Chapter 13 Assumptions (3) Other assumptions Flashcards
Describe other assumptions crucial to pricing and valuation.
Cost of capital
How do capital costs arise when selling new policies? (2)
How does the cost of capital impact the assumptions used during a pricing (or other) exercise for health insurance contracts? (4)
Cost of capital arises because
- Writing a policy requires need for regulatory reserves and statutory solvency margins.
- Riskier business has higher capital requirements.
Impact of cost of capital on assumptions
- Need to charge each new policy for cost of capital
- Charge is investment cost arising from holding ‘locked in’ statutory capital rather than investing them in business acquisition e.g.
- If IRR 10% and assets yield 4%, there is a -6% return, or ‘cost of capital’
- May decide not to charge for capital if adequately capitalised and desire to be competitive
Profit requirements: risk risk discount rate (RDR), intro
Explain what is meant by the term risk discount rate (3)
Risk discount rate refers to return on capital demanded by providers of that capital (shareholders, in the case of am insurance company), plus an allowance for risk associated with investment in the insurer in question
- it is made up of/should reflect:
- return shareholders could obtain from a risk-free asset
- plus risk premium to compensate for volatility of return
- essentially, shareholder requires a
- Risk Discount Rate = Risk Free Rate + Risk Premium
Profit requirements: RDR, methods
What methods can be used to determined RDR? (2)
Give an overview of how we may determine the risk discount rate (3)
In theory, how is the RDR applied to the various cashflows in pricing of healthcare contracts (or other exercises), and how does this compare to what’s done in practice? (3)
To determine RDR, can use
- CAPM
- Statistical methods
Overview for determining risk discount rate
- can be determined by quantifying risk premium appropriate for company e.g. using CAPM
- market availability of capital should also be taken into account
- it is important to note that market’s view of RDR is not necessarily most apt for any given product, as different products will have different levels of riskiness.
In theory
- each cashflow should have its own seperate RDR, and discounted as such
- not done in practice due to spurious accuracy/or perhaps due to the perception that this level of detailed modelling isn’t required
Profit requirements: deciding RDR, CAPM, intro
What assumptions does the CAPM rely on? (3)
What is the fundamental principle that the CAPM is based on? (1)
Assumes the following exist/hold true
- perfect market (well-diversifed portfolio avail to diversify risk)
- perfect information
- investors want risk free return + risk premium
Used by investors to determine RDR:
- idea is that a well-diversified portfolio of shares cancels out specific risks, leaving only systematic risk
Profit requirements: deciding RDR, CAPM, process
Outline how CAPM can be used to give guidance on the RDR to use for a particular exercise (8)
- Choose suitable proxy to represent risk free asset/risk free rate
- eg gov issued: short term deposits, bonds, long dated infl-linked bonds
- Estimate average risk premium which well-diversified portfolio has yileded over the risk free rate over a period of time
- Can then ask question: how risky is a particular company’s share compared with diversified portfolio?
- CAPM result is that proper risk premium is in proportion to Beta (market relation) => can use this info to estimate Beta for company
- From Beta we can estimate expected return for company as
- Exp Return = risk free + Beta*(Exp Market Return - risk free rate)
- Beta
- is covariance of market return and share return
- measures riskiness of asset relative to market; higher than 1=> more risky, etc
Profit requirements: deciding RDR, CAPM, pitfalls
Why can’t we simply use the CAPM when deciding on a suitable RDR to use in assumptions for health insurance contract pricing (or other exercises)? (3)
One of the biggest pitfalls of using the CAPM is that it doesn’t allow for the specific risk of the insurer, only market risks.
What factors might affect the riskiness of the insurer in terms of products/projects undertaken? (6)
Can’t simply use CAPM as
- assumptions may not hold true in practice
- one of biggest pitfalls: doesn’t allow for specific risk of company, only market risk
- not all projects company undertakes are equally risky (some products have more innovative features, eg)
6 things that might affect riskiness of products/project life company undertakes
- Lack of historical data
- High guarantees
- Policyholder options
- Overhead costs
- Complexity of design
- Untested market
Profit requirements: deciding RDR, statistical methods
Give an overview of how statistical methods are used to set a company’s RDR for a given pricing (or other) exercise of health insurance contracts (3)
How might we use a statistical approach to asses the insurer’s risks and allow for them in the RDR? (4)
Insurer can view itself as an investor, investing in various risky products. Moving towards new and innovative products makes the company riskier.
