Revision questions - September 2018

[1495_sc]

Hello,

While revising the core reading, I came across few parts which I didn't understand completely. Can someone please help with a solution?

1. In contribution method of distribution of profits to with profit policyholders, why do we use the investment return to calculate expense surplus? For interest surplus, we are using the difference between valuation and actual interest rate for obvious reasons as the (res+prem) amount is invested but can't seem to apply a clear logic for expense surplus formula.

2. For retention of profit on surrender, how is the formula (EAS-SV')+ (SV'-SV'') derived? Why don’t we always consider the equation (EAS- SV) in all cases? This is a part of core reading of chapter 21, surrender values.

3. For analysis of embedded value profit, (chapter 3- Monitoring experience), last bullet for how it helps the company is as follows-

'provide detailed information for publication in the company’s accounts or those of any parent company, in particular the value of new business taken on by the company'

How is embedded value related to value of new business? By definition, it only calculates profit from existing business.

Thank you in advance!

 

[Mark Willder]

Hello,

While revising the core reading, I came across few parts which I didn't understand completely. Can someone please help with a solution?

1. In contribution method of distribution of profits to with profit policyholders, why do we use the investment return to calculate expense surplus? For interest surplus, we are using the difference between valuation and actual interest rate for obvious reasons as the (res+prem) amount is invested but can't seem to apply a clear logic for expense surplus formula.

2. For retention of profit on surrender, how is the formula (EAS-SV')+ (SV'-SV'') derived? Why don’t we always consider the equation (EAS- SV) in all cases? This is a part of core reading of chapter 21, surrender values.

3. For analysis of embedded value profit, (chapter 3- Monitoring experience), last bullet for how it helps the company is as follows-

'provide detailed information for publication in the company’s accounts or those of any parent company, in particular the value of new business taken on by the company'

How is embedded value related to value of new business? By definition, it only calculates profit from existing business.

Thank you in advance!

1. The formula assumes that expenses are incurred at the start of the year, but surplus is distributed at the end of the year. So we must roll up expenses with interest.

2. Looking at the asset share less the surrender value tells us whether the company has made a profit, but not whether it is fair.

So we break the profit into two parts. EAS - SV' compares asset share to the value on the premium basis, so it is the accrued profit, which might be considered to be a fair profit to make. SV' - SV'' is then the excess profit made by using a surrender basis that is less generous than the premium basis.

3. Here we will see the value of the new business written last year, ie if the EV has gone up from last year's accounts due to new business.

Best wishes

Mark

 

[1495_sc]

Thank you, Mark! I have 2 follow up questions as follows-

1. The reason for rolling up expense for surplus calculation assuming they are incurred at the start of the year-is it because of the opportunity cost of accumulating the difference between valuation and actual expense somewhere else to generate return?

3. Can you please elaborate? In the financial statements of year ending 2020 , for example, the EV will only reflect shareholder owned net assets and future profits from existing business by definition. Are you suggesting that 'new business' here is the business written between 1st January- 31st December and if we compare this EV with that of 2019, we can understand the contribution of 'new business in 2020' to the EV?

 

[Mark Willder]

Thank you, Mark! I have 2 follow up questions as follows-

1. The reason for rolling up expense for surplus calculation assuming they are incurred at the start of the year-is it because of the opportunity cost of accumulating the difference between valuation and actual expense somewhere else to generate return?

3. Can you please elaborate? In the financial statements of year ending 2020 , for example, the EV will only reflect shareholder owned net assets and future profits from existing business by definition. Are you suggesting that 'new business' here is the business written between 1st January- 31st December and if we compare this EV with that of 2019, we can understand the contribution of 'new business in 2020' to the EV?

1. You are overthinking this one. We're just looking at the difference at the end of the year between expected expenses and actual expenses. So we need to roll them up to the end of the year.

3. Yes, that's exactly right.

Best wishes

Mark

 

[1495_sc]

Ok got it. Probably too much of variety with both SP2 and SP5 coming up!!

Thanks a lot!

 

[1495_sc]

Mark, can you also confirm if bid/offer spread is always applied to the offer price only (and not bid price)? I think so but the terminology 'bid/offer spread' can be misleading. There is context in Sept 2017's question paper, Q4 part iv).

 

[Mark Willder]

Mark, can you also confirm if bid/offer spread is always applied to the offer price only (and not bid price)? I think so but the terminology 'bid/offer spread' can be misleading. There is context in Sept 2017's question paper, Q4 part iv).

If a company has a bid offer spread of say 5% then the bid price will be 95% of the offer price. So we apply the bid offer spread to the offer price to get the bid price.

Best wishes

Mark

 

[1495_sc]

Ok. In Sept 2017 Q4 part iv), there is a bid offer spread of 2% and although bid price is 98% of offer price, we don't account for this spread directly in the bid price. Instead, apply this spread to the offer price. In exam style questions, is this approach correct? If we always apply this spread to offer price only, it should take care of the bid price as well. Please confirm.

