21 & 23 - Pricing & Financing Strategies + Expenses

Question 1

What are the different quantities that need to be priced by financial institutions?

Answer 1

• Premium of insurance policy
• Charges for long term savings products
• Commissions to intermediaries
• Interest to be charged on loans
• To customer, level of benefits received from product
• Costs around marketing, sales channels and admin work

Question 2

With regards to which factors is the premium charged based on?

Answer 2

• Characteristics of customers e.g. age, sex, make of car, no claims bonus years, no. of years of experience etc. which allow us to determine the VALUE OF BENEFITS
• VALUE OF EXPENSES
• PROFIT MARGIN
• EXPERIENCE RATING to adjust future premiums
• EXTERNAL FACTORS such as:
• —> Tax
• —> Reinsurance costs
• —> Investment income
• —> Provisioning bases
• —> Commission
• —> Cost of capital
• —> Competition in mkt. (price sensitivity)
• —> Contingency margins
• —> Options & guarantees
• —> Market regulation/legislation (price controls)

Question 3

Objectives of pricing:

Answer 3

• Prices should be high enough for profitability
• Prices should be competitive enough
• —> The mkt. competes on investment returns as well as prices charged.
• —> Firms can compete on having better investment managers or charging cheapest prices

Question 4

Stakeholders and their interests in pricing:

Answer 4

• Owners/employees/reinsurers want prices to be profitable
• Sales intermediaries/customers want competitive prices
• Sales intermediaries want higher commissions (conflict)
• Regulators/Govt want prices to be:
• —-> Profitable so businesses remain solvent
• —-> Competitive for TCF/barriers to entry reasons

Question 5

Why would we review pricing?

Answer 5

• Sales target is not being met
• Competition in the market (underwriting cycle)
• Profit target not met
• May need to change product design

Question 6

Pricing control cycle;

Answer 6

(1) Decide product prices
(2) Assess expected vs actual profits (profit testing vs reality)
(3) Consider results/risks including sensitivity/scenario tests
(4) Review the pricing
(1) Decide product prices
…..

Question 7

Cost vs Price definitions:

Answer 7

Cost: Theoretical cost of future benefits allowing for frequency/severity of claims & expenses

Price: The amount that we actually charge in the mkt. reflecting the competition in mkt. (think loss leaders)

Question 8

Methods used to set prices:

Answer 8

Cost-plus method:
-> Price = claims costs + expenses + profit loading

Competitor’s price method:

• > Slightly undercut competition e.g. 95% of competitor price
• > Sales/claims/expenses are modelled for profit testing

Question 9

Commercial considerations to think of when pricing:

Answer 9

Pricing/product design affects:

• Sales volume hence spread of fixed costs
• Profit per policy sold
• P/h reaction if prices change could be adverse
• Competitor’s reaction should be considered

Sales volume is a function of price/commissions:
–> Sales increase as price decreases/commissions increase

Question 10

Factors influencing difference b/w price and cost:

Answer 10

• distribution channels used (impacts how critical price competition is in the mkt.)
• price competition in mkt. (insurance cycle)
• price elasticity (may be determined my sales channel)
• Provider might have a captive market which is not price sensitive

Question 11

Sales dbn channels that can be used:

Answer 11

• independent intermediaries (customer selects from most providers’ products)
• tied agents (sell products of small no. of providers)
• own sales force (sell only one provider’s products)
• direct marketing (telephone mail or internet)

Question 12

Steps to setting assumptions for pricing:

Answer 12

• Identify NEED for assumption in determining price
• Sources and availability of DATA for assumptions
• –> Ideally in-house recent past experience on that product
• –> Might have to seek external sources
• EXTERNAL data used should be adjusted for:
• –> Changes to product design
• –> Changes to sales channel used
• –> Changes to target market
• –> Changes expected in the period for which assumptions are to apply eg. regulations changes
• –> Changes to claims experience/inflation
• Consider MARGINS for assumptions:
• –> For prudence (to allow for adverse claims exp.)
• –> Reflects opinion on how risky the product is e.g. higher prices for new products with scarce data

Question 13

Approaches to setting pricing margins and potential drawbacks:

Answer 13

• Each assumption is adjusted for its own margin
• –> Overall margin calculated might be excessive to compete in mkt.
• Single margin added overall:
• –>Best estimate assumptions and explicit profit margin, with adverse experience reducing profits

Question 14

Primary objective when pricing for long-term spending commitments:

Answer 14

• To ensure that there is sufficient future income to provide benefits (investment returns together w contributions sufficient to provide future benefits)
  Examples of long-term commitments include:
  -> Pension plans
  -> Long service leave liabilities
  -> Funding higher education research students

Question 15

Approaches to the PACE of funding benefits:

Answer 15

• PAYG: Benefits & expenses paid as they arise, no build up of funds (State schemes method)
• Initial funding: Funds paid at outset equal to PV(future benefits + expenses)
• Accrued benefits: Funds paid in = PV(benefits for next n years + current expenses) –> normal insurance policy
• Projected benefits: Funds paid in = PV(total future benefits to be built up) spread over future time periods before benefit received –> normal pension method

Question 16

Bases on which to assess the funding levels of long-term benefits funded in advance:

Answer 16

• What benefits are we targeting?
• –> Ongoing: Members’ benefits fully funded by the time they normally fall due e.g. retirement age
• –> Discontinuance: Fund’s asset value should be at least equal to minimum benefits payable if all members left the scheme immediately.

