Chapter 20 - Product Design

Question 1

A proprietary life insurance company is considering launching a new without profits whole life assurance contract. Regular monthly premiums will be payable from inception for the first 20 years of the policy or until earlier death.

Describe the factors that the company would take into account in deciding whether to launch this product [12]

~2008 - s1 - uk

Answer 1

The factors that the company would take into account in deciding whethe to lauch this product include:

Demand in the market
* Consider whether there is sufficient demand for this product in the market
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* The extent to which there is a need for this product must be assessed. If the product fulfils a clear customer need then it is likely to be easier to market and sell the product.
* e.g. the primary purpose of the product may be to provide for funeral expenses or it may be to meet a tax liability that may arise on death (due to inheritance tax).
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* The extent to which competitors already similar products in terms of premium rates and product design should be taken into account, as should the level of sales achieved by competitors.

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• In assessing the likely demand for the product the insurer will also take into account the alternative investment vehicles that may be available to the customers to meet the same needs.
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• It may be that there is a required demand for this product from the distribution channels of the insurance company
• e.g. if the company sells through independent financial advisers then they may have requested the insurer to consider launching such a product so that the insurer is offering a fulll product suite to meet customers’ needs.
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• The company should consider the impact on sales of other product lines within the company - it may be that sales of other products will be reduced.
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• An alternative may be that the insurer is at risk fo losing other types of business if it does not consider adding this product to its suite of prouducts,
• since, for example a firm of independent advisors may choose not to recommend any products from an insurer that does not offer a wide variety of product lines.

Profitability

• The company needs to make sure the product is profitable
• Profitablity is a function of volumes and the expected unit profit per policy.
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• The company will need to write sufficient volumes of business such that the overheads of developing and launching the product, including making system changes and designing sales and marketing literature etc, can be covered.
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• However, the company would not need to write such high volumes of business that created administration probles in terms of servicing, which in turn may lead to customer complaints / bad press.
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• The company would carry out cashflow projections of the business, taking into account the expected likely future levels of investment returns, expenses (allowing for expense inflation), mortality, lapses and withdrawals and so on, to determine the likely future profit stream that will arise in the future.
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• The insurer would assess the sensitivity of the shareholders profits arising to variations in the assumption
• (e.g. if investment returns turned out to be generally lower than anticipated, or expenses higher than expected, mix of business by policy size)
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• The insurer would need to consider the level of surrender benefits, if any, to be paid and build this into the profit testing.
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• The insurer would consider whether reinsurance is available, and whether it is necessary to manage risks.
• This would need to take into account the cost of any reinsurance
• There may be the possibility of obtaining technichal assistance from the the reinsurers.
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• The insurer would need to assess alternative uses of shareholders capital and whether there is a more profitable product that could be launched
• or an alternative way of utilising capital (e.g. launching a new distribution channel, unit linked product, or addition of options on existing products) that is likely to offer a greater return.

Capital required

• Overall launching any new without profits contract is likely to be fairly capital intensive, due to the initial new business strain and the capital support required at outset.
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• The insurer would consider the popularity of traditional without profits contracts in comparison to launching another savings contract with lower capital requirements (e.g. unit linked savings contract)
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• The insurer would take into account the level of free assets and its ability to write business that is capital intensive.

Regulatory and economic environment

• The insurer will consider the local regulatory environment.
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• It is likely that the local regulations would allow such a product to be launched but there may be requirements in respect of the minimum surrender value that must be paid at a particular duration
• or there may be particular tax regulations that should be taken into account when designing the contract.
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• In addition, the local insurance regulator may stipulate other items, e.g. cap on the total charges that can be taken from such a product, the impact of charges on the death / surrender payouts if death / surrender occured after particular durations, the stipulation of premium rates, or level of disclosure required etc.
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• These will all impact the charging structure taht the insurer can use and the level of attractiveness of the product to the end customer
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• The insurer will also consider more general factors such as economic scenario, and whether generally now is a good time to launch such a product.

Other

The insurer would also want to consider:

• Whether the level of risks introduced are accaptable (e.g. mortality risk)
• whether the administration system can cope with this product desing
• any additional costs involved in training / system developments
• potenital lapse and re-entry issues in the future, and may want to mitigate this risk by, for instance, builiding in premium or benefit reviews, or reducing the premium payment term (policyholders are likely to lapse close to the end of the terms)

Question 2

A life insurance company is considering writing a new flexible unit-linked product that would be targeted at high net worth individuals. The product would allow flexibility in terms of premiums payable and could be used either as a savings vehicle or to provide life cover, or a mixture of the two. The life cover would be charged via deductions from units. These charges would be based on mortality rates guaranteed at the point of sale.

The only other charge would be an annual management charge of 1% p.a., and this would be guaranteed not to change. The surrender value would be the bid value of the units.

The contract would allow cover to be increased or decreased within limits without any medical evidence at the time of certain lifestyle changes (e.g. marriage, birth of a child); otherwise the usual underwriting procedures would be used.

