Ch 27: Cost of guarantees and options Flashcards
Mortality options description
- PH can choose to extend term or increase the level of benefit at normal premium rates without providing further medical evidence
- To the extent that the option might be excercised by someone in poor health, the company will bear a cost: diff between ordinary premium under option terms and the premium the company would have charged had the life been underwritten
Examples of investment guarantees
- Guaranteed min maturity value
- Guaranteed min surrender value
- Guaranteed annuity option
Implications of guarantees and options on investment strategy (3)
- If PH has a choice to exercise an option, the company will not know which option will be chosen and hence with option it should match in investment terms
- Surrender value guarantees: company will not know when the assets must cover the liabilities as time of exercise is under control of PH
- For maturity guarantees in with-profits contracts, company has conflicting interests between investing to meet the guarantee and investing for max performance. If guarantee is not matched by investments, cost of guarantee must be included in original pricing basis
How can the cost of guarantees be valued (3)
The cost of the guarantee is covered by an additional premium or higher charging basis to reflect the extra sums it may need to pay out under the guarantee.
* Option-pricing techniques - assess the extra premium by looking a the market price of a derivative that would mitigate the risk.
* Stochastic simulation of investment performance - Extra sums likely to be needed under a guarantee can be modelled by simulating a range of investment scenarios
Valuing invsetment options and guarantees under stochastic simulation method
- Project forward value of assets using stochastic investment model and comparing this with sum payable under guarantee.
- Possible to find expected cost of guarantee over a range of investment scenarios
- Assumptions underlying the model must correspond the company’s planned investment strategy
Mortality options examples
- Purchase additional benefits without providing further evidence of health at normal premium rates (for life of that particular age) at the date on which the option is excercised
- Renew a life insurance policy without further evidence of health
- Change part of the sum assured from one contract to another (from term assurance to endowment assurance)
How to reduce selection against the company when options are offered:
Apply terms and conditions at outset of the policy:
* Option can only be exercised at fixed points in time (every five years or anytime a qualifyng event occurs (birth of a child, new job with higher salary))
* Extent of the option specified (cannot exceed original sum assured)
How proportion of lives who exercise and health of exercising lives affect the cost of option
- Total expected additional costs of an option depend on health status of those who exercise the option and the proportion of lives who exercise the option
- Smaller proportion - the worse subsequent mortality experience would be
Factors effecting mortality options (6)
- Term of the policy - Longer the term, the more likely it is that at some time their health would make the option worthwhile
- Frequency of when option is exercisable
- Conditions relating to size or choice of contracts
- Encouragement given to PHs to exercise (the more healthy lives exercise the more new policies are written to good risks) but balancing act as it may also attract more high risk lives
- Extra cost to PH when exercising (healthy lives may shop around leaving us with poor risks and loss of potential future profits)
- Selective withdrawals (healthy lives may surrender policy since policy without option is cheaper, leaving unhealthy lives who will exercise - also selective withdrawals reduces the premiums would have received from whole risk pool but the cost of option (only depedns on unhealthy lives) will be little altered
Valuing a mortality option and extra assumptions
- Cashflow projections which includes the expected additional benefits and additional premiums expected to be received, to the extent to which the option is assumed to be taken up.
- Additional premiums would be based on expected premium rates that would be charged to standard lives for additional benefit as at the option exercise date
- Should also allow for additional expenses relating to admin of option
- If purpose is to price option need to allow for additional reserves that should be held, before and after exercise.
- Additional assumptions:
* Probability that option will be exercised at each available date
* Additional benefit level that will be chosen (if at discretion of PH)
* Expected mortality of lives who choose to exercise the option
* Expected mortality of lives who choose not to exercise the option
* Additional expenses relating to the option
Option take-up rate assumption
- May assume all eligible PHs will take up the option and that max level of benefit will be taken (unlikely to happen in practice but has advantage of simplicity)
- If many option dates or available options then model may assume worst possible option in financial pov of company is chosen with probability 1.
- Or assumptions could vary by exercise date or by alternative option, ideally be based on past experience
Assumption for mortality rates in option valuation
- Due to anti-selection expected mortality of lives who take up the option will be heavier than those who do not
- Should be a link between assumed take-up rate and assumed mortality rates
- If assumed all PH will take up option, mortality assumption could be Ultimate xp that corresponds to Select xp which would have been used if underwriting was completed as usual.
- Problem: If lives who take up the option are assumed to have higher than base mortality, the assumption for the lives who do not take up the option should be lower than base mortality assumption such that the average of all lives is the base mortality assumption.
