Contract Design and Pricing

Question 1

What should we think about for suitable design?

Answer 1

1. Profit
2. Marketability
3. Customer needs
4. Competitveness
5. Distribution method and remuneration
6. Financing/capital requirements
7. Guarantees and options
8. Sensitvity of profit
9. Extent of x-subsidies
10. Admin systems
11. Service standard
12. Reputation
13. TCF
14. Level of risk
15. Underwriting standard
16. Tax
17. Reinsurance terms and capacity
18. Admissibility of assets (use in valuation)
19. Legal/Regulatory constraints
20. Monitor and review performance and terms regularly

Question 2

Why is discounted cashflow approach used for pricing over equating present values?

Answer 2

1. Only approach to price unit-linked
2. Allow for tax easily
3. Account for term structure of interest rates
4. Easier to have assumptions varying over time e.g. stochastic
5. Reinsurance can be allowed for, including financing
6. G’s and O’s modelled better
7. Easily allow for withdrawals/PUPs
8. Easily cope with complex charging structures like where charges/benefits depend on future assumptions
9. Explicitly allow for set up of reserves and meeting solvency requirements
10. Can investigate sensitivity of profit to different assumptions easily
11. Allows measuring expected return providers of capital will receive, for WP expected contribution to free assets
12. Use to assess NB financing requirements easily

Question 3

Why is CWP sometimes priced using equation of value, and when is it more appropriate to be discounted cashflow?

Answer 3

1. Equation of value as contracts not finally priced until go off books
2. Not good for proprietary company - doesn’t quantify rate of return company hopes to get on sales

Question 4

What are the main assumptions to think about in the pricing basis?

Answer 4

Mortality
Investment return
Expenses
Persistency
Tax
Risk discount rate
Profitability target

Question 5

What needs to be considered in terms of mortality for pricing?

Answer 5

1. Method of finding rates - standard table adjustment/past experience/reinsurer data/cmi data
2. Mortality improvements particularly for annuities
3. Anti-selection including withdrawals
4. Underwriting standard
5. Nature of policyholders targeted

Question 6

What needs to be considered in terms of persistency in pricing?

Answer 6

1. Based off results of experience investigation of this type of contract or one close to it
2. Separate rates for withdrawal/pups may be needed
3. Possibly vary by premium level

Question 7

What needs to be considered in terms of tax in pricing?

Answer 7

1. Appropriate rate e.g. if BLAGAB or not
2. Allow by reducing discounted net cashflow by it
3. Then compare to profit criteria

Question 8

What needs to be considered in terms of profit criterion in pricing?

Answer 8

1. Appropriate target needed
2. May be IRR on initial capital strain
3. May be NPV profit as % of premium

Question 9

What needs to be considered in terms of expenses in pricing?

Answer 9

1. Assumption from recent experience investigation on that type
2. If no recent investigation/unreliable then similar type of contract
3. If 1 and 2 unsuitable, then reinsurer/consultant data if appropriate
4. Overheads and development costs relies on expected volume of new business
5. Allow for future inflation, consistent with investment return
6. Allow for commission at expected rates of that market

Question 10

What needs to be considered in terms of investment return in pricing?

Answer 10

1. Consider matching assets and yields from them
2. Allow for default risk and liquidity risk in corporate bonds vs. govt. bonds (explicit in stochastic)
3. If market consistent pricing, risk free rates probably term dependant to be used
4. Financial guarantees to be priced using option price theory or stochastic modelling
5. Financial guarantee assumptions needed are economic scenarios and correlations between inflation and investment returns
6. Allow for reinvestment risk, stochastic has this explicitly

Question 11

What needs to be considered in terms of risk discount rate in pricing?

Answer 11

1. If traditional pricing, allow for margin above risk free to reflect shareholder required return
2. High margin for high sensitivity/variance in profit
3. Risk free rate based on current term structure of interest rates
4. Market consistent uses risk free discount rate, risk allowed for in experience assumptions of cost of capital method under SII
5. MC approach can lead to greater volatility in price to be charged for given profit criteria
6. So companies could use approach to help understand difference between traditional and MC valuations
7. MC approach gives info consistent with Value added of NB under MCEV

Question 12

What’s the other thing I need to learn for pricing?

Answer 12

The example in the notes in unit 15!