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Chapter 19 Flashcards

1
Q

What are the various uses of models?

A
  • Product pricing
  • Assessing return on capital
  • Assessing the profitability of EB
  • Developing an appropriate investment strategy
  • Projecting future supervisory solvency position
  • Other financial projections required by the LIC
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2
Q

What are the different features that need to be considered when using models for product pricing?

A
  • Need to determine the premium or charging rates
  • Need to consider the profit criteria
  • Need to consider the marketability of the product being modelled
  • Need to take account of the capital requirements of the product being modelled
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3
Q

How would the model points be determined for an existing and new product?

A

Existing product - use profile of existing business, modified to allow for any expected changes in the future to obtain model points
New product - use the profile of a similar existing product combined with advice from the marketing department to obtain model points

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4
Q

What existing business will be used for model point selection?

A

EB written recently and adjusted for expected changes in mix of business in near future

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5
Q

The net projected CFs will be discounted at a RDR that allows for:

A
  • Return required by the company
  • Level of statistical risk attaching to the CFs under the particular contract
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6
Q

Why is a separate RDR applied to the different components of CFs in practice?

A

The statistical risk associated with each component will be different

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7
Q

Define profit criteria.

A

It is a single figure that summarises the relative efficiency of contracts with different profit signatures

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8
Q

How can profit criteria be used to determine the contract that makes the most efficient use of the company’s capital?

A

By applying the profit criterion to different contracts with different profit signatures and by ranking the results in order, it may be possible to say which contract makes the most efficient use of the company’s capital

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9
Q

What are the different profit criteria that can be used to determine the capital efficiency of a contract/project?

A
  • NPV - choose the one with the highest NPV
  • IRR - choose the one with the highest IRR
  • DPP - choose the one with the smallest DPP
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10
Q

How is the NPV determined?

A

By discounting the profit signature at a RDR.

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11
Q

What is the managers’ priority with regards to the net present worth of the company?

A

To maximise the net present worth of the company.

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12
Q

What is the best profit criterion to use and why?

A

The NPV. If any profit criterion disagrees with the NPV, choose the NPV. This result depends on several assumptions:
* There is a perfectly free and efficient capital market
* When two risky investments are compared, each is discounted at a RDR appropriate to its own riskiness

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13
Q

What does a positive/zero NPV indicate?

A

The rate of return on the CFs >= RDR

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14
Q

What are some practical points to bear in mind when using the NPV as profit criterion?

A
  • It is subject to the law of diminishing returns - if not, the company could sell unlimited of one policy with positive NPV and increase the value of the company without a limit
  • It says nothing about competition - there is no point in designing a high profit contract with high NPV if it cannot be sold (only want to study the profitability of saleable contracts)
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15
Q

How can the NPV be expressed as?

A

It can be expressed in relative terms such as in proportion to:
* Commission that rewards the salesperson - ties in with intuitive approach that sales motivator should be in line with profitability of contract
* PV of total income - PH measures cost of insurer in terms of premiums and industry trade associations measure size of market in terms of premium income of ICs

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16
Q

What is the advantage of expressing the NPV as a proportion of the PV of total premium income?

A

It enables the company to focus its efforts on increasing its market share (they know that profitability will be increased as a result)

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17
Q

What is the IRR?

A

The rate of return at which the NPV of CFs is zero.

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18
Q

Does the IRR always agree with the NPV?

A

No.

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19
Q

What are the problems with the IRR as profit criterion?

A
  • May not exist - if policy makes profit from outset
  • May not be unique - due to more than one sign in stream of profits in profit signature
  • Cannot be related to other indicators such as premiums or sales costs
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20
Q

What is the DPP?

A

The policy duration at which the profits that have emerged so far have a PV of zero.
It is the time it takes for a company to recover the initial investment with interest at the RDR.

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21
Q

Why is the DPP a useful reference to see when the initial capital investment is recouped?

A
  • A company with limited capital may prefer this criterion and will want it as short as possible.
  • DPP is of most importance for LT policies with large initial capital strain
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22
Q

Will the DPP agree with the NPV?

A

Usually not, since all the CFs beyond the DPP are ignored.

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23
Q

What is a common approach of using the different profit criteria?

A

Use the NPV, expressed in terms of the initial sales cost, as the prime criterion, and refer to the DPP.
For a given NPV, you would choose the product design with the shortest DPP.

24
Q

What might the consideration of premiums and charges for marketability lead to?

A

It might lead to the reconsideration of:
* Design of the product (add features that differentiate the product from those offered by competitors and remove features that increase the risk of the CFs)
* Expense assumptions (e.g. contributions to overheads, cross-subsidies, etc.)
* The distribution channel used (linked to expenses)
* Company’s profit requirement
* Whether to proceed with marketing the product

