Chapter 18 - Models (1)

Question 1

Outline the operational issues that need to be considered when designing and constructing a model

Answer 1

SCARCER FILES

Simple, but retains key features
Clear results
Adequately documented
Range of implementation methods should be available to facilitate testing
Communicable workings and output
Easy to understand
Refineable and developable

Frequency of cashflows (balance accuracy vs practicality)
Independent verification of outputs
Length of run not too long
Expense not too high
Sensible joint behavior of variables

Question 2

What are model points? Why are they used? How may they be chosen?

Answer 2

A model point is a representative single policy

The business being modelled may comprise a very large number of different policies and it may be too time consuming to run all of these through a model.

So, policies are classified into relatively homogeneous groups.

A model point for each group is chosen that is representative of the whole group.

The model point is run through the model and the output is then scaled up by the number of policies in the group to give the results of the whole group.

For pricing purposes, model points are chosen to reflect the expected profile of future business to be sold. This could be based on the existing profile, or that of a similar product.

Question 3

In what ways does political commitment affect LTCI business

Answer 3

The government can strongly influence future take-up of LTCI policies by its influence on what alternatives (to such private funding) are provided by the State.

Question 4

Why would you expect it to be difficult to estimate sales volumes for income protection business

Answer 4

• Sales are dependent on both economic and political factors, whose impact is always difficult to predict
• Most markets are quite significantly under-insured
• These are protection products, and so will be subjected to quite keen competition
• There is potential for mis-handling claims, which could have important repercussions on company reputation

Question 5

What factors would influence the number of model points chosen

Answer 5

CASITAS V

• The COMPLEXITY of the contracts in force
• The AVAILABILITY and power of computers
• whether the model is STOCHASTIC or deterministic
• the IMPORTANCE of the investigation
• the TIME available
• the AGE of the company
• the SENSITIVITY of the results to using more or fewer model points
• the VARIABILITY of contracts sold

Question 6

Does the cashflows need to allow for interactions when assets and liabilities are modelled together

Answer 6

yes

Question 7

What are the desirable features of the stochastic model compared to the deterministic approach

Answer 7

• The method allows a probability distribution to be assigned to one or more of the unknown future parameters
• A positive liability can be calculated where a deterministic approach might otherwise produce a zero liability, eg where the cashflow includes a minimum guaranteed benefit
• The future parameters may be assumed to vary together as a dynamic set, which is particularly useful for modelling with-profits business

Deterministic:
- Quicker, cheaper and easier to design, build and run
- Clearer what scenarios have been tested
- Results are easier to explain to a non-technical audience

Stochastic:
GATE I

• Good at identifying extreme outcomes, which may not have been thought of under a deterministic scenario
• Allows naturally for the uncertainty of outcomes
• Test a wider range of scenarios
• Enable better modelling of the correlations between variables
• Important in assessing the impact of financial guarantees

Question 8

What are the disadvantages of Stochastic modelling

Answer 8

• Time and computing constraints
• The sensitivity of the results to the (deterministically chosen) assumed values of the parameters involved

Question 9

What are the different calibration of stochastic models

Answer 9

Risk neutral - The focus of these calibrations is to replicate the market prices of actual financial instruments as closely as possible, using an adjusted (risk neutral) probability measure

Real world calibration - Typically used for projecting into the future. The focus of these calibrations is to use assumptions which reflect realistic ‘long-term’ expectations and which consequently also reflect observable ‘real world’ probabilities and outcomes

Question 10

What are the 4 main types of models defined by the business they are modelling

Answer 10

• Single policy profit test model - Projects the expected cash and profit flows from a single policy from the date of issue
• New business model - This projects all the expected cash and profit flows arising from future sales of new business
• Existing business model - Projects all expected cash and profit flows arising from existing business at a particular time
• Full model office - The sum of new business model and the existing business model

Question 11

How to check the output from the model against data that are independent of the model

Answer 11

• To reconcile results with those of the last supervisory valuation
• To reconcile with the results from the last time the model was run
• To perform simple ratio checks on future years’ results

Question 12

Why would you expect it to be difficult to estimate sales volumes for income protection business?

Answer 12

• Sales are dependent on both economic and political factors, whose impact is difficult to predict
• Most markets are quite significantly under-insured, which means that there is plenty of potential for getting the sales assumptions wrong
• These are protection products, and so will be subject to quite keen competition, especially if trying to sell to a reluctant public
• There is a potential for mis-handling claims, which could have important repercussions on the company’s reputation

Question 13

The time period for calculating the cashflows in the projection needs to be chosen bearing in mind?

Answer 13

• The more frequent the cashflows are calculated the more reliable the output from the model
• The less frequently the cashflows are calculated the faster the model can be run and results obtained

Question 14

Which ways could a model be inaccurate?

Answer 14

MICRO MIND PUP PPB
- Misinterpretation of results by management because not communicated clearly
- model points based on INCORRECT data
- know imminent CHANGES not allowed for
- RISK discount rate does not make adequate allowance for cashflow variance
- policy OPTIONS ignored
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- MODEL points badly selected
- INTERACTION of inter-dependent variables not correctly dynamic
- NEW business assumptions wildly optimistic
- DETERMINISTIC approach where stochastic approach required
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- incorrect PROGRAMMING of product structure
- UNIT of time within model too big
- some PRODUCTS not modelled
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- PERIOD of projection too short
- incorrect PARAMETER choice
- miscellaneous software BUGS