Chapter 4- Contract Design and Pricing

Question 1

Describe contract design factors? (9)

Answer 1

• Marketability:
o Attractive to potential policyholders and intermediaries
o Meets needs (real and perceived) of both target markets, at a cost comparable to other companies

• Distribution method:
o Intermediaries  commission regulation is key
o Direct  simplified design is key

• Profitability:
o Expected profitability should yield a return greater than the life office’s hurdle rate, after allowing for the risk-adjusted cost of capital
o Sensitivity of profit to levels of sales, lapses, surrenders and mortality experiences  use profit testing to analyse

• Financing:
o Risks involved (particular guarantees and options) must be acceptable to shareholders or policyholders providing capital
o Must not subject office to a significant risk of insolvency
o Under SAM
 Product development & pricing is part of ORSA
 Demonstrate impact of new product on
• projected balance sheet
o including solvency and eco cap requirements
• risk appetite – best estimate & more conservative

• Administration systems:
o Capable of managing all the product features

• Regulatory requirements:
o Meet these (e.g. minimum surrender values) e.g. LTIA Regulation 5 (85% policy value on surrenders after 2009)
o TCF

• TAX (incentives to encourage sales)

• Reputation of the insurer:
o Underwriting and claims philosophy will influence this
• Reinsurance (if needed):
o Consider reinsurance terms and capacity

Question 2

Describe the discounted cashflow method of pricing as well as the advantages associated with the method? (3, 11)

Answer 2

Discounted cash flow method – most common approach:
• All future expected cashflows (premiums, claims, expenses, commission, investment income and changes in liabilities) are projected in order to produce a profit signature
• Premium is then determined as the value that satisfies the chosen profit criteria
o (i.e. profit testing on the emerging cashflows)

Advantages of DCF over equating present values/everything to allow for in pricing:
• Expected return on capital can be measured
• Sensitivity of profit to variations in experience can be investigated
o  to determine margins for parameter values
• Reserves and solvency capital requirements can be explicitly allowed for
• Financing requirements for a new contract can be assessed
o Use CFs & new business volumes and mix
• Withdrawals and [conversions to paid-up] can be more easily allow for
• Benefit and charging structures that depend on future assumptions can be allowed for
• Time-dependent and stochastic assumptions can be included
• Options and guarantees can be allowed for
• Reinsurance and financing arrangements can be allowed for
• Risk discount rate can allow for the term structure of interest rates
• Tax can be allowed for more appropriately

Question 3

Describe the five steps involved in setting a basis? (2,2,6,3,2)

Answer 3

Step 1: Identify reference points
• Def = Sources of data or information (quantitative or qualitative) that can assist in the basis development:
o past experience on the same or similar risks,
o published statistical tables,
o industry-wide publications for the same or similar markets,
o national statistics
• Consider all reference points collectively but place more weight on those that are more credible

Step 2: Identify and assess rating factors:
• Criteria for including a rating factor:
o Significant  explains the risk
o Measurable  can be quantified
o Verifiable WITHOUT incurring an unacceptable level of cost
o Socially acceptable and legal
o (low) Correlation to factors already used
o (standard) Market practice  collected and hence data is available
• If two rating factors are highly correlated  construct a two-way table of adjustment factors, which allows for the impact of both factors rather than allowing for each in isolation

Step 3: Determine the crude incidence rates
• If adequate (internal) data  derive adjustment from own experience
o Use in isolation or jointly with other sources of data
• Data should relate to an appropriate period of years so that:
o Volume of data is credible
o BUT avoid excessive heterogeneity due to trends over time is not introduced
• Divide data into homogeneous groups, subject to adequate volumes of data being retained within each cell to ensure credibility of estimates (e.g. may need to group into age bands at extreme ages)
• Ensure consistency between exposure and incidence data (particularly when grouping)
• Allow for trends and cycles in experience (e.g. extrapolate the expected continuation of the trend)
• Maintain an audit trail of the derivation of crude rates (calculations performed, justification for decisions made)

Step 4: Graduate the crude rates

o produces smooth set of rates that have an
o acceptably good fit to observed data,
• Needed where there are (random) fluctuations in a series of observed incidence rates, as opposed to being a true reflection of the experience
• Usually graduate crude rates across age (but can also be done across other rating factors e.g. income/ birth cohort)

Step 5: Test the basis
• Test goodness of fit against original set of crude experience
• Compare resulting office premium against competitors

Question 4

Describe the five steps involved in setting a basis?

Answer 4

Step 1: Identify reference points
• Def = Sources of data or information (quantitative or qualitative) that can assist in the basis development:
o past experience on the same or similar risks,
o published statistical tables,
o industry-wide publications for the same or similar markets,
o national statistics
• Consider all reference points collectively but place more weight on those that are more credible

Step 2: Identify and assess rating factors:
• Criteria for including a rating factor:
o Significant  explains the risk
o Measurable  can be quantified
o Verifiable WITHOUT incurring an unacceptable level of cost
o Socially acceptable and legal
o (low) Correlation to factors already used
o (standard) Market practice  collected and hence data is available
• If two rating factors are highly correlated  construct a two-way table of adjustment factors, which allows for the impact of both factors rather than allowing for each in isolation

Step 3: Determine the crude incidence rates
• If adequate (internal) data  derive adjustment from own experience
o Use in isolation or jointly with other sources of data
• Data should relate to an appropriate period of years so that:
o Volume of data is credible
o BUT avoid excessive heterogeneity due to trends over time is not introduced
• Divide data into homogeneous groups, subject to adequate volumes of data being retained within each cell to ensure credibility of estimates (e.g. may need to group into age bands at extreme ages)
• Ensure consistency between exposure and incidence data (particularly when grouping)
• Allow for trends and cycles in experience (e.g. extrapolate the expected continuation of the trend i.e. improvements in longevity due to medical science or the impact of AIDs pandemic)
• Maintain an audit trail of the derivation of crude rates (calculations performed, justification for decisions made)

Step 4: Graduate the crude rates

o produces smooth set of rates that have an
o acceptably good fit to observed data,
• Needed where there are (random) fluctuations in a series of observed incidence rates, as opposed to being a true reflection of the experience
• Usually graduate crude rates across age (but can also be done across other rating factors e.g. income/ birth cohort)

Step 5: Test the basis
• Test goodness of fit against original set of crude experience
• Compare resulting office premium against competitors