Chapter 10: Contract Design Flashcards
Contract factors
A - Administration systems M - Marketability P - Profitability L - Level and form of benefits E - Early leaver benefits
D - Discretionary benefits I - Interests and needs of customers and other stakeholders R - Risk appetite E - Expenses vs charges C - Competition T - Terms and Conditions of contract
F - Financing requirements A - Accounting implications C - Consistency with other products T - Timing of contributions O - Options and guarantees R - Regulatory and Statutory requirements S - Cross-SUBSIDIES
Consider potential conflicts between these factors.
Who are the parties in contract design?
What are their needs and interests?
- Client
- Client’s customers
- Financial backers
- Actuaries
- Lawyers
- Accountants
- Administrators
Needs of the client
Needs are influenced by
- cost efficiency,
- the chosen market,
- the capital available
- expertise available
- and its objectives.
Needs of the client’s customers
Needs are influenced by
- their capacity to pay,
- risks to be covered,
- benefits needed at different points in the future, their -
- attitude to risk
- financial sophistication
Needs of the lawyer
Involved in drafting of the contracts
Needs of the accountants
Ensure that income and outgo is correctly accounted for.
Needs of the financial backers
Require regular reports on the use of their funds
Needs of administrators
Want simplicity.
How would a savings product meet a wide range of risk appetites?
By offering a WIDE RANGE OF FUNDS and therefore meeting customers’ different and changing needs over the policy term
What do the level and form of the benefits depend on
- the risks to be covered
- the client’s needs
- the client’s ability to pay
How might you charge for options and guarantees
- as an upfront charge
- as a reduction in benefits when they fall due
2 Main ways of financing benefits
- funding in advance
- pay-as-you-go
9 Examples of expenses and other factors that should be covered by loadings on the premium
R - Renewal administration expenses A - Asset management expenses P - Profit loading I - Initial administration expenses D - Design expenses
C - Commission
O - Overheads
S - Sales and Advertising expenses
T - Terminal expenses (eg paying benefits)
Initial administration expenses
e.g. setting up new client records
What does it mean for a product to be “profitable”
the premiums charged should cover the benefits and expenses in most foreseeable circumstances.
What should a provider consider in relation to the riskiness of the contract?
How much risk it is willing to absorb internally or to reinsure.
How might regulatory requirements influence contract design?
Might have a direct impact on:
- the benefits
- premiums
- investments
Might have an indirect impact on:
- the level of provisions required.
What is the Contract Design Acoronymn?
AMPLE DIRECT FACTORS
What are the factors in the first word of the Contract Design acronymn?
AMPLE Admin systems Marketability Profitibility Level and form of benefits Early leaver benefits
What are the factors in the 2nd word of the Contract Design acronymn?
DIRECT Discretionary benefits Interests and needs of customers Risk appetite Expenses vs charges Competition Terms and conditions of contract
What are the factors in the 3rd word of the Contract Design acronymn?
FACTORS Financing (capital requirements) Accounting implications Consistency with other products Timing of contributions or premiums Options and guarantees Regulatory requirements Subsidies (cross)
What costs do product providers need to think about?
RAPID COST
Renewal admin Asset managements Profits Initial admin Design of contract
Commission
Overheads
Sales/advertising
Terminal e.g. paying benefits
What are the characteristics of a well run project?
PROJECT CRAMPS
Planning (full)
Risk analysis (thorough)
Objectives (clear and reflect customer needs)
Judge (monitor) development
Excellent intercommunication
Conflict management (leads to development)
Thorough testing at all stages
Critical path analysis
Relationships with external suppliers (challenging and stable)
Appropriate pace, so deadlines reach on time
Milestones review schedule
Performance and quality standards are set and measured
Supportive environment
What are the contents of a written strategy document?
PROSE
Policies Roles and responsibilities Objectives Schedule Expected cost
What criteria would be used in an initial appraisal?
SPURS
Synergies with other projects Political constraints Upside potential Results (financial side) Scarce resources
What tools do you use to identify risks?
DR RUB
Desktop analysis Risk analysis at high level Risk register/matrix Upside as well as downside risks identified Brainstorming
What types of risk to the project are there? (identify causes of risk)?
