Chapter 24: Pricing and financing strategies Flashcards
What is the cost of the benefits and what are the main factors affecting the cost of the benefits?
Determining the cost of benefits
- The ‘cost’ of benefits can be described as the amount that should theoretically be charge for them
- Main factors affecting the cost of benefits will be the:
Frequency of occurrence (which will affect the timing of the benefits)
Severity (which will affect the amount of the benefits)
- Theoretical value of benefits alone (risk premium) may be determined using a formula or using a discounted cashflow model
How is an office premium calculated?
Calculating a premium
- Model first developed to determine the theoretical value of benefits to be provided, then work done to translate this value into a premium or cost to the customer
- Known as office premium
- The premium or contribution could be calculated such that:
Value of premium(s) = value of benefits + value of expenses + contribution to profit
What are some other factors that also need to be taken into account when setting the office premium?
Other adjustments
- Premiums or contributions should allow for:
the theoretical value of the benefits to be provided
the value of expenses that will be incurred
a contribution to profit
- Other factors that also need to be taken into account:
taxation
commission – might be included in expenses
the cost of any capital supporting the product
margins for contingencies
the cost of any options and guarantees
the basis used to set future provisions for liabilities
– this may be different from the basis used to determine the cost
the use of experience rating to adjust future premiums
investment income – if formula method used then investment income is allowed for implicitly within the discount rate to obtain the PV of future premium, benefits and expenses
reinsurance costs
What is the influence of provision or reserving requirements?
The influence of provision or reserving requirements
- Risk margins included in various assumptions
- Resultant costs of financial product made no allowance for cost of establishing provisions on a prudent supervisory basis or of any solvency capital needed to be held
- With a regulatory move to risk-based capital requirements for financial product providers, both the basic product costing basis and reserving basis will be on best estimate basis
- Solvency capital thus becomes entirely explicit rather than being partially held as prudential margins in valuation basis
- In past more common for provisions to be calculated on prudent basis i.e. more cautious than best estimate
- Under such approach, solvency capital held is combo of prudential margins within valuation basis and additional capital requirements imposed by regulator
- Regulators have moved to approach which uses best estimate basis to calculate basic liabilities or provisions – with added risk-based regulatory capital requirement
- In such cases, the solvency capital held is made up the latter
- This solvency capital cannot be used for any other purpose
- Thus, it is NB to allow for opportunity cost of the capital not being available for use by organisations on other ventures
- Cost of establishing provisions and solvency capital should be included as negative cashflows during term of contract
- And any prudential margins in provision and explicit solvency capital should be released as positive cashflow when contract terminates
How is the robustness of the premium tested?
Testing the premium for robustness
- Once premium or contribution determined, provider will want to know whether contract will be profitable if actual experience turns out to be different from that expected
- Profit testing models can then be used to estimate results of providing the product under different scenarios
- Scenarios can be tested using either stochastic or set of deterministic scenarios
- Unlikely that product can be priced to be profitable in all possible scenarios
- Need to determine min level of profit that is made in all but predetermined tail
- E.g. profit of x% of premiums is exceeded in 95% of simulations
- Lastly, need some market testing to assess that product is actually one that customers want and can afford
- Two ways of viewing product price:
Factor a profit criterion into pricing process and thus calculate resultant premium – test whether premium is acceptable in market
Input desired premium into pricing model and calculate the resultant profit – test whether this is acceptable to company
What is the price of the benefits and why may it differ from the cost?
Determining the price of benefits
- Price of benefits can be described as amount that can be charged under particular set of market conditions and may be more or less than the cost
Why the price may differ from the cost
- May charged premiums or require contributions that differ from actual cost e.g.
Provider’s distribution system may enable it to sell above market price or take advantage of economies of scale and reduce premiums charged
Examples of distribution systems include selling through:
Independent intermediaries – select products for clients from all or most of those available on market
Tied agents – offer products of one provider or small number of providers
Own sale force – employed by particular provider to sell its products direct to public
Direct marketing – via press ads, over telephone, internet or mailshots
Extent to which distribution system enables provider to sell above market price will depend on level of competition within distribution approach
- Provider may have captive market such as an affinity group that is not price sensitive
- May choose to sell product that covers its direct fixed and variable costs but does not cover its expense overheads and min profit requirement
Purpose is to simulate sales of product or other more profitable products – known as loss-leading
Taking extreme approach, the company might allow for no contribution to any fixed costs, direct or indirect – marginal costing
Another extreme – contribution to profit might even be negative
- Cheap product may attract customers to other, more profitable products of the company
Company may expect greater profits across its whole product range
Choose not to make profit on one product in order to cross-sell more profitable products
- If there are only limited number of providers in market, demand may exceed supply and so higher premiums can be charged
If there are many providers and customers can choose between them premiums will fall
What is marginal costing and when is it used?
