2017 Sept Q5 - Market consistent EV

[Trevor]

Hi, I am trying to understand the solution for the 2017 September Question5.

In part 2, we were told that the insurer moves from a passive EV basis to a market consistent basis.
Given part (i) asked about passive and active valuation approach, I would assume question 2 meant calculating reserves using an active rather than passive approach, so my conclusion is:

Assets increase
As passive approach takes the book value/historical costs, active approach takes the market value
Assuming assets prices generally inflate, assets value should increase.

Demographic assumption strengthens
This is a CI and LTC book, which demographic experiences are Morbidity, Expense, and Lapse rates.
Under a passive approach, assumptions are locked-in as of when they were written, so this will be very out-dated. In general medical inflation will worsen the claim amount and expenses, so the passive approach is understating the claim experience.
Moving to an active approach will make them realise the experience is actually much worse than expected, so the demographic assumptions strengthens therefore reducing PVIF and increasing reserves

Ignoring the investment and discounting changes, the net effect is:
Net asset reduces as the increase in reserves may outweight increase in asset
PVIF will definitely reduce
Therefore EV will be lower

However, the solution has no mention about changes in reserves, and implies that net assets are already on market value, which contradicts the passive valuation approach.
They have also mentioned there will be no affect on the claim elements of PVFP calculation, implying demographic assumptions doesn't change.


Can I know why is this the case? the question hasn't mentioned if it is the projection basis, or reserving basis, or both that gets changed, so I assumed they both changed.

Thanks,
Trevor

 

[Mark Willder]

Hi, I am trying to understand the solution for the 2017 September Question5.

In part 2, we were told that the insurer moves from a passive EV basis to a market consistent basis.
Given part (i) asked about passive and active valuation approach, I would assume question 2 meant calculating reserves using an active rather than passive approach, so my conclusion is:

Assets increase
As passive approach takes the book value/historical costs, active approach takes the market value
Assuming assets prices generally inflate, assets value should increase.

Demographic assumption strengthens
This is a CI and LTC book, which demographic experiences are Morbidity, Expense, and Lapse rates.
Under a passive approach, assumptions are locked-in as of when they were written, so this will be very out-dated. In general medical inflation will worsen the claim amount and expenses, so the passive approach is understating the claim experience.
Moving to an active approach will make them realise the experience is actually much worse than expected, so the demographic assumptions strengthens therefore reducing PVIF and increasing reserves

Ignoring the investment and discounting changes, the net effect is:
Net asset reduces as the increase in reserves may outweight increase in asset
PVIF will definitely reduce
Therefore EV will be lower

However, the solution has no mention about changes in reserves, and implies that net assets are already on market value, which contradicts the passive valuation approach.
They have also mentioned there will be no affect on the claim elements of PVFP calculation, implying demographic assumptions doesn't change.


Can I know why is this the case? the question hasn't mentioned if it is the projection basis, or reserving basis, or both that gets changed, so I assumed they both changed.

Thanks,
Trevor

Hi Trevor

The question says:

"The insurer currently reports profits on a passive embedded value basis. Currently, the future investment return assumptions are the insurer’s expected long-term returns and the risk discount rate is used to reflect the risks inherent in the business. The insurer is moving to a market-consistent embedded value basis."

So the question tells us it is the embedded value (projection) basis that is changing rather than the reserving basis. Note that the insurer cannot choose which reserving basis to use in its EV calculation - it must use the regulator's basis.

The question explicitly talks about the investment return assumption, so this is where we should focus our efforts.

Best wishes

Mark

 

[Trevor]

Hi Mark,

Sorry I didn't get the chance to respond to this over the week.
Although the question focuses on the backing assets for these products, I am still trying to understand why the demographic assumptions do not change. Although not explicitly hinted in the question, I believe it has an impact on the PVIF.

The wording of the question mentions "passive" "embedded value basis", so this would imply it is the EV basis rather than reserving basis that changed.
However, the word "passive" to "market consistent" basis leads me to thinking it is changing from a passive to active basis (Active approach is actually a market consistent one), which will be a nice follow up from question part (i).

If I view "passive/active embedded value" similarly as "passive/active valuation" as in the notes, this would imply the demographic assumptions will be changed since:

• Under passive approach, the demographic assumptions are not updated unless experience worsens (page 18, chapter 22)
• Under Market consistent approach, demographic assumptions are set to be consistent with market values, in a way a Best Estimate assumption. (page 10, chapter 22)

From this perspective, the current demographic assumptions will be out of date, changing it to best estimate will make it worse (as experience generally deteriorates).

