19. Models Flashcards
1
Q
List uses of models
A
- Pricing
- Assessing return on capital
- Assessing capital requirements
- Assessing profitability of existing business incl present value of future profits on existing portfolio
- Developing an appropriate investment strategy
- Projecting future solvency position
- Any other work with financial projections
2
Q
Describe how model would be used for pricing
A
- Choose model points to represent new business
o Existing product: current data with modifications for future changes
o New product: similar existing product and advice from marketing - Use single policy model to project cashflows for individual model points
- Cashflows must allow for reserving and solvency margin requirements
- Cashflows will be discounted at RDR allowing for:
o Return required by company
o Level of statistical risk attaching to cashflows for contract - Find premium or charges that satisfies profit criteria.
- Profit criteria could be:
o NPV
o IRR
o DPP - Price must consider:
o Marketability
o If capital is sufficient to finance sales volumes
o If return on capital for business is satisfactory - Model office and new business models may be used to assess last two points.
- Prices must be sensitivity tested in all stages of modelling.
3
Q
What actions/considerations might company make after modelling premiums/charges?
A
- Change design of product to reduce riskiness
- Change design of product to differentiate it
- Revise distribution channel- if would permit revised assumption or higher premium/charges
- Profit requirement
- Whether to proceed with marketing product
- Re-examine assumed expenses esp acquisiotion costs, marginal admin costs and expense contribution to overheads
4
Q
How would pricing model be used to test capital requirements of product?
A
- Net cashflows scaled up for expected new business and added to model for whole company
- Can assess impact on capital by looking at modelled amount and timing of cashflows
o On economic or regulatory basis - If capital is a problem, may reconsider design of product to reduce, or change timing of financing requirements
- When acceptable premiums for model points are determined, can determine premiums for all contract variations
5
Q
How would pricing model be used to assess return on capital of product?
A
- Net cashflows grossed up for new business and to assess amount of capital needed to write product.
- Performed on economic or regulatory basis.
- Can add once-off development costs to extent that they haven’t been amortised and included in expense cashflows used.
- This gives total capital requirement and is compared with profits expected to emerge from product to determine expected return on capital.
6
Q
Describe how model would be used to determine profitability of existing business
A
- Use an existing business model to calculate the embedded value of life insurance company.
- Define embedded value
- Data
o Will use full policy data set or …
o … choose representative model points.
o Model points from a previous assessment may be used and modified for changes from new business that was taken on and business that went off.
o Can also do model point generation process from start based on current portfolio.
o Must check suitability of model points, can calculate supervisory reserves and compare to published value - Find PV of projected cashflows using appropriate RDR
- Total all policies / scale up model points gives expected profit
- Adding future shareholders’ share of net assets gives embedded value.
- Can look at PVFP by:
o Product
o Product class (G/IL)
o Distribution channel
o Subsidiary
7
Q
Describe how model would be used to assess solvency
A
- Must assess amounts and types of capital needed given L and risks in L.
- Must project L into future given long term nature allowing for new business plans
- Supervisory projections must allow for management actions e.g. changes in bonus and investment policy
- Measuring solvency:
o Compare value of A to L
o Two ways of valuing:
- Supervisory/ regulatory- based on supervisory reporting basis
- Economic: best estimate basis or market consistent - Solvency testing:
o Static testing: determine solvency at point of time
o Dynamic testing: project revenue acc and balance sheet for sufficient period
of time so potential risks are identified
o Need to project solvency to measure impact of future variations in
experience not allowed for in supervisory reserving basis.
o For dynamic testing, must consider projection basis.
o Deterministic projection- use expected assumptions and assumed margins to
test adverse future experience
o Stochastic projection- use simulations to assess probability of adverse
scenarios occurring
o Must decide whether to include new business or not
8
Q
Why does a company need capital?
A
- Withstand adverse, often unexpected, conditions
- Finance new business strain
- Allow riskier investment strategy than matching would dictate
9
Q
Describe how sensitivity testing would be carried out:
A
- Aim: show vulnerability of results to unexpected future experience
- Assess effect of varying parameters on the output.
- Must allow for correlation between parameters
- Can allow for variations in:
o Model point assumptions (if applicable)
o Parameter values - On a deterministic basis, can help determine margins necessary for a basis
- Margins in each parameter could be way to allow for risk in pricing as an alternative to risk margins in the RDR
- Sensitivity can help determine variance of results
- Stochastic simulation techniques can be used to assess variance.
10
Q
Explain what is meant by Net Present Value
A
- Discount of the profit signature at the RDR.
- Normally expressed as:
o Proportion of initial sales costs
o Proportion of total discounted premium income
11
Q
What are the assumptions underlying NPV?
A
- There is a perfectly free and efficient capital market
- When comparing two risky investments, each is discounted at RDR appropriate to its riskiness
12
Q
What are practical points underlying NPV?
A
- Subject to law of diminishing returns
- Says nothing about competition
13
Q
Explain what is meant by Internal Rate of Return
A
- Rate of return at which discounted value of cashflows is zero.
14
Q
What are the drawbacks of IRR?
A
- Might not exist
- Might not be unique
- Can’t be related to other indicators such as sales/premiums
15
Q
Explain what is meant by Discounted Payback Period
A
- Policy duration at which profits that have emerged so far have a present value of zero.
- Useful if want to recoup initial expenses quickly.
- Useful if capital is scare and can assist in designing capital efficient products.
