Mock Exam A Solutions Q1 (iv) describes BLAGAB for savings contracts: "Profit can be measured as premiums plus investment return less expenses less claims (including increase in reserves). However, as these products are savings contracts, we expect that the premiums will be lower than the claims/reserves increase. Hence the minimum profits test is unlikely to bite". 1. Why does being a savings contract mean that premiums will be lower than claims/reserves increase ( does this not make the contract loss making if P < C or does this just mean our profits are coming mainly from the I component as a savings type contract?) 2. How do we get from P < C + (V1 - V0) to saying that MP < ( I - E)? 3. Also what would the situation in 1. be if the contract was a protection type contract (I know these are no longer BLAGAB) just to make sure I am understanding it correctly thanks people
More from the same solution: 1. "Capital gains (on equities) are also excluded until they are realised. As the company is new and expanding, it is possible that these gains will not be realised for some time as the expenditure can be met from premium income." Q: Don't the high initial expenses (u/w and commission) mean that expenditure will be much higher than the regular premiums early on hence the whole XSE scenario? 2. "Premiums (for CWP) or charges (for AWP) could then be reduced to relect the deferral of the payment of tax." How does the deferral of tax allow us to give better terms? The tax has been deferred, it hasn't gone away or been reduced. Isn't this unfair on the policyholders who then take out a policy when the company is XSI later on when the contracts are priced as XSI on worse terms? Hmmm maybe I should just give up now I seem to be on this forum more these days than in my books
Here’s my reasoning but I don’t think it’s perfect, so take it with a pinch of salt. The P+I’+A’-E-C-(V1-V0) is a fair amount of taxable profits for consistency with other proprietary companies. When designing a savings contract (i.e. endowment), the death/maturity benefits will be more than total premiums. Otherwise there is no value for money at all for policyholders. So premium P should be less than claims C (P<C). Reserves will generally build up to cover maturity amount over time. Hence reserves will be big and so changes in reserve should be big for maturity buildup. So V1 >V0 and P < V1-V0. So we get P < C + (V1 - V0) I think MP < I - E might because the E in MP is recognised as accrued i.e. high E in initial year whereas initial high E in I-E is defered over 7 years. Put all those factors together, the result is MP is less likely to bite. I think there are other factors too but can’t think off my head. If it was protection, assuming it’s still BLAGAB, its probably XSE. So company is probably taxed only on minimum profits i.e. MP > ( I- E). But I think it really depends on the circumstances of the company. So I suspect under certain situations it might be MP < (I – E)
Here’s my reasoning but I don’t think it’s perfect, so take it with a pinch of salt. Question 1 I think it’s possible. In fact the ActEd solution does agree to this possibility. Question 2 For XSE, contracts are taxed at (I – E)*t or (I*t – E*t). There’s a reduction on tax payable of E*t or better put it; the company receives credit on tax for the incurred E. So this gives room for the company to price premiums lower to make same profit margin compared to a XSI firm which has higher I. On fairness/unfairness to policyholders I think there will be inevitable cross subsidizing. But the tax transition regime for BLAGAB protection and OLTB protection products should partly take care of this issue. I am not based in the UK, so I don’t have any real experience on how taxation is set during the pricing stage. I’ve always thought the tax level charged in premiums is based on company wide trading profits or I – E rather than at individual pricing level. So the XSE/XSI status depends on the product mix of the company and subsequently affects pricing. But the solution does not agree with this, so I would appreciate some clarification here.