Could you clarify my confusion here?

Thanks,
Trevor

 

[Mark Willder]

Hi Mark,

Sorry I didn't get the chance to respond to this over the week.
Although the question focuses on the backing assets for these products, I am still trying to understand why the demographic assumptions do not change. Although not explicitly hinted in the question, I believe it has an impact on the PVIF.

The wording of the question mentions "passive" "embedded value basis", so this would imply it is the EV basis rather than reserving basis that changed.
However, the word "passive" to "market consistent" basis leads me to thinking it is changing from a passive to active basis (Active approach is actually a market consistent one), which will be a nice follow up from question part (i).

If I view "passive/active embedded value" similarly as "passive/active valuation" as in the notes, this would imply the demographic assumptions will be changed since:

• Under passive approach, the demographic assumptions are not updated unless experience worsens (page 18, chapter 22)
• Under Market consistent approach, demographic assumptions are set to be consistent with market values, in a way a Best Estimate assumption. (page 10, chapter 22)

From this perspective, the current demographic assumptions will be out of date, changing it to best estimate will make it worse (as experience generally deteriorates).

Could you clarify my confusion here?

Thanks,
Trevor

Hi Trevor

Everything you've said above is true. But the questions says:

"Currently, the future investment return assumptions are the insurer’s expected long-term returns"

so we know the investment return assumption is currently passive. The question makes no mention of what the insurer has been doing with the other assumptions. As we can score full marks just covering the investment assumption mentioned in the question, then we shouldn't bring in other ideas that are not in the question.

Best wishes

Mark

 

[Varsha Agarwal]

Hi Mark,

I have a follow up query for understanding purpose-
Here, our future investment return assumption is changing from passive to active approach.
So Impact on EV can be broken up as(keeping reserving assumption the same)-
1.Impact on PVIF-- As active assumptions might lead to increase in asset returns, hence increase in investment income and RDR for shareholders might also increase.
so net increase in PVIF could be difficult to say as there is increase in profitability due to investment income but decrease in PV of future profits due to higher discounting factor.
I would like to know if my understanding is correct here.
2. Impact on NAV- As rightly said by Trevor above, asset value might improve..keeping liability same,Net assets will increase.

So the overall impact of changing from passive to Market consistent basis should lead to increase in EV.

Please help to understand if i missed something.

Thanks
Varsha

 

[Trevor]

Hi Varsha, allow me to chip in my opinion:
Assuming only the embedded value basis is updated, assets & liabilities (hence NAV) is unchanged. however:
1. I think the investment returns assumption reduce instead. Changing to an active approach means it is using the risk free rate rather than yields of the actual backing asset. There is no change in the actual investment returns.
RDR will most likely decrease as well, because they (could be) previously based on shareholder's cost of capital/inherent risks.
In the active valuation approach, this has to be the risk free rate which will almost certainly be lower than the shareholder's CoC.
Future investment income reduces, but PV(future profit) has increased due to lesser discounting,

If Investment return = RDR, then no change in PVIF
However if Investment return > RDR, which will be likely if illiquidity premium is added on top of risk free rates, then PVIF will reduce.

2. After discussion with Mark, I think asset value should not increase because the embedded value assumptions should not impact asset values.

Overall:
Unit linked CI: very minimal change in EV, because RDR (=rf) ~= Investment return, so it cancels off each other
Conventional CI: could be reduced EV, because RDR(=rf+illiquidty premium) > investment returns. Lower PVIF hence lower EV.

Though I am not sure if my argument is correct, could Mark verify this?

Thanks,
Trevor

 

[Mark Willder]

Hi Mark,

I have a follow up query for understanding purpose-
Here, our future investment return assumption is changing from passive to active approach.
So Impact on EV can be broken up as(keeping reserving assumption the same)-
1.Impact on PVIF-- As active assumptions might lead to increase in asset returns, hence increase in investment income and RDR for shareholders might also increase.
so net increase in PVIF could be difficult to say as there is increase in profitability due to investment income but decrease in PV of future profits due to higher discounting factor.
I would like to know if my understanding is correct here.
2. Impact on NAV- As rightly said by Trevor above, asset value might improve..keeping liability same,Net assets will increase.

So the overall impact of changing from passive to Market consistent basis should lead to increase in EV.

Please help to understand if i missed something.

Thanks
Varsha

Hi Varsha

Please see Trevor's excellent reply. In particular, see his important point that the actual investment return/strategy doesn't change, just our assumptions about the return.

Best wsihes

Mark