Chapter 22 - Pricing (4) - Options and guarantees

Question 1

What are the common options in long-term insurance contracts

Answer 1

• Be able to purchase additional assurance without providing further evidence of health at the normal premium rates
• To renew a long-term insurance policy without providing additional evidence of health
• To reinstate mortality cover after an accelerated critical illness plan has paid out on a specified disease event

Question 2

What is the cost of an option

Answer 2

• It is the value of the excess of premium that should, in light of full underwriting information, have been charged for the additional insurance over the normal premium rate that is charged

Question 3

What are the factors that affect health options

Answer 3

SCENT E

• SELECTIVE withdrawals - A healthy life may cancel a renewable policy shortly after taking it out because he realises that the cover without the option is cheaper
• CONDITIONS attaching to exercising the option - eg. limiting the size of the option or restricting the choice of contracts available under the option
• the ENCOURAGEMENT given to policyholders to exercise the option - encouraging more of the healthy lives to exercise the option will not cause any additional loss, and should contribute to the company’s total profit
• the NUMBER of times the policyholder gets the chance to exercise the option - eg every 5 years or policy anniversary
• the TERM of the policy with the option - the longer the term, the longer the policyholder will have the option, and the more likely it is that, at some time, his/her health will deteriorate, thus making the option appear worthwhile
• the EXTRA cost to the policyholder who exercises the option - if the option involves a steep increase in premiums, then the healthier lives might shop around to try to get the same cover cheaper elsewhere

Question 4

What are the extra steps involved when valuing a mortality/morbidity option as part of the pricing basis

Answer 4

• the probability that the option will be exercised
• the expected mortality/morbidity of the lives who choose to exercise the option

Question 5

How to calculate the EPV of an option using the North American method

Answer 5

The cost of the option is the difference between the EPV of the benefits and premiums

Question 6

What are the limitations of the North American method to valuing a mortality/morbidity option

Answer 6

• Insufficient data to estimate the decrement rates

Question 7

What are the underlying assumptions of the conventional method of valuing mortality / morbidity options

Answer 7

• All lives elidgible to take up the option will do so
• The mortality/morbidity experience of those who take up the option will be the ultimate experience that corresponds to the select experience that would have been used as a basis if underwriting has been completed as normal when the option was exercised

Question 8

What are the limitations of the conventional method of valuing mortality / morbidity options

Answer 8

• It is not possible to use this method when there are MANY possible dates on which an option may be exercised
• When at some (or all) option dates there is a choice from SEVERAL alternative options, one or more of which may be chosen
• It is normal to assume that the WORST option from the financial point of view of the company is chosen with probability one