Hi, I would like to understand this concept numerically. Say cost of capital (coc)= 6% * required capital Under standalone basis for a new product, coc will be allowed as 6%* required capital including capital of new product in marginal basis, coc= 6% * required capital of new product only (required capital including capital of new product- required capital without new product) Hence, in marginal basis, coc will be lower. Similarly, for expense assumption, standalone assumes per policy expense = total expense /number of policies marginal basis expense= expense of writing new product only/new policy count (expected basis?) Expense example does not look correct to me; please advice. Marginal basis is not beneficial if product volume increases in future. Can someone explain why? How is it related to cost of capital and expense assumption in pricing? I am referring to April 2022, Q3 vi). Thank you,
This is along the right lines but not quite correct. Under the standalone basis, the cost of capital allowed for in the pricing would be based on the required capital needed for holding that product only, calculated as if that were the only product that the company was writing. Your statement for the marginal basis cost of capital is correct. So the difference relates to the fact that the standalone basis ignores any diversification benefits against other products, but the marginal basis would include such benefits - hence is lower.
Have a look at the glossary definition of 'Marginal pricing', which is what is relevant here. If a marginal costing basis is used, this means that the contract makes no contribution to overheads. So using a marginal costing basis means expense loadings are based on the marginal costs of writing those extra policies only (ie direct variable costs only). [This should be familiar from Subject CP1.] The alternative (a normal pricing basis) would be to include some contribution to overheads within the expense loadings.
If a company is using a marginal costing basis for a particular product, it is not gaining any contribution to overheads from that product and is relying on other products to cover all of the overheads. If the marginally costed product becomes a high proportion of the business sold, that position becomes untenable.
