Pricing Financial Services

Price is a measure of value and the only element of the marketing mix that represents revenue

The pricing puzzle

Pricing policy is Pricing policy is the last stronghold the last stronghold of medievalism in of medievalism in modern modern management management Perhaps few ideas have Perhaps few ideas have wider currency than the wider currency than the mistaken impression that mistaken impression that prices should be prices should be determined by costs of determined by costs of production production

Pricing is the single Pricing is the single judgement that translates judgement that translates potential business into potential business into reality. Yet pricing is the reality. Yet pricing is the least rational of all least rational of all decisions decisions

From Hoffman and Bateson, Services Marketing 2005

Profit drivers and the role of price

PROFIT SALES REVENUE SALES VOLUME PRICE

TOTAL COST VARIABLE COSTS FIXED COSTS

SALES VOLUME

X
VARIABLE UNIT COST

Differential impact of 10% change in each profit driver

Before Price 100 After 110 Profit before Profit after 30000 40000 Profit change

+33.3% +16.7% +16.7% +6.7%

Sales volume Variable Unit cost Fixed cost

1000

1100

30000

35000

50

45

30000

35000

20000

18000

30000

32000

PRICE DRIVES PROFIT LIKE NO OTHER DRIVER

Elastic and inelastic demand

Demand is sensitive to price change Demand is relatively insensitive to Increase demand Q2 more than price change compensates for lower price P2 At P1 increased revenue more than compensates for reduced demand Increased demand Q2 doesnt compensate for reduced price P2

Price sensitivity decreases as:

The perceived number of substitutes decreases (open plan/offset mortgage) The perceived unique value of the service increases (occupy a unique position ING) Switching costs increase (mortgages high exit fees, investments high surrender penalties/MVAF) The difficulty in comparing substitutes increases (NatWest Advantage bundle) The extent to which price is used as a quality cue increases (HNW private banking/stockbroking The expenditure is relatively small (credit card balance protection insurance) The less price sensitive consumers are to the end benefit (non-standard credit lenders) Shared costs for the expenditure increase (fee free mortgages) Price is perceived as fair relative to similar services/circumstances (store credit cards) Ability to build an inventory decreases
Hoffman and Turley 1999

What is price in financial services?

GENERAL INSURANCES CREDIT MORTGAGES SAVINGS ACCOUNTS
Premium and excess, insurance premium tax Interest rate/unauthorised charges Interest rate, survey fee, arrangement fee Notice period, penalty for early withdrawal Charges, zero interest

CURRENT ACCOUNTS

INVESTMENTS
Bid/offer spread, annual management charge

Covert and overt pricing methods

PRICING METHOD DEFINITION COVERT Hidden or implicit pricing Cost to consumer may be non-monetary (eg time, psychic) Explicit charging Cost is mostly obvious and monetary EXAMPLE Free banking (no interest). Maintain minimum balance, notice for withdrawal of savings NatWest Adv Gold monthly fee Transaction costs Management fees

OVERT

(Based on Harrison 2000)

Factors affecting pricing decisions

Short term cash flow survival Volume revenue, market share Value profit, ROI Image service quality, differentiation

Bundling, relationship Loyalty, service Delivery, distribution

Capital Fixed Variable

Insurance, default, shareholder funds,

Factors affecting mortgage pricing

Govt fiscal/ monetary policy Long term risk Free rate (Govt Bond) (4.56%) Lifetime value Basis Bundled benefits (Low margin with 5 year Swap cost @ 4.90%) Economic conditions Industry standard Lender Specific standards

Prepayment risk premium of lender Required return on FR mortgage

Risk premium of lender

Off-set through redemption penalties 4.99% 5 years + 500 arr fee

PRICE OF FR MORTGAGE

Price of a unit trust

Price consumer pays Determined by Price of individual shares

Unit price 100p/105p Bid/Offer spread 5% Annual Management Charge 1%

Asset specific risk Risk aversion Interest rates Next dividend Profit growth

Demand Sales, management and marketing costs Profit margin Performance Administration costs Competition Profit margin Distribution agreements

Price and non-price competition

Harrison 2000

Non-price competition
When is a good deal not a good deal? When the price looks good, But they let you down When it really matters
Direct Line UK motor insurance TV advertising campaign April 2006

Market responses to price cut at different demand elasticities

Market for motor and buildings insurances which are both obligatory Inelastic generic demand and elastic brand demand

A B

Brand A gains market share after price cut. Market demand is unchanged.

B and C cut prices to regain share. Market demand does not grow. Sales revenues decline

Market responses to price cut at different demand elasticities

Market for credit and for medical insurances Elastic generic demand and elastic brand demand

Brand A gains share after price cut

B and C cut price to regain share. Demand increases. Volume sales and industry revenues increase

Unique considerations of service pricing

Full disclosure of all aspects Bundling can make cross-elasticities Important. Price discrimination viable DEMAND Can emerge over time High fixed costs COST

LEGAL

Price has different names. Can be PRODUCT bundled to make price determination difficult

SERVICE PRICE

Price is one of few CUSTOMER cues available during pre-purchase

PROFIT COMPETITOR Price bundling can help profits Price comparison very difficult for many financial products

Pricing and product bundling

Consumers implicitly bundle many services/prices (eg football, cinema) Consider cross-price elasticities of bundled components How can revenues be maximised by understanding responsiveness of demand for one product relative to changing price for another?

Bundling and house purchase

Consumers create implicit bundle of total house purchase costs: Mortgage instalment 450 Life assurance 25 Buildings insurance 20 Contents insurance 35 Payment protection 25 Total monthly cost 555

Components of bundle are complementary resulting from negative cross price elasticity decreasing mortgage instalment increases likely demand for bundled components Price bundle based on understanding of differential profitability of bundle components

Summary
Pricing of financial services is highly complex involving internal and external factors Increasing focus on price as a competitive tool New entrants bring increased competitive pressures and new value propositions Product bundling has emerged as a form of non-price competition Overt pricing methods can help reduce dependency on interest margin for income Pricing and distribution are increasingly interrelated as new channels are used to reduce costs