Chapter 10: Contract Design 2

Question 1

Competitiveness

Answer 1

• Premiums charged shouldn’t depart too far from competitors for equivalent product
• Difficult to compare innovative product or additional benefits
• Consider likely response of competitors to introduction of product
• Consider success of similar products from competitors
• Consider sales method

Question 2

Profitability

Answer 2

• Cover expected claims and expenses, meet profit criterion
• May conflict with marketability and competitiveness
• Minimum premium/ contribution ensures policies make a minimum contribution to fixed expenses
• Lapse assumptions may be important when considering profitability

Question 3

Risk appetite

Answer 3

• Key risks of product must be identified and quantified
• Range of cover = catering for different consumer risk appetites
• Risk acceptable to insurer depends on ability/willingness to absorb or reinsure risk
• Optional benefits = anti selection risk
• New contract = greater risk as company has no past data or experience relating to this contract (uncertainty around setting assumptions due to parameter error)
• Offering contract in unit linked form will avoid a long term guarantee

Question 4

Extent of cross subsidies

Answer 4

• Risk = mix of business being different to expected
• Avoiding cross subsidies may conflict with simple premium structure and admin
• Core/ additional benefits; Large/small policies; New business/renewals; Lapsing/remaining policies

Question 5

Level and form of benefits

Answer 5

• Full claim amount or fixed %/ amount of each claim

* Apply excess to each claim

Question 6

Contract terms and conditions

Answer 6

• Too tight= reduced marketability
• Too loose = unanticipated claims
• Advice from lawyers, reinsurers and relevant experts

Question 7

Consistency with other contracts

Answer 7

• Premiums/ benefits fairly consistent with existing products to avoid discontentment from existing policyholders
• Pricing and design should be consistent with other products to reduce admin requirements
• Major change = significant systems development (costs time and money)

Question 8

Admin systems

Answer 8

• If existing admin system can’t cope with complexity, product will have to be simplified/ modified or new admin system will need to be built/bought (may be costly)
• Consider how to minimise costs and load appropriately in the premium
• Increased admin complexity:
o Frequent premiums/ contributions
o Option to lapse
o Any prizes
• More complex= greater risk of error (op risk)

Question 9

Financing requirements

Answer 9

• Consider new business strain
• Design to minimise capital requirements
• Pay regular commission payments over a period of time rather than lump sum at outset
• Additional capital needed to cover any guarantees
• Annuities – consider lower initial annuity and max increase if guarantees are involved
• Consider term of product and size of fund build up
• Payout linked to contributions = lower financing requirement
• Financing reqs lower for Unit Linked contracts due to lower benefit guarantees offered and ability to vary charges

Question 10

Premium pattern

Answer 10

• Need to decide on premium frequency (annually, monthly, etc.)
• Consumer flexibility = more marketable but more complex to administer

Question 11

Stat/ reg requirements

Answer 11

• Take into account any stat/ reg requirements on contract design or premiums that can be charged
• Consider solvency requirements

Question 12

Accounting implications

Answer 12

• Consider effect that new product has on accounting requirements.

Question 13

Onerousness of guarantees/options

Answer 13

• Need to assess likely cost of guarantee, a stochastic model is likely to be most suitable
• Consider whether to use derivatives of replicating basket of assets to match index (if guarantee is index linked)
• Option to withdraw
• Need to be charged for through increase in premium of reduction in benefit
o Not charging through premiums will increase sales but result in adverse reaction when benefits are unexpectedly reduced

Question 14

Extra wrap up sentence

Answer 14

“These contract design factors are not necessarily independent, in that meeting one may mean another cannot be met. The insurer will seek the optimal solution.”