September 2020 Que3

[prachi]

Hi, could you please help me with this query in Que 3 (i) of sept 2020 exam paper:

*****************
The answer on page 9 on examination report talk about the asset share movement as follows:
* The asset share will be impacted depending on the investment strategy of the conventional with profit fund… [½]
• … but the movement in the asset share is likely to match the movement in the assets baking the asset share… [½]
• However, the matching may not be exact. [½]
• Any allowance for smoothing may impact the own funds, if it is assumed that the full impact of the shock would not feed through to smoothed asset share.

Que1 , why asset share is being mentioned here in calculating the net asset/own funds impact? is it because the ultimate payouts depend upon "max (gteed benefits, (smoothed)asset share )". Hence, while describing BEL, it is important to consider asset share movements as well?

Que 2: why the answer didn't talk about the impact of interest rate decreasing on own funds? Won't the decrease in interest rate will cause the decrease in risk free rate and hence increase in reserves?

Que 3: if above is true, I believe that the ultimate change in own funds will depend on the matching position...of how asset backing the reserves are matched to reserves. In with profit funds case, matching is though unlikely. but shouldn't this also needs to mentioned in answer?
******************
Que 4: Is cost of guarantee used in calculation on BEL for with profit contracts?

Que 5: How Cost of guarantee impacts/allowed in the estate/own funds? Is it that- the cost of guarantee increases the reserve, and therefore, automatically leads to reduced estate? How the deduction of cost of guarantee charge from asset share will impact the estate?

******************
In the same question (sept 2020 q3, page 10)
Que 6: "The impact on net asset value for the units of the unitised fund value should be zero, as the assets would be expected to be invested to match policyholder liabilities.".
In understand that in UWP, unitized funds is bid value value of units i.e. premiums less charges growing at rate of bonus. So these rate of bonus have relation which actual holding of assets, but they can vary also due to smoothing. Also, unit funds once increased can't be decreased even if the actual assets fall in value. It is likely that company can do mismatch in UWP also.
Then why, the examination report qouted so (which seems applicable more in unit linked funds rather than unitized )

Que 6: In the same question (sept 2020 q3) , the impact on SCR (Page 10) is mentioned in examiner's report. i am not sure why there is nothing mentioned about insurance risk module ? Could you please suggest the likely impact on different sub modules under this category?
******************

Que 7: page 13 of examiner's report say that " The company would need to consider the ability to alter the investment of assets backing asset share which would be determined by policyholder communication".
Assets backing the asset share are essentially the assets backing reserves?


Thanks and kind Regards.

 

[Em Francis]

Hi
I would advise going through Chapter 11 of ActEd's CMP, to gain a better understanding of the calculation of BEL for WP business.

Hi, could you please help me with this query in Que 3 (i) of sept 2020 exam paper:

*****************
The answer on page 9 on examination report talk about the asset share movement as follows:
* The asset share will be impacted depending on the investment strategy of the conventional with profit fund… [½]
• … but the movement in the asset share is likely to match the movement in the assets baking the asset share… [½]
• However, the matching may not be exact. [½]
• Any allowance for smoothing may impact the own funds, if it is assumed that the full impact of the shock would not feed through to smoothed asset share.

Que1 , why asset share is being mentioned here in calculating the net asset/own funds impact? is it because the ultimate payouts depend upon "max (gteed benefits, (smoothed)asset share )". Hence, while describing BEL, it is important to consider asset share movements as well?

Yes

Que 2: why the answer didn't talk about the impact of interest rate decreasing on own funds? Won't the decrease in interest rate will cause the decrease in risk free rate and hence increase in reserves?

The solution does cover the impact on own funds (implicitly) as it goes through impact on assets, liabilities and required capital.

Que 3: if above is true, I believe that the ultimate change in own funds will depend on the matching position...of how asset backing the reserves are matched to reserves. In with profit funds case, matching is though unlikely. but shouldn't this also needs to mentioned in answer?

This is not necessarily answering the question (Which asks for a description of the impact of combined stresses)

******************
Que 4: Is cost of guarantee used in calculation on BEL for with profit contracts?

Yes

Que 5: How Cost of guarantee impacts/allowed in the estate/own funds? Is it that- the cost of guarantee increases the reserve, and therefore, automatically leads to reduced estate? How the deduction of cost of guarantee charge from asset share will impact the estate?

