Hi, Could a tutor please explain to me the distinction between mismatching profits and "yields on actual backing assets vs discount rate to determine liabilties"? My understanding of economic variances is more in line with the latter, its the difference between the yield we get on our assets vs the yield we have assumed within our liability valuation. Is it more correct to say that "mismatching" contributes to this, rather than it being a completely separate thing? I am having confusion in understanding this clearly. Maybe an example of a situation where an insurer is matched vs not matched and how the "ecomonic variance" is split in each circumstance would help me? Thank you!
Hi If the valuation is market-consistent, the liabilities would be valued using the risk-free rate (and possibly a matching/volatility adjustment) , this is the expected yield, and will be independent of the assets held. And so the difference between actual yield and expected yield (economic variance) is (as you say) the difference between discount rate and yields on actual backing assets. eg Bond yields are 3% Discount rate = risk-free rate (eg 1%) plus any matching/volatility adjustment (eg 1.5%) = 2.5% Therefore, economic variance will be partly due to the 0.5% differential (profit) earned over the year But economic variance also includes any profits or losses that arise due to backing assets not moving in line with liabilities following change in yields or volatilities, etc. eg Bond yields increase to 4% If a market-consistent approach is taken, then the economic variance will reflect the difference between this 1% increase relative to the movement in the risk-free rate plus any movement allowed for in any matching/volatility adjustments. I would say they are both an example of mismatching as asset proceeds and liability proceeds are not completely matched. Hope this helps. Thanks
