Hi. In chapter 0, we have a statement under "Developing the solution" for the annuity example: "The assumed reserving basis and capital requirements will also be an input to the profit testing of the product" Can someone please elaborate on this?
Hi Profit testing means evaluating whether the premium rates charged by the annuity will generate satisfactory profits or not. In order to perform such an assessment, we would need several inputs, for example, mortality assumptions, investment returns, expenses as well as reserving basis and capital requirements. The reserving basis refers to the method and assumptions used to set aside funds (reserves) to cover future annuity payments. Capital requirements refer to the amount of capital that the insurance company needs to hold to cover unexpected events or losses. By incorporating these elements into the profit testing, ensures the insurance company has adequate reserves and capital to cover expected and unexpected cash outflows. I hope this answers your question.
Great answer Darshan. It's also worth noting that, whilst the requirement to hold reserves and capital will not reduce overall profits for products (ie profits summed over all policy years for products without discounting), profits will emerge later in a policy's term as a result of these requirements. This is because early income from policies will be used up by setting these up before, all being well, they are released as profit in later years in policies' terms. This will result in a lower net present value and internal rate of return. Also, due to the effect of profits being deferred, new business strain will be greater, so profit testing needs to include these otherwise initial capital requirements will be understated. In summary, the inputs mentioned need allowing for in profit testing so as to not overstate the attractiveness of a product to a provider.
