Guarantees and Options Flashcards
In what ways can insurance contracts sometimes have options or guarantees
Insurance contracts frequently contain guarantees or options beyond the commitment to provide contractual benefits.
Policyholders have option to continue the contract and so can cease at any time. Terms of this termination can be different. Might be: Contractual payment (guarantee), discretionary payment(ex: assessed surrender value) or other benefit(ex: policy made paid up)
Define a PUP
Paid up policy is a regular premium policy that you stop paying premiums, you get a scale down below it.
Remember - poeple don’t always stop paying premiums for rationale reasons. Lots of reasons.
What is another word for guarantee
Real otpion
What guarantees are bad idea for investment funds
Bad idea to guarantee surrender values when maturity value is also guaranteed because then there are two incompatible aims of investment of funds. It is often impossible to both be higher than the surrender value at each point in time and, at maturity, be at or above the maturity amount. This is because the matching investment for one is cash and the other is a bullet bond of suitable duration.
One exception is the surrender value of a motor insurance policy
Explain a bullet bond
A bullet bond is a debt instrument whose entire principal value is paid all at once on the maturity date, as opposed to amortising the bond over its lifetime.
If interest rates go up and you have a guarantee on current policy what will you do
Surrender the first policy and get something elsewhere in the market, it can be a bad scenario for the insurer
Why are surrenders and guarantees generally not a good idea
Tends to happen when it’s bad for the insurer.
With guarantees there can be no diversification
Also Strike price of real options can be difficult to workout
What are Surrender values often set to
Often set to recover: Expenses
Cost of any cover provided up to point of surrender
Expected contract profit
Penalty charge for breaking contract.
Why do banks not want people paying off mortgage earlier. and what scenario might this occur
If the bank has lent me money, the bank is assuming they will get a certain amount a year from me. But they will be annoyed if I pay it off early : mortgage interest I’m paying is going out on customer deposits. Banks dont get your cash flows then.
If interest rates fall - banks would be worried many people would pay off their mortgage early.
Banks cant ask for mortgage repayment early if short on capital must try get people to deposit more money
If inetrest rates fall what will those with a endowment savings policy do
Incentive in savers is to hold on tight and not surrender if interest rates fall.
Examples of Guarantees/Options in Insurance
The annuity amount,
The basic sum assured plus any declared bonuses
Pension related to final salary and years of service.
The interest rate on mortgage will track the ECB rate plus 50 bp
Examples of Guarantees/Options as add ons to the main benefit
Minimum value at maturity clause.
Option to buy an annuity in the future at some guaranteed annuity rate.
Unit linked contract can double the original amount of life cover without underwriting at any time.
At the end of the term assurance, policyholders can take out whole-of-life at the then standard rates
What are the Problems with Guarantees and Options
Introduce a systematic risk as guarantees are in value for all tranches of a policy same time
Guarantees need reserves boosts
but there is no extra cash flow from policies so need free reserves
Difficult to manage risk as guarantees bite at bad times
Difficult to price- sensitive to small changes.
Policyholders don’t value guarantees or options more than what they cost
Generally options are secondary to the main benefit
What is the Classic conservative assumption of movement in real options
‘selection against the office’ where you assume the holder will exercise in the money but never out of the money is generally too cautious.
How will real options or guarantees affect the provider
Move in and out of the money depending on market conditions.
Guarantees will become more or less onerous on the provider over time depending on how experience develops over time
