Ch 22: Assumptions 2

Question 1

Summary card

Answer 1

• Essentially cover the different purposes for which we need to set assumption basis
• Published results
• Internal management accounts
• Embedded value
• Appraisal value

Question 2

In the first chapter on setting assumptions, we considered setting assumptions for pricing.

What other exercises may we construct basis for? (4)

Answer 2

• Published results
• Supervisory reserves
• Internal management accounts
• Embedded values

Question 3

Valuing liabilities: overview

Broadly speaking, how do we value the liabilities of a life insurer? (4)

Answer 3

• Broadly speaking, determined as PV of

1. Future benefit outgo
2. plus claims expenses (including commission)
3. plus taxes (if appropriate)
4. less premums

Question 4

Valuing liabilities: overview

What impact do margins have on prudence on the calculation of liabilities? (1)

Answer 4

• Greater the margins assumed => more prudent the calculation of liabiltiies

Question 5

Valuing liabilities: overview

What implication does increasing/decreasing the RDR have on calculation of liabilities? (3)

Answer 5

• Impact of changes in the RDR
  
  1. all things being equal,
  2. decreasng (increasing) the RDR, will increase (decrease) degree of prudence for a positive reserve
  3. decreasng (increasing) the RDR, will decrease (increase) degree of prudence for a negative reserve, where this is permitted

Question 6

Valuing liabilities: Published accounts, key considerations

State the factors to consider when deciding assumptions for determining the value of liabilities to show in an insurance company’s published accounts (6)

Answer 6

• For country concerned, consider
  
  1. legislation
  2. accounting principles
• Matters to consider
  
  1. going concern or break-up basis
  2. required to show a true and fair value?
  3. best estimate basis or some other basis?
  4. precisely how terms used are to be interpreted

Question 7

Valuing liabilities: Internal management accounts, key considerations

State key driver that should determine the pricniples to be followed for determining the value of liabilities for internal management accounts (1)

State the most likely aim of such a valuation. (1)

Answer 7

• Key driver should be discussion with insurance company about the principles to follow, based on the purpose for which the internal accounts are required
• Most likely aim is to have best estimates of the company’s financial performance, based on realistic assumptions.

Question 8

Valuing liabilities: Supervisory reserves, key considerations

How might rules governing the solvency supervision process relate to rules for published accounts? (1)

Key considerations for supervisory reserves (4)

Answer 8

• If separate accounts required during process solvency supervision process , rules for preparation of separate accounts may/may not be same as rules for published accounts…
• Key considerations
  • for example may be required to use different basis (going-concern/break-up basis)
  • Should reference rules & guidance which was issued needing interpretation
  • will most likely be certain assumption restrictions which are either
    
    • specific (valuation interest rates must equal premium basis rate)
    • general (do valuation as wish, subject to not lower than X basis)
  • usually require prudent basis, some jurisdictions moved to market consistent approach

Question 9

Valuing liabilities: going-concern vs break up basis

Answer 9

• going concern
  
  • assume insurer continues issuing new bussiness into future
• break-up
  
  • assume new business cease immediately, or at some point in future e.g
  • …closed fund by company, or..
  • …transfer liabilities to another insurer, who will administer/procress claims until book runs down

Question 10

Reserving basis vs pricing basis: uncertainty in assumptions

What’s a key difference between setting assumptions for pricing vs reserving in terms of information available? (1)

Answer 10

Key difference is that in force policies can provide important information for setting reserving assumptions (compared to pricing assumptions)

Question 11

Reserving basis vs pricing basis: uncertainty in assumptions

What kind of useful info can in force policies provide for setting assumptions?

(1,3)

(1,5)

Answer 11

In force policies can help with following

1. Demographic assumptions
   
   1. already know who PHs are => good info about class of lives
   2. historical experience investigation likely to indicate future experience well (if data volume credible)
   3. hence less uncertainty in assumption than for pricing
2. Expense assumptions
   
   1. should be easier to assess for reserving because
      
      1. no future initial expenses
      2. less uncertainty over volume/mix of future business
   2. but share of fixed expenses covered by existhing PHs affected by new policies expected…
   3. …so expense assumption still has some uncertainty

Question 12

Reserving basis vs pricing basis: using pricing assumptions for supervisory purposes

What is relationship between pricing and reserving assumptions in some countries? (1)

Answer 12

• In some countries, standard practice uses prudent assumptions for pricing/premiums, then same assumptionsf or supervisory reserving

Question 13

Reserving basis vs pricing basis: using pricing assumptions for supervisory purposes

