Chapter 22: Expenses

Question 1

Typical Expenses of Financial Services Providers in Decreasing Order of Amount

Answer 1

• Staff Salaries, Pensions Contributions, National Insurance Contributions
• Commission Payments
• Office Rent and Related Expenses
• Office Equipment (eg Computers)
• Investment Costs
• Office Consumables (eg Stationary)

Question 2

Fixed Expenses

Answer 2

Remains broadly fixed in real terms

Question 3

Variable Expenses

Answer 3

Vary directly according to the level of business

Includes

• Volume of business (number of policies)
• Volumes and size (outsourcing underwriting relative to SA)
• Number of hours (consultants for a benefit scheme)

Question 4

Direct Expenses

Answer 4

Cost incurred by a particular class of business
Example:
- Savings vs Risk Products, then underwriting salaries direct relating to Risk Products
- Savings vs Whole Life vs Term - Then underwriting salaries indirect

Question 5

Indirect Expenses

Answer 5

• Cannot be attributed to a single class of business
• aka overheads
• support functions
• Need to be apportioned betweene the appropriate classes

Question 6

Give examples of expenses that are essentially fixed but can vary in large amounts from time to time

Answer 6

Staff related costs and accommodation costs can vary in the long term to meet changes in:

1. The structure of the organization
2. New and existing business levels
3. The services provided
4. The degree of automation used to provide services

Declining Operation
1. Sublet a while floor of its office premises when it becomes small enough

Question 7

List 3 allocation methods that could be used for indirect expenses and give an example of a cost that could be allocated by each method

Answer 7

1. Using a ‘charging out’ basis, e.g. computer time and related staff costs could be charged to the direct function departments based on actual use.
2. By floor space taken up by a department, e.g. premises costs
3. Using an arbitrary basis, e.g. statutory fees or senior management costs could be added at the end of the analysis as a percentage loading to all the other attributed costs

Question 8

How do the expenses relating to a benefit scheme differ from insurance company expenses?

Answer 8

1. No commission
2. May have no fixed overheads such as buildings maintenance
3. Administration, legal advice, actuarial advice or investment management may be delegated to a third party who charged a fee for the service
4. If done ‘in-house’ by the sponsors employees it will form part of the sponsor’s total overheads

Question 9

Explain why almost all direct expenses other than commission are fixed for a financial services provider that is running below full capacity

Answer 9

In order to write new business it does not need to increase capascity (eg takaing on extra admin staff)

Therefore it should have few truly direct variable expenses other than sau commision and postal costs

Question 10

How to you allocate expenses to products

Answer 10

• First allocate to a class of business:
• Then allocate by function
• Then determine appropriate expense loadings
• Make expense loadings for pricing purposes

Question 11

How to you allocate expenses to class of business

Answer 11

Direct expenses
- Easy to allocate to class to which it related

Indirect Expenses

1. Expenses incurred “close” to class of business
   - eg business capturing department deals with both savings and risk products
   - Need some proxy to allocate expenses
   - eg ime spent on capturing a savings application form vs a risk application form
2. Expenses further away from a class of business
   - eg CEO’s salary
   - One option:
   > Allocate to departments closer to the class of business
   > And THEN allocate that departments costs to the class of business

Question 12

What would be a reasonable way to allocate salaries of the underwriting department

Answer 12

• % of Sum Assured (relatively more time on large sum assured)
• % of premium (bigger SA = bigger premium AND more time spent on rated lives)

Question 13

What would be a reasonable way to allocate salaries of the new business capture department

Answer 13

• per policy (assuming the small/large products take about the same time to capture)

Question 14

What would be a reasonable way to allocate time by the actuarial department doing valuations

Answer 14

• % of assets of pension fund (more time spent on the larger funds)
• per scheme AND % of assets (there is a minimum amount of time spent, irrespective of size to prepare data …)

Question 15

What would be a reasonable way to allocate cost of the marketing department of a general insurer

Answer 15

• per policy (‘cost’ to convince a person to buy product same for everyone)
• % of premium (maybe marketing department targets the high income individual)

Question 16

Reason for which expenses might be allocated by “function”

Answer 16

• Apportioned by function so they can be allowed for in determining product pricing or provisions for future liabilities. In order for them to be loaded onto premiums.

