8I-U - Pricing
Book:Life Insurance Products and Financing (Atkinson/Dallas) - Chapter 11 - PROFIT MEASUREMENT AND ANALYSIS
Book:Life Insurance Products and Financing (Atkinson/Dallas) - Chapter 14 - FINANCIAL MODELING
Book:Life Insurance Products and Financing (Atkinson/Dallas) - Chapter 15 - STOCHASTIC MODELING
Book:Life Insurance Products and Financing (Atkinson/Dallas) - Chapter 16 - FINANCIAL MANAGEMENT
Book:Life and Health Marketing (LOMA) - Chapter 12 - PRICING: A MARKETING PERSPECTIVE
Book:Study Notes and Published Refences - Note TSA XXXIX - PRICING IN A RETURN-ON-EQUITY ENVIRONMENT
Book:Study Notes and Published Refences - Note SN8I-200-00 - EXPERIENCE ASSUMPTIONS FOR INDIVIDUAL LIFE INS AND ANNUITIES
Book:Study Notes and Published Refences - Note SN 8I-201-00 - GROSS PREMIUMS FOR DISABILITY WAIVER BENEFITS
Book:Study Notes and Published Refences - Note SN 8I-202-00 - VARIABLE ANNUITY MINIMUM DEATH BENEFITS - A MONTE CARLO PRICING APPROACH
Book:Study Notes and Published Refences - Note SN 8I-204-01 - REPORT OF THE SOA TASKFORCE ON PREFERRED U/W
Life Insurance Products and Financing (Atkinson/Dallas) - Chapter 11 - PROFIT MEASUREMENT AND ANALYSIS
Distributable Earnings
- Calc in 3 steps
- pre-tax solvency earnings
- deduct taxes to detmine after-tax solvency earnings
- adjuste after-tax solvency earnings for incr req captial and add after-tax inv income on assets backing req'd capital
- Pre-Tax Solvency Earnings
- product cash flow - ProdCashFlow(t) = Prem(t) - Ben(t) - Exp(t)
- adjust for reins if necessary
- increase in solvency reserves - SolvResIncr(t) = SolvRes(t) - SolvRes(t-1)
- investment income - InvIncome(t) = PolLoanInt(t) + InvInc(t) + CashFlowInt(t)
- PreTaxSolvEarn(t) = ProdCashFlow(t) + IncIncome(t) - SolvResIncr(t)
- After-Tax Solvency Earnings
- AfterTaxSolvEarn(t) = PreTaxSolvEarn(t) - Tax(t)
- Adjustment for Req'd Capital
- ReqCapIncr(t) = ReqCap(t) - ReqCap(t-1) -> increase in req'd capital
- ATInvIncRC(t) = InvIncRC(t) - TaxInvIncRC(t) -> after tax inv income on assets backing req'd cap
- DistEarn(t) = AfterTaxSolvEarn(t) - ReqCapIncr(t) + ATInvIncRC(t)
- often not practical to price over lifetime of product, instead use 10/20/30 years
- if n is pricing horizon, need to account for all profits beyond n
- release req'd capidal @ end of n (ReqCap(n) = 0)
- either explicitly or set lapse for n to 100%
- present value of all future events need to flow through year n calc
Stockholder Earnings
- solvency reserves distort profit w/ significant NB strain, earnings reserves have smoother pattern, often no loss in first year
- Pre-Tax Stockholder Earnings
- similar to pre-tax solvency earnings
- product cf are identical
- main diff: change in earning reserves (net of DAC) vs change in solvency reserves
- assume invested assets = solvency reserves + req'd capital
- PreTaxStockEarn(t) = ProdCashFlow(t) - BenResIncr(t) - DACAmort(t) + InvIncome(t) + InvIncRC(t)
- DACAmort(t) = DAC(t-1) - DAC(t) where DAC(0) = 0
- From Solvency Reserves
- PreTaxStockEarn(t) = PreTaxSolvEarn(t) + SolvResIncr(t) - BenResIncr(t) - DACAmort(t) + InvIncRC(t)
After-Tax Stockholder Earnings
- need to deduct 3 components of tax
- Tax(t) - PreTaxSolveEarn tax
- TaxInvIncRC(t) - Tax on Inv Inc earned on assets backing req cap
- DefTaxProv(t) - Tax on diff between shareholder and solvency earnings excluding II on req'd capital (aka Provision for Def Taxes)
- AfterTaxStockEarn = PreTaxStockEarn(t) - Tax(t) - TaxInvIncRC(t) - DefTaxProv(t)
- Positive Distributable earnings - max amount that can be paid to stockholders
- Negative Distributable earnings - capital contributions stockholders must pay into co
- After-Tax stockholder earnings - earnings reported to stockholders
- often exeeds distributable earnings for a growing co
Return on Equity (ROE)
- After-Tax stockholder earnings / stockholder equity base
- stockholder equity base
- stockholder equity @ BOY OR
- avg of BOY and EOY stockholder equity
- stockholder equity = Assets - Liab
- Assets = DAC + inv assets backing solvency reserve + req'd capital
- Liab = benefit reserves + def'd tax liab
- StockAssets(t) = SolvRes(t) + ReqCap(t) + DAC(t)
- StockLiab(t) = BenRes(t) + DefTaxLiab(t)
- StockEquity(t) = StockAssets(t) - StockLiab(t)
- EquityBase(t) = StockEquity(t-1) or 0.5*(StockEquity(t-1) + StockEquity(t))
- ROE(t) = AfterTaxStockEarn(t) / EquityBase(t)
- ROE varys by year therefore tough to determine if co's ROE goal is met over product lifetime
Selection of Profit Goals
- basic questions
- which acctg basis to calc profits
- how to reflect products degree of risk
- what rate to discount future values or as targeted rate of return
- should impact of req'd capital be reflected (authors assume yes)
- Choice of Acctg Basis
- solvency earnings
- important to regulators and rating agencys
- solvency reserve and cap req drive shareholders investments
- stockholder earnings
- if co places heavy emphasis on stockholder earnings
- added difficulty so not as popular
- Reflecing Risk in Profit Goals
- profit goals related to risk (more risky, higher profit margin)
- possible ways to reflect risk
- formula that might reflect lapse/mort/exp/inv risks
- profit margin set to estimated degree of risk
- sensitivity analysis to estimate degree of risk and set profit margins
- examine product design adn origin of assumptinos used to id risks that req special treatment and possibley make design chagnes to minimize risk
- Choice of Discount Rates adn Rates of Return
- factors to consider when choosing discount rate
- company's cost of capital - weighted avg and marginal
- "opportunity cost" of capital - what could they earn if that money was elsewhere
- current capital position adn expected capital position over next few years - might be receptive to lower yield s/t opportunities
- how will discounting be used
- generally based on cost of capital or opportunity cost
- if discounting to give more weight to early years, pretax or after-tax yields on inv assets may be appropriate
- rate-of-return rate that discounts the stream of profits to zero
- it taxes are level % of pre-tax profits, pre-tax and after-tax rates of return are same
Present Value
- PVPrem = sum(Prem(t)*DiscFactor(t-1)) => t-1 b/c prems paid at BOY
- PV(var,n) = sum(var(t)*DiscFactor(t)) over n years
- if some PVFP < 0 [ i(t) - normal disc rate j(t) - discount rate when profits are neg - typically after-tax int rate earned on invested assets]
- PVFP(n) = Profit(n)
- for t = n to 1 step -1
- If PVFP(t) > 0 then
- PVFP(t-1) = PVFP(t)/(1+i(t)) + Profit(t-1)
- else
- PVFP(t-1) = PVFP(t)/(1+j(t)) + Profit(t-1)
- endif
- next
- PVFP(n) = PVFP(0)
- if n = 1, Profit(0) = 0
Profit Measures
- Overview
- Embedded Value Return on Investment (ROI) Weighted-avg return on equity (ROE)
- Profit as % of Prem/Assets/revenues/risk charges
- Accum Porift at % of reserves breakeven year new business strain
- most co use ROI or ROE along w/ profit as % of prem
- publicly traded stock cos tesnd to use embeddev value, ROI/ROE as one of their profit goals - each involves a targeted rate of return
- Embedded Value (aka value added)
- simplest measure - only one decision - hurdle rate
- hurdle rate - rate of return owners expect
- s/b in line w/ weighted avg cost of capital for stock co
- s/b consistent w/ return avail on investments of comparable risk
- normally base profits on after-tax solvency earnings or distr earnings
- distr earnings better reflect owners' expected cash flows
- EmbeddedValue(n) = PV(Profit,n)
- Return on Investmetn (ROI)
- solved for discount rate that causes PV Profits = 0
- normally base profits onafter-tax solvency earnings or dist earnings
- Dist earn preferrable - better reflects owners' expeced cash flows
- ROI can be primary or seconday profit goal
- ROI fails if all policy years are profitable
- posses in later years can olso produce meaningless ROI
- Simple ROI
- 0 = sum(Profit(t)/(1+i)^t and solving for i
- Multiple ROIs
- # positive roots of polynomial = # sign changes of Profit(t)
- Generalized ROI
- if muliple sign changes, use an int rate for borrowed money (j(t)) adn use iterative process to solve for i
- PVFP(t-1) = PVFP(t)/(1+[i(t) or j(t)]) + Profit(t-1)
- Weighted-Avg Return on Equity
- calculate a weighter avg return = (after-tax stockholder earnings) / weighted avg equity base
- can weight by discounting using ROI goal or hurdle rate
- can link to targeted growth rate
- WtdAvgROE(n) = PV(AfterTaxStockEarn,n) / PV(EquityBase,n)
- hopefully each policy year ROE approx = WtdAvgROE
- Profit as Percentage of Premium
- one of most common profit measures
- advantage: fairly concrete and easy to explain
- common to use pre-tax or after-tax int rate eaerned on assets for discounting
- using ROI or Hurdle rate, PVProfits approx = 0 therefore meaningless
- this logic applies to all measures that compare PVprofit to another measure
- Proft%Prem(n) = PVProfit(n) / PVPrem(n)
- Profits as Percentage of Revenue
- generalization of Profit%Prem
- useful mainly as way to compare relative profitablilty of similar product types
- NOT useful at comparing two diverse products
- not all products use premium as important soure of revenue (ex. UL -> inv income and charges)
- Profits as Percentage of Assets (aka Return on Assets or ROA)
- many product priced w/ targeted spread between rate earned and rate credited
- useful to know how much of spread (on avg) retained as profits
- numerator and denominator need ot be in sync
- after-tax solvency earnings <-> solvency reserves
- dist earn <-> solv reserves & req'd cap
- after tax stock earnings <-> solv resv & req'd cap & DAC
- ROA(n) = PVProfit(n) / PV(Assets,n)
- Profits as Percentage of Risk Charges
- Risk charges -attempt to quantify degree of risk inherent in product
- may consist of mortality, lapse and inv components
- simpler: risk charge as % or req'd capital (assuming req'd capital is accurate measurement of risk)
- no std approaches
- PVProfits(n) / PV(risk charges,n)
- attraction: compares profit to risk
- detraction: may be illusion since risk charges somewhat arbitrary
- difficult to explain concept to management
- Risk-Free Rates and Risk Charges
- investors want higher reterns for higher risks
- minimum rate of return for risk free investment
- goal to developing meaningful risk charges - profits net of risk charges earn risk-free rate
- w/ PV based on risk-free rate, PV(Profits) = PV(Risk Charges)
- use industry avg rates of return to establish appropriate level of risk charges
- ensures pricing roughtly in line w/ rest of mkt
- Accumulated Profit as Percentage of Reserves
- one of earliest profit goals - primarily mutuals
- goal - one generation of PO provides capital to fund next generation
- rarely used (currently) for new products
- sometimes used for setting div scales
- usually after tax solvency earnings and usually after-tax int rates
- AccumProfit(n) = sum(Profit(t)*AccumFactor(t))
- AccumProfitPct(n) = AccumProfit(n) / Res(n) where Res(n) is appropriate reserve
- Breakeven Year
- Policy year when accum profits first turn positive adn remain positive
- more of an indicator or danger signal than profit measure
- Modified Breakeven Year - assume all policies lapse at end of given year, releasing req'd capital and excess reserves inro profit calc
- first yer w/ accum profits (including releases) is modified BE year
- late BE year may be acceptable for mutual
- req'd as part of US Illustration Reg supportability test
- New Business Strain
- Not truly a profit measure
- often evaluated as part of pricing process
- often converted to % 1st yr prem
- coupled w/ prem projections, can easily estimate capital necessary to finance NB
- NBStrain = DistEarn(1) / Prem(1)
Sample Problems - text p
Life Insurance Products and Financing (Atkinson/Dallas) - Chapter 14 - FINANCIAL MODELING
Modeling of Liabilities
- Overview
- create financial model by combing results of numerous ages and risk classes
- multiply per-unit-issued results by wieghts for dist of business by age adn risk class and summarize the weighted results
- General Steps
- calc results on per-unit issued basis for a number of cells
- multiply each cell's per-unit-issued results by appropriate # units -> gross results/cell
- sum up gross results to calc total model results
- Uses of Liability Models
- heavily for product decisions - including feature design and price structure
- combined from several products -> entire product line
- decide to introduce new product/discontinue existing one
- assess value of block of business to be acquired/sold
- essential tools to decide to continue/sell/close down LOB or Co
- Types of Liab Models - purpose of model will determine scope/size/complexity
- Pricing Models
- prelim models typically few representative IA/sex/risk/pol size cells w/ highest expected sales
- final models include complete range of representative ages
- often use refined models for bulk of pricing and simplified methods to handle rest
- usually necessary to develop rates for all rep IA for both genders for at least some subset of cells
- allows you to cross-subsidize results between pricing cells
- higher profits from most cells may support lower profits at one or two key cells
- New Business Models
- for planning and budgeting purposes
- project amt and fin impact of NB
- more useful - model that reflects effect of exp NB from all major products
- usually sufficient to model results of co's best sellers and gross up
- InForce Models
- uses
- combined with NB models for planning/budgeting
- calc value of block to be sold/acquired
- determine adequacy of reserves
- test reasonableness/equity of revised div scale/COI rates/int crediting strategy
- project future liab CF to maatch asset CF
- similar products usually grouped together
- law of diminishing returns - additional accuracy gained not worth time it takes to model the next product
- maybe vary issue ages modeled - fewer for smaller products
- Building Data for Liab Model
- type type of data input: aggregate and cell data
- aggregate data
- few assumptions, assumption multipliers and other parameters
- easily changable
- cell data
- mainly product parameters and assumptions
- assumptions in cell data include mort rates/lapse rates/expense rates/avg size/# units
- many assumptions from pricing assumptions or recent experience studies
- avg size/# units usually from inforce data
- many cos use purchased modeling software
- extract used to input to liab model - normally cnotains plancode/issuedate/IA (or DOB)/sex/risk class/units/SAPVx/TaxVx/AcctVal(ul)/Amt Reins
- Liability Model Calculations
- want model to reasonably approximate fin statement results, therefore cal yr results
- may need quarterly projects for plan/budget
- book assumes 1/1 issue date to ease calendar year reporting
- can group data so 1/1 is avg issue date
- Model Variables
- calyr = issyr + t - 1 where t is policy year
- issyr = calyr - t + 1
- t = calyr - issyr + 1
- Number of Units
- reflects distribution of business among cells
- NumUnits(c) - # units for cell c (# issued)
- NumUnitsIF(c) - # units inforce @ start of model for cell c
- NumUnits(c) = NumUnitsIF(c) / SurvFactor(c,begyr-1)
- if SurvFactor(c,begyr-1) = 1, above adjustment not necessary
- Total Results
- variable_tot(calyr) = sum(variable(c,calyr)*NumUnits(c))
- Cell and Total Calculations
- cash flows, reserves, reins calced @ cell level
- ii, taxes, req'd cap, profit measure could be calced @ cell or total level
- calcing @ cell level
- probably slower
- makes summarization simpler adn more flexible
- calcing @ total level
- more contol over final results
- Quickly adjust total only parameters adn recalc results
- Validating a Liability Model
- essential to validate prior to use
- NB or Pricing - compare ratios/patterns over time
- Inforce Model - reproduce starting inforce #s
- static validation - reproducing actual values @ given point in time
- ways to improve model
- changing representative issue ages
- adjusting avg issue date
- splitting into more issue periods
- after initial inforce validated - reasonability of model going forward
- test model using inforce from year-1 and compare to actual results
- validating over a period of time - dynamic validation
- instead of tuning assumptions, sometimes just make adjustments @ total level
- Liability Model Output
- commonly rows for each result and coulms for time periods
- s/b organized into familiar and useful formats, such as I/S or B/s
- other common outputs include
- product cash flows - useful for planning inv strategies
- inventory reports - ins inforce, # pols inforce
- AmtInfIF(c,calyr) = DB_pu(c,calyr)*NumUnits(c)*SurvFactor(c,calyr) (_pu is per unit)
- NumPol(c) = NumUnits(c) / AvgSize(c) where AvgSize(c) = avg # units / policy issued
- NumPolIF(c) = NumPol(c)*SurvFactor(c,calyr)
- AmtInsLapsed(c,calyr) = DB_pu(c,calyr)*Lapses(c,calyr)
- Annualqw(calyr) = AmtInsLapsed_tot(calyr) / AmtInsIF_tot(calyr - 1) -> annualized lapse rate
- Total Profit Measures
- w/inforce data included, can onlyl calc meaningful results for ROI, ROE, adn EV
- EV can be calced sep for inforce and each future issue year
- Aggregate Models
- over short-term - relatively simple aggregate models commonly outperform elaborate cell-based models
- focus on growth rates adn trends of ratios
- ex. Income Stmt items as % of prem - probably see stable relationships and clear trends
- some kinds of business better predicted as % of assests or some other base
- no std approaches to aggregate models
- aaggregate models are poor predictor if co makes significant changes
- best models combine s/t fit of simple aggregate models w/ long term predictive capability of cell-based models
