B2 C19 SR and CR 1

Question 1

Define the gross premium valuation method.

Answer 1

Gross premium valuation method

This method calculates a value of a life insurance company’s liabilities that
explicitly takes into account the future office premiums payable, expenses and
claims, including future discretionary benefits (where appropriate)

Question 2

Describe how a gross premium reserve would be calculated, for conventional
business, from a projection of future cashflows

Answer 2

Gross premium valuation method – cashflow approach

 For a policy in force at the valuation date, project the expected net
outgo for each future year, according to the valuation assumptions.
 The net outgo is the expected claim payments plus expenses, less
premiums (if relevant).
 Discount each year’s net outgo at the appropriate discount rate (which
may vary by duration).
 Sum the present values of all year’s net outgoes to obtain the reserve.

Question 3

List six key features of the gross premium valuation method.

Answer 3

Key features of gross premium valuation method

1. Explicit allowance is made for expenses
2. Explicit allowance can be made for bonuses
3. Future premiums valued are actual (‘office’) premiums expected
4. Any differences between pricing and valuation bases immediately taken
   as profit or loss
5. Reserves can initially be negative for non-linked business, partly due to
   initial expenses and partly due to capitalising expected future profit
6. Reserves tend to be quite sensitive to changes in basis

Question 4

List the two components of the liability that must be considered when valuing
a unit-linked policy.

Answer 4

Valuing unit-linked policy

Two components to consider are:
1. unit reserve – directly relating to value of units

2. non-unit reserve – relating to anything else, eg: future expenses and
   mortality costs etc.

Question 5

Outline what is meant by the unit reserve and state how it is calculated.

Answer 5

Unit reserve

 Part of reserve that life insurance company needs to set up in respect of
its unitised contracts.
 Represents life company’s liability in terms of units under contracts.
 Calculated as:
number of units * ‘bid’ price of units
ie price at which life company is contractually obliged to buy units off
policyholders.

Question 6

Explain why a positive non-unit reserve may be required for a prudential
valuation of a unit-linked contract.

Answer 6

Non-unit reserve
 The life company will receive monetary payments in the form of policy
charges to cover non-unit liabilities …
… eg expenses of managing the business
… or benefit payments in excess of the unit fund.
 If it expects the charges will not be sufficient to cover these liabilities at
any point on a cashflow basis, it has to hold a non-unit reserve to
provide for the deficiency.

Question 7

Describe how to calculate a non-unit reserve for a prudential valuation.

Answer 7

Calculation of the non-unit reserve for a prudential valuation

 Use a model to project forward the non-unit cashflows (eg charges less
expenses and benefits in excess of the unit fund) on a policy-by-policy
basis on the reserving basis.
 Start with the last projection period in which the net cashflow becomes
negative.
 Set up an amount at the start of that period which is sufficient, allowing
for earned investment return over the period, to ‘zeroise’ the negative
cashflow.
 Deduct this amount from the net cashflow at the end of the previous
time period.
 Continue to work backwards towards the valuation date, with each
negative being ‘zeroised’ in this way.
 If the adjusted cashflow at the valuation date is negative then a positive
non-unit reserve is set up equal to the absolute value of that negative
amount.

Question 8

Explain when a negative non-unit reserve may arise.

Outline the three conditions that the regulator may require to hold before a
negative non-unit reserve can be held under a prudential valuation.

Answer 8

Negative non-unit reserve

 May arise when life insurance company anticipates that future charges
will be more than sufficient to meet future non-unit liabilities.

 May be allowed by regulator if the following conditions all hold:
1. total reserves (unit and non-unit) exceed surrender value –
ensures that company is holding enough money if policy
surrenders
2. future profits arising on policy with negative non-unit reserve
need to emerge in time to repay the ‘loan’ that has effectively
been made from other contracts which have positive non-unit
reserves
3. there are enough positive non-unit reserves held by company
from which to ‘deduct’ negative reserves.

Question 9

State how the calculation of a non-unit reserve may be different when
calculated for a best estimate valuation (as opposed to a prudential valuation).

Answer 9

Non-unit reserves for a best estimate valuation

 The calculation would value all future non-unit cashflows, ie it would not
disregard cashflows occurring after the last projection period in which
there is a net outflow, and there would be no other restrictions.
 It would generally be the case that negative non-unit reserves can be
held.