Chapter 21-Expenses Flashcards
- Define, with examples, the terms ‘fixed expenses’ and ‘variable expenses’.
Variable expenses are those that vary directly according to the level of business being handled and may be linked to the number of policies or claims or the amount of premiums or claims.
Fixed expenses are those that, in the short term to medium term, do not vary according to the level of business being handled.
There is a third category of expenses that is essentially fixed, but that can vary in large amounts from time to time. Within this category would be a senior management team that would normally be a relatively fixed expense but would be changed if the structure or business of the company changed significantly. Similarly, a declining operation might be able to sub-let a whole floor of its office premises, when it becomes small enough. 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 and the degree of automation used to provide those services.
- How do the expenses incurred by a benefit scheme differ from those of an insurance company?
The expenses incurred by a benefit scheme may differ from those described above, 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.
- Define the terms ‘direct expenses’ and ‘indirect expenses’.
Direct expenses are those that have a direct relationship to a particular class of business.
Indirect expenses are those that do not have a direct relationship to any one class of business. So they need to be apportioned between the appropriate classes.
- Outline how different types of direct and indirect expenses can be allocated to classes of business.
Direct expenses
Direct expenses may arise from a department dealing purely with one class of business, in which case the expenses relating to that department can immediately be allocated to the relevant class. If direct expenses arise from areas dealing with more than one class of business then timesheets can be kept (either for a period or permanently) to help split costs between classes.
Indirect expenses
The indirect expenses are harder to allocate. The departments concerned are not related directly to any particular class of business, but form a support function for the provider. In this case, it is necessary to find a sensible apportionment of the expenses across direct business activities.
For some costs a ‘charging out’ basis could be used - computer time and related staff resources could be charged to the direct function departments based on actual use.
Premises’ costs can be allocated by floor space taken up by a department.
For other costs, such as statutory fees or senior management costs, a more arbitrary basis may be required. These costs could simply be added at the end of the analysis as a percentage loading to all the other attributed costs.
- Explain how expenses must be apportioned by function (ie by timing).
It is necessary to split expenses first by function and then into further sub-divisions because they will need to be allowed for in different ways when determining expense loadings for use in premium rating.
Additionally, a more detailed breakdown of the new business costs helps with analysis of expenses by targeting sources of profits or inefficiencies.
Knowing whether the function of a particular expense relates to
* securing new business
* maintaining existing business (policy renewal administration and investment expenses)
* terminating business (including claims)
gives information as to the timing of the occurrence of the expense. This subsequently helps the provider in deciding whether the expense should be loaded for as an initial, renewal or termination expense, when pricing a contract.
Sub-dividing such expenses further can ensure that costs which are only incurred by regular premium business are not included in expense loadings for single premium and paid-up policies.
- Outline the purpose of expense loadings in the pricing or provisioning basis.
These are required to ensure that sufficient premiums are charged or adequate provisions established to cover not only the expected claim costs, but also the costs of expenses related to administration and claims handling for the business written, including a contribution to the general fixed costs of the provider.
- Describe how commission costs would normally be loaded and allowed for in pricing or provisioning.
In most cases commissions paid to third parties and to employed sales staff for securing business will be proportional to the size of the contract and will usually be expressed as a percentage of premium. These costs can be allowed for by incorporating the commission rates directly into a formula calculation or a cashflow model.
- Describe how investment expenses would normally be loaded and allowed for.
Similarly, investment expenses would normally be expressed as a percentage of funds under management and these can be allowed for directly by a deduction from the investment return assumed.
- Describe how office administration expense loadings would normally be expressed.
In most cases, office administration expenses relate to activities that are independent of the size of the contract. For example, the cost of collecting a contribution is largely the same no matter the size of the contribution. These expenses would normally be expressed as a monetary amount (with an allowance for future expense inflation) per new contract issued or per contract in force, as appropriate.
- Describe the different possible approaches to treating claims expenses.
The treatment of claims expenses differs by the type of business.
In general, for claims that depend on death or survival of lives, the claim expense is often likely to be independent of claim size and expressed as an amount per claim.
For general insurance business, the expenditure on claims administration will be proportionate to the size of claim, with small claims being accepted (especially if there is the loss of a no claims discount) with minimal evidence, larger claims requiring assessment of multiple estimates, and the largest claims involving appointment of firms of loss adjusters.
- Give an example that demonstrates the importance of functional analysis of expenses.
The functional analysis of expenses is important in determining which expenses are charged to which contracts. For example, in a life insurance company the costs of regular premium collection would not be charged to single premium or paid-up policies.
- Why might the final amount and form of expense loadings in premiums be modified from the theoretical values?
The final amount and form of the expense loadings in the premiums charged may be modified from the theoretical values to ensure marketability and competitiveness.
- Describe how the actuary could derive expense loadings for annuity pricing basis in order to perform the check on the adequacy of existing expense loadings.
Staff costs
The various departments are likely to deal with several classes of business and so we need a method of allocating their expenses between classes, in order to isolate those expenses that relate specifically to annuity business.
For example, staff timesheets with activities split between classes could be used for all departments other than the support function departments. Support function department staff costs could be allocated between classes in proportion to the overall allocation of the other departments.
Once the annuity-related expenses for each department have been isolated, we need to decide on how to load them in the annuity premium basis.
For example:
* Sales and marketing - percentage of single premium
* Underwriting - one-off initial per policy expense or percentage of premium if the level of underwriting varies with the size of the policy
* New business processing - one-off initial per policy expense
* Existing business servicing - regular per policy deduction from the annuity payments.
The support function expenses could be allocated between the three categories of loadings in proportion to the overall allocation of the other departments.
The next task is to determine the size of the loadings.
* To determine a loading as a percentage of single premium, we would need to divide the total annuity ‘percentage of single premium’ expenses by the total annuity new business single premium written over the period of investigation.
* To determine a loading as a one-off initial monetary deduction from the premium, we would need to divide the total annuity ‘one-off’ initial per policy’ expenses by the total number of new business annuity policies written over the period of investigation.
* To determine a loading as a regular monetary deduction from the annuity payments, we would need to divide the total annuity ‘regular per policy deduction’ expenses by the total number of existing annuity policies being handled during the period of investigation.
Buildings’ and computing costs
The buildings’ rental costs would be allocated by charging a notional rent to each department, based on floor space occupied.
For ongoing computing costs, a charging out basis could be used by charging out computer time by departments.
One-off computing costs, such as purchasing new systems, could be converted into more regular costs by spreading the cost of the system over its estimated working lifetime (amortisation).
The buildings and computing costs for each department could then be split between classes of business in the same proportion as for the salaries of the employees of each department and converted into an expense loading by using the split used for staff costs.
Alternatively, we may decide to take a more pragmatic approach and just allocate all of these costs to one of the three types of loading.
