Chapter 33: Pricing and Financing Strategies Flashcards
Cost of benefits
The amount that should theoretically be charged for them.
Premiums should be calculated as…
The value of benefits and expenses plus a contribution to profit.
Premiums/contributions should allow for… (12)
- theoretical value of the BENEFITS to be provided
- value of the EXPENSES that will be incurred
- REINSURANCE costs
- COMMISSION
- contribution to PROFIT
- PROVISIONING bases
- OPTIONS and guarantees
- the use of EXPERIENCE RATING to adjust future premiums
- TAX
- INVESTMENT income
- COST OF CAPITAL
- CONTINGENCY MARGINS
Price of benefits
The amount that can be charged under a particular set of market conditions and may be more or less than the cost.
3 Factors influencing the price
- 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
Main methods of financing benefits
- UNFUNDED
- Pay-as-you-go - FUNDED:
- lump sum in advance
- terminal funding
- regular contributions
- just-in-time funding
- smoothed pay-as-you-go
2 Main factors affecting the cost of benefits
- frequency of occurrence (affects the timing of the benefits)
- severity (affects the amount of the benefits)
2 ways of viewing a product price
- 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.
4 Examples of distributions systems
- independent intermediaries
- tied agents
- own sales force
- direct marketing
Independent intermediaries
Individuals who select products for their clients from all or most of those available on the market.
Tied agents
Offer the products of one provider or a small number of providers.
“own sales force”
Usually employed by a particular provider to sell its products directly to the public.
Direct marketing
Press advertising, over the telephone, internet or mailshots.
Financing
A term used for putting a price on benefits payable on future contingent events, primarily in the context of benefit schemes.
The section looks at the timing (or incidence) of monies paid in, ie contributions.
Unfunded
Find the money to pay for the benefit as the benefit falls due.
Funded
To some extent, the monies to meet the benefit costs are set aside before the benefits fall due.
Terminal funding
Funds that are expected to be sufficient to meet the cost of a series of benefit tranches can be set up as soon as the first tranche becomes payable.
Lump sum
Regular contributions
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.
Just-in-time funding
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 the benefits (eg bankruptcy or change in control).
Smoothed PAYG
Funds that are set up to smooth the costs under a pay-as-you-go approach to allow for the effects of timing differences between: - contributions and benefits - short-term business cycles - long-term population changes. Working fund has surplus some years
3 Reasons the actual contribution rate may be different from the calculated contribution rate
- the assets held are higher or lower in value than the accrued liabilities and thus there is a surplus or a shortfall.
- The sponsor may want to change the pace of funding of the scheme by paying a higher or a lower contribution in any year. (3 subpoints)
- Regulatory constraints on how much can be contributed (Tax advantages)
3 Reasons for changes to the pace of funding
- changes in the fortunes of the sponsor
- the opportunity cost of the contributions and alternative investment opportunities
- changes in view over the degree of caution / optimism required
5 advantages of pay-as-you-go
- 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 (opportunity cost)
- 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
Why might a surplus arise in a benefit scheme? (3)
Think of same question flipped
- the assumptions about future experience were unduly pessimistic
- the assumptions were reasonable but the experience turned out to be favourable
- the sponsor paid more than the recommended contributions
Why might the “price” of benefits be different from the cost? (4)
- The provider’s DISTRIBUTION CHANNEL may enable it to sell above the market price or take advantage of economies of scale
- Provider has a CAPTIVE MARKET that is not sensitive to price. (Affinity groups)
- There may only be a LIMITED NUMBER OF PROVIDERS in the market and so a higher premium might be charged.
- LOSS LEADING
- MARGINAL COSTING
- The provider will also need to decide whether it is prepared to offer the business on a single premium basis or a regular premium basis or both. The provider may charge a higher regular premium in order to encourage policyholders to pay upfront.
