Ch24: Pricing and financing

Question 1

Why is chapter on pricing and financing strategies important?

Answer 1

Explores why cost of benefits and the price charged for benefits are different and the factors that cause this difference is discussed.

Question 2

Premiums and contributions need to allow for what factors to translate the risk premium into an office premium: (12)

Answer 2

• Theoretical value of benefits to be provided (risk premium)
• Value of expenses to be incurred
• A contribution to profit
• Taxation (want profit after tax)
• Commission (might be included as an expense)
• Cost of capital supporting the product (cost of needing to hold solvency capital + opportunity
  cost of capital not being able to be used by the
  organization for other ventures)
• Margins for contingencies
• Cost of any options or guarantees
• Basis that will be used to set future provisions for liabilities (may be different from basis used
  to determine the cost)
• Use of experience rating to adjust future premiums
• Investment income (allowed for implicitly within the discount rate used)
• Reinsurance costs

Question 3

Reasons why the office premium calculated (the cost) is different from the price. (6)

Answer 3

• Distribution system used may enable provider to sell product above market price or to take
  advantage of economies of scale and reduce premiums charged. (level of competition
  within the distribution approach will affect the extent to which provider is able to sell above
  market price)
• Provider may have a captive market such as an affinity group that is not price sensitive. (Price
  maker or price taker?)
• A product may be used as a loss leader i.e. is used to generate further business via cross
  selling (contribution to profit of a product may be negative but is expected to generate
  profit in future renewals or by generating profitable sales in other product lines.
• A product may make use of marginal costing. (the price of the product makes no allowance for
  contributing to overheads but instead only to cover its direct fixed and variable costs. This
  can be done when within the current business written, overhead costs are already covered
  and new policies only need to cover its variable costs to make a profit.
• Prices are adjusted depending on where the market currently is in the underwriting cycle. (few
  providers, demand exceeds supply and premiums can be higher, many providers,
  customers can choose between them and premiums will fall.
• Cross subsidies between products and within product lines.

Question 4

Outline 6 funding approaches.

Answer 4

• PAYG (only unfunded approach; find the money to pay for the benefit as it becomes payable)
• Smoothed PAYG (funds that are set up to smooth the costs under a PAYG approach; maintain
  a fund as a working balance; allows for effects of timing diffs of contributions and benefits,
  short-term business cycles and long-term pop change)
• Just in time funding (fund is set up as soon as a risk event occurs which impacts the
  probability of the benefit being paid. e.g. bankruptcy (post-loss funding))
• Terminal funding (Funded as soon as a benefit starts to be paid; usually an annuity type
  benefit)
• Regular contributions (Funds are gradually built up to a level sufficient to meet the cost of
  benefit, over the period of the promise being made and the benefit first becoming payable)
• Lump sum in advance (Funds that are expected to be sufficient to meet the cost of the benefit
  is set up as soon as the benefit promise is made, e.g. single premium)

Question 5

State 3 reasons why actual contribution rate may be different from calculated contribution rate in benefit schemes.

Answer 5

• The current funding level may be at a shortfall or surplus. (could be due to optimistic/pessimistic
  assumptions, differing experience than expected, sponsor paid less or more than
  recommended contributions)
• Sponsor may want to change the pace of funding. (may be due to changes in fortunes of
  sponsor, changes in opportunity cost of contributions vs alternative investment ops, changes
  in views over the degree of caution/optimism required)
• Contribution limits may be impacted by regulation (upper limit due to tax incentives, lower limit
  to ensure min level of security)