Part 2

Question 1

What are the general risks

Answer 1

Risk a life drown cats

1. Reinsurance failure
2. Investment
3. Short-termism of senior management
4. Kompetition

5. Actions of distributors

6. Legal and regulatory There are possible regulatory risks, eg there may be regulations covering treating customers fairly and sales processes., These could lead to fines and reputational damage. New regulations might be introduced, eg maximum premium levels or restrictions on the company's ability to use rating factors in pricing.

7. Inflation
8. Fraud There is a risk from fraud, eg: .  1. applicants may withhold significant information during the underwriting process  2. fabricated death claims could be made.
9. Expenses -  There is a risk of expenses being higher than assumed in pricing. The risk of future expense inflation being higher than assumed will contribute to this risk. This is quite a large risk for term assurance business as expenses form a relatively large proportion of the premiums. The effect of high expense inflation could be a particular risk for individualterm assurances, where premiums are normally level and non-reviewable.

10. Data - There is a risk of having inadequate mortality data with which to price the business, resulting in inadequate premiums being payable.
11. Rates of mortality - The main risk to a life company of writing term assurance business is mortality risk, ie the risk of higher mortality rates than the company assumed in pricing.

12. Options and guarantees
13. Withdrawals (persistency) There is a risk on early withdrawal as the asset share will be negative in the early stages as a result of the high initial term assurance expenses (eg commission, underwriting expenses) and relatively low premiums. This may persist longer for decreasing term assurances, unless the premium-paying term has been shortened. This is because the claim costs are highest at early durations, preventing the asset share from becoming positive until later in the policy term. There is a mortality risk from selective withdrawal, as those in worse health are less likely to withdraw and so the average mortality of those remaining worsens.

14. New business - There is a risk of low new business volumes. This could result in overheads not being sufficiently covered by the per-policy loadings to cover them There is a risk of high new business volumes. This could cause capital strain that exceeds the capital available and could threaten solvency. The guarantees and high initial expenses of individual term assurances, in conjunction with typically small regular premiums, mean that new business strain could be significant. There is also a risk in this scenario that admin capabilities will be over-stretched, leading to errors, poor customer service and reputational damage. lf cross-subsidies exist, there is a risk from the mix of business sold, eg it is likely that large policies will subsidise small ones, so that there is a risk of the average sum assured being smaller than expected.

15. Controls
16. Aggregations
17. Tax There is a risk that the amount of tax payable will be different from expected, eg due to change in tax regime, causing losses. Changes in the ways that policyholder benefits and/or premiums are taxed could also lead to reduced demand for the product.
18. Selection

Question 2

What can the government do to increase the insurance market

Answer 2

Changes.

a. They could lower the tax and provide tax breaks for customers on certain insurance products.
1. changing how insurance companies are taxed
2. changing how individuals are taxed (eg increasing tax relief on premiums and/or reducing the tax payable on benefits received).

The effectiveness of changing insurance company tax in boosting sales depends on:

1. the extent to which the cost of life insurance products was the cause of low sales o the extent to which companies pass on the advantage to customers via lower premiums.

lmproving the tax advantages of life insurance products is likely to be effective. Using available tax breaks is often a priority of customers who can afford to use them and the tax breaks may be used in marketing messages of companies and advisers.

This will however depend on the taxation of life insurance compared to similar, competing products, eg un¡t trusts and other savings vehicles.

b.Compulsion

The government could introduce elements of compulsion to purchase insurance products,

1. require employers to purchase a pension savings product for each employee
2. reqire an annuity to be purchased with the proceeds of pension savings
3. reguire individuals to take out life cover for any mortgage borrowing.

From a company’s point of view, large customer numbers may help with economies of scale (helping to keep costs down) provided the company can achieve sufficient market share.

However, the premiums chargeable are also likely to be low in order to be affordable to the customers compelled to buy the product.

This is likely to be effective for products and circumstances where it is justifiable, but there may only be a limited number of products / circumstances (as a reasonably high proportion of customers may not want or be able to afford the insurance).

A less extreme approach than compulsion would be to rely on customer inertia, eg enabling employees to automatically be enrolled to various insurance products unless they took the deliberate step of opting out.

c. Encourage product innovation and new product designs

The government could remove restrict¡ons on the types of products that could be offered’

This may enable product innovation, eg launching products that have been sold successfully in other countries.

This may be effective in increasing sales if the new products meet customer needs that existing products do not meet.

Distribution chonnels and the selling process
The government could increase insurance companies’ freedom to sell, eg by allowing the use of multiple distribution channels.

This may be effective if it improves customer access to insurance products.

The government could also change the rules about the information insurance companies provide to customers at the point of sale.

This may be effective if it was a lack of information (or too much information) that was preventing customers from buying insurance products.

d. lnvestment freedom

The government could reduce the investment restrictions on insurance companies.

This may enable them to invest in more risky assets with higher expected returns.

This may be effective in improving sales if these higher returns are passed on to customers through lower premiums and if high premiums had been a cause of the decline in sales.

e. Premium or charge cops
The government could introduce measures to make products cheaper, eg by introducing charge
caps.

This is likely to be effective if the problem is that insurance is too expensive for customers. lt could be especially effective for certain customers (eg those with less disposable income) and certain products.

Its effectiveness could be limited if it led insurance companies to withdraw from the market (if charge caps made products unprofitable to sell) and so reduced the availability of certain insurance products.

Rating factors

The government may relax the use of certain rating factors, eg gender, family medical history.

