SP2, Chapter 20

[Bharti Singla]

Hi All,

On pg3 of ch20, there are different approaches of reserving basis.

1. First is calculating premiums on prudent basis and the same basis is used for reserving.
2. Secondly, the premiums are calculated using assumptions that reflect expected future experience, with risk being allowed in risk discount rate. In this case, pricing assumptions couldn't be used for reserving.
3. And the third approach is to use market-consistent assumption in reserving.

I guess market consistent approach is same as best estimate approach.
But what exactly the difference between the two highlighted above i.e. Expected future experience and Market-consistent approach?

 

[Mark Willder]

Hi All,

On pg3 of ch20, there are different approaches of reserving basis.

1. First is calculating premiums on prudent basis and the same basis is used for reserving.
2. Secondly, the premiums are calculated using assumptions that reflect expected future experience, with risk being allowed in risk discount rate. In this case, pricing assumptions couldn't be used for reserving.
3. And the third approach is to use market-consistent assumption in reserving.

I guess market consistent approach is same as best estimate approach.
But what exactly the difference between the two highlighted above i.e. Expected future experience and Market-consistent approach?

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

 

[Bharti Singla]

Hi Mark,

As per the first para above, risk free rate is used in market consistent approach and so it will not be a best estimate. But we add a 'liquid premium' and 'risk margin' to allow for the extra risk.
In this context, how this is different from expected future experience approach?

 

[Mark Willder]

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

 

[Varsha Agarwal]

For example
In Expected future experience -
As per the current risk free rate in market,taking companies portfolio Best estimate for int rate for calculation of liability for example is 6%.
Now the risk margin for valuations is taken as 100bps,so revised valuation assumption is 5%
This is allowing risk through risk discount rate for valuation.

Market consistent valuation-
Current Risk free rate- 4% is used for valuation of liabilities.
Apart for this, there is quantification of risk margin by CoC method with respect to all interest rate risk pertaining to company's portfolio.
Total of liabilities- Value of liabilities at current risk free rate + risk margins.

This is my general idea..Market consistent valuations has further application in other bases too.

 

[Mark Willder]

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

 

[Varsha Agarwal]

Completely agree with you.
Thanks a lot.