ILA-LPM C Flashcards
List 3 flaws in the traditional approach to pricing life insurance
- Unit-based profitability analysis
- Cost-plus approach for setting price
- Allocate non-marginal expenses on a unit basis
Describe flaws in the traditional approach to pricing life insurance:
- Unit-based profitability analysis
- (unit = policy, premium, etc.)
- Assumes total profit = profit per unit units sold (Q)
- Problem: in reality, Q = f (P) and f’(P) < 0
Describe flaws in the traditional approach to pricing life insurance:
- Cost-plus approach for setting price
- same problem as unit-based profitability analysis
- sets a price equal to cost of product + profit requirement
Describe flaws in the traditional approach to pricing life insurance:
- Allocate non-marginal expenses on a unit basis
- Problem: non-marginal expenses have no impact on optimal price
- When maximizing (differentiating) total profit, NME vanishes
- Overhead affects all choices equally and doesn’t vary with unit sales
- Therefore it shouldn’t affect decisions to sell additional units
Describe the problem of open decision points in product development
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Marketing and actuarial usually can’t agree on price
- Marketing wants a lower price (higher sales)
- Actuarial wants a higher price to cover cost and profit
- The project stalls ⇒ “loops” through plan proposals and ends when:
- Time runs out
- Actuaries agree to get more aggressive with price
- Fatigue results in compromise
- One side triumphs through political power
Describe the 3 broad steps of decision making
- Identify decision set (all available choices)
- Evaluate financial consequences of each choice
- Make the optimal choice based on expected consequences
List the key changes of macro pricing
- Project-based analysis (instead of unit-based)
- Use of purely marginal expense assumptions
- Optimization of price
Who has the responsibility for final price decision?
Marketing
What are the primary advantages of macro pricing?
- Maximizes chance of reaching an optimal price
- Removes political considerations
- Closely aligns incentives of actuarial and marketing
Describe the key advantages of project-based analysis
- Key advantage: accounts for the law of demand
- Projects production and profitability over the product’s expected shelf life
- Typical shelf life is < 3 years
Describe 3 additional advantages of project-based analysis
- Results show actual financial impact on the company
- Easier for marketing/management to grasp than unit-based numbers
- More accurately reflects capital and development costs
- Allows for common sense decisions
- Unit-based analysis conceals total profit
Describe why pricing should be an optimization process
- Pricing should seek a profit-maximizing price
- Consider a range of possible sales levels
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In reality, profitability can only be optimized; it cannot be chosen
- The optimal price may not provide enough total profit to justify the project
- Solution: look for other projects
Define and describe the importance of marginal expenses in pricing
- MEs can be eliminated by at least one option in the decision set
- Overhead = expenses that exist for all courses of action
- Overhead expenses are irrelevant when evaluating the decision set
- Allocating overhead is misleading and overstates the economic cost of any action
- Use of overhead undermines value-based decision making
But did we cover the overhead?
- This is a misguided question because:
- We can’t choose a total profit level (that’s up to the market)
- We can only optimize profit
Describe the relationship between marginal expenses and levels of decision-making
The level of decision making determines when a ME becomes a NME
-
Continue the company?
- MEs: C-suite salaries, buildings, etc.
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Enter the term market, VA market, etc.?
- MEs: certain staff salaries, admin systems, etc.
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Offer GLBs on the VA product?
- Now the higher level MEs have become NMEs
- At this level, pricing structures, admin system mods, etc. are MEs
Describe how the demand curve for life insurance products can be represented in the macro pricing process
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The demand curve for ILA can’t be specified
- Players are biased
- ILA demand is complex and more of a “surface”
-
Solution: The Price-Production Graph
- Shows a range of possible prices and production levels
- Each row is a possible decision
Describe the macro pricing decision process when updating an existing product form
- Select a profit benchmark based on the existing product
- This is the “no action” decision
- Actuarial projects various combinations of price and production level
- Show neutral pairs of price/production to marketing
-
Marketing chooses its desired pair
- Will never know if it was the optimal price
- Marketing should make the final decision because:
- They have incentive to max out production
- They have the responsibility to meet production goals
Describe the macro pricing decision process when entering a new market
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Marketing creates a set of equal-effort price/production pairs
- Choose a satisfactory pair
- If none are satisfactory, expand decision set
- Creates incentive for marketing to be diligent
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Management sets benchmark = min required profit to carry out the project
- Same steps as updating an existing product forms
Describe how to account for product displacement in macro pricing
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Displacement = lost sales on existing products result from sales of new products
- As new product price decreases, displacement increases
- Marginal Displacement Cost = Total Displacement - Residual Displacement
- Residual displacement is the level of independent of new product price
- Reflect marginal displacement in the price-production graph
- Separate graphs for each existing product that will be affected
- Distinguish between internal vs. external displacements (competitor-driven)
Describe the steps in the macro pricing algorithm
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Steps 1–6: Product features, constraints, and possible prices
- Competitive focus, external constraints, retail prices, competitive comparisons, unit-based ME, wholesale prices
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Steps 7–11: Additional work to complete the price-production graph
- Usages, sales profile, non-unit-based MEs, model office projections, price-production graph
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Steps 12–15: Meet and either:
- Marketing makes a choice => refine design, finish product detail and file
- Determine scope of additional analysis
- Step 16: Expand Decision Set
Describe considerations when expanding the decision set
- Canceling is only an option if the decision set allows it
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If canceling is not an option, marketing must pick the best option
- But they may “withhold it from the market”
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If canceled, management will probably want to expand the decision set
- Other possible product forms
- Alternative product lines or even markets
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Decision set expansion continues until one of these happens:
- Marketing finds an acceptable price-production pair
- Further expansion is impossible
- The top level of the company is reached (continue vs. discontinue enterprise)
List 4 ancillary effects of the macro pricing algorithm
- Reduced time for decision convergence
- Alignment of marketing and actuarial incentives
- Greater marketing responsibilities
- Subjective assumptions get closer scrutiny
Describe real world pricing approaches
- Uses real world scenarios (uncalibrated to market conditions)
- Discount rates include market risk premiums (higher investment income)
- Uses best estimate assumptions without margins
- Examples: IRR, premium margin, ROA, TEV
Describe risk-neutral pricing approaches
- Uses risk-neutral scenarios
- Requires market-consistent assumptions calibrated to current market prices
- Reflects non-hedegable (insurance) risk using a CoC approach
- Discount cash flows at risk-free rates or reference rate
- Adjust discount rate for illiquidity
- Gross of taxes and expenses (FCs)
- Reference rate usually swap rate adjusted for liquidity