Chapter 23 - Contract design Flashcards
List the main considerations when designing a contract.
Stakeholder needs and interests
- Provider
- Customer
- Other
Characteristics of other stakeholders involved
Risk appetite of stakeholders
Regulatory environment
Commercial considerations
- Profitability
- Market and marketability of the product
- Competitive pressures
Level and form of benefits
Options and guarantees
Discretionary benefits
Benefits offered on discontinuance
Contract terms and conditions
Capital requirements
Method of financing the benefits
Premium/contribution pattern
Charges vs expenses
Extent of cross-subsidies
Consistency with other contracts
Administration systems
Accounting implications
What are the main influences on the provider and customer needs respectively?
INFLUENCES ON PROVIDER’S NEEDS
Chosen market
> demographic and economic characteristics of customers
> general economic and commercial environment (can expand this point)
Capital available
Expertise available
INFLUENCES ON CUSTOMER’S NEEDS
Capacity to pay
Risks to be covered
Different timing of future liabilities (and hence required benefits)
Risk appetite
List the other stakeholders (i.e. excluding customer and provider) involved in contract design.
Actuaries Lawyers Accountants Financial backers Administrators Sales and marketing
Discuss how the risk appetite of customers and providers affects contract design.
Important that financial structure of contract meets risk profile of intended customers
- Risks involved in the product must be clearly communicated to the customer
Sales will be optimal if contract can be designed to be suitable for customers with wide range of risk appetites and risk exposures
- Give the customer a degree of choice in their investments
- Option to convert to other contract type
Risk appetite of provider may also be relevant
- New types of contracts may be difficult to price due to lack of data and experience
- Will influence:
> Form of product (e.g. unit linked)
> Level of reinsurance
> Sales process (e.g. sell as rider benefit)
> Size of margins in premium rates or assumptions used to determine premium rates to allow for risk
Discuss how the regulatory environment affects contract design.
Contract design must comply with applicable legal or regulatory requirements.
Certain contract designs/types may be attractive in a particular financial or tax regime.
If regime is optional, provider needs to decide on whether to design the contract inside or outside of the regime
- Impact on benefits should be made clear to customer
Providers will need to recoup/reduce initial expenses when regulation stipulates a cooling-off period for contracts
- Set initial charges
- Cross-subsidise with premiums from in-force contracts
- Try to incentivise customers to stay on until cooling-off period has completed
Regulation may require providers to present specific information to potential customers such as
- illustrations of discontinuance terms
- policy on discretionary bonuses
Regulation may include TCF requirements
Discuss the main factors which affect the profitability of a contract
The main variables which have an affect on the profitability of a contract include:
Actual claims compared with expected claims experience will affect profitability if there are differences in:
- claims frequency
- claims severity (amount)
- claims inflation
- options and guarantees exercised
Expenses and inflation of expenses
Investment returns
Withdrawal experience
New business volume and sales mix
*Many other sources of profit so expand list if necessary, but these are most important
Discuss how the market and marketability of the product will affect the contract design.
Design of financial products will need to meet the specific needs of the target market.
Products aimed at low income individuals are likely to be simple contracts with a clear insured event to ensure affordability and comprehension for the customers.
Products aimed at high net worth individuals will likely be flexible products that can be adjusted as their financial circumstances change. This would typically include options and guarantees, which add cost, but which the target market will usually be willing to pay for.
When products are designed for advisors/brokers, the needs of their customers should be considered.
Discuss how competitive pressures affects contract design.
The desire to be competitive in the market conflicts with the goal of profitability.
The two main types of competitive pressures are:
PRICE
- Comparability/Substitutability of product is important
> Simple/standardised products are more price elastic since there will probably be numerous comparable products
> Complex/unique products will be less price competitive
PRODUCT FEATURES - Some products are not so easily comparable with others in the market, and so the product features will determine the attractiveness to the target market > Risks covered > Admin systems and claims process > Degree of underwriting > Sales/Distribution method * > Options and guarantees
- Products sold through own sales force will not need to be as competitive as those sold through brokers or other intermediaries.
Advantages of differentiating product features from competition
- Positive sales point as it can offset a less price competitive product. - Good innovations may also force the market to catch up
Disadvantages of differentiating product features from competition
- There is risk of differentiating contract design from the rest of the market as consumers may expect consistent terms with the rest of the market and be disappointed when they do not receive the benefits.
