Contribution method (Q&A 3.6)

[User 1234]

Could anyone please help me understand how the contribution method works in calculating the expense surplus when there is no expense loading in premium basis. Q&A 3.6 part (ii) is one of such examples.

The solution (ii) says "Contribution method involves a comparison of actual and expected (valuation basis) expense. For this contract there are no "expected expenses" in the premium basis. If the valuation basis allows for expense then comparing real against valuation expense will not be of much interest...................However if there is no expense element in the valuation basis then this would be a good way for the company to recoup expense"

My question is:

1. I thought the bonus = difference between actual and expected expenses (valuation basis). Why the solution suddenly brings up premium basis here? What does it to do with the premium basis?
2. Why it says "will not be of much interest"?
3. I understand the latter part -assuming actual expense is 10, expense element in valuation basis is 0, then the expense surplus is 0-10=-10, so we could reduce the bonus rates by 10. However I don't understand the point the former part is trying to give.

Thanks a lot in advance

 

[Darrell Chainey]

Unusual and tricky question. If you get the latter part then I think you've understood the most important stuff.

Your thought in your Q1 is correct. However, with this method (and the revalorisation method) the valuation basis is often set to equal the premium basis (to avoid any immediate profit/loss being made). Here we've deduced that the pricing basis expense loading is zero, which might then imply we have the same for the valuation basis. This leads to the -10 surplus you mention. If, we more realistically had a non-zero expense valuation assumption then it doesn't really work. We would be comparing actual expenses against a somewhat arbitrary valuation expense that wasn't used when working out the initial sum assured.
Because this doesn't really work, it won't be of much interest (perhaps not the most helpful language to use).

I wouldn't lose any sleep over the subtleties here - very tricky!!