Chapter 13 Unit pricing

Question 1

Management Box

Advantages and disadvantages

Answer 1

The ‘management box’ for a fund consists of units that have been created but are not owned by
policyholders, at any point in time. These units are therefore owned by the life insurance
company itself.

Advantages and disadvantages

The primary advantage of the management box is that it enables the company to maintain a
steady offer or bid basis, rather than having to change too frequently the basis on which it prices
units.
This achieves ‘broad equity’ between different unit-holders and avoids unnecessary and artificial
volatility in published unit prices.

The main disadvantage to the company is that it will be exposed to the investment risk of holding
a large number of units for its own account. Although with careful management it is a potential source of additional profit.

Question 2

Define an internal unit-linked fund (3)

Answer 2

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.

Question 3

State the basic equity pricinple of unit pricing for an internal unit-linked fund (5)

Answer 3

• 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, showing fund value to policyholders

Question 4

Outline the difference between an offer basis and a bid basis, and which basis is used in practice? (7)

Answer 4

• 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 (expropration) basis

Question 5

Appropriation price
Expropriation price

Answer 5

Appropriation price
* NAV of fund on an offer basis
amount of money per unit put into a unit-linked fund for each new unit approprated ie created, 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
amount of money taken out of a unit-linked fund for each unit expropriated cancelled, such that the net asset value per unit is the same after as before the expropriation.
therefore, it is the price at which a company will cancel units

Question 6

Outline how the appropriation price is calculated (4)

Answer 6

1. market ‘offer price’ value of assets held by fund plus the expenses and any duty that would be incurred in the purchase
2. value of any current assets, such as cash on deposit or investments sold byu not yet settled
3. value of any liabilities, such as investmens purchased but not yet settled or loans to the fund
4. any allowance/accrual for tax, if applicable

This gives a net asset value of the fund on an ‘offer basis’. Dividing the number of units existing at the valuation date i.e. before any new units are created, gives the appropriate price.

Question 7

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)

Answer 7

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