Chapter 24: Pricing and financing strategies

Question 1

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

Answer 1

The cost of benefits can be described as the amount that should theoretically be charged for them.

The price of benefits is the amount that can actually be charded 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 factors other than the theoretical value of benefits, the value of expenses and a contribution to profit that should be considered when determining the cost of benefits

Answer 3

1. Taxation
2. Commission
3. The cost of capital supporting the product
4. Margins for contingencies
5. The cost of any options and guarantees
6. The provisioning basis
7. The use of experience rating to adjust future premiums
8. Investment income
9. Reinsurance cost

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 chep product may attract customers to other, more profitable products of the company
5. Underwriting cycle: there may only 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 effects of timing differences between contributions and benefits, short term business cycles and long term population change

Question 8

Lump sum in advance

Answer 8

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

Question 9

Terminal funding

Answer 9

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

Question 10

Regular contributions

Answer 10

Funds are gradually built up between promise and first benefit payment

Question 11

Just-in-time funding

Answer 11

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

Question 12

Factors influencing the choice of financing strategy

Answer 12

1. Tax treatment: In some situations, for example to encourage retirement saving, governments may use the tax system to make some of these approaches more advantageous than others.
2. Risk: Different approaches to the incidence of funding will also affect the allocation of risks between the individual or company exposed to the contingent event, and the provider of a financial product to mitigate those risks

Question 13

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

Answer 13

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 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.