Ch 16: Unit pricing Flashcards
Define an internal unit-linked fund (3)
- Consists of a clearly identifiable set of assets, for example equities, property, fixed-interest securities and deposits.
- Fund is divided into equal units consisting of identical sub-sets of fund’s assets and liabilities.
- Responsibility for unit pricing rests with company, subject to any relevant policy conditions.
What is a management box?
What is an advantage of maintaining a management box?
What are the risks of maintaining a management box?
The management box is the excess of units that facilitates the management of the fund. By owning some units, it will enable the company to meet the day-to-day needs of policyholders without having constantly to create and cancel units.
Advantages
1. If the company varies the number of units it owns in the box, it can reduce the
need to cancel or create units each day
2. Enables the company to make a steady offer and bid basis, rather than having to change the basis too frequently.
3. This achieves “broad equity” between different unit holders (as the basis is only changed when there is a significant cashflow movement against the existing basis) and avoids unnecessary and artificial volatility in published unit prices
Risks
1. If the value of the underlying asset goes down –> the value of the units that the company is holding for its own account decreases
* Therefore, the company should keep the management box small
2. Expenses of managing the box are > expected (setting down guidelines as to how the box is maintained, what happens in the event of severe market movements)
3. Operational risks –> keeping track of which units belong to the policyholder vs the company
State the basic equity pricinple of unit pricing for an internal unit-linked fund (5)
- The interests of unit-holders not involved in a unit transaction should be unaffected by that transaction.
- Creation/cancellation of units should not given rise to change in NAV per unit
- Prices should only depend on backing asset performance
- and charges deductible under policy provisions
- shouldn’t be affected by unit creation/cancellation, else cross-subsidies exist
- Policy documents state how pricing will work
- of a unit, but often in general terms, e.g. max prices for allocating/min price for surrendering units
- Strictly only needed for transactions
- prices at other times have no use, apart from measuring fund performance and showing fund value to policyholders
Outline the difference between an offer basis and a bid basis, and which basis is used in practice? (7)
- Offer basis
- used for fund expansion
- marginal transaction involving creation of units
- money put into fund = net number units being created * appropriation price
- Bid basis
- used for fund contraction
- marginal transaction involving cancellation of units
- money taken out of fund = net number units cancelled * expropriation price
- Companies more likely practice broad equity approach under which basis is only changed if there is a significant movement against existing basis
- e.g. significant inflow for fund currently priced on bid (expropriation) basis
Define:
- Appropriation price
- Expropriation price
Appropriation price
- NAV of fund on an offer basis divided by the number of units existing at the valuation date
- amount of money per unit that the company should put into the fund for each new unit it creates, such that the net asset value per unit is the same after as before the appropration.
- therefore, it is the price at which the company will create a unit
Expropriation price
- NAV of fund on a bid basis divided by the number of units existing at the valuation date
- amount of money that the company should take out of a the fund for each unit it cancels, such that the net asset value per unit is the same after as before the expropriation.
- therefore, it is the price at which the company will cancel units
Outline how the appropriation price is calculated
Appropriation price = (net asset value of the fund on an offer basis)/ (number of units existing at the valuation date i.e. before any new units are created)
Net asset value of the fund on an ‘offer basis’
= market ‘offer price’ value of assets held by fund
+ expenses and any duty that would be incurred in the purchase
+ value of any current assets, such as cash on deposit or investments sold but not yet settled
— value of any liabilities, such as investments purchased but not yet settled or loans to the fund
+any accrued income
— any allowance/accrual for tax, if applicable
Explain how the calculation of the expropriation price differs from that of the appropriating price (2)
- Main difference is that starting point is the proceeds that would be received from selling the assets in the fund
- This requires that the investments of the fund are valued on a market ‘bid basis’, and that the expenses that would be incurred in the sale are deducted.
Describe the 2 main adjustments that are likely to be made to either the appropriation price or the expropriation price in order to determine the offer price and bid price used when dealing with policyholders (2)
Initial charges
- companies may want to make a charge to contribute towards initial expenses, including any commission and possibly profit
- offer price is then taken as appropriation/expropration price plus the initial charge and the bid price as the appropriation/expropration price
- initial charge may also be referred to as bid/offer spread
Rounding
- it is normal to quote prices rounded to a certain number of decimal places
Outline the difference between an offer price and a bid price
- Bid/offer spread
- Offer price - price at which units offered for sale to policyholder
- Bid price - price at which units will be bought from policyholder
- can be offer or bid basis
- offer basis
- Number of units being allocated exceeds that being surrendered (requires net creation of units in fund). Company could use an unadjusted appropriation price for dealing with policyholders, but for commercial and practical reasons there are two types of adjustments that may be made.
- bid basis
- daily pricing, where for a particular fund on a particular day the number of units being surrendered exceeds that being allocated. Prices derived from the expropriation price.
Offer basis
Offer price = appropriation price + initial charge
Bid price = appropriation price
Bid basis
Offer price = expropriation price + initial charge
Bid price = expropriation price
What considerations should be given to charges levied on the unit-linked fund, hence unit price?
- What the charges are used to fund
- expenses (initial, renewal, termination)
- cost of capital
- profit
- death/maturity guarantees
- Charges start low level (then grow as fund increase)
- Matching cashflows
- difficult to match initial expenses, since charges start low
- likely to be greater than ongoing costs later
- Charges calculation
- fixed amount or related to fund value?
- related to FV exposes company to market risk, particularly when majority of charges will be of this form
What are the principle risks associated with unit pricing? (7)
- Underlying assets
- Volatile
- Large movement in market values (company liabilities depend on unit price, thus not exactly matched to underlying assets)
- Timing delays (introduces price risk needing to be managed)
- Approximations included in price
- Tax on unrealised capital gains
- Accrued assets/liabilities (e.g. accrued interest not year received)
- Estimates of asset market values (e.g property prices not immediately observable; risk of estimates being wrong compared to correct price)
- Errors in actual calculations
- Appropriation/expropriation basis (risk of wrong basis used to calc UP)
- Prices based on incorrect data (e.g. ass manager gives wrong asset MV)
- Error in calculation routine
- Regulations restricting policy charges (which may be included in price, changes in this pose a risk)
- Negative impact on company profits/income
- because charges are based on value of units
- company expected to make up shortfall in policyholder benefits resulting from pricing error
- Negative impact on reputation (in turn affect new business/increasing withdrawals)
- Anti-selection (policyholders selectively disinvesting if aware that UP overstates NAV)
