Effect of RDR on Return on Capital variance

[Kelly_]

I am confused about how increasing the RDR would make up for a variance of return on capital. In the solution to Q&A Bank 3.8, it says that you can calculate the impact of the return on capital by varying the assumptions and then from that will indicate how much the RDR needs to be increased in order to compensate for the potential shortfalls.

My question is that, if you are varying your assumptions and that will give a range of possible profits, why are you increasing the RDR to make up the shortfall? I would have thought for a reduced level of profit, if you increased the discount rate it would just reduce the profits further?

Also for these scenarios, I assume that the denominator of the capital required will also vary if you are in a 'bad' scenario? As you need more reserves to make up for the shortfall? Or is the capital required just the initial reserve at the start and doesn't consider that you might need more capital further into the policy?

 

[Jian_901]

Hi Kelly

My understanding of that part of the solution is that, in a profit testing model, your premium is the ultimate output, by increasing the RDR, you will need to increase your premium to achieve the same profit or NPV.

I think the solution is simply saying that you can work out the new RDR to give you the same level of profit, if the solvency criterion is increased from a level of sufficiency of, say 50%, to 95%.

The difference between the old and new RDR is then your margin (I think somewhere in the notes it says that adding to your discount rate is one way of allowing for prudence...)

Hope this helps,
Jian