Pricing on Gross/Net Basis

[Always Trying]

Hi All,

Thanks for the anticipated replies.

I am struggling with the concept of pricing on gross and net bases, and how this affects the competitiveness of the premiums.

Aprill 2010 Q2(iv) discusses this effect. It states in reference to term assurance:

'When taxed on XSI basis will result in competitive premiums as expenses receive tax relief. If the company moves to an XSE basis, this may result in uncompetitive premiums as investment income and expenses will assumed to be gross in the pricing basis.'

1. What does it mean when it says 'expenses receive tax relief' ??
I understand that the E is used to offset the I, but why does that affect the expenses in the pricing basis? Wouldn't that just change the amount of tax payable?

2. Why are investment income and expenses on a gross basis when the company has moved to XSE?

3. I have always thought that when a company is on an XSE basis, the amount of tax payable will be lower than those on an XSI basis, since you don't have to pay tax on I-E, only the NC1 profit.

I also thought that the only thing affecting the competitiveness of the premiums would not be whether a company is XSI or XSE, but simply by the amount of tax assumed in the pricing basis.

I must be missing something here.

Thanks for your help!

 

[Mark Willder]

I am struggling with the concept of pricing on gross and net bases, and how this affects the competitiveness of the premiums.

Aprill 2010 Q2(iv) discusses this effect. It states in reference to term assurance:

'When taxed on XSI basis will result in competitive premiums as expenses receive tax relief. If the company moves to an XSE basis, this may result in uncompetitive premiums as investment income and expenses will assumed to be gross in the pricing basis.'

1. What does it mean when it says 'expenses receive tax relief' ??
I understand that the E is used to offset the I, but why does that affect the expenses in the pricing basis? Wouldn't that just change the amount of tax payable?

When we are pricing the contract we will look at the profit vector:

P - C + I - E - Increase in reserves - Tax.

For a mutual that is XSI, the tax that is paid is:

(I - E) x tax rate

So the profit vector becomes:

P - C + I - E - Increase in reserves - (I - E) x tax rate

= P - C + I x (1 - tax rate) - E x (1 - tax rate) - Increase in reserves.

So, when we price the contract we use net investment return and net expenses. The expenses have been used to offset the tax on the investments - this is identical to receiving net investment return and paying only net expenses. We say that the expenses have received tax relief, because we price as if the tax authority have given us a refund at the tax rate on the expenses.

2. Why are investment income and expenses on a gross basis when the company has moved to XSE?

Again, when we are pricing the contract we will look at the profit vector:

P - C + I - E - Increase in reserves - Tax.

For a mutual that is XSE, no tax is paid is. So the profit vector becomes:

P - C + I - E - Increase in reserves

The profit vector includes the investment return and expenses at there full gross amounts.

3. I have always thought that when a company is on an XSE basis, the amount of tax payable will be lower than those on an XSI basis, since you don't have to pay tax on I-E, only the NC1 profit.

I also thought that the only thing affecting the competitiveness of the premiums would not be whether a company is XSI or XSE, but simply by the amount of tax assumed in the pricing basis.

Yes, an XSE company will pay less tax than an XSI company (all other things being equal). And yes, the competitiveness of the premium will depend on the amount of tax assumed in the pricing basis.

However, consider 2 companies.

Company A is XSE and only sells term assurances. It must price its term assurances using gross expenses and gross investment return.

Company B is XSI because it sells lots of savings contracts. However, it also sells some term assurances. It can price the term assurances using net I and net E (because the expenses on the term assurances can offset some of the investment return on the savings business).

Company B should have cheaper premiums for term assurances as it only needs to charge for net expenses (instead of the higher gross expenses). Company B will assume a lower investment return, but this hardly matters as term assurance reserves are so low.

This makes it really hard for new XSE insurers to enter the term assurance market as they are always at a disadvantage to the XSI insurers. For this reason all new term assurance is to be taxed on profits from next year - see Section 6 of Chapter 7.

Best wishes

Mark

 

[Always Trying]

Hi Mark,

Thank you very much for the reply! Very detailed and I understand it well now.

Thanks

Andrew