Chapter 19 - Models (2)

Question 1

What are the main uses of models

Answer 1

• Costing and reserving options
• Model office - new business projections, embedded values, solvency, takeovers
• Reserves - statutory and management accounting
• Pricing - Profit, premium rates

Question 2

Cashflow approach to pricing

Answer 2

Many Elephants Prefer Apples, It’s Definitely A Favorite Until Pears Disappear

• Choose MODEL points to represent expected new business.
• For an EXISITING product, modify the profile of the existing business to obtain the model points; for a new product, use the profile of any similar existing product with advice from the marketing department.
• PROJECT cashflows for each model point, including typical elements of cashflow (e.g., premiums, expenses, claims)
• ALLOWANCE could be made for lapses, premium holidays, reinsurance, etc for long term products
• INVESTIGATE net cashflows for negative flows and the need for additional reserves.
• DISCOUNT net projected cashflows at a risk discount rate.
• ANALYSE the net cashflow to assess the adequacy of the premium in producing the desired return.
• FINE-tune calculations for required premium levels by focusing on particular model points.
• If certain model points are UNPROFITABLE, aggregate profitability is exposed to changes in mix and volumes of contracts sold.
• PERFORM sensitivity tests by varying assumptions.
• DETERMINE acceptable premiums for model points, then use them to determine premiums for all contract variations

Question 3

What is a profit criteria

Answer 3

It is a single figure that tries to summarise the relative efficiency of contracts with different profit signatures

Question 4

What are the different profit criteria

Answer 4

NPV
IRR
DPP

Question 5

What is the NPV
Given a choice between two different investments, which one should the investor choose?

Answer 5

It is discounting the profit signature at the risk discount rate

The one with the higher NPV

Question 6

What is the IRR

Answer 6

It is the rate of return at which the discounted value of the cashflows is zero.

A company should prefer a contract that has a higher IRR.

however, the IRR does not always agree with the NPV

Question 7

Why is NPV more reliable than IRR

Answer 7

• If there is more than one change of sign in the stream of profits in the profit signature, there is no unique IRR
• the NPV can be related to useful indicators of the policys’ worth to the company, in terms of sales effort or market share. There is no way to do this with the IRR
• If a policy makes profit from the outset then the IRR may not even exist. The NPV always exists

Question 8

What is DPP

Answer 8

It is the policy duration at which the profits that have emerged so far have a present value of zero.

I.e it is the time it takes for the company to recover its initial investment with interest at the risk discount rate

The DPP ignores completely all the cashflows after the DPP

Question 9

What might a company reconsider to make the premiums charged more marketable

Answer 9

• The DESIGN of the product, either remove features that increase the riskiness of the net cashflows, or to include features that will differentiate the product from those of competing companies.
• The DISTRIBUTION channel used, if that would permit either a revision of the assumptions to be used in the model, or a higher premium to be used without loss of marketability
• The company’s PROFIT requirement
• Whether to PROCEED with marketing the product
• Re-examination of assumed expenses involved, notably the acquisition costs, marginal admin costs, and required expense contribution to fixed overheads

Question 10

What is the embedded value of a company

Answer 10

It is the value of the future profit stream from the company’s existing business together with the value of any net assets separately attributable to shareholders

Question 11

Cashflow approach to profitability

Answer 11

Fishing may require some patience, especially during tough-times

• The FULL policy data set can be used to model individual policies.
• Alternatively, MODEL points can represent the business. Previous assessments may form a starting point for the model points, with adjustments for new business and business going off the books.
• It is common to REDO the model generation process based on the current policy portfolio.
• Check the SUITABILITY of any model points used.
• To check the PROFITABILITY of the business, use model points to determine supervisory reserves and compare with the published value.
• For EACH policy or model point, obtain the present value of projected cashflows using the cashflow approach to pricing.
• DISCOUNT cashflows using an appropriate risk discount rate.
• TOTAL the present value of projected cashflows across all policies or scale up the results of each model point to determine the expected profit from the existing business

Question 12

How does a company measure solvency at a point in time

Answer 12

It can be measured by comparing the value of its liabilities with the value of its assets

There are two main ways in which the value of assets and liabilities can be determined:

• Supervisory values - These would be the values as determined for supervisory reporting purposes
• Economic values - These would be the values calculated on the basis of the expected experience of the company or on a ‘Market-consistent’ basis

Question 13

Capital needs for financial providers

Answer 13

ABCD FOG SIP

• achieve strategic AIMS
• meet BENEFITS before sufficient premiums / contributions received
• hold CUSHION against unexpected events (adverse claim experience)
• meet DEVELOPMENT expenses ( product development, R&D, marketing)
• demonstrate FINANCIAL strength to customers and advisors
• OPPORTUNITIES such as new ventures ( M&A)
• sell products with GUARANTEES
• meet STATUTORY capital requirements ( fund new business strain )
• INVEST more freely
• PROFIT smoothing, smoothing discretionary benefits, smoothing dividends

Question 14

What is sensitivity analysis

Answer 14

• It involves assessing the effect on the output of the model of varying each of the parameter values

Question 15

How are model points chosen to represent new business under a product

Answer 15

• For existing business, the profile of the existing business, modified to allow for any expected changes in future, can be used to obtain the model points
• For a new product, the profile of any similar existing product combined with advice from the company’s marketing department will be used

Question 16

Is NPV subject to the law of diminishing returns? Why?

Answer 16

Yes, If it were not, then a company could sell one policy with positive NPV unlimited times to make unlimited profit

Question 17

If certain model points are unprofitable, the aggregate profitability of the business is exposed to

Answer 17

• Changes in mix and volume of contracts sold

Question 18

What are the disadvantages of writing capital-intensive business

Answer 18

• If solvency is not immediately threatened, the reduction of capital could weaken the company’s resilience to falls in the value of assets
• It will reduce the company’s apparent financial strength
• It represents an opportunity cost, in that the company could use the same amount of capital to write more business which is less capital intensive
• If the company sells too much, it could lead to problems with supervisory solvency

Question 19

The amount of Capital will reflect the company’s ability to

Answer 19

• Write new business, that is, to meet the development costs of new contracts and the capital requirements that arise from writing new business
• Adopt a less restrictive investment policy to meet the investment aims of the company