- once it is understood how to adjust s/t results to better match aggregate results, same techniques can be used to adjust l/t results
Asset/Liab Modeling
- Purpose of A/L Modeling
- design investmetn strategy that fits product/liab portfolio
- more accurately predict inv income
- determine potential effect of diff int rate scenarios
- test strategies used to set credited rates
- asset modeling is driven by inv strategy, but informed inv strategy can only be develped once cash flows have been estimated
- Designing an Investment Strategy
- most non term products depend heavily on investment returns
- Predicting Investment Income more Accurately
- calc investment income from an asset model tied to liab cash flows
- already know a lot about own portfolio - use this knowledge to predict future ii
- ii from asset model has two parts
- income from existing assets
- income from future assets
- Testing the Effect of Interest Rate Scenarios
- can predict how cash flows change to various int rate scenarios
- modeling assets allows testing of investmetn strategies
- rise in int rates can cause losses for a company
- if co subsidized the credited rate to stay competitive, reduces profit but keeps business
- if rate not competitive, PO surrender, minimal SC, large outflow when L/T assets have depress mkt value
- testing of int rate scenarios can have several positive effects
- makes co more aware of significant risks it is taking
- may change inv strategies to reduce exposure to certain risks
- may change the products offered to reduce exposre ot certain risks
- may limit total amt of certain kinds of business it will accept to limit aggregate risk
- may increase certain kinds of business to better balance and diversify its risks
- some type and levels of risk acceptable
- Developing Int Crediting Strategies
- mostly some capability to test int rate scenarios needed to develop and test int crediting strategies
- need to estimate how competitor's credited rates, our credited rates and prodcut CF will vary w/ diff int rate scenarios
- Introduction to Asset Modeling
- asset model used to project CF, mkt values, book values and otherh items for portfolio of assets
- assuming that asset portfolio being modeled is tied to specific liab portfolio
- assumptions
- bonds can be purchased at time in reality
- all bonds purchased at end of quarter, immediately after coupon payment made
- all coupon and maturity payments at end of quarter
- BookValue(b,cyq) = Price(b) - when bond purchased @ cyq (calyr qtr)
- BookValue(b,cyq) = BookValue(b,cyq - 1)*(1+Qtryield(b)) - GrossCashFlow(b,cyq)
- Gross Cash Flow includes coupons and par @ maturity
- Book Values can also be calced as PV(future gross cash flows) @ yield rate
- from book value, can calc net cash flows (CumCashFlow)
- CumCashFlow(b,cyq) = GrossCashFlow(b,cyq)-[DefaultRate(b) + InvExpRate(b)]*BookValue(b,cyq-1)/4 (/4 since quarterly cf)
- InvIncome = NetCF + delta BookValue
- InvIncome(b,cyq) = CumCashFlow(b,cyq) + BookValue(b,cyq) - BookValue(b,cyq-1)
- Assembling Data for an Asset Model
- Items needed (in addition to liability items)
- prelim asset strategy
- inventory of assets available for purchase
- inventory of assets currently backing liab (for inforce block)
- assumptions that describe future int rate patterns
- strategy for dealing w/ negative CF
- Preliminary Inv Strategy
- need to narrow the universe of assets to consider for model
- attributes of assets to consider (acceptable classes, quality, dur, maturity)
- used to guide model to types and mix of assets to purchase from future positive CF
- s/b joint effort between co's inv mgr and those responsible for liab
- characteristics will depend on
- co's general inv philosophy
- A/L already on books
- regulatory restrictions
- Assets Available for Purchase
- inventory of assets avail for purchase is needed
- s/b consistent w/ prelim inv strategy
- select a relatively small # of representative assets
- "model assets" that reflect mix of quality ratings and assoc yields
- do NOT mix assets w/ diff maturities - mat date greatly affects CF pattern
- Assets Currently backing Liabs
- Inventory of existing assests hould include all infor needed to project future asset CF, book values and mkt values
- Future Int Rate Patterns
- Assuming future int rates modeled one set at a time
- Handling Netative Cash Flows
- Two common strategies
- borrow money
- typically from other porduct lines w/in same co
- need assumption as to int rate charged when borrowing is necessary
- rate for external borrowing should reflect co's credit quality
- borrowed funds to be repaoid at earliest opportunity from pos CF
- S/T rates appropriate
- selling assets
- model must calc MV adn needs rules for which to sell first, such as
- assets w/ largest cap gains first
- assets w/ shortest time to mat first
- assets held for at least 1 year first
- Asset Adequacy or Free Cash Flows
- Asset Adequacy
- performed on block of inforce to test adequacy of assets allocated to block
- projection of both a/l under various int rate scenarios
- total assets > total liab, assets adequate for scenario
- if insufficient under many scenarios, actuary can require more assets allocated to back block
- can be performed w/ beginning assets < or > beg reserves
- Free Cash Flow
- assets rebalances @ end of each period to match solvency reserves + req'd capital
- free cash flow - fee to be uses as co chooses OR
- req'd to be contributied to support business
- Asset Modeling Process under Free Cash Flow Methodology
- focus on meling assets of policy year basis
- for model, assum CF only at BOY, middle, EOY and rebalancing only @EOY
- at BOY and Mid-year
- cum CF is determined
- if cum CF > (<) 0, int rec (paid) next CF date = 1/2 years int on this cum CF
- Beginning of Year
- AssetsReq(t-1) = SolvRes(t-1) + ReqCap(t-1)
- CumCashFlowBeg(t) = AssetCashFlowBeg(t) + LiabCashFlowBeg(t)
- if CumCashFlowBeg(t) < 0
- IntReceivedMid(t) = 0
- IntPaidMid(t) = CumCashFlowBeg(t)*IntPaidRate(t)
- if CumCashFlowBeg(t) > 0
- IntReceivedMid(t) = CumCashFlowBeg(t)*IntReceivedRate(t)
- IntPaidMid(t) = 0
- Middle of Year
- CumCashFlowMid(t) = CumCashFlowBeg(t) + AssetCashFlowMid(t) + LiabCashFlowMid(t) + IntReceivedMid(t) - IntPaidMid(t)
- IntPaid[Rec'd]End(t) = CumCashFlowMid(t)*IntPaid[Rec'd]Rate(t) (and other is 0)
- End of Year
- CumCashFlowEnd(t) = CumCashFlowMid(t) + AssetCashFlowEnd(t) + LiabCashFlowEnd(t) + IntReceivedEnd(t) - IntPaidEnd(t)
- AssetsEnd(t) = AssetsReq(t-1) + InvIncome(t) - AssetCashFlow(t)
- Free Cash Flow
- AssetsReq(t) = SolvRes(t) + ReqCap(t)
- AssetsEnd(t) + CumCashFlowEnd(t) - FreeCashFlow(t) = AssetsReq(t)
- FreeCashFlow(t) = SolvRest(t-1) + ReqCap(t-1) - [SolvRes(t) + ReqCap(t)] + CumCashFlowEnd(t) + InvIncome(t) - AssetCashFlow(t)
- = CumCashFlow(t) + InvIncome(t) - AssetCashFlow(t) - SolvResIncr(t) - ReqCapIncr(t)
- Free Cash Flow and Dist Earnings
- FreeCashFlow(t) = LiabCashFlow(t) + InvIncome(t) + IntReceived(t) - IntPaid(t) - SolvResIncr(t) - ReqCapIncr(t)
- new formula for dist earnings
- Validation of Asset Model
- compare avg int rates for each period w/ assumed yield on ne and existing assets
- compare asset purcahses w/ resulting asset net CF taht follow
- amts not expected to match exactly, s/b saem range
- par value, book value and avg yield @ beg of model should match inforce portfolio
- Asset Model Output
- liab cash flows
- assets purchased
- asset cash flows
- loans to fund cash shortfalls & repayment of prin and int
- inv income
- book value of assets
- mkt value of assets
- avg yeild on new assets purchased
- avg yield on entire asset portfolio
- avg dur of new assets purchased
- avg dur of entire asset portfolio
Asset/Liability Matching
- Overview
- immunization - matching of assets and liabs
- reduced financial effect of changes inint rates
- assuming liab CF not affected by int rate changes
- Exact Matching
- begin by matching final liab CF and working backwards to curretn time
- cant to exact matching for very L/T (> 30 yr) liabs
- Practical Problems w/ exact matching
- future pos cash flows need ot purchase assets. Cant purchase future assets until then
- need to factor future asset purchases into matching plans
- if significant disintermediation risk, migh need to match shortest dur first
- asset defaults or calls, matching is out of balance. more assets need to be purchased
- if liab CF deviates significant from expectd, portfolio needs rebalancing
- Exact matching case study - pp 756-759
- Duration Matching
- exact matching is not usually practical
- duration matching mor common
- secondary use: excellent predictor of effect of small int rate changes
- if both A/L durations matche, small change in int rates should have equal effect on A & L
- company will have to rebalcnae occassionally to maintain matching of A/L
- Macauly Duration
- duration - a measure of average time of a series of CF
- Macauly dur - weighted avg w/ PV(CF) used as weights
- MacDuration(i) = sum(t*v^t*CashFlow(t)) / sum(v^t*CashFlow(t))
- MacDur of a single cash flow is that cash flow's time
- MacCur of multiple CF is wtg avg time of the CF
- when matching A/L dur, both need to use same int rate stream - usually current rate
- Modified Duration
- used to estimate the effect of a small change in int rates on PV of CF
- useful for predicting changes in PV due to int rate changes
- mod dur is what most people mean when they say "duration"
- PVCashFlow(i) = sum(v^t*CashFlow(t))
- ModDuration(i) = d(PVCashFlow(i))/di / PVCashFLow(i)
- = sum(t*v^(t+1)*CashFlow(t)) / sum(v^t*cashFlow(t))
- = v*MacDuration(i)
- %change in PVCashFlow(i) = -ModDuration(i)*delta(i)
- w/ duration matching - not exact matching of CFs
- dur matching implicitly assumes mismatches can be offest by investing/borrowing @ int rate used for dur calc
- possible to match dur and have terrible mismatch of CF
- Convexity
- 2nd order deriviative of PVCashFLow(i) (modDur is 1st order)
- Convexity(i) = sum(t*(t+1)*v^(t+2)*CashFlow(t)) / sum(v^t*CashFlow(t))
- Mod Dur and convexity combined - more accurately calc effect of change in i on PVCashFLow(i)
- % change in PVCashFlow(i) = -ModDuration(i)*delta(i) + 1/2*Convexity(i)*delta(i)^2
- cannot expect 2 term formula to reproduce complexity of n cash flows
- when matching using convexity
- calc dur and convexity for liab CF
- create 2 asset portfolios w/ same dur
- blend to get convexity to match liab convexity
- Horizon Matching
- exact matching used first few years (5-10) adn remaing CF matched using dur matching
- as time progressed, rebalcned w/ migration of some CF to exact matching group
- Summary of A/L Matching
- requires collaboration between actuaries (liab experts) adn investmetn dept (asset experts)
- year-by-year CF can be significantly mismatched
- if disintermediation is most significant risk - asset dur s/b < laib dur
- if reinvestment risk is most significant risk - asset dur s/b > liab dur
-
- discussions ingored fact that most liab CF ARE affected by int rate changes
- policyowner optionality - PO elecing options that affect CF
- partial w/d, pol loans, surrenders
Exercises - beginning p 772
Life Insurance Products and Financing (Atkinson/Dallas) - Chapter 15 - STOCHASTIC MODELING
Introduction
- chapter focus on practical applications of mathematical and statistical techniques
- best estimate assumptions can usually be established w/ fair degree of confidence
- int rate is hard to predict w/ confidence
- strategies to reduce effect of int rate unpredictability
- conservative assumptions for i
- offer products that adjust benefits when int rates change
- match asset & liab cash flows
- stochastic modeling produces distribution of likely results
- allows answers to questions such as "what is prob of ROI < 7%" or "avg roi for worst 10% of scenarios"
Overview of Stochastic Modeling
- Uses of Stochastic modeling
- single product, portfolio of products, or entire company
- increasingly used for both pricing and ongoing mgmt of A/L
- can be applied to any variable/assumption - most commonly int rate/inv returns
- Steps Involved in Stochastic Modeling
- select a distribution function
- choose a random number generator
- stochastically generate sets of variables
- calc results for each set of rates
- liab or prodcut related results
- asset-related results
- Select a Distribution Function
- should generate values that best fit the range/freq/deviation of possible outcomes
- shoudl reproduce expected mean and variance
- mortality - typically a binomial dist function
- int - often normal or lognormal dist to reflect the change in int rate
- should test to see how well it fits w/ experience over a number of years
- parameters adjusted to improve fit
- Choose a Random Number Generator
- used in conjunction w/ dist function to generate random values
- Stochastically Generate Sets of Variables
- random number generator applied to dist function to create many sets of variable being modeled
- one set of rates is however many rates are needed to run the model once
- ex. mortality, sep rates for each cell in each period of the model
- ex. int rates - sep yield rates for each type of asset avail for purch in each future time period (in practice - only key assets & rest are determined via reference to key rates
- Calcualte Results for Eaach Set of Int Rates
- A/L Calcs perfomred as of deterministic model (w/ currently generated sets of rates)
- make sure affected variables adjusted
- ex. int rate assumptions can/will affect
- credit rate and acct values for dynamic products
- divs for par products
- lapse rates
- sales levels
- premium levels
- asset mkt values
- asset calls and prepayments
- some models will adjust for these automatically
Random Variables
- developed by combine dist function w/ random number generator
- general steps
- develop cdf F(x) that reflects distribution
- calc random number S ~ U(0,1)
- calc x for each S F(x) = S (if continuous) F(x-1) < S <= F(x) (if discrete)
- Binomial Distribution
- X(n) -> sum of n trials where P(x=1) = p
- mean (mu) = np variance (sigma squared) = npq std dev (sd or sigma) = (npq)^0.5
- Normal Distribution
- for sufficiently large values of n (book suggests minimum value of n = 30)
- Z(n) = (X(n) - 0.5n) / 0.5*(n)^0.5 ~ N(0,1)
- ex. generate 30 random values to calc X(30)
- so if you need 2000 values, need 2000 * 30 = 60000 random numbers
- then determine dist function f(x) (prob X(n) = x) ^ CDF F(x) (prob X >= x)
- otherwise can be used to generate values of Z
Stochastic Mortality
- mortality fluctuations can be quite significant
- stochastic mort models can help to understand likely variability of mort results and design products or programs (such as reins) to stabilize results
- models presume all lives independent
- not quite true, but good enough
- multiple policies on same insured
- disaster can simultaneously kill many insureds that work/travel together
- common accidents on family members
- lonely heart syndrome
- Seriatim Stochastic Modeling
- simplest approach is model 1 policy at a time
- perform for each policy each period
- qd and qw for that policy that period
- S ~ U(0,1)
- is S <= qd policy is marked as dead (set qd = 1)
- if not dead, S ~ U(0,1)
- if S <= qw policy is lapsed (set qw = 1)
- once policy terminated, s/b removed from inforce for future periods
- essentially, each policy is its own cell
- Alternate to Stochastic Modeling
- volatility of largest policies modeled using seriatim apporach
- volatility of remaing policies modeled as follows
- deterministic model to determine expected deaths each period
- calc avg expected mort rate (q(t) for each period
- total variance for each period approx = (#pols)*(q(t)*(1 - q(t))*(avgDB)^2
- assumes identical policies
- better estimate - calc variance for each cell and sum variance
- best estimate - calc variance for each cell and sum results
- law of large numbers - mean and variance above and normal dist allown prediction of distribution of DC
- Binomial Stochastic Modeling
- best fits a group of independend lives w/ same mort & DV
- often the case for a single cell
- useful wehn seriatim approach not feasible
- Applying the Binomial Distribution
- allows use of 1 random number to determine outcome for n policies at once
- how-to for 1 cell in 1 period:
- determine assumed qd and qw and # policies in force (no) (# pols will decrease from period to period)
- using Bin Dist, create CDF F(x) for # deaths (x) in peroid based on n pols in force
- S ~ U(0,1)
- if F(x-1) < s <= F(x) then x is # deaths and qd = x/n
- using Bin Dist, create CDF F(x) for # lapses (y) in period based on n - x pols in force
- S ~ U(0,1)
- if F(y-1) < s <= F(y) then y is # lapses and qw = y / (n-x)
- # pol inforce beg next period is n-x-y
- Calculating teh Binomial Dist Function
- apply bin dist to cell n w/ prob death = q
- f(x) = nCx*q^x*(1-q)^(n-x) where nCx = n! / ((n-x)!*x!)
- nCx can be gotten from Pascal's triangle
- fratio(x) = f(x) / f(x-1)
- fratio(x)
- f(x) can be calculated directly (see above) but more efficient to calc iteratively
- f(x) = f(x-1) * fratio(x) where f(0) = (1-q)^n
- fratio(x) = q/(1-q) * (n-x+1)/x
- Cumulative Dist Function F(x)
- F(s) = sum(f(x)) from 0 to s
Stochastic Interst Rates
- Overview
- more scenarios created, more credibel the results
- # scenarios limited by speed of software/hardware
- time for additional scenarios vs value of additional information
- stochastic modeling of int rates best performed in aggregate
- complexities include
- must product yield rates for all possible future asset purchases, not just one rate for each future period
- int rates driven by world events which can have long term effects on rates
- can randomly generated rates adequately reflect this?