This will mean that each policy contributes an appropriate amount to the total level of expenses.

Question 17

3 “functions” of costs (by which they’re divided)

Answer 17

Relates to the timing of expenses

For most types of business the high level division is into the costs of

• securing new business
• maintaining existing business (policy renewal administration and investment expenses)
• terminating business (incl. claims and surrender)

This division may then be further subdivided.

For example, new business costs may be split into:

• marketing
• sales and commission
• administration
• underwriting

Question 18

Why would the cost of securing new business not be allowed for in determining provisions?

Answer 18

Provisions are established in respect of future liabilities once a contract has been sold. The cost of securing new business will already have been incurred and will not be included in provisions for future liabilities

Question 19

Determining appropriate expense loadings

Answer 19

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 handelings for business written, including contribution to the general fixed costs of the provider

The expense loading could be expressed as:

1. Fixed amount per contract - administration expenses (have to allow for inflation)
2. % of premium - commission
3. % of SA - underwriting expenses
4. % of funds under management - investment expenses
5. Fixed amount per claim - death benefit processing expenses
6. % of claim amount - general insurance claims administration expense
7. A combination of the above

Read p 9 and 10 for more

Question 20

Adjustments to expense loadings for pricing purposes

Answer 20

• Take account of Cross-Subsidies (for example same premium charged for new and renewal business, expenses may be higher than actual expenses for renewal policies, and expense loadings may be lower than actual expenses of writing new business - The assumption regarding the proportion of policies expected to be renewed will be crucial)
• Inflation - The allocation of expenses will be based on historical data, whereas loadings will need to reflect the current level of expenses
• Competition - Ensure marketability and competitiveness

Question 21

Describe the two elements of the inflation adjustment needed to determine an appropriate expense loading for premium rating

Answer 21

• historic - to bring the expense data up to date
• prospective - to inflate the expense data to the time when the expenses are expected to be incurred

Question 22

For what purposes do expenses need to be allocated?

Answer 22

Pricing
- Pricing philosophy
> Extent of cross-subsidy between classes (small
premium vs large premium) and within
a class (sold direct vs sold through fin advisors)
> Probably like it to be closer to best estimate

Valuation/Reserving
- Main purpose
> financial soundness of the company => prudent
>probably will NOT allow for future expense savings
until “proven”
- Often responsible for monitoring product profitability
>expense allocation between products affects the
view provided by the valuation’s actuary
- Going Concern vs Closed to New Business
> If closed to new business the # inforce policies will
shrink over time possibly at the faster rate
than the company is able to reduce its ongoing
expenses

• Budgeting / Business management
• Funding of schemes
• Business Case Preparation
• Understanding the profitability of a particular product
• Analysing sources of surplus
• Analysing areas of inefficiency within the organisation
• Financial planning
• Cashflow management

Question 23

Risks of setting expense loading

Answer 23

Mix-Risk (Cross-subsidy)

• Between classes
• Between instances of products within a class

Volume risk

Question 24

Where do you get the information from (to set the assumptions)?

Answer 24

Company Internal Financials
- May not be in the correct format
- Historic (once-offs)
> Recurring - need to take account of in allocations
> Genuine - do not include in analysis

External Sources

• eg regulator
• other companies’ financials

Question 25

What to do when faced with a new venture (setting expenses)

Answer 25

Launch a new product with underwriting for the first time

• Costs of outsourcing underwriting
• Parent company has underwriting - use their charges

Calculate premium for Group Scheme

• Can do detailed internal calculation
• What other service providers charge

Start a new division / company
- Consider high level cost structure of a small insurer