CH22 - Contract design

Question 1

Factors to be considered in determining a suitable design for financial products (20)

Answer 1

1. customer needs and interests
2. the characteristics of other stakeholders involved in contract design
3. risk appetite of the parties involved
4. the regulatory environment
5. profitability
6. the market for the product
7. competitive pressures
8. the level and form of the benefits
9. options or guarantees
10. discretionary benefits
11. benefits offered on discontinuance
12. contract terms and conditions
13. capital requirements
14. method of financing the benefits
15. premium / contribution pattern
16. charges vs expenses
17. extent of cross-subsidies
18. consistency with other contracts
19. administration systems
20. accounting implications

Question 2

Exam tip - indications in questions that contract design is being tested indirectly (3)

Answer 2

Questions include phrases such as:

1. ‘launching a contract’
2. ‘setting up a new scheme’
3. ‘changing a feature of a product from X to Y, e.g. upfront charges to regular charges’

Question 3

Parties involved in contract design (8)

Answer 3

1. the providers
2. the providers’ customers
3. actuaries
4. lawyers
5. accountants
6. financial backers
7. administrators
8. sales & marketing

Question 4

The needs and interests of providers and providers’ customers (3)

Answer 4

The providers and their customers will want financial structures that meet their needs in a cost-effective manner.

The provider’s needs will be influenced by:

1. the chosen market (demographic and economic composition of the customers and the general economic and commercial environment)
2. the capital available (affects the type of contract designed and features offered)
3. the expertise available (affects the need to obtain expertise from external sources and hence the ultimate cost of providing the benefits)

Question 5

The provider’s customers’ needs are influenced by (4)

Answer 5

1. capacity to pay
2. the risks to be covered
3. the benefits that are needed at different times in the future
4. attitude to financial risk

Question 6

Actuaries involved in contract design

Answer 6

Actuaries will be involved in the initial costing of the financial structures and the subsequent determination of the provisions that will need to be held to meet future liabilities.
They will also be involved in the ongoing design process through assessing the impact on both the cost and the provisioning implications of modifications to the benefit design.

Life & General insurance:

• initial costing called pricing or rating
• ongoing design process of determining how much money to hold back is called provisioning or reserving

Pensions:

• initial costing refers to determining an appropriate initial level of contributions
• subsequent determination of the provisions that will need to be held to meet future liabilities will be done as part of the funding valuation

Question 7

Lawyers involved in contract design

Answer 7

Lawyers will be involved in the drafting of the contracts supporting the financial structures to ensure that the provider is not exposed to the risk of providing more benefits or entering into greater risks than intended.

Question 8

Accountants involved in contract design

Answer 8

Accountants will be involved in ensuring that the provider of the financial structures properly accounts for the income and outgo.

Question 9

Financial backers involved in contract design

Answer 9

The financial backers will want regular reports demonstrating proper stewardship of the finance provided.

Question 10

Administrators involved in contract design

Answer 10

Administrators will need to administer the financial structures. The more complex the financial structures are, the greater the cost of administration. This should be reflected in the amounts paid by the customers.

In addition, the more complex the structure, the greater the risk of error, i.e. of operational risk. Therefore, costs might arise from complexity both in terms of administration time and error correction.

Question 11

Sales and marketing involved in contract design

Answer 11

Sales people need training on the financial structures. The more complex the financial structures are, the greater the cost of training and the harder the contracts may be to sell.
Marketing teams can provide important information on the characteristics of the target market as part of the design process.

Question 12

Risk appetite and risk aversion

Answer 12

It is important hat the financial structure as designed meets the risk profile of the intended customer, and that the risks involved in the product are clearly explained to the customer.
Sales of a financial product will be optimised if the product can be designed to be suitable for customers with a wide range of risk appetites.

Question 13

Risk appetite/aversion for savings products

Answer 13

Savings products, whether insurance contracts or benefit schemes, this can be achieved by offering a range of investment choices. Having a range of funds available means that the contract can allow for any change in the customer’s risk appetite during the term of the policy.
The risk averse investor can select investment funds that are designed for the cautious investor.
The speculative investor can choose a fund with a low or zero fixed-interest content, and where the equity content is unconstrained.

