Ch5, page 7 Cost of capital: There is this line mentioned that negative non unit reserves helps in reducing new business strain. I am not understanding how. Could you please explain with example.
Hi Mahima Here's an example. Consider a four year unit-linked contract with initial expenses of 5 and initial charges of 2. This gives a loss of 3 at outset if we ignore reserves, ie we have new business strain. But lets say that the charges at the end of each year are 2 and the regular expenses are 1. So there is a positive cashflow in each of the four future years of 1. If the insurer is allowed to have negative non-unit reserves then (ignoring discounting, mortality etc) we have a negative reserve of -4. So there is an initial loss before reserves of 3, but the reserves to be set up are -4, so in total the profit at outset is 4-3=1. So there is no new business strain and the insurer actually makes a profit. I hope this example helps. Best wishes Mark
