Chapter 22-Contract design

Question 1

1. List seven parties involved in the contract design process.

Answer 1

• the providers
• the providers’ customers
• actuaries
• lawyers
• accountants
• financial backers
• administrators

Question 2

2. State the factors influencing the provider’s needs and the provider’s customers’ needs in relation to contract design.

Answer 2

The providers and their customers will want financial structures that meet their needs in a cost-effective manner.
The provider’s needs will be influenced by:
* the chosen market
* the capital available
* the expertise available.
The provider’s customers’ needs will be influenced by:
* capacity to pay
* the risks to be covered
* the benefits that are needed at different times in the future
* attitude to financial risk.

Question 3

3. Describe the needs of the other parties involved in contract design.

Answer 3

Actuaries will be involved in the initial costing of the financial structures and the subsequent determination of the provisions that will need to be held to meet future liabilities. They will also be involved in the ongoing design process through assessing the impact on both the cost and the provisioning implications of modifications to the benefit design.
Lawyers will be involved in the drafting of the contracts supporting the financial structures to ensure that the provider is not exposed to the risk of providing more benefits or entering into greater risks than intended.
Accountants will be involved in ensuring that the provider of the financial structures properly accounts for the income and outgo.
The financial backers will want regular reports demonstrating proper stewardship of the finance provided.
Administrators will need to administer the financial structures. The more complex the financial structures are, the greater the cost of administration. This should be reflected in the amounts paid by the customers.

Question 4

4. Why is it important to consider the risk appetites of the intended customers of a financial product?

Answer 4

It is important that the financial structure as designed meets the risk profile of the intended customer, and that the risks involved in the product are clearly explained to the customer.
Sales of a financial product will be optimised if the product can be designed to be suitable for customers with a wide range of risk appetites.

Question 5

5. Give an example of how the design of savings products can be made suitable for customers with a wide range of risk appetites.

Answer 5

For savings products, whether insurance contracts or benefit schemes, this can be achieved by offering a range of investment choices. Having a range of funds available means that the contract can allow for any change in the customer’s risk appetite during the term of the policy.
The risk averse investor can select investment funds that are designed for the cautious investor. These funds might have a significant percentage in cash or high quality short-dated bonds, with a relatively small equity content. The equity content might be restricted to invest only in ‘blue-chip’ companies.
The speculative investor can choose a fund with a low or zero fixed interest content, and where the equity content is unconstrained. Equity investments might include unquoted companies, emerging markets, and high-risk industries.

Question 6

6. Give an example of how the design of general insurance products can be made suitable for customers with a wide range of risk appetites.

Answer 6

General insurance products normally allow for differences in customers’ risk appetite through the range of risks that can be insured.
For example, motor insurance is commonly written on three bases:
* third party only
* third party, fire and theft
* fully comprehensive.

Question 7

7. List the factors that will affect the appetite for risk:

Answer 7

The appetite for risk will be affected by:
* the size of the company- a large company is likely to be able to take on more risk
* the nature of the company’s business
* the availability of diversification
* the level of capital available
* the culture of the company- which will be dependent on:
○ past experience
○ views of the board
○ views of shareholders
* the extent to which the risks relating to the new products differ from the existing risks
* any regulatory requirements/ level of regulatory control to which it is exposed.
An indication of the risk appetite may be found from looking at public documents, such as the company’s annual report.

Question 8

8. Describe, including an example, how legislation or regulation can provide a more attractive fiscal environment for a product, and the key implications of this for the provider.

Answer 8

Legislation or regulation may provide a more attractive financial or taxation regime if the policy meets certain conditions. For example, there may be tax advantages that apply to a life insurance product as long as the sum assured on death is a minimum of a specified multiple of the premiums paid. A government might impose this to ensure that products provide a minimum level of protection cover and are not just savings plans.
Where these regimes are optional, the provider needs to decide whether the contract will be designed to be inside or outside the regime. In either case the position needs to be made clear to the customer at the point of sale to avoid misleading them.

Question 9

9. Explain what is meant by a ‘cooling-off period’ and how the provider might deal with the problem that arises when a customer cools off.

Answer 9

Many regulatory regimes impose a ‘cooling-off period’ for financial products where the customer can cancel and get a full refund within an initial period, perhaps 14 days.
For policies that are cancelled in this way, the provider will have incurred initial set up expenses and will make a loss on the policy. It is important that such expenses are recouped. The normal way of doing this is to set initial charges by dividing the total expenses of the new business operation, including dealing with policy cancellations, by the number of policies that go into force, ie are not cancelled.

