Speaker Name & Country :

Andrew D Smith, United Kingdom

andrewdsmith8@Deloitte.co.uk

Topic:

Embedded Options and Stochastic Models

Examples of Options
Five Vignettes

Some Examples of Guarantees:

Aishas Holiday Money
Aisha lives in the USA.
She changed $2000 into 1200 (60 pence per dollar) before a holiday in the UK.
Dealer promise: Aisha can change back any leftover pounds back to dollars, at
the original rate of 60p.
She spent all this money in London.
After she returned, the dollar strengthened to 75p.
She borrowed $1600 to buy another 1200.
She returned to the original currency dealer, changing 1200 back at the original
rate to get $2000.
Extra transaction: $400 profit.
What did the guarantee cost the currency dealer?
3

Examples of Guarantees
Bens Lapse and Re-entry Option
Ben decided to take out life assurance, 500 000 sum assured.
Ten -year policy charging premiums of 150 per month.
Two and a half years later, he checked online and found he could get the same
cover for 130 per month.
So he stopped paying premiums on the original policy and took out a new policy
for 130 per month, saving 20 every month, equivalent to 1800 in total.
What is the guarantee cost to the original insurer?

Examples of Guarantees
Mortgage Pre-payment Option
Charlie has a $240 000 mortgage, interest fixed for 5 years at an interest rate of
5% per annum, equivalent to $1000 per month. There is no penalty for early
repayment.
After two years, interest rates fell dramatically. Charlie decided to refinance the
mortgage, borrowing $240 000 from another lender, at only 3.5%.
The original mortgage was paid off, replacing monthly payments of $1000 with
$700 and saving in total more than $10 000.
What did the option cost the original lender?

Examples of Guarantees
Dianes Gas Supply
Diane has natural gas supplied to her London home.
In a typical year she uses 10 000 kWh of gas.
She had an energy contract at a rate of 5p per kWh, guaranteed for a 3 year
period.
One year into the deal, another firm contacted her and persuaded her to switch
to a tariff of 4p per kWh. Over the two remaining years, Diane saved 200
relative to the original tariff.
What did the price guarantee cost the original supplier?

Our Insurance Guarantee Example

An Endowment Policy with Guaranteed Surrender Values
Instant Access Account
Changeable interest rate
Customer can add or
withdraw funds at will

Customer fears
falling interest
rates; future
account value
unknown.

Term Deposits
Fixed 6% interest rate
Early exit (lapse)
forbidden or heavily
penalised

Insurance endowment
Guaranteed 4% interest rate
Instant access to return of premiums
+ accrued interest

Customer fears
lack of flexibility
to withdraw cash

Insurance endowment provides the best of all worlds, but is 2% the right charge?
Options and Guarantees

Economic Scenario
Generators
Stochastic Forecasts

Economic Scenario Generator Output

5-Year Swap Rate History and Monte Carlo Scenarios
20%
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
2000

2005

2010

2015

2020

2025

2030

20%

Market interest rate (5-Year )

14%

18%

12%

16%
10%

14%
12%

8%

10%
6%

8%
6%

4%

4%
2%
0%
2000

2%
0%
2005
History

2010
Scenario

2015

Lapse gain = (rate 4%) remaining term

Calculating the Option Benefit to the Policyholder

Assuming the Policyholder Picks the Best Point in 5 year period.

2020

Lapse Gain (RHS)

10

Levels of Rationality
Effect on Profitability
Most profitable

Least profitable

Hindsight
Best possible time to lapse; no regret

Options and Guarantees

11

Dynamic Lapse Models

Capturing Lapse Effects

12

Flat Lapse Assumption

Constant Lapse Rate Regardless of the Level of Rates
Most profitable

Least profitable

Hindsight
Best possible time to lapse; no regret

Zero intuition

Lapses independent of interest rates

Options and Guarantees

13

When might a Customer to Lapse a Policy?

Possible causes of customer lapses
Cash flow / liquidity reasons
Drop in income
lapse to meet increased net
expenditure

Value optimisation
Market interest > guaranteed
rates
Better interest rates available
elsewhere
Other reason
- Salesforce churn
- Divorce
- Not known / not recorded
Options and Guarantees

14

Risks from Writing Guaranteed Endowment Business

Finding a Matching Investment Strategy

High lapses

You invest in bonds to match

policy benefits
Then market interest rates rise
(and bond prices fall)
And many policies lapse
Attract new business at old rates
or sell assets at a loss?