- int rates also driven by supply/demand
- to handle great variety of yields available on different investments, yields assumed to be some of two pieces
- gov't yield rate from same maturity of an asset
- spread over that yield rate (in BPS)
- int'l standard for comparing s/t rates - LIBOR
- In US, spread usually vs Treasuries
- Assuming spread is fixed and unchanging for each type of asset
- Yield Curves
- shows yield rates on one axis and time to maturity on other axis
- normally slope upwards w/ increasing time to maturity (normal yield curve)
- inverted yield curve - yield curves that slope downward w/ increasing time to maturity
- in practice, yield curves defined by one S/T and one L/T rate (90 day and 10 yr) and other rates determined from these
- interpolated rate = (1-Factor)*[90 day rate] + factor*[10 year rate]
- sample factors
- 90 180 1yr 2yr 3yr 5yr 7yr 10yr 20yr 30yr
- 0 .1694 .3600 .5671 .6706 .7647 .9059 1.0000 1.0784 1.1176
- Interest Rate Scenarios
- int rate scenario consists of one yield curve for each future period in model
- int rates from one period to the next are highly correlated so we can't jut generate two random int rates
- 90 day adn 10yr rate are correlated - often fall and rise in unison or partial unison
- three approaches to handling (among many)
- arbitrary method
- probablistic method
- successive ratios method
- Arbitrary Method
- not a stochastic model
- involves manually creating a set of int rate scenarios in an arbitrary fashion
- different scenarios may test effect of gradual or sudden incr/dec in int rate
- of limited value - rarely sufficient # to be credible
- arbitrary input -> arbitrary output
- ex. NY 7
- Probablistic Approach
- assume every curve defined by level (10 yr rate) and slope (90 day/10yr)
- using historic info, develop prob of each level changing to any other level during next period
- probabilities arranged into grid
- in example grid
- sum(prob) = 1.0 for each row
- min i = 2% and max i = 15%
- rates equally likely to move up or down near middle of grid
- near edges, more likely to move away from edge
- similar grid showing probability of each slope changing to any other slope
- randomly determine change in level and slope, still end up w/ 10yr and 90day rates that are related
- develop CDF F(x) for each level and slope
- can combine F(x) for current level and rand number to stochastically generate teh level for the next period's yield curve
- can combine F(x) for current slope and another rand numberto generate slope for next period's yield curve
- Jetton - single grid w/ yield curves and probabilities of moving from one curve to the next - only need 1 rand #
- Successive Ratios Approach
- assume ln of rato of successive int rates is normally distributed
- don't want to apply to both 10yr adn 90 day since would end up w/ 2 ind rates
- use one RV w/ successive ratios approacht to generate next 10 yr rate
- combo of RV_10 adn RV_90 to generate 90 day
- RV_10*weight_10 + RV_90*weight_90 = 90 day rate
- weights reflect degree of correlation between 10 and 90 day
- alternate approach uses volatility factor (VolFactor)
- Z1,Z2 - 2 sep RV ~ N(0,1)
- Correlation - degree of correlation between changes in i90day(t) and i10yr(t)
- Z10yr - RV used to generate changes in i10yr(t) (reflects some correlation w/ i90day(t))
- i90day(t+1) = i90day(t)e^(Z1-VolFactor)
- Z10year = Z1*Correlation + Z2*(1-Correlation^2)^0.5
- i10yr(t+1) = i10yr(t)*e^(Z10yr-VolFactor)
- Advantages (compared to probablistic method)
- not limited to predetermined # of int rates or yield curves
- not necessary to research adn create large tables of probabilities
- only need volatility factor and correlation factor
- Disadvantages (can be corrected w/ adjustments)
- no min/max int rate
- no corridor...if you feel int rates will gravitate toward certain level
- tends to product more inverted yield curves than you'd normally expect
- Might need to bias formula towards normal curves
- differnece between 90day and 10yr can grow to unrealistic extremes
Effect on Liabilities
- overview
- Int Scenarios ->Int Rates->Product Cash Flows->Asset Cash Flows
- four rates determined beginning of each period
- avg rate earned on exiting assets - prior period inv income / prior period avg assets
- int rates avail on new investments - scenario yield curve
- int rates avail on competing products - aka Mkt Rates
- int rates creditd to company's products being modeled - credited rate
- Modeling Interest rates
- mkt rate - rate avail from financial alternatives
- if co is crediting rates in line w/ mkt rates
- surrenders, w/d s/b normal
- if co is crediting > mkt rates - improved persistency
- if co is crediting < mkt rates - worse persistency
- if big difference, could see large cash outflows
- partial w/d adn loans also affected by mkt rates (vs credited rates)
- term generally immune to int
- however prolonged inflation can erode value leading to lapses
- possibly reflect non-ins product int rates
- money mkt fund, 5yr bank CDs 10 yr govt bonds
- new money vs portfolio rate
- relevant mkt rate might be max(new money, portfolio)
- probably approximated fairly well as constant spread from gov't yeild rate
- Modeling Credit Int Rates
- function of 4 int rates
- portfolio rate (avg net int rate earned on products backing portfolio)
- new money rate (avg net int rate on new investments)
- guaranteed int rate (for product)
- mkt rate
- int guarantees & mkt rate act as constraints on what co can credit
- if segmentation method
- new deposits get new money rate
- existing deposits - net int earned on assets backing segment
- if portfolio method - earned rate => portfolio rate (w/ some adjustment for new funds @ new money rate)
- a product can have one or more guarantees
- long-term guaranteed rate
- short term current int rate guarantee
- bailout rate
- credited rate can't be less that LT or ST guarantees
- can be < bailout rate if willing to waive SC
- most co's have targeted spread they wish to earn
- credited rate = earned rate - targeted spread
- some cos have strategy of largest spread mkt will allow, subject to a max spread while maintaining a credited rate subject ot a min spread
- most cos - credited rate w/in certain range of mkt rates
- sample formula
- Max Possible Spread (MPS) = earned rate - 90% mkt rate
- credited rate = 90% mkt
- if MPS > 2%, credited rate = earned rate - 2%
- if credit rate > 110% of mkt rate, credited rate = 110% mkt rate
- if mps < 1%, credited rate = earned rate - 1%
- credited rate formula could reflect SC
- existence of SC allows co to credit slightly lower rate than if no SC
- Modeling the Effect on Lapses
- Life Ins products sole as investement vehicles generally have lapses quite sensitive to diff between mkt adn credit rates
- especailly sensitive if product has explicit credited rate
- study industry and company experience to develop formulas to help predict changes in lapse based on diff between mkt and credited rates
- formula should produce no additional lapses when spread is small
- change large and positive - lapse rates should increase
- change large and negative - lapse rates should improve
- sample lapse formulas
- qw(t) = qwBasic(t)(1+0.5*(100-difference)^2) - SC% min(0.01), max(0.50)
- qw(t) = qwbasic + 1.25*difference*3.25^|100*difference| - SC%, min(0.01), max(0.60)
- in general, a formula should cause lapses to fall below the base rate if credited rate exceeds mkt rate
- lapses should increase/decrease exponentially as the spread widens
- existence of SC should lower the lapse rate
- Modeling other Product Cash Flows
- credited rates affect dynamic CV and reserves
- div int rate affects amt divs paid and amt applied to div options
- partial w/d and prem persistency affected by spread for flex prem products
- pol loan utilization increases as mkt rates increase (esp if fixed LIR)
- expenses might inflate faster than expected
- could model inflation = mkt rate - constant
- anti-selection as unhealthy lives persist while healthy one lapse for more competitive products
Effects on Assets
- Steps applied to assets each period
- asset cash flows are determined, reflecting effect of current yield curve
- net CF determined = asset CF + product CF - dist earnings
- if net CF > 0, new assets purchased based on inv strategy
- if net CF < 0, model rules dictate sell assets or borrow cash
- book and mkt values determined for all assets @ EOP
- inv income, cap g/l determined for period
- Major Asset Classes
- questions for each asset adn how it relates to an ins company
- what are typical cash flows
- what are unusual cash flows and when can you expect them (what triggers them)
- does borrower have any rights to alter CF (by delaying or accelerating payments)
- does co have any rights to alter cash flow (puts)
- what expenses will co incur for mgmt/accting of each asset
- what % of investmetn will be lost to defaults/devaluation
- how liquid is the asset
- Gov't Securities
- diff between purchase price adn par is discount/premium
- if purchased @ discount, bond's yield > coupon rate
- if purchased @ premium, bond's yield < coupon rate
- amount of discont/premium amortized to 0 over life of bond in a fashion that results in a constant yield to maturity
- gov't bonds generally not callable
- assumed default rate often 0%
- usually lowest yielding asset
- expenses s/b consisten w/ corp bonds
- very liquid (most) - active mkt allows efficient trading
- Corp Bonds
- can have call adn put options
- call - borrow can repay early
- put - co can ask for early redemption
- usually issue non-callable when rates low
- call premium
- penalty on borrow for early repayment
- diff between call price and mat value
- helps reimburse bondholder for lost int
- call price that decreases over time ex 104%, 103, 102, 101, 100
- private bonds have more substantial call premium
- typically PV of all remaing int & prin payments calced using spread over yield rate on govt securities
- model needs to make assumption as to when bond will be called
- futher away from original yield, greater prob. @ 1%-2% change, most bonds usually called
- puts less common
- allows borrow to repay @ less than full maturity value
- put option valuable for matching A/L
- ins co can liquidate assest @ favorable prices when rates high and reinvest @ higher rates or fund outflows
- most bonds in public mktplace
- u/w and sale managed by one or more investment banking groups
- privates negotiate and issued directly between borrower and lender
- Inc Co's like privates b/c investment banker fees saved
- privates shoudl have slightly higher yield b/c no inv banker fees
- privates often have sinking fund provision
- sinking fund provision clearly affects CFT timing
- cost to borrower for call option, therefore then to have higher rate
- put options tend to have lower rate
- public bonds more liquid that privates (day vs week w/ higher trading costs on private)
- diff in liquidity another reason why privates should have higher rate
- bond have different levels of seniority. Higher seniority, less default risk, lower rate
- BBB or higher - inv grade - majority of what ins cos purchase
- public less expensive to manage in portfolio b/c info more readily available
- High Yield Bonds (Junk)
- rated lower than BBB
- higher probability of default (5-10%) therefore higher yields to compensate for higher risk
- historically higher yield has more than compensated for higher defaults
- call option on high yield should have lower chance of being exercised
- like mortality anti-selection
- Commercial Mortgage
- large loans on commercial real estate (retail/office buildings)
- normally prin & int over 20 years, due @ 10 (10 year ballon)
- borrow usually pays origination fees
- usually contain prepayment provision
- prepayment penalties usually modest
- default risk usually highly correlated by geographic area
- not as risky as junk, but don't want too high a concentration
- fairly illiquid w/ no active mkt
- can usually sell a group of comm mort in about a month
- high asset monitoring costs
- Residential Mortgages
- loans on residential real estate - typically 50-80% of mkt value of real estate
- monthly payments of int and prin
- most 15 adn 30 year
- fixed of variable int rates
- mortgage may be purchased at either premium or discount
- amortized over life of mortgage, altering yield somewhat
- can be prepaid, usually w/o penalty
- if penalty exists, only first couple years
- level of prepayments based on multiple factors
- as int rates drop, more refinancing
- default risk
- usually related to unemployment, dis, death
- increases during recession (like junk and comm mortgages)
- fairly illiquid w/ no active market
- Collateralized Mortgage Obligations (CMOs)
- mortgage specialists assemble pools of thousands of indiv mortgages, then sell slices to investors
- securitization - creation of a new financial security that is backed by underlying cash flows
- by purchasing a slice of thousands of geographicly diverserve mortgages, buy can diversify risk
- tranche - slice of CMO
- payment and interest of each tranche varys depending on underlying cash flow
- each int paymetn dependent on underlying morgage prin outstanding
- each tranche receives its principle (subject to default) but amt of int rec'd depends on prepayment speed
- shorter tranches generally receive most of principle repayments first
- modeling is difficult b/c sensitivity of prepayments to change in i
- PAC (planned amortization class) - specialty tranche developed to address stability issues for investors
- PAC investure assured of getting fixed, pre-scheduled payments over speciifed period over a wide range of prepayment scenarios
- more volatile tranches created to absorb flucuations
- PAC has lower yield therefore other tranches can have higher yield for higher uncertainty
- many CMOs backed by gov't securities therefore no defaults and AAA rating
- CMOs actively traded and liquid (some volatile tranches may be difficult to sell)
- considered investment grade
- Asset-Backed Securities (ABS)
- consumer/corp debt - ex. credit card balances, auto loans, home equity loans, bank loans, commercial mortgages
- similar to CMOs
- some unique regulatory/acctg issues make these not as popular w/ ins cos
- CBO - collateralized bond obligation - corp bonds
- Real Estate
- most produce rental income - modest and uncertain compared to bonds and mortgages
- cash outflows req'd to maintain property
- largest cash flow is from sale of property
- sizable portion of return from apprectiate in property value
- perhaps most illiquid asset
- poor match for most ins liab (modest/variable CF)
- makes sense when matched against very long-term liab or portion of co's capital
- Common Stock
- trend toward smaller divs (as % of stock price)
- rarely purchased for ongoing cash flows
- appreciation in price is main attraction
- prices highly variable
- very liquid - related to # shares outstanding (more shares, more liquid)
- historically 9-11% total return over 20-year periods
- poor match for most liab (low CF, volatility in price, acctg treatment)
- makes sense when matched against very long-term liab or portion of co's capital
- liquidity could be welcome addition
- Preferred Stock
- similar to bond w/ no maturity date
- junior to all bonds
- some have options to convert to common stock
- potentially valuable is stock price increases
- tax treatment of Pref Stock divs different from bond int
- fairly liquid, but ont as liquid as CS or bonds
- prices behave much like prices for 30+ year bonds
- if yield/quality acceptable, non-callable PS could make excellent match for longest LT liab, esp > longest bond mat avail
- Policy Loans
- if fixed int rate, utilization increases when PO can earn higher rate elsewhere
- some co's reduce credited rate on portion of value loaned
- par products make adjustments for loaned policies as well
- if variable rate, utilization will be more stable
- an increase in int rates can cause
- increase in surrenders (which repays policy loans)
- increase in policy loan activity
- Summary of Asset Cash Flows
- Positive Asset cash flows
- sales of any asset type
- bonds
- coupon payments
- calls (mat val + call prem)
- puts (mat val - put discount)
- sinkng fund payments
- maturity payments
- mort/cmo/abs
- regular payments of prin & int
- prepayments of prin and any prepayment penalties
- maturity payments
- real estate rental income
- CS & PS dividends
- policy loans
- int payments
- prin repayments
- Negative Asset cash flows
- investment expenses for all types, incl real estate maint
- improvements to real estate
- nwe/add'l policy loans
- asset defaults
- Stochastic Modeling of Asset Cash Flows
- overview
- extrememly difficult undertaking
- basic groupings
- sales of assets
- prescheduled CF
- premature CF
- asset defaults
- prescheduled can be easily reflected once others addressed
- Sales of Assets
- many models assume assets held until they mature/prematurely repaind
- often @ odds w/ actual mgmt sime portfolios often actively managed
- best to reflect reality
- if activley managed portfolio, strategy s/b discussed & reflected in model
- Premature CF
- bond calls driven almost entirely by int rates
- to model bond calls, build grid of bond call rates that vary by change in i and bond quality rating
- bond puts
- controlled by insurer
- establish some parameters for exercising puts
- ex. if put price >10% above mkt value or neg CF & put price > mkt value
- extra sinking fund payments - modeled similarly to calls
- mortgage prepayments - similar to calls
- residential mortgages - add'l level of prepayments unrelated to delta i (relocations, bigger homes, etc)
- CMO/ABS prepayments - brute force approach - model all tranches to figure out what your trache will do
- recommended alt - table of prepayment rates that vary w/ delta i
- Default Assumptions
- CF interrupted on first default
- many times, assets in default are rehabbed and missed payments made up
- other times, asset sold @ reduced price
- reduction in price & missed payments is true cost of default
- simplest approach is treat defaults as perm loss of % of asset
- ex. if 0.4% annual default, carried in book @ 99.6%, 99.2%, etc
- economic downturn will incr default rates for many asset types
- if possible, vary default rates w/ economic activity
- Purchasing New Assets
- inventory of possible new assets part of input into model
- need to purchase from this inventory, if positive net cash flows
- ways to apply co's inv strategy
- input data may specify % of new assets to be invested in various classes of various quality and maturity
- input data may specify dist of new assets by asset class & quality and let model determine maturity to better match A/L CF
- might have different strategies for different LOB
- Covering Cash Shortfalls
- what to do when net CF is negative - borrow $ or sell assets
- sell assets closest to mat date - MV least affected by delta i
- if investors don't care about unrealized g/l, sell assets w/ offsetting cap g/l
- sell assets that help co better match A/L
- ex. if assets longer than liab, sell LT assets
- modify strategy to min net cap g/l
- Calculation of Investment Results
- Book Values
- for many assets - price originally paid
- bonds, mort, cmo, abs - starts equal to price paid
- bonds: book = mat val + unamortized prem/discount
- mort/cmo/abs: book = loan priinciple + unamortized delta(price paid/principle)
- Capital G/L
- delta price sold and book value @ time of sale
- defaults recorded as capital losses
- Investment Income
- includes capital g/l
- InvIncome = Net Asset CF + increase in book value during period
- if new assets included in net asset CF as negative, will be included in delta book as positive
- no effect if purchased @ EOY
- 6 mo growth if mid-year purchase
Summarizing Stochastic Results
- # of scenarios depends on variablity of results
- depends on speed of modeling software and complexity of model being tested
- once all scenarios tested, results arranged sequentially, summarized by percentile adn sometimes gruoped to see range of possible results
Exercises
Life Insurance Products and Financing (Atkinson/Dallas) - Chapter 16 - FINANCIAL MANAGEMENT
introduction
- fin goals vary widely from co to co in ins industry
- focus on ROE, embedded value, consistent growth in earnings & revenues, total return to stockholders, total return to PO
- factors influencing choice
- type of co
- co tradition
- company strengths and weaknesses
- past co results
- competition
- regulation
- fin mkts
- personalities and beliefs of senior mgmt
- need to activley monitor and manage finances in 3 braod areas
- risk management
- earnings management
- capital management
- in most cases - risk mgmt motivated by desire to stabilize earnings
- protects company's solvency
Tools of Financial Management
- overview
- Informational Tools - Financial analyasis and modeling
- Risk transfer options - reinsurance adn acq of business
- Finanacial Analysis
- worthwhile analysis provides info that leasd to decisions
- I/S & B/S results (broke down by LOB or finer)
- mortality and lapse studies
- inv results, including net int rates and default costs, inv expenses, cap g/l by asset class and segment
- distribution fo sales by product, risk class, gender, etc
- relevant unit costs for vaious levels fo decisions
- by reviewing past, learn from mistakes, see where doing good and adjust accordingly
- Modeling
- ability to project future financial results
- results need to be at least as detailed as various summaries avail from fin analysis
- useful for testing effect of various decisions on future earnings and other results
- can be used to produce PV of future results
- Embedded Value(begyr) = sum(DistEarn_tot(calyr)*1+i)^(begyr-calyr))
- allows determination of which products/pkts/other factors contributing/detracting from goals
- can be used to roughly estimate costs and potential value of adding new markets, new dist systems, new products
- Combined Financial Analysis and Modeling
- connect teh past and future - giving more complete view
- combined results can help w/ questions such as
- to stop offering certain products
- exit certain markets