Question 10

10. Describe possible disclosure requirements and their implications.

Answer 10

In some countries there may be requirements on providers to present certain information to potential customers. This may include illustrations of discontinuance terms. If these disclosures are thought to be a feature of a customer’s decision to take the policy then the provider may wish to show attractive figures. Disclosure requirements may also set out the discontinuance basis to be used and hence influence the extent to which policies terminating later, or remaining to maturity, subsidise the benefits offered on short duration discontinuance.

Question 11

11. Explain, with examples, how the intended target market will affect the design of a financial product.

Answer 11

The intended target market will affect the design of a financial product. Products directed at lower income individuals are likely to be simple contracts with a clear insured event. Such simplicity reduces cost and the product is more likely to be affordable and comprehensible to the target market.
At the other extreme, high net worth individuals are likely to favour flexible products that can be adjusted as their financial circumstances change. The provision of options and guarantees is likely to be attractive to this group. These features add cost, but the target market would normally understand the cost of flexibility and guarantees and be prepared to pay it.
The same applies when products are being designed for advisers to sell to their customers - it is the needs of the advisers’ customers that should be considered.

Question 12

12. List the two main types of competitive pressure.

Answer 12

There are two main types of competitive pressure:
* price
* product features.

Question 13

13. Give examples of products that are designed to cover basic insurance needs and explain how they tend to be sold.

Answer 13

Some products are designed to cover basic insurance needs where the risk is well defined: term life insurance, annuities, private motor insurance, employer’s liability insurance. These products tend to be sold on price and the provider with the lowest price is likely to get the greatest volume of business.

Question 14

14. Give examples of items other than price that feature in the decision to purchase.

Answer 14

Other products cannot be directly compared on price and instead the risks covered, the administrative systems and the claims process all feature in the customer’s decision. For example, motor breakdown cover may or may not cover breakdown at the driver’s home, may provide a guarantee of attending a claim within a specified time, may offer different options if the vehicle cannot be repaired at the roadside. All these items feature in the decision to purchase as well as the price.

Question 15

15. Outline the advantages and disadvantages of offering products terms that are very different from those offered by the rest of the market.

Answer 15

There is a risk to a provider of offering terms that are very different from the rest of the market. Customers may assume that the terms are consistent with the rest of the market and be disappointed if they don’t receive what they expect, even if they receive the benefits specified by the policy.
A provider who offers different terms from the market may attract selective business which means that the product mix is not as expected. However, differentiation can be a positive sales point, as it can offset a less price competitive product.

Question 16

16. Give an example of how innovation can force the rest of the market to catch up.

Answer 16

In some cases, being different from the market can force the market to catch up with the innovators. Because there are more non-smokers than smokers in the UK, the first provider to offer lower life assurance premium rates for non-smokers (and higher rates for smokers) than the rest of the market secured a lot of business. Providers that did not discriminate attracted smokers who benefited from a mixed aggregate premium rate, and therefore those providers’ mortality experience was worse than expected. This soon forced the whole market to change to differentiating by smoking status.

Question 17

17. What three factors will affect the level and form of the benefits to be provided?

Answer 17

The level and form of benefits to be provided under any specific financial structure may vary according to:
* the customer’s needs
* the risks to be covered
* the customer’s ability to pay

Question 18

18. Give examples of how the level and form of the benefits to be provided might differ for a customer wanting car insurance.

Answer 18

For example, some car owners may want full cover against damage to or theft of their car, combined with legal protection and an additional premium to protect any no claims bonus they have accumulated.
Other car owners may just want the minimum cover to enable them to drive legally.

Question 19

19. Explain what is meant by an option in a financial product.

Answer 19

One party to a contract has a choice to do something, and the other party cannot prevent the action. However, often the other party can set the conditions under which the option can be exercised.

Question 20

20. Give examples of possible early termination terms.

Answer 20

The approach taken may vary depending on the type of contract.
For example, on early termination of some types of insurance policy there may be no value. Policies such as term assurances can be terminated by the policyholder stopping premiums. Life cover ceases and there is no surrender payment made to the policyholder.
Other policies may have a value on termination, and the policyholder may receive a payment if they choose to surrender the policy.
For a motor insurance policy, the contract may state a formula for a partial refund of the premium if the policy is cancelled early.
For a with-profit life assurance a surrender value is paid but there is no guarantee of the amount, which is at the discretion of the company.