What is impact on WP products of using pricing assumptions prudent enough to also be used for reserving? (1)

Answer 13

• For WP products, surplus will emerge from actual experience being better than that assumed in prudent assumptions ie. even if margins are high, surplusses from experience can be given back to PHs through bonuses

Question 14

Reserving basis vs pricing basis: using pricing assumptions for supervisory purposes

Why would prudent pricing basis strong enough for supervisory purposes be problematic for without profits business? (1)

Answer 14

• Less appropriate for without-profits products as overly high margins => uncompetitive, hence usually small margins are used, meaning pricing basis cannot be used for supervisory solvency

Question 15

Reserving basis vs pricing basis: using pricing assumptions for supervisory purposes

How appropriate is pricing basis for supervisory purposes if expected experience is used? (2)

Answer 15

• Sometimes use expected experience for pricing, with risk allowed for through RDR.
  
  • Inappropriate for supervisory reserving if reserves need prudent calc, since RDR has to be investment return assumption (risk free rate, if market consistent) and RDR is measure of return required by shareholders on their capital (hence irrelevant to reserve calculation, since unrelated to investment return assumption

Question 16

Reserving basis: best estimate reserves + market consistent reserves

What do we usually use best estimate reserves for? (3)

Market consistent valuation basis (1)

Answer 16

We usually use best estimate reserves when

• management want best estimate of company’s financial performance e.g
  
  • if insurer is to be sold
  • directors to award key staff for specific contributions to overall company growth

Market consisten valuation basis are covered more in

• Chapter 21 (assumptions part 1)
• Chapter 24

Question 17

Reserving basis: best estimate reserves + market consistent reserves

What are the key characteristics of best estimate reserves? (5)

Answer 17

Key factors to consider:

1. assumptions use company best estimate of future experience, with no margin, and basis is closer to new business prices, without efect of undewriting (ie most select lives assumed to now be ultimate)
2. all experience items would be allowed for explicitly (expenses, persitency, investment return, mortality)
3. no elminitation of negative reserves
4. cashflow method used for estimates of reserves needed
5. gross premium formula for non-linked business, with explicit best estimate assumptions for all variables and permitting negative values; likely to be unrealistic because doesn’t allow for discontinuance (and losses/profits therefrom)

Question 18

Valuing liabilities: Embedded value, key considerations

Define embedded value (4)

Answer 18

• Embededed value is defined as sum of:
  
  • starting point for realistic assessment of value of insurer
  • shareholder-owned share of net assets
  • present value of future shareholder profits from existing business, including release of shareholder assets
  • EV essentially recognises
    
    • value of assets in excess of reserves
    • and value to shareholders of future margin releases from reserves

Question 19

Valuing liabilities: Embedded value, key considerations

Why might we need to calculate embedded values? (2)

Answer 19

• May need embedded values for
  
  • published accounts as supplementary info
  • internal managaement accounts

Question 20

Embedded Value: Calculation

Shareholder owned share of net assets (6)

Answer 20

• Net assets are defined as the excess of assets held over those required to meet liabilities.
• These assets may be valued at
  
  • market value or
  • may be discounted to reflect lock in, e.g. if they are required to be retained within the fund to cover solvency capital requirements.
• Net assets may have to be invested cautiously to ensure that solvency capital requirements are met and
  
  • may as a result achieve lower return than could be achieved with a less constrained investment strategy,
  • and so they will be worth less than their market value to the shareholders.

Question 21

Embedded Value: Calculation PV of future shareholder profits

Briefly outline the calculation (3)

Answer 21

By PV of future shareholder profits

• similar to conducting profit test, excluding certain elements (eg new business expenses)
• project future CFs on existing business to estimate future profits
• allowing for tax
• discount future profits at appropriate discount rate (shareholder required return) to determine PV

Question 22

Embedded Value: Calculation PV of future shareholder profits

List components that make up the present value of future shareholder profits from existing contracts, for the following types of business:

• conventional without-profits (3)
• unit-linked (2)
• with-profits (1)

Answer 22

Conventional without-profits business

• present value of future premiums plus investment income, less
• claims and expenses, plus
• release of supervisory reserves and required solvency capital

Unit-linked business

• present value of future charges less expenses and benefits in excess of unit fund, plus
• investment income earned on, and release of, any supervisory non-unit reserves and required solvency capital

With-profits business

• present value of future sharheolder transfers, for example, as generated by bonus declarations

Question 23

Define appraisal value (2)

Answer 23

Embedded value is starting point for value of insurer, but doesn’t allow for future new business.

