Chapter 23: Contract Design

Question 1

List 18 factors to consider when designing or redesigning a contract

Answer 1

AMPLE DIRECT FACTORS

Administration systems
 Marketability
Profitability
Level and form of benefits
Early leavers benefits

Discretionary benefits
Interests and needs of customers
Risk appetite of the parties involved
Expenses vs charges
Competition
Terms and conditions of the contract

Financing (capital requirements)
Accounting implications
Consistency with other products
Timing of contributions or premiums
Options and guarantees
Regulatory requirements
Subsidies (cross-)

Question 2

List the 7 key parties involved in contract design

Answer 2

ALPACAS

Actuaries
Lawyers
Providers of benefits
Accountants
Customers
Administrators
Shareholders / financial backers

Question 3

List the factors influencing the needs of the provider

Answer 3

1. The chosen market
2. The capital available
3. The expertise available

Question 4

List the factors influencing the needs of the customer

Answer 4

1. The capacity to pay
2. The risks they need to be covered
3. The benefits that are needed at different times in the future
4. Attitude to financial risk

Question 5

Give examples of how a contract can be designed to cater for different risk appetites amongst customers

Answer 5

1. Different investment funds , e.g. low, medium and high risk
2. Different levels of cover, e.g. comprehensive vs third party

Question 6

Give examples of how the regulatory environment may influence the design of a product

Answer 6

Products must meet legal or regulatory requirements, if any.

Products can be designed to benefit from favorable financial or taxation regimes.

Products should be designed to ensure that initial expense can be recouped if a policy is cancelled within any regulatory ‘cooling-off’ period.

Regulation may require information to be disclosed to potential customers, for example discontinuance terms.

Question 7

Give examples of contract design features that make a contract more marketable

Answer 7

1. Guarantees, options and choices
2. A competitive (low) price
3. Transparency and simple to understand
4. Features that distinguish it from the competitors

Question 8

Give examples of options relating to:
premiums,
benefits,
the use of contract proceeds
and any other options that might be offered as part of a contract design

Answer 8

1. Premium options:
   - waiver of premium

• option to increase / decrease premium
• option to choose / change premium frequency

2. Benefit options:
   - discontinuance
   - early or late or ill-health retirement
   - spouse’s benefits
   - rider benefits
   - option to protect a no-claims discount
3. Use of the contract proceeds:
   - choice of annuity provider
   - choice of hospital under health insurance
4. Other options:
   - option to renew / convert a term assurance without further underwriting

Question 9

List examples of guarantees that might be offered as part of a contract design

Answer 9

1. Guaranteed benefits
2. Guaranteed minimum maturity value
3. Guaranteed minimum growth rate
4. Guaranteed annuity rates
5. Guaranteed premiums
6. Guaranteed charges

Question 10

What is the underlying principle to consider in setting discontinuance terms for an insurance company or benefit scheme?

Answer 10

FAIRNESS between:

• the policyholder or member who is leaving
• the remaining policyholders or members
• the provider of the benefits

Question 11

Surrender

Answer 11

The policy stops, there is no further cover and the policyholder receives a lump sum payment (the surrender value)

Question 12

Lapse

Answer 12

The policy stops, there is no further cover and usually no payment is made to the policyholder by the insurance company

Question 13

Paid-up

Answer 13

The policyholder ceases to pay premiums but the policy continues to offer the policyholder some cover.

In this case the benefit is reduced to reflect that there are no more premiums and is called the paid-up value.

Question 14

Withdrawal

Answer 14

This normally encompasses surrender and lapse, as the policy does not stay in force.

Question 15

How does an insurance company decide on which contracts to offer discontinuance terms?

Answer 15

It will look at:
- market practice

• regulatory requirements
• anti-selection risk
• the difficulty and cost of assessing and implementing suitable terms

The insurer may also consider past practice.

