16. Unit pricing

Question 1

Basic principle

Answer 1

Unit price = value of pool of assets / number of units

Question 2

What are the components of the Net Asset Value

Answer 2

1. Market “offer/bid” price value of the assets held by fund
   
   • expenses that would be incurred incurred in purchase
     + current assets e.g. cash on deposits or investments sold but not yet
     settled
     + accrued income e.g. interest income from fixed-interest securities
     and deposits, net of outgo e.g. fund charges
     - current liabilities e.g. investments purchased but not settled / loans
     - allowance for tax if applicable

Question 3

Management box

Answer 3

• Consists of additional units that have been created but not owned by policyholders at any point in time.
• These units are owned by life company itself.
• More units than necessary to cover unit liabilities

Question 4

Why own a management box

Answer 4

Meet day-to-day needs of ph without having to constantly create and cancel units

Question 5

Advantages of holding a management box

Answer 5

• Enables company to maintain steady offer/bid basis, rather than having to change too frequently basis on which it prices units.
• Achieves “broad-equity” approach between diff unit-holders (as basis is only changed if there’s significant cashflow movement against existing basis) and …
• …avoids unnecessary and artificial volatility in published unit prices.
• By using box, unnecessary creation and cancellation of units is avoided.

Question 6

Disadvantages of holding a management box

Answer 6

• Exposed to investment risk of holding large number of units for its own account
  
  • However, with careful management might be source of profit
• May be problems with control- setting down guidelines as to how large a box is maintained, what to do in event of severe market movements or large unit purchases/encashments.
• Risk of management expenses being higher than expected
• Operational risks e.g. keeping track of which units belong to ph and which to company

Question 7

Basic equity principle

Answer 7

• Interests of unit holders not involved in a transaction must be unaffected by transaction
• For the holder of a unit the only prices relevant are those at which they buy units in the fund and those at which they redeem units.
• In theory, the movement in price between those two events should only reflect the performance of the assets backing the unit and charges deductible under the policy terms.
• Therefore the price of units should not be affected by creation or cancellation of other units, otherwise cross subsidies between unit holders will arise.

Question 8

Appropriation price definition

Answer 8

• Amount of money per unit that company must put into the unit-linked fund for each unit appropriated (created) such that …
• … the net asset value per unit is the same before and after the appropriation to preserve interests of existing unit holders.
• Price at which company will create a unit.
• Net asset value on an offer basis divided by number of units before new units created

Question 9

Expropriation price definition

Answer 9

• Amount of money per unit that company must be taken out the unit-linked fund for each unit expropriated (cancelled) such that …
• … the net asset value per unit is the same before and after the expropriation to preserve interests of existing unit holders.
• Price at which company will cancel a unit.
• Net asset value on a bid basis divided by number of units before units cancelled

Question 10

How does appropriation (expropriation) price achieve broad equity principle?

Answer 10

To achieve the basic principle of equity this price per unit is such that the net asset value per unit is the same before and after the creation (cancellation) of the units.

Question 11

Pricing basis when fund is expanding

Answer 11

• Offer basis

Question 12

Pricing basis when fund is contracting

Answer 12

• Bid basis

Question 13

Broad equity approach

Answer 13

• The interests of unit holders not involved in a unit transaction should be unaffected by it.

Question 14

Bid price

Answer 14

• Price life comany uses to redeem units it has alloacted to a contract.

Question 15

Offer price

Answer 15

• Price life comany uses to alloacte units to a contract.

Question 16

What are the two price adjustments

Answer 16

• Initial charge on the offer price (add)
• Rounding
  
  • may round up/down in favour of company/unit holder
  • depends on market

Question 17

Explain how units are priced in an expanding fund

Answer 17

• Follow broad-equity principle: interests of unit-holders not involved in unit transaction shouldn’t be affected by transaction
• Pricing depends on whether company is creating or cancelling units in fund
• Might be looked at daily, or, over longer period to avoid changing basis too frequently
• If company is creating units&raquo_space; offer basis
• Under offer basis, offer and bid prices are calculated from appropriation price.
• Appropriation price is amount of money that should be put into fund in respect of each unit created for interest of existing unit-holders are preserved.
• It can be calculated as the net asset value of the fund on an “offer-basis” divided by the number of units in the fund (before creation of new units)
• Net asset value is offer price per unit of fund’s underlying assets, adjusted in respect of fund’s current assets and liabilities, accrued income and acquisition dealing expenses.
• Given basis, company will calculate unit price as:
  o Offer price = appropriation + initial charges rounded up
  o Bid price = appropriation rounded down
• Above prices must be rounded. Some co round offer price up and bid price down. However, common to round to nearest decimal.

Question 18

Explain how units are priced in a contracting fund

Answer 18

• Follow broad-equity principle: interests of unit-holders not involved in unit transaction shouldn’t be affected by transaction
• Pricing depends on whether company is creating or cancelling units in fund
• Might be looked at daily, or, over longer period to avoid changing basis too frequently
• If company is cancelling units&raquo_space; bid basis
• Under bid basis, offer and bid prices are calculated from expropriation price.
• Expropriation price is amount of money that should be taken out of fund in respect of each unit cancelled for interest of existing unit-holders are preserved.
• It can be calculated as the net asset value of the fund on a “bid-basis” divided by the number of units in the fund (before cancelling units)
• Net asset value is bid price per unit of fund’s underlying assets, adjusted in respect of fund’s current assets and liabilities, accrued income and acquisition dealing expenses.
• Given basis, company will calculate unit price as:
  o Offer price = expropriation + initial charges rounded up
  o Bid price = expropriation rounded down
• Above prices must be rounded. Some co round offer price up and bid price down. However, common to round to nearest decimal.

Question 19

Bid-offer spread

Answer 19

Initial charge = offer price - bid price

Question 20

Principal risks in defiving unit price

Answer 20

• Unit prices are generally set at discrete points in time, whereas the underlying asset values effectively change continuously.
• This is a particular risk if:
  o The underlying asset values are volatile or if there is a sudden once-off movement in market values.
  o Any timing delay in adjusting unit price introduces a pricing risk for the company due to the mismatch between the company’s liabilities, dependent on the unit price, and the value of the underlying assets.
• The unit price calculation would include some approximations, including:
  o An allowance for tax on unrealised capital gains.
  o An allowance for accrued assets and liabilities, e.g. accrued interest not yet received.
  o Estimates of the market value of assets, where the market value is not immediately observable.
  o For example, property, as there is a risk that the actual values are very different to the estimates.
• There could be errors in the actual unit price calculations:
• This could be a particular risk if:
  o Unit prices are based on the appropriation/ expropriation prices of the underlying assets, depending on whether the company is creating additional (net) units or cancelling (net) units. There is a risk that the company uses the wrong basis when calculating the unit prices.
  o The unit prices could be based on incorrect data (e.g. the asset managers provided the incorrect market values of assets).
  o There could be an error in the calculation process/ method.
• Although regulations generally do not specify how units are to be priced, regulations may restrict what policy charges, for example, may be included in the unit price. Any changes to regulation could be a risk to the company (e.g. if regulation is incorrectly interpreted the prices determined may be incorrect and need subsequent correction).