 

[Mark Willder]

Ok. In Sept 2017 Q4 part iv), there is a bid offer spread of 2% and although bid price is 98% of offer price, we don't account for this spread directly in the bid price. Instead, apply this spread to the offer price. In exam style questions, is this approach correct? If we always apply this spread to offer price only, it should take care of the bid price as well. Please confirm.

In this question we have a bid price of 7.28925. So using the 2% bid offer spread we have offer price of 7.28925 / 1.02. So there is the required 2% difference in prices.

I think what you are really asking is whether the expropriation price is the bid price or the offer price. The answer is that all transactions are performed using the bid price (eg paying surrender/maturity benefits or deducting charges or adding premiums). So when we need to sell assets in the fund, ie the fund is contracting and we need to destroy units, then the value of the assets sold (the expropriation price) will be the bid value.

Best wishes

Mark

 

[1495_sc]

Ok. What I was really curious is to know 'where' to apply the bid offer spread in any question. Lets say we are calculating the offer price only-in this case should we simply deduct a 2% spread ? If we are only calculating bid price in a question which also mentions a 2% bid offer spread- is there any action point in this case?

I have few more miscellaneous questions based off Sept 2018's question paper. Can you please help?

Q5- How are premiums paid for unit linked annuity and charges? The solution comments about risks related to charges. The question mentions that its a unit linked annuity so shouldn't we assume that it is a single premium policy too? If single premium, will charges (if any), simply vary on the basis of movement of fund values and not any addition (like premium) to the fund value?

Q4-iii) If shareholders are entitled to 10% of the surplus in with profits fund, would it not imply that we should simply add 10% of the surplus to EV ? The solution mentions that we should add both 10% of surplus and future distributions of surplus. What is the fundamental logic behind this? Its a common mistake per Examiner's report also but I still didn't follow the logic.

Q3-iii) If after correction, the number of units allocated should be lower than current/redeemed units, how is this adjustment done? Especially for previous unit holders whose accounts have already been settled.
If there is a negative impact i.e units allocated should be higher than current units, it is reasonable to allocate additional units to existing policyholders and make cash payments to previous policyholders. Is there any real-life example of this situation that happened in UK or anywhere else?

Q2-We haven't talked about the administration system aspects of each bonus method. For example, how addition to benefits is most straightforward and simple while the company may not have credible information as its a new product for revalorization method. Is this because we are clearly in favor of accumulating with profits approach?

Q4. The embedded value for non-profit fund is the release of margins in statutory valuation basis compared relative to embedded value basis
However, we know that EV also consists of future profits from existing business which includes release of reserves and shareholder owned assets. Is the statement above a subset of what EV actually constitutes (only reflecting release of reserves)?

Thanks a lot for helping so far!!

 

[Lindsay Smitherman]

Ok. What I was really curious is to know 'where' to apply the bid offer spread in any question. Lets say we are calculating the offer price only-in this case should we simply deduct a 2% spread ? If we are only calculating bid price in a question which also mentions a 2% bid offer spread- is there any action point in this case?

Hi - as described in Section 6.2 of Chapter 13 of the course notes:
Offer price = appropriation (or expropriation, depending on pricing basis) price PLUS bid/offer spread
Bid price = appropriation (or expropriation) price

Working through practice question 13.3 will demonstrate this.

 

[Lindsay Smitherman]

Q5- How are premiums paid for unit linked annuity and charges? The solution comments about risks related to charges. The question mentions that its a unit linked annuity so shouldn't we assume that it is a single premium policy too? If single premium, will charges (if any), simply vary on the basis of movement of fund values and not any addition (like premium) to the fund value?

Yes, it is an annuity and so would be single premium. It is unit-linked, so charges are likely to be taken initially from the premium (eg bid/offer spread, allocation rate), there could well be an annual fund management charge taken as a % of the remaining unit fund value (this is what that particular solution point is referring to) and there could potentially also be a policy fee (monetary amount taken per policy).

 

[Lindsay Smitherman]

Q4-iii) If shareholders are entitled to 10% of the surplus in with profits fund, would it not imply that we should simply add 10% of the surplus to EV ? The solution mentions that we should add both 10% of surplus and future distributions of surplus. What is the fundamental logic behind this? Its a common mistake per Examiner's report also but I still didn't follow the logic.

This is not a mistake. Embedded value (EV) = shareholders' share of net assets + present value of future shareholder profits.
In other words, EV = shareholders' share of surpluses that have already arisen and are retained in the company, plus shareholders' share of surpluses (ie 'profits') that are expected to arise in future on the existing business.

So the solution refers to adding both the share of the surpluses accrued to date and the share of those that are expected to arise in future.

 

[Lindsay Smitherman]

Q3-iii) If after correction, the number of units allocated should be lower than current/redeemed units, how is this adjustment done? Especially for previous unit holders whose accounts have already been settled.
If there is a negative impact i.e units allocated should be higher than current units, it is reasonable to allocate additional units to existing policyholders and make cash payments to previous policyholders. Is there any real-life example of this situation that happened in UK or anywhere else?

