Chapter 23: Contract design

Question 1

List 18 factors to consider when designing or redesigning a contract

Answer 1

AMPLE DIRECT FACTORS
* Administration systems
* Marektability
* Profitability
* Level and form of benefits
* Early leaver benefits
* Discretionary benefits
* Interests and needs of customers
* Risk appetite of the parties involved
* Expenses vs charges
* Competition
* Terms and conditions of the contract
* Financing (capital requirements)
* Accounting implications
* Consistency with other products
* Timing of contributions or premiums
* Options and guarantees
* Regulatory requirements
* Subsidies (cross-)

Question 2

List the 7 key parties involved in contract design

Answer 2

ALPACAS

• Actuaries
• Lawyers
• Providers of benefits
• Accountants
• Customers
• Administrators
• Shareholders / financial backers

Question 3

List the factors influencing the needs of the provider

Answer 3

1. The chosen market
2. The capital available
3. The liquidity available
4. The expertise available

Question 4

List the factors influencing the needs of the customer

Answer 4

1. The capacity to pay
2. The risks to be covered
3. The benefits that are needed at different times in the future
4. Attitude to financial risk

Question 5

Discuss the involvement of each of the parties in contract design

Answer 5

1. Actuaries: Initial costing (pricing) of the financial structures and the subsequent determination of provisions. Involved in the ongoing design process through assessing the impact on both the cost and the provisioning implications of modifications to the benefit design
2. Lawyers: Drafting of contracts to ensure that the provider is not exposed to the risk of providing more benefits or entering into greater risks than intended
3. Accountants: Ensures the provider of the financial structure properly accounts for the income and outgo
4. Financial backers: Will want regular reports demonstrating proper stewardship of the finance provided
5. Administrators: Administer the financial structures. The more complex the structures are, the greater the cost, as well as an increased risk of error
6. Sales and marketing: Sales people need training, more complex structures increase the cost. Marketing teams provide information on the characteristics of the target market as part of the design process.

Question 6

Give examples of how a contract can be designed to cater for different risk appetites amongst customers

Answer 6

1. Different investment funds, e.g. low, medium and high risk
2. Different levels of cover, e.g. comprehensive vs third party

Question 7

Give examples of how the regulatory environment may influence the design of a product

Answer 7

Products must meet legal or regulatory requirements, if any.

Products can be designed to benefit from favourable financial or taxation regimes.

Products should be designed to ensure that initial expense can be recouped if a policy is cancelled within any regulatory “cooling-off” period.

Regulation may require information to be disclosed to potential customers, for example discontinuance terms.

Question 8

What are the 6 outcomes of TCF?

Answer 8

1. Culture and governance - customers should feel confident they are dealing with firms who have TCF as a central pillar to their corporate culture.
2. Product design - products and services marketed and sold should be designed to meet the needs of identified customer groups and are targeted accordingly
3. Clear communication - customers are given clear, accurate and timely information that keeps them appropriately informed before, during and after point of sale
4. Suitable advice - where advice is given, there is confidence that the advice is suitable and takes account of customer circumstances
5. Performance and standards - products must perform as firms have led customers to expect, and service is of an acceptable standard and as they have been led to believe
6. Claims, complaints and changes - customers do not face unreasonable post-sale barriers imposed by firms to change product, switch providers, submit a claim or make a complaint

Question 9

What are the important variables that might impinge on the profitability of an insurance contract?

Answer 9

• Claims experience
• Expenses and expense inflation
• Investment returns
• Withdrawal experience
• New business sales volumes and mix

Question 10

Give examples of contract design features that make a contract more marketable

Answer 10

1. Guarantees, options and choices
2. A competitive (low) price
3. Transparency and simple to understand
4. Features that distinguish it from the competitors

Question 11

What are the two main types of competitive pressure?

Answer 11

1. Price
2. Product features

Question 12

Discuss the importance of these competitive pressures

Answer 12

1. Some products are designed to cover the basic insurance needs where the risk is well defined. These products tend to be sold on price and the provider with the lowest price is likely to get the greatest volume of business.
2. Other products cannot be directly compared on price and instead the risks covered, the administrative systems and the claims process all feature in the customer’s decision. There is a risk to a provider of offering terms that are very different from the rest of the market. Customers may assume that the terms are consistent and be disappointed if they don’t receive what they expected, even if they receive the benefits specified by the policy. It can also attract selective business, which means the product mix is not as expected.

The desire to be competitive often conflicts with the profitability of the design

Question 13

In deciding the benefits to offer on a contract, the level and form of the benefits need to be taken into account.

How may the level and form of benefits vary between contracts?

