Hi,
I am trying to understand in the 2013 September, Question 2ii, why will the future Embedded Value increase following a reduction of future sales volume?
I agree that Reducing sales volume means:
- Lesser business inforce, so lower reserves. hence increasing net assets
- Lesser profit to be expected in the future, lower PVIF
However it is difficult to ascertain what is the net impact on the embedded value, it depends on whether the effect of (1) or (2) is larger.
The
net asset may not increase as much,
Despite reserves reduce, the future asset values will reduce too because we would have received lesser premium as a result of not making sales.
Also the insurer will have lesser increase in asset level because there is no need to buy more assets in excess of the increase in reserves.
In a way, the net asset will not change significantly assuming the assets and liability are well matched, they should both move in the same direction, approximately same magnitude.
From this perspective, the impact of (2) will outweigh (1), therefore
Embedded Value should decrease.
This makes intuitive sense. If we are not able to generate sales, we are not generating values for the shareholders.
The examiner report quotes that assuming new businesses are written in profitable terms, the Embedded value should increase instead, at a lower rate than usual.
I understand that if they are profitable, then every single policy sold should increase the EV. So as long as we sell even one policy, it is increasing EV.
However I am struggling to piece this final conclusion with the 2 points above.
Embedded value = Net Assets + PVIF
if Net assets increase (slightly) and PVIF reduces significantly, the formula tells us EV should reduce.
The argument given in the examiner report is implying the increase in net assets outweighs the decrease in PVIF, hence net increase in EV but at a smaller magnitude.
Wouldn't this contradict the argument given, because if it is written in profitable terms the decrease in PVIF should be significant?
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