Chapter 4 - Contract design and pricing

Question 1

Describe contract design factors? (9)

Answer 1

• Marketability:
  Attractive to potential policyholders and intermediaries
  Meets needs (real and perceived) of both target markets, at a cost comparable to other companies
• Distribution method:
  Intermediaries –> commission regulation is key
  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
• 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

What is the Discounted Cash Flow (DCF) method in life insurance pricing?

Answer 2

The DCF method projects all future expected cash flows (e.g., premiums, expenses, claims, commissions, and investment income) and discounts them to determine the premium or charges that satisfy a chosen profit criterion.

Question 3

Why is the Discounted Cashflow Flow method preferred over simple present value calculations? (7)

Answer 3

It allows for:
* profit testing
* sensitivity analysis - profit variations
* solvency requirements
* financing needs
* complex benefit structures
* reinsurance
* tax considerations
* allow for withdrawal and paid-up conversion
* options and guarantees modelled more explicitly
* risk discount rate can take account of term structure of interest rates

Question 4

Describe macro-pricing in life insurance? (6)

Answer 4

• Considers interaction between price and demand.
• Accounts for overhead vs. variable costs.
• Recognizes potential cannibalization of existing products.
• Maximizes profit contribution across products.
• Balances risk exposure across offerings.
• Involves collaboration between actuaries and marketing.

Question 5

What are the key steps in setting a risk basis for life insurance?

Answer 5

Risk Basis: A set of probabilities (e.g., mortality, disability rates) used in product development.

• Step 1 - Identify Reference Points: Use past experience, statistical tables, industry data.
• Step 2 - Assess Rating Factors: Consider significance, measurability, legality, and market practice.
• Step 3 - Determine Crude Incidence Rates: Use internal/external data, adjust for trends.
• Step 4 - Graduation: Smooth crude rates to remove random fluctuations.
• Step 5 - Test the Basis: Compare against crude experience and competitor pricing.