Chapter 27 - Cost of guarantees and options Flashcards
Why are investment guarantees useful?
- Traditional life insurance contracts transfer mortality, expense and investment risk from the policyholder to the life insurance company.
- Unit linked and index linked contracts leave the investment risk with the policyholder
- These contracts’ attraction can be enhanced if part of the investment risk is transferred to the company by the company offering guarantees to protect the policyholder from the downside risk.
Give examples of investment guarantees
3
- Guaranteed minimum maturity value
- Guaranteed minimum surrender value
- Guaranteed annuity options - eg, Convert endowment proceeds to immediate annuity on guaranteed terms
Why is transfer of investment risk to the policyholder lower for with-profits contracts than unit-linked contracts
Due to smoothing for with-profit contracts
If a company chooses not to invest to match the guarantees, what must be done:
- has control over the investment policy
- does not have control over investment guarantee (unit-linked)
Has control over investment policy
* include cost of the guarantee in the original pricing basis
Does not have control over investment policy
* include cost of guarantee in the original charges to the extent that the guarantee will not be matched
What impact does time/outstanding term play on risks faced by insurer due to offering investment guarantees (2)
generally, longer time-frame implies greater chance of things go wrong vs current forecasts eg offering guarantee annuity rate for 5 years, vs 20 years
for with profits business, actually tricky to say: longer term may give insurer time to act on profit distribution levels if investment returns are disappointing
How do insurer’s meet the cost of the liability created by the investment guarantee? (1)
What methods are available to price the costs of the guarantee? (2)
- Insurer’s meet the cost of the additional liability created by the guaranteed by charging an extra premium to reflect the extra sums it may need to pay due to the guarantee biting
To determine the extra premium to charge, the insurer can use
- option pricing techniques
- stochastic simulation
Describe the general principle behind option pricing techniques to calc the extra premium for an investment guarantee (1)
Give examples of options which can be used to meet the different investment guarantees insurers may offer (6)
Option pricing/market valuation techniques assess the extra premium by looking at market price of derivative/option insurer could use to mitigate risk
Options which can be used to mitigate the following investment guarantees
- Guaranteed maturity value - European style put option on investment funds at an exercise price = maturity guarantee
- Guaranteed surrender value - Similar American style put option/series of puts with different exercise prices which match guaranteed surrender values
- Guaranteed annuity rate - call option on bonds that are needed to ensure guarantee is met
+ie at exercise price which generated the required fixed rate of return
+can also be mirrored by option to swap floating rate returns at the option date for fixed returns sufficient to meet guaranteed annuity option (swaption)
Explain how stochastic simulation is used to estimate a premium to cover the cost of a financial option
- Determine the present value of the liability by discounting the simulated cost of exercising the option
- Carry out multiple simulations to generate a distribution of the cost of providing the guarantee
- Set the premium to the market cost of providing the guarantee i.e. the average simulated costs plus a margin
Give common examples of mortality options offered by life insurers
Common examples of mortality options include
- Purchase additional benefits with no further evidence of health at normal premium rates (for a life of that particular age) at the date on which option exercise
- Renew life insurance policy
+eg term assurance, at end of original term
+with no further evidence of health - Change benefit type
+eg change part of a sum assured from one contract to another
+eg from term assurance to endowment assurance
Mortality options give great scope for anti-selection against the insurer; how might the insurer reduce this? (5)
- ensuring that terms and conditions under which the option can be exercised are clearly set out in the original policy
- only allowing options to be exercised at specific points in time
+eg, every 5 years
+anytime, provided a qualifying event has occurred eg childbirth, new job with higher salary - specifying the extent of the option allowed’
+eg additional sum assured cannot exceed original sum assured
What is the rough cost of mortality options
[proportion of lives exercising the option] x [average health of lives exercising the option]
What factors generally affect mortality options? (6)
- Term of the policy with the option
+longer term, longer PH will have option, and more likely that at some time their health will make option appear worthwhile - Number of times option available to exercise
+eg every 5 years, every policy anniversary, any time whatsoever - Conditions to exercise option
+eg limiting size of option; restricting choice of contracts available for - Encouragement given to exercise option
+low take up=> only those with most to gain will exercise
+encouraging healthy lives to exercise will not cause any additional expected loss + should contribute to insurer’s total profit as it issues business to good risks
+care should be taken not to encourage poor risk lives - Extra cost to PH exercising option
+if option involves a steep increase in premiums, would cause healthier lives to shop around to get the same cover elsewhere
+the company would lose out on potential profits from these healthy lives - Selective withdrawals
+healthy life may cancel 10 year renewable term assurance after 2 years if cover without option is much cheaper
+withdrawal by healthy lives before the option date reduces the income (extra premiums) that we would have expected to receive from the whole risk pool
Describe how a mortality option would be valued? (6)
- Cashflow projections would normally be used
- Cashflows include addtional benefits and premiums expected to be paid in relation to the option
- Cashflows allow for extent to which the option is assumed to be taken up
- Additional premiums based on the expected premiums to be charged to standard lives, as at option exercise date
- Allow for additional expenses relating to option eg writing to PH to remind of option
- If purpose of valuation is to price option (rather than setting liability), then need to allow for additional reserves that should be held, both before and after
List 5 additional assumptions required to price a contract if a mortality option is added (5)
- probability that option will be exercised, at each possible exercise date i.e. take-up rate
- additional benefit level that will be chosen, if at discretion of PH
- expected mortality of lives who choose to exercise option
- expected mortality of lives who choose not to exercise option
- additional expenses relating to option
What are 2 alternative assumptions that are typically made regarding the mortality of those lives that don’t take up a mortality option? (4)
- Assume lives that don’t up option will continue to experience base mortality
+implies that average mortality for all lives is higher than the base mortality assumption
+(because those taking up the option assumed to experience higher than base mortality) - Assume that mortality of those who don’t take up option us such that average mortality for all lives remains at the expected base level.
+here, the assumed mortality of those who do not take up the option would be less than (1), ie less than base mortality
