Chapter 20 Pricing (4) Options and guarantees Flashcards
Value proposition of guarantees
Why are gurantees on insurance contracts useful? (3)
What kind of gaurantees may be offered for healthcare contracts? (3)
- Traditional life insurance contracts transfer mortality, expense and investment risk from the policyholder to the life insurance company.
- Some contracts e.g. unit linked and index linked contracts leave the investment risk with the policyholder
- but these contracts’ attraction can be enhanced if part of the investment risk is transferred to the company by the company offering guarantees to protect the policyholder from the downside risk.
For healthcare contracts
- offering investment guarantees is not the norm (they may be found on unit linked savings contracts, which offer health benefits as riders, eg CI payment, or LTC payments)
- however, in some markets, demand premium and benefit gaurantees, and so the actuary must produce appropriate prices
Mortality/morbidity options: intro, definition
What do we mean by mortality and morbidity options? (1)
What kind of healthcare contracts do we typically find options for? (4)
Mortality/morbidity options are
- features of health insurance contracts which give the policyholder the option to exercise certain choices on their contracts at specficied option exercise dates, as per terms/conditions specified in their contracts…
- …usually at standard premium rates applicable at option exercise date, without further proof of health required
Healthcare insurance contracts with mortality morbidity options
- usually long-term insurance contracts (CI, LTCI)
- options have little impact on a one-year contract (PMI), if the terms and acceptance are variable every year.
Mortality/morbidity options: examples
Give examples of various mortality/morbidity options which may be found on long term insurance contracts (8)
Examples of mortality/morbidity options (usually for LTCI policies
- to purchase additional assurance/extend the term of existing insurance…
- …without providing evidence of health…
- …at normal premium rates…
- …on the date which option was exercised
- to renew a LTCI policy eg a term CI insurance policy
- at the end of its original term
- without providing additional evidence of health
- to reinstate mortality cover after an accelerated critical illness plan has paid out on a specified disease event
Implications of mortality/morbidity options
What is the key risk/implication for an insurer that offers contracts with mortality/morbidity options? (1)
What makes the above key risk even more difficult to control? (1)
The key risk/implication for insurers offering mortality/morbidity is that at specific times in future, the cost of the option being exercised is more than can be afforded by the insurer.
This key risk becomes particularly diffcult to control because:
- there is natural anti-selection risk for the insurer…
- …the policyholder has choice over whether to exercise option or not
Terms and conditions of options
Mortality options give great scope for anti-selection against the insurer; how might the insurer reduce this? (7)
The insurer can reduce anti-selection by
- ensuring that terms and conditions under which the option can be exercised are clearly set out in the original policy
- only allowing options to be exercised at specific points in time
- on occurance of major life events
- at a fixed single point
- at fixed multiple points eg only every 5 years
- anytime, provided a qualifying event has occured eg childbirth, new job with higher salary
- specifying the extent of the option allowed
- eg additional sum assured cannot exceed original sum assured
Cost of mortality/morbidity options
The presence of mortalty options comes with a cost.
Describe the cost to the company of a health insurance policy mortality option (6)
Using the above, what influences the total cost of options the insurer faces on thier overall book of health insurance contracts? (3)
Give a basic expression for the overall cost of mortality/morbidity options to the insurer (2)
Cost of a health insurance policy mortality/morbidity option to the insurer equals
- value of additional premium that should have been charged for additional insurance cover, with full underwriting, over normal premium rate actually charged as per terms of the option
- if life is in good health and would satisfy normal underwriting requirements, then option generates little or no additional costs
- if life in bad health, exercise of option generates considerable additional costs
Hence, total expected additional costs (across all policies) depends on:
- health status of those who do exercise option
- proportion of lives that choose to exercise option
Cost roughly can roughly be expressed as:
- {proportion of lives exercising} * {ave health of lives exercising}
List key factors affecting mortality/morbidity options
What key factors generally affect mortality/morbidity options? (6)
- Term of policy with option
- Number of times option available to exercise
- Conditions attached to exercising the option
- Encouragement given to policyholders to exercise the option
- Extra cost to PH of exercising the option
- Selective withdrawals
Briefly describe key factors affecting mortality/morbidity options
Breifly describe the following key factors that generally affect mortality/morbidity options:
- Term of policy with option (1)
- Number of times option available to exercise (1)
- Conditions attached to exercising the option (2)
- Encouragement given to policyholders to exercise the option (4)
- Extra cost to PH of exercising the option (2)
- Selective withdrawals (2)
- Term of policy with option
- longer term, longer PH will have option, and more likely that at some time their health will make option appear worthwhile
- Number of times option available to exercise
- eg every 5 years, every policy anniversary, any time whatsoever
- Conditions attached to exercising the option eg
- limiting size of option
