CA1 Paper 1 April 2005 Qsn 5

[nyaman]

This question was particularly challenging for me in terms of generating sufficient points and structuring them in a way that is logical and earns good marks. I did not think of marginal costing which is actually key in answering this question. I also did not consider further issues on how to deal with the conflict but rather focused on regulatory actions that can arise for the company.
My question is the solution states that "A reduction in fixed interest yields will mean a reduction in annuity rates." I thought that a reduction in fixed interest yields will lead to an increase in annuity rates since a lower rate of interest will be used to price them and also prices of the bonds to match annuities would have also increased. So annuity rates may need to be reviewed upwards. I don't know if am missing something.

 

[Lindsay Smitherman]

Hi

When offering annuity rates, the provider needs to think about what yield it can earn on the assets it will purchase to back the new annuities (e bonds).

Bond yields fall (equivalently, bonds get more expensive to purchase) -> the investment return that providers can earn on those assets falls -> amount of annuity that providers can afford to pay falls -> annuity rates fall

If you want to think about this in terms of the pricing calculation, then simplistically if we used a formulaic pricing approach and ignore expenses, profit margin, cost of holding reserves etc, then the amount of annuity X will be set as:

Single premium = X. a"(x)

As yields reduce, a"(x) increases and so X has to reduce.

Hope that helps.

 

[nyaman]

Hi

When offering annuity rates, the provider needs to think about what yield it can earn on the assets it will purchase to back the new annuities (e bonds).

Bond yields fall (equivalently, bonds get more expensive to purchase) -> the investment return that providers can earn on those assets falls -> amount of annuity that providers can afford to pay falls -> annuity rates fall

If you want to think about this in terms of the pricing calculation, then simplistically if we used a formulaic pricing approach and ignore expenses, profit margin, cost of holding reserves etc, then the amount of annuity X will be set as:

Single premium = X. a"(x)

As yields reduce, a"(x) increases and so X has to reduce.

Hope that helps.

Thanks for the explanation. So the annuity rate being referred to here is the annuity payment X. I thought the annuity rate being referred to in the solution is the annuity factor a"(x) which will increase as you explained above. So can you confirm another name for an annuity payment is annuity rate?

 

[Lindsay Smitherman]

The annuity rate is the ratio of annuity benefit to premium.

Often market annuity rates are quoted, for example, as the amount of annuity per £100,000 premium.

 

[nyaman]

The annuity rate is the ratio of annuity benefit to premium.

Often market annuity rates are quoted, for example, as the amount of annuity per £100,000 premium.

Noted. Thanks.