Chapter 22: Expenses

Question 1

Why do we need to understand the expenses?

Answer 1

For a financial services provider to set the premium or contribution for a financial contract or to establish provisions for existing contracts – it is necessary to understand the nature and timing of the expense

Question 2

What are the types of expenses?

Answer 2

Types of expenses

• Fixed and variable expenses:

 Some expenses may remain broadly fixed in real terms

 Others will vary directly according to level of business being handled at time

 May be linked to the number of policies or claims or amount of premiums or claims

• Direct and indirect expenses:

 Some expenses can be identified directly as belonging to particular class of business

 Others do not have direct relationship to any one class of business

 Need to be apportioned between the appropriate classes

Question 3

Discuss further fixed vs variables expenes.

Answer 3

Fixed vs variable expenses

• All expenses can vary in long term – so concept of fixed expenses makes most sense in short term
  Insurance company expenses
• E.g. variable expenses that might relate to one or more different measures of amount of business are:

 Commission – related to amount of premium income

 Postal costs for sending contract documents and claims forms – related to number of contracts sold and number of claims

 Legal expenses – related to the claim amount

• No fixed rule as to boundary between fixed and variable expenses – some expenses could fall into either category
• Third category of expenses that is essentially fixed but can vary in large amounts from time to time
• Within this category would be a senior management team – normally fixed expense but would be changed if structure or business of company changed significantly
• Staff-related expenses might remain fixed in real terms in short term
• In long term, staff costs will vary to meet:

 Changing level of new and existing business

 Changes in services provided

 The degree of automation used to provide those services

• Isolating variable expenses is NB in assessing the contributions needed to provide benefits on future financial events
• Once variable expenses have been isolated left with fixed expenses
• Spreading of fixed expenses between contracts will depend crucially on estimates of amount of new business to be written or handled
• Indirect fixed expenses sometimes referred to as overheads of the business

Benefit scheme expenses

• Expenses incurred by benefit scheme may differ from the ones above – as scheme may have none of the fixed overheads such as building maintenance or rent
• Possible that much of work of scheme, e.g. administration, legal advice, actuarial advice or investment management is delegated to 3rd party who charge fee for service
• Where services provided in-house this may be done by sponsor’s employees and costs will form part of sponsor’s total overheads

Question 4

Discuss further direct vs indirect expenses.

Answer 4

Direct vs indirect expenses

• Direct expenses are those related specifically to particular class or classes of business
• E.g. direct expenses relating to term assurance contract may include underwriting costs, commission, contract administration and claims settlement expenses
• Indirect costs relate to support functions such as:

 Computing
 Human resources
 General management

Question 5

How are expenses allocated and what are the main reasons for carrying out an expense analyse?

Answer 5

Expense allocation – principles

• Expenses need to be allocated between:

 Classes of business

 Functions – activity or operation e.g. expense might relate to activity of underwriting

• Main reasons that expenses need to be allocated in this way is so that can be loaded into premiums
• This means that each policy contributes an appropriate amount to total level of expenses
• Other reasons for carrying out expense analyses include:

 Determining expenses loading for calculating expenses

 Understanding profitability of a product

 Analysing sources of surplus

 Analysing areas of inefficiency within organisation

 Financial planning (expenses budgeting)

 Cashflow management (to ensure that liquid funds are available to pay expenses)

• Expenses form NB component of total outgo analysed in internal management accounts and financial plans
• Thus, expenses need to be allocated to different types of business as realistically as possible

Question 6

Discuss further allocating expenses by class of business.

Answer 6

Allocating expenses by class of business

Allocating direct expenses

• Direct expenses may arise from department dealing with only one class of business
• In this case expenses relating to that department can immediately be allocated to relevant class
• If direct expenses arise from areas dealing with more than one class of business – then timesheets can be kept to help split costs between classes
• E.g. staff in underwriting department may deal with several classes of business – costs can be allocated to each of these classes based on time recorded as being spent underwriting each of them

Allocating indirect expenses

• Indirect expenses – more difficult to allocate
• The departments concerned are not related directly to any particular class of business but form support function for provider
• Necessary to find sensible apportionment of expenses across direct business activities
• Must allocate indirect expenses to different classes of business
• No single correct approach for this – may help to allocate expenses to different departments
• Finally, must allocate expenses according to when they were incurred

Question 7

Discuss further allocating expenses by function.

