SP7 Sep 2023 Q3 (iii)

[Toby Griffiths]

I really don't understand how the majority of the marking schedule for this question talks about the capital charge increasing following the change to parametric trigger instead of indemnity.

From what I understand, parametric trigger policies provide a pre-defined benefit upon the trigger event being met. Capital is held to protect against uncertain outcomes. Trigger based policies are inherently less volatile/uncertain (either you pay the pre-defined amount or you don't) - how can the argument be that capital increases??

For example, from the mark scheme (in italics):

• Underwriting risk may increase as it will be more difficult to price a parametric policy
  
• How??? All you have to do is estimate the event probability then multiply by the pre-defined payout??
• Liquidity risk could increase as payment is required faster compared to indemnity based
  
• How can you argue that liquidity risk increases if you know with certainty what the payment will be if a claim occurs?

Thanks,
Toby

 

[Darren Michaels]

Hi Toby

I think you make some valid points, which would probably also be worth some credit in the exam.

Don't forget though that we do need to tailor our answer to the specifics of the question, so we are dealing with insurer that hasn't written this type of business previously and so they may find it more difficult to price on the one-hand. Equally, since the payments are required to be made more quickly, this may cause them some liquidity issues.

Don't forget that the timing of any event is also uncertain, although this also applies to indemnity-based cover.

In our solution in the ASET, we provide a more balanced answer where we acknowledge factors that could decrease, as well as potentially increase, the insurer's capital requirements.

There is no harm in the exam expressing both points of view. For example, on the one hand underwriting risk may increase as the insurer may lack the experience to price the policy, yet on the other it could decrease because arguably it is a more straightforward arrangement to price.

Also, it is always a good idea to use lots of words like 'may' or 'could' as that helps to demonstrate that things aren't always black or white, which is often the case in the real world.

 

[Toby Griffiths]

Hi Darren,

Thanks for getting back so quickly!!

Okay great that all makes sense, thank you very much!