CHP 33 Flashcards
- Determining the costs of benefits
The cost of the benefits is the amount that should theoretically be charged for them.
1.1. Calculating a premium
Once the theoretical value has been calculated, this will be used in the calculation of the premium.
The premium could be calculated such that:
Value of future premiums = value of benefit + value of expenses + contribution to profit
The contribution to profit may be negative, depending on market conditions.
1.2. Other adjustments on premiums
- Tax
- Commission – this may be included in the expense
- Cost of any capital supporting the product (e.g. solvency capital)
- Margins for contingencies
- Cost of any options and guarantees
- Basis that will be used to set future reserves for liabilities – as this may be different from the basis used to determine the cost
- Use of experience rating to adjust future premiums
- Investment income
- Reinsurance cost
1.3. The influence of provisioning or reserving requirements
Solvency capital, made up of both explicit and prudential margins in the reserving basis, cannot be used elsewhere. An allowance for this opportunity cost must be made.
The cost of setting up reserves must be included as a negative cashflow during the term of the contract. The prudential and solvency margins in the provision and explicit solvency capital should be released as positive cashflows when the contract terminates.
1.4. Testing the premium for robustness
Profit testing models can be used to estimate the results of providing the product under different scenarios.
Scenarios can be tested deterministically or stochastically. This will depend on the relative risk exposure and the cost / benefit analysis of the proposed modeling approach.
Finally, market testing – see if customers want it and can afford it. There are usually 2 ways of viewing a product price:
• Factor a profit criterion into the pricing process, and thus calc the resultant premium – then test if the premium is acceptable in the market.
• Input the desired premium into the pricing model and calculate the profit resulting. Test if this is acceptable for the company.
- Determining the price of benefits
The price of benefits can be described as the amount that can be charged under a set of market conditions and may be more or less than the cost.
2.1. Why the price may differ from the cost
• The provider’s distribution system for the product may enable it to sell above the market price, or take advantage of economies of scale and reduce the premiums charged.
A cheaper premium might also be because the provider takes a lower contribution to expense overheads and profit.
• There may only be limited number of providers in the market, and thus higher premiums can be charged. The converse also holds. This is known as the underwriting cycle.
A cheap product may attract customers to buy other more expensive products and may raise overall profitability of the company
• Decide it the business is to be sold on a single premium basis, recurring premium basis or both.
- Determining the incidence of monies paid in
Where significant sums of money are involved, it is usual for monies to be set aside before the full benefit becomes due. This mitigates the risk of direct paying approaches and there is a range of options that could be followed.
Tax treatment
In some cases government will make some approaches more attractive by tax treatment.
3.2. Unfunded approach – pay-as-you-go
It’s not always necessary for funds to be established to provide benefits on future contingent events.
Lump sum in advance
Funds that are expected to be sufficient to meet the cost of the benefit can be set out as soon as the promise of the benefit is made – lump sum in advance.
Terminal funding
Funds that are expected to be sufficient to meet the cost of a series of benefit tranches can be set u as soon as the first tranche becomes payable.
Regular contributions
Funds are gradually built up to a level expected to be sufficient to meet the costs of the benefits. This will happen over the period of the promise being made and the benefit becoming payable.
Just-in-time funding
Funds expected to be sufficient to meet the cost of the benefit can be set up as soon as a risk arises in relation of the future financing of the benefits. E.g. bankruptcy or change in control.
Smoothed PAYG
Funds are set up to smooth the costs under the PAYG approach. This is to allow for the effects of timing differences between contributions and benefits, short-term business cycles and long-term population changes.
- Determining the amount of contributions for defined benefit pension schemes
For a benefit scheme the calculated contribution rate based on the cost of the benefits accruing is often adjusted to determine the actual contribution rate in any year.
