Sep 2009 Q1 (iii) (d)

Sep 2009 Q1 (iii) (d) - question closed thanks for helping

Below is the examiner's report regarding cost of smoothing, when the equity return is higher than expected over the year:

"The cost of smoothing over the year will be lower than expected (or may be
negative), which will increase working capital.
However the cost of smoothing liability (part of the future policy related liabilities) would be expected to increase, and overall this should have a neutral effect on working capital"

I understand that the cost of smoothing is lower than expected over the year, as asset shares are more likely than payout when equity return is higher, however I am struggling to understand why the cost of smoothing liability would be expected to increase. Is this because the cost of smoothing is targeted at 0 overtime, and we are expecting worse equity return in the future after a good year?

Any help is very appreciated!

 

Hi,

I think you are refering to Sep 2009 Q2(iv) (d)?

Here’s my reasoning but I don’t think it’s perfect, so take it with a pinch of salt.

Yes smoothing is supposed to cost neutral (value 0) i.e. just purely spread out the profit/loss such that the total of spread profit/loss remains the same.

To illustrate, say an insurer makes a profit of 100 in Year 1 and spreads it over 5 years. So the expected profit arising pattern would be:

Y1: 20 (100/5 or 100 - 100*4/5 <-Cost of smoothing)
Y2: 20 (100/5 or 80 - 100*3/5 <-Cost of smoothing)
Y3: 20 (100/5 or 60 - 100*2/5 <-Cost of smoothing)
Y4: 20 (100/5 or 40 - 100*1/5 <-Cost of smoothing)
Y5: 20 (100/5 or 20 - 100*0/5 <-Cost of smoothing)
CHECK: 20+20+20+20+20 =100 as expected

So in a year of unexpected high profit, say Y3 there is no need for smoothing, so expected profit from smoothing is 0. But the total profit of 100 wouldnt be recognised unless we increase t the cost of smoothing in Y4 or Y5 i.e. the FPRL smoothing cost. So in this example we might increase cost of smoothing in Y5 as - 100*1/5 from 0 (i.e. FPRL increases).

The result (if change cost of smoothing in Y4,Y5)

Y1: 20 (100/5 or 100 - 100*4/5 <-Cost of smoothing)
Y2: 20 (100/5 or 80 - 100*3/5 <-Cost of smoothing)
Y3: 0
Y4: 40 (60 - 100*1/5 <-Cost of smoothing)
Y5: 20 (40 - 100*1/5 <-Cost of smoothing)
CHECK: 20+20+0+40+20 =100 as expected

 

Many thanks for your reply, calibre 2001, I do appreciate you tookthe time to explain using an example. I didnt understand why the smoothing profits changed from 20 to 0 after a good year in year 3 in your example, but if the smoothing profits are targeted at neutral overtime, I understand that the future cost of smoothing will be higher after a good year (when actual cost of smoothing is lower for the good year).

Thank you!

 

-----Question now closed many thanks for helping.