April 2018 Q2. viii

[Aubameyang]

The question asks how the company's Solvency II and IFRS calculations can be adapted to determine a customer value for term assurance policyholders. So we would need to calculate some form of "embedded value" associated with the customer plus also some "goodwill" element to reflect the fact the customer may purchase products in future. There are a couple of points in the mark scheme that I'm finding confusing:

1.The mark scheme states that we could use the Solvency II valuation to determine the "embedded value" component and there are marks available for stating that "we need to incorporate the release of the SCR and risk margin, hence we would require a methodology to determine that release profile". I'm confused why we would need to do this, as embedded value using Solvency II methodology is just: free surplus + SCR - risk margin (assuming any PVIF due to contract boundaries etc. is negligible). Is the question actually asking us to determine how a customer value will change over time, hence we need to determine the SCR release profile?

2. The mark scheme states the company "may want to split the assumptions using customer segmentation". Is this in relation to calculating the "embedded value" component of the customer value or the "goodwill" component or both? I'm, not sure how this would help us calculate the "embedded value" component but I think this is what's being referred to.

Thanks.

 

[Lindsay Smitherman]

1.The mark scheme states that we could use the Solvency II valuation to determine the "embedded value" component and there are marks available for stating that "we need to incorporate the release of the SCR and risk margin, hence we would require a methodology to determine that release profile". I'm confused why we would need to do this, as embedded value using Solvency II methodology is just: free surplus + SCR - risk margin (assuming any PVIF due to contract boundaries etc. is negligible). Is the question actually asking us to determine how a customer value will change over time, hence we need to determine the SCR release profile?

Hi - we need to be careful here. We are determining a 'customer value' not an EV, so we are considering the value to the shareholders of each customer (not of the company as a whole).

Also: if we were determining a full company EV, your statement that under Solvency II we would have EV = FS + SCR - RM is not correct, even if PVIF is negligible. Under the EEV approach, we have EV = FS + {RC - COHRC} + PVIF. Taking various simplifying assumptions this can be approximated under a Solvency II balance sheet as EV = FS + SCR = own funds, as is explained in Section 3 of Chapter 18. These simplifications include not just PVIF being negligible, but this being 100% shareholder-owned business (so not 90:10 WP business, for example), RC being defined as SCR+RM and COHRC being proxied by the RM - which itself can be rather dubious since the RM is only the cost of holding capital against non-hedgeable risks (not the cost of holding the whole RC) and it is determined at a 6% frictional cost parameter which is unlikely to represent the actual frictional cost of locked-in capital to the company).

So, since we need to determine the value of each individual customer (or, more likely, of cohorts of customers), and because we therefore need to retain a decent degree of accuracy, and because the above sweeping assumptions may well not hold anyway, we need to determine the present value of future profits for each customer cohort 'properly'.

{RC - COHRC} is the value of 'the release of the SCR and risk margin' and can be determined for each customer cohort by projecting forwards the relevant subset of the {SCR+RM} and using the release profile to determine the lock-in cost of holding.

 

[Lindsay Smitherman]

2. The mark scheme states the company "may want to split the assumptions using customer segmentation". Is this in relation to calculating the "embedded value" component of the customer value or the "goodwill" component or both? I'm, not sure how this would help us calculate the "embedded value" component but I think this is what's being referred to.

It would be used for either. For the PVIF component, for example, the co could make different persistency rate assumptions for different cohorts of customers.

 

[Aubameyang]

This is clearer now - thanks!

 

[1495_sc]

Hello- I am finding it difficult to understand the application of Customer Value in core reading in these two parts (2 vii and viii).

Few takeaways from the solution which I understood are-

Starting with customer level data instead of policy data.

Using persistency rates or EV measures for measuring customer value.

Including profit or addition to value expected from multiple future policy purchases as well as insurance company fulfilling changing needs of customers over time.

Can someone please help in explaining the remaining points in a cohesive and simple manner?

Thank you

 

[Em Francis]

Hello- I am finding it difficult to understand the application of Customer Value in core reading in these two parts (2 vii and viii).

Few takeaways from the solution which I understood are-

Starting with customer level data instead of policy data.

Using persistency rates or EV measures for measuring customer value.

Including profit or addition to value expected from multiple future policy purchases as well as insurance company fulfilling changing needs of customers over time.

Can someone please help in explaining the remaining points in a cohesive and simple manner?

Thank you

As explained above customer value is the value to the shareholders of each customer and one way to determine this value is to work out the embedded value contribution from each customer. To do this we would need to work out PVIF and net assets belonging to each customer. We can also extend this so it doesn't just include existing policies but also future new business.

Thanks
Em

 

[1495_sc]

Alright. Thank you for simplifying!

 

[Aman]

Hi - is embedded value still a material topic for the examination?

 

[1495_sc]

Yes