Chapter 23-Pricing and financing strategies Flashcards
- Define the terms ‘cost of benefits’ and ‘price of benefits’.
The ‘cost’ of benefits can be described as the amount that should theoretically be charged for them.
The ‘price’ of benefits can be described as the amount that can be charged under a particular set of market conditions and may be more or less than the ‘cost’.
- Give a formula for calculating the theoretical cost of a set of benefits.
Value of premium(s) = value of benefits + value of expenses + contribution to profit
- List nine other factors that should be taken into account when calculating the ‘actual’ cost of benefits.
Other factors also need to be taken into account, for example:
* taxation
* commission - although this might be included as an expense
* the cost of any capital supporting the product
* margins for contingencies
* the cost of any options and guarantees
* the basis that will be used to set future provisions for the liabilities - as this may be different from the basis used to determine the cost
* the use of experience rating to adjust future premiums
* investment income
* reinsurance costs
- How are the costs of establishing provisions and solvency capital allowed for in calculating the cost of financial products?
Traditionally, financial product providers calculated the cost of financial products using a formula. Risk margins were included in the various assumptions. The resultant costs of the financial product made no allowance for the cost of establishing provisions on a prudent supervisory basis, or of any explicit solvency capital that needs to be held.
With a regulatory move to risk-based capital requirements for financial product providers, both the basic product costing basis and the reserving basis will be on a best-estimate basis. The solvency capital therefore becomes entirely explicit rather than being partially held as prudential margins in a valuation basis.
This solvency capital cannot be used by the product provider for any other purpose. Thus, it is important to allow for the opportunity cost of the capital not being available for use by the organisation on other ventures.
The cost of establishing provisions and solvency capital should be included as negative cashflow during the term of the contract, and any prudential margins in the provision and the explicit solvency capital should be released as a positive cashflow when the contract terminates.
- Once a cost has been determined, what else must the provider test?
Profit-testing models can then be used to estimate the results of providing the product under different scenarios.
The scenarios can be tested using either stochastic simulation or a set of deterministic scenarios, depending on the relative risk exposure and the cost / benefit analysis of the proposed modelling approach.
It is unlikely that a product can be priced to be profitable in all possible scenarios. The provider will need to determine a minimum level of profit that is made in all but a predetermined tail - for example, that a profit of x% of premiums is exceeded in 95% of simulations.
Finally, there will need to be some market testing to assess that the product is actually one that customers want and can afford. There are normally two ways of viewing a product price:
* Factor a profit criterion into the pricing process, and thus calculate the resultant premium. Test whether the premium is acceptable in the market.
* Input the desired premium into the pricing model and calculate the resultant profit. Test whether this is acceptable to the company.
- Give three examples where benefits might not be funded for in advance.
It is not always necessary for funds to be established to provide benefits on future contingent events. For example:
* A company may choose to self-insure its motor damage risks. It will just pay for repairs as they arise.
* A government may choose to pay State benefits to the retired out of current taxation revenue from working individuals and companies.
* Where risks are insured, the period of cover may be short, and each contribution might just purchase cover until the next contribution is due.
- Where benefits are funded for in advance, outline five funding options.
Where significant sums are involved for individuals and companies, it is usual for monies to be set aside before the full benefit becomes due. This mitigates the risks of the direct payment approaches, and there are several options that could be followed:
* funds that are expected to be sufficient to meet the cost of the benefit can be set up as soon as the benefit promise is made - a lump sum in advance, or single premium
* funds that are expected to be sufficient to meet the cost of a series of benefit payments can be set up as soon the first payment becomes due - terminal funding
* funds are gradually built up to a level expected to be sufficient to meet the cost of the benefit, over the period between the promise being made and the benefit first becoming payable - regular funding
* funds that are expected to be sufficient to meet the cost of the benefit can be set up as soon as a risk arises in relation to the future financing of the benefits (eg bankruptcy or change in control) - just-in-time funding. If the anticipated risk event does not happen then terminal funding or a pay-as-you-go approach could be used.
* funds that are set up to smooth the costs under a pay-as-you-go approach to allow for the effects of timing differences between contributions and benefits, short-term business cycles and long-term population change.
- Why and how might the government make some of these options more advantageous than others?
In some situations, for example in order to encourage retirement saving, governments may use the tax system to make some of these approaches more advantageous than others.
- Explain how different approaches to the incidence of funding can affect the allocation of risks.
Different approaches to the incidence of funding will also affect the allocation of risks between the individual or company exposed to the contingent event, and the provider of a financial product to mitigate those risks. Consequently this will influence the level of contributions required.
For example, in a territory with a well-developed fixed-interest investment market, a single premium at inception can be invested at a known yield to provide appropriately timed cashflows. If a stream of regular premiums is paid, the provider will have to include a margin for the risk of changes in future investment rates. This will increase the overall cost.
- Why might the insurance premium charged or contribution required differ from the actual cost of the benefits?
Providers selling financial products may charge premiums or require contributions that differ from the actual cost, for example:
* The provider’s distribution system for the product may enable it to sell above the market price or to take advantage of economies of scale and reduce the premiums charged.
* The provider may have a captive market, such as an affinity group, that is not price sensitive.
* The provider may choose to sell a product that covers its direct fixed and variable costs, but does not cover its expense overheads and minimum profit requirement. The purpose of this strategy is to stimulate sales of the product or other more profitable products. The company may expect greater profits across its whole product range. This is known as loss-leading.
* If there are only a limited number of providers in the market, demand may exceed supply and so higher premiums can be charged. If there are many providers are in the market and customers can choose between them, premiums will fall.
- Explain what is meant by marginal costing and why it might be undertaken.
As long as a company’s fixed costs are covered by margins from business currently on the books, each new policy only needs to cover the variable costs attributable to it, and it will make a profit for the company.
This means that only the variable expense margins need to be included in the product pricing and lower prices will therefore result. These lower prices might enable much larger volumes of business to be written.
This approach only works as long as the expenses included at least cover the variable costs. This is called marginal costing. If variable costs are not covered, each policy makes a loss, and writing large numbers is a disaster for the company.
- Outline limitations on the use of marginal costing.
While marginal costing can work, it must be remembered that it cannot be done for all product lines. As the existing business that is supporting the fixed costs goes off the books, new business that supports the fixed costs will be required.
- Why might the actual contribution rate for a benefits scheme differ from the (theoretical) calculated rate?
The actual contribution rate may be different from the calculated contribution rate for the following reasons:
* The assets held are higher or lower in value than the accrued liabilities and there is thus a surplus or shortfall. This will normally be used to adjust the calculated cost for a number of future years.
* The sponsor may want to change the pace of funding of the scheme by paying a higher or lower contribution in any year. This might be due to the sponsor’s financial circumstances and be unrelated to the scheme’s financial position. The limits within which contributions can be paid may in some circumstances be restricted by legislation.