This may be effective if it improved the ability of insurance companies to rate fairly and lead to lower prices on average (as companies had less need for prudence in the pricing given they no longer have to allow for the uncertainty about cross-subsidies resulting from the mix of business)

Using more rating factors would result in insurance companies dividing customers into more groups for pricing purposes.

Some groups will gain and some will lose out from such a change, eg allowing gender as a rating factor would make annuities more attractive to males and less attractive to females.

The move is therefore likely to be effective in promoting more purchases from the groups that benefit from lower premiums, but could change the mix of policyholders.

f. Underwriting

The government could relax restrictions on the ability of insurance companies to underwrite products.

For example, insurers could be allowed to use genetic test results or allow them to decline policyholders with certain medical conditions.

This tighter underwriting is likely to be effective in reducing premiums and so increasing sales.

g. Resrving and capita I requirements

The government could relax the regulations about the reserves and solvency capital that insurance companies are required to hold to demonstrate solvency.

This may increase sales, particularly as products with marketable features, eg with more guarantees, may be especially capital-intensive.

Question 3

How to mitigate risks

Answer 3

1. Longevity risk

Possible mitigations are:

ensuring that sufficient allowance is made for future mortality improvements when determining the value of assets to be transferred .

Ensuring assumptions are tailored to the nature of the lives in the portfolio o keeping up to date with the latest developments in projecting longevity improvements, eg with reinsurers’ assistance o after the transfer,

Regularly monitoring the longevity experience .

Using reinsurance, for example using quota share or excess of loss reinsurance or arranging a longevity swap.

2. Concentration risk

Diversify by writing or buying blocks of business exposed to mortality risk, eg protection business, although there will be basis risk due to the different populations involved.

The risk from the particular portfolio could be transferred, eg using a reinsurance arrangement …

… or to the capital markets yio a securitisation of the future profits on the in-force annuity portfolio.

4. Investment Risk

The company may be able to hold more closely matching assets. lt could improve the portfolio matching after the transaction has taken place …

… either by selling the assets it receives or by switching them with assets it already holds.

It could hedge any currency risk exposure using derivatives.

The company should monitor corporate bond performance and credit risk exposure,

It could control credit risk by restricting the bonds it holds, eg to those with sufficiently good credit ratings …

… and by using credit derivatives or credit insurance.

3. Expense

The company should monitor its expense experience closely.

It could look to improve operational efficiency, eg by investing in better systems or training or outsourcing.
It could look to improve economies of scale eg by increasing the scale of its annuity book.

It could seek to hedge its expense inflation by using real assets, eg index-linked bonds.

4. Data Risk

Data risks could be mitigated by:

ensuring the pension scheme provides the insurance company with an explanation of all the data items

performing checks on the data before the transfer, eg due diligence and/or doing a ‘trial run’data transfer .

agreeing that the pension scheme will bear any costs arising as a result of it providing poor quality data.

5. Other Risk

The risk of regulatory or tax changes may be mitigated by keeping up to date with changes, responding to consultations on proposed changes and lobbying where appropriate.

Operational risks could be mitigated by thoroughly testing and documenting all systems and processes and by staff training.

The risk that the assets transferred to cover the annuity liabilities are insufficient can be mitigated by ensuring a larger margin is allowed for in pricing the transaction …

… or getting the proposed price reviewed by an independent party

An appropriate pricing methodology should be used to determine the loading. Including appropriate assumptions.
And an extra margin for uncertainty.

The increased mortality risk can be mitigated by means of reinsurance

A minimal level of underwriting could be used.

The margin for mortality could be an explicit margin for mortality…
… or a reduction in the rate of improvement.

New business

Ensure that the loadings are competitive relative to those charged by competitors for such options.
Monitor competitors’ offerings. Advertise/market the product.

Thorough testing of the administration changes will be needed

The sales literature for this product should be clear and not mis-leading

Distributors should be trained on the new product.
Administration staff should be trained on the new product. [
There should be clear process documentation and controls.
External data/expertise could be used.
e.g. from reinsurers.
Expenses should be controlled carefully. Outsourcing could be used.
Sufficient capital buffers should be put in place.
The company could withdraw the option completely.
Lapse and re-entry risk managed with appropriate margin, pricing or training

Question 4

Difference between intermediatary vs internal sales force

Answer 4

Different social econmic selection

Clients from intermediatary are more likely to be more sophisticated and wealthier

Selective withdrawls could be higher through intermediataries,

Intermediary are more likely to compare rates around the market and reivew premiums

More selective withdrawals could results in worse motality

Question 5

How premiums could be different in intermediary vs internal

Answer 5

Expense

For policies in intermediatry they will need to consider the following

1. Commissions
2. Other costs and maintaining the business
3. Cost of underwriting could be different
4. Volumes could be different and so per policy expense could be different

Persistency could be different

Risk profile will be different

Mix of business will be different

Question 6

Approach to modelling investment projections from the asset side

Answer 6

Decide whether or not to adopt stocahstic or deterministic

In determinisitic, assumptions are a point estimation of future investment returns

The estimate could be the average return over all asset classes

or it could be done for individual asset classes seperately, with averaging over the explicit mix of assets assumed in each future year period

A central assumption could be supplemented by scenario or sensitivity testing

A stochastic modelling, involves treating investment return as random variable

A probility distribution must be determined for investment return

This could be done for each class of assets seperately or as an aggregagte over the expliciit assmed mix of assets

A model would be used by running a large number of simulations

The average of all projections will be an estimate of the expected value of outcome

The model will have to deal with

1. investment return from existing assets
2. reinvestment procceeds from existing assets
3. investment of future premiums on existing and new business.