impact on EV: Reducing sales volume

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:

1. Lesser business inforce, so lower reserves. hence increasing net assets
2. 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?

 

Hi Mark,

I am still trying to understand this, it sounds rather contradicting: how can we get lower EV if it is increasing at a slower pace?

In a sense, I agree that if we are still making profits (selling profitable businesses), we are increasing EV, just not as high as it usually is.
I read the examiner report again and got more confused:
Using the argument above, it should mean the PVIF should increase at a lower rate (in contrary to what the examiner report says).
Also, why will the net asset be higher than before if there is a new business strain? Shouldn't the new business strain eat up the asset value?

 

Thanks Mark, that is a lot clearer now.
The final part now is to deduce whether the net effect is increasing or decreasing EV, as the net assets increases while PVIF increase.

Usually in this situation where one increases the other decreases, it depends on how the investment return compares with the discount rate in the PVIF.
If the returns are lower than the RDR, the impact of PVIF will be much lower due to discounting; the opposite is true of returns are higher than RDR.

Should this be factored in our solution as well, to finally deduce it is a net increase or decrease in EV?