- sell or close down LOB
- keep co independent or seek affiliation via merger/aquisition/being acquired
- can calc LT performacne measures such as ROI or wtg avg ROE
- solve 0=sum(DistEarn_tot(calyr)(1+ROI)^(-calyr)) across all years for ROI
- remember: simple ROI can be misleading, esp if multiple sign changes
- Reinsurance
- possibly most flexible tool for managing financial position
- in addition to transferring risk, it can shift earnings, capital, revenue, benefits, expenses, assets adn liab from one co to another
- Effect on Stability of Earnings
- can be used to stabilize earnings - more than any other tool
- can be used ot offest virtually every kind of risk
- usually used to stabilize mortality risk
- Effect on Pattern of Earnings
- pattern of YRT prem rates often doesn't match pattern of exp mort
- difference in patterns can affect incidence of earnings by yera
- varying term adn features allow possibility of many diff fin objectives
- when risk is transferred, req'd capital also transferred
- pattern of earnings can be shifted or left alone
- can be designed to have benef effect on taxes,esp when unused tax losses about to expire
- usually affects timing of solvency earnings adn taxable earnings (including current period earnings)
- effect of reins on expected stockholder earnings usually spread over dur of agreement
- sometimes designed specifically to ahve desired effect on solvency or taxable earnings
- Reinsurance as Capital
- can be used to obtain financing more quickly, often cheaper, compared to debt/equity
- since risk transferred, also financies strain of new business and lowers ceding co's capital req
- allows co to write higher levels of NB if sales take off
- can assume reins to put excess capital/dis earnings to work
- may be possible to generate tax losses
- every reins trx has same effect on capital of both cos
- possible to construct reins to accomplish several targets, such as
- transfer of targeted risks
- transfer of a targeted amt of cash (including none)
- targeted increase/decrease in
- solvency earnings
- solvency capital
- assets
- liab
- req'd capital
- not only increase co's capital, but decreases need for capital by reducing risk and req'd capital
- some countries limite reins severely
- reins as capital can behave more like equity or deby
- if amoutn of reief is large in relation to future earnings, like equity, small, more like debt
- Reinsurance Leverage
- can be used to leverage a co's returns
Acquisition or Sale of Business
- Overview
- most complex & difficult way to affect co's fin results
- sometimes sell blocks of business to raise capital
- usually dispose because does not have econ of scale, not a stategic fit, low rate of return
- buy blocks to build econ of scale, add value by cutting expenses, put idle capital to work, grow co for benefit of owners
- excess capital amoung life ins often leads to fierce price competition for acquisitions
- Assumption Reinsurance and Indemnity Reins
- acq or sale of blick of business usually accomplished by special form of reins
- reins not needed for sale of entire co
- Assumption Reinsurance - company that issued policies is removed from liab after block of business sold
- some jurisdictions require PO approval for assumption reins
- in those cases, use indemnity reins w/ transfer of admin
- no right to recapture for any reason
- Indemnity Reins - company that issued policies is NOT removed from liab stream
- seller relys on reinsurer to reimburse for all benefits paid
- admin typically transferred to buyer
- buyer handles all transactions
- seller still has to reflect business on books (w/ 100% offset)
- accomplishes most of toals of assumption
- seller receives fair value and no longer has to admin pols
- however, since still on books, ultimately liable if something happens to reinsurer
- this risk is usually better than deling w/ requirements that might be imposed in assumption situation
- seller has no right to recapture, except for breach
- Prerequisites for an Acquisition
- number of conditions
- buyer must have access to capital necessary to complete acq
- must be likely to improve buyer's earnings
- "buyers curse" - historically, results of most acq significantly worse than orig expectations
- buyer must have resources to complete acq
- need staff capable of handling integration from start to finish
- differences in business practice can force complex choices
- most difficult aspect -> people
- if acq driven by expense saving from combining operations -> downsizing
- better integration strategy is very few changes immediately after acq
- gradually institure changes that buidl on strengths and bring orgs closer together
- Prerequisites for a Sale
- seller must have use for capital raised by sale
- sale must be likely to improve seller's earnings
- seller s/b aware of pirce currently avail for business (might not be right time to sell)
- what effect will sale have on remaining staff if only part of co sold
- Determining the Purchase Value of an Inforce Block
- when block of inforce purchased, need to agree on two things
- what amount of liab will buyer assume? Typically solvency reserve of block
- what amount of assets will seller transfer to buyer in order for buyer to assume liab
- Typically assets transferred < liab transferred
- Purchase Value = liab transferred less assets transferred
- = SolvRes(0) - Assets(0) wehre time 0 is purchase date
- Assets(0) most difficult part of negotiations
- typically begin w/ EV(0) using buyer's desired rate of return
- = SolvRes(0) + ReqCap(0) - EV(0)
- Purchase value typically tax deductible, but still may be tax impact @ time 0
- Tax(0) = (SolvRes(0) - TaxRes(0) - PurchaseValue - TransCosts)*EarnTaxRate
- other items might affect Tax(0) and need to be taken into account
- Assets(0) = SolvRes(0) + ReqCap(0) + Tax(0) + TransCosts - EV(0)
- PurchaseValue = EV(0) - Tax(0) - TransCosts - ReqCap(0)
- EV(0) = PurchaseValue + Tax(0) + TransCosts + ReqCap(0) (rearranging prev formula)
- New Business and Goodwill
- closed block = no new business
- if block sold still has NB coming on (and sale assumes will continue), results in intangible asset on B/S
- often reflected only in stockholder acctg
- Goodwill
- value of future new business
- a risky asset for stockholder accounting
- value of intellectual capital, reputation, brand name, and other intangible assets
- for stockholder acctg, balancing item to force assets = liab @ purchase
- Amortization of goodwill reduces earnings
- straightline over X years (10-40 typically)
- some countries allow goodwill to be expensed immediately
- can have major effect on acq, depending on how quickly amortized adn tax deductibility
- no simple formula for determing purchase value for an ongoing business
- usually only include 3-5 year NB in purchase value b/c of risk and uncertainty
- Purchase Price and Purchase Value
- no consistent def of purchase price
- press release version is typically some function of public acctg stds used by cos involved
- purchase value defined b/c of lack of definition
- other considerations - stock co
- effect of acq on stockholder EPS & ROE
- if dilutive for more than S/T, might not be attractive
- wtd avg ROE < target b/c of acq might not be attractive
- Earnings Mgmt
- Act or sales of business can help manage earnings
- can sell loss-producing business. Loss now, but avoids future losses
- can buy business - usually moves it earnings up a notch (or more depending on size)
- strategy of growth primarily through acquisition
- need confidence and backing of fin mkts to raise capital necessary
- or convince sellers to accept buyer's stock
Risk Management
- Overview
- understanding, balancing, and controlling the risks inherent in a LIC
- Market Risk
- Int Rate Risk Asset Valn Risk SubOptimal asset allocation
- Mkt Fluctuation Risk Spread widening risk currency fluctuation risk
- Interest Rate Risk
- discussed previously
- fin derivatives can be purchased as int rate hedges
- even matched A/L can have risks b/c of acctg quirks
- some assets marked to mkt and liab not
- ways to control risk
- encourage saels of products w/ MVA, incl variable products
- limit sales of products w/o MVA
- hold extra capital to be able to withstand int rate fluctuations
- work w/ regulators & acctg bodies to bring acctg fo rliab in line w/ acctg for assets
- Market Fluctuation Risk
- MV of volative assets (CS & Real Estate) subject to considerable fluctuations over time
- 3 main strategies for managing risk of loss do to a fall in mkt values
- use volatile assets mainly to back products w/ MVA (incl variable products)
- otherwise limit volatile assets to small percentage of overall assets
- hold extra capital to be able to withstand mkt fluctuations
- Asset Valuation Risk
- risk of overly agreesive valuation of assets
- difficult to determine MV is not an active mkt for a particular type of asset
- sometimes person who purchased asset is same person who asked to provide MV
- if significant portoin of co's capital in affiliated co, need to take extra precautions to ensure unbiased estimate
- undervaluing assets can also be a problem
- step to reduce asset valuation risk
- majority of funds in assets w/ readily available & verifiable MV (such as publicly traded stocks and bonds)
- ensure controls exist so that those determining MV of assets do so independently
- independent audits should reinforce these controls
- for large inv in an affiliate, consider IPO to sell parot of the affiliate to public and establish an independent mkt value for it
- Spread Widening Risk
- an asset class can fall out of favor, resulting in spread widening
- spread widening is a function of supply and demand
- strategies to control spread widening risk
- invest mainly in assets w/ small risk of spread widening - high quality, heavily traded, widely held securities
- use assets w/ large spread-widening risk mainly w/ products that have MVA (including variable products)
- otherwise limit to small % of total assets
- hold extra capital to be able to withstand effect of spread widening
- SubOptimal Asset Allocation
- level of asset risk s/b tied to capital position
- extra capital -> take on more risk
- is enough risk being taken given the co's capital position?
- Currency Risk Fluctuation
- balance sheet risk and i/s risk
- B/S risk - a/l significantly out of balance by currency
- currency change could reduce co's capital
- managed by balancing a/l by currency
- I/S risk - income, benefits & expenses significantly out of balnace by currency
- currency change could reduce co's net income
- buy currency hedges, but not common
- normal fluctuations in earnings often > fluctuations due to currency changes
- might not make sense to stabilize relatively small currency risk
- Credit Risk
- overview
- several categories (first 3 asset related)
- asset default risk
- concentration risk
- risk of inadequate spreads
- counterparty risk
- Asset Default Risk
- excessive asset defaults that may result from prolonged poor economic conditions or poor asset selection
- managed by
- share risk of default w/ PO via MVA and variable products
- invest in mainly inv grade assets
- limit investments that are below inv grade to a small % of assets
- hold extra capital to withstand effect of excessive asset defaults
- Concentration Risk
- risk associate w/ large protion of co's investments concentrated in a particular issuer/sector/industry/part of country/part of world
- can be controlled by adopting (and following) a strick policy of diversification of risk
- Risk of Inadedquate Spreads
- credit-realted spreads may not adequately compensate investor for credit risk assumed
- risk is smaller where reliable info is available over a long period
- controlled by limiting % of assets invested in newer/less familiar issuers/sectors/countries/classes of assets
- Counterparty Risk
- risk that outerh parties not able to fulfil their obligations
- controlled by only dealing w/ high-quality business partners or diversify by spreading risk w/ multiple business partners
- for reinsurance, YRT and Coins Term largely "paygo" so minimal risk
- larger risks can be reduced by placing assets in trust or securing letters of credit
- Liquidity Risk
- overview
- risk of not being able to meet the cash flow obligations on time
- types of liquidity risk
- "run on the bank"
- holding co
- risk of excessive liquidity
- "Run on the Bank" Risk
- risk that ratings dwongrade or other adverse publicity could cause many of co's PO to simultaneously demand cash from the co
- strategies for dealing w/ run-on-the-bank risk
- give co an option to delay payments when designing ins contracts
- avoid "hot money" products - products sold to those who quickly move their money when conditions change
- maintain some % of co's portfolio in highly liquid asses/gov't securities/st investments/cs)
- establish credit facilities that allow co to raise cash immediately in a time of need
- Holding Company Liquidity Risk
- applies to LIC owned by holding co
- LIC may have adequate liquidity, but holding parent may not
- holding co needs $ to pay divs, int on debt, cover expenses, etc
- holding co only regular source for additional cash if divs from subs
- if subs growing and need add'l capital - could be problematic
- regs often limit amt of divs that can be paid by LIC (to protect solvency)
- other source for holding co $ is capital mkts
- holding co liquidity risk best managed by planning well ahead
- Risk of Excessive Liquidity
- could maintain too much liquid assets and not get enough yield
- determine optimal level of liquidity
- credit may provide liquidity protection cheaper (compared to loss of yield w/ liquid securities)
- Pricing Risk
- Mortality/Morbidity/Longevity/Pricing Assumption/Liability option
- Mortality Risk
- RBC factors for mort risk based on 1918-1919 flu epidemic
- advances in medical science, but partially offset by potential to spread quickly (air travel and increased mobility)
- natural disasters
- man-made disasters
- selective lapsation - genetic testing
- should take measures to protect against - w/in reason
- hold extra capital
- reinsurance - regular and cat
- Morbidity Risk
- primary cause of unexpectly hig morbidity cost - ability of insured to outwit ins co
- us economy of 80/90s let to situation where more attractive to be disabled than working
- liberal u/w & loopholes in definition of dis allowed relatively healthy insureds to make legitimate claims against policy
- controlled through
- careful u/w
- diligent handling of claims
- clear and verifiable benefit provisions
- designing benefits that encourage beneficial behaviour (partial dis benefit)
- Longevity Risk
- annuitiants living longer than expected (reverse mortality risk)
- little can be done to cotrol risk
- allow fo rgreater mort improvement when pricing
- attractive priced reins hard to find - reinsurers have similar concerns
- Pricing Assumption Risk
- danger pricing assumptions wrong
- new mkts/new products/new u/w stds/new dist systems
- inadequate experience to base assumptions
- unlikely to happen when pricing assumptions based on credible experience
- sometimes price below cost in anticipation of being able to reduce cost
- good ways to reduce pricing risk
- reinsure business that has worrisome levels of pricing risk
- work w/ pricing experts (consultants/reinsurers) to develpo assumptions that reflect latest information/techniques available
- Liability Option Risk
- improperly priced options given to PO
- perhaps greatest shortcoming in life ins pricing
- cost of most options is never quantified and never explicitly reflected in pricing
- to manage risk
- greater level of awareness and cost of such options
- use of reinsurance
- consciously avoid too large a concentration of option risk
- manage concetration of risk similar to how done for assets
Earnings Management
- overview
- decisions and actions a co can take to influence FUTURE earnings (usually too late to affect current period earnings)
- two common goals
- grow earnings over time - usually @ targeted growth rate
- minimize unexpected fluctuations in earnings
- Product Management
- managine inforce products and design adn intro of new products to help co better meet fin goal
- essential for good earnings mgmt
- limited ability to adjust inforce products to achieve fin goal and manage earnings
- divs/non-guar prem/credited int rates/COI rates all changeable
- considerations when making these adjustments
- delivery on promises
- equity among policyowners
- effect on persistency
- regulatory restrictions
- pricing of new prducts - most imprtant tool to drive future earnings
- increase profit margins on new products
- introduce productw w/ features that reduce risk, increase earnings, improve competitiveness and sales levels OR reduce capital needs
- Asset Management
- Inv strategies can be shifted
- Avg yields and earnings increase by shifting to riskier (or less liquid) investments
- if in position to easily handle greater risk, wise to improve yields
- could focus on reducing volatility of earnings
- usually not possible to both increase yield and decrease volatility
- A/L matching strongly encouraged
- reasons why mismatching occurs
- liab CF too unpredictable to match, except over short horizon
- A/L purposely mismatched to improve avg yields adn expected earnings
- best handled by co that is over-capitalized and consciously using excess capital to support mismatching
- LT yields can be improved by increasing proportion of assets in stocks/realestate
- need strong capital position to absorb up/downs of mkt
- disadvantage: treatment of cap gains by stock mkts essentially ignored by stock mkts b/c can use to artificially inflate earning in a given year
- if co & stock mkts focused primarily on operating income (excl g/l)
- some volatility acceptable if confined to capital g/l
- Expense Management
- lower expenses generally means higher profits
- quality and friendliness sometimes matter more than price or efficiency
- crucial to understand what matters to customers and dist system
- look @ not only cost, but what it buys you in customer satisfaction of agent loyalty
- some worthless activities can be ingrained into organization adn therefore hard to recognize and eliminate
- Major Expense Reductions
- common techniques
- across-the-board cut - not always a good thing since some areas need to expand, not shrink
- "surgical incissions" - intelligently reduce expenses in areas that most need reductions
- corp raider perspective - look at company from view of corp raider - "slash & burn" areas to shave expenses and boost profits
- ask what a corp raider would do, then do it yourself
- start-up perspective - look @ co from POV of new, start-up co
- Minor Expense Reductions
- analyze jobs throughout co & derive value that each job adds to co
- might also identify structural problems such as too many layers of mgmt & not enough workers
- pursue outsourcing - allows a co to focus on what it does best
- if someone else can do it cheaper, let them
- reengineer processes - involves redesigning or automating processes to improve service or reduce costs
- restructure or reorganize all/part o fthe company so various units wrok together more effectively
- identify ways that company culture can be shifted to improve collaboration, communication, decision making, initiative, creativity, retention of staff, etc
- Allocation of Corp Expenses
- expenses that directly or indirecty relate to a product line s/b allocated accordingly
- expenses not related to anything but total co (corp expenses) should not be allocated
- create a "corp" LOB
- possible def of corp expenses - those that would be eliminated or replaced if company merged into larger organization
- allocating corp exp to LOB may disguise true contibution of each LOB
- Legacy Systems
- outdated, patched-together systems used for u/w, issue, billing, etc
- conversion is hugely difficult, maint is increasingly complex and expensive
- solving this problem has huge savings potential
- possible solution
- modern system for all NB
- bridge over existing as needed
- eventually only the most difficult products left on legacy system
- "incentive" replacement to PO to get policies off books or put forth the effort to get the final policies moved
Capital Management
- overview
- maintaining the proper amounts and types of capital needed to efficiently and safely run the company
- Determining the Proper Amount of Capital
- several perspectives
- insurance regulations
- specify min amt capital req'd to remain solvent and operate independently
- co's strive to maintain capital well in excess of min reg to handle fluctuations
- rating agencies
- rate financial strength/claims paying ability of inc cos
- use req'd capital formulas similar to regulators
- more likely to adjust req'd capital to reflect greater familiarity w/ bus of each co
- company
- internal point of view as to how much is proper
- in line w/ primary competitors
- formulas based on historical events and designed to provide enough capital to survive all but most unusual/extreme events
- Determining the Proper Capital Structure
- debt/equity/reinsurance - options more limited for mutuals
- Corporate Structure
- most common - stand-alone life insurer w/ no parent and no subs
- can issue stock to raise equity capital
- cannot make effective use of deb (ins regs - debt is not capital for solvency purposes, but liability)
- many ins cos have parent holding co - to make effective use of debt
- parent co issues debt and uses proceeds to make captial contribution to ins sub (debt from parent becomes equity to ins co)
- single ins co w/ all ins operations creates some capital efficiencies
- same capital can be used to support mult ins businesses, often w/ complementary risks
- common for large corp to have many holding cos and many ins cos
- add'l holding cos oftern useful for capital and tax reasons
- corp structure partially driven by careful planning and partially by historical events, such as past acq
- Equity
- usually largest component of capital
- owner's capital contributions & retained earnings of co