Question 14

Risk appetite/aversion for general insurance products

Answer 14

General insurance products normally allow for differences in customers’ risk appetite through the range of risks that can be insured.
For example, motor insurance is commonly written on three bases:
- third party only
- third party, fire and theft
- fully comprehensive

Question 15

How were the providers’ risks for offering critical illness contracts reduced? (4)

Answer 15

By:

1. Offering the contract in unit-linked form to avoid a long term guarantee
2. Reinsuring a large part of the risk
3. Incorporating ample margins in the premium rates
4. Offering the contract as a rider benefit rather than stand alone

Question 16

The regulatory environment

Answer 16

• It is essential that the design of a financial product is consistent with any legal or regulatory requirements that apply to the provider or to the particular type of product.
• Legislation or regulation may provide a more attractive financial or taxation regime if the policy meets certain conditions. A government might impose this to ensure that products provide a minimum level of protection cover and are not just savings plans. Where these regimes are optional, the provider needs to decide whether the contract will be designed to be inside or outside the regime. In either case the position needs to be made clear to the customer at the point of sale to avoid misleading them.
• In some countries there may be requirements on providers to present certain information to potential customers. This may include illustrations of discontinuance terms. Disclosure requirements may also set out the discontinuance basis to be used and hence influence the extend to which policies terminating later, or remaining to maturity, subsidise the benefits offered on short duration discontinuance.

Question 17

Profitability (5)

Answer 17

Profitability is a key issue in designing insurance contracts.
The important variables that might impinge on the profitability of an insurance contract are:
1. claims experience (including mortality and morbidity experience)
- claims frequency
- claims severity
- claims inflation
- options and guarantees
2. expenses and expense inflation
3. withdrawal experience
4. new business sales volumes and mix

Question 18

The market for the product (marketability)

Answer 18

The intended target market will affect the design of a financial product.
The design will need to be attractive to the target market and appropriate for the sales method.

Question 19

Aspects of a contract’s design that will make the contract marketable (4)

Answer 19

Other aspects of a contract’s design that improve marketability include:

1. having innovative design features such as options and guarantees (high net worth individuals are likely to favour flexible products that can be adjusted as their financial circumstances change)
2. simplicity - easy to understand (products directed at lower income individuals are likely to be simple contracts with a clear insured event)
3. transparency - good disclosure of information to the customer
4. low charges

Question 20

Competitive pressures (2)

Answer 20

There are two types of competitive pressures:

1. price
2. product features

Question 21

Competitive pressures - the importance of price

Answer 21

The simpler the product, the more price sensitive the product is likely to be.
Some products are designed to cover basic insurance needs where the risk is well defined (term life insurance, annuities, private motor insurance, employer’s liability insurance). These products tend to be sold on price and the provider with the lowest price is likely to get the greatest volume of business.

Question 22

Competitive pressures - the importance of product features

Answer 22

Other products cannot be directly compared on price and instead the risks covered, the administrative systems and the claims process all feature in the customer’s decision.
There is a risk to a provider of offering terms that are very different from the rest of the market. Customers may assume that the terms are consistent with the rest of the market and be disappointed if they don’t receive what they expect, even if they receive the benefits specified by the policy.

Question 23

Deciding on the benefits to offer (level and form of benefits) (3)

Answer 23

The level and form of benefits to be provided under any specific financial structure may vary according to the:

1. customer’s needs
2. risks to be covered
3. customer’s ability to pay

Question 24

Examples of how the level and form of benefits may vary according to the customer’s needs in relation to a term assurance contract (6)

Answer 24

Variations in the level and form of benefits relating to a term assurance contract may include:

1. the amount of the sum assured
2. whether the benefit is decreasing or level
3. additional rider benefits such as critical illness
4. waiver of premium benefit, e.g. in the case of sickness, accident, unemployment
5. whether or not premiums can be reviewed
6. a renewal option at the end of the term, with or without further underwriting.

Question 25

Options

Answer 25

Options: one party to a contract has a choice to do something, and the other party cannot prevent the action. However, often the other party can set the conditions under which the option can be exercised.

The approach taken may vary depending on the type of contract. For example:

• on early termination of some types of insurance policy there may be no value. Other policies may have a value on termination, and the policyholder may receive a payment if they choose to surrender the policy.
• for a motor insurance policy, the contract may state a formula for a partial refund of the premium if the policy is cancelled early.
• for a with-profits life assurance a surrender value is paid but there is no guarantee of the amount, which is at the discretion of the company.

Some policies give the policyholder the option to convert from one type of policy to another.
Policies may give the insurer the option to increase charges, usually subject to a cap.
Regulations may impose restrictions on the exercise of options that are deemed to be unfair to the consumer.

