Chapter 10: Contract design Flashcards
Contract design factors
A - ADMINISTRATION simplicity M - MARKETABILITY P - PROFITABILITY L - LEVEL & form of benefits E - EXPENSES & charges
D - DISCONTINUANCE benefits I - INTERESTS of customers R - RISK APPETITE of parties involved E - discretionary ENEFITS C - COMPETITION T - TIMING of contributions & premiums
F - FINANCING requirements A - ACCOUNTING implications C - CONSISTENCY with other contracts T - TERMS and CONDITIONS O - OPTIONS & guarantees R - statutory / REGULATORY requirements S - extent of cross-SUBSIDIES
Parties involved in contract design (7)
- providers
- providers’ customers
- actuaries
- accountants
- lawyers
- administrators
- financial backers
- sales & marketing
3 influences on client’s actual needs
- chosen market
- available capital
- available expertise
4 influences on the actual needs of a client’s customers
- capacity to pay
- risks to be covered
- benefits needed at different times in the future
- attitude towards financial risk
Stakeholders involved in contract design:
- Actuaries
Actuaries will be involved in
- the INITIAL COSTING of the financial structures
- the subsequent determination of the PROVISIONS that will need to be held to meet future liabilities.
- the DESIGN through assessing the impact of both the cost and reserving implications on modifications to the benefit design.
Stakeholders involved in contract design:
- Lawyers
Involved in DRAFTING 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.
Stakeholders involved in contract design:
- Accountants
involved in ensuring that the provider of the financial structures PROPERLY ACCOUNTS for their income and outgo.
Stakeholders involved in contract design:
- Financial backers
Financial backers will want REGULAR REPORTS demonstrating proper stewardship of the finance provided.
Stakeholders involved in contract design:
- Administrators
- Sales & marketing
- Need to ADMINISTER, MARKET & SELL the financial structures.
- Complex financial structures result in:
o Greater cost of administration
o Greater cost of training and tough sells
3 Basis motor insurance is commonly written on
- 3rd party only
- 3rd party, fire and theft
- fully comprehensive
Level and form of the benefits to be provided to a customer vary according to (3)
- client’s needs
- risks to be covered
- client’s ability to pay
Financial products and schemes often contain terms and features that provide options to the client with respect to: (4)
- payment of premiums (increase/decrease of premiums or change of frequency)
- benefits (lump sum vs regular income, option to add rider benefit, protected no claims discount)
- use of the contract proceeds (option to choose b/w hospitals for treatment in healthcare)
- other items (option to renew term assurance w-out further health checks)
4 Commercial considerations associated with contract design
- profitability
- marketability
- competitiveness
- statutory / regulatory requirements
5 important factors that might affect profitability of an insurance contract:
o Claims experience o Expenses & expense inflation o Investment returns o Withdrawal experience o New business sales volumes and mix
4 Elements regarding the profitability element of claims experience:
- frequency
- severity
- inflation
- options and guarantees
Regulation can affect (6)
- CAPITAL REQUIREMENTS of a contract
- contract DESIGN (through tax incentives or compulsion)
- PREMIUM (min or max)
- SALES METHOD/PRACTICES used (might need to provide info. to potential customers eg. discontinuance terms in marketing literature)
- level of UNDERWRITING allowed
- POST-SALE practices eg. compulsory cooling-off periods
New business strain
New business strain arises because the premium received in the first year may be less than
- sum of the initial expenses,
- initial commission paid
- initial increase in provisions (or reserves)
- and the initial solvency capital requirements.
- Some contracts might be profitable however they require holding unacceptable levels of capital
4 methods of financing regular benefits before they are paid out:
- pay-as-you-go
- funding all the benefit in advance
- regular payments building up a fund
- paying an amount when the event happens for example purchasing an annuity at the point of retirement
Pay-as-you-go
A situation where the sponsor makes the necessary payments only at the points that each separate tranche of a benefit becomes due.
Costs for an insurance company setting up a contract
INITIAL:
- contract design
- advertising/sales
- commission
ADMINISTRATION:
- of setting up new client records
- the ongoing administration of collecting contributions / premiums
- the administration of paying benefits as they fall due
OTHER:
- management of assets
- the profits of the provider
- the overheads of the provider
Risk appetite considerations when designing products:
- Sales are optimized if the product can be designed to suit wide range of risk appetites
- Product should suit the risk profile of the customer
- Risks should be clearly explained to customer
Characteristics of risk seeking vs risk averse customers in context of making savings through a pension plan:
RISK SEEKING
- young (long time to retirement to correct any adverse experience)
- no dependants
- pension benefits available from other sources (State and employer)
- other wealth (eg equity in large home)
RISK AVERSE
- close to retirement
- family to support
- limited or no other sources of pension provision
- limited wealth
What do you consider when trying to make a product marketable?
- The target market will affect the design of the product
- Components that influence marketability:
o Innovative features like Os & Gs (flexibility)
o Simplicity: easy to understand
o Transparency: good disclosure of info to customer
o Low charges
What are customer product expectations driven by?
- Market standard
- Past practices of the company
- Marketing literature about the products
