CH23 - Pricing and financing Flashcards
Cost vs price
The cost of benefits is the amount that should theoretically be charged for them.
The premium(s) or contribution(s) should be calculated by equating the value of premiums with the value of benefits and expenses plus a contribution to profit. value of premium = value of benefits + value of expenses + contribution to profit
The price of benefits is the amount that can be charged under a particular set of market conditions and may be more or less than the cost.
The theoretical value of the benefits alone (also known as the risk premium) may be determined using a formula or using a discounted cashflow model.
Once a model has been developed to determine the theoretical value of benefits to be provided on future financial events, further work needs to be undertaken to translate this value into a premium or cost to the customer. This is sometimes known as the office premium.
Factors taken into account for adjusting premium (9)
- Taxation
- Commission - although this might be included as an expense
- Cost of capital - e.g the cost of needing to hold solvency capital
- Contingency margins
- Options and guarantees costs
- Provisioning bases - as this may be different from the basis used to determine the cost
- Experience rating to adjust for future premiums
- Investment income
- Reinsurance costs
Factors influencing the price (4)
- The distribution channel(s) used (may enable it to sell above the market price or to take advantage of economies of scale and reduce the premiums charges)
- The level of competition in the market
- The approach taken to expense and profit loading (e.g. marginal costing, loss-leading)
- The provider may have a captive market that is not price sensitive
- The need to cross-sell.
Once a price has been determined, it should be profit tested and market tested.
The main methods of financing benefits (6)
- Unfunded (finding the money to pay for the benefit as the benefit falls due)
- Pay-as-you-go - Funded (to some extent the monies needed to meet the benefit costs are set aside before the benefit falls due)
- lump sum in advance
- terminal funding
- regular contributions
- just-in-time funding
- smoothed pay-as-you-go
Factors influencing the choice of financing strategy (2)
- Tax treatment: Whether the government has used the tax system to make some approaches to financing more advantageous than others
- Risk: The way in which the approach to the incidence of funding affects the allocations of risks between the individual and company.
Reasons why the actual contribution rate could be different to a calculated rate for a defined benefit pension scheme (3)
- So as to rectify any shortfall or surplus in the pension scheme
- To reflect the sponsor’s desire to pay less or more into the scheme
- Due to legislative constraints
Main factors affecting the cost of benefits (2)
- Frequency of occurrence (which will affect the timing of the benefits)
- Severity (which will affect the amount of the benefits)
Ways of viewing a product price (2)
- 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.
Examples of distribution systems in the UK (4)
- Independent intermediaries, who sell products for their clients from all or most of those available on the market
- Tied agents, who offer the products of one provider or a small number of providers
- Own sales force, usually employed by a paticular provider to sell its products direct to the public
- Direct marketing, via press advertising, over the telephone, internet or mailshots.
Affinity group
An affinity group is a group of people linked by a shared interest or objective, such as a hobby, professional status or political interest. A group insurance arrangement may be set up to cover all members of such a group or society.
Loss-leading
The provider may choose to sell a product that covers its direct fixed and variable costs but does not cover its expense overheads and minimum profit requirement. The purpose of the strategy is to stimulate sales of the product or other more profitable products.
Marginal costing
Taking an extreme approach, the company might allow for no contribution to any fixed costs, direct or indirect.
As long as the company’s fixed costs are covered by margins from business currently on the books, each new policy only needs to cover the variable costs attributable to it, and it will make a profit for the company.
This means that only the variable expense margins need to be included in the product pricing and lower prices will therefore result. These lower prices might enable much larger volumes of business to be written.
Financing
Financing is a term used for putting a price on benefits payable on future contingent events, primarily in the context of benefit schemes.
Unfunded financing approach - PAYG (3)
It is not always necessary for funds to be established to provide benefits on future contingent events.
For example:
1. A company may choose to self-insure its motor damage risks. It will just pay for repairs as they arise.
2. A government may choose to pay State benefits to the retired out of current taxation revenue from working individuals and companies.
3. Where risks are insured, the period of cover may be short, and each contribution might just purchase cover until the next contribution is due.
Funded financing approach - Lump sum in advance
Funds that are expected to be sufficient to meet the cost of the benefit can be set up as soon as the benefit promise is made, i.e. a lump sum in advance, or single premium.
The lump sum is designed to be sufficient to provide all future benefit outgo. The entire funding payment is made even though the first benefit payment may not be expected for some considerable time.
