Chapter 23 - Supervisory reserves and capital requirement 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
What are the 2 primary reserving methods
What about unit-linked business - valuation of non-unit cashflows?
- Gross premium valuation
- Net premium valuation
For unit-linked business, valuation of future non-unit cashflows may require the application of a separate method. Can be thought of as a special case of the gross premium 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 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
What would be the difference between a prudential valuation and best estimate valuation for non-unit reserves
- Prudential would require mathematical reserves to be prudent
+there would not be any negative non-unit reserves, i.e zeroise the negative reserves - Best estimate would value all cashflows
Gross premium valuation method: negative non-unit reserves
Describe some other features related to negative non-unit reserves (4)
few other general points about negative non unit reserves
- 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)
- improves capital effeciency, since it reduces total reserve under policy
- 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)
- needs adequate surrender penalty, to ensure value of future CFs not lost if PH withdraws
Gross 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
- total reserves (unit + non unit) > guaranteed surrender value
+ensures company holding enough money if policy surrenders - future profits arising on the policy with the negative non-unit reserves need to emerge in time to repay the “loan”
- there should be no further valuation strain
- in aggregate, the sum of all the non-unit reserves should not be negative
Gross premium valuation method: negative non unit reserves
How do we go about calculating negative non-unit reserves? (6)
- Model projected non-unit CFs on reserving basis (may need per policy)
- Identify last net cashflow whether positive or negative (allowing for discounting and survival)
- Reserve = amount at start of that period which is sufficient, allowing for earned investment return over the period, to ‘zeroise’ that cashflow
- Check that total reserve (unit + non-unit) > guaranteed surrender value i.e unit reserves less surrender penalty
- 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.
- 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 premium valuation method: key features
List key features of the net premium valuation method ( 4)
- Simple: formula used and data required is simple
- Makes no explicit allowance for future expenses
+Could make implicit allowance.
+Common approach for future expenses: assume future annual policy expense is less than difference between net premium company is valuing with this method, and office premium will actually receive, but will only work for regular premium business. - Makes no explicit allowance for future bonuses
- Reserves relatively insensitive to changes in valuation basis
+For regular premium business.
When the reserving basis changes for gross premium valuation, the gross premium used in the calculation doesn’t change, but for the net premium valuation, the net premiums used in the calculation changes. - Used for conventional with profits
+Since it does not capitalise the profit margins in the future gross premiums.
Net premium valuation method: 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
