Sept 2011

[rlsrachaellouisesmith]

Q2(iii) a 14 mark question on balance sheet impact of an equity fall.

The solutions are not in line with SII, so I wanted to check my understanding.
- a realistic basis is mentioned in the question, but if this was an SII balance sheet this would not be a relevant piece of information
- if economic balance sheet then this would need to be taken into account wrt discount rate

Assets would be expected to behave in the same way as set out in the solution, and could call out specifics such as:
- asset strategy may lead to a lower or higher fall than the market.
- existing surplus assets may be heavily invested in equity so this may lead to a greater fall in surplus assets compared to the assets backing the AS.
- management actions may lead to proportion of assets being held as equities being reduced, leading to a crystallised loss on these assets, and a higher proportion in FI assets. possible impact reduce assets due to trade costs.

Liabilities would be expected to increase
- discount rate unlikely to change since FI asset values unch
- BEL is ~=EPV(max(gtd benefit, smoothed EAS))+EPV(expenses)
we would expect this to increase for two reasons
gtee more likely to bite as AS fallen in value - the extent of the increase would depend on how the Assets backing AS were invested.
Expenses may be expected to increase too because management of WP fund would be more costly under this situation.
BEL may reduce if management actions set out in PPFM following such a market fall could lead to reduction in bonus declaration this year, reduce reserves for this year's RB.
might expect BEL to reduce further if future RBs also reduce, so lower reserves need to be held with respect to these. However, might not be able to do this due to PRE.
Still on balance would expect the liabilities to increase.
p/h response - lapses could increase, but this will depend on whether SVs are gtd or whether expected to be equal to smoothed EAS.
GAO point in mark scheme still relevant
Stochastic model point also still relevant

Therefore leading to a reduction in surplus.

Are there any key bits that I have missed/misunderstood if the question had been asked about a simple SII balance sheet?

Thank you,

Rachael

 

[Lindsay Smitherman]

This is rather a detailed question to deal with on the forum, but to pick up on a few things:

Not sure what you mean by 'if economic balance sheet then this would need to be taken into account wrt discount rate'. The question is about a WP fund that was subject to the 'realistic basis' (Peak 2) version of Solvency I that applied in the UK. In other words, it had to produce a regulatory balance sheet under a set of 'realistic basis' rules that (for WP business) does have similarities with the Solvency II approach.

Formula for the BEL: this is conventional business, so BEL = PV {Future benefits + future expenses - future premiums}. You appear to have omitted the future premiums deduction.
For conv with-profits business, this approximates to: current asset share + cost of guarantees + (possibly) cost of smoothing.

Impact of 40% equity fall on Solvency II balance sheet for WP business: the basic impacts are as stated in the original solution for Peak 2 (just using different terminology). As is explained there, liabilities will likely reduce not increase.

• Assets down
• BEL likely down ...
• ... which is mainly due to asset shares falling ...
• ... although this will be offset to some extent by an increase in the cost of guarantees (COG) component (due to the asset share fall, thus greater chance of maturity and death guarantees biting) ...
• ... and a likely increase in any cost of smoothing
• If RB rates are expected to be cut as a result of the fall, this would reduce the BEL further (lower COG)
• If there are GAOs, their cost will fall due to applying to a smaller fund (lower COG)
• If the equity volatility assumption is increased as a result of the fall, this will increase the COG component, offsetting the above to some extent
• SCR likely down due to the reduction in equity exposure, although this would be offset to some extent if the equity volatility assumption is increased
• Management actions that change the equity backing ratio as a result of the fall would of course impact the COG and SCR calculations

Hope that helps to set it out a little more clearly.