Chapter 22 - Expenses Flashcards
What are the reasons for evaluating expenses? Name some considerations to be made for each.
Pricing individual and grouped policies
- Try to use best estimate of expenses
- Determine extent of cross-subsidies within product classes
- Determine extent of cross-subsidies between product classes
Valuation/Reserving
- Ensure financial soundness of the company
- Will not allow for future expense savings until these are proven to be real
Budgeting/Business management
Funding of schemes
- Similar to valuation
- Typically long-term outlook
What is going concern? What is the opposite of this?
Company expects business volumes to increase and are open to new business.
- This assumption could be used when valuing or pricing.
Closed to new business
Where do we get information for expenses assumptions? Mention any potential issues with each source.
Internal company financials
- May not be in required format
- May be random, once off fluctuations
External sources such as:
- Regulator
- Competitors financial statements
- Quotes from external businesses used for underwriting or other administration purposes
- Need to consider confidence intervals of what level of expenses information is likely to indicate
What are the main types of expenses?
Note these are generally definitions for a short term as all expenses will vary in the long run
Fixed expenses
- Fixed regardless of level of business
Variable expenses
- Variable by level of business, or other variable
Direct expenses
- Cost incurred by particular class of business
Indirect expenses
- Support functions - anything that can’t be classified to a single class of business
(Note error in second sentence of bottom paragraph of p.6 and chapter summary in notes)
How are expenses allocated to a particular policy?
See diagram.
- Basically make assumptions to determine the expense incurred by each product.
- Must consider assumptions carefully as well as their implications
- Important considerations include:
Timing of expense (initial, maintenance or termination)
Inflation
Cross-subsidies (do they exist and are they efficient or logical)
What is the difference between expense allocation and product charge?
Allocation is what we consider to be the expense incurred by each product, based on our assumptions.
Product charge is what we charge the client
- Charges can be derived after expense allocation
- Should be sufficient to cover profit, expense loadings and cost of risk
List some qualitative aspects which need to be considered when allocating expenses?
Risks
- Assumption and model risk
- Cross-subsidy risk
- volume risk
Potential implications of expense assumptions
Effect on competitive position
Fairness to client
Understanding of relative profitability
Other
(Previous cards are notes from lecture)
What is the general process for loading expenses onto a financial contracts?
Isolate and estimate the variable expenses
Spread the fixed expenses between contracts based on the estimates of new business to be written (this is a crucial assumption)
What are the possible differences in expenses between an insurance company and a benefit scheme?
A benefit scheme (BS) is often offered by employers to their employees.
BS may not have fixed overheads such as building maintenance or rent.
Much of the work (admin, legal advice, actuarial advice, investment management) could be outsourced to third parties
Otherwise, in-house services may be done by sponsor’s employees and so costs form part of the sponsor’s total overheads.
What class of expense do overheads fall into?
Indirect fixed expenses.
What is the main principle of expense allocation?
Expenses need to be allocated between:
Classes of business
Functions - related to the timing of the expense
What is the general guideline for allocating direct expenses?
If DE fall into single class of business, expenses can be allocated to that class.
If DE fall into multiple classes of business, timesheets (or other methods) can help assess how to split costs fairly between the applicable classes.
What is the general guideline for allocating indirect expenses?
More difficult to allocate.
Sensible steps may be to allocate expenses according to which departments they are most related to, as well as when the expenses are incurred.
What is the general method for allocating expenses by function?
Determine whether expenses are related to initial expenses, maintenance/renewal expenses or termination/maturity expenses.
Split the costs appropriately between the relevant functions of business.
Discuss some methods for loading expenses for premiums.
Depends on the form of the expense and how it is related to the premiums/claims/sum assured etc.
Percentage of premium or sum assured
- Some expenses are expressed as a percentage relative to the size of the contract, e.g. commission or underwriting
- Can be allowed for through incorporation in a cashflow model or formula calculation
Percentage of funds under management
- Some expenses can be expressed as a percentage of funds being managed and can be allowed for by deducting from the assumed investment return.
Fixed amount per contract
- Some admin expenses may relate to activities that are independent of the contract size.
- Expenses can be expressed as a fixed monetary amount per new contract or contract in force (e.g. single premium vs regular premium)
Fixed amount per claim or percentage of claim amount
- Claim expenses dependent on death or survival are normally independent of claim size and can be expressed as a fixed monetary amount
- For general insurance, the frequency of claims leads to expenses being expressed as a fixed percentage of the claim amount.
Would usually be a combination of the above
