EV - discount rate used in projection basis

[ahtohallan]

Hi

In section 2.3 under the sub heading of "setting and reviewing assumptions", the projection assumptions use a market consistent approach. It also says that the MC valuation approach could be risk neutral or best estimate.

In the Analysis of EV change section, the operating assumptions component of the AoC mentions that the economic assumption changes should include changes to the risk discount rate. Does this imply that the risk discount rate is always used for the projection basis?

If the risk neutral approach is used, does this mean that the AoC in the operating assumptions will include the change in risk free discount rates and any related risk margin?

Thanks in advance

 

[Lindsay Smitherman]

In section 2.3 under the sub heading of "setting and reviewing assumptions", the projection assumptions use a market consistent approach. It also says that the MC valuation approach could be risk neutral or best estimate.

Hi - be careful about your interpretation of this section. Section 2.3 covers a set of possible general EV principles - they are not specific to the MCEV approach. In fact, they are more based on the European EV (EEV) principles, which did not require a market-consistent valuation.

In practice, some companies chose to use a market-consistent projection approach (typically risk-neutral, with risk-free projected investment returns and risk-free discount rates) ... but many continued to use a 'traditional' projection basis (ie typically best estimate assumptions, including investment returns, and discounted at a 'risk discount rate').

[This is all set out under the 'Setting and reviewing assumptions' heading, including the statement 'There may be freedom about whether or not to adopt a market-consistent approach'.]

 

[Lindsay Smitherman]

In the Analysis of EV change section, the operating assumptions component of the AoC mentions that the economic assumption changes should include changes to the risk discount rate. Does this imply that the risk discount rate is always used for the projection basis?

As indicated above, there would be a 'risk discount rate' used if the EV were being performed on a 'traditional' projection basis. If that were the case, then changes to the risk discount rate assumption would cause a change in EV, hence needing to be recognised in the analysis of change.

 

[ahtohallan]

Hi there

I need more help on this please.

Also in section 2.3, under the Required Capital and cost of required capital sub section the notes say "for a company using a traditional approach, this cost reflects the capital only being able to earn a relatively low investment return because it is being held in assets to demonstrate solvency...."
What is the traditional approach mentioned here? Is it the traditional EV approach? Or is this if the balance sheet is built on a traditional basis e.g. a company not subject to Solvency II. I think it is the latter. If it is the latter, do we only care about the liabilities that are valued on a traditional basis? What is the discount rate used to value the liabilities? And is this lower than the risk free rate that might have been used under an MC - risk neutral approach?

Then to follow on from there, how does this traditional basis referred to above relate to the traditional EV approach? I think it means that the projection basis will need an implicit risk margin (since traditional EV). But was will emerge in the as PVIF?

Apologies if my question is unclear as I am quite confused with this.
Any direction would be appreciated. Thanks in advance

 

[Lindsay Smitherman]

If the risk neutral approach is used, does this mean that the AoC in the operating assumptions will include the change in risk free discount rates and any related risk margin?

This is a slightly trickier question because of the close relationship between the risk-free rates assumed for the future and the actual experience outcome over the year. Some companies might include changes in the risk-free rates as an assumption change, but it might instead be included as part of the economic experience item. Alternatively, these components might simply be combined in the analysis - see Chapter 15 Section 2.5, which talks about this issue in relation to the analysis of surplus (where the same consideration applies).

 

[Lindsay Smitherman]

Hi there

I need more help on this please.

Also in section 2.3, under the Required Capital and cost of required capital sub section the notes say "for a company using a traditional approach, this cost reflects the capital only being able to earn a relatively low investment return because it is being held in assets to demonstrate solvency...."
What is the traditional approach mentioned here? Is it the traditional EV approach? Or is this if the balance sheet is built on a traditional basis e.g. a company not subject to Solvency II. I think it is the latter. If it is the latter, do we only care about the liabilities that are valued on a traditional basis? What is the discount rate used to value the liabilities? And is this lower than the risk free rate that might have been used under an MC - risk neutral approach?

Then to follow on from there, how does this traditional basis referred to above relate to the traditional EV approach? I think it means that the projection basis will need an implicit risk margin (since traditional EV). But was will emerge in the as PVIF?

Apologies if my question is unclear as I am quite confused with this.
Any direction would be appreciated. Thanks in advance

No, 'using a traditional approach' refers to the EV projection basis (not the balance sheet).

Under the traditional EV projection basis, investments are projected forwards at the best estimate investment return (eg 4% pa, say, if invested in fixed-interest assets) and discounted back at the 'risk discount rate' (eg 7% pa, say, to reflect the s/hs' required rate of return including allowance for risk). Since the capital is invested in assets earning less than the s/hs' required rate of return, there is a cost to the s/hs of having that capital locked into the company (not allowing them to use it for other purposes), that cost being the difference (ie 3% pa here).

The liabilities in the balance sheet are valued using whatever discount rate the regulator requires the company to use (eg risk-free rates if it were Solvency II).

 

[1495_sc]

Would this mean that EV requires 3 assumption basis-

1. Assumptions (statutory) for projecting liabilities
2. Assumptions (Realistic) for projecting profits
3. Assumptions for projecting assets

Or, 2 and 3 are inter-related and belong to the same basis i.e assumptions for projection of assets/profits

 

[Lynn Birchall]

2 and 3 are the same

To maybe help see this, we can consider profit formula as being broadly:
profit for a time period = P + I - E - C - [ Liabilities(end of time period) - Liabilities(start of time period) ]
= [increase in assets over time period] - [increase in liabilities over time period]

 

[1495_sc]

Ok. In the comment above where Lindsay has posted, it mentions that investments are projected using realistic return and then discounted using risk discount rate.

On top of that, we have the risk free discount rate for liabilities (Statutory basis). Hence, is this not equivalent to 3 different assumptions for interest rate?

 

[Lynn Birchall]

There are 2 assumption bases (ie full set of mortality, interest rate, expenses assumptions etc). These are 1 and 2/3 in your post, ie the supervisory basis for liabilities and the (realistic) projection basis to determine the profit cashflows.

In a 'traditional EV approach', having projected profits using these 2 bases, yes there is then a need for a separate risk discount rate to discount these future profits to give their current value. So there are potentially 3 different interest rates used in the EV.

Hope this clarifies!

 

[1495_sc]

Yes thank you!