Question 16

Factors to consider when determining discontinuance terms

Answer 16

Fairness, hence the starting point will be the ‘asset share’ of the contract (a current value determined retrospectively from the accumulation of net cashflows)

Other factors include:

• PRE
• New business disclosure and any subsequent communications
• competition
• regulation / legislation affecting discontinuance terms
• administration expenses of determining and implementing the terms
• ease of calculation and frequency of change of terms

Question 17

Main factors to consider in determining suitable discontinuance terms for an individual leaving a benefit scheme

Answer 17

1. Fairness between the leaving member and those staying
2. Whether the member want to stay in the scheme as a deferred member or take a transfer value to another scheme
3. The scheme’s funding level at the point of discontinuance
4. Regulation / legislation affecting discontinuance terms
5. Administration expenses of determining and implementing the terms
6. Ease of calculation and frequency of change if terms

Question 18

Define ‘new business strain’

Answer 18

New business strain is the shortfall that occurs when a contract is written.

It occurs when the initial expenses, the provisions and any solvency capital exceed the premium received.

New business strain results in a capital requirement (to finance the shortfall)

Question 19

List ways in which a contract could be designed in order to reduce new business strain

Answer 19

1. Avoid options and guarantees
2. Match charges with expenses, and keep charges variable.
3. Low initial expenses / commission
4. Offer contracts with low statutory provisioning requirements.
5. Use single premiums rather than regular premiums

Question 20

List four methods of financing benefits

Answer 20

1. Pay as you go
2. Funding all the benefits in advance
3. Regular payments building up a fund
4. Paying an amount when the benefit event happens, for example purchasing an annuity at the point of retirement

Question 21

Outline the main administrative considerations that relate to contract design

Answer 21

These include:
1. whether to outsource the administration or perform it in-house
2. whether existing systems can carry out the functions that have been built into the product design
3. the need to produce a new or updated product literature
4. the cost of making systems and admin process changes
5. whether some of the changes can be deferred because they are not required at short policy durations - whilst bearing in mind the potential difficulty of scheduling these changes for a later time

Question 22

List 8 items that the expense charges of an insurance company would be expected to cover

Answer 22

COST RAID

Commission
Overheads
Sales / advertising
Terminal, e.g. paying benefits

Renewal administration ,e.g. collecting premiums
Asset management
Initial administration
Design of the contract

Question 23

Explain the significance of cross-subsidies within a class of business in relation to contract design

Answer 23

Cross-subsidies occur when certain policies contribute more to profit and overheads than other policies.

Where there are cross subsidies, the mix of business written becomes important!

If the actual mix is different to the expected mix, then profits may be higher / lower than expected

Question 24

Give examples of conflicts between contract design factors

Answer 24

1. Profitability vs competitiveness
2. Avoiding cross-subsidies vs simplicity of administration
3. Offering options and guarantees vs minimizing risk
4. Offering options and guarantees vs financing requirements
5. Offering options and guarantees vs simplicity of administration
6. Marketability vs strict terms and conditions

Question 25

Stakeholders involved in contract design: | - Actuaries

Answer 25

Actuarial will be involved in - the INITIAL COSTING of the financial structures - the subsequent determination of the PROVISIONS that will need to be held to meet future liabilities. - the DESIGN through assessing the impact of both the cost and reserving implications on modifications to the benefit design.

Question 26

Stakeholders involved in contract design: | - Lawyers

Answer 26

Involved in DRAFTING THE CONTRACTS supporting the financial structures to ensure that the provider is not exposed to the risk of .... providing more benefits .... or entering into greater risks than intended.

Question 27

Stakeholders involved in contract design: | - Accountants

Answer 27

Involved in ensuring that the provider of the financial structures PROPERLY ACCOUNTS for their income and outgo.

Question 28

Stakeholders involved in contract design: | - Financial backers

Answer 28

Financial backers will want REGULAR REPORTS demonstrating proper stewardship of the finance provided.

Question 29

Stakeholders involved in contract design: | - Administrators

Answer 29

Need to ADMINISTER the financial structures. | The more complex the financial structures, the greater the cost of administration will be.

Question 30

Regulation can affect (5)

Answer 30

- CAPITAL REQUIREMENTS of a contract - contract DESIGN - PREMIUM (min or max) - SALES METHOD used - level of UNDERWRITING allowed