PNE FC PB
Political (opposition from 3rd party, sponsors)
Natural (storms/volcanoes)
Economic (interest rate, curr, infln)
Financial (refinancing issues, incorrect cashflow estimates)
Crime (fraud)
Project (poor design, over-budget)
Business (competition, loss of key personnel, safety)
What are the fat risk mitigation techniques?
FAT SIR
Further research
Avoid
Transfer
Share
Insure
Reduce
How do you evaluate risk mitigation options?
OFFER
Overall impact on distn of NPV's Feasibility and cost Further mitigation required in response to secondary risks Effect on frequency/severity/correlation Resulting secondary risks
What are the contents of an investment submission? (submission for whether to take on project)
FIRM PEN
Financial results (ENPV, distn of NPV’s)
Identifying and analysing key residual risks
Recommendation
Mitigation strategy (best one)
Proposed method of financing it
Effect on investors
Non-Monetary issues, e.g. synergies, political risks
What more do you consider beyond the investment submission?
LAND HO
Last minute considerations
Allowance for approximations and bias
Nowledge not in possession of those preparing the submission
Doubts over feasibility
Hunch
Overall credibility
What are the types of policies considered in the strategy documents
Financial Legal IT Risk management Tech Communications
What are the 4 things that should DEFINITELY be included in strategy document?
AIRS
Aims
Issues necessary for implementing project
Risk areas effecting viability
Strategies for dealing with risk areas
What is the definition of a capital project?
Initial expenditure, with future income and running costs (not necessarily a physical asset constructed)
Explain what WACC is?
The cost of raising incremental capital to carry out a project, the rate which a project must earn so shareholder are no better/worse off
Explain the formula for WACC
The weighted average cost of raising capital, with weights set to the optimal proportions of bonholders (debt) and shareholders (equity)
What is the WACC formula?
WACC=MVdebt/(MVdebt+MVeq) * debtholder req return + MVeq/obvious * eq holder req return
What is the debtholder required return?
Real return on IL bonds plus margin for creditworthiness * (1-corp tax)
What is the equity holder required return?
Real return on IL bonds + eq risk prem
The WACC is a real discount rate, what does that mean?
It should be applied to cashfolows in todays values
What do you do to the WACC if project is higher risk than normal?
Increase as higher systemic risk, look at other companies, or take arbitrary increase
What testing should you do with WACC
Sensitivity on different discount rates
Why shouldn’t you have a really high discount rate on WACC
Because that would mean lower importance on late cashflows so may accept a risky project (gets risky later on)
What are the characteristics of a successful team?
Commited to success of project Leaders are good Excellent communicator Friendly but not afraid of each other Experience is varied Deadlines are met
What are the characteristics of a successful leader?
Motivates Organisation of resources is good Decisive action taker Establish directions Strong/experiences to drive team forward
What are the NPV advantages?
Measure of expected added value
Time value of money allowed for
Riskiness (Disc rate) allowed for
What are the IRR advantages?
Comparison is possible because single number
Understandable
Comparison of CoC to rate of return possible
What are the Payback Period advantages?
Simple calculation and communication
Periods that are critical are useful, if cashflows are critical to company
What’re the NPV disadvantage?
Length of project not taken into account
Timing of profits not taken into account
What are the IRR disadvantages?
Multiple solutions or none are possible
Size of project not taken into account
Length of time of project not taken into account
What are the Payback Period disadvantages?
Cashflows after payback period not accounted for
Time value of money not accounted for (DPP)
Customer needs
- Consider whether contract meets needs of target market
- Risk appetite, benefits desired (core/ additional), capacity to pay for insurance
- Current/ future; logical/emotional
- Flexibility (benefit and premium, amount and timing)
Marketability
• Additional benefits and innovative products enhance marketability
• Flexibility = marketability
• Guarantees should enhance marketability
• Guarantee too complex = contract more difficult to understand = less marketable
• Consider whether expected sales volumes will be sufficient for the company to make an adequate contribution to fixed expenses and profits
o Rider benefits as opposed to stand alone contract= greater volume sold (easier to see “optional extra” than completely new product)
• Min/ max prem/cont/benefit = reduced marketability (restrictive for low/high earners)
• Weak discontinuance terms = reduced marketability
• Potential prizes increase marketability but must involve reasonable chance of winning
• Low charges and transparency increase marketability