- May attract selective business, and so the product mix will not be as expected
Discuss how the decision of benefits, options and guarantees to offer affects contract design.
The level and structure of benefits offered will be affected by:
- customer’s needs
- risks to be covered
- customer’s ability to pay
The options and guarantees inserted in the contract design will depend on
- regulation
> What is permitted
> Ability to fund additional capital requirements
- customer needs
- willingness to pay for such options/guarantees
- practice of competitors
- marketing and sales considerations (such as sales/distribution method)
Types of options:
- Surrender/withdrawal benefit
- Conversion option
- Increase/reduce premiums or contributions
- Paid-up policy
- Timing of premiums/contributions
- Inclusion of rider benefits
- Guaranteed insurability
- Flexible charges, premiums or benefits (on side of provider)
> Regulation will monitor options of provider to ensure they are fair to customers
Guaranteed options are options with some form of guarantee attached
- E.g. Guaranteed surrender value
- Clear explanation of option is necessary and likely to be regulated
Will need to decide on how to share surplus with clients through discretionary benefits. Influences will include:
- Desire to smooth benefits
- Level of benefits generally offered by competitors
- Expectations of client
Pricing for options and guarantees in contract
1) Value options/guarantees with aid of stochastic model and include charge in premiums paid
2) Reduction in benefits when they fall due
- May aid sales due to lower premium
- May negatively influence reputation and future sales
> Customer may not have understood/expected that benefit will decrease
Discuss how benefits offered on discontinuance affects contract design for life insurance contracts.
The key considerations when setting the level and type discontinuance benefits are:
- fairness
> to customers deciding to discontinue AND remaining customers
> to provider
- policy value > Could be based on 1) assets policyholder holds (e.g. unit-linked) 2) time policy has been in force 3) size of reserve
- policyholder expectations
> premiums plus interest (especially in early stage of contract)
> size of benefit (especially in late stage of contract) - competitive considerations
Other considerations:
Which contracts to offer discontinuance terms based on
- market practice
- regulatory requirements
- likelihood of selective withdrawals
- difficulty of assessing terms
The form of the benefits and terms on which they are paid
- Surrender
- Lapse
- Paid-up
- Withdrawal means customer surrendered OR lapsed
Administration costs
The method used to set discontinuance terms (read p.22-23 for more detail)
Practical considerations relating to the discontinuance terms
- Ease of calculation
- Frequency of change of discontinuance terms
Discuss how benefits offered on discontinuance affects contract design for general insurance contracts.
Insurer is likely to provide a lump-sum discontinuance payment reflecting the premium for the outstanding cover less an administration fee.
Discuss how benefits offered on discontinuance affects contract design for benefit schemes.
The key considerations include:
The form of the benefit being offered
- For DC, discontinuance benefit will reflect the member’s account at the date of withdrawal
- For DB, discontinuance benefit is usually based on the number of years service and the salary at the date of withdrawal increased at some low inflationary rate (based on years to retirement)
- Could have the option to retain the discontinuance benefits in the scheme instead of transferring out (almost like paid-up value)
How to set the discontinuance benefits - Key principle is fairness and main stakeholders are > Sponsor > In-force members > Deferred members
Other considerations
- Reduced discontinuance benefits due to funding level (see p.27)
- Scheme rules
- Regulation
Why are discontinuance benefits unlikely to be offered on micro insurance products?
Aim is to keep costs low and so discontinuance benefits, which result in many admin costs, would be avoided normally.
Discuss how financing considerations affect contract design.
CAPITAL REQUIREMENTS
- Capital needs to be held to finance
> New business strain
> Risk that experience is worse than expected and loss is incurred in future years - Attractive/Innovative contracts may be unprofitable due to unacceptably high capital requirements
- Ways to reduce capital requirements > low/no guarantees > flexible charges in terms of timing and level > reduce initial expenses > single premium contract (no NBS)
FINANCING METHOD
- Choice as to when and how reserves should be set aside to pay future benefits
- Decide on investment strategy, which will depend on
> the risk appetite of the stakeholders
> structure of benefits and other liabilities for company (matching)
- Different types of funding include: > Pay as you go (unfunded) > Funding all the benefits in advance > Regular payments building up a fund > Paying an amount when the benefit event happens
Discuss how admin and accounting issues affect contract design.
Administrative considerations
- Use own systems or outsource
- Adaptability to existing and future product features
- Operational risk incurred and need for expertise when using advanced systems
Impact of product on accounting requirements should be considered
