Ch 24: Pricing and financing

Question 1

What is the difference between the costs and the price of a set of benefits?

Answer 1

The cost of benefits is the amount that should theoretically be charged for them.

The price of benefits is the amount that can actually be charged under a particular set of market conditions. It may be more or less than the cost.

Question 2

Formula for the value of premiums to charge

Answer 2

Value of premiums = value of benefits + value of expenses + contribution to profit

Question 3

List other factors to consider when determining the cost of benefits

Answer 3

1) Tax
2) Commission
3) The cost of any capital supporting the product
4) Margins for contingencies
5) The cost of any options and guarantees.
6) The provisioning basis
7) Experience rating
8) Investment income
9) Reinsurance

Question 4

Give 5 reasons why the price charged might differ from the cost for an insurance contract

Answer 4

1) The provider’s distribution system for the product enable it to sell above the market price, or to take advantage of economies of scale and reduce the premiums charged.
2) The provider might have a captive market, such as an affinity group, that is not price sensitive.
3) A cheaper price might also be the result of the provider taking a lower or no contribution to expense overheads and profit.
4) Loss leader: A cheap product may attract customers to other, more profitable products of the company.
5) Underwriting cycle: There may be a limited number of providers in the market and so higher premiums can be charged. Alternatively, if there are lots of providers in the market, premiums will fall.

Question 5

List 6 ways of financing pension scheme benefits

Answer 5

1) Pay-as-you-go
2) Smoothed pay-as-you-go
3) Terminal funding
4) Just-in-time funding
5) Regular contributions
6) Lump sum in advance

All financing strategies are influenced by RISK TOLERANCE and TAX TREATMENT

Question 6

Pay-as-you-go

Answer 6

Benefits are met out of current revenue and there is no funding

Question 7

Smoothed pay-as-you-go

Answer 7

The same as pay-as-you-go but with a small fund to smooth the effects of timing differences between contributions and benefits, short-term business cycles and long term population change.

Question 8

Terminal funding

Answer 8

A lump sum is set aside to cover all the expected benefit costs when the first tranche of business becomes payable.

Question 9

Just-in-time funding

Answer 9

Funds are set aside only in response to an external event such as the sale of an employer.

Question 10

Regular contributions

Answer 10

Funds are gradually built up between promise and first benefit payment.

Question 11

Lump sum in advance

Answer 11

A lump sum is set aside to cover the expected benefit cost when the benefit is promised.

Question 12

Give 3 reasons why the actual contribution rate might differ from the calculated theoretical cost of the future benefits in a pension scheme (3)

Answer 12

1) The scheme may be in a deficit and the contribution rate may have to be increased to eliminate the deficit. Alternatively, the scheme may be in a surplus and the contribution rate may be reduced to eliminate the surplus.
2) The sponsor may want to alter the pace of funding by paying a higher or lower contribution in any year.
3) There might be legislative restrictions (upper and lower) on contributions.

Question 13

3 Factors influencing the price

Answer 13

• Distribution channels implied
• 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

Question 14

2 Ways of viewing a product price

Answer 14

• 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.

Question 15

4 Examples of distribution systems

Answer 15

• Independent intermediaries
• Tied agents
• Own sales force
• Direct marketing

Question 16

Independent intermediaries

Answer 16

Individuals who select products for their clients from all or most of those available on the market.

Question 17

Tied agents

Answer 17

Offer the products of one provider or a small number of providers.

Question 18

“Own sales force”

Answer 18

Usually employed by a particular provider to sell its products directly to the public.

Question 19

Direct marketing

Answer 19

Press advertising, over the telephone, internet or mailshots.

Question 20

3 Reasons for changes to the pace of funding

Answer 20

• Changes in the fortunes of the provider
• The opportunity cost of the contributions and alternative investment opportunities
• Changes in view over the degree of caution/optimism required

Question 21

5 Advantages of pay-as-you-go

Answer 21

1) Allows benefits to be introduced at a worthwhile level in early years as there is no need to wait for a fund to accumulate.
2) Involves lower transaction costs (there is no funding)
3) Prevents funds from being tied up in the scheme
4) For State-operated schemes, it can increase solidarity within the community
5) Makes it easier to organise payment according to need with contributions according to ability to pay.