Question 26

Give examples of options that might be offered on an insurance contract

Answer 26

Examples of options include:

• Payment of premiums
  1. waiver of premium - where the customer has the option to stop paying premiums, e.g. in the case of sickness, accident, unemployment
  2. the option to increase or reduce the level or premiums
  3. payment frequency, e.g. monthly, annual, single premium
• Benefits
  1. lump sum vs regular income
  2. protected no claims discount
  3. option to add rider benefits, e.g. critical illness to a term assurance contract
• Use of the contract proceeds
  1. option to choose between a number of hospitals for treatment under a medical expenses (health) insurance contract
• Other items
  1. Option to renew term assurance without further health checks

Question 27

Guarantees

Answer 27

The most common guarantee in financial products is the basic sum assured under a life insurance policy, or the sum assured plus bonuses under a with-profits policy.
Other products are written with a conditional guarantee: the maturity value under a unit-linked assurance might be the value of units with a monetary minimum - the guarantee is in the money when unit prices are low.
A more complex guarantee might be where a contract’s value depends on the growth in a specified equity index with a guaranteed minimum growth rate.

Question 28

Give examples of guarantees that might be offered under the following contracts

(i) an immediate annuity
(ii) household property insurance
(iii) a defined benefit pension scheme

Answer 28

(i) immediate annuity
- annuity payments guaranteed not to fall or guaranteed to increase in line with a fixed amount or with an index
- benefits paid for life but subject to minimum guaranteed period, e.g. 5 years
(ii) household property insurance
- guarantee of payment of benefits upon proof of occurrence of an event that is covered by the contract
(iii) defined benefit pension scheme
- guaranteed retirement pension, e.g. a proportion of final salary for each full year worked subject to a maximum of X years
- guaranteed death-in-service lump-sum benefit or dependent’s pensions

Question 29

Guaranteed options

Answer 29

Guarantees and options are frequently combined. A policyholder may have a choice whether to take a guaranteed surrender value on a specified date, or to continue the policy in the hope of a better return at some later date.

Any options or guarantees that are included in the financial structure will need to be charged for. Ideally this should be a charge included in the premiums paid. The alternative is to charge for guarantees through a reduction in the amount paid when the benefits fall due.

Question 30

Discretionary benefits

Answer 30

A decision needs to be made as to the extent to which surplus arising may be shared with the client.
If a contract offers discretionary benefits the primary consideration in deciding what level of discretionary benefits to offer is PRE (Policyholders’ Reasonable Expectations)

Question 31

Benefits ordered on discontinuance (3)

Answer 31

The principles underlying the determination of the benefits payable on discontinuance or transfer of right are broadly the same for insurance contracts and benefit schemes in that the amount offered on discontinuance should be fair to:

1. the policyholder or scheme member
2. other policyholders and scheme members
3. the provider of the benefits

Question 32

Discontinuance and life insurance contracts (4)

Answer 32

When setting the discontinuance terms for life insurance contracts, the insurance company should consider:

1. which contracts to offer discontinuance terms on
2. the form of the benefits being offered
3. how it goes about setting the discontinuance terms
4. any practical considerations relating to the discontinuance

Question 33

Determining the contracts for which to offer discontinuance terms (4)

Answer 33

An insurance company needs to decide the contracts for which it will offer discontinuance terms. These may be governed by:

1. market practice
2. regulatory requirements
3. the likelihood of selective withdrawals
4. or simply the difficulty of assessing suitable terms, such as the lump sum to pay on the discontinuance of an immediate annuity

Question 34

Administration costs involved in determining and implementing the terms compared with the benefit available on discontinuance (6)

Answer 34

1. Cost of determining a calculation basis
2. Computer systems development and maintenance costs
3. Costs of employing and training staff to deal with discontinuance quotations and subsequent queries / complaints
4. Marketing literature costs
5. Losses incurred due to providing overly generous discontinuance terms or due to errors in calculations
6. Cost of reviewing the discontinuance terms

Question 35

The form of the benefits offered in a life insurance context for discontinuance (3)

Answer 35

1. Surrender: the policy stops, there is no further cover and the policyholder receives a lump sum payment (the surrender value) from the insurance company.
2. Lapse: the policy stops, there is no further cover and no payment is made to the policyholder by the insurance company.
3. Paid-up: here the policyholder ceases to pay premiums but the policy continues to offer the policyholder some cover. In this case the benefit is reduced to reflect that there are no more premiums and is called the paid-up value.

Another term frequently used is withdrawal. Withdrawal encompasses surrender and lapse. The implication is that, in both cases, the policy does not stay in force and therefore it has been withdrawn.

For some types of contract the discontinuance terms, or the method of calculating them, may be guaranteed as part of the contract.

