ALM and pricing of life insurance products Vladimír Krejčí Prague, 1 April 2004.
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Transcript of ALM and pricing of life insurance products Vladimír Krejčí Prague, 1 April 2004.
Product design and pricing
Design Passing the investment risk to clients Possibility to hedge the risk borne by
shareholders
Pricing (profit testing) Reasonable assumptions about
Future yields Discount rate
Let‘s start – question 1
Does profitability of a life insurance product depend on investment strategy?
Example 1
Single premium endowment without profit sharing Policy term 10 years Zero mortality and lapse rates
Let‘s assume 2 scenarios of investments a) 10Y government zero coupon bond b) 10Y corporate zero coupon bond
Traditional DCF approach
Let‘s measure profitability in the form of Value Added by New Business
Different investment return assumptions a) VANB = EUR 10 b) VANB = EUR 15
RDR increased by 2% in b) a) VANB = EUR 10 b) VANB = EUR 12
Possibility to increase allocated capital
Alternative approach
The same cashflows in the first day Premium paid, expenses
After the first day:
Liabilities: the same in both a) and b)(technical reserves of EUR
100)
Assets: a) EUR 100 in government bond b) EUR 100 in corporate bond
„We do not invest risk free and therefore our yields will be higher than risk free.“
Risky investment strategy increases the profit potential You can make more profits if you are good
(succesful, lucky)
But it increases the loss potential as well „…our yields will be probably higher…“
=> it does not increase market value
Does profitability of this life insurance product depend on investment strategy?
Traditional DCF
YES
Alternative approach
NO
What approach is more appropriate?
Question 2
Is market value the appropriate measure?
Why do we have different PV? Information, investment horizon, risk attitude
What decisions are we willing to base on our PV?
Credit risk
Corporate bond from the example 1 valued via DCF
Expected future cashflow Notional amount * (1
- probability of default*(1-recovery rate)) We could also allow for cost of capital PV = EUR 102,5
Isn‘t this PV the right one from our shareholders‘ point of view?
Why is the market price different?
What factors we did not allow for?
Market can expect different probability of default
Potential downgrades
Volatility of credit spreads
Market can have different cost of capital
Investors are risk averse
How did the market arrive at the price?
Supply / Demand consensus of market participants
Who are market participants? Banks, insurance companies, investment funds, …
Komercni banka, CSOB, Ceska sporitelna, Ceska pojistovna, ING, Deutsche bank, Morgan Stanley, Meril Lynch, Bank of America, Credit Lyonais, …
Very well educated, trained and experienced teams
Very well informed teams – equally informed
Efficient market
Stock markets
Forward on stocks – what is the forward price? Expected yield (arbitrage) Risk free yield
Stock returns over a long horizon
Sentiment, trends, bull/bear markets
Interest rates risk, duration mismatch
What do we estimate?
Macroeconomic development Decisions of billions of people all around the
world Estimate of these decisions by thousands of
analysts and market players Sentiment, media, psychology, hedging
Time horizon
Why is our PV different than market value?
Do we have better know how?
Are we better informed?
Are the markets efficient?
Do we really have arguments for the PV we have calculated?
Why is our PV different than market value? We do not have better information, so …
…our shareholders have to be differently risk averse than the market… do we know their utility function that well?
…or not interested in short term results what about if the investment strategy
reports high losses and we say these are only temporary?
What decisions are we willing to base on our PV?
Purchase of particular security
Investment strategy
Liability product design and pricing
Summary
Is market value the appropriate measure for valuation of life insurance liabilities?
Does profitability of this life insurance product depend on investment strategy?
A practical problem
Profit in life insurance is a small sum of
Large positive numbers Premium income, investment income
Large negative numbers Claims, expenses
It is very difficult to adjust the discount rate to particular investment assumptions
The problem – cont.
The smaller the profit, the bigger the problem
Low interest rate environment Lower margins are relatively more sensitive to
changes in investment income
Products with profit sharing Change in profit sharing Change in company‘s margin
Do we have market evidence for use of the traditional EV in M&A?
Suggested solution
EV with risk free investment returns and risk free discount
Do we know to evaluate the mortality, lapse, expense, … risks?
Risk free EV can be some comparative basis – the traditional EV should not be higher (negative value of mortality, lapse, expense, … risks)
What about products with profit sharing?
Risky investment strategy increases the profitability (compared to risk free strategy) if you pass to clients more risks and less profits
If you pass to clients more profits than risks then: The riskier investments, the lower
profitability