Meeting the Clients Needs: Good Product Design

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Chapter 6
Asset-Liability Management for Actuaries

• Meeting the Clients Needs Good Product Design

Shane Whelan, L527
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The Heart of the Matter

• Good (financial) product design resolves the
  tension between developing a product that meets
  the needs of (targeted) customers and meeting the
  providers need for profit (return on capital)
  with acceptable risk.
• Aside from capital, the provider brings other
  less tangible but important assets to the table
• Knowledge and expertise that reduces risk
• Competitors products new or increased demand
  from underlying demographic or sociological
  shifts using technology to reduce costs
  changing regulations/taxation/social welfare
• In-place systems that reduce marginal cost
• Salesforce, other sales channels, head office and
  its systems
• Its in-force business that can help diversify
  risk of new product.

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Product Design Cycle
Identify a need/market
Design a Product
Review Product Design
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Characteristics of Good Design

• Meet, and demonstrably meet, customers needs
• So meet effective demand
• Level of benefit and contingencies on which paid.
• Flexible to change as customers needs change?
• Be profitable
• Acceptable levels of profitability will depend on
  capital requirements, which, in turn, depend on
  the riskiness of the benefits promised.
• Is it best use of scarce capital?
• Options guarantees are especially
  capital-intensiveare they sufficiently
  appreciated by customer?
• Whenever there is a period of time between
  contract effected and the benefits actually being
  provided, there is a decision as to how and when
  monies should be set aside to pay for the
  benefits. Matching assets? Invested in what
  assets? This can be key.
• Simple to understand
• Kitemarking
• Everything should be made as simple as possible,
  but not simpler. Einstein
• Is With-Profits a product that is oversimplified?
• Cross-subsidies can helpbut beware of dangers!

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Characteristics of Good Design (Cont.)

• Be transparent in its structure and charges
• This is often in conflict with other
  characteristics, especially to sell product in
  volumes. The resolution of the conflict depends
  on the time-scale you are thinking inbut
  short-termism now seems to dominate.
• The charges levied will need to meet the costs
  incurred by the provider in setting up and
  managing the financial structures.
• Product design, advertising, administration
  set-up
• Commission, other sales costs, cost of collecting
  contributions, cost of paying benefits,
  overheads, profits, management of assets.
• Have a large enough market
• Remember, we want to maximise total profit
  profit per unit X number of units.
• Provide fair terms on premature terminationsee
  next few slides.
• Fair to policyholder, to other policyholders and
  to provider.
• Be aware of self-selection or selection-against-th
  e-office. This might inform benefits on premature
  termination making policy paid-up rather than
  giving a surrender value or never granting
  surrender terms.
• Also market practice, regulatory requirements,
  and how to set fair terms.

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Benefit Schemes Early Leavers

• For a benefit scheme the actual benefits on
  discontinuance are likely to be well-defined, but
  if they are to be transferred away to another
  provider a value will need to be placed on them.
  
• Such a value will need to be equitable between
  members who leave and members who remain.
• What happens if assets are insufficient to
  provide the full value of the accrued benefits
  for all members?
• Reduce lump sum payment to leaving member to
  reflect the lower level of funding.
• But give the member the option not to transfer
  benefits away, or, at any event, disclose the
  reduction factor applied.
• Check regulations!
• What happens if assets more than sufficient?

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Insurance Contracts Early termination

• Should company take full profit from sold
  contract or accept reduced share as contract
  clearly not ideal for surrendering policyholder?
• Key concept is asset share accumulated premiums
  less actual expenses and cost of cover, at actual
  earned net rate of return.
• Asset share sets maximum that company can pay out
  in the long run.
• Policyholder will generally just look at premiums
  paid in early years or, at later years, the
  maturity benefits.
• To be fair or to be seen to be fair?
• What company said in illustrations

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Product Design Issues

• Product definition
• Event(s) giving rise to valid claim
• Exclusions
• Underwriting
• Rating factors in setting standard premiums
  (e.g., age, sex, smoking or age, sex, engine cc)
• Need to know target market to set standard rates
  and rating factors
• Pricing
• Here we mean pricing strategy cost-based
  pricing, marginal costs only, market or
  competition-based pricing
• Determine price relatives between different
  marketing channels.
• Customer Service
• Level of support/administration and its cost.
• New system or altering existing one?

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Product Design Issues (cont)

• Marketing Distribution
• Many channels differentially priced?
• Staff training
• Capital requirements
• New business strain timing of capital needs
  risks.
• Monitoring the emerging experience
• For operational, financial and risk management.
• Also statutory reports
• Sub-divided by sales channel or other
  classification.
• Meeting legislative and regulatory requirements
• Valuations, etc.
• Reinsurance

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Risk Process Planning (RPP)

• Any project has risks. Risk Process Planning is
  a method of assessing and controlling risk
  specifically in financial product development.
• RPP made up of the following parts
• Risk event definition
• Define the risk events e.g., failure of product
  to sell, high lapse rate, etc.
• Timing
• When will risk event be known to have happened
• Risk scoring or evaluation
• Probability of event sometimes scored
• Scoring of severity is often on scale 1 to 5 with
  1minor loss 5unbearable loss
• Also consider correlation with other risk
  underwritten

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Risk Process Planning (RPP)

• Cont. RPP made up of the following parts
• Management
• Control that can be exercised on risk event
  again sometimes simply scored.
• Actions to prevent or limit damage of risk event.
• Parties involved
• Team of experts on different aspects
• Can see the big picture
• A risk-scoring team will often be a subcommittee
• Facilitator
• A general expert in applying RPP

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Risks of a Motor Insurance Book

• A small general insurance company writes only
  individual motor insurance business.
• Discuss the areas of risk and uncertainty
  inherent in the claims experience of this insurer
  and how they might be reduced.

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Solution might include

• Risk in the claims experience
• Outcome of business on books and future business
• Claims frequency and amount variable so
  especially so for small insurer due to random
  incidence and amounts.
• With delay in recognition due to late
  notification/time to eventual settlement
• High variably might disguise underlying trends
• Risk characteristics of policyholders may change
  in time
• Underpricing when introducing new policy options
• Crime or fraud increasing with time
• General claims inflation higher than expected
• Taxation of cars or repairs or other changes to
  legislation
• Court award inflationnew precedents on allowable
  claims or quantification of damages
• Unintended consequences of policy wordingdirect
  or with reinsurer

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Solution might include

• A catastrophe event
• Due to geographical concentration flooding,
  hailstones, hurricane leading to multiple claims
  in portfolio.
• One huge claim
• Competition and the insurance cycle.
• So how are the identified risks reduced?

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Product Development Process
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Example

• A life company is considering launching an
  immediate annuity, the amount of each future
  payment dependent on the level of the equity
  market at the time, subject to a guarantee that
  the payment in any year will not be less than 95
  the payment of the previous year.
• Discuss the product design, and indicate if you
  are satisfied that this product should be
  launched.

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Completes Chapter 6
Asset-Liability Management for Actuaries

• Meeting the Clients Needs Good Product Design

Shane Whelan, L527