Options - how do they work?

[eevee]

Hi there,

It just occured to me that when we learn about options, we learn the difference between the North American and the Conventional method.

But I actually have no idea how an option works in real life. For example, does the policyholder pay for the option at the start of the policy (included within the standard premiums) or does the policyholder pay the the option when he/she exercises it?

Some explanation and examples would be great.

Thanks

 

[Mark Willder]

Hi there,

It just occured to me that when we learn about options, we learn the difference between the North American and the Conventional method.

But I actually have no idea how an option works in real life. For example, does the policyholder pay for the option at the start of the policy (included within the standard premiums) or does the policyholder pay the the option when he/she exercises it?

Some explanation and examples would be great.

Thanks

For example, let's assume that the policyholder has taken out a 10 year critical illness contract for 100,000, with an option to take out a 5 year critical illness contract for 30,000 at time 4.

The policyholder effectively pays three premiums:

The premium for the 10 year contract (using select rates as they have just been underwritten). This premium starts now and will be paid for 10 years.

The premium for the 5 year contract if they choose to take up the option. The deal is that this will be calculated using select rates too. This premium is paid from time 4 for 5 years.

The premium for the cost of the option (as the policyholder will get a good deal on the 5 year policy if their health has deteriorated). This might be paid for the first 4 years, ie up until the option date, but the exam question will tell you.

Both North American and Conventional methods are trying to work out the size of this third premium.

Best wishes

Mark