If policyholders have been given too many units in error, the company could choose to explain the issue to them and make the correction, or it could decide to leave things as they are (eg if the cost to the company isn't too great but the risk of reputational damage is). If individuals have already received payments based on the wrong (higher) number of units, it is likely to be very difficult to reclaim the excess - so the company may just have to put up with the loss.

If the policyholders have not been given enough units due to the error, it isn't just 'reasonable' to give them the missing units and to make up any shortfalls in claims already paid out, it is likely to be a requirement to do so in order to treat customers fairly etc.

 

[Lindsay Smitherman]

Q2-We haven't talked about the administration system aspects of each bonus method. For example, how addition to benefits is most straightforward and simple while the company may not have credible information as its a new product for revalorization method. Is this because we are clearly in favor of accumulating with profits approach?

This question isn't asking for all of the factors that the insurer would consider when deciding which method to use, it is asking whether each method is suitable for using for distributing surplus for that particular product. So we need to think about the technical reasons why a particular method might or might not work. How much hassle it might be for the insurer to change its systems doesn't really come into it.

Re your point about not having credible information as it is a new product: bear in mind that bonuses are based on the actual experience incurred under the product (hence the actual surplus arising), so in any case the insurer would not have that until it actually starts writing the policies.

 

[Lindsay Smitherman]

Q4. The embedded value for non-profit fund is the release of margins in statutory valuation basis compared relative to embedded value basis
However, we know that EV also consists of future profits from existing business which includes release of reserves and shareholder owned assets. Is the statement above a subset of what EV actually constitutes (only reflecting release of reserves)?

Yes: this is referring only to the {present value of future shareholder profits} component of EV. We also need to add on the shareholders' share of net assets.

Be careful though: the present value of the release of the prudential margins in the reserves differs from the value of the release of the reserves themselves. Basically (ignoring tax):

PVFP (ie the present value of future shareholder profits)
= PV {Premiums + investment return - claims - expenses + release of reserves}
= PV {Release of prudential margins in reserves}

 

[1495_sc]

Hi - as described in Section 6.2 of Chapter 13 of the course notes:
Offer price = appropriation (or expropriation, depending on pricing basis) price PLUS bid/offer spread
Bid price = appropriation (or expropriation) price

Working through practice question 13.3 will demonstrate this.

Thank you! This was helpful.

 

[1495_sc]

Yes, it is an annuity and so would be single premium. It is unit-linked, so charges are likely to be taken initially from the premium (eg bid/offer spread, allocation rate), there could well be an annual fund management charge taken as a % of the remaining unit fund value (this is what that particular solution point is referring to) and there could potentially also be a policy fee (monetary amount taken per policy).

Ok. Sounds good, thank you!

 

[1495_sc]

This is not a mistake. Embedded value (EV) = shareholders' share of net assets + present value of future shareholder profits.
In other words, EV = shareholders' share of surpluses that have already arisen and are retained in the company, plus shareholders' share of surpluses (ie 'profits') that are expected to arise in future on the existing business.

So the solution refers to adding both the share of the surpluses accrued to date and the share of those that are expected to arise in future.

Was referring to this as a mistake by students.

Ok so we are just applying the traditional definition of EV here. Somehow the word 'surplus' made me think about PVFP only. Thank you!

 

[1495_sc]

If policyholders have been given too many units in error, the company could choose to explain the issue to them and make the correction, or it could decide to leave things as they are (eg if the cost to the company isn't too great but the risk of reputational damage is). If individuals have already received payments based on the wrong (higher) number of units, it is likely to be very difficult to reclaim the excess - so the company may just have to put up with the loss.

If the policyholders have not been given enough units due to the error, it isn't just 'reasonable' to give them the missing units and to make up any shortfalls in claims already paid out, it is likely to be a requirement to do so in order to treat customers fairly etc.

Alright. Thank you for clarifying.

 

[1495_sc]

This question isn't asking for all of the factors that the insurer would consider when deciding which method to use, it is asking whether each method is suitable for using for distributing surplus for that particular product. So we need to think about the technical reasons why a particular method might or might not work. How much hassle it might be for the insurer to change its systems doesn't really come into it.

Re your point about not having credible information as it is a new product: bear in mind that bonuses are based on the actual experience incurred under the product (hence the actual surplus arising), so in any case the insurer would not have that until it actually starts writing the policies.

10 marks for this question made me think beyond technical aspects of each form of distribution. If we cover both technical aspects and operational issues related to these bonus types, will we get awarded for operational issues also? How can we distinguish when to talk about these issues and when not to?

Like I also thought of the cost element, consistency with existing bonus, administration requirements of each type. I understand your concern around being asked for factors vs suitability but in exam condition, making this distinction may not come naturally when high marks are allocated unless I know the caution keywords to look at before answering. Please advice.