Assignment X6 Question 7

[dChetty]

I am referring to part (ii) of the solution, Why are long-dated domestic government bonds appropriate for "additions to benefits" and the revalorisation method. Please advise.

Please explain the following part from the solution:

"Under the revalorisation method there is no deferral of profit distribution. This makes equity investment prohibitively risky. Government bonds may therefore be the predominant asset class......"

 

[Mark Willder]

I am referring to part (ii) of the solution, Why are long-dated domestic government bonds appropriate for "additions to benefits" and the revalorisation method. Please advise.

Please explain the following part from the solution:

"Under the revalorisation method there is no deferral of profit distribution. This makes equity investment prohibitively risky. Government bonds may therefore be the predominant asset class......"

Think about how terminal bonus can be used to control risk from equity investment.

 

[dChetty]

Thanks. When equity markets fall then the insurer will not give a terminal bonus. Please advise.

 

[Mark Willder]

Thanks. When equity markets fall then the insurer will not give a terminal bonus. Please advise.

When markets fall, the terminal bonus will be lower, and possibly even zero.

 

[dChetty]

Hi
Is the solution saying equity will not be used and government bonds will be used because government bonds are less riskier than equities and is likely to give returns? Please advise.

 

[Helloall]

Hi Mark,

I was wondering if my understanding of these contracts was correct.

Lets assume i have a single premium additions to benefits and revalorisation policy.

For addition to benefits and revalorisation I have some initial sum assured. I would assume that for both of these contracts i match the initial sum assured liability with fixed interest assets and then hold the additional assets in equities.

My understanding is then that over time i declare regular bonuses in the additions to benefit method. As i declare these bonuses i will then start selling out of some of my equities and buying more fixed interest to match these guaranteed and declared regular bonuses. At the end of the policy i just declare the value of the equities as a terminal bonus.

Why cant i do the same for revalorisation? Match the initial sum assured with fixed interest and then hold additional equity. When equity performs good (k*(i-i')), declare profit onto sum assured (and perhaps increase premiums). Swap some of the equity assets into fixed interest to match liability and continue?

 

[Mark Willder]

Hi Mark,

I was wondering if my understanding of these contracts was correct.

Lets assume i have a single premium additions to benefits and revalorisation policy.

For addition to benefits and revalorisation I have some initial sum assured. I would assume that for both of these contracts i match the initial sum assured liability with fixed interest assets and then hold the additional assets in equities.

My understanding is then that over time i declare regular bonuses in the additions to benefit method. As i declare these bonuses i will then start selling out of some of my equities and buying more fixed interest to match these guaranteed and declared regular bonuses. At the end of the policy i just declare the value of the equities as a terminal bonus.

Why cant i do the same for revalorisation? Match the initial sum assured with fixed interest and then hold additional equity. When equity performs good (k*(i-i')), declare profit onto sum assured (and perhaps increase premiums). Swap some of the equity assets into fixed interest to match liability and continue?

Hi

Your suggested strategy would work well for conventional with-profits and an insurer that wanted to be well matched would do exactly that.

A numerical example might help. Let's say the premium is 60, the sum assured is 50, and bonds earn 0% interest. The the insurer matches the sum assured with bonds of 50 and places 10 into equities. Next year the equities go up in value to 15, the insurer declares a reversionary bonus of 4. So it buys 4 more bonds (total of 54) and has 11 left in equities. It continues in this way each year and then at maturity it can sell the equities and pay out their value as terminal bonus.

This approach doesn't work for revalorisation as there is no terminal bonus. So if we used your suggested approach there would be some assets left over at the end that the policyholder would not benefit from.

Best wishes

Mark