October 2012 Q1(vi)

[edcvfr]

The ASET solutions says:

"The choice of Peak 1 basis is subjective as the regulator imposes only a minimum level of prudence required. This creates a conflict of interest between policyholders and shareholders. The stronger the basis that is used, the higher the cost of bonus and hence the higher the shareholder transfer will be."

Why would the policyholder want a weaker basis used? Is it because there will be more free surplus and hence investment freedom, resulting in a potentially higher terminal bonus?

 

[Lynn Birchall]

The suggestion here is about using Peak 1 basis just to calculate the shareholder transfers. Post Solvency II, the free surplus/investment freedom etc will depend on the Solvency II results, not the Peak 1 basis.

So, the reason the policyholder might want a weaker Peak 1 basis is just to reduce the size of the shareholder transfer. This is a subtle & potentially confusing effect of how shareholder transfers are worked out. For example, suppose the company has declared a certain bonus rate, and is going to deduct a shareholder transfer from WP asset shares of 1/9th Value of that bonus. The shareholder transfer will be bigger (and so remaining asset shares will be smaller) the more prudent the valuation basis used.

Hope this helps.
Lynn

 

[edcvfr]

The suggestion here is about using Peak 1 basis just to calculate the shareholder transfers. Post Solvency II, the free surplus/investment freedom etc will depend on the Solvency II results, not the Peak 1 basis.

So, the reason the policyholder might want a weaker Peak 1 basis is just to reduce the size of the shareholder transfer. This is a subtle & potentially confusing effect of how shareholder transfers are worked out. For example, suppose the company has declared a certain bonus rate, and is going to deduct a shareholder transfer from WP asset shares of 1/9th Value of that bonus. The shareholder transfer will be bigger (and so remaining asset shares will be smaller) the more prudent the valuation basis used.

Hope this helps.
Lynn

That makes sense, thanks!!!

 

[Sponge]

This may have already been answered elsewhere.

But exactly how is the cost of bonus calculated. Is this the RB and TB declared less the actual investment return or is it simply RB and TB. Is this charged to the Asset Shares?

 

[Lindsay Smitherman]

The "cost of bonus" for TB is the actual TB amount paid out. The "cost of bonus" for RB is the present value of the additional benefit amount added by the RB declaration, allowing for discounting back to the current date from the time at which this additional benefit is expected to be paid out. (This is because RB is not actually paid out when it is declared, but at some point in future when the policy becomes a claim.)

Only the shareholder transfer (typically 1/9 of the cost of bonus) is deducted from asset share.

Asset shares are used to assess the sustainability of RB rates and the amount of TB that can be paid; the amount of bonus declared is not deducted from or added to asset share.

 

[wkornu]

Cost of bonus
Why don't we need to discount the TB back to the current date to get the "cost of bonus" for TB?
If the TB is on maturity, then it is actually paid at the same time as RB (and we need to discount back the RB but not TB?).
Or is it because TB can be paid out on death and surrender too? In this case why don't we also need to discount back allowing for the probabilities of death and surrender?

Solvency 2 BEL for discretionary benefits
I would like to also ask how the Solvency 2 technical provisions for discretionary benefits (under addition to benefits method) are calculated. I would like to understand how shifting towards RB relative to TB increases the technical provisions.

Thank you very much!

 

[Lindsay Smitherman]

Cost of bonus
Why don't we need to discount the TB back to the current date to get the "cost of bonus" for TB?
If the TB is on maturity, then it is actually paid at the same time as RB (and we need to discount back the RB but not TB?).
Or is it because TB can be paid out on death and surrender too? In this case why don't we also need to discount back allowing for the probabilities of death and surrender?

Hi - just to pick up on your point here about the cost of bonus calculation. The original thread is all about determining what the shareholder transfer is, ie how much is actually transferred to the shareholder. It isn't about calculating the present value of future expected shareholder transfers - that might be where you are getting confused?

A shareholder transfer under the additions to benefits method is triggered when either (a) a reversionary bonus declaration is made or (b) a terminal bonus is paid.