- the higher the risk, the higher the RDR
- competition makes it difficult to allow properly for high risk business
Can assess levels of statistical risk (and allow for them) by
- analytically, by considering variances of individual parameter values used i.e VaR[Return]
- sensitivity analysis
- using stochastic models
- comparison with any available market data
Profit requirements: deciding RDR, combining methods
How do we bring together the 2 approaches for deciding on the RDR? (CAPM and statistical methods) (7)
Bringing CAPM and statistial meths for RDR estimation together
- If we consider CAPM to give overall true expected return required, then less risky than average products will have RDR < CAPM return, and vice versa
also consider that
- if expected return hasn’t changed much since last pricing, don’t need to change RDR
- risk reduces as profit emerges, but fundamental risk profile remains the same
- RDR must be > risk free rate; if risk free changes => RDR changes
- Margin between risk free and RDR must attempt to reflect all sources of risk on product
- RDR on different products => reflect relative risks of products
- RoC on whole company must meet required rate of return from capital providers
- RDR is number used as profit criterion
Profit requirements: profit criteria
What do we mean by ‘profit criteria’? (4)
What do we mean by profit criteria?
- profit criteria is a hurdle/requirement that has to be met by pricing premiums/charges, given assumptions used.
- it’s actually also an assumption affecting the overall outcome of the exercise
- eg
- NPV: expected future profits, discounted at RDR
- can set profit criteria to have NPV = 0
Margins: intro, why we use them
What are margins and why do we include them in our assumptions? (1)
What key factors infuence the margins to use for pricing (or other exercise) for healthcare insurance contracts? (3)
Margins are additional prudence built into the assumptions used for pricing (or other exercise)
Why do we use margins when pricing (etc) for healthcare contracts
- use margins because risk to company arises from potential for adverse future experience compared to what’s expected
- in healthcare, volume of statistics not as readily available, claim outcomes are more subjective and influenced by factors outside of control.
- higher margins than life insurance required for prudence.
Margins: influence on margins to use
What key factors infuence the margins to use? (3)
What additional factors influence the margins used and the ultimate price set for a healthcare insurance contract? (6)
Use of margins depends on
- degree of risk associated with each parameter used
- financial significance of the risk from each parameter
- purpose for assumptions
- pricing => competitiveness (but also prevent losses)
- if margins are too high, risk competitiveness
- if margins too low, risk losses
- pricing => competitiveness (but also prevent losses)
Margins and ultimate price ultimately depend on
- level of competition
- company’s unique selling proposition
- attitude to risk
- credibility and relevance of data
- size of company’s reserves
- guarantees
Margins: determining margins
How might we allow for margins in the assumptions used to price healthcare insurance contracts (or some other exercise)?
(3 main points)
(6 subpoints)
Parameters discussed so far would mostly be best estimate parameters. We can allow for risk through:
- through the risk element of the risk discount rate
- only applicable to cashflow model
- using stochastic approach
- only applicable to cashflow model
- using best estimate for non-stochastic assumptins, using a risk free rate, modelling one/more assumption stochastically
- assessing margins to apply to expected values
- and using a risk free rate to discount
- applicable to either cashflow/formula model
- formula model needs judgement, as doesn’t help actuary determine extent of risk
Unit charges
In what way do unit charges feature in the set of assumptions reqiuired to price health insurance contracts (or perform other exercises)? (3)
- Require assumptions for unit charges. Often residual when other profit contributions are fixed.
- Assumptions required for
- management charges,
- bid-offer spreads and
- surrender penalties.
Consistency between assumptions: intro
Consistency between assumptions is of vital importance. What do we mean by consistency? (3)
- By consistency, we mean
- considering assumptions in totality, not just isolation
- realistic allowing for how variables behave together, if where correlated
- sometimes relationships between 2 parameters more important than absolute value
Consistency between assumptions: examples
Give some examples of aspects where consistency is important between parameters used (9)
- Investment return and inflation
- long term relationship btwn expense inflation & returns on diff asset classes must be valid
- sometimes, no need to allow for future investment conditions if no reinvestment risk exists
- Tax
- if company taxed on “i-E”, investment income and expense assumptions must reflect this
- profits from profit testin should be measured net of tax
- Withdrawal rates, non-renewal and investment return
- lapse rates affected by general economic climate, which feeds into investment return
- lapse also affected by: bonus levels, discontin terms, renewl comm
- Morbidity and Investment Return: higher claim inception when economic conditions poor
- Morbidity and Claim Expenses: higher claim severities pushes up claims experience
- Morbidity, Non-Renewal and Lapse: higher lapses, higher chance for selective lapsation
- Consistency with other products
- basis consistent with other related products…basis for other products may even form a starting point for the assumptions being set
- inconcistency could lead to too similar products being sold at different prices, affecting consumer buying/discontinuance
- lapse and re-entry
- bad publicity/marketing risk
- profits will be at increased risk from changes in new bus mix
- New business and expenses
- Loadings for expenses: such that given anticipated sales volumes over expected lifetime give total loadings which recoupe develop costs + pay fair share towards company overheads
- Profit contribution: if new bus assumptions don’t turn out to have been optimistic, product shold make additional profit contribution
- Assumption should reflect competitive position: or product in market