Answer 13

1. Customer needs
2. Risks to be covered
3. Customer’s ability to pay

Question 14

Give examples of options relating to:
* Premiums
* Benefits
* The use of contract proceeds
* And any other option that might be offered as part of a contract design

Answer 14

1. Premium options:
* Waiver of premium
* Option to increase / decrease premium
* Option to choose / change premium frequency

2. Benefit options:
* Discontinuance
* Early or late or ill-health retirement
* Spouse’s benefits
* Rider benefits
* Option to protect a no-claims discount

3. Use of the contract proceeds:
* Choice of annuity provider
* Choice of hospital under health insurance

4. Other options:
* Option to renew / convert a term assurance without further underwriting

Question 15

List examples of guarantees that might be offered as part of a contract design

Answer 15

1. Guaranteed benefits
2. Guaranteed minimum maturity value
3. Guaranteed minimum growth rate
4. Guaranteed annuity rates
5. Guaranteed premiums
6. Guaranteed charges

Question 16

What is discontinuance by policyholders?

Answer 16

Discontinuance means the policyholder voluntarily deciding to stop paying any more premiums.

Question 17

What is the underlying principle to consider in setting discontinuance terms for an insurance company or benefit scheme?

Answer 17

FAIRNESS between:
* the policyholder or scheme member who is leaving
* The remaining policyholders or members
* The provider of the benefits

Question 18

Surrender

Answer 18

The policy stops, there is no further cover and the policyholder receives a lump sum payment (the surrender value)

Question 19

Lapse

Answer 19

The policy stops, there is no further cover and usually no payment is made to the policyholder by the insurance company

Question 20

Paid-up

Answer 20

The policyholder ceases to pay premiums but the policy continues to offer the policyholder some cover.

In this case the benefit is reduced to reflect that there are no more premiums and is called the paid-up value

Question 21

Withdrawal

Answer 21

This normally encompasses surrender and lapse, as the policy does not stay in force

Question 22

What should the life insurer consider when setting discontinuance terms?

Answer 22

• Which contracts to offer discontinuance on
• The form of the benefits being offered
• How it goes about setting the discontinuance terms
• Any practical considerations relating to the discontinuance

Question 23

How does an insurance company decide on which contracts to offer discontinuance terms?

Answer 23

It will look at:
* Market practice
* Regulatory requirements
* The likelihood of selective withdrawals
* Or simply the difficulty of assessing suitable terms, such as the lump sum to pay on the discontinuance of an immediate annuity

The insurer may also consider past practice

Question 24

Factors to consider when determining discontinuance terms

Answer 24

Fairness is the key concern when setting discontinuance terms, however, determining what is fair is not always straightforward.

The key principles and factors to consider in determining discontinuance terms for life insurance contracts are:
* what the policy is “worth”
* policyholder expectations
* competitive considerations

Practical considerations include:
* the ease of calculation of the discontinuance benefits
* the frequency of change of the discontinuance terms

Question 25

Main factors to consider in determining suitable discontinuance terms for an individual leaving a benefit scheme

Answer 25

* The form of the benefits being offered * How discontinuance terms might be set * Any other considerations relating to the discontinuance, in particular how the funding level of the scheme might affect the discontinuance terms offered.

Question 26

What is new business strain?

Answer 26

New business strain arises because the premium received in the first year may be less than the sum of the initial expenses, the initial commission paid and the initial increase in provisions. It may also include the need to cover initial solvency capital requirements.

Question 27

List ways in which a contract could be designed in order to reduce new business strain

Answer 27

Contract design features that could be used to reduce the financing requirement include: * low guarantees * charges that match the expenses by nature and by timing * low initial expenses / commission * low statutory provisioning requirements * single premium In life insurance, unit-linked designs tend to have lower financing requirements than without-profit or with-profit designs because of the lower benefit guarantees offered and the ability to vary charges

Question 28

List the 4 methods of financing benefits

Answer 28

1. Pay as you go 2. Funding all the benefit in advance 3. Regular payments building up a fund 4. Paying an amount when the benefit event happens, for example, purchasing an annuity at the point of retirement.

Question 29

Outline the main administrative considerations that relate to contract design

Answer 29

The system used for administration needs to be able to carry out the functions that have been built into the product design at the cost that has been built into the product price. Systems changes needed to adapt to the requirements of a revised product design also need to be included as part of the development cost of the product. Many product designs involve options or changes that only take effect some years after the launch of a product. It is clearly not necessary to have these surrender processes working at the product launch, and if they are omitted the product can be launched more quickly. The need to carry out the work at some point will always be present, and it may be difficult for the business to schedule an appropriate time to carry out such work.

Question 30

List the items that the expense charges of an insurance company would be expected to cover

Answer 30

1. Contract design 2. Advertising / sales 3. Commission 4. The initial administration of setting up new policyholder records 5. The ongoing administration of collecting premiums 6. The administration of paying the claims / benefits as they fall due 7. Management of assets 8. The overheads of the insurer

Question 31

Give examples of conflicts between contract design factors

Answer 31

* The desire for a profitable contract with big profit margins in the premium rates may conflict with the desire for a competitive contract * The desire to offer guarantees will conflict with the desire to reduce the financing requirement * The desire for "bells and whistles" to improve marketability will conflict with administrative simplicity