Chapter 27: Cost of guarantees and options

Question 1

What are 3 examples of investment guarantees?

Answer 1

1. Guaranteed minimum maturity value
2. Guaranteed minimum surrender value
3. A guaranteed annuity option

Question 2

What are 3 examples of mortality options?

Answer 2

1. Purchase of additional benefits without providing further evidence of health. (New)
2. Renew a life insurance policy without additional evidence of health (Extension)
3. Change part of the sum assured from on contract to another (Change)

Question 3

Why does an insurance company need to model the investment guarantee?

Answer 3

There is an extra liability that he company needs to have if the guarantee is higher than the asset share of the contract.

Question 4

What are the two methods of calculating cost of guarantees?

Answer 4

1. Option-pricing
2. Stochastic simulations

Question 5

Describe the Option-pricing technique of calculating the cost of a guarantee

Answer 5

We assess the extra premium by looking at the market price of a derivative that the insurance company can acquire to mitigate the risk

Minimum maturity value= put option on investment funds

Minimum surrender value = American style option (because it can be exercised at any time)

Guaranteed annuity rate = call option on the bonds necessary to ensure guarantee is met OR swaption (swap floating rate for fixed rate to meet guaranteed annuity option)

Question 6

Describe the Stochastic simulation technique of calculating the cost of a guarantee

Answer 6

Extra sums likely to be needed under the guarantee can be modelled by simulating a range of investment scenarios

Question 7

Mortality options can be valued using cashflow projections. What assumptions are required for this?

Answer 7

1. Option take-up rates
2. Benefit chosen
3. Mortality of those that exercise the option vs those that don’t
4. Expenses relating to the option

Question 8

Factors affecting mortality options

Answer 8

1. Term of the policy with the option (longer term -health deteriorates and likely to use option)
2. No of times p/holder get to exercise option
3. Encouragement to take option
4. Conditions of option
5. Cost of the option
6. Selective withdrawals