Ch 24: Pricing and financing strategies

Question 1

What is the difference between the cost and the price of a set of benefits?

2

Answer 1

• The cost of benefits is the amount that should theoretically be charges for them based on frequency and severity.
• The price of benefits is the amount that can actually be charged under a particular set of market conditions. It may be more or less than the cost.

Question 2

How are premiums calculated?

2

Answer 2

• Model is developed to determine theorethical values of benefits
• Value of premiums = value of benefits + value of expenses + contribution to profit

Question 3

List other factors to consider when calculating a premium

9

Answer 3

1. tax
2. commission
3. the cost of any capital supporting the product
4. margins for contingencies
5. the cost of any options and guarantees
6. the provisioning basis
7. experience rating
8. investment income
9. reinsurance

Question 4

Influence of regulation

3

Answer 4

• Move to risk based capital requirements, so solvency capital increases with amount of risk benefits have and cannot be used for any other purpose.
• This increases overal lcost of benefits as there is now a cost of capital component that needs to be added (opportunity cost)
• Solvency capital is released over lifetime of a policy as no longer needed

Question 5

Robustness of premiums

3

Answer 5

• Profitability is checked by comparing actual and expected experience using profit testing models
• Scenarios tested use stoch simulations to determine min level of profitability in the tail of distribution
• eg profits in 95% of all scenarios

Question 6

Factors influencing the price of benefits

5

Answer 6

• Distribution channels enable above market price
• Economies of scale: reduce premiums charged
• Captive markets: No sensitivity to price changes
• Loss leading products: NUB sales cover direct costs but not profits and overheads in order to stimulate sales of mor profitable products
• Supply < Demand

DECLanS

Question 7

Marginal costing

4

Answer 7

• Variable costs: Policy related costs
• Fixed costs : Management and overheads
• Aim is to let existing business cover fixed costs so NUB only needs to cover variable costs to make a profit
• Allows only variable cost margins to be included, makes price of benefits cheaper @ NUB

Question 8

Examples of distributions systems

4

Answer 8

• independent intermediaries
• tied agents
• own sales force
• direct marketing

Question 9

Independent intermediaries

Answer 9

Individuals who select products for their clients from all or most of those available on the market.

Question 10

Tied agents

Answer 10

Offer the products of one provider or a small number of providers.

Question 11

“own sales force”

Answer 11

Usually employed by a particular provider to sell its products directly to the public.

Question 12

Direct marketing

Answer 12

Press advertising, over the telephone, internet or mailshots.

Question 13

Financing strategies

3

Answer 13

• Financing: putting a price on benefits payable on contingent events
• Unfunded: PAYG, find money for benefits as due ++Risk
• Funded: Money to fund benefits set aside in advance

Question 14

List 6 ways of financing pension scheme benefits

Answer 14

1. Pay as you go (unfunded)
2. Smoothed pay as you go(funded)
3. Terminal funding(funded)
4. Just in time funding(funded)
5. Regular contributions (funded)
6. Lump sum in advance (funded)

Question 15

Pay-as-you-go

Answer 15

Benefits are met out of current revenue and there is no funding

Unfunded

Question 16

5 advantages of pay-as-you-go

Answer 16

• allows benefits to be introduced at a worthwhile level in the early years as there is no need to wait for a fund to accumulate
• involves lower transaction costs (there is no funding)
• prevents funds from being tied up in the scheme
• for State-operated schemes it can increase solidarity within the community
• makes it easier to organise payment according to need with contributions according to ability to pay

Question 17

Smoothed pay-as-you-go

2

Answer 17

• The same as pay as you go but with a small fund to smooth effects of timing differences between contributions and benefits, short term business cycles and long term population change.
• Maintain balance in the fund for smoothing

Question 18

Terminal funding

2

Answer 18

• Funds to cover a series of benefit payments are set up as 1st payment is due.
• Lump sum is paid earlier than PAYG unles single premium

Question 19

Just-in-time funding

2

Answer 19

• Funds are set aside only in response to an external event in relation to the benefit payment.
• eg bankrupcy. != terminal/PAYG unless no event occurs

Question 20

Regular contributions

1

Answer 20

Funds are gradually built up between promise and first benefit payment

Question 21

Lump sum in advance

2

Answer 21

• A lump sum is set aside to cover the expected benefit cost when the benefit is promised
• Fund expected to cover all liabilities and ties up funds

Question 22

Factors that influence choice of financing

2

Answer 22

• Tax treatment: certain approach may have an advantage
• Risk Appetite: can exclude certain strategies

Question 23

3 Reasons for changes to the pace of funding

3

Answer 23

• changes in the fortunes of the sponsor
• the opportunity cost of the contributions and alternative investment opportunities
• changes in view over the degree of caution / optimism required

Question 24

2 ways of calculating benfit schemes product price

2

Answer 24

• Factor a profit criterion into the pricing process, and thus calculate the resultant premium. Test whether the premium is acceptable in the market.
• Input the desired premium into the pricing model and calculate the resultant profit. Test whether this is acceptable to the company.

Question 25

Give three reasons why the actual contribution rate might differ from the calculated theoretical cost of the future benefits in a pension scheme

Answer 25

1. The scheme may be in a deficit and the contribution rate may have to be increased to eliminate the deficit. Alternatively, the scheme may be in surplus and the contribution rate may be reduced to eliminate the surplus.
2. The sponsor may want to alter the pace of funding by paying a higher or lower contribution in any year.
3. There might be legislative restrictions (upper and lower) on contributions.