25
Does all the model points have to be profitable for the IC company to make an aggregate profit?
No. It is possible for the desired level of profitability to be reached in aggregate without requiring every single model point to be profitable.
26
What is the consequence of certain model points being unprofitable?
The aggregate profitability of the IC is exposed to changes in mix and volume of contracts sold.
27
How should you look at the aggregate profitability of a new (or re-priced) product?
Look at the projected impact on the company's EV.
28
How can the impact of writing a new product in capital management terms (either on a regulatory basis or economic capital basis) be assessed?
By observing the modelled amount and timing of the CFs. This may, if capital is a problem, lead to reconsideration of design of the product to reduce, or amend the timing of the CFs.
29
Once acceptable premiums, or charges, have been determined for model points, ...
premiums or charges for all contract variations can be determined.
30
How do you assess the profitability of EB?
The full policy data set may be used. Modelling may be done on a policy-by-policy basis or by using model points.
31
What are the pros and cons of assessing the profitability of EB on a policy-by-policy basis?
It should be more accurate than using model points, but it will be more costly in terms of time and resources.
32
Is it better to use the previous MP files and adjust them to assess the profitability of EB, or should you rather redo the MP generation process?
Redo the model point generation process based on policy portfolio as it appears now. This is much less prone to error than adjusting previous model point files.
33
How can the suitability of model points for modelling the profitability of EB be checked?
Where the profitability of business is assessed at the same time as the supervisory reserves are calculated, one check is to use the model points to determine the supervisory reserves and compare this with the published value.
34
How is the profitability of EB business assessed?
For each policy/model point: * PV of projected CFs can be obtained and discounted at an appropriate RDR. * Totalling across all policies/scaling up model points = expected profit from EB.
35
To which levels can the PV of future profits from EB be broken down?
* By product * By product class * By distribution channel * By subsidiary, if appropriate
36
How is solvency measured?
By comparing the value of assets and liabilities on a supervisory and economic basis: * Supervisory values: values as determined for supervisory reporting purposes * Economic values: values calculated on the basis of the expected experience of the company or on a market-consistent basis
37
What is a static solvency test?
It is the determination of the solvency position at a particular point in time.
38
What is the disadvantage of using a static solvency test for determining the solvency position?
The IC will not be able to assess its ability to withstand future changes in both external economic environment and particular experience of the company.
39
What is dynamic solvency testing?
Projection of the IC's revenue account and balance sheet for a specified future period so that full effect of the potential risks may become apparent.
40
What model is required to perform DST?
A full model office, with realistic representation of the liability portfolio by model points.
41
How could the projection be done under DST?
Deterministic - using deterministic assumptions with margins to test the effect of future adverse experience. Stochastic - use stochastic assumptions with simulation to assess the level of probability of adverse circumstances occurring.
42
When will you get the most useful assessment of the LIC's solvency position?
By using DST and including NB in the projections, unless intended that the company will cease to write NB.
43
What are the benefits of DST?
* It can be used to assess how well a company can withstand variations in both economic elements of experience as well as demographic adverse future experience. * DST will demonstrate whether there is a risk of insolvency given NB growth scenarios - rapidly growing insurers * It can be used to assess the impact on solvency of any other business decisions * Insurer can assess its risk of insolvency as a result of adverse experience on items being guaranteed * DST will allow management to take corrective action before solvency deteriorates to an unacceptable level
44
What will usually be the main risk criterion when performing full model office of EB projections for the purpose of decision making?
The probability of ruin.
45
How can the probability of ruin be determined?
It could be done in the context of a DST, either on a supervisory or economic value basis. This requires assessment of the probability that at some point in future the LIC would become insolvent.
46
What is the result of the future projected balance sheets requiring stochastic calculations?
It can present modelling challenges and might necessitate use of approximations such as closed form solutions/proxy models.
47
What is an alternative assessment, to using DST, of the probability of ruin in respect of EB only?
Projecting forward in the simulations just the revenue account of the company and seeing whether it ran out of assets before the last contract went off the books. The proportion of all the simulations which lead to insolvency is then an estimate of the probability of ruin in respect of EB.
48
Why do we need to project the future solvency position of a LIC?
To measure the impact of future variations in experience not allowed for in the supervisory reserving basis.
49
What is important to remember for projecting forward a LIC's solvency position?
* The modelling of such variations will need to be dynamic * Solvency projections may also allow for management actions where appropriate * The projection can be done on either a stochastic or deterministic basis and may be on an ongoing basis or consider just the existing portfolio
50
What are the reasons for holding capital/free assets?
FASSARWM * Finance NB strain * Allow a riskier investment strategy than strict matching would dictate * Smooth surplus distribution to WP PHs * Smooth dividend payments to SHs * Allow the company to seize any profitable business opportunities as they present themselves * Reduce the need for RI * Withstand adverse, often unexpected, conditions * Min level will probably be required by the regulator
51
What can be assessed if you include NB in DST?
The adequacy of internal capital in allowing the company to fulfil NB plans can be assessed.
52
What is sensitivity testing?
It involves assessing the effect on the output of the model of varying each of the parameter values separately. It is a way of understanding the parameter risk, without the difficulty, subjectivity, and perhaps spurious accuracy of deciding upon some arbitrary probability distribution to represent the uncertainty.
53
What are 2 important aspects to remember for sensitivity testing?
Correlation between different parameters should be allowed for. When several parameters are changed, it is called scenario testing.
54
If a particular parameter is highly uncertain ...
you would try to design your product to be as financially insensitive as possible to variations in that parameter.
55
Why is sensitivity testing useful?
It will help to assess the margins needed in parameter values. It is useful as a qualitative check that the model is functioning correctly as far as dependencies on parameters are concerned.
56
What are alternative ways to allow for risk?
* Where a probability distribution can be assigned to a parameter, it may be possible to derive analytically the variance of the profit or return on capital. * Stochastic (MC) simulation techniques can be used to assess profit variance
57
When is it appropriate to use stochastic (MC) simulation techniques to assess the profit variance?
* When you are trying to assess the impact of guarantees * When the variable of interest does have a reasonably stable and predictable probability distribution * When you want to indicate the effect of year-on-year volatility on risk * When you want to identify high risk future scenarios

Life Insurance principles (21 decks)

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