Chapter 21 - other considerations Flashcards
Profit criterion
single figure that tries to summarise the relative efficiency of contracts with different profit signatures
- NPV
- IRR
- DPP
Profit signature
sequence of profits over time from inception to termination
advantages of NPV
- given the choice between the future cashflows from two different investments, economic theory states that the investor should choose the one with the higher NPV
- can be related to useful indicator’s of the policy’s worth to the company, in terms of sales effort or market share
The NPV results depends on several assumptions:
- there is a perfectly free and efficient capital market
- when two risk investments are compared, each one is discounted at a RDR appropriate to its riskiness
Other considerations for NPV
- subject to law of diminishing returns
- it says nothing about competition. no point in designing a product with a high NPV if it cannot be sold
Shortfalls of IRR
- if there is more than one change in sign in the stream of profits in the profit signature, there is not generally a unique IRR
- No way to relate the IRR to useful indicator’s of the policy’s worth to the company, in terms of sales effort or market share
- if a policy makes profits from the outset, then an IRR may not even exist
Advantage of IRR
- concept that may be generally easier to understand
DPP
Policy duration at which the profits that have emerged so far have a PV of zero i.e. time it takes for the company to recover its initial investment with interest at the RDR
Disadvantages of DPP
- ignores all cashflows after the DPP (doesn’t often agree with NPV)
Advantages of DPP
- a company with limited capital might prefer to sell contracts with the shortest payback periods
Premiums produced need to be considered for marketability. This might lead to a reconsideration of:
- product design
- distribution channel
- company’s profit requirement
- whether to proceed with marketing this product
The impact of competitor pricing depends on:
- market structure
- sales channel
- features of the product
- availability of comparison quoted
- other features of the market
Advantages of reinsurance
- technical assistance in data provision and pricing basis
- risk sharing and limiting overall exposure
- smoothing profitability
- providing financing to support new business strain
- tax arbitrage where the reinsurer is taxed on a different basis
- solvency capital arbitrage where the reinsurer is required to hold less capital per unit risk
- enabling the insurer to accept large risks
Size of reserve for cross-subsidy will depend on:
- the speed at which the premium can be reviewed
- the likelihood that policyholders will renew their contracts as the premium level is being increased
