Chapter 23-Supervisory Reserves and Capital Requirements (1) Flashcards
Reserves: background
What are the 2 key fundamentally different purposes for calculating reserves? (2,3)
Reserves are mainly calculated to
demonstrate solvency
+to regulators, by meeting a min valuation standard, showing insurer capable meeting all guaranteed liabilities
+given uncertain future, valuation standards likely to require prudent assumptions; using more best estimate assumptions=> more solvency capital required
quantify the realistic position of a company which helps determine
+bonus declarations to determine long term sustainability of profit distribution rates
+realistic profitability for information of shareholders/management
+general financial management
Reserves: background
What 2 primary methods can be used for reserve calculations? (2,1)
Gross premium valuation method
+under unit-linked business, special case of the gross premium arises
+where valuation of future non-unit cash flows may need a separate method to identify and reserve for future negative CFs
Net premium valuation method
Define the gross premium valuation method ( 3 )
Calculates value of a life insurance company’s liabilities that explicitly takes into account
+the future office premiums payable
+expenses & claims (potentially including future discretionary benefits)
Reserves = PV(expected future benefit outgo) + PV(expected future expenses) - PV(expectd future office premiums)
Gross premium valuation method: Formula method
List the 5 key points surrounding the Formula method used for Gross Premium Valuations (5)
(1) Method can often be expressed as a formula, eg for a without profits end:
SAA(x+t:n-t) + REa(x+t:n-t) - P’*a(x+t:n-t)
where: SA = sum assured, RE = regular expenses, P’ is office premium
(2) Contract usually priced so office premiums> claims & expenses
so on CF approach (alternative meth to formula approach), reserves theoretically negative at policy start , just before pmt of first premium/initial expenses
init expenses often higher than firs premium (for regular bus), leading to reserves being even more negative
(3) After contract start, no need to reserve for first premium/init expenses
however, any prudence in reserves (relative to pricing assumptions) may lead to reserves being positive even at policy commencement
(4) Cost of benefits and ren expenses generally increase with pol term, but premiums remain level
(for a reg prem, non-linked without-profits contract)
(5) There over time future benefits + expenses > premiums
except very early on in contract, giving a smooth progression of reserves, which start negative and finish with value equal to final benefit payment
Describe how a gross premium reserve would be calculated for conventional business from a projection of future cashflows
For a policy in force at the valuation date, project the expected net future outgo for each future year, according to valuation assumptions.
The net expected outgo is expected claims, expenses less premiums
Discount each year net outgo by the appropriate discount rate
Sum the present value of all years net outgo to obtain the reserve
Gross premium vln mthd: unit-linked reserves
List the 2 key components of the liability that must be considered when valuing a unit-linked policy (2)
unit-reserve
+part of reserve insurer sets up for its unitised contracts
+represents liability in terms of the units held under these unitised contracts
+calculated as number of units x ‘bid price’ of units
non-unit reserves
+part of reserve insurer sets up for its unitised contracts
represents liabilities other than that attributed to the unit reserve e.g. future expenses and mortality costs etc
Explain why a positive non-unit reserve may be required for a prudential valuation of a unit-linked contract (2)
Life company will receive monetary payments in form of policy charges to cover non-unit liabilities…
…eg expenses of managing 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
Gross premium valuation method: non-unit reserves
What general features are associated with non-unit reserves?
(1,2,4,4,1)
(1) Pattern of income not necessarily as smooth as without profits endowment.