- capital w/ highest risk, therefore investors demand the highest return on equity capital
- PS & CS do not have to be repaid
- no scheduled maturity date adn no repayment of prin
- normally pay divs
- CS divs must be discontinued before PS divs are cut
- cutting of divs viewed by mkts as sign of poor performance/weakness/distress
- Debt
- mainly used by stock cos
- holding co needed to make debt useful to ins co
- viewed as low-risk capital (for co's w/ good fin ratings)
- often, int paid on debt is tax deductible to the borrower
- since relatively safe, investors settle for much lower rate of return on debt capital
- cost of debt (usually) only slightly higher than yield avail on new investments of similar quality and maturity
- most appropriate for supporting low-risk capital needs
- should structure maturity of various debt offerings to match release of excess reserves adn capital
- s/b structured in conjunction w/ A/L management since debt is another form of liab
- bond debt most commoon
- bank debt - usually S/T @ s/t floating int rate
- if co fails to make int or prin payments on time, faces bankruptcy
- cost of borrowing increases as % of capital in form of debt increases
- rating agencies will lower ratings if it adds too much debt
- investors will criticize if co doesn't make sufficient use of debt to leverage returns
- WACC - weighted avg cost of capital
- = % of capital in equity * desired return on equity + % of capital in debt * after-tax cost of debt
- if co has long range target ratio of debt adn equity, WACC can serve as basis for hurdle rate
- Combinations of Debt and Equity
- aka mezzanine financing
- convertible bonds and surplus notes - types of mazzanine fin used by ins cos
- convertible bond - features of both debt and equity
- similar to regular bond except
- much lower rate of int
- convertible to CS @ price that s/b attractive in a few years
- rating agencies might view as more equity than debt depending on how attractive conversion option is
- surplus notes - function like bonds, except coupon and mat payments
- subject to ongoing approval by ins regulators
- if regulators prevent payment, co is NOT in default and lenders can take no action
- treated as equity for solvency purposes
- rating agencies view as more debt than equity since likely to be repaid
- Reinsurance
- favorable attributes of using reins as capital
- transfer of risk as well as capital
- reduction in need for outside capital
- access to capital as needed, vs prematurely raising idle capital in the form of equity or debt
- Methods of Raising Capital
- Sources of Capital for Mutual Cos
- if formed by original group of PO, these PO would provide capital needed to start co
- if formed by mutualization of stock co, capital remaining after stockholder buyout is starting capital
- once capitalized, no ability to raise add'l equity except retained earnings
- two levers to keep actual capital in line w/ req'd capital
- carefully manage growth so capital needs do not outstrip growth in capital
- manage divs to PO so existing PO provide add'l cap needed to finance new PO
- Sources of Capital for all Cos
- reinsurance (in most jurisdictions)
- amounts and timing of provided captial can be dovetailed to closely match the business needs
- surplus notes (where regs permit)
- sell all or part of one of its businesses to raise capital
- moving a successful business to a sub and selling a piece of it to the public particularly effective way to raise capital
- when a co sells all or part of one of its businesses, may move from too little capital to too much and not know what to do with it
- need to consider where/how to deploy raised capital
- if too much, may be other ways to structure sale
- Sources of Capital for Stock Cos
- in addition to prev choices, fin mkts to raise debt and equity capital
- debt
- easier to raise
- greater a co's fin strength, lower the int rate
- lareg amt of debt usually financed by selling bonds to public
- moderate amts - sometimes sold privately
- s/t adn smaller amounts - usually provided by bank debt
- bank debt - couple days to arrange
- public bonds - a couple months for req'd documentation and approvals
- private - quicker
- equity
- can be problematic
- existing stockholders & new investors have opposite points of view
- existing stockholders - dilutes their ownership
- unless capital rec'd from add'l shares can be immediately deployed to earn same rate as existing capital, offering will be dilutive to EPS
- if permanently dilutive - offering was a stupid idea
- new investors - need to be drawn to offering
- must regard co and/or stock price as attractive
- IPO - takes approx 6 mos
- subsequent offerings - much faster b/c most of req'd info already publicly reported
- Methods of Deploying Excess Capital
- most obvious and most ignored option - distribute to owners
- Distributing Excess Capital to Owners
- special dividend if stock co or increase div rate to pay out over longer period
- buy back shares of stock (if publicly traded)
- tends to raise price of shares since remaining shares own greater portion of co
- more tax-efficient than dividends depending on tax laws
- enhance PO benefits (if Mutual) - increase divs, enhance crediting rates, lower COI
- Deploying Excess Capital into Current Operations
- examine current operations to see where extra capital could do some good while providing adequate return on that capital
- if capital has been main pricing constraint, more capital-intensive be developed or existing products repriced
- expand distribution capabilities
- significant projects to improve productivity or service capabilities
- when raised through debt/equity offering, often more capital than it can immediately use
- makes sense to deploy excess capital through a few large/ST transactions
- Deploying Excess Capital into New Operations
- opportunity to start up new LOB, enter new mkt, build new dist system or pursue acquisition
- must ultimately change or face obsolescence
- Internal Capital Management
- overview
- Company must allocate capital to each business to properly measure performance
- assets backing liab & capital of each business must be allocated
- allows inv income to be calced for each business
- two common methods for allocating capital: historical and req'd capital methods
- Historical Method
- tracks results for a business from inception, accumulating actual cash flows and ignoring capital reqs
- pro:
- tracks inception-to-date contribution of each business
- current results can be viewed in context of historical capital contributions
- con:
- ignores reality by ignoring req'd capital, since buiness must maintain some req'd capital
- understates earnings when accum earnings < req'd capital
- overstates earnings when accum earnings > req'd capital
- ROE grossly misstated (both earnings and equity distorted)
- requires co to keep accurate records of capital contributions to and distributions from each buinsess
- can lead to significant misunderstandings and mistakes
- Req'd Capital Method
- allocates amt of capital req'd to support a business, ignoring past results
- actual earnigs calced consistent w/ dist earnings
- results for young and old business NOT distorted by historical results
- can be allocated by region, etc
- Authors believe req'd capital is THE RIGHT METHOD for measurinng current performance
- however, many co still use historical method
- if no clearly defined std for req'd capital, may be hard to apply
- Value At Risk
- two components of req'd capital (RC)
- portion truly at risk
- portion req'd to satisfy redundant req'd reserves/excess cap req
- value at risk - method of allocating capital that reflects both components
- two-tier approach for each business
- high-risk req'd capital - amt of capital necessary to withstand adverse experience (amt to withstand 99% of 1 yr fluctuations)
- low-risk req'd capital - amt needed to maintain fin ratings or attain desired level of fin strength
- third-tier - not allocated - overall excess (or shortage) of capital
- ideally Tier 1 s/b backed by equity adn Tier 2 by debt
- in reality, debt req'd for Tier 2 would not be acceptable
- if Tier 3 < 0, capital s/b raised
- Using VAR to Allocate Cost of Capital
- calc WACC
- allocate asses backing reserves & Tier 1 req'd capital to LOB
- retain assets backing Tier 2 in unallocated corp segement
- allocate a charge for Tier 2 req'd capital to LOB
- retain assets backing tier 3 in sep unallocated segment
- allocate NO charge since excess corp capital
- ROE = [after-tax LOB income - charge for Tier 2 RC] / Tier 1 RC
- calc charge for Tier2 RC as % of Tier 2 RC
- This percentage is set so co achieves targeted ROE if all LBO achieve target ROE
- company's LOBS will have different proportions of high/low risk capital needs
- measures return on each LOBs high-risk capital while taking into account extra cost of add'l capital
- more common in banking industry, but applicable to ins world as well
- Allocation of Excess or Shortage of Capital
- authors recommend
- if viewed as temporary, allocate to corp segment
- if viewed as perm, calc of req'd calc s/b revised to reflect this
- alternate approach
- allocate all capital in proportion to req'd capital for each LOB
- results can be distorted by reins
- if reins trx designed to help overall company, not just single line, may be appropriate to share costs and benefits across all lines
- Rationing of Capital
- particularly important when shortage of capital
- difficult choices when capital is short
- who should get it?
- some LOB may bet it even w/ inferior returns if of strategic importance
Achieving Financial Goals
- Basic Requirements
- simple story that explains why company will succeed
- told to employees, rating agencies, investors, customers (sometimes)
- explains how co will apply competitive adv to serve mkts that provide opportunities for desirable profits and growth
- embodied in co's vision, mission, strategy
- to achieve goals, many areas need to work together
- products developed
- assets managed
- reins/acq/divestitures coordinated w/ mgmt of risk, earnings, capital
- find right balance between growth, profitability & risk to match availability of capital
- Financial Management Techniques
- simple techinqes/behaviors that can help a co serve owners better
- better to underpromise and overdeliver
- make modestly conservative acctg adn reserving choices -> reduces chance of negative surprises
- increase vigilance when times are good - tend to get overconfident and careless when times are good
- timing is important w/ capital mkts
- raise capital in advance of when you need it...when it is cheap
- have bias toward opportunities w/ more upside than downside potential
- options historically a major source of added earnings & unexpected losses
- strive to include options that benefit co and minimize options that could hurt
- build speed into org
- many opportunities more attractive to those who react first
- Achieving Fin Goals for Mutual Policyowners
- they want fin security adn max value from their pols
- they don't care how fast/slow a co grows, just max value
- when acq costs high and returns low, PPO may be better served by closing down NB & running off inforce and returning all capital to PO
- Demutualization
- since mutuals return much value through PO divs, ROI/ROE often far below that for stock co
- when demutualized, starts as stock co w/ very low ROE
- effective way to unlock mutual PO's value in co w/o dismantling coin process
- most use demutualization and opportunity of IPO to raise add'l capital
- Achieving Stockholder Financial Goals
- want to maximize return through stock price appreciation & stockholder divs
- stock price driven by 2 main factors
- outlook for co and industry
- recent history of co under current management team
- largely a function of P/E ratios (stock price to EPS)
- P/E ratios largely function of expected growth rate for co, tempered by current attractiveness of life ins industry
- ins cos tend to have lower P/E ratios than stock mkt avg
- if privately held, still a fair amt of importance to stockholder divs
- public - not as important. Price appreciation now main focus
- investors focus on stockholder reporting, not regulatory reporting
- co can show negative solvency earnigns and investors will hardly notice
- (rating agencies adn regulators WILL notice)
- fast growing co typically has soaring stockholder earnings and plummeting solvency earnings
- b/c of extreme conservatism in most solv reserves
- slow growing co may experience opposite - solvency > stockholder reserves
- as conservative solvency reserves released on old business
- Embedded Value (EV)
- gaining acceptance in capital mkts as important fin measure
- EV - PV of co's distributable earnings, including any current exess capital
- future NB not included
- EV represents run-off value for co, discounted @ given rate
- why EV may become key driver of Life Ins Stock prices
- used extensively in Europe
- actuarial valuation tool
- used by buyers to substantiate take-over prices
- value of target in 3 pieces: EV, goodwill, multiple fo potential annual cost savings
- allows investors to see how much of a co's current value is represetned by inforce business and how much is based on expected future growth
- good test of recoverability of life ins intangibles (DAC)
- should provide a minimum value for a LIC
- Does have limitations
- time and staff consuming to implement and maintain
- sensitive adn can change significantly w/ assumption change
- difficult to explain to mgmt and outside analysts from one perios to the next
Exercises
Life and Health Marketing (LOMA)
Chapter 5 - PLANNING MARKETING GOALS AND STRATEGIES
Marketing Management - process of planning, organizing, implementing and controlling a company's marketing activities in order to create effective and efficient exchanges
Marketing Management Process
- Planning
- - Set Marketing objectives
- - establish guidelines for implementation and control of mktg activities
- Organizing
- - establish a framework for carrying out mktg plans
- Implementation
- Control
- - analyze results
- - evaluate performance
- - make necessary changes
Types of Planning
- +Corporate Planning
- primarily strategic
- consists of establishing company's overall business plan
- top-down. begins by deining the company's mission - defines scope of org's business activities and business direction
- Establishs Corp objectives - long term results co hopes to achieve
- Outlines Coprorate Strategies - long term methods used to achieve objectives
- must regularly evaluate plans to make sure still appropriate
- +Marketing Planning
- bottom up portion of planning process
Stategic Marketing Planning
- 1-5 years into the future. review and update as necessary. as oftern as every 6 months. focus on long term
- - establishes marketplace objectives
- - defines the target market
- - develops mktplace stategies
- - defines resource needs
Tactical Marketing Planning
- 1-2 years into the future - focus on the day-to-day
- - develops action-oreineted product, price, distribution and promotion tactics
- - describes when activities will take place, how they will be performed and who will perform them
The Planning Process
- 3 primary activities: analyze situation, establish objectives, develop course of action
- Conducting a Situation Analysis
- 3 primary parts: environmental analysis, environmental forcast, internal assessment
- Environmental Analysis - ongoing exam of outside events/relationships that can influence strategic decion making
- Key environmental areas for Financial Services Corp (fig 5-3 p 105)
- - current target markets
- - competition
- - economy
- - society
- - technology
- - regulation
- - labor
- - distributors
- - international conditions
- Environmental Forcast - prediction of major environmental trends that will affect a companies business activities
- several types of forcasts available from businesses, universities, governments and industry associations
- commercial forcasts are a good starting point
- Internal Assessment - exam of co's current activities, strenghts, weekenesses and ability to respond to potential threats & opportunities in environment
- internal factors that have greatest effect on co's mktg planning:
- - mission
- - fin, tech, human resources
- - current distribution systems
- - product lines
- - operational efficiency
- Tools of Analysis
- SWOT Analysis
- Strengths, Weaknesses, Opportunities and Threats
- Mktg Opportunity arises when right combo of circumstances allows co to use its strenghts to take advantage
- Strategic Window - time period where optimum fit between co's distinct capabilities and key requirements of mktg opportunity
- Business Portfolio Analysis
- allows co to evaluate business units according ot their potential contribution to co
- determines units potential for:
- - generating financial resources
- - requiring financial resources
- SBU - strategic business unit
- - operated as a separate profit center
- - own seperate set/share of customers adn competitors
- - own mgmt (generally)
- - owm mktg strategy
- Marketshare/Mkt Growth matrix - Boston Consulting Group
- - Star - high mkt share, high growth mkt - becomes a cash cow when mkt growth slows
- - Cash Cow - high mkt share, low growth mkt
- primary role - provide income to cover corp overhead, pay divs, finance R&D
- - Question Mark (aka Problem Child) - low mkt share, hight growth mkt
- requires more cash than they generate
- - Dog - low mkt share, low growth mkt
- generate enough revenue to cover their own expenses
- unlikely to become stars or cash cows
- many SBUs have the following life cycle
- Question Mark -> Star -> Cash Cow -> Dog -> sold/discontinued
- Market Attractiveness/Business Strength Matrix - GE and McKinsey & Co
- created to address problems w/ mktshare/mkt growth matrix
- 9 matrix cells
- business strength - strong/average/weak (x-axis)
- mkt attractiveness - high/medium/low (y-axis)
- "A" - good investment/growth opportunity
- "B" - average opportunities
- "C" - little growth/investment potential
- mkt attractivness - composite index - uncontrollable env factors
- - market size - market growth rate
- - gov't regulation - mkt stability
- - competitive intensity - tech reqmnts
- business strength - composite index - controllable factors
- - price competitivness - product quality
- - customer loyalty - mktg skills
- - sales growth rate - relative cost advantages
- - tech and fin resources
Establishing Objectives
- objectives s/b
- - clearly stated
- - specific and measurable
- - realistic
- - actionable
- objective shoudl specify (in quantifiable terms) what is to be accomplished and time period to accomplish it
- Corp Objectives - normally 1-5 years
- Marketing Objectives
- primary - describe overall mkt response they hope to achieve in target mkt
- secondary - cover mktg functionnnnnnns needed to carry out plan
Developing Stategies and Tactical/Action Programs
- Corporate Strategies
- - intensive growth strategy - usually requires significant financial resource
- + Market Penetration - increasing sales of current products to current mkts
- + Mkt Development - increasing sales of current products to new mkts
- + Product Development - increasing sales of new/modified products to current mkts
- - diversified growth strategy - venture beyond normal business domains
- + Horizontal Diversification - intro diff products to co's current mkt
- + Concentric Diversification - new mkts, new products similar to current products or current mktg methods
- + Conglomerate Diversification - new mkts, new products that bear no relationship to curernt products
- same product related new product unrelated new product
- new mkt mkt development concentric diversification conglomerate diversification
- same mkt mkt penetration product development horizontal diversification
- - Integrated Growth Strategy - taking over another level of industry or dist channel
- + Forward Integration - control of distribution channel
- + Backward Integration - upstream (manufacturer or supplier)
- + Horizontal - competitor
- Marketing Strategies
- focus w/r to SBU's mkt share
- + Build Strategy - increase mkt share. usually S/T loss (capital outlay) for L/T gain
- most appropriate w/ relatively low mktshare in relatively high growth rate mkts
- Question Marks or "A"s
- + Hold Strategy - maintain mkt share
- Cash Cows or "B"s
- appropriate for high mkt shares in low growth mkts
- + Harvest Strategy - maximize S/T earnings and cash flow
- appropriate for weak growth potential
- weak Cash Cows, Qeustion Marks, Dogs adn "C"s
- + Withdrawal Strategy - selling/discontinuing a SBU
- appropriate for weakest growth and inv potential
- Tactical/Action Programs
- - what activites are to be performed
- - how/when/where they are to be performed
- - who is responsible for performing each activity
- - how much each activity will cost
- - type and magnitude of results expected from each activity
- - main elements of uncertainty involved
- - how results will be monitored and evaluated
- Benchmarking - identify best practices adn outcomes
- - emulate best practices to equal/surpass best outcomes
- avoids reinventing the wheel
- programs must be coordinated and integrated to be successful
- formed for each marketing area and combined to form annual mktg plan
- Setting Budgets
- tell Sr Mgmt how much and when - bottom up
- sometimes top down and funds need to be allocated. Proposed programs scaled up/down as necessary
- budgets provide feasibility info
The Marketing Plan
- written document that specifies marketing goals for a product/product line and describes strategies and implementation and control efforts co intend to use to achieve those goals
- focuses on target markets and elements of marketing mix
- Benefits
- - facilitates communications among all levels of org and among function units
- - allows mgmt to monitor consistency of actions across units
- - focuses EE on right issues
- - keeps poeple focused on overall goals
- - provides basis of performance comparison
- Elements
- - executive summary
- - situation analysis
- - mktg objectives
- - mktg strategies
- - tactical/action programs
