Chapter 24 - Pricing and financing strategies Flashcards
What are the main factors affecting the cost of benefits?
Frequency of claims
Severity of claims
What are the cost of benefits?
Theoretical value of benefits alone
What is the risk premium?
Amount that should theoretically be charged as premiums to fund the cost of benefits.
What is the office premium?
Value of benefits + value of expenses + profit loading
Apart from the factors included in the office premium, what other factors may be taken into account when pricing benefits?
Taxation
Commission (but this could be seen as an expense)
Cost of capital
- Relatively recent move to risk-based capital requirements
- Solvency capital becomes explicit rather than a prudential margin in calculations
- Cost of capital therefore refers to opportunity cost of holding supporting capital for a financial product
Margins for contingencies
Cost of any options and guarantees
Reflect differences in provisioning basis and pricing basis
Experience rating to adjust future premiums
Investment income
Reinsurance costs
How is the allocated premium tested for robustness.
Use profit-testing models to estimate results of a premium for a product/range of products under different scenarios.
Model could be deterministic (scenario testing and sensitivity analysis) or stochastic.
Product should be profitable in all scenarios but for predetermined acceptable conditions
Market testing will also need to be performed to ensure product structure is one customers want and can afford
What is the price of benefits?
Amount that can be charged for benefits under a particular set of market conditions. This amount may differ from the cost of benefits.
What are some possible reasons for the difference between cost and price of benefits.
Provider may have a captive market such as an affinity group that is not price sensitive
Product may be used as a loss-leader in an attempt to stimulate sales of products and increase overall profits.
The number of providers relative to demand for products can lead to increased or decreased prices.
Marketability
- Customer needs
- Competitor offerings
Distribution
- Distribution system may enable company to sell above market price, or conversely take advantage of economies of scale and reduce the premiums charged
- Examples of distribution systems are
1) independent intermediaries - require competitive prices
2) tied agents
3) own sales force
4) direct marketing - Market conditions due to underwriting cycle
Strategy
- Profit loading
- Account for cross-subsidies within product lines
- Account for cross-subsidies between product lines
Give a brief description of marginal costing.
When other product lines already cover fixed costs, it is possible to price other products to cover only the variable expenses related to that product. This will then results in a profit. This method, of only allowing for variable costs in the pricing of premiums, is called marginal costing.
Only a subset of products can use this approach as fixed costs must be covered somehow.
Level of cross-subsidy needs to be monitored carefully if using this approach
See p. 8 for more detail.
What is financing?
Putting a price on benefits (i.e. determining contributions) payable on future contingent events, primarily in the context of benefit schemes.
Outline the main approaches to financing
UNFUNDED APPROACH
- aka pay-as-you-go
- fund benefits when they fall due
FUNDED APPROACHES
- monies needed to meet benefits are, to some extent, set aside by the provider in advance of the benefit falling due.
Lump sum in advance
- 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
- This corresponds with all single-premium business
Terminal funding
- Fund is set up as soon as first benefit payment becomes due
- Fund may never exist if benefit is single payment or secured with a third party
Regular contributions
- Fund 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 refers to the timing of contributions, but the amounts may vary
Just-in-time funding
- Funds expected to be sufficient t 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
- Difference from terminal funding is that fund is set up when an external event triggers the contribution, not the benefit payment itself
- Will switch to terminal or PAYG funding if anticipated risk event doesn’t happen
Smoothed PAYG
- Funds are set up to smooth the costs under a PAYG approach to allow for the effects of timing differences between contributions and benefits, short-term business cycles and long-term population change.
- Fund is maintained as a working balance to make up for shortfalls or added to in years with profits
Discuss the factors influencing the financing strategy.
Tax treatment
- Taxation systems may make certain funding approaches more attractive
Capital requirements
Risk
- Funding can influence the risk allocation between the individuals and the company
Timing and level of income
Discuss possible reasons that the actual contributions may differ from the calculated contribution rate?
Contribution rate needs to account for variation in value of the scheme’s assets which was not accounted for at the outset.
- This would lead to a surplus or shortfall and contributions will be adjusted accordingly in future years.
The sponsor may also want to change the pace of funding due to their financial circumstances
- This could be unrelated to the scheme’s financial position
- Would have to be done within any specified regulations or contractual agreements.
Regulation changes may also change maximum level of contributions if tax system is being taken advantage of.
