Chapter 24: Pricing and financing

Question 1

Cost of benefits

Answer 1

The amount that should theoretically be charged for them.

Question 2

Premiums should be calculated as…

Answer 2

The value of benefits and expenses plus a contribution to profit.

Question 3

Premiums/contributions should allow for… (12)

Answer 3

• theoretical value of the BENEFITS to be provided
• value of the EXPENSES that will be incurred
• REINSURANCE costs
• COMMISSION
• contribution to PROFIT
• PROVISIONING bases
• OPTIONS and guarantees
• the use of EXPERIENCE RATING to adjust future premiums
• TAX
• INVESTMENT income
• COST OF CAPITAL
• CONTINGENCY MARGINS

Question 4

Price of benefits

Answer 4

The amount that can be charged under a particular set of market conditions and may be more or less than the cost.

Question 5

3 Factors influencing the price

Answer 5

• distribution channels employed
• level of competition in the market
• premium frequency

Think about the things to consider when a model spits out a premium:

• distribution channel
• product design
• size of market (competition)
• profit requirement

Question 6

Main methods of financing benefits

Answer 6

1. Pay-as-you-go (unfunded)
2. FUNDED:
   - lump sum in advance
   - terminal funding
   - regular contributions
   - just-in-time funding
   - smoothed pay-as-you-go

Question 7

2 Main factors affecting the cost of benefits

Answer 7

• frequency of occurrence (affects the timing of the benefits)
• severity (affects the amount of the benefits)

Question 8

2 ways of viewing a product price

Answer 8

• 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.

Question 9

4 Examples of distributions systems

Answer 9

• independent intermediaries
• tied agents
• own sales force
• direct marketing

Question 10

Independent intermediaries

Answer 10

Individuals who select products for their clients from all or most of those available on the market.

Question 11

Tied agents

Answer 11

Offer the products of one provider or a small number of providers.

Question 12

“own sales force”

Answer 12

Usually employed by a particular provider to sell its products directly to the public.

Question 13

Direct marketing

Answer 13

Press advertising, over the telephone, internet or mailshots.

Question 14

Financing

Answer 14

A term used for putting a price on benefits payable on future contingent events, primarily in the context of benefit schemes.
The section looks at the timing (or incidence) of monies paid in, ie contributions.

Question 15

Unfunded

Answer 15

Find the money to pay for the benefit as the benefit falls due.

Question 16

Funded

Answer 16

To some extent, the monies to meet the benefit costs are set aside before the benefits fall due.

Question 17

Terminal funding

Answer 17

Funds that are expected to be sufficient to meet the cost of a series of benefit tranches can be set up as soon as the first tranche becomes payable.

Question 18

Regular contributions

Answer 18

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.

Question 19

Just-in-time funding

Answer 19

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).

Question 20

Smoothed PAYG

Answer 20

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 changes.

Question 21

2 Reasons the actual contribution rate may be different from the calculated contribution rate

Answer 21

• the assets held are higher or lower in value than the accrued liabilities and thus there is a surplus or a shortfall.
• The sponsor may want to change the pace of funding of the scheme by paying a higher or a lower contribution in any year.

Question 22

3 Reasons for changes to the pace of funding

Answer 22

• changes in the fortunes of the sponsor
• the opportunity cost of the contributions and alternative investment opportunities
• changes in view over the degree of caution / optimism required

Question 23

5 advantages of pay-as-you-go

Answer 23

• allows benefits to be introduced at a worthwhile level in the early years as there is no need to wait for a fund to accumulate
• involves lower transaction costs (there is no funding)
• prevents funds from being tied up in the scheme
• for State-operated schemes it can increase solidarity within the community
• makes it easier to organise payment according to need with contributions according to ability to pay

Question 24

Why might a surplus arise in a benefit scheme? (3)

Answer 24

• the assumptions about future experience were unduly pessimistic
• the assumptions were reasonable but the experience turned out to be favourable
• the sponsor paid more than the recommended contributions

Question 25

Why might the “price” of benefits be different from the cost? (3)

Answer 25

• The provider’s distribution system may enable it to sell above the market price or take advantage of economies of scale
• There may only be a limited number of providers in the market and so a higher premium might be charged.
• The provider will also need to decide whether it is prepared to offer the business on a single premium basis or a regular premium basis or both. The provider may charge a higher regular premium in order to encourage policyholders to pay upfront.