Appraisal value is sum of:

• embedded value (shareholder share of net assets + PV future profits from existing business)
• goodwill, which represents an estimate of the present value of future shareholder profits from future new business

Question 24

Embedded Value: Assumptions

What is the key determinant of assumptions used for EV? (3)

Answer 24

Key determinant of assumptions used for EV is

• purpose for which EV is needed
• insurer offering itself for sale likley use best estimate/realistic (no margins)
• insurer purchasing may use cautious, wth margins

Question 25

Embedded Value: Assumptions

What 2 different kinds of basis do we need for EV calculations? (2)

Answer 25

We need 2 basis for EV calculations

• Reserving basis:
• Projection basis:

Question 26

Embedded Value: allowing for risk

What risk do we need to allow for on EV calculations for the 2 different basis used? (2)

Answer 26

Allowing for risk in EV cal

• Our reserving basis must use supervisory regulations (which will inherently include risk, however the projection basis needs to also allow for risk adequately.
• Risk allowed for in projection basis is for unpredictability of profit emergence for life insurance business

Question 27

Embedded Value: allowing for risk

What approaches may be used to allow for risk we need to include for the 2 basis needed for the EV calc? (3)

Answer 27

Approaches used to allow for risk

• RDR for future profit streams will traditionally reflect risk. All things equal, increasing RDR => increasing risk
• Stochastic approach: would highlight range of possible values profits might take
• Market consistent approach: using RDR as discount rate, then risk margin deducted from EV to reflect non-investment risks e.g using cost of capital approach to be covered in next chapter

Question 28

Embedded Value: compared to Best Estimate

What are the key differences between Embedded Values and Best Estimate Values?

Best estimate basis (3)

Embedded value basis (3)

Answer 28

Both basis may use realistic assumptions, but try to focus on different things.

Best estimate basis

• present liability calculated per policy using realistic assumptions
• sum over all PHs compared with total aset value to give measure of realistic solvency (measure of PH benefit security)
• but change in retained profit each year can also be used to give measure of profit as extra piece of information

Embedded value basis

• consider CFs across portfolio each time period, rather than PV for each PH. Focus of calculation is SH profit
• takes full account of cost of capital in value of SH transfers, because each year’s transfer has to be made from profits that arise in excess of supervisory reserves held (increase in supervisory reserves will postpone emergence of profit for SHs, at least for without profit business and thereby give reduced PV when discounted at the RDR)

Question 29

Consistency of assumptions: in setting valuation basis

Discuss different aspects where consistency is important when setting a valuation basis

(7)

(2)

(3)

(1)

Answer 29

Consistency with previous basis

1. starting point in selecting valuation basis
   
   1. any deviations need justification
   2. eg apprpriate to adjust to new evidence eg if gross redemption yield from gov bonds had changed
2. changing basis can have significant impact on published results
   
   1. weaker basis, justify not just to accelerate profits
   2. stronger basis, justify not just to defer profits (tax)
3. manage conflict of interest when setting reserving basis
   
   1. overreserve, delay surplus emergence, reduces returns from capital providers
   2. underreserve, accelerate profits, increase returns, but poses risk
4. educate capital providers
   
   1. to believe interests best served by solvent company
5. indentify impact of basis changes seperately in accounts

Assets vs liabilities

1. basis for valuing liabilities, consistent with basis for valuing assets
2. eg if assets valued market value, then investment return assumption of liability basis must reflect current market yields (ie expected future market yields for risk free assets) if market consistent approach is taken

Pricing basis

1. allow for cost of setting supervisory reserves in pricing model used (these reserves will have been based on some reserving basis)
2. price determined will have allowed for CoC
3. essential that pricing basis reserves consistent with actual reserving

Supervisory vs internal valuation

1. Doesn’t necessarily need to be close, but should be considered

Question 30

Consistency of assumptions: in setting embedded value basis

Discuss different aspects where consistency is important when setting an EV basis

Answer 30

Previous basis

1. starting point will be basis used for previous EV calc
2. difference to prev will immediately cause some movement in EV
3. any change must be justifiable, esp if EV being used to report externally on insurer’s real worth
4. basis change appropriate if best estimate assumptions have changed

Assets vs liabilities

1. Same comments as for setting valuation basis
2. basis for valuing liabilities, consistent with basis for valuing assets

eg if assets valued market value, then investment return assumption of liability basis must reflect current market yields (ie expected future market yields for risk free assets) if market consistent approach is taken

Pricing basis

1. EV basis likely to be more best estimate than pricing basis
2. However, 2 should be looked at side by side. Any differences will immediately lead to embedded value movements on writing new business different to those implied in pricing basis