Chapter 21 Pricing (3) - Other considerations

Question 1

Profit criteria: 3 commonly used functions are?

Answer 1

• net present value
• internal rate of return
• discounted payback period

Question 2

What is a profit criterion?

Answer 2

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

Question 3

What is net present value?

Answer 3

-discounting the profit signature at the risk discount rate produces a net present value.

Question 4

How good is net present value as a profit criterion?

Answer 4

• The higher the NPV between two investments the better.
• This choice is optimal and cannot be improved.
• The NPV is the best profit criterion to use, if any other profit criterion disagrees with it a company should go with the NPV.

Question 5

The important results of the NPV depends on several assumptions including?

Answer 5

• there is a perfectly free and efficient capital market.

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

Question 6

Practical points to consider when using the NPV profit criterion

Answer 6

• it is subject to law of diminishing returns.

- it says nothing about competition. There is no point in designing a contract with a high NPV if it cannot be sold.

Question 7

How should the NPV be expressed?

Answer 7

• when observed in isolation NPV doesn’t give us any meaningful information.
• eg you can double the NPV by doubling premiums used in the model points.

-One approach is to express NPV in a way that reflects the effort that would be expended on selling a policy. One such measure is initial commission that rewards the salesperson.

• In proportion to total discounted premium income since this relates to the size of the market.
• An advantages of this method is that it focuses on increasing market share of company.

Question 8

What is the internal rate of return?

Answer 8

• The rate of return at which the discounted value of the cashflows is zero.
• All other things being equal a company should prefer a contract that has a higher internal rate of return.
• the IRR doesn’t always agree with NPV.

Question 9

How good is IRR as a profit criterion?

Answer 9

• The NPV may be more reliable in some cases, for example:
• If there is more than one change of sign in the stream of profits in the profit signature, there is generally not a unique IRR.
• NPV can be related to useful indicators of policy’s worth to the company in terms of market share. There no way to do this with IRR.
• If the policy makes profits from the outset then the IRR may not even exist. The NPV always exists, however.

Question 10

What is discounted payback period?

Answer 10

-the policy duration at which the profits that have emerged so far have present value zero ie time it taks company to recover its initial investment with interest at risk discount rate.

Question 11

How good is the discount payback period?

Answer 11

• This method ignores all cashflows after the discounted payback period.
• A company with limited capital might prefer to sell contracts with the shortest payback periods possible.

Question 12

Marketability

Answer 12

• The premiums produced need to be considered for marketability.
• This might lead to reconsideration of:
• the design of the product, so as either to remove features that can increase riskiness of the net cashflows, or include features which will differentiate the product from those of competing companies.
• the distribution channel to be used, if that would permit either a revision of the assumptions to be used in model, or higher premium to be used without loss of marketability.
• the company’s profit requirement
• whether to proceed with marketing the product.

Question 13

Competitveness

Answer 13

• rating factors need to be consistent with competition to avoid/reduce anti-selection risk.
• Volume is important to cover fixed expenses. Premiums may need to be reduced in order to secure sufficient volumes against competition.
• Inadequate premiums may be charged eg loss-leader product however this must be compensated by large margin in other lines of business.
• A product lines should aim to meet return on capital requirements, taking all cross-subsidies into account.

Question 14

The impact of competitor pricing on the insurer depends on the?

Answer 14

• market structure
• sales channel
• features of the product
• availability of product
• availability of comparison of quotes
• other features of the market

Question 15

Reserving & Solvency capital requirements

Answer 15

• premiums rates should explicitly include the cost of holding the supervisory reserves and required solvency capital in the profit calculation.
• The charge is the investment cost arising from holding the underlying assets as “locked-in” statutory capital rather than investing them directly in business acquisition.
• SCR may be reduced by the use of suitable reinsurance arrangements.

Question 16

Reinsurance impact on pricing

Answer 16

-The role of reinsurance can be very important in the day-to-day management of product development and profitability.

• It can provide a number of roles in this area:
• technical assistance in data provision & pricing basis
• risk sharing & limiting overall exposure
• smoothing profitability
• providing financing to support new business strain
• tax arbitrage where the reinsurer is taxed on a different basis from the insurer
• solvency capital arbitrage where the reinsurer is required to hold less capital per unit of risk
• enabling insurer to accept larger risks

Question 17

Benefit of reinsurance

Answer 17

-Where the financial benefits of reinsurance exceed the expense increase or premium loss eg by tax arbitrage, the actuary is likely to want to prce the product on a net of reinsurance basis to ensure premiums are as competitive as possible.

Question 18

What approval may be needed by the reinsurer and under what circumstances?

Answer 18

• A large portion of risk may be passed on the insurer to the reinsurer by way of quota share. Especially its in new insurer or an insurer new in a specific line of business.
• It may be normal then for the reinsurer to have a major say in production of premium tables,
• or at least have the right to vary an reinsurance commission payable.

Question 19

Regulator’s impact on pricing

Answer 19

• pricing bases, premium rates, or rating factors can be put under direct control of the regulator.
• where the insurer is seen as playing a role in provision of welfare payments it is likely the pricing basis for such insurance will be closely monitored by the supervisors.
• The regulator can also affect pricing basis indirectly by restricting insurer operation.
• These will affect the pricing assumptions and hence the price that will be charged.

Question 20

Cost impact of regulators on pricing

Answer 20

• Any regulatory restriction on commercial operations may impose a cost that needs to be reflected in the premium assumptions. for eg
• a requirement to invest in local assets may impact the investment return that can be included in calculations.
• the need for the insurer to collect premium taxes will also necessitate a further expense loading in the premium basis.

-such additions should affect all insures in a market equally and thus should not affect competitive positions.

Question 21

What are the three different types of investigations relating to premium rates?

Answer 21

• monitoring assumptions used for pricing new business
• monitoring the assumptions used for pricing reviewable premium business
• monitoring whether the reserves set up to cover losses from loss-leaders are adequate

Question 22

Regula monitoring of new business

Answer 22

• pricing of new business will require most up-to-date info.
• actuary will keep all items in his assumptions set under review.
• where any one of these is no longer valid the effect of changing this must be tested.
• info leading to changes in assumptions may come from internal experience sources or outside influences.

Question 23

Regular monitoring of reviewable premiums

Answer 23

• many healthcare insurance products avoid the large cost of guarantees by having reviewable charge rates.
• The premium may be subject to review on a regular basis and adjusted when overall experience is judged to have changed significantly.
• Where an increase in premium is called for the actuary must be careful about how selective lapsing may come about.

Question 24

Premium adequacy tested for reserving purposes

Answer 24

• where policy is sold at less than full premium rate for expected claims and expense outgo, reserves will need to be set up t the extent the pricing basis is inadequate.
• The size of the reserves will depend on:
  1. speed at which the premium can be reviewed
  2. likelihood that policyholders will renew their contracts as the premium level is increased.
• where the inadequate rates apply on long term insuance on guaranteed terms there are serious considerations for the actuary responsible.
• his course of action will depend on the codes of professional guidance in the territory where he/she is operating.