Yes, the cost of guarantee will increase technical provisions.
The charge for this cost will come out of asset share and likely go into own funds. But is a 2nd order impact.

******************
In the same question (sept 2020 q3, page 10)
Que 6: "The impact on net asset value for the units of the unitised fund value should be zero, as the assets would be expected to be invested to match policyholder liabilities.".
In understand that in UWP, unitized funds is bid value value of units i.e. premiums less charges growing at rate of bonus. So these rate of bonus have relation which actual holding of assets, but they can vary also due to smoothing. Also, unit funds once increased can't be decreased even if the actual assets fall in value. It is likely that company can do mismatch in UWP also.
Then why, the examination report qouted so (which seems applicable more in unit linked funds rather than unitized )

Because in comparison to CWP, they are relatively matched. But the solution does cover the fact that there may be an impact due to the guarantee: 'The unitised with profit fund may be subject to a minimum guaranteed return, and the cost of this guarantee may change'. ie The stresses will only impact the UWP fund to the extent that there are guarantees.

Que 6: In the same question (sept 2020 q3) , the impact on SCR (Page 10) is mentioned in examiner's report. i am not sure why there is nothing mentioned about insurance risk module ? Could you please suggest the likely impact on different sub modules under this category?.

The stresses relate to non-insurance risks, so you wouldn't include an impact from these modules, hence why the risk margin is only impacted by a change in the discount rate.
******************

Que 7: page 13 of examiner's report say that " The company would need to consider the ability to alter the investment of assets backing asset share which would be determined by policyholder communication".
Assets backing the asset share are essentially the assets backing reserves?


Thanks and kind Regards.

They are some of them. But remember that technical provisions is BEL + RM. And BEL depends on assets shares and cost of guarantees.

 

[Arush]

Hi, same question, part i) Why fall in equity / property under stress leads to lower SCR? I thought required capital stress = Base avl capital - stress avl capital and the fall in equity / property would be part of the stressed avl capital calculation. I don'r understand why the answer says that the reduced assets values are base positions. Helpful with an example if possible.

 

[prachi]

Hi, same question, part i) Why fall in equity / property under stress leads to lower SCR? I thought required capital stress = Base avl capital - stress avl capital and the fall in equity / property would be part of the stressed avl capital calculation. I don'r understand why the answer says that the reduced assets values are base positions. Helpful with an example if possible.

Let's say equity is EUR300 , and to calculate SCR, stress of 40% reduction is applied.
So SCR from equity risk would be 300*0.4

Now if economic condition worsen and equity in balance sheet has reduced to eur200, the scr on this balance sheet equity will be
200*0.4

Thus the base has reduced from 300 to 200 and equity risk scr has also reduced

 

[Arush]

Let's say equity is EUR300 , and to calculate SCR, stress of 40% reduction is applied.
So SCR from equity risk would be 300*0.4

Now if economic condition worsen and equity in balance sheet has reduced to eur200, the scr on this balance sheet equity will be
200*0.4

Thus the base has reduced from 300 to 200 and equity risk scr has also reduced

hi, thanks. I understand the change in base impact (300 to 200). Still not sure about the 40% stress. The 40% stress also reduces the equity price isn’t it (to 180), so why does it not have a similar impact?

 

[Em Francis]

hi, thanks. I understand the change in base impact (300 to 200). Still not sure about the 40% stress. The 40% stress also reduces the equity price isn’t it (to 180), so why does it not have a similar impact?

The 40% stress is applied to a lower absolute value, so (from the example above) instead of a 120 impact, it will have an 80 impact.

 

[Arush]

Thanks.
And from a stress perspective, for equity scr, will the equity price be increased or decreased? Let’s assume under 2 scenarios, unit-linked product as well as a conventional product.

 

[Em Francis]

Thanks.
And from a stress perspective, for equity scr, will the equity price be increased or decreased? Let’s assume under 2 scenarios, unit-linked product as well as a conventional product.

If a standard formula is used, assets and liabilities subject to equity risk are only exposed to a fall in the level of equity prices and not to a rise in those prices, ie a downward equity stress scenario.

