CH 21 (WM) Flashcards
Define the term “profit criterion”. [2]
It is a single figure that tries to summarize✓✓ the relative efficiency of contracts with different profit signatures✓✓.
By applying a profit criterion to different contracts with different profit signatures and ranking the results in order✓✓ it may be possible to say with confidence which contract makes most efficient use of a company’s capital.✓✓
State what is meant by the “net present value” of a contract, and how it would be calculated [2]
Q&A 4.23 (i)
The NPV requires the calculation of the profit signature for a given model point. [1⁄2]
The profit signature is the expected (usually annual) future profit stream that would be generated by a single (long-term) policy. [1⁄2]
The first step is the projection of future cashflows, these being the difference between income (premiums or charges, and investment returns) and outgo (expenses, claim costs and tax). [1⁄2]
The annual cashflows will be reduced by the expected cost of increasing the supervisory reserve each year, and increased by the investment returns earned on the reserves. [1⁄2]
The future profit flows are then adjusted to allow for future survival and withdrawal, to produce the profit signature. [1⁄2]
The NPV is the discounted value of the profit signature at the risk discount rate. [1⁄2]
[Maximum 2]
Explain the various ways in which health and care insurance companies can make use of net present value calculations. [2]
*Q&A 4.23 (ii)
(ii) Using net present values
The NPV is an example of a profit criterion: a single figure that tries to summarise the relative efficiency of contracts with different profit signatures. [1⁄2]
By applying a profit criterion to different contracts with different profit signatures, and by ranking the results in order, it may be possible to say with confidence which contract makes most efficient use of a company’s capital. [1⁄2]
Such a criterion can also be used to price a long-term healthcare insurance contract, by finding the premium (or charges) that satisfies the required profit criterion, based on a given set of future experience assumptions. [1⁄2]
Given a choice between the future cashflows from two different investments, economic theory states that an investor should choose the one with the higher NPV. This choice is optimal, and cannot be bettered. [1⁄2]
Another way to put this is that the first priority for the managers of any company is to maximise the net present worth of the company.
[1⁄2]
Also, the NPV can be usefully expressed either as:
* a percentage of the commission payable under the contract [1⁄2]
* a percentage of the expected present value of the premiums payable under the contract. [1⁄2]
*
If the first measure as the profit criterion is used, ie:
c = [NPV/Initial commission]x100
then c shows the net present value relative to the effort expended selling the policy. [1]
Assuming that sales effort is geared towards maximising the commission paid to intermediaries, then pricing using this criterion will ensure that the sales process will also maximise the company’s profits, regardless of which products are actually sold. [1]
If the second criterion is used, ie:
c’ = [NPV/EPVFP]x100
then the company will be sure that its profitability will increase in proportion to any increase in market share that it can achieve for any product. [1⁄2]
The company would choose which of these to adopt on the basis of which factor was most influential in driving sales: increasing commission payments or increasing market share. [1⁄2]
The use of NPVs is not confined to measuring the worth of new healthcare insurance policies. An insurer has other possible uses for its capital, such as the improvement of its administration systems for the support of existing business, or the development of a new sales channel. [1⁄2]
The company can use net present value to compare all kinds of capital investment projects, regardless of their nature. [1⁄2] [Maximum 6]
Describe why a health and care insurance company might choose to use the net present value as a profit criterion, rather than the internal rate of return or the discounted payback period. [6]
*Q&A 4.23 (iii)
(iii) Why net present value in preference to other criteria?
According to economic theory, the NPV cannot be bettered, so if any other criterion disagrees with it then the company should go with the NPV. [1⁄2]
Internal rate of return (IRR)
The IRR is the rate of return at which the discounted value of the cashflows is zero. [1⁄2]
All other things being equal, a company should prefer a contract that has a higher IRR. However, the IRR does not always agree with the NPV. [1⁄2]
Calculating an IRR requires an iterative approach, whereas a NPV does not, and so the latter is simpler. [1⁄2]
NPV may be more reliable in some cases, for example:
If there is more than one change of sign in the stream of profits in the profit signature, the IRR will not usually be unique. [1⁄2]
The NPV can be related to useful indicators of the policy’s worth to the company, in terms of sales effort or market share.
