Part 3 Flashcards
- What is basic equity principle
Interests of unit holders not involved in the transaction should be unaffected by that transaction
i. A unitholder’s return is the difference between the allocation and subsequent redemption price of a unit
ii. This should depend only on the earning of the backing assets less charges
It should be unaffected by any other unit transactions during the period otherwise cross-subsidies between unit holders will occur
internal unit linked fund
a. Consists of a clearly identifiable set of assets, for e.g. equities, properties, fixed interest securities and deposits.
b. The fund is divided into a number of equal units of consisting of identical subsets of the funds assets and liabilities
c. Responsibility for unit pricing rests with the company subject to any relevant policy conditions
d. Some companies may create more than necessary to cover the corresponding liabilities. The excess is known as Box management.
Appropriation price
i. Price at which the company will create a new unit
ii. It is the amount of money that should be put into the fund, per unit created, that preserves the interests of the existing unit holders
iii. The net asset value per existing unit must not alter as a result of creating a new unit
iv. An offer basis means that unit prices (both offer and bid) are derived from the appropriation price.
Expropriation prices
i. Price at which the company will cancel a unit, this is when the fund is contracting and some of the assets backing the unit funds need to be sold
ii. It is the amount of money that should be taken out of the unit fund, per unit cancelled, that preserves the interests of the continuing unitholders
iii. The net asset value per existing unit must not alter as a result of cancelling any existing unit
iv. This will be used to determine the bid price of the units
v. The offer price is the amount a policyholder will have to pay when purchasing units
1) 2 types of adjustments
a) Initial charge - this is the expropriation price plus charges
b) Rounding
vi. A bid basis means that unit prices (both offer and bid) are derived from the expropriation price
How do you calculate the Appropriation price and Expropriation price
i. Appropriation
1) Market value (offer price)
2) Plus expense
3) Less the value of current liabilities
4) Plus any accrued income from fixed income securities and deposits, net of any outgo such as fund charges
5) Less tax
6) plus the value of any current assets, such as cash on deposit or investments sold but not yet settled
7) less the value of any current liabilities, such as investments purchased but not yet settled or loans to the fund
8) This gives the net asset value of the fund on an ‘offer basis’.
9) Dividing by the number of units existing at the valuation date, ie before any new units are created, gives the appropriation price
10) Rounding of the unit price based on stated rules
11) This gives the value under offer basis. Dividing by the number of units existing at valuation date.
12) The appropriation price is the unrounded bid price
13) Initial charge is added to the appropriation price to give the offer price
14) Initial charge may also be referred as bid/offer price
15) It is normal to quote bid of offer price to a certain number of decimals
16) The rounding could be done in the company’s favour by rounding the offer price up and the bid price down
ii. Expropriation price 1) Market value is calculated on a bid price 2) Less expense that would be incurred in the sale 3) Plus the value of any current assets, such as cash on deposit or investment sold but not yet settled 4) Less the value of any current liabilities, such as assets investments purchased but not yet settled or loans to the fund 5) Plus any accrued income, such as interest income from fixed interest securities and deposits net of any outgo 6) Less any allowance for accrued tax 7) This gives the net asset value of the fund on a bid basis 8) During an outflow of money, if the fund was one off the company would switch back to offer 9) Could use box management to avoid having to temporarily switch to a bid basis 10) 'management box' (ie create more units in the fund than are needed to meet policyholders' liabilit¡es) to avoid having to temporarily switch to a bid basis 11) Divide by the number of units existing at the valuation date before any units are cancelled to get the expropriation price
Things to consider during a mergers and acquisitions
Basic equity
pricing basis
Other
Practicalilities
Basic feature of a life insurance model
i. Single policy tests - This Projects the expected cash and profit flows from a single policy from the date of issue.
ii. New business model - This projects all the expected cashflows arising from future sales of new business. It is useful for assessing future capital requirements for new business, It is useful for assessing future capital requirements for new business and overal return on capital achieved
iii. Existing business model - This is cash and profit flows projection from all exisiting business a company has in force at a particular tiime. This is used to evaluate the intrinsic value of the existing business and testing solvency
iv. Need to account for cash flow
v. Capital requirement for either supervisory or solvency
vi. Allowance for interactions
1) Interactions between assets and liabilities
vii. Allowances for guarantees and options
How to assess solvency
a. Measuring solvency
b. Economic values
c. Static vs dynamic testing
d. The need for capital and the role of the estate
e. How to determine the future solvency
i. Use a model to project its future assets and liabilities
ii. Specify its future solvency objective e.g. does it wish to determine its solvency objective on a regulatory basis or economic basis
iii. Aa regulatory basis would determine solvency as for supervisory reporting purposes and would assess the company’s ability to meet the regulatory requirements in the future
iv. An economic capital basis would determine solvency using best estimate or market consistent approach and would enable the company to understand its ability to withstand future adverse experience
v. In some jurisdictions, the approach may be equivalent or very close
vi. The company should decide whether to use a deterministic or stochastic model
vii. A deterministic model could be used with best estimate assumptions
1) Combined with scenario or sensitivity tests to assess the impact of adverse future experience
viii. Alternatively, at least some of the variable maybe modelled stochastically in order to look at a range of outcomes, particularly adverse scenarios that might pose a threat to solvency
1) Investment returns on various asset classes and associated economic variables, such as inflation are likely to b modelled using stochastic simulations
ix. Depending on the nature of the company’s products and so the importance of mortality or longevity risk, morality may also be modelled stochastically
x. The company should decide how many simulations to run
xi. The company would need to decide a risk tolerance e.g. probability of insolvency in 1 years time to be less than 0.5%
xii. The company should decide over how long a time horizon it wishes to project its future solvency
xiii. e.g. it could look over a fixed planning horizon e.g. 5 years or until all the existing business has runn off
xiv. The company should decide whether and to what extent to include future new business in tis projection of future solvency
xv. Including only the existing in force business is more objective and may be sufficient to satisfy regulatory solvency requirements
xvi. Including future new business requires subjective assumptions to be made about volumes and mix of future business
xvii. But will provide a more realistic assessment of the company’s likely future solvency position given its business plans
xviii. As a full projection of future solvency might require nested stochastic calculations, the company may adopt a simplified approach
Product design factors
- Financing
Unless the company has substantial capital resources, it will want the benefits and charges to be designed so as to minimise its financing requirement.
