Good day I understand that there are mainly 2 reserve calculation methods: The formula method and cashflow method. Q1 - Am I right to assume that within each of these methods, we can apply either market consistent or prudent approaches? So for example, if i chose the formula method and applied market consistent approach then I would be discounting using the risk free and my other assumptions will include a margin. However, if I picked the prudent approach, then I would have to discount at a rate that reflects the held assets and include margins. Q2 - Also, say I chose the prudent approach with the formula and cashflow method. I recall that reserves MUST be discounted at the investment return rate. For example, say that my backing assets will provide a return of 8%. Then in the cashflow method - I must use exactly this 8% (cannot include margins - But margins will be included in the other assumptions). While with the formula method, I can discount using say 6% and I have included a prudent margin. Please illustrate using an example if my understanding is incorrect. Thanks in advance.
Hi Yes, we can calculate reserves using the formula method or the cashflow method. Q1. Yes, reserves can be market-consistent or prudent. It would be difficult to use the formula approach to calculate a market-consistent reserve. Market-consistent calculations usually use a term-dependent interest rate but the formula approach usually uses a constant interest rate. We could use a cashflow approach to calculate a market-consistent reserve. Yes, this would be based on the risk-free rate of interest. We would start with best estimate assumptions for parameters that cannot be observed in the market - we would add some form of margin to these to allow for risk, either by directly applying a margin to the assumption, or by the cost of capital approach. We could calculate prudent reserves with either the formula or cashflow methods. The regulator would specify the rules - they might base the interest rate on the assets held. A low interest rate would be prudent. Q2. I don't agree that we must use the investment return as the discount rate. In fact to be prudent, the interest rate assumption should be lower than the expected investment return. Whatever we do will be driven by regulation. For example the regulator might specify that the reserving interest assumption must be the income yield on the assets held less a reduction for risk. Best wishes Mark
