Chapter 17 Pricing (1) Overview and methods Flashcards
Pricing method: intro
What different approaches can be taken to price healthcare insurance contracts? (2)
- Formula approach (also known as ‘equation of value’ approach)
- Projecting cashflows
Pricing method: equation of value (EOV), intro
What is this approach also known as? (1)
What principle is this pricing method based on? (2)
Write down the equation of value to price products via this method and comment on the discount rate used with this method (2)
Also known as formula approach
Key principle is that:
- value of income must be greater than or equal to value of outgo,
- with surplus belonging to supplier of capital
Equation of value
- EPV[Outgo] = EPV[Premium] + EPV[Other non-premium income]
- Discounted using suitable interest rate equivalent to return achievable by investing proceeds of policy as they arise during policy duration
Pricing method: EOV, components, intro
What components are allowed for in the equation of value approach? (6)
Outgo components
- claims & related expenses
- other expenses
- value of tax
- value of profit transfer to insurer
Income components
- premiums and related expenses
- investment income
Pricing method: EOV, outgo components
What components are allowed for in the equation of value approach under the following
- Claims and related expenses (2)
- Other expenses (2)
- Tax (2)
- Profit transfer (1)
*
Claims & related expenses
- discounted value of future claims outgo
- claims handling expenses, including inflation
Other expenses
- other expenses not related to expenses already projected (eg admin expenses)
- with standard inflation assumption being used
Value of tax
- can adjust discount rates to simplify or
- make explicit allowance adjust profit criteria/expenses
Value of profit transfer to insurer
- can include a profit objective in the formula, then solve EOV
Pricing method: EOV, income components
What components are allowed for in the equation of value approach under the following
- premiums and related expenses (4)
- investment income (3)
Premiums & related expenses
- projected and discounted, allowing for
- escalation,
- withdrawals and
- premiums holidays
- related expenses e.g commission, if directly related to premiums, allowing for inflation/escalation where applicable
Investment income
- reserves ignored in formula approach
- can include a cashflow item for investment income to account for timing different beween cash flows where amounts are invested
- usually allowed for through discount factor and timing
Pricing method: EOV, advantages disadvantages
What is the key advantages of using the EOV/formula approach to pricing health insurance contracts? (1)
What are the drawbacks of using the equation of value approach (EOV) to pricing contracts? (9)
Advantages of Formula Approach:
- the approach is simple/has reduced modelling complexity => better for short term contracts
Drawbacks of Formula Approach
- Doesn’t allow for proper timing of events
- Doesn’t allow for accumulation of reserves
- Doesn’t allow for capital requirements
- Doesn’t allow for impact of net negative cash flows (assumes cash borrowed at discount rate)
- Doesn’t allow for separate inspection of premium flows
- Doesn’t allow variation in returns
- Doesn’t allow for changes in assumed future experience or sensitivity of profit
- Doesn’t allow for sensitivity analysis
- Cannot easily allow for complex product structures
Pricing method: cashflow techniques, overview
Give a brief overview of the cashflow technique used to price healthcare insurance contracts (6)
Overview
- primary method used to price contracts
- involves projecting actual cashflows expected to emerge for contract being priced
- especially popular/important for long-term contracts (CI, LTCI), not so much for short-term contracts (PMI) as it can be overly complex
- where cashflow tecnhiques are used for short -term contracts:
- can be used to test spreading of initial expenses,
- can assess premium adequacy over longer term
Pricing method: cashflow techniques, advantages
Give the key advantages that arise from the use of a cashflow model to price healthcare insurance contracts (6)
In general, cashflow modelling techniques many of the shortfalls of the formula approach
- Can easitly perform sensitivity tests (simply by varying assumptions).
- Can model complex products (more so than with formula approach)
- Commercial software packages available
- Can do stochastic modelling of complex product features
- Can investigate negative cashflows and need for additional reserves
- Can assess adequacy of premium for producing desired return
Pricing method: cashflow, model components
What components typically form part of a cashflow model? (11)
- Premiums
- Expenses
- Commission
- Claims
- Contributions to Unit Reserves or Contributions to Statutory Reserves
- Contribution to Solvency margin
- Interest on Reserves or Yield on Units
- Policy Fees
- Management Charges
- Risk Charge Deductions
- Tax
- …essentially all cashflows expected to emerge under the contract being modelled
Pricing: overview of pricing exercise
What is product pricing? (4)
Pricing is the process of setting the premium/charging structure, for
- new busines or
-
existing business
- continually monitoring validity of premium rates on exist bus
- re-examine if expected future experience changed from that used in initial pricing)
Pricing: steps, intro
List the steps involved when models are used for product pricing (4)
- Choose model points
- Project cashflows
- Discount cashflows at RDR that allows for
- Premium/charges for model point set to produce profit required by company
Pricing: steps
Outline how models are used for product pricing according to the following steps (4)
- Choose model points (4)
- Project cashflows (2)
- Discount cashflows at RDR that allows for (3)
- Set premium/charges (1)
Choose model points
- representing either expected new business, or existing business, depending on purpose
- new bus: can use profile of existing bus, adjusted for expected future changes
- existing bus: can use profile of similar busisness, with advice from marketing department
Project cashflows
- For each MP, project all cashflows…
- …allowing for reserving + solvency capital requirements, on basis of set of assumptions
Discount cashflows at RDR that allows for
- return required by company
- level of statistical risk attaching to cashflows (so in theory, separate RDR for each component of cashflows)
- theoretically, separate RDR used for diff CFs, since statistical risk associated with each will be different
Premium/charges for model point set to produce profit required by company
Pricing: level of calculation
At what level of calculation may a pricing exercise be performed?
