Supervisory Reserves And Capital Requirements

Question 1

Reasons for calculating reserves for a life insurer

Answer 1

TIC TIC PEVILS

Transfer of book of business
Independent assessment of reasonability of reserves
Commutation negotiation

Tax liability calculation
Internal management accounts for decision-making
Case estimates for RBNS reserves

Profit distribution rate analysis and setting
Estimating claims costs from recent periods as part of rating process
Value company for sale or acquisition
Information on business performance by area
Liability determination for insurer’s balance sheet
Supervisory solvency calculation

Question 2

List the key features of the net premium methods

Answer 2

1) Simple in formula used and data required
2) Makes implicit level allowance for future expenses
3) Makes implicit level allowance for future bonuses where applicable
4) Not appropriate for single premium business without adjustment
5) For regular premium business, the reserves are relatively insensitive to changes in valuation basis
6) Mainly used for conventional with-profits as it does not capitalise the profit margins in the future gross premiums

Question 3

Unit reserve

Answer 3

That 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

= (# units).(unit bid price)

Question 4

Non-unit reserve

Answer 4

The present value of excess of expected non-unit outgo less present value of expected non-unit income.

= EPV(non-unit outgo) - EPV(non-unit income)
= EPV(expenses + benefits in excess of unit fund) - EPV(charges + unallocated premiums)

Question 5

List the uses of capital

Answer 5

Initially:
1) To write new business
2) To meet development costs
3) To pay claims at early durations before sufficient reserves have built up

During operation:
4) Reduce need for reinsurance
5) Enables greater investment freedom
6) Enables company to sieze short lived investment opportunities
7) Enables expansion

Relating to the big boys and girls:
8) Smoothing profits, bonus distribution and dividend distribution
9) Meet statutory capital requirements to demonstrate capital adequacy
10) To demonstrate financial strength

Question 6

List the two fundamental purposes for valuing assets and liabilities

Answer 6

1) To demonstrate solvency to the supervisory authorities
2) To investigate the realistic/”true” position of the company

Question 7

NRR

Answer 7

Negative rand reserve

Called a “negative non-unit reserve” im a unit-linked contract

Question 8

STEPS to calculate a prudential non-unit reserve (zeroising CFs from Life Con)

Answer 8

1) Project all future non-unit cashflows
2) Find the last projection period in which the net CF is negative
3) Determine the reserve required to offset that negative net CF at that point
4) At the beginning of that time period, set up a reserve equal to the discounted value of that amount
5) Account for the net CF occuring then and check if the resulting reserve is negative. If so, repeat steps 3,4,5
6) Continue to work backwards to the valuation date, zeroising each negative net CF so that all reserves after the valuation date are net-negative
7) When the process has been completed, set up an initial reserve equal to the absolute value of the adjusted net CF at the valuation date.

Question 9

Why would a company want to hold NRRs?

Answer 9

1) To recognise profit upfront
2) To reduce total reserve liability
3) To improve capital efficiency

Question 10

Why would a company decide to not hold NRRs?

Answer 10

1) For more prudent reserves
2) To delay profit recognition

Question 11

Regulations regarding NRRs may include…

Answer 11

1) (Unit fund + Non-unit fund) > Guaranteed surrender value

2) Future profits arising on the policy with the negative non-unit reserve need to emerge in time to repay the “loan”

3) After zeroising future net CFs, there should be no further negative cashflows for the policy

4) In aggregate, the sum of all non-unit reserve should not be negative

Question 12

STEPS to calculate a best estimate non-unit reserve

Answer 12

1) Project expected future non-unit cashflows from the policy

Working backwards:
2) Identify the last CF
3) Set the reserve at that time as the amount needed to offset that net CF, regardless of its sign
4) Check that total reserve exceeds the surrender value
5) Move back to the previous period, discount the reserves and subtract it from the previous net CF to obtain a new reserve. Repeat step 4’s check
6) Repeat the process, working backwards until you reach the valuation date.
7) Set up a non-unit reserve equal to the adjusted T0 CF.

Working forwards:
2) At every time period, set up a reserve equal to the EPV of all the future cashflows

Question 13

How can one incorporate prudence into a BE non-unit reserve?

