CP1 Ch 37: Surplus arising

[Bhoomi Sindhi]

Hi, It is mentioned that surplus arising in any given year is equivalent to profit. On page 5 of this chapter, they've mentioned how equivalence can be drawn between the two and a few subtleties to watch out for. Could you please explain with the help of a numerical example? I'm not particularly clear on how this equivalence is drawn.

 

[Lindsay Smitherman]

Hi - what this is saying is that surplus arising is effectively the same as profit for an insurance company, provided we are careful with our definitions.

Surplus arising = {assets at end - liabs at end} - {assets at start - liabs at start} = {assets at end - assets at start} - {liabs at end - liabs at start}

Profit for an insurance company = Premiums + investment earnings - claims paid - expenses incurred - increase in liabilities

The assets held will increase over the period by + cashflows in (= premiums) - cashflows out (= expenses and claims paid) + investment earnings

So we can see by working through and using each of the above statements that:
Surplus arising = increase in assets minus increase in liabilities = premiums + investment earnings - claims - expenses - increase in liabilities = Profit (as required)

The 'subtleties' referred to basically mean
(1) the increase in assets part of the surplus arising (and also the 'investment earnings' part of profit) would likely include unrealised gains (not just realised gains) - and that wouldn't necessarily be the case under every accounting standard, and
(2) be careful to remember that profit for an insurance company includes 'minus increase in liabilities' (or plus reduction in liabilities), which isn't typically something that we would expect to see in a profit/loss statement for a 'normal' type of company.

Hope that helps

 

[Claudio]

Hi there I would just like to ask some questions based on this.

In respect to the surplus the surplus that arises may not be an actual profit due to it being unrealized. For example, if there was an increase in equities this would lead to a surplus but we haven't sold these equities and haven't realized an actual profit?

And then concerning the increase/decrease in liabilities would this be a change in reserves or provisions and what would the distinction between the two be? How would proviso versus reserves change over the lifetime of a product?

 

[James Nunn]

Hi Claudio

I agree with your example - this is a situation where the increase in surplus over the year in question wouldn't be equal to the profit for the same year, if accounting standards do not allow unrecognised asset gains to be treated as profit.

Regarding what you say about the increase/decrease in liabilities, yes - what you say is correct (reserves/provisions being the value of liabilities). Also, yes - 'reserves' and 'provisions' can be treated as meaning the same thing for CP1; please see the fourth, fifth and sixth paragraphs in the introduction section to Chapter 31 ('Provisions') for more commentary on provisions vs reserves.

A few examples of the change in provisions / reserves for different products

For many life / general insurance policies with fixed terms where a benefit may not be paid, we would expect a provision or reserve to decrease to zero at the end of the policy's terms, all other things being equal (as the probability of a claim decreases). However, all other things may not be equal, and the provision or reserve may increase in some years if, for example, assumptions are strengthened or the level of cover is increased.

For a whole-of life assurance or endowment assurance contract, for example, a benefit will be paid and so the provision or reserve is likely to increase over time as discounting (to the expected time of the payment of the benefit) decreases.

CP1 is about pensions too. All other things being equal, provisions or reserves for member's pension are likely to increase between the date of joining the scheme and the date of retirement (due to additional years of accrual and less discounting of retirement benefits over time); they will then decrease after retirement as benefits are paid and the member's expected future lifetime (over which benefits are paid) decreases.

 

[Sayantani]

Hi,

I had a question regarding the surplus arising and the valuation basis. " The choice of the valuation basis will not affect the total amount of surplus arising over the life of a contract which will depend solely on the differences between the actual experience and that assumed while pricing the contract. However it will affect the timing of the emergence in surplus during the life of the contract."
1. While pricing we do have the cost of provisions and capital requirements set, in other words the valuation basis taken initially at pricing will ultimately affect the amount of surplus? If we have extra prudence assumed in the valuation basis , then greater amount of surplus later in the contract ? Hence, I am not sure why its mentioned that the valuation basis will not affect the amount of surplus?

 

[Lindsay Smitherman]

Yes, if there is 'extra prudence' in the valuation basis then we would expect to see higher profits (ie surplus arising) later in the contract as those extra prudential margins are released. However, when these 'extra prudent' provisions are initially set up, that will mean there is a lower amount of profit arising at that point. So the concept still holds: the total amount of profit (surplus arising) over the life of the contract is not impacted by the choice of reserving basis. (More prudent -> lower profit at the start, higher later on; less prudent -> higher profit at the start, less later on.)