Chapter 22-Setting Assumptions (2)

Question 1

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

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

Answer 1

Published results

Supervisory reserves

Internal management accounts

Embedded values

Question 2

Valuing liabilities: overview

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

Answer 2

Broadly speaking, determined as PV of

Future benefit outgo

plus claims expenses (including commission)

plus taxes (if appropriate)

less future premiums

Question 3

Valuing liabilities: overview

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

Answer 3

Impact of changes in the discount rate

all things being equal,
decreasing (increasing) the discount rate, will increase (decrease) degree of prudence for a positive reserve

decreasing (increasing) the discount rate, will decrease (increase) degree of prudence for a negative reserve, where this is permitted

Question 4

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 4

For country concerned, consider

+legislation
+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 5

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 5

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 6

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 6

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 7

Valuing liabilities: going-concern vs break up basis

Answer 7

going concern
assume insurer continues issuing new business 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/process claims until book runs down

Question 8

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 8

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

Question 9

Reserving basis vs pricing basis: uncertainty in assumptions

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

Answer 9

Demographic assumptions

+already know who PHs are => good info about class of lives

+historical experience investigation likely to indicate future experience well (if data volume credible)

+hence less uncertainty in assumption than for pricing’

Expense assumptions

+should be easier to assess for reserving because
no future initial expenses

+less uncertainty over volume/mix of future business

+but share of fixed expenses covered by existing PHs affected by new policies expected…

+…so expense assumption still has some uncertainty

Question 10

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

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

Answer 10

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

Question 11

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 11

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

Question 12

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 12

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 13

Valuing liabilities: Embedded value, key considerations

Define embedded value (4)

Answer 13

Embededed value is defined as sum of:
+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 14

Valuing liabilities: Embedded value, key considerations

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

Answer 14

May need embedded values for

+published accounts as supplementary info

+internal management accounts

Question 15

Embedded Value: Calculation

Shareholder owned share of net assets (6)

Answer 15

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.

The value of the reserves (used in NAV) needs to be consistent with the assumption used in determining the emergence of future profit.

Question 16

Embedded Value: Calculation PV of future shareholder profits

Briefly outline the calculation (3)

Answer 16

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 17

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 17

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 shareholder transfers, for example, as generated by bonus declarations

Question 18

Define appraisal value (2)

Answer 18

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 19

Embedded Value: Assumptions

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

Answer 19

purpose for which EV is needed

insurer offering itself for sale likely use best estimate/realistic (no margins)

insurer purchasing may use cautious assumptions including margins

Question 20

Embedded Value: Assumptions

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

Answer 20

We need 2 bases for EV calculations

Reserving basis: This is used to determine the technical reserves used.

Projection basis: This is used to project the emergence of cashflow due to differences from the reserving basis.

Question 21

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?

Answer 21

Approaches used to allow for risk

RDR for future profit streams will traditionally reflect risk. All things equal, increasing RDR => increases allowance for risk (more conservative)

Stochastic approach: would highlight range of possible values profits might take

Market consistent approach: using Risk-free rate 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 22

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 22

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