- - budgets
- - control mechanisms
Life and Health Marketing (LOMA)
Chapter 6 - ORGANIZING, IMPLEMENTING AND CONTROLLING MARKETING ACTIVITIES
Organizing Marketing Operations
- Essential Mktg Functions
- - Information Management
- - Marketing research
- - product development and pricing
- - sales and distribution
- - advertising, sales promotion and publicity (aka Mktg Communications)
- - customer relations
- - mktg personnel development
- - mktg mgmt and admin
- Four common mktg structures: function/product/geog region/customer type
- Organization by Function
- most common
- different areas of responsibility depending on work performed
- ex. Chief Mktg Officer/Mkt Research Mgr/Sales Mgr/etc
- Advantages
- - simplicity
- - focuses on developemnt of managerial and tech skills
- works best w/ small cos or cos w/ homogenous customers
- Organization by Product
- each SBU responsible for its mktg (most of)
- may be some shared services
- Organization by Geographic Region
- usually mktg manager for each region
- usually some shared services
- Organization by Customer Type
- mktg manager for each division
- ex: households/small business/big business
- Combination Structures
- flexible - meets both co's strategic implementation needs and customer needs
- Matrix Organizational Structure
- project manager directs individuals from different function areas
- two bosses during project
Implementing Marketing Strategies
- Mktg Implementation - process of translating mktg plans and strategies into action
- accomplished through day-to-day tactical and operational activities
Controlling Marketing Activities
- marketing control - process of examing results of mktg plans and company to plan and taking actoin to keep it on track
Performance Evaluation
- performance std - internal vs external std
- - usually incorporated into mktg plan
- management by exception - mgmt only gets involved if performance outside acceptable range
- - saves time and allows attention to be focused on problems/opportunities
- if a problem, read to identify toe cause and take actions to correct
- - change tactical/action programs
- - establish new implementation method
- - new strategies
- - modify how performance data collected/analyzed
- - re-evaluate performance standards
- control tools
- sales analysis vs
- - forcasted sales - prior years sales
- - expenses to generate sales - competitors' sales
- - estimated mkt potential - current industry sales
- measured - # products, 1st yr comm, face ,avg prem, etc
- expense analysis
- natuaral accounts - ledger accounts
- functional accounts - based on purpose
- expense ratios - ex. mktg expenses/$1m face sold
- profitability analysis
- compares sales to expense incurred to generate sales
- use several years data since for line ins, 1st yr expenses > 1st yr revenues
- valuable source of info since combines sales and expense info
- mktg audit
- systematic examination and appraisal of mktg environment, objectives, startegies, tactical/action prgms, organiztional structure and personnel
- key areas of mktg audit (chart p 135)
- mktg environment
- macro environment
- task environment
- mkts adn customers
- other factors in mktg system
- mktg strategy
- business mission and mktg objectives
- mktg strategy
- budgets
- mktg organization
- formal structure
- functional efficiency
- cross-functional efficiency
- mktg systems audit
- mktg info system
- mktg planning system
- mktg control system
- new product developemnt
- mktg productivity audit
- profitability analysis
- cost-effeciveness analysis
- mktg function audit
- products
- price
- distribution
- promotion
- Reporting Sytems
- - provide managers w/ detailed summary info as needed
- - provide accurate adn timely info
- - be flexible to adjust to co's changing info needs
- - be cost effective
- - easily understood by
- + those who evaluate performance
- + those whose performance is being measured
- detail s/b appropriate for level
- lower level needs more detail
- higher level mgmt needs just summary
-
Life and Health Marketing (LOMA)
Chapter 7 - MARKET SEGMENTATION AND TARGET MARKETING
Market Segmentation
- dividing large markets into smaller markets w/ similar product/mktg mix needs
- single variable segmentation - only 1 variable to segment market
- multiVariable segmentation - uses combo of variables
- Requirements for Effective Segmentation
- - customers should have similar product needs/buying habits
- - needs/behaviours s/b distinguishable from other segments
- - potential sales/costs/profits s/b lare enough to be measured and compared to other segments
- - profit potential enough to warrant segment attention
- - customers accessible thorugh currently available means
- - size/composition s/b relatively stable over planning period
- Bases for Segmenting Consumer Markets
- Geographic Segmentation
- country/region/state/county/zip/legal boundaries/rural-suburuban/urban
- Demographic Segmentation
- age/sex.marital.household composition/income/education/occupation/family life cycle/nationality/race/etchic group/social class
- GeoDemographic Segmentation - combo of geographic adn demographic
- economic means/cultural background/perspective/neighborhood
- Psychographic Segmentation
- lifestyle/activities/interests/opinions
- Behavioristic Segmentation
- benefits sought/usage rate/buyer readiness/pref method of purchase/risk tolerance/buyer loyalty
- Demographic - commoonly used in consumer markets
- traditional life ins demographics - hi/middle/low-income households and families/boomers/seniors
- Bases for Segmenting Organizational Markets
- Organizational Mkts - group benefits and continuation of business operations
- therefore two markets, group and business
- Georgraphic Segmentation - simialr to consumar markets
- Demographic Charachteristics
- business activity/type of group-organizatoin/size of group-organization
- SIC - Std Industrial Classification - 1930
- NAICS - N. American Industry Classificatino System - by-product of NAFTA
- small groups <=100 - 80% of contracts, 25% or prem
- medium groups 101-499 - 10% of contracts, 25% of premiums
- large groups 500+ - 10% of contract, 50% of prem
- Behavioristic Segmentation
- similar to consumer markets - usage is a key
Target Marketing
- process to identify, select and focus mktg efforts
- Evaluating Potential Target Markets
- Mkt Size and Growth Potential
- majority fallacy - blind pursuit of largest, most easily identified or most accessible mkt segment
- competition makes big mkts less profitable
- should offer combo size/growth/profitability that best meets co's needs
- Mkt Attractiveness
- depends on level of compettition and buying power of consumers
- Company Goals and Resources
- only puruse targets if it has (can easily get) fin/tech/hr necessary to compete sucessfully
- Target Mktg Strategies
- Undifferentiate Mktg - mass mktg - singel mktg mix for entire mkt
- + cheaper since only one mkt strategy
- - might miss differences w/in segment
- - disadvantage to specialty marketers
- Concentrated Mktg
- for a product - focus all mktg efforts on a single segment of total mkt
- Niche Mktg - form of concentrated mktg w/ narrowly defined mkt
- - all eggs in one basket
- + can be profitable
- Differntiated Mktg
- offer differing product/mktg mixes to appeal to diff segments
- - most expensive
- + better served customers = incr customer satisfaction = incr sales
- Factors to consider when picking mktg strategy
- company resources - if limited, concentrated probably best strategy
- product variability - homogenous products - undifferentiated mktg
- Mkt Variability - if buyers have similar usage/purchase patterns - undifferentiated
- product's life cycle stage - new products - concentrated/undiffernetiated
- Consumer and Organizational Target Markets for Ins Products
- Affluent Consumers
- mass affluent - 100k -$1mil liquid assets - 99.9% of affluent mkt, 54% of total mkt assets
- high-net-worth - $1-25 mil liquid assets - 0.1% of mkt, 31.3% of assets
- ultra-high-net-worth - 0.001%, 15.1% of total mkt assets
- Single-Parent Families - need large amt ins to protect single wage earner
- Non-family Households - low need for life ins, high need for health/retirement products
- Working Women - strong potential for wide range of products
- Employer Groups - ex. negotiate trusteeship/voluntary trade assoc/MEWA
- Small Businesses - rapidly growing segment - approx 99% of businesses are small businesses
- significant market for products that
- - protect against loss due to death/dis of owner
- - preserve value/prevent liquidation due to owner/partner death
- - preserve sharelohlder equity/mgmt control due to majority shareholder death
- - protect against death tax on inherited business
- - enhance credit/fin stability by assuring business continuation
- - source of emergency funds
- - non-qual def comp to attract/retain key employees
- - EE health/life/dis ins and qual ret plans
-
Life and Health Marketing (LOMA)
Chapter 11 - PRODUCT DEVELOPMENT
Product Innovations
- Major Innovations - new prduct that meets needs not addressed before by other products
- Start-up Businesses - new product for a mkt served by a similar product
- New Prroducts for Currently Served mkts - new product for co, but product avail from other cos
- Prodcut Line Extensions - new product forms adn items to existing product line to give customers wider choice
- Product Modifications - characteristic changed ot allow competitive advantage over similar prod
- Style Changes - alter appearances or tangible aspects (ie logo change)
Product Development Process
- 5 basic steps - after first 3 steps (each one) decide continue/abandon/refine
- Product Planning/Business Analysis/Tech Design/Implementation/Monitor & Review
- Product Planning
- Idea generation
- Screening
- two potential screening errors
- - potential of a good idea underestimated and idea rejected
- - poor idea looks deceptively attractive and pursuded, wasting resources
- may use a screening critera checklist to help objectively screen
- - compatible w/ corp goals and strategic inititiatives
- - will prodcut enhance copr image
- - does a need exist in target market
- - can current prodcut be modified to meet this need
- - will product generate new sales or shift sales
- - mkt potential large enough to generate enough business to make product profitable
- - can product be mkted through existing methods
- - support a level of commissions that will motivate slaes force
- - can current systems handle the product
- - will target mkts understand the product
- - would it be more attractive if offerred thorugh a sub
- Concept Testing - measures acceptability w/o actually producing items
- - helps determine how customers would compare product ot existing products
- - what sets of benefits/attributes customers like most
- - which ideas are unacceptable in the mktplace
- - which target mkt to taimfor
- Field Advisory Council - group of agents to test new ideas on for feedback
- Comprehensive Business Analysis
- Mkt Analysis - study of environmental factors that might affect sales
- - potential value of product ot customers
- - nature adn size of target mkt
- - potential value of product to company
- - nature of products competition inthe mkt
- - customer appeal of product
- - appeal of product to distributors
- - products relationship to other products offered by co
- - potential legal/regulatory problems w/ product
- - special tax considerations
- - economic considerations
- - product/company fit
- Product Design Objectives - products basic characteristics/features/benefits/issue lmits/u/w classes/etc
- Feasibility Study - operational & technical viability of producing/offering/admin of product
- Mktg Plan - outlined in C 5
- Prelim Sales & Fin Forcasts
- If analysis indicates good potential, product proposal prepared for mgmt
- Product proposal typically details
- - product objectives - product description
- - mktg strategy - mktg fit
- - fin fit - inv fit
- - systems fit - scope of product implementation
- - legal/regulatory
- Techical Design
- writing contract/actuarial assumptions/rate structure/benefit levels/issue u/w standards
- usually several revisions utnil compromise reached
- prod dev process flow/timeline/budget assembled
- all put together and presented to management
- areas involved
- Mkts/Distributors/IS/Actuarial/Investments/Admin/Acctg/Legal-Compliance
- Implementation
- establishing admin structure adn processes necessary to take product to market
- 3 concurrent activities
- - obtain necessary legal approvals
- - design promo & training materials
- - develop IS systems/procedure to mkt & admin product
- Policy filing - dynamic process b/c state variations
- Design of Promotion and Training Materials - product naem, sales lit
- need to get approval from legal on most materials
- some might need state approvals
- Systems Activities
- IS might need to buy/develop new systems to support product
- usually takes greatest amount of time in process
- Product Introduction
- offering new product for sale and having mktg and product support in place
- Intro sales kit
- - outline of product features and how they work
- - desc adn sample of policy and fin statement insured will get each year
- - table of issue and u/w limits
- - commission scales
- - table of premium rates
- - list of possible mkts
- - sample illustrations
- - saels presentations
- - suggested sales solutions for diff mkt situations
- - samples of local and national advertising to intor product to public
- - sample pre-approach letter adn/or postcards
- - booklet about product for producer
- - brocure about product to give to prospects
- - prospectus (if req'd)
- - sample app
- - details on promo campaign
- - privace disclosures
- - instructions on how to access website for more info
- Training classes
- Incentive prizes/awards
- Sales Monitoring and Review
- review PD cycle to see if time/budget met
- review sales to see if matching forecast - if not, attempt to determin why
- check fin results to see if goals met
- Product Modification
- - s/b systematic as development for new products
- - changes might occurr because of actual sales/profit experience
- Product Withdrawal
- sometimes necessary b/c of legal regs
- sometimes end of lifecycle or unprofitable
- may meet resistance from agents
- good to have an acceptable replacement product
- review portfolio periodically to see if anything should go
Life and Health Marketing (LOMA) - Chapter 12 - PRICING: A MARKETING PERSPECTIVE
Pricing - the process of determining the amt to charge a customer for a product
Primary Factors Affecting Pricing Decisions
- Pricing Objectives - goal co wants to achieve when pricing profit
- ideally stated in writing so they can be verified against actual results
- Profit-Oriented Pricing objectives
- Profits (or contributions to surplus)
- Target return objective - specific level of profit as an objective
- often used to evaluate performance
- Sales-Oriented Pricing Objective
- Mkt share
- Types of competition-oriented pricing objectives
- - discouraging the competition
- - beating the competition
- - meeting the competition
- nonprice competition - product features, quality customer service, etc
- Cost - a big unknown since costs not known until blocksize = 0
- projected costs a big estimate
- some costs hare to split by product
- Direct Cost - directly attibutable to the product (u/w cost/comm/etc)
- Indirect Cost - not directly attributable (rent/shared services/etc)
- Fixed Cost - constant regardless of volume sold (rent/utils/prod dev/etc)
- Variable Cost - varys w/ volume (pol issue/prem tax/comm/etc)
- Demand - determines upper limit of products' price
- Price Elasticity - % change in qty demanded / % change in price
- Elastic Demand - change in price results in greater than proportional change in qty demanded
- Inelastic Demand - change in price results in less than proportional change in qty demanded
- Price elasticity depends on
- - number of substitute products available
- - need associated w/ product
- - level of expenditure req'd to purchase a product
- Customer Influences
- Purchasing Power (aka buying power) - measure ability of customer to buy goods and services
- affected by economic conditions - inflation/taxes/unemployment
- Price Consciousness - importance that customers attach to price
- Price Flexibility Desired - guaranteed price stability vs risk of higher price for chance at savings
- Competition
- - number of competitors and competing products
- - cost factors assoc w/ product and level of costs facing each competitor
- - level of fin resources avail to each competitor
- - level or resources each competitor has already commited to product
- - historic pricing behavior of each competitor
- - expected reaction of each competitor to price changes
- - each competitors overall strengths and weaknesses
- Regulatory Requirements
- need apporval for healt ins rates. Normally not for life ins
- solvency requirements
- XXX
- Other Mktg Mix Variables
- Type of promo efforst, form of distribution and product (features, benefits, levels of service, etc) aslo affect overall price
Pricing Strategies
- Cost-Driven Pricing Strategies
- establish price that will cover all costs and profit objectives
- most effective if a market leader
- might also work if
- - exclusive agent force
- - little competition
- - exclusive access to customer base (worksite)
- - fraternal
- can be problematic in competitive mkt situations
- Competition-Driven Pricing Strategies
- base price on competitors price and place in market hierarchy
- adjust conversion/renewability options, commissions to arrive at price (ie. products modified to fit price)
- Penetration Pricing - low price to build mkt share
- Flexible Pricing - negotiable price w/ each customer
- competitive bidding
- negotiated contract
- Customer-Driven Pricing Strategies
- usually focuses on compensation element of pricing
- focus on "product value"
- Psychological pricing - certain types of prices more appealing to customers
- 99.95 vs 100 or monthly vs annual
- Price Skimming - charging highest possible price that customers who most desire product will pay
- more true for tech than for fin services
- Promotional Pricing - lower (than normal) prices on certain items to stimulate all sales
- Price Leaders - low cost products to attract customers to all products at regular prices
- Loss Leaders - price leaders priced below cost
Rate Structures
- Preferred Risk Discounts - better rates for those with characteristics of loewr mortality
- Quantity Discounts - rates graded by size of policy
- banding
- policy fee system
- Gender Based Pricing - like PRD - know difference in M/F mortality
- Market-by-market pricing - different rates by jurisdiction/geor area/target market/prem taxes/mandated product features/reserve requirements
- Contingency Pricing - adjustable premiums/experience refunds
- High & Early cash value pricing - used on UL for early buildup of Cd
- intial prem rates higher to pay for this
- High and Late CV pricing - lower early prems
- discourages early surrenders w/ SC
- Indeterminate premium pricing - dual prem structure - curr and guar
Pricing Methods
- specific procedure co uses to set final price (or price structure) for a product
- cost-based/competition-based/customer-based
- Asset Share Calculation
- Asset Share - amount of assets a block will have accum at any given time
- Asset Share Calc - mathematical simulation of A/L/Surp interaction over years on a block
- Basic steps
- - establish gross prem based on estimate costs/demand and competition - starting point
- - choose conservative mort talbe and int rate to calc products reserves
- - choose more liberal mort and higher in to estimate NP req'd to pay benefits
- - choose a div assumptoin, expense rate, lapse rate nad profit margin objective for all years
- Validation period - breakeven period - time req'd for product to become profitable or begin adding to surplus
- Validation point - end of validation period
- if validation period is too long, co will abandon product or adjust assumptions
- increase GP or lower benefits/expenses
Price Evaluation
- assess
- - price's impact on co's fin performance
- - impact on performance of producers & other distributors
- - reactions of both competitors and customers
- factors to monitor
- - investment margin
- - u/w margin
- - expense margin
- - lapses (diff between actual and expected)
- - taxes (actual vs expected)
Product Line and Portfolio Pricing Considerations
- Pricing a Product Line
- rank each item from lowest to highest price and determine price of each item
- need price set to cover all product line costs
- if one item is priced low to meet competition, other need higher prices to make up diff
- Pricing a Product Portfolio
- need ot ensure all products cover all costs
- model office - whole co model - can help verify pricing is correct for entire portfolio
-
Study Notes and Published Refences - Note TSA XXXIX - PRICING IN A RETURN-ON-EQUITY ENVIRONMENT
Overview
- ROE = GAAP Income / Prior YE GAAP equity
- corp profitability measure common in ins industry
- relationship between pricing objective ROI and corp profit measure ROE
- examing relationship between ROE and after-tax ROE
- StatSurplus(t) = StatSurlus(t-1) + StatIncome(t) - Dividend(t)
- GAAPEquity(t) = GAAPEquity(t-1) + GAAPIncome - Dividend(t)
- StatIncome(t) = BookProfit(t) + i*(StatSurplus(t-1))
- DAC(t) = DAC(t-1) - (DAC(0)*g*v^(w-t+1))/(1-v^w)
- v = 1/(1+g) where g = i from DAC amort sched and w is amort period
- GAAPIncome(t) = StatIncome(t) - DAC(t-1) + DAC(t)
- ROE = GAAP Income / GAAP Equity
- example shows what happens if DAC < ROI adn i < ROI
- since i < ROI, stat income invested @ lower rate, brings down ROE below ROI
- DAC amortizes more at lower rate than ROI rate which brings down ROE in early years
- trend reverses in later years
- can fix i < ROI problem by releasing Stat Income via divs to other LOB or to stockholders
- ignoring taxes, 2 main reasons why ROI = ROE objective is prevented
- stat surplus not used to acq NB will hurt performance if surplus not earning an annual return equal to RO objective
- GAAP requires degree of conservatism.