Interest rates fall

You invest in cash so you can pay

lapses from liquid assets
Then market interest rates fall below
the guaranteed rate
And policies do not lapse
You lose on future reinvestment.

Low lapses

Interest rates rise

Options and Guarantees

15

Intuitive Customer Behaviour

Possible Description of Lapses
Minimum lapse probability min
Contingent lapse probability max- min
Lapse if market rate > gtee rate + trigger
Trigger ~ N(trigger, trigger)

Lapse rate

Policy in force

Retention probability 1-max

50%
40%

rmkt rgtee trigger

lapse = min + (max min ) 0

trigger

30%

0= cumulative normal distribution function

20%
10%
0%

1%

2%

3%

4%

Market interest rate

5%
Options and Guarantees

16

Levels of Rationality
Effect on Profitability
Most profitable

Least profitable

Hindsight
Best possible time to lapse; no regret

Positive intuition
Lapse probability an increasing function of interest rates
Zero intuition

Lapses independent of interest rates

Options and Guarantees

17

Accounting Implications
Amortised Cost and Fair Value

18

Accounting and Lapse Impact

Under IFRS fair value, lapse sum-at-risk depends on mark-tomodel policy reserve change.
Accounting
Method

Market rates move

(down) in Insurers
favour

Market rates move (up)

in Customer Favour

Amortised
cost

Policy reserves
insensitive to market
rates.
Lower lapses erode
future margins by
locking insurer into
expensive funding.

Policy reserves
insensitive to market
rates.
High lapses erode future
margins by forcing
insurer to refinance
assets at higher market
rates.

Fair value

Policy reserves fall below

Policy reserves rise
surrender value
above surrender value.
Higher lapses trigger
Lower lapses erode
immediate losses by
margins as expected
crystallising surrender
lapse profit fails to
value.
materialise.
19

Optimal Lapses
How would you Play the Game?

20

How would You Choose to Lapse?

Introducing a Coin Tossing Game

= Heads

Tails =
21

Our Game Simulates a Lapse Decision

Coins and Sweets

The number of coins in

the pile represents the
number of turns
remaining in the game.

The number of sweets in

the pile represents the
market interest rate minus
the guaranteed rate.

Every time a coin is

tossed, it is removed
from the pile.

Every correct/incorrect
coin toss
increases/reduces the
sweets pile (with a
minimum of zero).

22

Objective of the Game

Maximises the number of sweets

Start with 10 coins and 1 sweet.

At each stage, the player can call heads, tails or stick.
Game outcome = number of sweets in the pile
number of remaining coins
This represents interest rate differential
number of years remaining

23

Analysis from the Customers Perspective

Possible Strategies
If I want, I can get 10 sweets immediately.
Shouting stick, I immediately get 1 sweet x 10 remaining
tosses = 10 sweets
The largest possible gain is 30 sweets
If I get 4 correct guesses and then stick, there 5 sweets in the
pile x 6 remaining tosses
But there is only a 1/16 chance of getting there
Stupid to use up all 10 tosses
Because any sweets remaining in the pile are multiplied
by 0 (the remaining number of flips) before I get them

Options and Guarantees

24

Expected Payoff from Different Strategies

Min

Average

Max

10

10.00

10

Continue to the end:

0.00

Stop first time pile reaches 2 sweets

12.91

18

Stop first time pile reaches 3 sweets

10.45

24

Stop first time pile reaches 4 sweets

6.88

28

Stop first time pile reaches 5 sweets

3.86

30

Stop if pile reaches 2 sweets, but stick

at 1 sweet if there are four or fewer
flips left

13.08

18

10

17.30

Strategy
Stick immediately:

Hindsight knowing all coin tosses

30

Options and Guarantees

25

Analysis of Heads-Tails-Sticks

8
7

Sweets in pile

6
5
4
3
2
1
0
10

Untossed Coins Remaining

0
Options and Guarantees

26

Making the Game Real

Relating Sweets to Interest Rates
Suppose current market interest rate is 6.00% compared to a
policy guaranteed rate of 4.00%
Suppose that every 30 minutes, the market rate increases or
decreases by 0.01%, with equal probability (equivalent to an
annual volatility of = 1.32%).
Ignoring compounding, the gain on surrender =
Account balance
(market rate guaranteed rate)
remaining policy term

