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September 2017 Q7 Paper 2 (ii)

O

o.menary11

Active Member
Hi,

This question asks "Consider a guaranteed contract that has just been issued and received its first contribution. Explain how the guarantee will have a value to the customer, immediately and in the future."

Ans provided:
  • "Likely that premium paid will be greater than value of units. Because: bid offer spread.
  • Likelihood that the initial allocation rate to units is significantly less than 100%, because this will be the only practical way to recoup initial costs given that 100% of unit value is offered at all durations
  • Customer has locked into the guarantee for the future (eg even if insurer later withdraws guarantee/product)."

i am confused with the answer regarding how the guarantee has value immediately.
1. Why is the premium greater than the value of units? To create a demand for a product, should the premium not be smaller than the value of units?
2. Additionally, if the premium is higher, how does the guarantee create value?

Any help would be greatly appreciated :)
 
I'm assuming the question implies that the guarantee is the premiums paid to date.

When a unit-linked contract is sold, the initial premiums will be heavily charged in order to recoup initial expenses for the company. So without this guarantee, a customer may receive lower than the premiums they have paid into the contract if they surrender early on.
Therefore having the guarantee in place means that the customer will at least get the premiums they have paid, thereby creating value to the customer.

There is also future value to the customer in the case of low or negative investment returns, the customer will always at least receive the premiums back. Without the guarantee, the customer could actually have paid in premiums and the fund performs badly and the value of the units is less than the premiums paid to date, the customer would make a net loss.

I think when the question says the 'value' of the guarantee, it is asking what is the difference between having the guarantee and not having the guarantee.
 
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