The absence of any surrender penalties may increase the reserving requirements.
However this depends on the allocation rate for the single premium. lf the allocation rate is sufficiently low, the company may immediately cover its initial outgo.
The reserving requirements may also be increased by any mis-matching between charge income and expense outgo.
Capital requirements may be increased if there is more uncertainty around the future exper¡ence of this new product than there would be of an existing product.
The company may then have insufficient capital resources to support any new business strain, especially if new business volumes are high if the new product is a success.
2. Onerousness of guarantees The insurance company needs to decide whether to guarantee any charges, eg the AMC. Guaranteeing charges will increase the capital requirements of the product. 3. Regulation
The company should comply with any relevant regulatory requirements, eg maximum charge
caps.
4. Consistency with other products
The company should compare its intended charges for this product with those on its other products.
Lower charges on the new product may lead to customers with existing policies being unhappy, and so may increase the persistency risk on the existing business.
5. Extent of cross subsidies As the allocation rate and annual management charge will deduct more from larger policies than smaller policies, there will be cross subsidies between policies of different sizes. Such cross-subsidies would put the company at risk of the business mix changing and it having more smaller policies and fewer large policies than it expected. 6. Distribution channel 7. Competitiveness
The company should consider similar products offered by competitors and, in particular, their charge levels.
A low annual management charge (AMC) may be particularly important as it is the easiest point of comparison between different companies.
The company should also consider other elements of competition, eg fund past performance or the range of unit funds offered.
lf the company compares favourably in some of these elements, it may be able to set higher charges than otherwise and still remain competitive.
8. Risk characteristics The company should consider how the charges for the product affect the risks of the product. The AMC applied as a percentage of the unit fund means the company faces the risk of poor investment performance reducing its charge income. When considering the matching between expenses and charges, the company should consider matching by both nature and timing. Anti-selection The AMC may be a good match to any investment expenses and may also provide a broad hedge against inflation of ongoing policy expenses. The policy fee could be a good match to ongoing expenses ... ... especially if the policy fee increases in line with an inflation index. The company may face persistency (withdrawal) risk as there are no surrender penalties ... ... although the extent of this depends on the balance between a low allocation rate (which reduces this risk) and a high AMC and policy fee (which increases it). The company should test sensitivity of profit to key items of experience, eg unit fund performance, persistency. 9. Admin systems (and other expertise)
The company’s systems would need to be capable of administering the types of charges the company is proposing.
This will depend on how similar the product is to the company’s current products.
10. Marketability The company will want its new product to launch successfully and so will want the charges to be marketable.
The level of charges (lower charges improve marketability)
The flexibility to vary charges (more guaranteed charges improve marketability)
How easy the charges are to explain
the balance between the different types of charges, eg the management charge and policy fee might appeal more than a low allocation rate.
11. Profitability
ldeally the product needs to be priced so that the total premium income over the whole business will be sufficient to cover all benefits and expenses, including the required share of overheads and development expenses, and make at least the required level of profit.
The company will need to consider the assumptions it will use for pricing the product. Key assumptions include mortality, investment and expenses.
The intended backing assets will need to be considered, as these are crucially important to annuity pricing. These are likely to bonds (fixed-interest or index-linked as appropriate), with a possible use of corporate bonds to gain higher yields.
The company will want to ensure that the charges overall will be able to cover the expenses incurred, including commission, and to provide adequate profit.
An adequate profit is one that meets the required rate of return of the capital providers, eg the shareholders if the company is proprietary.
Different profit measures may be considered, eg net present value, internal rate of return, discounted payback period.
The company will need to estimate future expense levels, which may be difficult as this is a new product.
The company also needs to decide on the extent to which the product will contribute to general overheads of the company …
… and the period over which it wishes to recoup the product development expenses.
The pricing assumptions also include inflation, new business volume and new business mix.
The assumed mix of business will be important in order to set risk factors and model points’
12. Sensitivity of profit
The sensitivity of profit to variations in experience needs to be considered. This will not only include the sensitivity to changes in the mix of business (due to cross-subsidies), but to all other components eg mortality, investment return, expenses, inflation and new business volume. Appropriate sensitivity tests, involving all these factors, would need to be carried out.
How to calculate the Free Surplus
Asset
1. We will use the market value if available
Liabiliites
To determine the liabilities, future unknown parameter values and cashflows are set so as to be consistent with market values, …
.. where a corresponding market exists.
ln particular, assumed future investment returns are based on a risk-free rate of return, irrespective of the type of asset actually held, and the discount rates are also based on risk-free rates.
However, adjustments may be made for an illiquidity premium and for the uncertainty associated with non-hedgeable risks (eg yio a risk margin).
For without-profits immediate annuities, longevity and expenses are non-hedgeable basis elements.
Main risk with options in a policy for insurance companies
The main risk is that the cost of the option is higher than expected…
.. and so the loading applied to the original premium is insufficient…
… and so the company makes a loss.