Marginal costing
- Expenses of setting up and maintaining policy can be divided into fixed and variable costs
- Variable costs arise directly from policy-related activities
- Fixed costs relate to management and overheads
- If company’s fixed costs are covered by margins from business currently on the books – each new policy only needs to cover variable costs attributable to it and will make a profit
- This means that only variable expense margins need be included in product pricing and lower prices will therefore result
- Lower prices might enable much larger volumes of business to be written
- This approach only works as long as expenses included at least cover variable costs
- Called marginal costing
- If variable costs are not covered each policy makes loss and writing large numbers is disaster for company
- While marginal costing can work – cannot be done for all product lines
- Fixed costs have to be covered somehow – thus has to be subset of products offered which bear these expenses
- As existing business that is supporting fixed costs goes off the books new business that support fixed costs will be required
- Marginal costing may be used as technique to enter a new market or sell affordable products to lower income earners
What are the two approaches to financing the benefits?
Determining the incidence of monies paid in
Introduction
- Two approaches to financing benefits: unfunded or funded
- Unfunded – finding the money to pay for the benefit as the benefit falls due (also called pay-as-you-go approach)
- Funded – to some extent the monies needed to meet the benefit costs are set aside before the benefit falls due
- Where significant sums are involved – usual for monies to be set aside before full benefit becomes due
- Mitigates the risks of direct payment approach
Discuss further the unfunded or PAYG approach.
Unfunded approach – Pay-as-you-go
- Not always necessary for funds to be established to provide benefit on future contingent events
- For example:
Company may choose to self-insure its motor damage risks – just pay for repair as they arise
Government may choose to pay state benefits to retire out of current taxation revenue
Where risks are insured and each contribution might just purchase cover until next contribution is due (period of cover may be short)
What are the different variations of a funded approach?
Lump sum in advance
Terminal funding
Regular contributions
Just-in-time funding
Smoothed PAYG
What are the different variations of a funded approach? - Lump sun in advance
Lump sum in advance
Funds expected to be sufficient to meet cost of benefit can be set up as soon as benefit promise is made i.e. lump sum in advance or single premium
Lump sum is designed to be sufficient to provide all future benefit outgo
Entire funding payment made even though first benefit payment may not be expected for some time
Method of funding in which payment is made as early as possible
Fund is expected to cover liabilities of scheme
Payment made may turn out to be too high or too low if actual experience differs from that assumed
What are the different variations of a funded approach? - Terminal funding
Terminal funding
- Funds expected to be sufficient to meet outgo of series of benefit payments can be set up as soon as the first payment become due
- Payment is made whenever the benefit starts to be paid
- Payment is capital sum – designed to be sufficient to provide all future payments of benefit
- Under TF, fund exists from point at which benefits start to be paid
- Thus, contributions paid earlier than would be the case with PAYG
- Even when terminal contribution paid, fund might never exist within scheme
- Example, there would be no fund if benefit payable is:
Single payment e.g. lump sum payable on retirement
What are the different variations of a funded approach? - Regular contributions
Regular contributions
- Funds gradually built up to level expected to be sufficient to meet cost of benefit, over period between the promise being made and benefit first becoming payable
- E.g. pension contributions may be paid each month over working lifetime of member to provide pension from retirement age
- Regular contributions may vary
- E.g. contributions may be equal to:
level % of some factor e.g. salary
fixed amount per period of time in monetary terms
fixed amount per period of time in real terms e.g. linked to inflation
- Wide range of possibilities under this method for speed at which funds are built up – pace funding
What are the different variations of a funded approach? - Just-in-time funding
Just-in-time funding
- Funds can be set up as soon as risk arises in relation to future financing of benefit
- Payment is made at the last possible moment
- Payment triggered by external event (not benefit event) which jeopardises the security of the fund – this distinguished method from TF
- In case of pension scheme e.g. include employer insolvency or sale of an employer
- If anticipated risk event does not happen then TF or PAYG approach could be used
- This form of funding must be used in conjunction with some other form of funding
- Otherwise if risk event does not occur no funds would ever be set up
What are the different variations of a funded approach? - Smoothed PAYG
Smoothed PAYG
- Funds that are set up to smooth costs under PAYG approach to allow for effects of timing differences between contributions and benefits, short-term business cycle and long-term population changes
- The idea is to smooth income and outgo over time by maintaining fund as working balance
- Working balance is necessary because:
in some years, income will exceed benefit outgo and working balance will increase
in other years, benefit outgo will exceed income and working balance can be drawn on to make up shortfall
