NPV calc

[andy orodo]

In Unit 15- Setting Assumptions, under the net present value section 2.7.2.1 it states:


"There are also some practical problems to bear in mind when using net present value, including;

- It is subject to the law of diminishing returns. If it were not then a company that could sell one policy with a positive NPV could sell an unlimitted number of policies and increase the value of the company without limit"


Is that just another way of saying market saturation? Either way does the initial funding of new business not get in the way of selling too much anyway?

I'm struggling to see the relevance of this point. Does this point suggest that applying an approach to pricing policies based on using a few model points with weightings representing the likely mix of new business and then multiplying the result by the expected volumes of that new business is an incorrect approach to pricing, and that some variable contingent on the volume of business input into the pricing model should be added that would effectively decrease the NPV? I wouldn't imagine so

Very confused

 

[b_colgan]

Essentially, it's saying that you can sell more and more policies and so increase NPV up to a point. After that point you might continue to sell more but decrease NPV or even sell less because diseconomies of scale would kick in.

For example, you might sell GBP£1m worth of policies with a NPV of, say, GBP£0.5m. However, selling GBP£5m might only increase your NPV by, say, GBP£ 2.0m (or GBP£0.4m for every GBP£1m premium). Possible reasons are paying staff over-time to administer the bigger business volumes or paying agents, sales staff or both higher commission for higher business volumes.

Market saturation would mean there's a limit to how many policies you can sell because of limited demand. You might consider this as a sort of diseconomy of scale. Initial funding would be a practical constraint of how much business you can afford to sell while demand would influence how much you actually sell. Scaling up sample modelpoints is a valid approach to pricing as covered in the Core Reading. The volume of business would be implicit in the pricing model. For example, your fixed expenses are fixed over a particular time horizon and within a particular business volume. If you were to price writing a substantially bigger block of business than normal, because of a change in strategy for example, then you would have to examine your fixed expense assumptions or risk under-pricing the business.

 

[andy orodo]

Essentially, it's saying that you can sell more and more policies and so increase NPV up to a point. After that point you might continue to sell more but decrease NPV or even sell less because diseconomies of scale would kick in.

For example, you might sell GBP£1m worth of policies with a NPV of, say, GBP£0.5m. However, selling GBP£5m might only increase your NPV by, say, GBP£ 2.0m (or GBP£0.4m for every GBP£1m premium). Possible reasons are paying staff over-time to administer the bigger business volumes or paying agents, sales staff or both higher commission for higher business volumes.

Market saturation would mean there's a limit to how many policies you can sell because of limited demand. You might consider this as a sort of diseconomy of scale. Initial funding would be a practical constraint of how much business you can afford to sell while demand would influence how much you actually sell. Scaling up sample modelpoints is a valid approach to pricing as covered in the Core Reading. The volume of business would be implicit in the pricing model. For example, your fixed expenses are fixed over a particular time horizon and within a particular business volume. If you were to price writing a substantially bigger block of business than normal, because of a change in strategy for example, then you would have to examine your fixed expense assumptions or risk under-pricing the business.

thanks for the explanation

in other words you might think that you end up with greater efficiency through increased economies of scale but what you could end up with is lower efficiency due to the strain on resources to push for higher new business volumes

 

[b_colgan]

Yes, that's about it.