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Best Estimate Cashflows and Liquidity

F

Flying_Penguin

Member
Hi folks,

Apologies in advance if this is a silly question but it is frying my brain!
My understanding is that in Solvency II, the Best Estimate Liability is the present value of future cashflows.

But my question is, how does this allow for future periods of strain?
For example, consider a profit stream over ten years of £5, £5, -£30, £5, £5, £5 ,£5, £5, £5, £5

If the discount rate is 0%, then I’m calculating a negative BEL of -£15 (i.e. 9 x £5 = £45 - £30).
But the company will go insolvent in year 3 because of the large £30 loss.


Am I missing something really obvious here?
I know that the old “Sterling Reserves” approach would allow for this, but how does it work in Solvency II??

Any thoughts would be appreciated!
 
It might be worth starting by thinking about what kind of product would generate a cashflow pattern like this on a best estimate basis?
 
Thanks Lindsay. I am thinking of a product that I have seen at work - unit linked product with a loyalty bonus if premiums are paid after 3 years. The cash-flows in my example are a bit exaggerated but there is a future strain and I just can't figure out how this is captured in the BEL
 
OK - yes, loyalty bonus is a good example of this.

Bear in mind that it is unlikely that everyone's loyalty bonus will need to be paid at the same time, and there should be offsetting positive cashflows across other policies, including from other products that don't have the loyalty bonus.

Have you asked your valuation team how they allow for it? I suspect that it is simply allowed for as a cashflow in the non-unit component of the BEL without any particular adjustment.
 
Thanks for you help with this Lindsay.

I have asked the valuation team and as you suspected it is simply allowed for as a cashflow in the non-unit component of the BEL.
But it turns out that the negative cashflow exists in total (large volume of plans getting their loyalty bonus in that particular year)

So, I guess my question really relates to whether this is a weakness of the BEL method or am I misinterpreting how BEL is calculated. It looks like the future profits (after the strain) are being used to offset the strain - but this doesn't feel prudent.

E.g. Future Profits = 5, 5, -30, 5, 5, 5, 5, 5, 5, 5, 5
BEL = -20 (Assuming discount factor of 0%)

Is it right for the profits after the -30 strain to be allowed to offset the strain at time 0?
It feels like we should have a reserve 20 to be able to meet the liability in year 3, instead the BEL is a negative reserve of 20.

From a work perspective, I'll leave it to the reporting team but from a theory perspective I just want to make sure that I've got the idea of BEL correct.
 
Hello
Flying_Penguin said:
So, I guess my question really relates to whether this is a weakness of the BEL method or am I misinterpreting how BEL is calculated. It looks like the future profits (after the strain) are being used to offset the strain - but this doesn't feel prudent.
Click to expand...

It sounds like your understanding of how the BEL is calculated is aligned with my understanding.

The BEL is supposed to be a best estimate, and so it understandable that it doesn't feel prudent.

As part of ORSA, firms should carry out projections of balance sheet and capital requirements in order to assess their ability to continue meeting capital requirements. This analysis highlight strains like in your example. Once identified they can be addressed.

Thanks
Amit
 
Thanks Amit and Lindsay,

I have checked with the reporting team and this is where it is captured.
It feels strange that people thought Solvency II was an improvement - it feels to me like now you have to go looking for things that would have been obvious in Sterling Reserve land!! :D

Case closed as far as I am concerned - thank you for your help.
 
Good to hear. (Thanks Amit also - you beat me to it with the 'not feeling prudent' vs 'realistic' point!)

I think you will find that there are actually quite a few elements of Solvency II that aren't particularly seen as a good thing, eg the 6% cost of capital parameter in the risk margin!
 
How would the old “Sterling Reserves” allow for this? By the zeroisation of negative cashflows?
 
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Yes, that's right. And also (if a prudent approach is being taken) by ignoring the positive cashflows that emerge after the final negative one - as is described in the SP2 course.

It was still permissible under Solvency I regulations to hold negative non-unit (ie 'sterling') reserves. However, certain conditions needed to be met in order to permit this - including relating to the timing of emergence of future positive and negative cashflows, to ensure that there was no future valuation strain. These ideas are covered in a little more detail in Subject SP2.
 
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