Question 21

21. Outline four elements that a surrender value penalty can be set to cover.

Answer 21

The surrender value can be set to recover:
* the expenses which have been incurred (including actual costs of processing the surrender)
* the expected profit on the contract - the insurer could choose to recover a proportion of the expected profit, based on the duration in force, or it could choose to recover all the profit that was expected to be earned if the policy remained in force
* a penalty charge for breaking the contract
* the cost of any life cover provided up to the point of surrender.

Question 22

22. Outline two other types of option.

Answer 22

Some policies give the policyholder the option to convert from one type of policy to another.
Policies may give the insurer the option to increase charges, usually subject to a cap.

Question 23

23. State a possible restriction that might be imposed on options.

Answer 23

Regulations may impose restrictions on the exercise of options that are deemed to be unfair to the consumer.

Question 24

24. Give three specific examples of guarantees offered on insurance products.

Answer 24

The most common guarantee in financial products is the basic sum assured under a life insurance policy, or the sum assured plus bonuses under a with-profit policy.
Other products are written with a conditional guarantee: the maturity value under a unit-linked assurance might be the value of units with a monetary minimum - the guarantee is in the money when unit prices are low.
A more complex guarantee might be where a contract’s value depends on the growth in a specified equity index (such as the FTSE 100) with a guaranteed minimum growth rate.

Question 25

25. Outline two administrative concerns when guarantees are offered.

Answer 25

Product providers’ systems should be designed to pay out the guaranteed amount when a guarantee is in the money. A more difficult issue is whether to tell a customer that a forthcoming guarantee is in the money if the customer seeks, for example, to surrender the policy a few months before the guarantee date.

Question 26

26. Describe two examples of where guarantees and options are combined.

Answer 26

Guarantees and options are frequently combined. A policyholder may have a choice whether to take a guaranteed surrender value on a specified date, or to continue the policy in the hope of a better return at some later date.
Life insurance policies designed to provide a pension, but which fund for a cash sum at retirement, sometimes have an option to use the cash available at retirement to purchase a pension at a guaranteed rate that is substantially better than the current rates available in the market.

Question 27

27. Outline why the customer might face a difficult choice in relation to one of these examples.

Answer 27

Sometimes these policies also have an option to take the proceeds in a lump sum, part of which may be tax free to the recipient. This gives the customer a difficult choice.

Question 28

28. Describe the two choices that are available to a provider offering very attractive in-the-money guaranteed annuity rates, but only for single life pensions that are payable monthly.

Answer 28

The provider has two choices:
* Extend the guarantee voluntarily and generate annuity option rates for other frequencies of pension payment and for joint life annuities, using the same actuarial basis as in the policy guaranteed rates. Then all options can be offered to the customer fairly, but at an increased cost to the insurance company.
* Require that joint life and other frequencies of annuity are purchased at non-guaranteed current rates. This will be less costly for the company. However, it will need to ensure that the existence of better rates for monthly single life is made clear, including the financial benefit of selecting the guaranteed option. This approach would also expose the company to reputational risk if it were to be accused of unfair treatment of customers.

Question 29

29. Discuss how options and guarantees might be charged for within a contract.

Answer 29

Any options or guarantees that are included in the financial structure will need to be charged for.
Ideally this should be a charge included in the premiums paid. The alternative is to charge for the guarantees through a reduction in the amount paid when the benefits fall due.
While not charging for options and guarantees from the outset may aid sales, the adverse reaction of customers whose benefits are unexpectedly reduced on payment is likely to outweigh the earlier benefit. Imposing a charge for a guaranteed benefit at the time the benefit is paid - presumably by a deduction from the benefit - means that the benefit doesn’t have the guarantee the customer is expecting.

Question 30

30. What is the overriding principle in setting discontinuance benefits on insurance contracts and on benefit schemes?

Answer 30

The principles underlying the determination of the benefits payable on discontinuance or transfer of rights are broadly the same for insurance contracts and benefit schemes in that the amount offered on discontinuance should be fair to:
* the policyholder or scheme member
* other policyholders and scheme members
*the provider of the benefits.

Question 31

31. Describe the general considerations that apply in determining discontinuance terms for an insurance contract.

Answer 31

An insurance company needs to decide the contracts for which it will offer discontinuance terms. These may be governed by market practice, regulatory requirements, the likelihood of selective withdrawals or simply the difficulty of assessing suitable terms, such as the lump sum to pay on the discontinuance of an immediate annuity.
The provider will also consider the cost involved in determining and implementing the terms compared with the benefit available on discontinuance.
Where discontinuance terms are offered, these could take the form of a payment of a lump sum, or a conversion of the contract to a paid-up status with no more premiums being payable. For some types of contract the discontinuance terms, or the method of calculating them, may be guaranteed as part of the contract.