 

[sa2_doubts]

Hi, I understand the above responses and agree with them however I am finding it difficult to grasp that under a stressed economic environment the SCR requirement will be lower overall. Shouldn't the regulation mandate the company to hold more capital to ensure it is able to pay its liabilities?

 

[Lindsay Smitherman]

If equity values have just fallen, the company now has a lower equity exposure in absolute terms. If equity markets fall again (which is one of the events the SCR is there to cover), then the insurer now has less to lose - so it doesn't need to hold so much capital against that event now.

 

[Arush]

The 40% stress is applied to a lower absolute value, so (from the example above) instead of a 120 impact, it will have an 80 impact.

Hi again, we don't consider the impact on BEL? Let's say the product being backed is a UL endownment plan. A fall in equity would also reduce the BEL, isn't it? In that case, the overall difference between asset and BEL would determine the stress magnitude, isn't it?

 

[Arush]

If equity values have just fallen, the company now has a lower equity exposure in absolute terms. If equity markets fall again (which is one of the events the SCR is there to cover), then the insurer now has less to lose - so it doesn't need to hold so much capital against that event now.

Still trying to grasp this logic. Let's say an endownment without profits is backed by equity (assuming the company is very large and has many free assets and regulator allows). Say, as at 31.12.2022 the BEL was 200 and Asset 300. Now as at 31.12.2023, the BEL is still 200 but assets fell to 200 (fall in equity prices). Now are we saying because the equity exposure is less (by 100), the insurer needs to hold less capital? This doesn't sound right somehow.

 

[Lindsay Smitherman]

Hi again, we don't consider the impact on BEL? Let's say the product being backed is a UL endownment plan. A fall in equity would also reduce the BEL, isn't it? In that case, the overall difference between asset and BEL would determine the stress magnitude, isn't it?

Yes, for UL business the unit reserve component of the BEL will reduce under an equity market fall. However, {assets - BEL} will still likely be lower (in absolute terms) as a result of an equity market fall, because some of the own funds themselves are likely to be invested in equities.

[Bear in mind that this question is about with-profits business, not UL business, so although there will be some offset from a lower BEL (reduction in asset share), this will not have the same direct correlation as for UL business due to the inherent guarantees in WP business, which could well start biting under a significant equity market fall.]

 

[Lindsay Smitherman]

Still trying to grasp this logic. Let's say an endownment without profits is backed by equity (assuming the company is very large and has many free assets and regulator allows). Say, as at 31.12.2022 the BEL was 200 and Asset 300. Now as at 31.12.2023, the BEL is still 200 but assets fell to 200 (fall in equity prices). Now are we saying because the equity exposure is less (by 100), the insurer needs to hold less capital? This doesn't sound right somehow.

This is a horribly mismatched asset-liability position - so little surprise that the capital position is messy!

Using your figures, we seem to have a 33% fall in the value of equities as the 'event' that has happened (from 300 to 200).

With assets of 300 and BEL of 200, the company only has own funds of 100. It therefore doesn't have enough capital in place to cover a more typical SCR stress of say 40% fall in the value of equities. So let's say that the SCR stress is actually a 30% fall to avoid having to alter your example figures too much.

So before the fall in market values has happened, we have assets 300, BEL 200. So 'base' own funds = 100. After applying the SCR stress, we get stressed assets = 210 (300 x (1 - 30%)) and BEL remains at 200. So 'stressed' own funds = 10 (= 210 - 200), therefore have to hold an SCR of 90 (= 100 - 10).

After the fall in market values of 33%, we now have assets 200, BEL 200. So 'base' own funds = 0. After applying the SCR stress to the new position, we get stressed assets = 140 and BEL remains at 200. So 'stressed' own funds = -60 and have to hold an SCR of 60.

So the amount of SCR that the company has to hold to protect itself against future equity falls has fallen - because the company now has less equity exposure (in absolute terms) than it had before the market fall.

Of course despite this slight reduction in the SCR that has to be held, the company is still in a significantly worse position. It has zero own funds but has to cover an SCR of 60. So it is pretty much technically insolvent and the regulators would be straight in.

 

[Arush]

Very very helpful! You should be writing the core reading notes

Just a suggestion - examples like this in the course notes will be quite useful for students.