Chapter 33: Pricing and Financing Strategies. Flashcards
Cost of benefits
The price that should theoretically be charged for them.
Price of benefits
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.
What should the cost of benefits take into account?
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
3 Reasons why the price charged might differ from the costs for an insurance product
- 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.
3 Reasons why the actual contribution rate might differ from the actual costs of the future benefits in a pension scheme
- 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.
5 Ways of funding pension scheme benefits
- lump sum in advance
- terminal funding
- regular contributions
- just-in-time funding
- smoothed pay-as-you-go
Lump sum in advance
Funds that are expected to meet the cost of the benefit are set up as soon as the benefit promise is made
Terminal funding
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.
Regular contributions
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.
Just-in-time funding
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.
Smoothed pay-as-you-go
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
NPV Definition
Expected present value of future cashflows under a contract, discounted at the risk discount rate
NPV Advantages
- Economic theory dictate s that investor chooses project with higher NPV
- Can compare projects of different sizes, timings, unequal lives
- Takes into account investment size – absolute amounts of wealth change
- Can handle non-conventional cashflows
- Additive
- Assumes cashflows generated during life of project can be reinvested at rate equal to opp cost of capital - reasonable
NPV Disadvantages
- Assumes perfectly free and efficient capital markets
- Assumes discount rate correctly reflects inherent riskiness of product
- Not very simple to present to non-technical people
- By itself tells you very little – needs to be expressed in terms of a ratio to be more meaningful (eg in terms of pv of premium, dist cost/initial commission)
IRR Definition
Discount rate that would give a NPV of 0
