Chapter 23 & 24 - Supervisory Reserves And Capital Requirements

Question 1

Definition of gross premium valuation method:

Answer 1

A method for placing a value on a life insurance company’s liabilities that explicitly values the future office premiums payable, expenses and claims, with the latter possibly including future discretionary benefits

Question 2

Features of the net premium valuation model: (4)

Answer 2

1. It is simple (the formula used, the data required)
2. Makes no explicit allowance for future expenses
3. Makes no explicit allowance for future bonuses
4. For regular premium business, the reserves are relatively insensitive to changes in the valuation basis

Question 3

Features of the gross premium valuation model: (7)

Answer 3

1. Explicit allowance is made for expenses
2. Explicit allowance made for vested and expected future bonuses
3. Future premiums valued are the actual premiums expected
4. Any differences between the pricing and valuation bases will immediately be taken as profit/loss
5. Reserves may initially be negative for non-linked business, partly due to initial expenses and partly due to capitalising the expected future profit
6. Reserves tend to be quite sensitive to changes in basis
7. The discount rate should be based on the yields of assets matching the liabilities or the risk free rate

Question 4

What is a passive valuation approach?

Answer 4

It uses a valuation methodology which is relatively insensitive to changes in market conditions and a valuation basis which is updated relatively infrequently.

Assumptions may be locked in, may be a requirement that the nin-economic assumptions are updated if experience worsens. (So the same valuation interesr rate nay be used throughout the term of the policy)

Question 5

4 advantages of using the passive valuation approach:

Answer 5

1. Tend to be more straightforward to implement
2. Involves less subjectivity.
3. Tend to result in relatively stable emergence of accounting profit
4. May be less likely to be subject to procyclicality and systemic risk:
   - passive valuation of assets (such as historic book value) would be little affected by volatile asset prices
   - active approach (such as market value) may result in the need to sell risky assets after a fall in prices, which could lead to further price falls

Question 6

Disadvantages of an active valuation approach: (3)

Answer 6

1. More complex than passive approach
2. Calculations could take longer to perform
3. Can be more costly

Question 7

Level of solvency capital required can be determined by: (2)

Answer 7

1. Formula based (example increasing lapse assumption by 20%)
2. Or based on a risk measure such as VaR

Question 8

Disadvantages of net premium reserves:

Answer 8

1. Will not work for single premium or paid-up contracts
2. Need to check that the implied future expense allowance is prudent, if it is not additional margins will be required

Question 9

3 disadvantages of using the passive valuation approach:

Answer 9

1. Are at risk of becoming out of date
   - hence management might fail to take appropriate actions in time
   - in particular, they might fail to take account of important trends,
   - such as increasing mortality trends etc
2. May provide false sense of security when the reality is that market conditions have changed significantly
3. Tend to be less informative ito understanding the impact of market conditions on the ability of the company to meet its obligations
   - particularly in relation to O&G

Question 10

What is an illiquidity premium?

Answer 10

The extra premium that investors require to compensate them for the risk of greater price volatility of corporate bonds

Question 11

2 purposes of reserves:

Answer 11

1. Demonstrating solvency to supervisory authorities
2. To investigate the realistic/”true” position of the life company

Question 12

Financial strength of a company refers to its ability: (3)

Answer 12

• withstand adverse changes in experience
• to fulfil its new business plans
• to meet policyholder reasonable expectations