Ch18: Models (1)

Question 1

The requirements of a good model

Answer 1

VARIABLE CRISPS CARD
1. valid
2. adequately documented
3. rigorous enough for its purpose. produces realistic results under a wide range of scenarios
4. input parameters values appropriate and include all necessary inputs to reflect the features of the product
5. assumptions reasonable
6. behavior reasonable
7. length/expense of run not too long/high
8. easy to understand
9. communicable workings and output
10. reflects risk profile of financial products, schemes or contracts being modelled
11. independent verification of outputs
12. sensible joint behaviour of variables
13. parameters allow for all significant features
14. simple but retain key features
15. clear results
16. a range of implementation methods
17. refinable and developable
18. dynamics between assets and liabilities

Question 2

What factors would affect the number of model points chosen?

Answer 2

• the availability and power of computers
• the variability of contracts sold
• the complexity of the contracts in force
• the age of the company
• whether the model is stochastic or deterministic
• the importance of the investigation
• the time available
• the sensitivity of results to using fewer model points

Question 3

Four types of life insurance models

Answer 3

1. single policy profit test model
2. new business model
3. existing business model
4. full model office

Question 4

Single policy profit test model

Answer 4

• This projects the expected cash and profit flows arising from a single policy from the date of issue.
• It is a key model for pricing and product design

Question 5

New business model

Answer 5

• Projects all the expected cash and profit flows arising from future sales of new business
• useful for assessing future capital requirements for the new business and overall capital return achieved from future sales

Question 6

Existing business model

Answer 6

• this is a cash and profit flow projection from all the existing business a company has in force at a particular time
• important means of assessing intrinsic value of existing business (EV) and testing for solvency of the company’s existing business

Question 7

Full model office

Answer 7

• important in assessing the impact of future management decisions, of all kind, on the future financial development of the company

Question 8

Advantages of stochastic

Answer 8

• can cost guarantees and options
• shows likely distribution of outcomes, not just a single estimate
• the interaction between the variables can be explicitly included
• can estimate probabilities
• can indicate the effect of random fluctuation on risk
• can identify potentially high-risk future scenarios

Question 9

Disadvantages of stochastic

Answer 9

• time and computing constraints
• the sensitivity of the results to the deterministically chosen assumed values of the parameters involved

Question 10

When would deterministic be suitable?

Answer 10

• when sensitivity testing, in order to get an approximation to a stochastic result
• when the result obtained would be very similar to a stochastically produced result
• as a check on a stochastic model

Question 11

Different approaches to setting economic assumptions

Answer 11

• risk neutral (market-consistent) calibration
• real world calibration

Question 12

Risk neutral calibration

Answer 12

Focus is to replicate the market prices of actual financial instruments as closely as possible, using an adjusted probability measure

Typically used where there are options or guarantees

Question 13

Real world calibration

Answer 13

• typically used for projecting into the future
• e.g. calculating the appropriate level of capital to hold to ensure solvency under extreme adverse future scenarios at a given confidence level
• focus of this calibration is to use assumptions which reflect realistic long-term expectations and which reflect real world probabilities and outcomes

Question 14

Describe the key factors that influence the adequacy of an actuarial model, used for projecting cashflows to assess the profitability of a life insurance contract

Answer 14

pg.568
- output
- timing of cashflows
- parameters
- parameter values
- model points
- cashflows
- statutory reserves and solvency capital requirements
- interactions
- if stochastic, assumed distributions for random variables needs to be realistic

Question 15

Needs for models

Answer 15

1. product pricing
2. assessing return on capital
3. assessing capital requirements
4. assessing profitability of existing business
5. developing an appropriate investment strategy
6. projecting future supervisory solvency position
7. any other work involving financial projections

Question 16

Other pricing considerations

Answer 16

Price must also be considered for:
- marketability
- whether company has sufficient capital to finance expected sales
- whether the return on capital for the business as a whole is satisfactory

• model office and new business model can be used to assess the last two points