Chapter 27: Cost of guarantees and options

Question 1

Implications for the insurance company - Investment guarantees: (risk assumed?)

Answer 1

The risk assumed by the life insurance company is that at specified times in the future the “backing” assets will be insufficient to meet the guarantees.

Question 2

The liability created by an investment guarantee:

Answer 2

The liability created by an investment guarantee is the excess of the guaranteed amount, over the cost that would have been incurred at the time in the absence of the guarantee.

Question 3

The value of the investment guaranteed liabilities can be determined using: (2)

Answer 3

1. option-pricing techniques - These assess the extra premium by looking at the market price of a derivative that the insurance company could acquire to mitigate its risk.
2. stochastic simulation of investment performance - The extra sums likely to be needed under the guarantee can be modelled by simulating a range of investment scenarios.

Question 4

It is common for life insurance policies to include options to: (3)

Answer 4

1. purchase additional benefits without providing further evidence of health at the normal premium rates at the date on which the option is exercised.
2. renew a life insurance policy without providing additional evidence of health.
3. change part of the sum assured from one contract to another, e.g. from term assurance to endowment assurance.

Question 5

Implications for the insurance company - Mortality options (what is the cost):

Answer 5

The cost of an option is the value of the excess of the premium that should, in the light of full underwriting information, have been charged for the additional assurance over the normal premium rate that is charged.

Question 6

Some factors affecting mortality options: (6)

Answer 6

1. The term of the policy with the option.
2. The number of times the policyholder gets the chance to exercise the option.
3. Conditions attaching to exercising the option.
4. The encouragement given to policyholders to exercise the option.
5. The extra cost to the policyholder who exercises the option.
6. Selective withdrawals.

Question 7

Describe how to value a mortality option: (4)

Answer 7

1. Mortality options are normally valued using cashflow projections.
2. These cashflows would include the additional benefits expected to be payable under the option and the additional premiums expected to be received in relation to these benefits, to the extent to which the option is assumed to be taken up.
3. The additional premiums would be based on the expected premium rates that would be charged to standard lives for the additional benefit, as at the option exercise date.
4. The projections should also allow for any additional expenses incurred in the administration of the option.

Question 8

Valuing a mortality option requires extra assumptions as part of the basis: (5)

Answer 8

1. the probability that the option will be exercised, at each possible exercise date.
2. the additional benefit level that is chosen, if this is at the discretion of the policyholder.
3. the expected mortality of the lives who choose to exercise the option.
4. the expected mortality of the lives who choose not to exercise the option.
5. additional expenses relating to the option.

Question 9

Two methods that can be used to price mortality options: (2)

Answer 9

1. The conventional method, which assumes:
   - All policyholders take up option and the max additional benefit is taken.
   - Policyholders taking up the option experience ultimate mortality rates.
2. The North American method, which assumes:
   - A double decrement table is used to model the proportion of policyholders taking up the option.
   - After the option date a separate mortality table is applied for policyholders that take up the option.

Question 10

Cost of a mortality option

Answer 10

The cost of an option is the value of the excess of the premium that should, in the light of full underwriting information, have been charged for the additional assurance over the normal premium rate that is charged.

Question 11

It is common for life insurance policies to include options to: (3)

Answer 11

1. purchase additional benefits without providing further evidence of health at the normal premium rates (for a life that a particular age) at the date on which the option is exercised.
2. renew a life insurance policy, e.g. a term assurance at the end of its original term without providing additional evidence of health.
3. change part of the sum assured from one contract to another, e.g. from term assurance to endowment assurance.

Question 12

Some factors affecting mortality options are: (6)

Answer 12

1. The term of the policy with the option
2. The number of times the policyholder gets the chance to exercise the option
3. Conditions attaching to exercising the option
4. The encouragement given to policyholders to exercise the option
5. The extra cost to the policyholder who exercises the option
6. Selective withdrawals