September 2011 Question 4 (i) embedded value

[VSA_88]

Hi
In the revision books, the answer for this question says that it is assumed that the non-unit reserves do not increase with interest. Firstly, what would be the reason for this?
Secondly, why do the cashflow projections under column 5 start with an amount of 500. If the non-unit reserves don't accrue interest, should this not be 200? I can't figure out where the initial value is coming from.

 

[Mark Willder]

Hi
In the revision books, the answer for this question says that it is assumed that the non-unit reserves do not increase with interest. Firstly, what would be the reason for this?
Secondly, why do the cashflow projections under column 5 start with an amount of 500. If the non-unit reserves don't accrue interest, should this not be 200? I can't figure out where the initial value is coming from.

Hello

In practice the non-unit reserves would allow for interest, but we have no information in the question to tell us what that interest rate would be. In fact the question says:

"Non-unit reserves, which are calculated on a very prudent basis, and solvency capital requirements are released in the same pattern as the unit reserves mature."

so we run off the reserves in the same ratio as the number of the lives. The question tells us the reserves are very prudent, so this might explain the zero interest assumption.

The total reserves to consider here are the non-unit reserves (300) and solvency capital (200) giving 500. Again the solvency capital is treated in the same simple way as the non-unit reserves.

Best wishes

Mark