Chapter 16 Product design

Question 1

List 12 factors to be considered when assessing a product design

Answer 1

Financing requirements
Onerouseness of guarantees
Risk characteristics
Competitiveness
Extent of cross subsidies
Distribution channel
Consistency with other products
Regulation
Admin systems
Marketability
Profitability
Senstivity of profit

Question 2

Meeting customer needs

Answer 2

Savings
Protection
Disposal of income
Conversion of capital into income
Considering what stage they are in their lives

Question 3

Profitability

Answer 3

• Non-linked: premiums charged sufficient to cover benefits, expenses and provide profit margin
  Protection: mortality basis should cover risk involved, risk will gradually change and future chance should be allowed for if appropriate
  Savings: profit on investment income
  Administration: expense loadings cover marginal/admin costs incurred, allowing for cross subsidies
• Unit-linked
  Savings, protection, admin risk also relevant, but lower as
  investment risk largely borne by policyholder, and
  charges variable at company discretion
  Expense charge sufficient to cover expenses and provide profit margin

Question 4

Sensitivities

Answer 4

The company would need to perform some sensitivity tests, including whole office projections of
future embedded value and statutory solvency allowing for different new business volumes and
differences in other key assumptions. [1]

Question 5

describe assessment of product

Answer 5

Determine a range of suitable model points, to reflect the expected mix of business. [½]
These would need to differ by gender, age at entry, chosen retirement age, chosen unit fund link
and policy size. [1]
Construct a single-policy cashflow projection model that could be used for each model point. [½]
Unit fund values would need to be projected for each year, using the guaranteed charging
structure, which will require assumptions about unit growth rates and inflation rates (for
premium growth) as further inputs. [1]
Annual cashflows would be calculated, for which further assumptions are required (mortality
rates, paid-up rates, expense and expense inflation rates, and non-unit interest rates). [1]
First calculate net present values (NPVs) for each model point for the standard policy, including
only the standard 0.75% pa fund management charge. [½]
Initially need to project on the (possibly prudent) supervisory reserving basis to establish the level
of non-unit reserves required each year, if any. [1]
Also need to project the expected future solvency capital requirements. [½]
Then project the expected profit flows using the (realistic) pricing basis, allowing for the
supervisory non-unit reserves and solvency capital, and discount at the risk discount rate to
obtain the NPV. [1]
Next rerun the model including the cost of the guaranteed annuity option. [½]
This will require a stochastic model of investment yields and inflation rates at the projected
retirement date. [½]
The model chosen would be defined in terms of an assumed probability distribution and its
associated parameter values. [½]
Links would be included in the model so that the investment and inflation variables behave
realistically in relation to each other. [½]
The model will then need to be able to calculate the normal rates of annuity conversion that
would be applied at retirement, for the given simulated investment yield and inflation rate. (The
model effectively has to reproduce the annuity pricing exercise that the company would need to
perform in those simulated conditions.) [1]
In those simulations that produce worse conversion terms than guaranteed, the additional cost of
providing the guaranteed rates would be calculated as at the projected retirement date. [½]
A large number of simulations would be run, and an appropriate estimate of the cost of the
guarantee obtained from it. [½]
The unit fund and cashflow projection models would now incorporate the additional 1% pa fund
management charge. [½]
The model would again have to be run first on the supervisory reserving basis, so that the nonunit reserves can be established. [½]
These reserves (together with any required solvency capital) must enable the company to meet
the estimated cost of the guarantee at retirement, based on a prudent assessment. [½]
This could be found as the upper (say) 97.5th percentile of the distribution of simulated outcomes
of the guarantee cost. [½]
The new reserves and solvency capital are then incorporated into the premium basis cashflow
model as before, now including a realistic value of the expected cost of the guarantee at
maturity. [½]
This realistic value would be taken as the average of the simulated outcomes from the stochastic
model. [½]
The NPV is then recalculated, and compared with that previously calculated (for the same model
point) without the guarantee. [½]