(a) is done at the end of every year, but the RB is not actually paid out at that time - it won't be paid out until a claim is made. Therefore we calculate a 'cost of RB' which allows for the discounted value of the current RB declaration, based on when it is expected to be actually paid out. Then a shareholder transfer is triggered at the RB declaration date based on that discounted amount (eg shareholders get 1/9 of that 'cost of RB' amount).

(b) only happens when a terminal bonus is actually paid, ie a claim is paid out. At that point, a shareholder transfer is triggered based on the amount of TB actually paid (eg shareholders get 1/9 of that TB amount).

Hope that helps to clear this up.

 

[Em Francis]

Cost of bonus


Solvency 2 BEL for discretionary benefits
I would like to also ask how the Solvency 2 technical provisions for discretionary benefits (under addition to benefits method) are calculated. I would like to understand how shifting towards RB relative to TB increases the technical provisions.

Thank you very much!

The discretionary benefits include both terminal bonus and future reversionary bonuses.

The BEL is approximately asset share plus cost of guarantees, smoothing etc.
A stochastic model for determining the BEL would likely be used because the value of future discretionary benefits will vary under different investment scenarios. This variation arises due to costs of smoothing and guarantees. Also, the calculations need to reflect realistic management actions (eg dynamic reversionary bonus rates) that vary with economic conditions.

Whereas the above would be calculated on a per policy basis, the risk margin will (calculated via the cost of capital method) likely be calculated for the whole line of the specific with-profits policies, allowing for diversification.

Shifting towards RB relative to TB, increases guarantees as TBs are not guaranteed. This in turn will increase the required capital, needed to cover the risk of the guarantees biting.

Hope this helps.

Thanks

Em






Shifting towards RB relative to TB, increases guarantees as TBs are not guaranteed. This in turn will increase the required capital, needed to cover the risk of the guarantee biting.

 

[wkornu]

The BEL is approximately asset share plus cost of guarantees, smoothing etc.

Thanks Em! Just would like to seek for some further clarifications.

So for each simulation of the stochastic run, would BEL be the "PV of outgo minus income" based on the best estimate assumptions (allowing for management actions) plus "cost of guarantees" and "cost of smoothing"?

If so, shifting towards RB relative to TB would not affect the "PV of outgo minus income" right, since both RB and TB would be paid out at maturity and hence discounted over the same period. So I guess the reason shifting towards RB would increase the BEL is because this would increase the "cost of guarantees" and "cost of smoothing"?

Also, is the cost of guarantee calculated as the average of the PV of the difference between guaranteed benefits minus projected asset shares over many simulations varying investment returns? If so, would this be a nested stochastic calculation since determining the cost of guarantee is a stochastic run within the BEL stochastic run.

Please kindly advise. Thanks again for your help!

 

[Lindsay Smitherman]

Hi

As you say, BEL = PV{outgo minus income}. This outgo comprises future benefits and expenses. For with-profits business, the projected benefits on maturity or death would (simplistically) be calculated as the higher of the guaranteed benefits (= sum assured + accrued RB) and the smoothed asset share.

Because the BEL has to be calculated on a market-consistent basis, this calculation needs to be done stochastically in order to capture the time value of the guarantees (ie the chance that a guarantee might come into the money in the future, even if it is not in the money now).

So the 'cost of guarantees' element of the BEL is just part of the PV{outgo} component.

The higher the actual and assumed future RB rates, the higher the guaranteed component of the benefits, and therefore the higher the market-consistent value of guarantees (greater likelihood that the guarantee will bite) - and so the higher the BEL.

In the benefit projections, you are correct that it would be investment returns (on the assets held to back the asset share) which would be modelled stochastically. The model would basically then compare the projected smoothed asset share with the projected guaranteed benefits and use the higher of these whenever a claim is modelled to be paid out.

And yes, the market-consistent BEL is determined by taking the average across the simulations.

There is no need for nested stochastic calculations here. For each simulation, the above comparison is made at each point at which a claim is modelled, and this determines the amount assumed to be paid as the benefit.

Hope that helps to make this clearer.