Hello - Could you please help me with below queries:
Chapter 11 (Que 11.6 - Best estimate liability determination for unit linked contract - under SII)
The solution says that non-unit related liabilities are calculated by discounting the projected non-unit cashflows. I understand that
To calculate the charges (to be included in non unit cashflows), the unit fund is also required to be projected. These unit funds growth projection will be based on risk free rate, since we are following market consistent valuation under SII.
To calculate cost of maturity guarantees (which is the difference between the guaranteed payout and Unit linked fund value, subject to max 0), the stochastic model could be used.
- This will again involve projecting the unit fund but with the "investment return" assumption as a stochastic variable.
- This is calibrated using "risk neutral" approach i.e., using risk free rates (as we are using market consistent basis under SII).
- Additionally, a volatility assumption is also added to these "investment return" projection which will depend on the funds chosen by policyholder.
- Thousands of simulation would run and for each simulation, the projected unit funds will be compared to guaranteed payouts and the difference between them ( i.e., the maximum (guaranteed benefits-unit funds, 0)) is discounted using risk free rate ( using the risk free rate as generated for that simulation).
- The average of these discounted values will give the best estimate value for cost of guarantee.
Is my understanding correct? If yes, then I am confused that
1. why the volatility assumptions are allowed in unit fund ( for cost of guarantee calculation purpose)? Won't it be same thing as saying the units funds are allowed to be projected based on expected return on invested assets i.e., we are deviating from market consistent valuation which essentially depicts that we should use only risk free rates?
2. Why volatility assumptions are not used for calculation of charges ?
Chapter 14 (Page 11 extract says that : "The use of market-consistent techniques ensures that market and credit risks – the risks that cashflows will vary with interest rates, stock market movements, volatilities, credit spreads and defaults – otherwise known as non-diversifiable or systematic risks, are appropriately allowed for within the market value of the liabilities." )
I am again not able to understand "volatilities" here. Could you please help me with this?
Chapter 11 (Que 11.6 - Best estimate liability determination for unit linked contract - under SII)
The solution says that non-unit related liabilities are calculated by discounting the projected non-unit cashflows. I understand that
To calculate the charges (to be included in non unit cashflows), the unit fund is also required to be projected. These unit funds growth projection will be based on risk free rate, since we are following market consistent valuation under SII.
To calculate cost of maturity guarantees (which is the difference between the guaranteed payout and Unit linked fund value, subject to max 0), the stochastic model could be used.
- This will again involve projecting the unit fund but with the "investment return" assumption as a stochastic variable.
- This is calibrated using "risk neutral" approach i.e., using risk free rates (as we are using market consistent basis under SII).
- Additionally, a volatility assumption is also added to these "investment return" projection which will depend on the funds chosen by policyholder.
- Thousands of simulation would run and for each simulation, the projected unit funds will be compared to guaranteed payouts and the difference between them ( i.e., the maximum (guaranteed benefits-unit funds, 0)) is discounted using risk free rate ( using the risk free rate as generated for that simulation).
- The average of these discounted values will give the best estimate value for cost of guarantee.
Is my understanding correct? If yes, then I am confused that
1. why the volatility assumptions are allowed in unit fund ( for cost of guarantee calculation purpose)? Won't it be same thing as saying the units funds are allowed to be projected based on expected return on invested assets i.e., we are deviating from market consistent valuation which essentially depicts that we should use only risk free rates?
2. Why volatility assumptions are not used for calculation of charges ?
Chapter 14 (Page 11 extract says that : "The use of market-consistent techniques ensures that market and credit risks – the risks that cashflows will vary with interest rates, stock market movements, volatilities, credit spreads and defaults – otherwise known as non-diversifiable or systematic risks, are appropriately allowed for within the market value of the liabilities." )
I am again not able to understand "volatilities" here. Could you please help me with this?