Chapter 24 - Pricing and financing strategies

Question 1

Formula for the value of premiums to charge

Answer 1

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

Question 2

List factors that needs to be taken into account when determining premiums

Answer 2

COMET CRIB C

• Cost of solvency capital
• Options / guarantees costs
• Margins for contingencies
• Experience ratings used to adjust future premiums
• Taxation
• Commission
• Reinsurance Cost
• Investment Income
• Basis used to set future provisions for liabilities
• Competition

Question 3

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

Answer 3

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 4

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

Answer 4

DC UCL

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. 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
4. A CHEAPER price might also be the result of the provider taking a lower or no contribution to expense overheads and profit.
5. LOSS LENDER: a cheap product may attract customers to other, more profitable products of the company.

Question 5

What is marginal costing

Answer 5

It is when the expense included when pricing a contract only includes the variable costs that is related to that product.

Question 6

List ways of financing pension scheme benefits

Answer 6

PR LIST

• Pay as you go
• Regular contributions
• Lump sum in advance
• just In time funding
• Smoothed pay as you go
• Terminal funding

Question 7

Pay-as-you-go

Answer 7

Benefits are met out of current revenue and there is no funding

Question 8

Lump sum in advance

Answer 8

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

i.e a lump sum in advance or single premium

Question 9

Terminal funding

Answer 9

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

Question 10

Regular contributions

Answer 10

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 11

Just-in-time funding

Answer 11

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 benefits

payment is triggered by an external event. e.g insolvency of employer, which jeopardises the security of the fund

Question 12

Smoothed pay-as-you-go

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

Question 13

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

Answer 13

RAP

• RESTRICTIONS by legislation : there may be an upper and lower limit
• ASSETS held are higher or lower in value than the accrued liabilities and there is thus a surplus or shortfall
• The sponsor might want to change the PACE of funding: paying higher or lower contributions in any year

Question 14

3 Reasons for changes to the pace of funding

Answer 14

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

Question 15

5 advantages of pay-as-you-go

Answer 15

PALMS

• PREVENTS funds from being tied up in the scheme
• 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)
• MAKES it easier to organise payment according to need, with contributions according to ability to pay
• for STATE-operated schemes it can increase solidarity within the community