Commission would be paid by the customer directly to the insurance intermediary. Any medical fees incurred as a result of medical tests required during the underwriting process would also be paid directly by the customer.

i. Discuss the factors to take into account when considering the profitability and marketability of the product. [10]

The marketing manager has suggested that since the product is aimed at high net worth individuals, any policyholders who have been accepted at standard rates should be able to increase the level of life cover within the previous limits at any time without the need for further underwriting. He says that the decrease in expenses should outweigh the cost of any downside in experience rates, and that sales should increase. He also suggests that any impact on experience could be managed by making the charges applied for life cover reviewable.

ii. Discuss these suggestions. [9]

2008 - s2 - uk

Answer 2

i.

Profitability

• The charges need to be sufficient to cover both the expenses and profit margin.
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• The sensitivity of profit also needs to be considered
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• In particular, due to the back-end loaded nature of the charging structure
• profits from this contract are likely to accrue later in the policy term giving more risk it will materialize.
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• If investment performance is poor, the 1% annual management charge may not be sufficient to meet the fixed expenses.
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• The commission and medical fees are paid for directly
• and so the profits will be less sensitive to the number of times a customer increases their protection element.
• However, there are other initial expenses and underwriting costs which need to be covered by the annual management charge and these should be considered.
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• In particular, the annual charges may be low if the customer does not use this as a savings contract as the funds will be low or ultimately zero.
• The company should therefore consider allowing for some expense loadings in the protection charges, but this would affect the marketability and competitiveness of the contract.
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• The sensitivity of the profit to the level of the savings element should be tested.
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• If up-front costs are high, the profit will be sensitive to higher than expected levels of surrenders at early durations.
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• The profitability needs to allow for the cost of any reinsurance used by the company.
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• The level of profitability will depend upon the volumes of business sold.
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• The profit will be sensitive to the size of the premium if some costs are fixed in nature.
• The company may want to set a minimum premium to ensure that the value of the management charge is sufficient to cover fixed costs.
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• The option to increase or take out new protection on a lifestyle change could make the company open to anti-selection
• but this is not likely to be an issue if the conditions are strict enough.
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• The flexibility of the contract could result in more administration costs, which might affect profitability.
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• Guaranteeing the rates from the effective date does introduce an element of risk which could affect profitability.
• However, this is no different to rates being guaranteed on level premium business and this may be a risk the company is willing to take.

Marketability

• The marketability will depend on what the company’s competitors are offering.
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• The contract is very flexible and so should appeal to customers.
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• The guaranteed annual management charge and the guaranteed mortality charges are also appealing.
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• The transparency of the charges is likely to appeal to customers as they can see exactly what they are paying for.
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• In addition, further protection contracts can be taken out without the need for paying for the initial overheads you would usually have to pay for.
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• However, medical fees and commission payments are expensive and having to pay these directly may make the contract less marketable
• even though these charges would be loaded into the contract in some other way, if these were not paid for directly.
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• This is exaggerated by the fact that high net worth customers will tend to need higher levels of protection, which in turn usually requires more medical tests, which could make the contract less marketable.
• In addition, if the company is not paying, they may ask for more tests than they would do otherwise.
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• Since commission is paid directly this may limit the distribution channels open to the company, hence this could reduce marketability
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• A restricted choice of funds may not be marketable to high net worth individuals.
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• Limits on when underwriting free increments may be made on the policy may be too restrictive
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• No penalty on surrendering the policy would be a marketable feature
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• The level of marketability of the policy will be affected by the size of the high net worth target market.

ii.

Disadvantages of the suggestion

No underwriting

• The suggestion could introduce anti-selection risk where applicants in ill health would be able to take out increased life cover
• Also, applicants who currently have a clean medical record, but suspect for some reason they may become ill may take out the contract.
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• Underwriting requirements at the point of sale may need to be stricter
• because consideration would have to be taken of the potential sum at risk from future increases as well as for the level applied for on application.
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• This could both increase costs for the life insurance company and for the applicant making it less attractive for those who only want a small level of cover
• This could reduce sales.
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• The company needs to consider whether the level of risk taken on by this suggestion is acceptable.
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• The level of reserves would need to increase if no underwriting is performed, since the mortality experience would be expected to worsen.
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• If the product is reinsured, the company would need to check with the reinsurer before making any changes.

Reviewable rates

• Reviewable rates might make the contract less marketable.
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• It may also increase systems or administration complexity.

Advantages

No underwriting:

• The ongoing expenses would reduce because even though medical fees are met directly, there are other underwriting expenses which may not be covered by the annual management charge.
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• The marketing manager may be correct and the savings could outweigh the cost of the additional risk.
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• The contract may be more marketable.
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• Volumes could increase, which would also reduce per policy expenses, the level of further increases in cover would also increase
• However, the increase in volume is likely to be mainly due to anti-selection.
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• A worsening in mortality experience could be mitigated by an increase in standard rate charges offered to new business
• but this could mean that the healthy lives go elsewhere leaving the company with even worse experience

Reviewable rates:

• Making the rates reviewable would certainly ease the situation as it would allow any worsening of experience to be charged for.
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• In addition, the rates quoted could be lower as they do not need to incorporate the same risk margin for potential adverse deviations, which are required for guaranteed rates.
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• Reviewable rates may lead to lower reserving requirements.
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• However, there is a limit to how much rates can be increased by as policyholders will have certain expectations.
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• The level of impact on introducing reviewable mortality rates and no underwriting will also depend upon the practice and reaction of the company’s
  competitors
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• Overall, it is unlikely that the risks involved would be acceptable.