Ch 22: Setting assumptions (2)

Question 1

Deciding on a valuation basis - basis should reflect

Answer 1

• Expected future experience
• Margins to ensure adequacy of reserves
• Legislation/regulation (for published reserves)
• Need for consistency

Question 2

Regulations may impose certain rules on valuation basis for published accounts:

Answer 2

• Whether going-concern or break-up basis is to be used
• Whether accounts have to be true and fair
• Whether assumptions should be the best estimate or include margins

Question 3

Reserving basis vs pricing basis

Answer 3

• Big difference is that setting assumptions for reserving basis, the policies are already in force which can provide important information.
• Policyholders are known - good info on the class of lives involved (parameter uncertainty should be lower for reserving than pricing basis)
• Expense assumptions for reserving basis easier to assess since no future initial expenses to be concerned about and much less uncertainty about volume and mix of existing business, but still share of fixed expenses to be covered by existing policies will be affected by number of new policies in future.
• Extent of margins required depends on valuation approach and purpose.

Question 4

For reserving basis why can’t realistic pricing basis be used with an appropriate risk discount rate?

Answer 4

• For reserving basis the discount rate HAS to be the investment return assumption.
• Risk discount rate is a measure of shareholders’ required return on capital and has nothing to do with the investment return assumption and hence is irrelevant in calculating reserves

Question 5

Embedded value definition

Answer 5

• Not only recognises the value of assets in excess of reserves but also recognises the value to the shareholders of future releases of the margins in those reserves

Question 6

Calculation of embedded value

Answer 6

• Present value of future shareholder profits in respect of existing business including the release of shareholder-owned net assets
• Calculated as the sum of:
  * Shareholder-owned share of net assets (net assets defined as excess of assets held over those required to meet liabilities)
  * These assets may be invested cautiously to ensure that the solvency capital requirements are met - worth less than their market value to the shareholders
  * PV of future shareholder profits arising from existing business (process of determining this amount is similar to a profit test without new business expenses
• Important that reserves used in determinantion of net assets are the same used when determining PV of future profits
• Tax is allowed for as appropriate

Question 7

Appraisal value

Answer 7

• Sart with embedded value but add goodwill (reflecting estimated profits expected from future business)

Question 8

Assumptions and basis for embedded value

Answer 8

• Key aspect in deciding on an Embedded value basis is the purpose for which it is calculated
• Need two bases (reserving basis and projection basis)
• Need to know reserves now to calculate the net assets and we need to know the reserves in the future in order to calculate the PV of future shareholder profits (change in reserves is part of calc)
• Regardless of purpose of EV calc, reserves are always calculated using supervisory basis!!!
• Projection basis projects company’s xp into the future (basis depends on the purpose of calc)
• Margins included to allow for unpredictability of profit emergence (could be higher discount rate (risk disocunt rate) or based on a stochastic approach which shows range of possible values future profits might take