Hi Everyone, I could use some help with the soln for part 2. The part that speaks about the calculation of the expected loss of the guarantee speaks to whether the company is pricing on a risk neutral or real world basis. I am assuming that the rest of the soln is based on the assumption of a real world model. If the Company did price on a risk neutral basis, what would be the difference in the solution (for eg relating to the volatility or the returns)? Thank you!
Oops, I wanted to edit to say I assume if it were risk-neutral, the ESG would be calibrated such that all the assets earn the risk free rate and then the cashflows would be discounted at the risk free rate. Is that correct? Also, the soln mentioned whether the Co priced using a market consistent basis. Can a company price it's UL product using real world methods and still be compliant with Solvency 2?
Also for part 3, for the UWP, the cost for the guarantee goes up with bonuses because the fund will get larger with a bonus declaration so any shortfall between the actual fund return on the fund value and the guaranteed rate on the fund value will grow the larger the fund gets? Apologies for the long trail but With Profits is one of my trouble areas . This was a tough end of chapter ques. Thanks again.
If pricing on a risk-neutral then the expected investment return will be the risk-free rate and the variation around the mean will be modelled via the volatilities, which will be calibrated to the market.
A company can price how they like, Solvency II is about how they value the company to demonstrate solvency.
With regular / reversionary bonuses, once declared are guaranteed so that is why cost of guarantees go up with bonus declarations as the guarantees increase.
