Chapter 22: Pricing options and guarantees

Question 1

What are health options?

Answer 1

Additional benefits or longer periods of cover at normal premium rates without further evidence of health. There is a limited impact on short term contracts

Question 2

What is the difference between a life option and a health option?

Answer 2

Life you have to alive to exercise. Health option you have to alive and in good health in order to exercise the option.

If the PH is in a nearly sick state that does not yet meet the claim definition then the option will have value.

Question 3

How do you calculate the cost of an option?

Answer 3

1. Option cost= premium under normal circumstance - current premium charged
2. Expected cost of option = function of health & proportion of option takers
   a. Health- worse health = option cost is high
   b. Proportion - small prop = avg morb of taker is worse and option cost if higher

Question 4

What are the factors affecting health options and risks?

Answer 4

1. Policy term
2. Option dates (number of times option can be exercised
3. T&C of option

Question 5

What causes an option to be underexercised?

Answer 5

1. PH lethargy and unawareness
2. Encouraging ph lowers underexercise of the option

Lower utilisation = lower profits when healthy lives do not exercise the option

Question 6

What are some risks related to options?

Answer 6

1. Value of options has a high variance
2. Popularity of options
3. Disease breakout
4. Extra cost of options
5. Selective withdrawals
6. Anti-selection

Question 7

What are some risk management strategies for options?

Answer 7

1. T&C
2. Experience monitoring
3. Remove from new business
4. Underwrite extensively at inception
5. Reinsurance
6. Don’t remind ph about the options
7. Premium increaseW

Question 8

What are the 3 ways of pricing options?

Answer 8

1. North American - assumes a proportion exercise the option
2. Conventional - assumes everyone takes the option
3. Stochastic

Question 9

What are the pros and cons of the north-american method?

Answer 9

Pros
1. Easy to calculate
2. If data is available - competitive premium will be charged

Cons
1. Data intensive - data needs to be sufficient and reliable
2. For a new line of business there is no experience
3. Results are sensitive to assumptions
4. Risk of undercharging is high when data is not available

Question 10

What are the pros and cons of the conventional method?

Answer 10

Pros
1. Data requirements are chilled (fewer assumptions needed)
2. More prudent and less risk of wrong answer

Cons
1. Tough to deal with multiples options or multiples dates on which to exercise

The PH’s alive at exercise date are assumed to take it.

Question 11

What is the process of the stochastic method?

Answer 11

1. Future experience is projected
2. Investigate proportion of option takers for various options
3. Investigate probability of claim
4. Subdivide probabilities into different risk categories
5. Multiple simulations
6. Cost of option is calculated at a certain degree of accuracy

Question 12

What are some risks of guarantees?

Answer 12

1. Early withdrawals (when asset share is negative)
2. Poor investment returns on unit linked
3. Selective withdrawals
4. Liquidity risk - surrenders
5. Pricing risk - not enough data to price it properly
6. Increase in business strain if the guarantee is highly marketable

Question 13

What are some methods of managing the risk

Answer 13

1. Don’t offer guarantee
2. Reduce benefit amount
3. Offer guarantee after certain time has elapsed
4. Surrender charge
5. Compare with competitors
6. Increase reserves and capital
7. Derivatives
8. Reinsurance
9. Diversify product offerings