- Eliminates use of annual ROI pricing objective as inv earnings rate in development of DAC amort sched and benefit reserve
- therefore earnings deferred to later years and result is non-leve (incr) emergence of ROE
Effect of FIT
- ROI is minimally affected by FIT
- intro of FIT dramatically changes relationship of ROI to ROE
- 1st yr ROE reduced by factor of (1-T) - since initial equity not affected by after-tax ROE
- for ROE=ROI, GAAPEquity(t) = (1-T)DAC(t) w/ DAC amortized @ ROI
- and stat surplus = 0 or reinvested @ ROI/(1-t)
- a company holding surplus, invested at rate < ROI/(1-T), en excess of that necessary to producce new business &/or producing new business cannot produce a compnay-wide after-tax ROE = ROI pricing objective
- unless it owns a block w/ an after-tax ROE > company-wide after-tax ROE objective
- This could occur
- past business priced to produce ROI > current objective and pricng assumptions met
- experience emerged more favorably than was anticipated in pricing
- past accts practices were conservative and deferred earnings
- Potential soln - price new products using ROI objective > corp after-tax ROE objective
- advantages
- if corp after-tax ROE < ROI, will meet ROE goal quicker
- in later years, renewal business ROE would = ROI which is > corp ROE goal which will offset negative effect that production of NB has on corp ROE
- if goal was to meet ROE goal in 1st year, ROI pricing objective = ROE/(1-T)
- and renew ROE > corp ROE (approaches ROI) if suplus dividended out
- GAAP won't allow ROI as amort schedule rate
- marketplace may not allow success of ins product w/ ROI that high
- non-ins industries produce returns by leveraging equity w/ debt
- stat acctg principle eliminate this option for LIC
- equity (not just current assets) needed to acq new life ins business
- need to leverage new business w/ old
- growth in ne production dictated by
- past and current acct practices
- reinvestment adn stockholder div practices
- age of existing blocks
- relative size of existing blocks vs NB
- reinvestment and stock div practices must consider degree of risk assoc w/ existing block
- stat surplus in excess of what is needed to produce NB must be maintained and amt ret depends on risk elements assoc w/ block
- therefore, get effect on after-tax ROE of maintainnig this surplus must be considered when detererming how much NB can be writeene w/in ROE constraints
- Soln: calc ROI on new products on basis of stat "reserve" = reserve + add'l amt needed as risk surplus to ensure solvency of LOB (benchmark surplus)
- ROE = ROI shoudl emerge even though sufficient assets avail to ensure solvency
Generalized Case
- conclusions drawn from examples not dependent upon specific emergence of SAP profits assumed
- by def, Sum(PVProfit_SAP) = 0 @ ROI rate
- therefore sum(PVProfit_GAAP) = 0 @ ROI rate
- if inv earning rate for GAAP = ROI and all other assumptions = pricing
- GAAP book profit each year (leveled as % prem) must = 0
- ROE = ROI regardless of emergence of SAP profits if SAP-GAAP adjustments assume inv earning rate = ROI
Special Considerations
- DEFRA mess w/ GAAP income and ROE b/c of "fresh start"
- need to be taken into consideration during corp planning process
Conclusions
- Relationship between ROI and ROE dependent on # items
- past and current Acctg practices
- past and future reinsvestment and stockholder div practices
- risk assoc w/ existing block and stat suplus req'd to insure co's future solvency
- age of existing block of business
- relative size of existing block when compared to NB to be produced.
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Study Notes and Published Refences - Note SN8I-200-00 - EXPERIENCE ASSUMPTIONS FOR INDIVIDUAL LIFE INS AND ANNUITIES
Experience Assumption Process
- Introduction
- examples of models taht use expereince assumptions
- pricing adn repricing studies
- product design studies
- determination of reserve adequacy
- financial reporting (DAC)
- financial projections or forecasts
- actuarial appraisals
- categories of experience assumptions
- cash flow view
- 3 broad categories
- obligation or liability assumptions - mort, lapse, admin exp, taxes, div and int crediting strategies
- asset assumptions - earnings rates, default, inv expenses, inv strategy
- scenario assumptions - scenario(s) being analyzed
- degree of conservatism
- best estimate or include PAD - depends on how used
- acctg rules may require w/ or w/o PADs
- acctg/regulatory rules may prescribe assumption (may or may not be conservative)
- best estimate assumptions represents actuary's judgement as to most likely outcome
- if in doubt - pick more conservative choice
- in fin reporting context - conservative assumption means w/ higher liability or smaller asset
- in pricing context - lower benfit or higher charge to customer
- PAD should consider degree assumption is at risk in total and by duration
- adjusting a PAD shoudl make result more conservative
- prescribed assumptions usually contain implied PAD
- if doesn't seem conservative, test w/ realistic assumptions
- Establishing Experience Assumptions
- steps necessary to develop assumptions
- identify assumptions req'd
- determine structure of each assumption
- analyze experience and trends in experience for each assumption
- review and adjut set of all assumptions for reasonableness, consistency, and appropriateness
- document assumptoins
- monitor experience and update assumptions
- Identify Assumptions Req'd
- depends on model - different simplifying assumptions based on model purpose
- common assumptions
- obligation (liab) assumptions
- mort/morb rates tax rates
- lapse rates incidence and level of prem payments
- expense rates reins results
- Asset Assumptions
- inv earnings rate default rates
- capital gains rates inv expenses
- Scenario Assumptions
- specified set of deterministic int rate scenarios
- stochastically generated int rate scenario
- set of possible economic scenarios
- set of sensitivity tests
- Determining Structure of Each Assumption
- can be very simple or very complex depending on model and purpose and materiality
- assumptions determined for particular experience class
- purpose of grouping - establish homogenous groups for analysis expected to generate similar experience
- experience class consists of all contracts that
- similar type (UL/Term/WL/etc)
- same structure of charges/benefits
- issued over continuous time period
- similar mktg objects
- different assumptoins might have different classifications
- experience class used for pricing shoudl remain in tact - OK to merge w/ another class, but not split
- key principles to decide on complexity of assumption structure
- differences in exp assumptions shoudl reflect differences in experience
- ok to vary mort by IA/sex/smoker/dur
- ok to vary lapse by mode of payment
- if no differences in an assumption, don't split
- definition of class s/b objective and easily understood
- # class s/b practical and cost effective
- balance between precision and expense
- Analyze Experience adn Trends in Expereince for Each Assumption
- evaluate credibility of data
- homogenity of data - ex. split out substd from std for mort
- reasonability of methods and results
- Evaluate quality of data
- understand the data and how it will be used
- possible alternate sources of data - balanced w/ practicality
- can it be obtained in a reasonable time at a reasonable cost
- appropriateness of data - recent? limitations? biases?
- reasonableness and comprehensiveness of data - internally and externally consistent
- Use Actual or similar experience
- s/b that of class of business assumption applies to, provided experience is determinalbe, available, and credible
- if actual experience not determinable, available, or credible, base assumptions on
- "similar expereince" from same company
- similar business other cos
- other sources
- in this order
- Reflect Trends in Exp as Appropriate
- evaluate trends and make judgemenet whether trends will continue
- ok to ingore trends if doing so is conservative or not permitted in regs
- Reflect Company and external Factors
- review company business practices and reflect in assumptions
- esp true if company practices changed recently or will shortly or if relying on other co data w/ diff business practices
- mort rates shoudl reflect selection criteria for each rating class
- freq of u/w exceptions, reinstatement reqs, etc
- inv assumptions shoudl be consistent w/ limits on asset type, quality, duration, convexity
- different assumptions for each segment if appropriate
- Sensitivity Test Assumptions
- test to show impact of probable deviations that could have material financial effects
- standard stat tests or historical exp for likely range
- Review & Adjust Set of all assumptions for Reasonableness, Comsistency, & Appropriateness
- generally not a single assumption but a range fo assumptions that are consistent w/ underlying data
- set of assumptoins s/b comprehensive and internally consistent
- consistency checks
- inflation assumptions for expenses consistent w/ inv earning assumptions
- mort anti-selection assumptions consistent w/ lapse assumptions
- u/w exense and mort rates consistent w/ u/w practices
- inv expenses and returns consistent w/ inv policy
- model validation chekcs
- does model produce aggregate reserves consistent w/ most recent valuation
- does model produce cahnge in reserve in future years consistent w/ past trends in actual reserves
- Document Assumptions
- Documentation of experience assumptions should cover
- what the assumption is
- data underlying the assumption
- how assumption was developed
- how to use the assumption
- Monitor Experience and Update Assumptions
- need ot be reviewed and updated on a regular basis
- just because you reviewed doesn't mean you have to change it
Mortality Assumption
- normally of form of table of rates varying by IA and duration since issue
- q(x,t) = q(y,s) if x+t = y+s adn t>n and s > n (ultimates s/b in sync)
- q(x,t) <= q(y,s) if x+t = y+s and t<s and t<= n (same AA, qx for one closer to issue)
- ANB <=> ALB - normally just average rates @ adjacent ages
- q_ALB(x) = 1/2*(q_ANB(x) + q_ANB(x+1))
- q_ANB(x) = 1/2*(q_ALB(x-1) + q_ALB(x))
- M/F smoker/nonsmoker have signficantly different mort rates and relationship si NOT a simple multiple
- other distinctions usually just expressed as a multiple or other simple mod
- credibility of data plays role in whether experssed as multiple or completely different table
- common variations in mort class
- risk selection class
- selection process - simplified/guar iss blood/no blood
- size of policy - usually lower mort for higher face
- misc - mktg method, plan type, policy provisions, other
- Analyzing Experience
- Credibility
- confidence intervals - convenient way to judge credibility of co's experience
- 95% conf interval (of expected claims) E+/-1.96(VAR^.5)
- E = expected = nq
- Var = npq (for claims)
- 95% conf interval of mort rate [E+/-1.96(VAR^.5)]/n
- Risks Covered
- normally studies done on "std" issues and exclude
- policies not subject to normal u/w stds (GIO/group conv/term conv/simpl/guar iss)
- substd policies
- policies inforce under ETI/RPU
- multple life policies
- sep studies for excluded policies
- then use a multiple or other mod to std table
- multiple life mort generally derived from single life mort assumptions
- Mortality Studies
- anniv to anniv studies and calendar year studies
- ways into study - A-inforce @ BOP and N - new entract (age x+ r)
- ways out - B - inforce EOP W - w/d (age x+s) D- death
- use Balducci assumption for dist of deaths
- q(x) = D / [A + (1-r)N - (1-s)W]
- exposure for a cell - seriatim or aggregate
- if aggregate, use mid-year assumption for entry/w/d
- 6 ways to get through study and their exposure
- (A,W) s
- (A,B) 1
- (A,D) 1 <- no deduction for deaths)
- (N,W) s-r
- (N,D) 1-r
- (N,B) 1-r
- sum up indiv exposure to get total exposure
- aggregate - exposure = 1/2[P(x,z) + P(x,z+1) + D(x,z)]
- using calendar year-end inforce data and deaths
- Other Aspects of Mortality Studies
- need to look at several years for credibility concerns
- too long a study might not be representative of recent experience
- usually 5 years of data
- usually policy count or amt (or both ) study basis
- count basis
- distorted by multiple policies by same insured
- if overall # pols in large, s/b not an issue
- amount basis
- shows financial impact
- generally preferred
- credibility not as high as count (b/c of variation in amts of ins)
- Enhancing Credibility
- grouping IA & durations together can enhance credibility
- similar to adding years to study
- grouped results smoothed
- A/E analysis can also help credibility
- Credibility of A/E Ratios
- Var(expected # claims) = sum(pq)
- 95% conf interval of claims (CIC)
- E[# claims] +/-1.96*sqrt(var(# claims))
- 95% Conf Interval of mort ratio = CIC / E[# claims]
- Var(amt claims) = sum(A(i)^2*q(i)*p(i)) where A is Amt of ins
- E[amt claims] = sum(A(i)q(i)
- conf interval - amt of claims E[amt claims]+/-1.96*sqrt(var(amt claims))
- variation in policy size can increase size of confidence interval
- Adjusting Mortality Tables for Special Situations
- some mort assumptions derived from mort tables, not developed by study
- multiple life/substd
- Term conversions
- expected mortality is higher than regular u/w polices and needs to be accounted for in pricing and other models
- include term conv in regular mortality study and have all permanent policies share extra mort cost
- include charge in term pricing for PV of cost of extra anticipated mort on perm policy
- (q_c([x]+t+s) - q_s([x+t]+s)*NAR(s) <- cost of extra mort in year s after conv
- can do sep study on converted policy mortality if enough data
- extra mort can be estimated by making assumption about degree of anti-selection
- Anti-Selection
- several situations when PO can be expected to antiselect
- when ART rate @ renewal is higher than newly u/w policy
- if healthy enough to qualify for new policy, they can be expected to do so & those that cna't will keep policies
- conservation of deaths
- A - portion of policies that lapse @ dur r to buy new policy @ x+r
- A*q(x+r,t-r) + (1-A)q_AS(x,t) = q(x,t)
- A(s) - portion of policies that lapse @ s to buy new @ x_s
- q_AS(x,t) = [q(x,t) - sum(A(s)q(x+s,t-s))] / [1 - sum(A(s))] where sum are s=1 to t
- Blending Tables
- sometimes necessary to combine two tables to get a single blended table (ie Unisex)
- usually better to blend survival table (lx) instead of mort tables (qx)
- Adjusting Similar Experience
- factors to consider if using similar experience b/c actual not credible
- quality fo co u/w relative to experience underlying other experience
- distribution channels - more antiselection in brokerage than career
- anti-selectin from excessive lapses
- u/w reqs for preferred or substd risk classes
- reins quotes on the business
- if need a table in a country where no study of insured lifes mortality exists
- also consider
- starting w/ general population mortality studies
- quality of data
- cause of death info
- abiltiy to do medical u/w
- ability to contest claims
- liklihood of wars, epidemics, or natural disasters
Lapse Assumptions
- Stucture
- generally by duration since policy issue
- may also vary by
- IA
- freq of prem payment
- policy size
- plan type (term/WL/UL/annuity)
- mktg method
- market
- for perm, 1st year usually higher than renewal
- term and annuity - often shock lapse tied to product design
- annuity - when SC expires
- term - when level prem period ends
- lapse rates often vary by scenario for CFT or option pricing b/c of different interest rates
- expressed as a formula that adjusts base rate to reflect
- delta mkt and credited rate
- size of SC
- Lapses assumed to occur on prem due dates
- "lapse skew" might be appropriate depending on distribution of business
- Analyzing Experience
- Credibility
- generally less of an issue for lapses than for mort
- generally less refined assumptions than for mort (helps w/ credibility of data)
- lapse rates generally higher (helps w/ credibility of data)
- confidence intervals - calced same as mort
- Lapse Studies
- mechanics same as mort - except lapses & deaths switch spots in calcing claims and exposures
- Factors Affecting Lapse Rates
- product design
- policy size
- dist channel - brokerage higher lapses than career due to shoping
- effectivness of company conservation programs
- if lapse rates expressed as formula that varies by int rate scenarios
- significant judgement involved in setting parameters
- sensitivity of lapse to int rate usually varys by
- product type - DAs more sensitive than trad life
- dist channel - stock broker business more sensitive than agent sold
- Types of Lapses
- usually include
- termination w/o value b/c failure to pay prems
- cash surrenders
- transfers to ETI/RPU
- others that depend on study or purpose of assumptions
- term conversions
- if term conv charges attributable to term policy, need a sep study
- if cost absorbed by new policy, count as lapse
- partial w/d - usually included in lapse rate unless product design has provision for free partial w/d
- premium persistency - actual to target/billed from flex
- termination w/o value b/c policy loan > CV
Interest Assumptions
- Structure
- deterministic models generally use one of two appraoches
- portfolio avg
- Inv generation method (IYM)
- for IYM
- fixed prem policies grouped by issue year
- flex prem polices group prems by mo rec'd
- nv income assumptions generally net (after expenses & defaults)
- Policy loans can be asset CF or liab CF
- for deterministic models - generally aggregated w/ other investments
- therefore also need assumptions for
- policy loan int rate
- policy loan expenses
- policy loan utilization rate
- if model has multiple int rate scenarios, policy loans generally modeled as liab CF w/ utilization rate that varys by scenario
- how many?
