Chapter 10 - Profitability of exisiting and new business

Question 1

outline the criteria and accounting principles that define true and fair profitability? (4)

Answer 1

• The going-concern concept i.e. the insurer will continue in operation existence for the foreseeable future
  *The accruals concept i.e. revenue and costs are recorded as they are received or incurred not when cashflows are received or paid
• The consistency concept i.e. consistency from one period to the next
• The concept of prudence i.e. revenue and profit is not anticipated and provisions are made for known liabilities

Question 2

Outline reason why future surplus is expected to emerge on exisiting business? (4)

Answer 2

• Compulsory and discretionary margins included in published reporting reserving (where these are calculated on the FSV basis)
• Release of reserves (CSM and Risk Adjustment)
• Expected future shareholder cashflows not included in the liability e.g. cashflows for group business before the renewal date
• Shareholders entitlement to the portion of future declared bonuses on with-profit business (if not included in shareholder funds)

Question 3

List the components of EV?(3)

Answer 3

• Adjusted net worth (ANW) (free surplus available to shareholders and required capital (RC) to support business
• Present value of future profit after tax from policyholder fund (PVIF)
• Adjustment for the cost of required capital (CoRC)

Question 4

Outline the definition of covered business? (3)

Answer 4

• Contract regarded to regulators as long-term insurance business
• But it may be permissible to include non-life, health care administration and asset management business
• It may also be possible to exclude certain long-term insurance contracts if reported on separately

Question 5

Outline the components of ajusted net worth (ANW)? (2)

Answer 5

• The free surplus attributable to shareholders (the excess assets over liabilities and RC)
• Required capital (the assets attributed to business over and above assets backing liabilities)

Question 6

Explian why there is a cost in holding required capital? (4)

Answer 6

• Capital comes from shareholders and they expect a higher return on their money than the risk-free rate available in the market (because investing in a company is more risky)
• The required rate of return of shareholders is called the risk discount rate (RDR) i.e. risk-free rate plus a risk premium
• The RDR is expected to be higher than the investment return net of tax earned on required capital
• The difference creates an opportunity cost of required capital

Question 7

Outline the considerations that needs to be taken into account when considering using the risk margin in prudential valuations as the CoRC for EV purposes? (5)

Answer 7

• Is the risk margin is a suitable measure of CoCR from a shareholders perspective
  o Determine if an adjustment is required for non-hedgeable risk or capital buffers (Need to include cost of total Required capital)
• Whether the risk margins cost of capital rate of 6% is appropriate
• Comfortable that the friction cost of capital (e.g. double taxation and asset management) on targeted level of capital has been adequately allowed for in the risk margin
• Differences in contract boundaries
• Difference in the contracts included in risk margin calculation and contracts included in covered business

Question 8

Outline the modern financial economics approach to the calculation of EV? (3)

Answer 8

• Modern financial economics is based on the principle of no arbitrage and that investors cannot be rewarded for assuming non-systematic risk
• Under this approach EV should be calculated by discounting using the risk-free rate
• This approach does not take into account the investors pain of risk or individual utility

Question 9

Outline the traditional actuarial approach to the calculation of EV? (3)

Answer 9

• This approach assumes that shareholders require additional returns for taking on risks, not only systematic risks
• The traditional approach produces best estimates for future cashflows and is the approach described in APN 107
• However this does not preclude the use of market consistent methods or the prudential supervision basis adjusted appropriately

Question 10

Outline the additional complexity for participating business in the calculation for PVIF? (5)

Answer 10

in the South African context, this relates to participating business where the profit emerging is divided between shareholders and policyholders

• Therefore to calculate the future stream of shareholder profits, bonuses would first need to be projected
• This is likely to mean bonuses will be declared such that asset share will be paid out at maturity
• The value does not take into account that the policyholder may have to inject additional funds
• This represents a call option that needs to be deducted from the market value of the business (requires stochastic modelling to calculate)

Question 11

List the possible different basis required for with-profit contracts? (3)

Answer 11

• A basis to assess future bonus rates
• A projection basis to project liabilities to determine bonus given
• A valuation basis used to determine the cost of each future years bonuses

Question 12

Describe the critisms of traditional embedded value? (4)

Answer 12

• Allowance for the cost of financial options and guarantees
  o TEV projected cashflows on a deterministic basis and this resulted in financial options and guarantees being valued at intrinsic value
  o The time value of the option was only included implicitly through discount rates
• Allowance for the cost of capital
  o TEV allowed for the cost of holding minimum regulatory capital which does not allow for appropriate level of capital to be different from the minimum level of capital
• Risk discount rate
  o It was not clear whether the risk to which the shareholder are exposed were allowed for in the risk discount rate
• Lack of consistency in methodology, assumptions and disclosure
  o This made comparison between companies difficult

Question 13

outline market consistent embedded value? (3)

Answer 13

• MCEV is the present value of shareholder’s interests in the earning distributable from assets allocated to covered business after sufficient allowance for aggregated risk
• The allowance for risk should be set to match the market price of risk where observable
• The MCEV consists of the following components:
  o Free surplus allocated to covered business
  o Economic capital (required or available)
  o Value of in-force covered business
  o NO Cost of Required Capital