Discontinuance approach seems less prudent because if the members do not have the minimum required “years of service” they may not have a benefit paid on leaving the scheme.

Question 17

Why would the contributions towards long-term pension products need to be adjusted?

Answer 17

• Value of assets may be <> the value of accrued liabs:
• -> Adjustments for shortfall/surplus may be spread over a number of years as increase/decrease in % of salary contributed or in equal monetary amounts
• Sponsor may wish to change the rate of funding due to:
• -> Change in sponsor’s fortunes or motives (may be more/less generous)
• -> Opportunity cost of contributions relative to other investments
• -> If over-contributed, by law the sponsor may not be able to recover contributions once paid
• Limits within which contributions can be paid may in some circumstances be restricted by legislation

Question 18

Actuary’s responsibilities wrt. long-term benefits contributions:

Answer 18

• Choosing appropriate contribution rate & assumptions
• —-> In some cases this may be the sponsor’s or trustees/scheme manager’s choice
• —-> In such cases, the actuary recommends assumptions and contributions
• In other cases these assumptions/contribution rates may be set by legislation

Question 19

When thinking of the types of expenses to allow for in pricing a policy, we need to consider:

Answer 19

• The functions of the various expenses that arise:
• —> Initial expenses/commission/underwriting
• —> Renewal expenses
• —> claims expenses
• —> Administrative expenses (to operate the policy)
• The CLASS OF BUSINESS from which expenses arise
• —> Some expenses are related DIRECTLY to an individual policy e.g. printing of policy documentation for a policy. These are DIRECT EXPENSES.
• —> Some expenses will be a “share” of the overall costs of the business e.g. a proportion of rent expenses for office, these are INDIRECT EXPENSES

Question 20

Types of expenses:

Answer 20

Fixed (overhead) - remain the same in “long term” regardless of business volume written

Semi-variable - Fixed for certain volumes of business and then increase if business volumes exceed a certain level (step-wise changes)
e.g. salaries for senior managers, might need 1 additional manager beyond a certain volume

Variable expenses - change with the amount of business written (commission paid to intermediaries)

Direct expenses: those belonging to a particular class or classes of business

Indirect expenses: do not have a direct relationship to any particular class of business and will need to be apportioned

Question 21

Approaches to model expenses in pricing for policy classes:

Answer 21

(1) Marginal basis: variable expenses + change in semi-variable are loaded into individual policies, fixed expenses are ignored and allowed for somewhere - in profit margin implicitly included?
(2) Pricing on fully allocated basis where ALL company expenses are split over expected policy sales across the year somehow e.g. may be equally split or divided on some other basis
(3) Base on typical expenses in the industry and not modelling our own expenses

—> Follows argument: Because pricing is competitive, detailed modelling of theoretical price might be spurious, while knowing market price we need to charge anyways.

Question 22

Allocation and subdivision of expenses to policies process:

Answer 22

Expenses may be allocated do lines of business based on:

• Product type
• By function to which it is related i.e. is it related to:
• –> Selling new business (marketing, sales commission)
• –> Maintaining business (renewal expenses)
• –> Paying claims
• –> Old policies to be discontinued

And only after this subdivision do we move onto allocating to individual policies.

Question 23

How would a direct expense be split?

Answer 23

Split may be according to whether its proportional to:

• no. of contracts written
• amount of benefit written or sum assured
• amount of premium written or in force
• number of claims
• size of claims paid
• Staff-related direct expenses may be allocated using timesheet analysis

Question 24

How would indirect expenses be split?

Answer 24

• By using proxies such as floor space or electricity units
• Other approximate methods might need to be used
• Method of splitting fixed expenses might be arbitrary (for pragmatism purposes)
• Depends on assumption for business volumes sold for each line of business

Question 25

Methods to allow for fixed expenses:

Answer 25

• Assess contribution made to profit by each class of policy and allocate fixed costs accordingly
• Notional allocation e.g. per policy, per claim, per sum assured etc as for direct expenses
• Method used may affect relative competitiveness & profitability of products and may allow cross-subsidies b/w diff. groups of p/h
• NOTE: Inflation needs to be allowed for using historic inflation (to bring expenses up to date) and prospective inflation to allow for inflation from now to time when expense is incurred

Question 26

What’s next after expenses have been allocated using a chosen method?

Answer 26

PROFIT TESTING

• Pricing model used to compare the expected profits vs profit objectives (on individual policy basis & for the business as a whole)
• Through varying the premiums & charges, we can find what prices meet the profit objective

SENSITIVITY TESTS

• To show effect on profit of changing diff. assumptions to show:
• –> Which assumptions could cause profit targets to be missed
• –> Assumptions which are material to the results

o Useful to know how likely assumption changes are

PRODUCT MONITORING

• Compare the actual experience with the assumptions
• As a result of monitoring, may need to review PRODUCT DESIGN or PRICING

Question 27

Measures used to define profit objectives:

Answer 27

• Profit margin
• Internal rate of return
• Discounted payback period
• Return on capital

Question 28

What are the factors which influence the financing strategy for a retirement benefits product?

Answer 28

• Tax treatment make some approaches of financing more advantageous than others
• Risk: Allocation of risks b/w individual and sponsor
  eg. funding benefits well in advance provides security to the individual but could result in undue financial pressure on the sponsor