[1⁄2] There is no way to do this with the IRR. [1⁄2]
If a policy makes profits from the outset then the IRR may not even exist. The NPV always exists, however. [1⁄2]
The NPV can allow for the risks of the project by adjusting the risk discount rate and/or by including specific margins in the individual assumptions.
Only the second of these methods is possible using the IRR.
Discounted payback period (DPP)
The DPP is the policy duration at which the profits which have emerged so far have present value zero, …[1⁄2]
… ie it is the time it takes for the company to recover its initial investment with interest at the risk discount rate. [1⁄2]
A company with limited capital might prefer to sell contracts with as short a payback period as possible. [1⁄2]
The DPP will not usually agree with the NPV as it ignores completely all the cashflows after the DPP. [1⁄2]
Only the NPV provides any information about the size of the profit flow. Hence neither of the other two methods can be used without considering the NPV as well. [1⁄2]
[Maximum 6]
Describe the drawbacks of using the net present value as a profit criterion. [4]
*Q&A 4.23 (iv)
(iv) Drawbacks of net present value
Comparisons based on the NPV will only be valid if:
there is a perfectly free and efficient capital market, which is never exactly true [1⁄2]
the risk discount rates used to discount two (or more) risky investments appropriately reflect their riskiness, which may be very difficult to assess. [1⁄2]
The NPV is subject to the law of diminishing returns. [1⁄2]
If it were not, then a company that could sell one policy with positive NPV, could sell an unlimited number of policies and increase the value of the firm without limit. [1⁄2]
So even a marketable and competitive product would run out of customers once the market is saturated, and/or the cost of making more sales becomes increasingly prohibitive. [1⁄2]
It says nothing about competition at all. There is no point in designing a contract with a high NPV if it cannot be sold. [1⁄2]
However, these last two (related) problems can be effectively dealt with by comparing total NPVs for whole projects, based on realistic assumptions of future new business sales. [1⁄2]
If the expected cost of overheads is included in the NPV, this will also give a distorted comparison if the assumed volume upon which the fixed expenses are based is incorrect. [1⁄2]
This can be avoided by including only marginal profit in the NPV calculation. [1⁄2]
The NPV does not distinguish between policies that have very different initial capital requirements, and hence may have very different DPPs.
[1⁄2] [Maximum 4]
What is the “IRR”? [1.5]
- RoR at which the discounted value of future cashflow is zero.✓✓
- All other things being equal, a company should prefer a contract that has the higher IRR.✓✓
- However, the IRR does not always agree with the NPV.✓✓
What are some of the shortcomings of the “IRR” as profit criterion? [1.5]
- If there is more than one change of sign in the stream of profits in the profit signature, there is not generally a unique IRR.✓✓
- Unlike the NPV, it cannot be expressed i.t.o. useful indicators of the policy’s worth to the company.✓✓
- If a policy makes profits from the outset then the IRR may not even exist.✓✓
What is the “DPP” and how good is it as a profit criterion? [2]
- It is the policy duration at which the profits that have emerged so far have PV of zero✓✓, ie it is the time it takes for the company to recover its initial investment with interest at the RDR.✓✓
- It will not usually agree with the NPV as it completely ignores all cj’s after the DPP.✓✓
- A company with limited capital might prefer to sell contracts with the shortest payback periods possible.✓✓
What are the factors that will be reconsidered if the premiums or charges are uncompetitive. [4.5]
The design of the product✓, so as either:
remove features that increase the riskiness of the net cashflow,✓✓ or
include features that will differentiate the product from those of competitors✓✓.
The distribution channel to be used✓, if that would permit either:
a revision of assumptions to be used in the model,✓✓ or
A higher premium (or charges) to be used without loss of marketability✓✓.
The company’s profit requirement.✓✓
Whether to proceed with the marketing of the product.✓✓
Re-examine the expense basis✓, notable the following:
Acquisition costs (eg commission), the marginal administration costs and the required contribution to fixed overheads.✓✓✓✓
Add’n marks = 0.25
Describe how the competitor’s approach to pricing could adversely affect the insurer. [2]
A cheaper price may reduce the insurer’s market share.✓✓
But more importantly if the competitor applies a more detailed pricing differentiation and risk selection✓✓, then the better lives (lower risk) are more likely to go to the competitor (for a lower premium).✓✓
Consequently the insurer’s averaged pricing assumptions are called into question.✓✓
