Chapter 27 - Cost of guarantees and options

Question 1

If an insurance company offers guaranteed annuity payments on its without-profits deferred annuity contract, but invests to meet the open market cash option. Is it a risk from low or high interest rate at retirement?

What if the company invests to be able to pay the annuity?

Answer 1

Low, since the annuity may cost more to buy than the cash available

The risk is that interest rates are high and that the annuity the company has invested to be able to pay is worth less than the cash alternative

Question 2

How can the value of these liabilities be determined

Answer 2

Option-pricing techniques
Stochastic simulation of investment performance

Question 3

How are the options incorporated into life insurance contracts analogous to options traded in the market place

Answer 3

A guaranteed minimum maturity value corresponds to a ( European style) put option on the investment funds at an exercise price corresponding to the maturity guarantee

Question 4

What are the common options to include in life insurance

Answer 4

• Purchase additional benefits without providing further evidence of health at the normal premium rates ( for a life at that particular age)
• Renew a life insurance policy, Eg. a term assurance at the end of the original term without providing additional evidence of health
• Change part of the sum assured from one contract to another, eg from term assurance to endowment assurance

Question 5

What is the cost of an option

Answer 5

It is the value of the excess of the premium that should, in light of full underwriting information, have been charged for the additional assurance over the normal premium rate that is charged

Question 6

What does the total expected additional costs of an option depend on

Answer 6

It depends on the health status of those who choose to exercise the option, and the proportion of lives who choose to exercise the option

In general, the smaller the proportion who exercise the option, the worse will be the subsequent mortality experience of those exercising the option. If a substantial proportion exercise the option, then their subsequent mortality experience will on average be less extreme

Question 7

Which factors affect mortality options

Answer 7

SCENT E

• SELECTIVE withdrawals - A healthy life may cancel a renewable policy shortly after taking it out because he realises that the cover without the option is cheaper
• CONDITIONS attaching to exercising the option - eg. limiting the size of the option or restricting the choice of contracts available under the option
• the ENCOURAGEMENT given to policyholders to exercise the option - encouraging more of the healthy lives to exercise the option will not cause any additional loss, and should contribute to the company’s total profit
• the NUMBER of times the policyholder gets the chance to exercise the option - eg every 5 years or policy anniversary
• the TERM of the policy with the option - the longer the term, the longer the policyholder will have the option, and the more likely it is that, at some time, his/her health will deteriorate, thus making the option appear worthwhile
• the EXTRA cost to the policyholder who exercises the option - if the option involves a steep increase in premiums, then the healthier lives might shop around to try to get the same cover cheaper elsewhere

Question 8

What are the extra steps involved when valuing a mortality/morbidity option as part of the pricing basis

Answer 8

• the probability that the option will be exercised
• the expected mortality/morbidity of the lives who choose to exercise the option
• The additional benefit that is chosen, if this is at the discretion of the policyholder
• The expected mortality of the lives who choose not to exercise the option
• Additional expenses relating to the option