Basic Balance Sheet Dynamics

[Joseph Barnett]

Hi, hope everyone is well.

Forgive the very simple question - I have never worked directly in reporting or reserving so I just want to be sure that I understand all this correctly.

Suppose hypothetically we have an empty balance sheet (no assets or liabilities), and we want to sell some kind of product. Let's say that we've done some work and:

• The expected present value of the contract on the pricing basis is £2k, with present value of premiums being £10k
• The reserve calculated on the reserving basis (= best estimate) is £8k
• There's a marginal increase of £0.5k in the risk margin and £0.5k in the solvency capital requirement
• For simplicity there are no expenses

Not sure those numbers are consistent with each other but putting that to one side for now, I think this means that on day 1 Own Funds goes up by £1.5k, and Excess Own Funds goes up by £1k.

Now my question is around what the components of the balance sheet would actually look like on day 1. Here is what I understand to be the case:

• If the premium is paid on day 1 in a lump sum, then this is surely treated as an asset, and so the balance sheet will look like A = £10k, BEL = £8k, and RM = £0.5k, with a capital requirement of £0.5k. So there is a large increase to assets and a slightly smaller increase to liabilities.
• If the premium is paid over the term of the contract, then it is effectively treated as a negative liability and the company doesn't get any actual money from anywhere... and so A = £0, BEL = -£2k, RM = £0.5k and capital requirement = £0.5k.

Now the second bullet obviously looks pretty weird so I'm not sure it's right... but if it is, the company still needs to find £8k of reserves (since it needs that on day 1) and an extra £1k for the SII stuff to be solvent in the eyes of the regulator, so this is why we get a £9k capital strain even though the product is clearly expected to be profitable. So in order to to get that £9k it will need some kind of capital injection (which will have its own consequences). The balance sheet will then evolve according to the difference between the pricing basis and what actually happens.

I guess it's not a very well defined question but I'd appreciate of someone knowledgeable could read through what I wrote and let me know if I've got everything in order - and if not maybe help me straighten my story out.

Thanks in advance!

 

[Em Francis]

Hi, hope everyone is well.

Forgive the very simple question - I have never worked directly in reporting or reserving so I just want to be sure that I understand all this correctly.

Suppose hypothetically we have an empty balance sheet (no assets or liabilities), and we want to sell some kind of product. Let's say that we've done some work and:

• The expected present value of the contract on the pricing basis is £2k, with present value of premiums being £10k
• The reserve calculated on the reserving basis (= best estimate) is £8k
• There's a marginal increase of £0.5k in the risk margin and £0.5k in the solvency capital requirement
• For simplicity there are no expenses

Not sure those numbers are consistent with each other but putting that to one side for now, I think this means that on day 1 Own Funds goes up by £1.5k, and Excess Own Funds goes up by £1k.

Yes these numbers seem ok following the logic below:

OF = A-L = 10 – (8+0.5)=1.5

OF in excess of SCR = 1.5-0.5 =1

Now my question is around what the components of the balance sheet would actually look like on day 1. Here is what I understand to be the case:

• If the premium is paid on day 1 in a lump sum, then this is surely treated as an asset, and so the balance sheet will look like A = £10k, BEL = £8k, and RM = £0.5k, with a capital requirement of £0.5k. So there is a large increase to assets and a slightly smaller increase to liabilities.

Agree

• If the premium is paid over the term of the contract, then it is effectively treated as a negative liability and the company doesn't get any actual money from anywhere... and so A = £0, BEL = -£2k, RM = £0.5k and capital requirement = £0.5k.

Now the second bullet obviously looks pretty weird so I'm not sure it's right... but if it is, the company still needs to find £8k of reserves (since it needs that on day 1) and an extra £1k for the SII stuff to be solvent in the eyes of the regulator, so this is why we get a £9k capital strain even though the product is clearly expected to be profitable. So in order to to get that £9k it will need some kind of capital injection (which will have its own consequences). The balance sheet will then evolve according to the difference between the pricing basis and what actually happens.

I guess it's not a very well defined question but I'd appreciate of someone knowledgeable could read through what I wrote and let me know if I've got everything in order - and if not maybe help me straighten my story out.

Thanks in advance!

The negative BEL is effectively an asset (-£2k). The company will not need to find these reserves as it has already taken account of them when netting against future premiums. This -£2k (asset) would cover the SCR and the RM with £1k going straight to the BS as 'excess OF'.

Hope this helps