Answer 7

Allocating expenses by function

• Costs need to be apportioned by function so that can be allowed for in determining product pricing or provisions for future liabilities
• Function relates to timing of expenses – considering first high-level division of expenses by function
• For most types of business, the high-level division is into the costs of:

 Securing new business

 Maintaining existing business – policy renewal administration and investment expenses

 Terminating business – including claims

• Depending on purpose of expenses analysis items may be subdivided
• E.g. new business costs might be split into:

 Marketing
 Sales and commissions
 Processing and policy issue
 Underwriting

• Functional analysis of expenses is NB in determining which expenses are charged to which contracts
• E.g. in life insurance company the costs of regular premium collection would not be charged to single premium or paid-up policies

Question 8

How is the appropriate expense loading determined?

Answer 8

Determining appropriate expenses loadings

• An NB element of product pricing process or one that establishes provisions for future liabilities is the determination of loadings for expenses
• Required to ensure that sufficient premiums are charges or adequate provisions established to cover:

 Expected claim costs

 Costs of expenses related to administration and claims handling for business written

• Expenses loading could be expressed as a:

	% of premium or sum assured
	% of funds under management
	Fixed amount per contract
	Fixed amount per claim or % of claim amount
	Combination of above

Percentage of premium or sum assured

• Commissions paid to 3rd parties and to employed sales staff for securing business – will in most cases be proportional to size of contract and expressed as % of premium
• Costs can be allowed for by incorporating the commission rates directly into formula calculation or cashflow model
• Underwriting is example of expenses that might vary according to sum assured – since policies with high sums assured are likely to need more detailed and expensive underwriting

Percentage of funds under management

• Investment expenses would normally be expressed as % of funds under management and these can be allowed for directly by deduction from investment return assumed

Fixed amount per contract

• Office administration expenses relate to activities that are independent of size of contract
• E.g. cost of collecting a contribution is largely same no matter size of contribution
• These expenses normally expressed as monetary amount (with allowance for future expenses inflation) per new contract issued or per contract in force

Fixed amount per claim or percentage of claim amount

• Treatment of claims expenses differs by type of business
• For claims that depend on death or survival of lives – claim expenses often likely to be independent of claim size and expresses as amount per claim
• For general insurance business, expenditure on claims administration will be proportionate to size of claim – with small claims being accepted with minimal evidence, larger claims requiring assessment of multiple estimates and largest claims involving appointment firms of loss adjusters
• Thus, for life insurance business, claim or termination expenses are typically allowed for through fixed expense loading per claim (allowing for inflation)
• For general insurance business, claims expense loadings often expressed as % of claim amount

Question 9

What are some adjustments that can be made, for pricing purposes, after having determined appropriate expense loadings?

Answer 9

Adjustments to expense loading for pricing purposes

• Having determined appropriate expense loadings for each policy based on past data, it may necessary to make some adjustments for pricing purposes
• For example:

 To reflect cross-subsidies
 For past and future expense inflation
 Due to competition considerations

Cross-subsidies

• Example occurs in general insurance where same premium and thus expenses loading may be charged for both new business and renewal business – even though renewal cases are cheaper to administer
• Expense loading in renewal business premium may be higher than actual expenses of renewing policy
• Whereas expense loading in new business premium may be lower than actual expenses of writing new business
• So, renewals are subsidising new business
• Assumption regarding proportion of policies expected to renew will be crucial
• Life insurance companies have to consider extent to which larges policies should cross-subsidies smaller policies
• E.g. if expense loadings are weighted more towards % of premium or sum assured rather than fixed per policy amount THEN larger policies will be making higher contribution towards fixed costs
• Hence there is cross-subsidy benefit being given to smaller policies

Inflation

• Actual expense loading used in premium rates will need to take into account expense inflation
• Allocation of expenses described above will based on historical data
• Whereas expense loadings in premium rates will need to reflect level of expense occurring while such business is in force

Competition

• Final amount and form of expense loadings in premiums charges may be modified from theoretical values to ensure marketability and competitiveness