- specified by client/regulation?
- generated by stochastic model
- # scenarios depends on relative importance of asset risk and practical concerns (such as model runtime)
- for each scenario, int rates can vary by
- time
- asset class
- asset quality
- credit risk
- Inv returns can be measured on a book ro mkt value basis
- also need assumptions for
- mix of existing assets by asset class and maturity
- reinvestment and disinvestment strategy
- Analyzing Experience
- int rate determined as inv income from block / avg assets in block
- for "new money" rate - usually some benchmark rate + spread
- total returns on a mkt value basis - needs to realized and unrealized g/l
- r = (B-A-C)/(A+C/2) - C is net cash flows, A&B - mkt values
- mutual funds often calc daily and if assume that all CF @ end of day
- if evaluating rates of return over time
- time-weighted return - geometric mean of rates of return
- dollar-weighted return - level rate of return earned taking into acct timing of CF
Expense Assumptions
- Structure
- generally split between direct (aka marginal) expenses and indirect expenses
- certain expenses can be direct or indirect depending on model and purpose of model
- also split between acq, maint and overhead
- Analyzing Experience
- Units
- unit expense assumption = expenses / # untis
- experience study looks @ expenses by calendar year
- pricing
- policy year expenses
- usually charge expenses @ either BOY, EOY or midYear
- need appropriate unit count based on when expense is charged
- expenses charged BOY -> count = (A+B+N)/2
- Expense ALlocation
- important to understanc how co allocates expenses to LOB
- some expenses clearly associated w/ particular product or LOB
- other not so clearly - several methods to allocate
- first need to split total expenses into major components
- once categorized, allocate
- transaction or item counts
- transfer costs
- employee time allocations
- indexed based allocations (allocated by policy count or prems)
- Projecting Expenses
- future unit expenses depend on estimating of total level of expenses an dcount on which unit expenses based
- projection shoudl reflect
- historic trends
- expected future volumes of business
- expected inflation rates
- how expenses vary w/ changes in business volume (fixed/varaible/step rate)
- impact of any planned business changes
Study Notes and Published Refences - Note SN 8I-201-00 - GROSS PREMIUMS FOR DISABILITY WAIVER BENEFITS
Introduction
- insurers limit coverage at older ages
- dis rates increase dramatically at older ages
- hard to tell between dis and normal ret at older ages
- Calc of PV of benefits is a 2-step process
- benefit provided at point of where dis occurs must be calced
- benefit is a disabled life annuity = PV waived prems using int and rates of termination of dis
- PV @ issue of each benefit is calces using int, active life mort and rates of dis
- calced at each point dis can occur and summed
- calc of actual gross prem can be simplified by loading published valn net prem
- loading determined by fitting adjusted experience prems to valn net prems
Assumptions for Experience Premiums
- Prems Waived
- prems used in benefit calc s/b net cost to insurer of prems actually waived
- consider
- commissions paid on waived prems
- prem taxes not paid on waived prems
- if offered, sex-distinct prems s/b used
- if prems vary by size of policy, either
- avg size s/b used or
- sep prems calced for each band
- YRT - S&U - simplified by calcing single AA table based on ultimates
- Term Conversions - should use permanent plan's premium in calc
- if prems vary by s/ns - blended rates or sep prems
- Interest
- significant impact b/c long dur benefit
- conservative LT rate s/b used
- Expenses
- cost of initial and ongoing claims investigation
- acctg for waived prems
- reserving for coverage
- command prem tax on premium for benefit
- some cos charge share of overhead
- Active Life Mortality
- used to determine survivorship for non-disabled lives for
- PV (@ issue) of benefits
- annuities used to calc net ann prem
- use same experience assumption used for pricing base coverage
- table of commutation functions D([x]+k) = v^(x+k)*l([x]+k)
- Lapse Rates
- conservative to assume no lapses
- use base contract rates if using any
- Morbidity
- Rates of Disablement - measure chance of life aged (x) becoming disabled at age (x+k) (and remaining alive and disabled to end of waiting period)
- probability of disablement - r(x+k)
- absolute annual rate of disablement - r'(x+k)
- Rates of Termination of Disability
- needed to calc dis life annuity values
- measure probability of leaving the group of disabled lives (from recovery or death)
- highly select by duration since disablement
- usually monthly for first 2 years
- very few people beyond retirement age recover from disabled status
- Termination rates used to construct table for dis lives
- l_i([x+k]+m/12+s)
- k+1 - year disablement occurs
- m - months in waiting period
- s - duratoin since end of waiting period
- D_i([x+k]+m/12+s) = v^(x+k+m/12+s)*l_i([x+k]+m/12+s)
Experience Premium Formulas
- Assume
- disabilities occur mid policy year
- prem and benefit payments payable continuously throughout policy year
- waiting period is 6 months
- B(k+1) - benefit provided if dis occurs in year k+1
- P(k) - prem/14m payable during k+1
- u = age wvr benefits end
- h - prem paying period of base plan
- n - cvoerage period for waiver provisoin = min(h,u-x)
- h' - prem paying period for waiver provision
- B(k+1) = sum(P(k+s+1)*(D_bar_i([x+k+1/2]+1/2+s) / D([x+k+1/2]+1/2))) from s=0 to n-k-2
- if P is level = P*abar_i([x+k+1/2]+1/2:n-k-1|)
- if coverage retroactive, B(k+1) increased by half prem payable in k+1 (0.5*P(k))
- PVB = B(k+1)*v^(x+k+1)*l([x]+k+1/2*r'(x+k) / D([x])
- = B(k+1)*v^(1/2)*r'(x+k)*D([x]+k+1/2) / D([x])
- NWSP = sum(PVB) from k = 0 to n-1 -> net waiver single premium
- NAWP = NWSP / active life annuity
- = sum(B(k+1)*v^(1/2)*r'(x+k)*D([x]+k+1/2)) / sum(D_bar([x]+k)) for (numerator) k = 0 to n-1 and (den) k=0 to h'-1
- To load for expenses
- E_wp(pi) - exp prem, loaded for expenses
- B'(k+1) - expense loaded benefit if dis in k+1
- c(k) = active life % prem expense in k+1
- e(i) - active life per pol expense in k+1
- c_i(s+1) - dis life % benefit expenses paying in dis year s+1
- e_i(s+1) - dis life per pol expense in s+1
- assuming per pol expenses paid @ BOY and % expenses paid continuously
- B'(k+1) = .5*P(k) + sum{[P(k+s+1)*(1+c_i(s+1)) + e_i(s+1)]*[D_bar_i([x+k+1/2]+1/2+s)/D_bar_i([x+k+1/2])]} for s = 0 to n-k-2
- E_wp(pi) = sum{[e(k)*D([x]+k) + B'(k+1)*v^(1/2)*r'(x+k)*D([x]+k+1/2)]} / sum{(1-c(k))*D_bar([x]+k)} for (num) k=0 to n-1 and (den) k=0 to h'-1
Special Considerations
- substandard risks
- waiver usually restricted to least substd risks
- waiver prems usually multiples of std business wvr prems
- Payor Benefit
- waives premiums if payor of juvenile policy is death/dis until juv attaines 21/25
- prems depend on age of applicant, plan of ins, age of insured
- gross prems usually published at table of factors
- Riders on Insured Spouse or Children
- waives rider prems
- based on base insured, not spouse or children
- Non-traditional Products
- indeterminate prem products
- using guar prems in calc is conservative
- use judgement re: most likely scale of prems to be charged and use in calcs
- UL
- waiver of coi
- specified amt - use specified amt in formulas and is aount req'd to keep contract in force if all guarantees realized
- does not have any relationship to prms actually paid into contract
- either case, use same formulas, just different P(k) stream
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Study Notes and Published Refences - Note SN 8I-202-00 - VARIABLE ANNUITY MINIMUM DEATH BENEFITS - A MONTE CARLO PRICING APPROACH
Overview
- generous min DB designs, harder to understand risks in providing MGDB
- benefit costs little (if anything) usually
- could be very costly in certain events
- Monte Carlo approach
- large # scenarios b/c > 1/2 trials result in 0 or minimal cost
- but very long tail (sd > mean typically)
- results similar (but slightly higher) than B-S approach
- first tests using 3.75% base return assumption
- historical returns consistenly above that.
- author uses 8% remainder of note
- cost of MGDB drops drastically as assumed yield increases
- base return assumption is a CRITICAL ASSUMPTION
- distribution has large kurtosis
- large number of outliers
- sd > mean demonstrated volatility of results
Pricing
- approach pricing through an asset charge
- problem - charge collected over longer time frame than claims
- creates reserving problem and insurer exposed to lapse risk
- one approach - study point in each scenario where insurer is in worst position
- if distribution of results is unsatisfactory, try again w/ higher/lower asset charge
Enhanced DB Definitions
- enhanced DB provisions included in many contracts
- "Ratchet 5 to 70" increases (never decreases) min DB on every 5th anniv to then current policy value (if it is higher than prior min db)
- no increases after age 70
- "Increase 5% to 200%" - prems accumulated at 5% subject to 200% max, no age limit
- "combined to age 70" - combines ratcheted formula w/ int formulat - greatere DB under either formula, but no increases after 70
- enhanced formulas add signficantly to cost
Ratcheting Frequency
- resets are most important cost factor
- frequency of reset also significant cost factor
Summary - Volatile Results
- actual costs highly sensitive to
- base underlying yield assumption
- issue age
- mkt volatility
- lapse rate
- benfit provisions
Evaluation of Methodology
- B-S easily produces sensible, quick calcs of values for min DB for simpler cases
- complex for ratcheted formulas
- Monte Carlo - requires many trials, but easy enough w/ current spreadsheets
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Study Notes and Published Refences - Note SN 8I-204-01 - REPORT OF THE SOA TASKFORCE ON PREFERRED U/W
Overview
- based on 10 year term (level prem)
- generally experienced more insureds qualifying for pref non-smoker risk class than expected
- less qualifying for pref smoker than expected
- not takes generally lowest for most restrictive pref ns and highest for least restrictive std smoker
- most freq used risk criteria
- personal history
- diabetes
- heart disease
- cancer
- elevated cholesterol
- Lifestyle criteria
- alcohol and other substance abuse
- some allow exceptoins to pref risk criteria
- blood pressure and build
- family history
- slight variations in one criteria
- cholesterol level
- majority of respondents use captive or independent agents to sell pref risk products
Background
- pref risk class - risk class w/ better expected mortality from gruop of non-substd applicants
- std class - residual non-substd applicants
- pref risk class if very varied, even w/in same co
- varys between products and even generations of same product
- established by splitting an aggregate risk class into two or more risk classes
- common formulas
- q_pref = (1-discount)*q_agg
- q_std = [q_agg - q_pref*%qualifying]/[1 - %qualifying]
- two critical assumptions - based on pref u/w criteria chosen
- what discount to give to pref u/w class
- consider
- agg mort used
- screening tools used
- strictness and level of criteria used to qualify for pref risk class
- co's practices on u/w exceptions
- % of applicants desired to qualify for pref risk class
- stricter u/w -> better discount
- usually 10-20% range
- % expected to qualify
- normally cos determine this and adjust u/w criteria to make it happen
- the lower the assumption, the more aggessive the discount can be
- more applicant & producer dissatisfaction w/ lower assumption
- additional pressure on U/W to make exceptions
- possibly higher than expected not-taken rate
- important for actuarial/u/w/mktg to be involved and understand
- # applicant for pref class (initially) may be higher than expected b/c producers tent to bring better risks forward
- % placed in pref class initially exceeds expectations as well for same reason and higher not-takens
- other reasons for getting disproportionate share of pref or std risk class
- producer's client base
- specific criterion much different from what other cos use
- u/w concessions
- unreasonable initial expectations
- Why have new risk classed developed
- legitimate descrimination
- equity considerations
- mktg tool <- main reason
- most often developed for competitive reasons and/or defensive purposes
Results
- Risk Classes
- trend toward using more pref risk classes
- Percentage Expected to Qualify adn Percentage Actually Issued by Risk Class
- on avg, more policies issued in most restricive NS class than originally expected to qualify
- slightly less policies in most restrictive smoker class than originally expected to qualify
- if actual results appreciably different from expected, maybe investigate reasons
- possible explanations:
- agent selection
- improper initial assumptions
- u/w exceptions which allow more issues in pref risk class
- not takens in std risk class (which distorts the % placed in pref risk class)
- Not Taken Rates
- most restrictive NS (5%) < agg smokers < most ristrictive smoker < least restrictive NS < least restrictive smoker (24%)
- applicants dissatisfied w/ risk class may look elsewhere for better rating
- Expected Mortality
- in general, pref risks had decreased expected from prev study
- possible reasons
- tighter pref u/w
- shift from NS to NT
- better than expected early dur experience
- competitive mkt pressures
- Ratio of Std To Pref Mort
- Max IA and Min Face Amt Limits
- usually around 70/75 for pref class
- min face usually 100,000 for pref class
- Age and Face Amt for U/W req
- features that influence what reqs used
- company's mkt
- distribution system
- specific criteria that must be met to qualify on a pref risk class basis
- mortality expectations
- competitive environment
- u/w philosophy and expertise
- other fin objectives
- Common Reqs
- Blood Profile $100k+ sometimes lower over 20 tests
- DBS infrequent
- Oral Fluid (OFT) infrequent can test for HIV, continine and cocaine
- Urine $100k+ usually in combo w/ blood - tests fro continine, cocaine, diabetes, kidney probs
- Cotinine $100k+ as part of urine or OFT
- Cocaine $100k+ as part of urine of OFT
- Illegal drugs infrequent
- NonMed <$100k limits increasing w/ PHI, MVR adn agent collected fluids
- ParaMed $100k+ & older ages
- Medical $500k+ & older ages
- APS older ages adn $500k
- MVR about half $100k+
- ECG older ages
- PSA about half older ages
- HIV $100k and about half < 100k
- Collection of Fluids
- considerations when using other than paramed or med to collect
- legal liability
- chain of custody considerations
- confidence in quality of test results
- producer/consumer reaction
- must weigh cost savings against these issues
- Indicators Being Used as Preferred Risk Criteria
- Three broad categories of application info
- personal history
- family history
- lifestyle considerations
- some important info is verified independently from app
- sometimes favorable info could offset unfavorable
- personal history considered more important than family history
- personal history and lifestyle most freq used criteria
- Personal History
- except for cholesterol, at least half cos preclude applicant from qualifying for pref risk class for bad info on personal history
- diabetes/heart disease/high cholesterol/non-skin cancer/stroke/hypertension/melanoma/treatment for hypertension/mental-nervous/non-melanoma skin cancer/treatment for cholesterol/prescription drugs
- Family History
- heart disease/cancer/stroke/diabetes/hypertension/non-accidental early death
- heart disease is only family history that is an automatic preclude - approx 1/2 cos
- most base family history on occurence of death, not diag
- other factors
- whether natural parents or natural parents & siblings included
- # incidences of death or diagnosis allowed
- age limit for incident of death or diag
- offsetting family history w/ good applicant health or neg stress test in last year
- using gender specific cancers only
- Lifestyle
- MVR and body fluids verify lifestyle items
- if declined, will reconsider after they discontinue adverse activity for period of time
- alcohol abuse/illegal drugs/driving/DUI/aviatoin/avocation/hazardous sports/other tobacco/cigarettes/occupation/foreign residence/foreign travel/felony conviction/regular excercise
- all but exercise used regularly
- drug and alcohol abuse were automatic out
- Driving Record and DUI
- normally no more than 2 or 3 moving violations in 3 year peroid
- no DUI w/in last 3-5 years
- Cigarette and other tobacco use
- usually no usage in last 12-36 mo
- Differences in Criteria by Smoking Status
- rarely - blood pressure, build & cholesterol
- Diff in criteria by gender
- Other criteria use to Determine Pref
- Ranges of Criteria in Use (to qualify for Pref)
- total cholesterol - usually around 250 (220/240/250)
- Total Cholesterol/HDL-C ratio - 5.0/5.5/6.0
- GGT (tests for liver damage) - 65 units/liter
- SGOT (myocardial infarction/hepatitis) - 40/41 units/ml
- SGPT (liver enzyme - hepatitis) - 45 units/ml
- PSA (prostate) - 4.0 ng/ml
- Preclusion from Pref Risk Class due to lab test result
- approx 2/3 based on Tot-C/HDL-C
- < 1/2 on other criteria
- Blood Pressure
- considered a coronary risk factor - 140/90 as max untreated BP
- about 1/3 preclude individuals w/ treated hypertension
- remaining allow treated BP in range
- Height and Weight
- approx 1/2 do not automatically exclude if out of range
- Debits
- ome co's don't allow credits for pref u/w, some do
- max debits usually <= 25 (after credits)
- most <= 50 before credits
- U/W guidelines for Exceptions
- approx 1/4 ahve written guidelines for exceptions
- virtually all cos allow u/w judgement to pref qualification
- Exceptoins to Pref Criteria
- most allow exception if overall risk profile would still qualify for pref risk class
- Additional Comments
- one co has agent "IOUs" baed on production
- can be redeemed to reduce prem rating by up to 2 tables
- Dist Channels
- must used indepenant agents and captive agents
- about half use multiple dist channels
- Effect of Introduction of Pref Risk Class
- approx 2/3 saw increased production
- caveat - toher factors couls also affect sales
- Illustration Restrictions on Pref Risk Classes
- virtually all allow best class to be illustrated
- some discourage illustrating initially
- other allow, but must also illustrate on std class at same time
- some require field u/w assessment before allowing pref illustration
- Application for Pref Risk Class
- approx 10% require applicant to apply for best class to receive it
- Pref Risk Classes on OTher Products
- most cos w/ pref class have it on products in addition to 10yr Term
- Review of Pref Risk Criteria
- how often to review
- approx 1/2 review at least annually
- Future Changes in Pref Criteria
- approx 15% had plans to change pref criteria
- > 1/2 no plans
- rest didn't know
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Copyright © 2004 Steve Welander.
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