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.
The actual contribution rate may be different from the calculated contribution rate for the following reasons:
• Assets held are higher or lower in value than accrued liabilities and there is thus a surplus or short-fall. This will normally be used to adjust the calculated cost for a number of future years.
• The sponsor may want to change the pace of funding of the scheme by paying a higher or lower contribution in any year. This may be due to the sponsor’s financial situation and the scheme’s financial situation. The limits in which contributions can be paid could be stipulated by legislation.
Different approaches to the incidence of funding will also affect the allocation of risks. Thus between the individual or company exposed to the contingent event, and the provider of a financial product to mitigate those risks.
Consequently this will affect the level of contribution required.
What are the 4 problems of Discounted Cashflow method?
Couldn’t get away with it in the real world
Market value of assets not equal to discounted value
Doesn’t allow for financial or non-financial risks
How to pick the long term investment return assumption for discounting in first place?
In the discounted cashflows, how do we discount bonds, how do we discount equities?
Market spot rates for bonds
Discounted dividend model for equities
What is the general name for M2M method?
Replicating portfolio, fair value
What is the fair value alternate of M2M? what’s the weakness?
Bond yield plus equity risk premium
Doesn’t take default risk into account, so it lowers the liability pv but doesn’t account for risk
How and why do we adjust the discount rate on corporate bonds, different from that on government bonds
Government bonds is from market spot rate yield curve
Corporate bond needs to be adjusted for higher risk and lower marketability
4 types of share valuation
General DDM
Simplified DDM
EVA for exec compensation
Key factors and market price of equivalent companies
How would you value options like calls
Arb free methods
How would you value swaps
Series of forward contracts
the 3 other yield comparison’s rather than Exp Ret=Req Ret’s
Normal yield
Yield ratios
Technical analysis/index levels
The main influences on bond yields/prices
Inflation Interest Exchange rate Institutional cashflow Fiscal deficit Other factors that might effect inflation or interest rates PIA-RRR Supply
What are the investor preference factors?
Liabilities
Education
Fashion
Tax regime
Regulation
Uncertainty in politics
Marketing
What factors effect equity markets
Inflation, real, actual, expected, uncertainty Interest, real vs. inflation too Exchange rate (exporters) Institutional cashflow Fiscal deficit Other factors that might effect inflation or interest rates PIA-RRR Corporate growth in profits, dividends Expected profits Riskiness versus other assets Real economy growth Risk appetite Market sentiment Supply #rights issues/share buy backs/privatisations (supply side)
Who are the 3 main players in the property market?
Investors
Developers
Occupiers
Successful project?
PROJECT CRAMPS Planning (full) Risk analysis is thorough Objectives are clear and meet customer needs Judge (monitor) development Excellent communications Conflict management Thorough testing
Critical path analysis
Relationships with suppliers challenging and stable
Appropriate pace so right things are done on time
Milestone review schedule
Performance and quality standards are set and measured
Supportive environment
