SP2, Chapter 20

Hi Bharti

A market-consistent approach uses assumptions that are consistent with market prices where they exist. So the market-consistent interest rate assumption will be derived from the return available on government bonds, ie we use risk-free rates. We still use the risk-free rate even if the insurer chooses not to actually invest in the risk-free bonds, so this may not be the best estimate of what the insurer will actually earn.

In contrast, the expected future experience basis would consider the actual assets held and what they were expected to earn. So this would be a best estimate of the investment return.

So in terms of the interest rate assumption at least, 2 and 3 are different.

However, we generally do not have (deep and liquid) market prices for other assumptions such as mortality, withdrawals. For these assumptions, both methods 2 and 3 would often use best estimate assumptions.

However, the way the two methods deal with risk may be different. Method 2 suggested using a risk discount rate to allow for risk. The course describes how method 3 could use a cost of capital approach (similar to the risk margin approach used under Solvency II in the EU).

Best wishes

Mark

 

Hi Bharti

There's two separate things here. I'll take the risk margin first. A risk margin in a market-consistent approach is used to allow for the risks that we do not have a market price for. We have a market price for the interest rate, so wouldn't need a risk margin. Instead the risk margin is used for things like mortality. For example, we could take a direct margin in the assumption, ie higher than best estimate mortality for a term assurance, or we could use the cost of capital approach.

Now let's look at the liquidity premium. This would usually apply to assets such as corporate bonds (and would only be applied in certain circumstances, such as a buy and hold portfolio to match annuities). The yield on a corporate bond is made up of the risk-free rate, the liquidity premium, and the credit risk premium. The credit risk premium will be higher than the expected default rate, this provides a return for taking on this risk. So the best estimate return on a corporate bond is higher than the market-consistent assumption of the risk-free rate plus liquidity premium. We wouldn't apply a liquidity premium to assets such as equities, so the best estimate return is quite different to the market-consistent risk-free rate.

Best wishes

Mark

 

Hi Varsha

I think what you have written above is mostly ok, but I want to correct a couple of things.

Firstly, to allow for risk we use a high risk discount rate. Remember that the original post referred to pricing. To price the contract we project the profits and then discount at the RDR. A higher RDR means lower expected present value of profits. This will then mean a higher premium to allow for the risk and push the NPV up to the required profit criteria.

Under the market-consistent approach, the risk margin is used for risks that do not have a market price, eg mortality and withdrawals. There is no need for a risk margin / cost of capital for the interest rate as this has an observable market price.

I hope these posts help to clarify the position.

Best wishes

Mark