Question 36

Key principles and factors to consider in determining discontinuance terms for life insurance contracts (3)

Answer 36

1. What the policy is ‘worth’
2. Policyholder expectations
3. Competitive considerations

Question 37

The ease of calculation of the discontinuance benefits

Answer 37

Discontinuance terms will often consist of a simple formula, or table of applicable factors, which will allow mass production of surrender values and paid-up values by administrative staff, probably via some computer application. The actuary must balance the need for simplicity with the requirement for fairness of discontinuance terms.

Question 38

Discontinuance and benefit schemes (3)

Answer 38

In setting discontinuance terms for individuals in benefit schemes, it will be necessary to consider:

1. the form of the benefits being offered
2. how discontinuance terms might be set
3. any other considerations relating to the discontinuance, in particular how the funding level of the scheme might affect the discontinuance terms offered.

Question 39

Setting the discontinuance benefits for benefit schemes

Answer 39

For a defined benefit scheme, the benefits on discontinuance are likely to be known, but if they are to be transferred to another provider a value will need to be placed on them. The value will need to be equitable between members who leave the scheme and members who stay in the scheme.

The principle is that the transfer payment should be the expected costs of providing the benefits within the original scheme. So again, the overriding principle is that of fairness.

Question 40

Financial considerations - capital requirements

Answer 40

In life insurance, it is common for contracts to make a loss in their first year. This is commonly known as new business strain.

The capital requirements depend on the ‘riskiness’ of the benefits promised. Some ‘attractive’ contracts may require the provider to hold an unacceptable level of capital even if they can sell the contracts on profitable terms. This might particularly be the case where the regulatory capital requirements are assessed on a basis that is inconsistent with the economic capital requirements of the contract.

Question 41

Examples of contract design features that could be used to reduce the financing requirement (or new business strain) (5)

Answer 41

1. Low guarantees
2. Charges that match the expenses by nature and by timing
3. Low initial expenses / commission
4. Low statutory provisioning requirements
5. Single premium

Question 42

Methods for financing the benefits to be provided for an insurance contract

Answer 42

Whenever there is a period of time between a financial structure being set up and the benefits actually being provided, there is a choice as to how and when monies should be set aside to pay for the benefits.

For an insurance contract the policyholder will pay either a single premium, i.e. funding all the benefit in advance or regular premiums, i.e. regular payments building up a fund. We might say therefore that, to a greater or lesser extend, the benefits have been funded in advance.

Question 43

Methods for financing the benefits to be provided for a defined benefit scheme (4)

Answer 43

Whenever there is a period of time between a financial structure being set up and the benefits actually being provided, there is a choice as to how and when monies should be set aside to pay for the benefits.

For a defined benefit scheme, there are more choices than insurance in terms of the method of financing the benefits.
For example, for a benefit scheme the range of options that could be used are:
1. pay as you go (unfunded approach)
2. funding all the benefit in advance
3. regular payments building up a fund
4. paying an amount when the benefit event happens for example purchasing an annuity at the point of retirement

Question 44

Administrative issues

Answer 44

The product will need to be administered, this might be on the provider’s own systems or might be outsourced to a third party.
In any event, the system used needs to be able to carry out the functions that have been built into the product design at the cost that has been built into the product price.
Systems changes needed to adapt to the requirements of a revised product design also need to be included as part of the development cost of the product.

Question 45

Charges vs expenses

Answer 45

The charges that are levied will need to meet the costs incurred by the provider in setting up and managing the financial structures in place and contribute towards the profit of the insurer.

Charges: income to the provider, i.e. money taken from the customer (this may include a loading for profit)
Costs / expenses: outgoing payment from the provider

Question 46

Costs / Expenses for an insurance company (8)

Answer 46

1. Contract design
2. Advertising / Sales
3. Commission
4. The initial administration of setting up new policyholder records
5. The ongoing administration of collecting premiums
6. The administration of paying the claims / benefits as they fall due
7. Management of assets
8. The overheads of the insurer, e.g. rental of the office space, IT departments etc.

Question 47

Consistency with other products (3)

Answer 47

The provider will want to check for consistency in design and pricing with existing contracts that are being sold.

1. The key reason is that a major change will result in significant systems development, which will take time and cost money.
2. There are also benefits in terms of saving time and cost with such things as training administration and sales staff, printing marketing literature and so on.
3. There is also a possibility that a design that appears much more attractive or favorable to new customers, may seem unfair to existing customers and may lead to some dissatisfaction and possible marketing risk.