Chapter 23: Contract design Flashcards
List the factors to consider when designing or redesigning a contract
AMPLE DIRECT FACTORS
Administration systems
Marketability
Profitability
Level and form of benefit
Early leavers benefits
Discretionary benefits
Interests and needs of customers
Risk appetite of the parties involved
Expenses vs charges
Competition
Terms and conditions of the contract
Financing (capital requirements)
Accounting implications
Consistency with other products
Timing of contributions or premiums
Option and guarantees
Regulatory requirements
Subsidies (cross-)
List the parties involved in contract design
ALPACAS
Actuaries
Lawyers
Providers of benefits
Accountants
Customers
Administrators
Shareholders / financial backers
List the factors influencing the needs of the provider
- The chosen market
- The capital available
- The liquidity available
- The expertise available
List the factors influencing the needs of the customer
- Capacity to pay
- The risks to be covered
- The benefits that are needed at different times in the future
- Attitude to financial risk
Give examples of how a contract can be designed to cater for different risk appetites amongst customers
- Different investment funds, e.g. low, medium and high risk
- Different levels of cover, e.g. comprehensive vs third party
Discuss actuaries’ involvement in contract design
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.
Discuss lawyers’ involvement in contract 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
Discuss accountants’ involvement in contract design
Accountants will be involved in ensuring that the provider of the financial structures properly accounts for the income and outgo
Discuss financial backers’ involvement in contract design
The financial backers will want regular reports demonstrating proper stewardship of finance provided
Discuss administrators’ involvement in contract design
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.
In addition, the more complex the structure, the greater the risk of error.
Discuss sales and marketing’s involvement in contract design
Sales people need training on financial structures. The more complex the financial structures are, the greater the cost of training and the harder the contracts may be to sell.
Marketing teams can provide important information on the characteristics of the target market as part of the design process
Give examples of how the regulatory environment may influence the design of a product
Products must meet legal or regulatory requirements, if any.
Products can be designed to benefit from favorable financial or taxation regimes.
Products should be designed to ensure that initial expense can be recouped if a policy is cancelled within any regulatory ‘cooling-off’ period.
Regulation may require information to be disclosed to potential customers, for example disconitnuance terms.
List the important variables that might impinge on the profitability of an insurance contract
- Claims experience (including mortality and morbidity experience)
- Expenses and expense inflation
- Investment returns
- Withdrawal experience
- New business sales volumes and mix
Give examples of contract design features that make a contract more marketable
- Guarantees, options and choices
- A competitive (low) price
- Transparency and simple to understand
- Features that distinguish it from the competitors
Give examples of options relating to:
premiums, benefits, the use of contract proceeds and any other option that might be offered as part of a contract design
Premium options:
- waiver of premium
- option to increase / decrease premium
- option to choose / change premium frequency
Benefit options:
- discontinuance
- early or late or ill-health retirement
- spouse’s benefits
- rider benefits
- option to protect a no-claims discount
Use of the contract proceeds:
- choice of annuity provider
- choice of hospital under health insurance
Other options:
- option to renew / convert a term assurance without further underwriting.
List examples of guarantees that might be offered as part of a contract design
- Guaranteed benefits
- Guaranteed minimum maturity value
- Guaranteed minimum growth rate
- Guaranteed annuity rates
- Guaranteed premiums
- Guaranteed charges
What are the 2 main competitive pressures?
- Price
- Product features
What is the underlying principle to consider when setting discontinuance terms for an insurance company or benefit scheme?
Fairness between:
* the policyholder or member who is leaving
* the remaining policyholders or members
* the provider of the benefits
Surrender
The policy stops, there is no further cover and the policyholder receives a lump sum payment (the surrender value)
Lapse
The policy stops, there is no further cover and usually no payment is made to the policyholder by the insurance company
Paid-up
The policyholder ceases to apy premiums but the policy continues to offer the policyholder some cover.
In this case the benefit is reduced to reflect that there are no more premiums and is called the paid-up value.
Withdrawal
This normally encompasses surrender and lapse, as the policy does not stay in force.
What should the insurance company consider when setting the discontinuance terms for life insurance contracts?
- which contracts to offer discontinuance terms on
- the form of the benefits being offered
- how it goes about setting the discontinuance terms
- any practical considerations relating to the discontinuance
How does an insurance company decide on which contracts to offer discontinuance terms?
- Market practice
- Regulatory requirements
- The likelihood of selective withdrawal
- Or simply the difficulty of assessing suitable terms, such as the lump sum to pay on the discontinuance of an immediate annuity
Main factors to consider in determining suitable discontinuance terms for an individual leaving a benefit scheme
- The form of the benefits offered: 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.
- Setting the discontinuance benefits: 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.
- Other considerations: Any payment to a member leaving the scheme may be reduced to reflect a lower level of funding. For a defined benefit scheme, the scheme rules will need to set out the benefits that will be provided on discontinuance.
Define ‘new business strain’
New business strain arises because the premium received in the first year may be less than the sum of the initial expenses, the initial commission paid and the initial increase in provisions.
It may also include the need to cover initial solvency capital requirements.
List ways in which a contract could be designed to reduce the new business strain
- Low guarantees
- Charges that match the expenses by nature and by timing
- Low initial expenses / commission
- Low statutory provisioning requirements
- Single premium
List 4 methods of financing benefits
- Pay as you go
- Funding all the benefits in advance
- Regular payments building up a fund
- Paying an amount when the benefit event happens
Outline the main administrative considerations that relate to contract design
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.
It is not necessary to have surrender processes working at the product launch, since many product designs involve options or changes that only take effect some years after the launch of the product.If these processes are omitted the product can be launched more quickly.
However, the need to carry out the work at some point in the near future will always be present, and it may be difficult for the business to schedule an appropriate time to carry out such work.
List the items that the expense charges of an insurance company would be expected to cover
- 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
Give examples of conflicts between contract design factors
- The desire for a profitable contract with big profit margins in the premium rates may conflict with the desire for a competitive contract
- The desire to offer guarantees will conflict with the desire to reduce the financing requirement
- The desire for ‘bells and whistles’ to improve marketability will conflict with administrative simplicity.
