Chapter 23: Supervisory reserves and capital requirements 1

Question 1

There are two fundamentally different purposes for valuing the assets and liabilities of a life company: (2)

Answer 1

1. to demonstrate solvency to the supervisory authorities

2. to investigate the realistic/ “the true” position of the life company.

Question 2

Typical uses for a “realistic valuation”: (3)

Answer 2

1. to help determine the long-term sustainability of profit distribution rates and hence to help determine current bonus declarations.
2. to help determine the realistic profitability of the company for the information of shareholders (etc) and management.
3. to assist in the general management of a life company.

Question 3

The two primary reserving methods are: (2)

Answer 3

1. gross premium valuation; and

2. net premium valuation

Question 4

Definition: Gross premium valuation method

Answer 4

… 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 5

Definition: Unit reserve

Answer 5

The unit reserve is part of the reserves that a life insurance company needs to set up in respect of its unitised contracts. The unit reserve represents its liability in terms of the units held under the contracts.

Question 6

Definition: Non-unit reserve

Answer 6

The non-unit reserve is the present value of the excess of non-unit outgo (e.g. expenses, benefits in excess of the unit fund) over non-unit income (e.g. charges, unallocated premiums).

Question 7

The non-unit reserve can be calculated as follows: (5)

Answer 7

1. The calculation process starts with the last projection period in which the net cashflow becomes negative.
2. An amount is set up at the start of the period which is sufficient, allowing for earned investment return over the period, to “zeroise” the negative cashflow.
3. The amount is then deducted from the net cashflow at the end of the previous time period.
4. The process continues to work backwards towards the valuation date, with each negative being “zeroised” in this way.
5. When the process has been completed, if the adjusted cashflow at the valuation date is negative then a non-unit reserve is set up equal to the absolute of that negative amount.

Question 8

On negative non-unit reserves, regulations may specify that: (4)

Answer 8

1. The sum of the unit and non-unit reserve for a policy should not be less than any guaranteed surrender value.
2. The future profits arising on the policy with the negative non-unit reserve need to emerge in time to repay the “loan”.
3. After taking account of the future non-unit reserves, there are no future negative cashflows for the policy i.e. there should be no future valuation strain.
4. In aggregate, the sum of all non-unit reserves should not be negative.

Question 9

A general algorithm for calculating non-unit reserves (including negative non-unit reserves) is as follows: (7)

Answer 9

1. Project the expected future non-unit cashflow from the policy, i.e. income from charges less outgo.
2. Identify the last (most distant) cashflow (whether positive or negative).
3. Set the reserve as an amount needed to meet that cashflow at that point in time (even if the cashflow is positive set the non-unit reserve as a negative amount).
4. Check that the total reserve (i.e. unit plus non-unit) is greater than the surrender value.
5. Move back to the next previous cashflow, discount the reserve and then subtract from the reserve the new cashflow at the earlier time period. Repeat step (4)
6. Carry on repeating the process working backwards over time to the valuation date.
7. This will give the required non-unit reserve.

Question 10

Features of the gross premium valuation method: (6)

Answer 10

1. an explicit allowance is made for expenses.
2. an explicit allowance can be made for bonues
3. the future premiums valued are the actual (“office”) premiums expected.
4. any differences between the pricing and valuation basis will immediately be taken as profit or 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. the reserve tend to be quite sensitive to changes in basis.

Question 11

Features of the net premium valuation method: (4)

Answer 11

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