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CP1 - chapter 3 Regulation

C

Christina12

Member
Hi,

I'm a bit confused about the core reading question at the end of the chapter. I'm talking about the GI company that writes unemployment insurance for a finance house.
The surrender value is: P * 0.55 * t/n
where t is the number of complete months left to run

Say n=36 months ie policy duration
Premium = £120.

If you are at month 1 you have 35 months left to run: £120 * 0.55 * 35 / 36 = £64 surrender value at the early stage of the contract

If you are at month 30 you have 6 months left to run: £120 * 0.55 * 6 / 36 =£11 surrender value towards the end of the contract.

The following sentence appears in the core reading: "It will pay surrender values values that are too low at early durations and too high at later durations. "
-"will pay surrender values values that are too low at early durations" -are we saying that the insurer took the risk only for a short period of time and the surrender value that the customer receives is too low compared to the premium it paid?
"too high at later durations" -why is this too high? I'm wondering if I completely misunderstood the question.

Thank you.
 
Hi Christina

The key issue here is that the loan from the finance house is a repayment loan. Under a repayment loan little capital is repaid early on with most of the customer's monthly payment meeting interest costs, and this balance gradually changes over the loan term with the capital element falling and interest element increasing. The fall in the outstanding loan isn't linear over time.

So early on there is a very large amount of the loan outstanding, hence the comment 'more of the net single premium is required for the early months', so if the person repays the loan early the surrender value should be high reflecting there is a high level of cover at that point which is being given up ... more than might be suggested by the straight line formula. Whereas if the person repays the loan later on there is far less loan outstanding and so far less cover is being given up and so the surrender value given by the straight line formula is too high.

I hope this helps.
 
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