Chapter 33: Pricing and Financing Strategies.

Question 1

Cost of benefits

Answer 1

The price that should theoretically be charged for them.

Question 2

Price of benefits

Answer 2

The price that can be charged for benefits, under a particular set of market conditions.
It may be more or less than the benefit costs.

Question 3

What should the cost of benefits take into account?

Answer 3

Expected Net Present Value of the benefits,
+ the expenses
+ contribution to profit

Other factors may need to be taken into account, e.g.:
\+ tax
\+ commission
\+ the cost of capital supporting the product
\+ margins for contingencies
\+ the cost of any options/guarantees
\+ the provision basis
\+ experience rating
- investment income
\+ reinsurance

Question 4

3 Reasons why the price charged might differ from the costs for an insurance product

Answer 4

• the provider’s distribution system: how competitive this is, and whether it enables the provider to take advantage of economies of scale
• the number of providers in the market and the current position in the underwriting cycle.
• the contract may be sold as a loss-leader, with the aim of attracting customers to the other, more profitable products of the company in the future.

Question 5

3 Reasons why the actual contribution rate might differ from the actual costs of the future benefits in a pension scheme

Answer 5

• the scheme may be in deficit and the contribution rate may need to be increased for several years to eliminate the deficit
• the scheme may be in surplus and the contribution rate may be reduced over several years to eliminate the surplus
• the sponsor might want to alter the pace of funding by paying a higher or lower contribution in any year. Legislation might restrict the extent of this.

Question 6

5 Ways of funding pension scheme benefits

Answer 6

• lump sum in advance
• terminal funding
• regular contributions
• just-in-time funding
• smoothed pay-as-you-go

Question 7

Lump sum in advance

Answer 7

Funds that are expected to meet the cost of the benefit are set up as soon as the benefit promise is made

Question 8

Terminal funding

Answer 8

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

Question 9

Regular contributions

Answer 9

Where funds are gradually built up to a level that is 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 10

Just-in-time funding

Answer 10

Funds that are expected to be sufficient to meet the cost of the benefit are set up as soon as an external risk arises that threatens the future financing of the benefits.
E.g. the bankruptcy of a sponsor.
If the anticipated risk event does not happen, then terminal funding or the pay-as-you-go approach can be used when the benefits come into payment.

Question 11

Smoothed pay-as-you-go

Answer 11

Funds are set up to smooth the costs under a pay-as-you-go approach to allow for the affects of:

• timing differences between contributions and benefits,
• short-term business cycles and
• long-term business change