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Sept 2018 EV

Discussion in 'SP2' started by Sayantani, Mar 21, 2022.

  1. Sayantani

    Sayantani Very Active Member

    Hi,

    In the September 2018 question paper, Q4 (Embedded Value), Part iii). In the examiner's report it is mentioned that present value of a projection of future bonuses would need to be determined including the distribution of with profits fund estate over the remaining lifetime of the existing policies.
    My question is doesn't the above part relate to the cost of bonus? So why is it mentioned again in the answer?
    The surplus that we distribute as bonuses generally contains the profit due to difference between experience basis and premium basis. Also sometimes it considers the profit from non-profit policies but does it also distribute part of the estate which has been built up over the years in with-profits fund?
     
    Last edited: Mar 21, 2022
    Sayantani, Mar 21, 2022
    #1
  2. Sayantani

    Sayantani Very Active Member

    There is another confusion which I am having, if we leave embedded value aside for a moment and just talk about surplus that we distribute to the with-profits policyholders, it is mentioned that the surplus occurs because we take premiums using conservative basis and the company only has to achieve very modest experience to meet the guaranteed benefits. So here surplus is the difference between the premium and experience basis.
    In Chapter 30 we mention that, the surplus is the difference between the actual experience and the valuation assumptions. So which is the one that is considered, valuation basis assumptions or pricing basis assumptions or are they all linked?
     
    Sayantani, Mar 21, 2022
    #2
  3. Mark Willder

    Mark Willder ActEd Tutor Staff Member

    Hi Sayantani

    Both these statements are true.

    The insurer has to price a with-profits contract using prudent assumptions (or alternatively with an explicit bonus loading) to ensure that the premium is high enough for surpluses to emerge in the future.

    But when calculating the surplus each year the insurer would look at the difference between the actual experience and a prudent valuation basis.

    I'll return to your other question later.

    Best wishes

    Mark
     
    Mark Willder, Mar 21, 2022
    #3
  4. Mark Willder

    Mark Willder ActEd Tutor Staff Member

    Hi Sayantani

    I agree that the wording of the examiners report makes it sound like they are double counting the distribution of surplus and the cost of bonus, but that is not what they meant to say. They just mean that to calculate the one-ninth of cost of bonus then the insurer will first of all need to project what those bonuses are.

    Now let's consider the estate. We need to be careful to make a distinction between what we assume will happen for the purpose of performing an EV calculation, and what will happen in reality. In reality the insurer will keep the estate within the fund for perhaps many decades into the future. Eventually one day it will decide to close the fund and will use the estate to pay bonuses and hence shareholders will get one-ninth of the cost of bonus then. So we could calculate the EV by projecting the estate for many years into the future (ie roll it up with interest) until a bonus is declared and then discount it back. This approach sounds like incredibly hard work. So some insurers just assume for EV calculation purposes that this is approximately the same as giving 10% to shareholders now (and for some companies that are winding up that may indeed be the case in reality too).

    Best wishes

    Mark
     
    Mark Willder, Mar 21, 2022
    #4
  5. Sayantani

    Sayantani Very Active Member

    Hi Mark,

    Thanks for the reply above. I still have another doubt then. If we keep embedded value aside for a moment, in reality the surplus that emerges due to difference between experience basis and reserving basis, gets added to the estate of the with-profits fund. That estate is projected forward as is mentioned above into many years into the future. Its only when the fund is going to be closed that the insurer will use the estate to pay bonuses. But bonuses are declared regularly maybe twice a year. How does the insurer cope with that? Also shareholders should receive the transfers once a claim arises (maturity, death etc) which may happen before the insurer decides to pay the value of the estate by closing the fund?
     
    Sayantani, Mar 21, 2022
    #5
  6. Mark Willder

    Mark Willder ActEd Tutor Staff Member

    Hi Sayantani

    You said that the difference between experience basis and the reserving basis goes to the estate. This isn't usually the case. Instead, if the experience is good then the asset share will grow and the insurer will pay higher bonuses. So the problem you describe of keeping track of surpluses doesn't really occur. Instead the insurer calculates asset shares and pays a terminal bonus to ensure the policyholder get the asset share at maturity (subject to smoothing).

    Usually the shareholders get their share of the surplus when the bonus is declared, rather than when it is paid.

    Best wishes

    Mark
     
    Mark Willder, Mar 21, 2022
    #6
  7. Sayantani

    Sayantani Very Active Member

    Hi Mark,
    Yes I agree that that's how in fact we are determining the terminal bonus for a policy which we take as the difference between the target percentage of the asset share and the guaranteed benefits(sum assured plus already declared bonuses).
    But then how does the concept of estate come in here under with profits fund for the cost of bonus calculation is what I am confused about.
    If we already set bonuses by the approach you mentioned above, then whats the point of projecting the estate and declaring bonuses later? Perhaps a numerical example also might help.
    Another doubt is, in the embedded value calculation, the PV of future shareholder profits considers the profit or surplus emerging as as the difference in the value of change in assets to the value of the change in liabilities.
    so basically we have two ways of determining the profits : one in case of asset share exceeding the guaranteed benefits(which we use for bonus declaration) and the other is the analysis of surplus method described above(used in calculating a part of the embedded value). Am I correct in thinking this?
     
    Sayantani, Mar 21, 2022
    #7
  8. Mark Willder

    Mark Willder ActEd Tutor Staff Member

    Hi Sayantani

    One approach to calculating the EV is to split the assets into two parts: the assets backing the asset share and the other assets (which for convenience we've been calling the estate). There are other ways to calculate EV (which we cover in SA2), but this approach is fine for SP2.

    So imagine the insurer has assets of 100, asset share of 60, and shareholders get one-ninth of the cost of bonus (ie 10% of the surplus distributed).

    The present value of future profits is calculated by projecting bonuses so that the payout is equal to the asset share and allocating one-ninth of the cost of these bonuses to shareholders.

    Let's say we intend to distribute the estate as a terminal bonus in 40 year's time. The estate will be invested at 6% pa and the discount rate is 7% pa. The shareholder transfer would then be

    10% of 40 x 1.06^40 / 1.07^40

    and this is the shareholders share of the net assets part of the EV.

    Some insurers could argue that the interest rate and discount rate is the same, so

    10% of 40 x (1+i)^40 / (1+i)^40 = 10% of 40 = 4

    which is a much simpler calculation as we could just value the estate at 10% without the need for projecting. So we only need to project the estate if we believe that the shareholders required return (7% in our example) is more than the investment return (6%).

    There are many ways of calculating profit. For example in SA2 we will look at calculating profit in the accounts using IFRS17. But yes, in SP2 we can calculate the profit in the ways that you suggest.

    Best wishes

    Mark
     
    Mark Willder, Mar 22, 2022
    #8
  9. Sayantani

    Sayantani Very Active Member

    Hi Mark,

    Thanks for the reply. the concept is clear now :)
     
    Sayantani, Mar 22, 2022
    #9

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