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IAI Actuarial Core Principles · Business Economics · Pricing strategies in the financial services sector

A life insurer using full-cost pricing expects sales of 50,000 policies and sets premiums accordingly. Sales actually turn out at only 30,000 policies, with fixed costs unchanged. What is the main weakness of cost-plus pricing that this illustrates?

The weakness is that cost-plus pricing ignores demand. The unit cost depends on an assumed sales volume, and if actual sales fall short, fixed cost per policy rises and the intended margin is not achieved, so the price may be wrong for the market.

  1. AIt ignores customer demand, so the volume assumed in the unit cost may not be achievedCorrect
  2. BIt always sets prices below marginal cost
  3. CIt cannot include any allowance for profit
  4. DIt requires the firm to be a perfect competitor
  5. It guarantees the profit margin is earned whatever the sales volume

Explanation

Average fixed cost depends on an assumed output. If demand is lower, fixed cost per policy rises and the planned margin is not earned. The method does not consider demand, so options claiming guaranteed profit or no profit allowance are wrong.

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