Individual Policy Level:
- premiums/charges set so that each model point is profitable.
- can fine-tune individual model point premiums for profitability.
- can be uncompetitive for small policies.
Cohort Level:
- can use average assumptions to target total profitability across cohort.
- introduces some level of cross subsidy
Office Projections:
- build aggregate cashflows for product line or company.
- estimate company revenues against future solvency and capital requirements.
Pricing: profit criteria, definition, examples
Define the term ‘profit criterion’ and name 3 profit criteria (3)
Single figure that tries to summarise relative effeciency of contracts with different profit signatures
- NPV (net present value)
- IRR (internal rate of return)
- DPP (discounted payback period)
Pricing: profit criteria, NPV, definition
Describe the net present value criterion (2)
- NVP of profit signature is calculated by discounting all cashflows at risk discount rate
- Economic theory implies NPV is best profit criterion to use
Pricing: profit criteria, NPV, usefulness
How good/useful is NPV as a profit criterion? (3)
- The higher the NPV between two investments the better.
- This choice is optimal and cannot be improved.
- The NPV is the best profit criterion to use, if any other profit criterion disagrees with it a company should go with the NPV.
Pricing: profit criteria, NPV
List 4 issues regarind the NPV criterion (8)
It’s dependent on assumptions of
- RDR appropriately reflects risk inherent in each invidual investment
- operating in free and effecient capital market
NPV means little by itself (e.g. can double NPV by doubling MPs’ premiums), so NPV normally expressed in relative terms such as
- in proportion to initial sales costs (reflects relative to effort that would be expended in selling contracts)
- in proportion to total discoutned premium incomes (reflects relative to size of market; has advantage of focusing on increasing market share of insurer)
Subject to law of diminishing returns,
- else company could sell unlimited same policy with positive NPVs to increase profits
Says nothing about competitiveness:
- no point in having a high NPV if the product can’t be sold sell
Pricing: profit criteria, IRR
Define the internal rate of return profit criterion (3)
State 3 reasons why the NPV may be more reliable than the IRR (3)
- Defined as rate of return at which discounted value of cashflows (NVP) is zero
- All other things being equal a company should prefer a contract that has a higher internal rate of return
- Company will usually prefer contracts with higher IRR
Potentially NPV may be a better profit criteria to use than IRR
- If more than one change of sign in stream of profits, IRR wil not usually be unique
- NPV can be related to useful indicators of policy’s worth to company, IRR can’t
- NPV always exists. IRR may not exist (e.. if policy makes profits from outset)
Pricing: profit criteria, DPP
Define the discounted payback (DPP) profit criterion and state why it will not usually agree with the NPV (2)
When is the DPP an important criteria? (4)
What is the key issue with the DPP? (1)
- Policy duration at which the profits that have emerged so far have zero present value i.e. time it takes for company to recover initial investment with interest at risk discount rate
- DPP will not usually agree with NPV as it ignores cashflows after the DPP
When is the DPP criteria important:
- When limited capital available=> sell policies with short DPP so as to recoupe capital soonest
- When pricing long-term policies
- When contracts being priced involve large initial capital strain
- Greater variation in DPP
Key issue with DPP
- it ignores all cashflows after the discounted payback period
Pricing: other considerations, marketability
Briefly descri be 5 possible responses to premiums/charges being unmarketable (9)
(After premiums/charges that meet profit criterion have been determined, and marketability needs to be considered.)
- Reconsider product design e.g.
- remove risky features
- add product differentiating features
- Consider distribution channel change if would cause/permit
- assumption change in model
- higher premium/charges without loss of marketability
- Reduce company’s profit requirement
- Decide not to market the product
- Re-examine assumed expenses
Pricing: other considerations, capital requirements
Describe how capital requirements and expected return on capital should also be considered when performing a pricing exercise
Consider
- profitability of individual contracts vs entire book (2)
- impact on/of EV (2)
- sensitivity testing (1)
- Observing modelled cashflow timings and amounts (3)
Net CFs from new business MPs (after scaling up) will be included in model of business of whole company
Can compare with profits expected to emerge to determine expected return on capital.
Profitability of individual contracts vs entire book
- possible for desired profitability to be met in aggregate, and not every single MP being profitable
- …exposed to changes in mix of business
Look at EV
- Full model office since future new bus=> significantly affect future EV
- project EV to allow for management action: compare EV under different management decisions
Test outcome sensitivities to experience esp dif volumes/mix of business
Observe modelled CF timings and amounts
- ..to assess impact of writing new product. if capital is a problem, may need to reconsider prod design
- new/existing bus useful
- allow for supervisory min solvency margin
