24 Contract Design and Pricing

Question 1

What are the factors to consider when assessing a contract’s design? (39)

Answer 1

1. Profitability
   
   • Profit criterion (RoC, Payback Period)
   • What are the cashflows?
   • Key pricing assumptions
   • NB volumes required
   • Advice or data required?
2. Marketability
   
   • Customer needs / choices
   • Competitors’ products
   • Tax and State Benefits
   • Features (gtees, SVs, fund choice)
   • TCF
3. Capital Requirements
   
   • Onerous gtees?
   • Hedging (derivatives or reinsurance)
   • Measurement
   • Development costs
   • Initial capital required?
4. Sensitivity of Profit
   
   • Margins
   • Risk drivers
   • Risk mitigations
   • Scenario testing
   • Diversification with other products
5. Distribution
   
   • Sales channels
   • Additional training
   • Reputation & TCF
   • Remuneration
   • Underwriting philosophy?
6. Admin Systems
   
   • Systems
   • Training & Literature
   • Service Standards
   • Outsourcing
   • Struggle with high NB volumes

Question 2

Outline how to set the mortality assumptions when pricing a contract. (5)

Answer 2

1. Adjust a standard table using either the company’s past experience or CMI or reinsurer’s data.
2. Adjustments should be based on the expected nature of the policyholders to whom the business will be targeted.
3. For a product with longevity risk, allow for future mortality improvements.
4. Consider the level of underwriting and the potential for anti-selection.
5. The impact of anti-selective withdrawals may also need to be taken into account.

Question 3

Outline how to set the investment return assumptions when pricing a contract. (5)

Answer 3

1. Consider likely matching assets and their expected yields.
2. If corporate bonds are being used, consider the likely higher default risk and lower liquidity relative to government bonds - this can be allowed for explicitly if stochastic modelling is used.
3. If a market consistent approach is being used, the yields used would be based on risk-free rates and may be term dependent (yield curves).
4. Allow for any financial guarantees using option-pricing theory or by modelling stochastically. Assumptions would be needed for the generation of economic scenarios and the correlation between factors.
5. Adjust assumed yields for any investment risk in future years (stochastic modelling could again take this into account explicitly).

Question 4

Outline how to set the expense and inflation assumptions when pricing a contract. (6)

Answer 4

1. Look at recent expense investigation for this or a similar type of contract. If no such data exists, use a reinsurers or consultant’s experience.
2. Decide whether the contract will be required to take on a share of overheads and if so what proportion.
3. When loading for overheads and development costs, allow for the expected volume of business and expected average size of contract.
4. Allow for the likely incidence of costs, e.g. initial vs ongoing in order to reduce cross-subsidies.
5. Allow for inflation at a rate consistent with the investment return assumptions.
6. If applicable, commission would be loaded at the rates the company expects to pay.