Answer 13

Set all negative non-unit reserves equal to zero

Question 14

Gross premiums valuation method

Answer 14

tV = EPV(Benefit and expense outgo) - EPV(Gross/office premium income)

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

Question 15

Features of the gross premium method

Answer 15

1) Makes an explicit allowance for expenses
2) Makes an explicit allowance for vested and expected future bonuses
3) The future premiums valued are the actual office premiums expected
4) Any difference between the pricing and valuation bases will immediately be taken as profit or loss
5) Reserves are often initially negative for non-linked business (due to initial expenses and capitalisation of future profit)
6) The reserves are quite sensitive to a change in basis

Question 16

Net premium valuation method

Answer 16

tV = EPV(Benefit outgo) - EPV(net premium income)

A method for placing a value on a life insurer’s liabilities that values the future net premiums payable and claims, with claims including any vested discretionary bonuses but excluding any expected future bonuses

Question 17

Features of the net premium method

Answer 17

1) Simple in terms of the formula used and the data required
2) Makes no explicit allowance for future expenses
3) Makes no explicit allowance for future bonuses
4) For regular premium business, reserves are relatively insensitive to changes in the valuation basis

Question 18

List options for calculating market consistent liabilities

Answer 18

1) Work out current market price of assets in a replicating portfolio (portfolio with cashflows that perfectly replicate those of the liabilities under consideration)

2) Discount liability CFs at a risk-free interest rate

3) Discount liability CFs at discount rate determined from a weighted average of those on assets held to back liabilities (A and L will not be independent in this case)

Question 19

How may one derive risk-free discount rates?

Answer 19

1) Government bond yields
2) Swap rates

(Potentially with a deduction for credit risk or an additional illiquidity premium)

Question 20

For what kind of assumptions are risk margins used?

Answer 20

For assumptions where it is difficult to obtain a market-consistent assumption e.g. mortality, persistency, expenses due to the lack of a sufficiently deep and liquid market in which to trade or hedge such risks

Question 21

List two ways of incorporating risk margins

Answer 21

1) Including a risk margin for each assumption
2) An overall reserving risk margin determined using the Cost Of Capital approach

Question 22

STEPS of the cost of capital approach to setting a risk margin

Answer 22

1) Project the amount of capital we are required to hold in excess of our market-consistent estimate of the liabilities at each Tt
2) These projected capital amounts are then multiplied by a cost-of-capital rate
3) The product of the cost-of-capital rate and the capital requirement at each future projection point Tt is then discounted using risk-free rates for each Tt, and summed to give the overall risk margin

Question 23

List the two main events against which solvency capital requirements protect policyholders

Answer 23

1) Underestimation of the reserving basis
2) Drops in asset values

Question 24

How may the level of SCR be determined?

Answer 24

1) By a formula set by the regulator
2) Based on a risk measure e.g. VaR
- stress-test individual risk factors separately
- run-off method
- shock risk factors simultaneously

The aggregated capital requirement combines the separate stress tests to reflect any diversification benefits that may exist between various risks using correlation matrices or copulas

Question 25

Passive valuation approach

Answer 25

Is relatively insensitive to changes in market conditions and has a valuation basis which is updated relatively infrequently.

Question 26

Advantages of a passive valuation basis

Answer 26

1) Straightforward to implement
2) Involves less subjectivity
3) Results in relatively stable profit emergence

Question 27

Disadvantages of a passive valuation basis

Answer 27

1) At risk of becoming out of date
2) May not take account of important trends
3) May provide a false sense of security
4) Management may take action too late as solvency position has not appeared to change, when it has in reality

Question 28

Active valuation basis

Answer 28

Based more closely on market conditions, with the assumptions being updated frequently

Question 29

Advantages of an active valuation basis

Answer 29

Provide mpre information for understanding impact of market conditions on a company’s ability to meet its obligations (particularly with respect to financial guarantees and options)

Question 30

Disadvantages of an active valuation basis

Answer 30

1) Results are more volatile
2) More complex than a passive valuation approach (thus time-consuming and expensive)

Question 31

Deep market

Answer 31

A market of sufficient capacity that large trades would not materially affect prices

Question 32

Interest rate swap

Answer 32

A contract where one party agrees to exchange a series of payments based on a fixed interest rate for a series of payments made on a variable rate of interest. Usually collateralized to reduce credit risk

Question 33

Illiquidity premium

Answer 33

A.K.A Liquidity premium

The extra return that investors require to compensate for the greater price volatility of corporate bonds than government bonds

Question 34

Non-linearity

Answer 34

Capital requirements are often not related to risk drivers in a linear fashion i.e. a 1% change in any risk driver does not necessarily result in a 1% change in capital required

Question 35

Non-separability

Answer 35

If twobevents happen together, the combined effect is worse than if they had happened separately