- restricting choice of contracts available for
- Encouragement given to policyholders to exercise the option
- low take up=> only those with most to gain will exercise
- encouraging healthy lives to exercise will not cause any additional expected loss + should contribute to insurer’s total profit as it issues busines to good risks
- care should be taken not to encourage poor risk lives
- Extra cost to PH of exercising the option
- if option involves steep increase in premiums, would cause healthier lives to shop around to get same cover elsewhere
- company would lose out on potential profits from these healthy lives
- Selective withdrawals
- healthly life may cancel 10 year renewable term assurance after 2 years if cover without option is much cheaper
- option loading has not been collected for very long time but would still be leff with remaining unhealthy lives who will exercise option to cost of the company
Options risk management
What activity could a healthcare insurer conduct regulalry as part of its process to manage risk exposure due to options? (1)
Why is this important? (3)
As part of risk mitigating strategy, insurer should engage in
- constantly monitoring and review of the value of options for contracts it has written on which options exist regardless of its current experience
Important because
- whatever the current experience, it would not be unthinkable for a health insurance option to come into the money, much as deferred pension policies (despite being relatively worthless at the time of sale)
- eg …widespread onset of particular disease might make option to increase coverage without underwriting costly
Options valuation: overivew
Give an overview description of how a mortality/morbidity option would be valued? (6)
- Cashflow projections would normally be used
- Cashflows include addtional benefits and premiums expected to be paid in relation to the option
- Cashflows allow for extent to which the option is assumed to be taken up
- Additional premiums based on the expected premiums to be charged to standard lives, as at option exercise date
- Allow for additional expenses relating to option eg writing to PH to remind of option
- If purpose of valuation is to price option (rather than setting liability), then need to allow for additional reserves that should be held, both before and after exercise
Options valuation: assumptions required
List 5 additional assumptions required to price a contract if a mortality/morbidity option is added (5)
- probability that option will be exercised, at each possible exercise date
- additional benefit that will be chosen, if at discretion of PH
- expected mortality/morbidity of lives who choose to exercise option
- expected mortality/morbidityof lives who choose not to exercise option
- additional expenses relating to option
Options valuation: methods
What three methods can be used to value options? (3)
Broadly speaking, in what way do the 2 of the 3 methods differ? (2)
Different options
- North American method
- conventional method
- stochastic modelling/statistical methods
The North American Method and conventional method differ in the methodology behind the
- assumed take-up rates and
- the mortality/morbidity assumptions used.
Options valuation: methods, North American Method, overview, assumptions
Describe the North American method of valuating options in terms of
- overview (2)
- assumptions required (4)
Overview:
- assume more sophisticated take-up rates which vary by exercise date or by alternatively option
- would ideally be based on past experience
Requires two additional items in pricing basis:
- multiple decrement table for lives who have not exercised option with decrements of death/disability and exercising the option represented by the dependent rates of decerement at age x of (aq)dx and (aq)wx
- a mortality/morbidity table for lives who have exercised option represented by mortality/morbidity rates q’x
Options valuation: methods, North American Method, EPV, issues
Describe the North American method of valuating options in terms of
- expected present value of benefit (4)
- key issue with using this approach (2)
Expected present value of benefit is then:
- Pr[Death] x PV[Benefit] + Pr[Exercise Option] x PV[Benefit adjusted for Option]
Key issue with approach
- often difficult to obtain sufficient data to estimate all decrement rates required for North American Method…
- …for a new line of business there will be no direct experience -conventional method is often preferred choice.
Options valuation: methods, conventional method
Describe the conventional method of valuating options in terms of
- overview (2)
- assumptions required (4)
- expected present value of benefit
- benefits of conventional method (3)
Overview
- preferred choice over North American method (due to its data issues)
- this method is possible when there’s a single option date
- it is not possible to use this method when there are many policy dates which an option may be exercised; the approximate approach taken here is that the worst option from the financial point of view is chosen with probability one.
Assumptions
- assumes all eligible PHs will take up option (unlikely to be born in practice), and that maximium additional benefit will always be taken
- those who take up option will be Ultimate Experience corresponding to Select Experience that would have been if underwriting was completed
- morbidity/mortality used is not usually assumed to change over time, so only the data required are select and ultimate tables used in original pricing basis.
- experience can be thought of as 2 groups
- Select Group who incurs no additional costs to insurer by taking option
- Ultimate Group who incur additional costs by taking option
Advantages
- method is prudent and requires fewer assumptions than North Amrican method
- conventional method is conservative if it assumes no profits from the Select Group and all losses from the Ultimate Group. (won’t play out like this in practice)
