Chapter 24: Pricing and Financing Strategies

Question 1

What is the difference between the cost and the price of a set of benefits?

Answer 1

The cost of benefits is the amount that should theoretically be charged for them.

The price of benefits is the amount that can actually be charged under a particular set of market conditions. It may be more or less than the cost

Question 2

Risk Premium vs Office Premium

Answer 2

Risk Premium = Premium needed to cover benefits

Office Premium = Cost = Premium needed to cover benefits and expenses

Question 3

Factors affecting the cost of benefits

Answer 3

• Frequency of Occurrence
• Severity

Question 4

Formula for the value of premiums to charge

Answer 4

Value of premiums = value of benefits + value of expenses + contribution to profit

Question 5

See example p 3

Answer 5

DO IT

Question 6

List other factors to consider when determining the cost of benefits

Answer 6

1. tax
2. commission
3. the cost of any capital supporting the product
4. margins for contingencies
5. the cost of any options and guarantees
6. the provisioning basis
7. experience rating
8. investment income
9. reinsurance

Question 7

Influence of Provisioning or Reserving Requirements

Answer 7

With a regulatory move to risk-based capital requirements for financial services providers, both the basic product costing basis and the reserving basis will be on a best estimate basis (rater than a prudential basis). The solvency capital, therefore, becomes entirely explicit rather than being partially held as prudential margins in a valuation basis

This solvency capital therefore 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

Question 8

Testing the premium for robustness

Answer 8

Profit testing models can be used to estimate the results of providing the product under different scenarios such as:

• Economic scenarios (eg investment returns higher or lower than expected)
• Demographic scenarios (eg mortality rates being higher or lower than expenses)
• Business scenarios (eg expenses higher than expected, discontinuance rates higher than expected, new business volumes higher/lower than expected)

Special attention should be given to any guarantees and options

Reas p 6 and ch 18, modelling

Question 9

Give 5 reasons why the price charged might differ from the cost for an insurance contract

Answer 9

1. The provider’s distribution system for the product enable it to sell above the market price, or to take advantage of economies of scale and reduce the premiums charged.
2. The provider might have a captive market, such as an affinity group, that is not price sensitive.
3. A cheaper price might also be the result of the provider taking a lower or no contribution to expense overheads and only a minimum profit contribution - Known as loss-leading: a cheap product may attract customers to other, more profitable products of the company.
4. Underwriting cycle: there may only be a limited number of providers in the market and so higher premiums can be charged. Alternatively, if there are lots of providers in the market, premiums will fall.

Question 10

List 6 ways of financing pension scheme benefits

Answer 10

1. Pay as you go
2. Smoothed pay as you go
3. Terminal funding
4. Just in time funding
5. Regular contributions
6. Lump sum in advance

Question 11

Pay-as-you-go (Unfunded Approach)

Answer 11

Benefits are met out of current revenue and there is no funding established to provide benefits on future contingent events

eg

• Company self-insuring motor damage risks - pay for repairs as they arise
• Government choose to pay state benefits to the retired out of current taxation

Question 12

Smoothed pay-as-you-go (Funded)

Answer 12

The same as pay as you go but with a small fund to smooth effects of timing differences between contributions and benefits, short term business cycles and long term population change.

Ofter used by states

• Some years income (eg from tax) will exceed benefit outgo and the working balance will increase
• Other years benefits outgo will exceed income and the working balance can be drawn on to make up for the shortfall

Question 13

Terminal funding (Funded)

Answer 13

A lump sum is set aside to cover all the expected benefit costs when the first tranche of business becomes payable.

A payment is made whenever a benefit starts to be paid. This payment is a capital sum designed to be sufficient to provide all future payments of the benefits

A fund may never exist if the benefit is a single payment

Question 14

Just-in-time funding

Answer 14

Funds that are expected to be sufficient to meet the cost of the benefit can be set up as soon as the risk arises in relation to the future financing of the benefits (eg bankruptcy or change in control)

A payment is made at the last possible moment - The payment is triggered by an eternal event and not a benefit event, which jeopardizes the security of the fund

If the anticipated risk event does not happen, then terminal funding or a PAYG approach could be used

Must be used in conjunction with another funding method otherwise no funds would ever be set up

Question 15

Regular contributions

Answer 15

Funds are gradually built up to a level expected to be sufficient to meet the cost of the befit, over the period between the promise being made and the benefit first becoming payable eg pension fund

Question 16

Lump sum in advance

Answer 16

A lump sum is set aside to cover the expected benefit cost when the benefit is promised

Usually not used as the method ties up excessive funds which could be used better elsewhere

Question 17

Give three reasons why the actual contribution rate might differ from the calculated theoretical cost of the future benefits in a pension scheme

Answer 17

1. The scheme may be in a deficit (accrued liabilities > assets held) and the contribution rate may have to be increased to eliminate the deficit. Alternatively, the scheme may be in surplus and the contribution rate may be reduced to eliminate the surplus.
2. The sponsor may want to alter the pace of funding by paying a higher or lower contribution in any year. This may relate to the sponsors financial circumstances and be unrelated to the scheme’s financial positon
3. There might be legislative restrictions (upper and lower) on contributions.

Question 18

3 Factors influencing the price

WAAR?

Answer 18

• 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 19

2 ways of viewing a product price (for profit testing)

Answer 19

• 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 20

4 Examples of distributions systems

Answer 20

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

Question 21

Independent intermediaries

Answer 21

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

Question 22

Tied agents

Answer 22

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

Question 23

“own sales force”

Answer 23

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

Question 24

Direct marketing

Answer 24

Press advertising, over the telephone, internet or mailshots.

Question 25

3 Reasons for changes to the pace of funding

Answer 25

• changes in the fortunes of the sponsor eg if sponsoring company has performed badly it may have to cut contributions until it recovers
• the opportunity cost of the contributions and alternative investment opportunities
• changes in view over the degree of caution / optimism required

Question 26

5 advantages of pay-as-you-go

Answer 26

• 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 27

Marginal costing

Answer 27

As long a company’s fixed costs are covered by margins from current business 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

Only the variable expense margins need to be included in the product pricing and lower prices will therefore result. The lower prices might enable larger volumes of business to be written

It cannot be done for all products as the fixed costs need to be covered somewhere

Question 28

Factors affecting the choice of financing strategy

Answer 28

• Tax treatment

- Risk

Question 29

Possible reasons for there to be a surplus in a benefit scheme

Answer 29

• The assumptions about future experience were unduly pessimistic eg contributions too high
• The assumptions were reasonable but the experience turned out to be favourable
• The sponsor paid more than the required contributions