Chapter 18: Models (1)

Question 1

Distinguishing models both by their purpose and structure, list the different types of model: (4)

Answer 1

1. profit test model
2. new business model
3. existing business model
4. full model office

Question 2

What are the requirements of models: (9)

Answer 2

1. The model must be valid, rigorous and adequately documented.
2. The model points must represent the business accurately.
3. The model must incorporate all the material features of the business.
4. The parameter values must be set appropriately.
5. Different variables should behave realistically relative to each other.
6. The workings of the model must be easy to explain and understand.
7. Results should be clearly displayed, verifiable, and communicable to the intended recipients.
8. The model should not be overly complex.
9. The model should be capable of subsequent development and refinement.

Question 3

What are the basic features of life insurance models: (5)

Answer 3

1. Involves projecting cashflows
2. Cost of setting up supervisory reserves and required solvency margins needs to be allowed for in order to calculate profit flows.
3. Proper allowance must be made for guarantees and options: it is likely that a stochastic modelling facility will be necessary for this.
4. Allow for interactions and correlations between variables (dynamic links)
5. Internal time period (frequency) of cashflow projections must be short enough (e.g. monthly) to produce reliable results.

Question 4

A stochastic approach may be preferred, because: (4)

Answer 4

1. we need to cost guarantees and options.
2. we would wish to see the likely distribution of outcomes, not just a single estimate.
3. the interaction between variables can be explicitly included, enabling the effect of the interactions to be assessed.
4. we need to estimate a probability.

Question 5

Deterministic modelling can be used: (3)

Answer 5

1. with sensitivity testing, in order to get an approximation to a stochastic result.
2. where the result obtained would be very similar to (or, if not, more prudent than) a stochastically produced result.
3. as a check on a stochastic model.

Question 6

What is a model point (2)

Answer 6

• A “model point” is a data record that is fed into the computer as an input for the modelling program.
• It will represent either a policy or a group of policies, containing data on the most important characteristics of the policy (or group of policies.)

Question 7

Basic features of a life insurance model - Projecting cashflows and profit:

Answer 7

the model needs to allow for all the cashflows that may arise, which will depend on the nature of the contract(s), in terms of premium and benefit structure and any discretionary benefits such as non-guaranteed surrender values or bonuses.

Question 8

Basic features of a life insurance model - Allowance for supervisory reserves and solvency margin:

Answer 8

the model also needs to allow, where appropriate, for the cashflows arising from any supervisory requirement to hold reserves and solvency capital.

Question 9

Basic features of a life insurance model - Allowance for interactions

Answer 9

the cashflows need a to allow for any interactions, particularly where the assets and the liabilities are being modelled together.

Question 10

Basic features of a life insurance model - Allowance for guarantees and options

Answer 10

Where the business being modelled includes health options the potential cashflows from such options need to be allowed for.

Question 11

Basic features of a life insurance model - Projection frequency and time period

Answer 11

the time period for calculating the cashflows in the projection needs to be chosen bearing in mind that:

1. the more frequent the cashflows are calculated the more reliable the output from the model;
2. the less frequently the cashflows are calculated the faster the model can be run and results obtained.

Question 12

Describe the financial economic approach: (4)

Answer 12

1. The financial economic approach assumes market-consistent values for parameters.
2. The assumed investment return should be risk-free, as the potential additional returns from more risky assets should be exactly cancelled out by the increased risk.
3. Assets are valued at market value. Market-consistent values of the liabilities can be calculated as the current market values of the (risk-free) assets that match the liability cashflows.
4. Assessing the market values of other (non-financial) aspects of the liability (like mortality) is more problematic. There may be some actual market valuations of liabilities available - e.g. for traded endowments.

Question 13

Different approaches to the setting (“calibration”) of economic assumptions: (2)

Answer 13

1. Risk neutral calibration - The focus of these calibrations is to replicate the market prices of actual financial instruments as closely as possible, using an adjusted (risk neutral) probability measure.
2. Real world calibration - The focus of these calibrations is to use assumptions which reflect realistic “long-term” expectations and which consequently also reflect observable “real world” probabilities and outcomes.

Question 14

Choosing model points:

Answer 14

The model points chosen must be such as to reflect adequately the distribution of the business being modelled.

Question 15

Financial economic approaches:

Answer 15

Financial economic approaches to modelling insurance business generally seek to set future unknown parameter values so as to be consistent with market values, where a corresponding market exists.

Question 16

Financial economic approaches:

Answer 16

Financial economic approaches to modelling insurance business generally seek to set future unknown parameter values so as to be consistent with market values, where a corresponding market exists.