Question 32

32. Discuss the issues surrounding the provision of a discontinuance benefit for a policyholder who is surrendering a life insurance contract.

Answer 32

What the policy is worth
The starting point for determining the lump sum discontinuance terms should be assessing what the policy is worth, ie the retrospective reserve. Paying this amount should generally be fair to discontinuing / continuing policyholders.

Policyholder expectation - discontinuance at short duration
However at short durations this retrospective reserve is likely to be negative. At short durations, policyholders may have reasonable expectations of receiving a benefit equal to a return of premiums, possibly with interest, but with no adjustment for expenses.
Even if there are no guarantees, any surrender value illustrations provided will influence policyholder expectations.
Therefore, the insurer may have to pay out more than the policy is worth, particular at short durations. The losses on early discontinuance could be recouped by paying out less at later durations.

Policyholder expectation - discontinuance close to maturity
As maturity approaches, policyholders will have reasonable expectations that discontinuance terms smooth into the maturity value.
Over the full term of the contract, there should be a smooth progression in discontinuance terms. The insurer should honour any guaranteed discontinuance terms that are part of the contract terms and conditions.
The method used to calculate the discontinuance terms should be straightforward and well documented. The basis should not be subject to frequent change under normal circumstance.

Competitive considerations
It is quite reasonable for a company to want to be seen to offer competitive surrender values as well as competitive maturity terms.

Question 33

33. Discuss the considerations surrounding the provision of a discontinuance benefit for an individual leaving a defined benefit scheme.

Answer 33

For a defined benefit scheme, the benefits on discontinuance are likely to be known, but if they are to be transferred to another provider a value will need to be placed on them. The value will need to be equitable between members who leave the scheme and members who stay in the scheme.
Any payment to a member leaving the scheme may be reduced to reflect a lower level of funding.
When a member moves from active to deferred status in the scheme, the member is likely to be given the option not to transfer benefits away but to retain the full discontinuance benefits in the scheme.

Question 34

34. What does the provider need to consider in relation to the capital requirements of the contract?

Answer 34

The capital requirements depend on the ‘riskiness’ of the benefits promised. Some ‘attractive’ contracts may require the provider to hold an unacceptable level of capital even if they can sell the contract on profitable terms. This might particularly be the case where the regulatory capital requirements are assessed on a basis that is inconsistent with the economical capital requirements of the contract.

Question 35

35. List four ways of financing the benefits to be provided.

Answer 35

For example, for a benefit scheme the range of options that could be used are:
* pay as you go
* funding all the benefit in advance
* regular payments building up a fund
* paying an amount when the benefit event happens for example purchasing an annuity at the point of retirement.

Question 36

36. Describe the systems considerations that arise when there is a new or revised product design.

Answer 36

The product will need to be administered; this might be on the provider’s own systems or might be outsourced to a third party.
In any event, the system used needs to be able to carry out the functions that have been built into the product design at the cost that has been built into the product price. Systems changes needed to adapt to the requirements of a revised product design also need to be included as part of the development cost of the product.

Question 37

37. Discuss the feasibility of deferring some of the development and implementation of new / revised administrative processes until after the product launch.

Answer 37

Many product designs involve options or changes that only take effect some years after the launch of a product. An example might be offering a guaranteed surrender value on the fifth anniversary of a unitlinked savings bond.
It is clearly not necessary to have these surrender processes working at the product launch, and if they are omitted the product can be launched more quickly.
But the need to carry out the work at some point in the first five years will always be present, and it may be difficult for the business to schedule an appropriate time to carry out such work.

Question 38

38. What do the charges levied under a financial product need to cover?

Answer 38

The charges that are levied will need to meet the costs incurred by the provider in setting up and managing the financial structures in place, and contribute towards the profit of the insurer.

Question 39

39. List eight examples of costs incurred by an insurance company.

Answer 39

For example, for an insurance company the costs will include:
* contract design
* advertising / sales
* commission
* the initial administration of setting up new policyholder records
* the ongoing administration of collecting premiums
* the administration of paying the claims / benefits as they fall due
* management of assets
* the overheads of the insurer, eg rental of office space, IT departments etc