Ch 9 external environment - investment return in pricing

[kiki]

Hi, can someone please help me to understand the following two paragraphs from the core reading (page 15) :
1. A high rate of interest may indicate that expected inflation rates are high. If these interest rates are allowed for in pricing then it is important that the projected claims reflect a consistent level of inflation.

is my understanding correct : for higher interest rate may indicate higher inflation rate, therefore if higher inflation rate is allowed in the pricing ( ie increase premium ) then higher inflation rate need to be allowed in the claim. if not will lead to over estimate profit as under estimate claim amount?

2. Insurance companies typically place funds at shorter durations than the term of their longer-tailed liabilities. This is partly because they need to ensure liquidity and partly because any reductions in the market value of assets, even if they do not have to be realised, may be reflected in solvency margins. Therefore current rates, if high, may not continue to be available as funds are rolled over.

this is the part very confusing not sure what it is trying to say , duration of asset is shorter than duration of liability for the purpose of liquidity i get this , then i am totally lost for the sentence about "partly because any reductions in the market value of assets, even if they do not have to be realised, may be reflected in solvency margins. Therefore current rates, if high, may not continue to be available as funds are rolled over." ???

thank you very much for help

 

[Ppan13]

1. A high rate of interest may indicate that expected inflation rates are high. If these interest rates are allowed for in pricing then it is important that the projected claims reflect a consistent level of inflation.

is my understanding correct : for higher interest rate may indicate higher inflation rate, therefore if higher inflation rate is allowed in the pricing ( ie increase premium ) then higher inflation rate need to be allowed in the claim. if not will lead to over estimate profit as under estimate claim amount?

Hello.

"higher interest rate may indicate higher inflation rate," --> yes, this is correct

"therefore if higher inflation rate is allowed in the pricing ( ie increase premium ) then higher inflation rate need to be allowed in the claim." --->> your statement here seems a little back-to-front. Higher inflation rates in the projected claims will lead to the premiums being higher (e.g. if you adjust your claims for inflation when experience rating). Separately, you could also get a higher premium by adjusting your base rates upwards for inflation when exposure rating.

"if not will lead to over estimate profit as under estimate claim amount?" --> your conclusion here is right (underestimating the future/ ultimate claim amounts could lead to underpricing, which could initially overestimate profit) but I'm not sure if the logic you used to reach it was complete.

One thing you haven't mentioned in your explanation is the potential direct impact of interest rates. (You have mainly focussed on the impact of inflation itself on the claims and premium). The notes are basically saying that if your interest rate is high, and you allow for this directly when pricing by using a high discount rate to discount expected future claims and expenses, this would push the expected present value of the future claims and expenses downwards (therefore potentially pushing down your premium). But, because high interest rates may indicate expectations of higher inflation rates, the latter would have the effect of pushing the expected future claims and expenses upwards (which would push up your premiums, in turn). So you have to take both effects into account.

 

[Ppan13]

this is the part very confusing not sure what it is trying to say , duration of asset is shorter than duration of liability for the purpose of liquidity i get this , then i am totally lost for the sentence about "partly because any reductions in the market value of assets, even if they do not have to be realised, may be reflected in solvency margins. Therefore current rates, if high, may not continue to be available as funds are rolled over." ???

If you have a liability which is long-term, and you held an asset with an equally long term, there is a risk that the value of the asset might fall during that time ("reduction in the market value of assets"). Suppose you have have a long-term liability of £100k and back it with assets initially worth £100k. But if the value of that asset (bonds, for example) suddenly falls to £90k (due to movements in the bond market), then you may have assets worth less than your liabilities. In simple terms, you don't have enough assets to cover your liabilities any more, so you have a solvency problem. Even if you don't have to sell the bonds yet ("do not have to be realised"), the regulator will see that the value of your assets is too low to cover your liabilities. (Solvency margin is the 'excess of asset over liabilities', and is not allowed to fall below a minimum value. In my simple example here, my assets minus liabilities is already negative, so I'd be at risk of bankruptcy!)

Investing in shorter duration bonds reduces the interest rate risk (which basically makes the price of the bond less sensitive compared to long duration bonds), so possibly reduces the risk to the solvency margin. So that's one reason you might avoid longer duration investments (besides the liquidity argument)

If you invest in short duration funds, they have to be rolled over (i.e. reinvested) more frequently than long duration funds, but when you reinvest, you might not be able to get as high rates (of return) as when you made the initial investment (depending on market conditions). This was the meaning of the last sentence from the notes: "Therefore current rates, if high, may not continue to be available as funds are rolled over"

 

[kiki]

Thank you so much for your explanation , it is making sense to me . have a nice weekend