Chapter 19: Models (2)

Question 1

Need for models. Models can be used to assist with: (7)

Answer 1

1. product pricing
2. assessing return on capital
3. assessing capital requirements
4. assessing the profitability of existing business
5. developing an appropriate investment strategy
6. projecting the future supervisory solvency position
7. any other work involving financial projections

Question 2

Uses of models - Pricing

Answer 2

The model can be used to determine a premium, or charging, structure for a new or existing product that will meet a life insurance company’s profit requirement.

Question 3

The process for determining premiums or charging rates: (4)

Answer 3

1. A number of model points will be chosen to represent the expected new business under the product.
2. For each model point, cashflows will be projected, allowing for reserving and solvency margin requirements, on the basis of a set of base values for the parameters in the model.
3. The net projected cashflows will then be discounted at a rate of interest, the risk discount rate, that allows for:
   - the return require by the company; and
   - the level of statistical risk attaching to the cashflows under the particular contract.
4. The premium or charges for the model point can then be set so as to product the profit required by the company.

Question 4

Profit Criterion

Answer 4

A profit criterion is often a single figure that tries to summarise the relative efficiency of contracts with different profit signatures.

Question 5

The different profit criteria that could be used: (3)

Answer 5

1. net present value, expressed in different ways
2. internal rate of return
3. discounted payback period

Question 6

The NPV result depends on several assumptions, including that:

Answer 6

1. there is a perfectly free and efficient capital market

2. when two risky investments are compared each is discounted at a risk discount rate appropriate to its riskiness.

Question 7

Practical points to bear in mind when using net present value: (2)

Answer 7

1. It is subject to the law of diminishing returns
2. It says nothing about competition. (there is no point in designing a contract with a high net present value if it cannot be sold)

Question 8

Internal rate of return

Answer 8

This is defined as the rate of return at which the discounted value of cashflows is zero.

All other things being equal, a company should prefer a contract that has a higher internal rate of return.

Question 9

Net present value may be more reliable, in comparison to the internal rate of return, in some cases, for example: (3)

Answer 9

1. if there is more than one change of sign in the stream of profits in the profit signature, the internal rate of return will not usually be unique.
2. the present value can be related to useful indicators of the policy’s worth to the company, in terms of sales effort or market share. There is no way to do this for the internal rate of return.
3. If a policy makes profits from the outset then the internal rate of return may not event exist. The net present value always exists, however.

Question 10

Discounted payback period

Answer 10

The discounted payback period is the policy duration at which the profits which have emerged so far have a present value of zero.

i.e. it is the time it takes for the company to recover its initial investment with interest at the risk discount rate.

Question 11

The premiums, or charges, produced need to be considered for marketability. This might lead to a reconsideration of: (3)

Answer 11

1. the design of the product
2. the distribution channel to be used
3. the company’s profit requirement
4. whether to proceed with marketing the product

Question 12

Two main ways in which the values of the assets and liabilities can be determined:

Answer 12

1. supervisory (or regulatory) values - these would be the values as determined for supervisory reporting purposes.
2. economic values - these would be the values calculated on the basis of the expected experience of the company or on a “market-consistent” basis.

Question 13

Static solvency test

Answer 13

This is where determination of solvency is to be made at particular point in time.

Question 14

Dynamic solvency testing

Answer 14

This will involve the projection of the company’s revenue account and balance sheet forward for sufficient period of years so that the full effect of potential risks may become apparent.

Question 15

Why does a life insurance company need capital

Answer 15

The fundamental reason why a life insurance company needs capital is so that it can withstand adverse, often unexpected, conditions.

Question 16

The amount of capital will reflect the company’s ability to: (2)

Answer 16

1. write new business, that is to meet the development costs of new contracts and the capital requirements that arise from writing new business
2. adopt a less restrictive investment policy so as to meet the investment aims of the company