Chapter 16-Unit Pricing

Question 1

Define an internal unit-linked fund (3)

Answer 1

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.

Responsibility for unit pricing rests with company, subject to any relevant policy conditions.

Question 2

What are the principle risks associated with unit pricing?

Answer 2

Underlying assets
Volatile

+Large movement in market values (company liabilities depend on unit price, thus not exactly matched to underlying assets)

+Timing delays (introduces price risk needing to be managed)

Approximations included in price

+Tax on unrealised capital gains

+Accrued assets/liabilities (e.g. accrued interest not year received)

+Estimates of asset market values (e.g property prices not immediately observable; risk of estimates being wrong compared to correct price)

Errors in actual calculations

+Appropriation/expropriation basis (risk of wrong basis used to calc UP)

+Prices based on incorrect data (e.g. ass manager gives wrong asset MV)

+Error in calculation routine

Regulations restricting policy charges (which may be included in price, changes in this pose a risk)

Negative impact on company profits/income

+because charges are based on value of units

+company expected to make up shortfall in policyholder benefits resulting from pricing error

Negative impact on reputation (in turn affect new business/increased withdrawals)

Anti-selection (policyholders selectively dis-investing if aware that UP overstates NAV)

Question 3

State the basic equity principle 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

Question 4

Define:

(1) Appropriation price

(2) Expropriation price

Answer 4

Appropriation price

NAV of fund on an offer basis

amount of money per unit put into a unit-linked fund for each new unit appropriated i.e. created, such that the net asset value per unit is the same after as before the appropriation.

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 5

Outline how the appropriation price is calculated (4)

Answer 5

The market ‘offer price’ value of assets held by fund plus the expenses and any duty that would be incurred in the purchase

Plus the value of any current assets, such as cash on deposit or investments sold but not yet settled

less the value of any liabilities, such as investments purchased but not yet settled or loans to the fund

less 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 6

Explain how the calculation of the expropriation price differs from that of the appropriating price (2)

Answer 6

Main difference is that starting point is the proceeds that would be received from selling the assets in the fund

This requires that the investments of the fund are valued on a market ‘bid basis’, and that the expenses that would be incurred in the sale are deducted.

Question 7

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

Answer 7

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 (expropriation) basis

Question 8

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 8

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/expropriation price plus the initial charge and the bid price as the appropriation/expropriation 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

Question 9

What considerations should be given to charges levied on the unit-linked fund, hence unit price?

Answer 9

What the charges are used to fund
\+expenses (initial, renewal, termination)
\+cost of capital
\+profit
\+death/maturity guarantees

Charges start low level (then grow as fund increase)

Matching cashflows

+difficult to match initial expenses, since charges start low

+likely to be greater than ongoing costs later

Charges calculation
+fixed amount or related to fund value?
+related to FV exposes company to market risk, particularly when majority of charges will be of this form