27

Solutions of the Lapse Game

Theoretical Optimal Lapse (relative to guaranteed rate of 4%)
Remaining
Term (years)

Number of
half-hours

Optimal lapse
threshold

17532

4.85%

35064

5.20%

52596

5.47%

70128

5.69%

87660

5.89%

122724

6.24%

10

175320

6.67%

For large terms, the optimal rate is:

Guaranteed rate + b3 * volatility * sqrt(term)
b3 0.638833
28

Option value

Valuing the Option to Lapse, 5-year Term

Intrinsic Value = term * (market rate guaranteed rate)
20%
18%

Intrinsic

16%
14%
12%
10%
8%

Baumgartner-Smith Formula

6%

rm rg
3
2 (b3 ) t

t 3/ 2

4%
2%

Option

0%
0%

2%

4%

6%

Market Rate

8%
29

Levels of Rationality
Effect on Profitability
Most profitable

Least profitable

Hindsight
Best possible time to lapse; no regret
Rational optimiser
Best possible time in complicated model
Pragmatic optimiser
Optimal rule in simplified model
Positive intuition
Lapse probability an increasing function of interest rates
Zero intuition
Lapses independent of interest rates
Negative intuition

Lapse probability a decreasing function of interest rates

Options and Guarantees

30

Defining functions and constants in the BS Formula

Successive integrals of the normal distribution

n (bn ) = bn n 1 (bn )

x2
1
1 ( x) =
exp
2
2
1
0 ( x) =
2

b2 = 0.839924;
b3 = 0.638833

2
exp 2 d
x

1 ( x) = 0 ( )d = x 0 ( x) + 1 ( x)

2 ( x) = 1 ( )d =

3 ( x) = 2 ( )d =

1 2
( x + 1) 0 ( x) + x 1 ( x)
2

1 3
( x + 3 x) 0 ( x) + ( x 2 + 2) 1 ( x)
6

Options and Guarantees

31

Underwriting Customer Behaviour

The Importance of Knowing your Customer
Insurance has a long tradition of underwriting
To avoid adverse selection
Offer life insurance at standard rates to healthy lives
Impaired lives are declined or pay higher rates
Well known rating factors:
age, sex, smoker status
Additional rating factors:
sum assured, postcode, occupation, distribution channel
Guaranteed products are a bet on policyholder behaviour
What are the rating factors for optimising behaviour?
How to underwrite for this?

Options and Guarantees

32

Conclusions
Numerical Methods and
Behavioural Underwriting

33

Comparing Option Valuation Algorithms

Relative strengths and Weaknesses
Monte Carlo

Lattice

BS
formula

Easy to
implement

Intuitive
behaviour

Optimising
behaviour

Profit sharing

Lapse
penalty

Multi-factor
interest
model

Options and Guarantees

34

Conclusions
Valuing Options and Guarantees
IFRS 4 phase 2 is likely to increase the volatility associated with customer lapse
or option exercise behaviour, especially if markets have deviated from the
conditions when the business was priced.
There are several valid approaches for calculating guarantee fair values:
Monte Carlo simulation, Binomial lattice, Closed form
Computing numerical solutions as important as proving formulas
Key assumptions are:
Assumed behaviour of policyholders
Volatility of market interest rate
Operation of profit sharing (if any)
Writing guaranteed products looks like a bet on interest rates
But on closer analysis it is a bet on customer behaviour

Options and Guarantees

35

Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited (DTTL), a UK private company limited by
guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see
www.deloitte.co.uk/about for a detailed description of the legal structure of DTTL and its member firms.
Deloitte MCS Limited is a subsidiary of Deloitte LLP, the United Kingdom member firm of DTTL.
This publication has been written in general terms and therefore cannot be relied on to cover specific situations;
application of the principles set out will depend upon the particular circumstances involved and we recommend that you
obtain professional advice before acting or refraining from acting on any of the contents of this publication. Deloitte
MCS Limited would be pleased to advise readers on how to apply the principles set out in this publication to their
specific circumstances. Deloitte MCS Limited accepts no duty of care or liability for any loss occasioned to any person
acting or refraining from action as a result of any material in this publication.
2016 Deloitte MCS Limited. All rights reserved.
Registered office: Hill House, 1 Little New Street, London EC4A 3TR, United Kingdom. Registered in England No
3311052.