income = charges less outgo in terms of expenses and claims in excess of unit reserves
(2) Cashflow approach essential due to
complexity of contracts
greater CF patterns’ variety
(3) Liabilities for unit-linked contracts denomicated in units and monetary terms, leading to need forunit reserve as well as non-unit reserve. Non-unit liabilities include
administration costs
mortality costs if not paid by unit reduction
future guarantee costs (eg min benfts related to prems paid)
future guaranteed subsidy of allocation rate if not covered by other margins in UP eg allocating 106% allocation of premiums
(4) Non unit reserve=PV(excess non unit outgo over non unit income)
outgo: expenses, benefits in excess of unit fund
income: charges, unallocated premium
discounted CF method is used
if PV non unit income > PV non unit outgo => overall negative non unit reserve; may or may not be allowed by regulation
Calc depends on purpose and regulations
Gross premium valuation method: non-unit reserve calculation
Describe how to calculate a non-unit reserve for a
prudential valuation (8)
(1) Prudental valuation requires reserves to be prudent
(2) Defines non unit reserve as amount required to ensure insurer able to pay claims & meet continuing expenses without recourse to further finance
(3) Required to consider year-by-year/month-to-month non-unit CFs to determine if non-unit reserve needed
(4) Model projected non-unit CFs on reserving basis (may need per policy)
(5) Start with last projection period in which net cashflow becomes negative (allowing for discounting and survival)
(6) Set up amount at start of that period which is sufficient, allowing for earned investment return over the period, to ‘zeroise’ the negative cashflow
(7) Deduct the amount from the net cashflow at the end of the previous time period
(8) Continue process backwards towards valuation date, with each negative being ‘zeroised’ in this way
(9) 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
Gross premium valuation method: non-unit reserve calculation
Describe how to calculate a non-unit reserve for a
best estimate valuation (3)
Value all future non-unit CFs, including CFs after last proj period with negative net outflow
There would be no other restrictions
Negative non unit reserves can be held (occuring if future non unit charges expected to exceed future non unit outgo. Essentially we have an asset, used to loan finances to other contracts with positive non unit reserves
Gross premium valuation method: negative non-unit reserves
Explain when a negative non-unit reserve may arise (1)
Describe some other features related to negative non-unit reserves (4)
Negative non-unit reserves may arise when
the life insurance company anticipates that future charges will be more than sufficient to meet future non-unit liabilities
A few other general points about negative non unit reserves
(1) represent a loan from other contracts which have positive reserves, which will be repaid by emerging future profits from policy for which negative non unit reserve is held (simply taking credit for future profits from a policy)
(2) improves capital effeciency, since it reduces total reserve under policy
(3) used, in theory, whenever there are future positive CFs the company would like to take advance credit for (be careful not to take too much credit)
(4) needs adequate surrender penalty, to ensure value of future CFs not lost if PH withdraws
ross premium valuation method: negative non-unit reserves
Outline the conditions that the regulator may require to hold before a negative non-unit reserve can be held under a prudential valuation (5)
total reserves (unit + non unit) > guaranteed surrender value ensures company holding enough money if policy surrenders
future profits arising on policy with negative non-unit reserve need to emerge in time to repay ‘loan’ effectively made from other contracts with positive non-unit reserves
no future valuation strain, after taking account of future non unit reserves
in aggregate, sum of all non unit reserves should not be negative (including reserves even from non unit contracts)
note even if negative non unit reserves allowed, for prudential valuation, safer to assume
+future CFs are lower than best estimates
+interest rate used is higher than best estimate
+survival rates are lower than best estimates
Gross premium valuation method: negative non unit reserves
How do we go about calculating negative non-unit reserves? (6)
(1) Model projected non-unit CFs on reserving basis (may need per policy)
(2) Identify last net cashflow whether positive or negative (allowing for discounting and survival)
(3) Reserve = amount at start of that period which is sufficient, allowing for earned investment return over the period, to ‘zeroise’ that cashflow
(4) Check that total reserve (unit + non-unit) > guaranteed surrender value i.e unit reserves less surrender penalty
(4) Move back to next previous CF, discount the reserve and then subtract from the reserve the new cashflow at the earlier time period. Repeat step above.
(5) Carry on repeating process working backwards over time to valuation date.
Gross premium valuation method: key features
List key features of the gross premium valuation method (6)
Explicit allowance made for expenses
Explicit allowance can be made for vested/expected future bonuses (where appropriate…if done, also referred to as bonus reserve valuation)
Future premiums valued are actual (‘office’) premiums expected
Any differences between pricing and valuation bases immediately taken as profit or loss
Reserves can initially be negative for non-linked business:
+partly due to initial expenses and
+partly due to capitalising expected future profit
Reserves tend to be quite sensitive to changes in basis
Net prem vln meth: definition
How would we define the Net Premium Valuation method? (4)
PV of expected future benefit outgo, less PV expected future net premiums
calcultd on interest & mortality basis only ie no explicit expense allowance
benefit ougto includes
bonuses declared to date, no explicit allowance for future bonuses
net premium is premium insurer would charge from pol inception to cover initial guaranteed benefits only (so again, expenses are ignored), assuming the same basis as used for PVs (so this may not be same as original pricing basis
