CH21 - Expenses Flashcards
Types of expenses (2) + (2)
Expenses can be split between: - fixed - variable and - direct - indirect
Fixed vs variable expenses
Fixed expenses remain relatively constant in the short term (e.g. building maintenance).
Variable expenses vary by the amount of business (new business written or existing business handled).
Some expenses fall into a third category in between, where they are essentially fixed but can vary in large amounts from time to time, e.g. senior management costs.
Notes: Some expenses (such as building maintenance) may remain broadly fixed in real terms. Other will vary directly according to the level of business being handled at that time. These may be linked to the number of policies or claims or the amount of premiums or claims.
Direct vs indirect expenses
Direct expenses can be identified as belong to a particular class or classes of business. Indirect expenses cannot.
Some expenses can be identified directly as belonging to a particular class of business. Others o not have a direct relationship to any one class of business. These need to be apportioned between the appropriate classes.
Expense allocation (4) + (2)
Expense allocations take place for many different purposes including:
- pricing
- determining the expense loading for calculating provisions
- understanding the profitability of a particular product
- analysing sources of surplus (deviations of actual from expected expenses)
- analysing areas of inefficiency within the organisation
- financial planning (expense budgeting)
- cashflow management (to ensure that liquid funds are available to pay the expenses)
Expenses need to be allocated by:
- class of business
- function (activity or operation)
Expense allocation to class of business
Direct expenses are often allocated to class of business using staff timesheets.
Indirect expenses (or overheads) are harder to allocate can be allocated to class of business in several different ways. For example:
1. Premises’ costs can be allocated by floor space occupied by staff
2. Computing costs can be allocated using a ‘charge out’ basis
3. Other indirect expenses may be excluded until the end of the allocation and then allocated in proportion to all other expenses
Expense allocation to function (3) + (2) + (4)
The (non-commission) expenses can be split into:
- initial expenses (securing new business)
- maintenance expenses, including:
1. renewal expenses (policy renewal administration)
2. investment expenses - termination expenses (including claims)
This functional allocation helps to determine which expenses are charged to which contracts, e.g. regular premium vs single premium or paid-up policies.
Depending on the purpose of the expense analysis, these items may be sub-divided.
For example, new business costs might be split into:
- marketing
- sales and commissions
- processing and policy issue
- underwriting
Expense loading in premiums and provisions (5)
Premiums and provisions should be adequate to cover administration costs, claims handling costs and the fixed expenses of the provider as well as the expected claims or benefits arising under the contract.
The expense loading could be expressed as a:
- percentage of premium (e.g. commission) or sum assured (e.g. underwriting)
- percentage of funds under management (e.g. investment expenses)
- fixed amount per contract (e.g. administration expenses)
- fixed amount per claim or percentage of claim amount (e.g. termination or claim expenses, amount per claim for life insurance and percentage of claim for general insurance)
- combination of these methods
Adjustments to expense loadings for pricing purposes (3)
Having determined appropriate expense loadings for each policy based on past data, it may be necessary to make some adjustments for pricing purposes. For example:
- to reflect cross-subsidies (general insurance, same premium charged for new business and renewal business even though renewal cases are cheaper to administer. renewals are subsidising new business)
- for past and future expense inflation
- due to competition considerations
Examples of expenses for financial services providers (6)
For most financial services providers, the expenses, in roughly descending order of amount, might be:
- staff salaries, pensions contributions, national insurance contributions, etc.
- commission payments
- office rent and related expenses
- office equipment (e.g. computers)
- investment costs
- office consumables (e.g. stationery)
Insurance company variable expenses examples (3)
Examples of variable expenses that might be related to one or more different measures of the amount of business are:
- commission - related to the amount of premium income
- postal costs for sending contract documents and claim forms - related to the number of contracts sold and the number of claims
- legal expenses - related to the claim amount
Staff related expenses examples (3)
Staff-related expenses might remain fixed in real terms in the short term. In the longer term, staff costs (and accommodation costs) will vary to meet:
- changing levels of new and existing business
- changes in services provided
- the degree of automation used to provide those services
Benefit scheme expenses
The expenses incurred by a benefit scheme may differ from those already described, as the scheme may have none of the fixed overheads such as building maintenance or rent. It is possible that much of the work of the scheme, such as administration, legal advice, actuarial advice or investment management is delegated to third parties who charge a fee for the service. Where such services are provided in-house, this may be done by the sponsor’s employees and so the costs will form part of the sponsor’s total overheads.
Examples of direct and indirect expenses relating to term assurance contracts (4) + (3)
Direct expenses include
- underwriting costs
- commission
- contract administration
- claims settlement expenses
Indirect costs relate to the support functions such as:
- computing
- human resources
- general management
Examples of direct fixed expenses in the context of an insurance contract
- the salaries of:
- underwriters
- claims handlers
- administrators - product development costs
