Ch 27: Cost of investment guarantees and mortality options Flashcards
Why are investment guarantees useful? (3)
- Traditional life insurance contracts transfer mortality, expense and investment risk from the policyholder to the life insurance company.
- Unit linked and index linked contracts leave the investment risk with the policyholder
- but these contracts’ attraction can be enhanced if part of the investment risk is transferred to the company by the company offering guarantees to protect the policyholder from the downside risk.
Give examples of investment guarantees, as well as brief descriptions (3)
Guaranteed min maturity value
- guaranteed amount in monetary terms (for investment linked contracts)
- guaranteed amount in monetary terms for non-linked contracts
- eg non linked with profit endow assurance used to back mortgage
- very attractive, where eventual maturity unknown; could guarantee basic sum assured + bonuses >= certain value (set to size of mortage )
Guaranteed min surrender value
- give a guaranteed amount in monetary terms
Guaranteed annuity options
- convert endowment proceeds to annuity on guaranteed terms
- PH takes cash maturity value, can choose to buy immediate annuity from insurer at rate guaranteed at policy inception
- attractive if PH worried annuity may become more expensive at retirement
What is the key risk/implication for an insurer that offers contracts with investment guarantees? (1)
What makes the above key risk even more difficult to control? (2)
The key risk/implication for insurers offering investment guarantees is that at specific times in future, assets backing the guarantees are insufficient to meet the guarantees. Guarantee Bites
This key risk becomes particularly diffcult to control of PH has choice over whether to exercise option
- annuity guarantee: gives PH choice btwn cash or income at maturity.
- surrender value guarantee: insurer won’t know when surrender might happen
For insurers who have control over investment policy, what conflicts arise by providing investment guarantees ? (2)
What steps must insurer take to meet guarantees if it chooses not to invest to match the guarantees? (2)
Where insurer has control over investment policy (eg conventional, non linked contracts) conflicts due to investment guarantees arise in terms of
- conflict between investing to match guarantees, and investing for maximum returns
- eg if insurer providing with profits contracts, invests in backing assets to meet minimum guarantee, then all PH will recieve is this minimum return. may as well have just bought a without-profits contract
If company chooses to invest such that it doesn’t match guarantees,
* it must include cost of guarantee in original pricing basis
* if company has no control over investment policy (eg unit linked) , then to extent that guarantee will not be matched it must include cost of guarantee in original charges
* + prem/charges to offset risk
What impact does time/outstanding term play on risks faced by insurer due to offering investment guarantees (2)
Risk from investment guarantees depends on timeframe/outstanding term
- generally, longer timeframe=> greater chance things go wrong vs current forecasts eg offering guarantee annuity rate for 5 years, vs 20 years
- for with profits business, actually tricky to say: longer term may give insurer time to take corrective action with management actions
When valuing an investment guarantee, we need to consider the “liability created by that investment guarantee”; what does this mean? (2)
The liability created by the investment guarantee is
- the excess of the guaranteed amount (guaranteed maturity value/guaranteed surrender value/fund needed to purchase ‘guaranteed annuity’ at current market rates) over
- the cost that would’ve been incurred at the time in the absence of the guarantee
- Assume PH take option if it is in the money (bites for insurer)
How do insurer’s meet the cost of the liability created by the investment guarantee? (1)
What methods are available to price the costs of the guarantee? (2)
Insurer’s meet the cost of the additional liability created by the guaranteed by
- charging an extra premium to reflect the extra sums it may need to pay due to the guarantee biting
To determing the extra premium to charge, the insurer can use
- option pricing techniques
- stochastic simulation
Describe the general principle behind option pricing techniques to calc the extra premium for an investment guarantee (1)
Give examples of options which can be used to meet the different investment guarantees insurers may offer (6)
Option pricing/market valuation techniques assess the extra premium by
- looking at market price of derivative/option insurer could use to mitigate risk
Options which can be used to mitigate the following investment guarantees
- guaranteed maturity value
- European style put option on investment funds at an exercise price = maturity guarantee
- guaranteed surrender value
- similar American style put option/series of puts with different exercise prices which match guaranteed surrender values
- guaranteed annuity rate
- call option on bonds that are needed to ensure guarantee is met
- ie at exercise price which generated the required fixed rate of return
- can also be mirrored by option to swop floating rate returns at the option date for fixed returns sufficient to meet guaranteed annuity option
Once we’ve obtained a suitable option/derivative to hedge the risk of the investment guarantee, what does this provide? (2)
What difficulty may arise with the insurer’s investment fund compared to the market used to determine the premium for the investment guarantee? (2)
The market price of a suitable option produces a way of costing a financial guarantee or guarantee incorporated in a life insurance policy
- the insurer doesn’t actually necessarily purchase said option (that is a seperate matter, depending on the investment strategy)
- however, we now have a suitable price to charge for the investment guarantee
In practice, it is quite difficult to
- ensure that the insurer’s whole investment fund corresponds to a single option traded in the market
- to overcome this, an approximation is possible by using options written on market indices for equities and bonds
What are our expectations regarding whether the investment guarantee provided will be in the money or out of the money at policy issue? (4)
At policy issue, the investment guarantee will normally be
- out of the money
- Current market rates are more than sufficient to meet the guarantees, but will have a time value which is the result of views of the market of the present value of the likely future costs of the option.
- however, the guarantee may very well be in the money
- e.g. current yields may be historically so low that a life insurance company would be happy to provide a guarantee at a future date based on a higher yield (with the expectation that it may be out of the money at the future date).
Describe the general principle behind stochastic simulation of investment performance to calc the extra premium for an investment guarantee (3)
Stochastic simulations of investment returns to price extra premium
- Proj assets and comp with guar benefit=>
- the extra sums likely to be needed under the guarantee by simulating a range of investment scenarios
- a model of rates of return on investments is used to simulate the future price of assets, and we can compare this to the guaranteed sum payable
What 2 aspects are of crucial importance for stochastic simulations to be used to cost investment guarantees? (6)
Basis
Simulations
When stochastically simulating cost of investment guarantees, it is important that
-
key assumptions are evaluated carefull and should correspond with company’s planned investment strategy.
- key assumptions are
- probability distribution used to model investment return
- mean
- variance
- option take up, that needs to take account of PH behaviour and size of guaranteed amount relative to asset share
- key assumptions are
- we run a large number of scenarios/simulations to obtain reliable estimates
Describe the output from stochastic modelling? (3)
The key principle from stochastic modelling is as follows
- stochastic modelling will produce a distribution of results for the cost of the guarantee
- hence, the simulated average cost is an estimate of the expected value (for the cost) of the guarantee
- is is only an estimate, because there may still be random error, error in the structure of the model, or errors in the value of the parameters used
When using stochastic modelling to calculate the cost of the guarantee, how do we deal with issues surrounding guarantees which are ‘fixed’ vs guarantees which ‘vary’? (5)
For some guarantees, the liability generated if the guarantee is taken (or of the guarantee bites) may be
- fixed: eg maturity guarantee
- dependant on future market conditions: eg guaranteed annuity rates
- for these, factors influencing the value of the liabilities as well as assets will need to be simulated
- for guaranteed annuity rates, project market bond yields
- for with profit contracts, assumptions about future profit declarations
Once we’ve run our stochastic simulations, what would be the final step to calculate the amount to charge for providing the investment guarantee? (3)
For the final step, we
- discount the simulated cost of exercising the ‘option’
- repeated simulation will generate the probability distribution of the present value of cost of the option.
- then charge premium having a present value which reflects the market cost of providing guarantee (expected simulated cost plus margin).