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
Competitive considerations for the product:
- Price (important for standardized contracts but not when benefits are contingent on some other factor eg. investment performance)
- Product features (admin. & claims process factors into customer’s decision)
o Product differentiation can be good for marketability
o Risk of offering different terms to the rest of the market -> customer may be disappointed if they do not receive what they expected
How to reduce the capital requirements for a product?
- Low guarantees
- Charges that match the expenses by nature and by timing
- Low initial expenses / commission
- Low statutory provisioning requirements
- Single premium
Distinguish between charges & expenses
- Charges levied
o Meet the COSTS incurred by provider in setting up & managing financial structures in place
o Contribute towards providers’ profit - Expenses are outgoing payments from the insurer
Key risk related to charges vs expenses aspect of contract design:
Charges mismatch the expenses, in amounts, timing and nature (ie fixed, real or varying in some other way)
For an insurance company, the costs of an active policy include:
- Contract design
- Advertising / sales commission
- Initial administration of setting up new policyholder records
- Ongoing administration of collecting premiums/paying claims & benefits as they fall due
- Management of assets
- Overheads of the insurer e.g. rental of office space, IT departments etc.
How may each insurance company cost be matched by an appropriate charge?
- Contract DESIGN: Initial charge, % of premiums/ fixed amount per contract
- Adverts/sales/INITIAL commission: Initial charge, % of premiums
- RENEWAL commission: Ongoing charge, % of premiums or % of funds under management
- ADMINISTRATION:
o Setting up customer records - Initial charge fixed per policy
o Collecting premiums - Regular charge fixed amt per policy (increasing in line w an index)
o Pmt of benefits as they fall due - Termination charge fixed amount per policy - MANAGEMENT of assets: Regular charge as % of funds under management
- Provider’s OVERHEADS: Regular charge, loading on to one of the above charges
Explain cross-subsidies:
- Larger policies to contribute more towards expenses and profits than smaller policies
- So the larger contract may subsidize the smaller contract even if it is not profitable
Main risk when allowing for cross-subsidies:
- There is a risk that the business mix sold is not as expected
Importance of consistency with other contracts wrt. design & pricing:
- Major change results in significant systems development, which will take time and cost money
- Benefits: saving time and cost with training admin, sales staff, printing marketing literature etc.
- Inconsistency may seem unfair to existing customers and may lead to dissatisfaction and marketing risk
What are the main conflicts of contract features when designing a contract?
- Desire for profitable contract w big profit margins in premium rates may conflict with competitiveness
- Desire to offer guarantees will conflict with the desire to reduce the financing requirement
- Desire for ’bells and whistles’ to improve marketability conflict with administrative simplicity.
