible responses to premiums/charges being unmarketable.
(After premiums/charges that meet profit criterion have been determined, and marketability needs to be considered.)
Reconsider product design e.g.
+remove risky features
add product differentiating features
Consider distribution channel change if would cause/permit
+assumption change in model
+higher premium/charges without loss of marketability
Reduce company’s profit requirement’
Decide not to market the product
Re-examine assumed expenses
Define Embedded Value
The present value of the future profits of existing business together with the value of the net assets attributable to the shareholders
List the components that make up the present value of future shareholder profits from existing contracts for the following types of business:
Conventional without profit
Unit-linked
With-profits
Conventional without profits: the future premiums plus investment income less claims and expenses plus the release of reserves and required solvency capital
Unit-linked business: the present value of future charges less expenses and guaranteed benefits in excess of the unit fund plus release of supervisory non-unit reserves and required solvency capital
With-profit business the present value of shareholder transfers
Define Appraisal Value
The combination of present value of future profits from new business and embedded value
How do we go about assessing ROC (return on capital) during a pricing exercise? (6)
Group up net cashflows for existing/new business, and use to assess amount of capital required to write product
+regulatory basis
+economic basis
Add one off development costs: to the extent that they have not already been amortised/included in expense CFs used
Total capital requirement: given by above can be compared with profits expected to emerge from product so as to determine expected return on capital
What is ‘solvency’? (3)
Solvency relates to insurer’s ability to meet future outgo, both from existing bus and from future new bus may sell
Enough reserves for future liabilities on existing bus + extra for anything else (cost of smoothing bonuses, new bus strain)
Regular solvency projections required, as part of regular supervisory submission
Outline how an insurer should assess its capital requirements (4)
Insurer should assess amounts and types of capital needed given
+amount of liabilities
+types of risks inherent in those liabilities
Given liabilities span long period of years, necessary to project assets & liabilities into future years, allowing for:
+new business plans
+management actions e.g. changes in bonus and investment policy
Give 2 main bases on which the values of assets and liabilities can be determined, for the purposes of assessing solvency
Company needs to compare assets and liabilities at point in time to assess solvency, can use following bases
Supervisory values
as determined for supervisory reporting
Economic values
based on expected future experience or using a market-consistent basis
What is static solvency testing? (2)
List 3 disadvantages of static solvency testing (3)
Static solvency testing
Testing solvency at specific point in time
Won’t enable assessment of comp’s ability to withstand future changes in external economic environment and particular comp’s experience
3 disadvantages of static solvency testing
+considers only existing portfolio, no new business
+assumes experience for remaining duration
+guarantees are hard to cost
