6.1. Regulatory Framework

[andy orodo]

Could somebody please help explain this piece of the core reading?

"a particular asset distribution may allow a company to use a higher investment assumption and thereby reduce the value of the liabilities and increase the free assets. Typically, however, such distributions will not enable te company to maximise the expected investment return"

Does this mean that the discount rate will be set by the yield on the underlying assets and will hence reduce the liability? If so that's rewarding the company for investing in riskier assets so that can't make sense.

 

[Mike Lewry]

Does this mean that the discount rate will be set by the yield on the underlying assets and will hence reduce the liability?

Yes

If so that's rewarding the company for investing in riskier assets so that can't make sense.

I agree that using the full expected yield wouldn't be a sensible approach for the regulator to take.

In the UK, the discount rate is set with reference to the yield on the backing assets, but isn't simply equal to the expected total return. It is adjusted for risk by taking 97.5% of the "reliable" yield.

For example, for UK governemnt bonds, the reliable yield is the full gross redemption yield, but for corporate bonds this would need to be reduced to allow for credit risk.

For equities, the reliable yield is taken to be (broadly) the average of the dividend yield and the earnings yield, to prevent too much credit being taken for the volatile capital gains.

 

[andy orodo]

Yes


I agree that using the full expected yield wouldn't be a sensible approach for the regulator to take.

In the UK, the discount rate is set with reference to the yield on the backing assets, but isn't simply equal to the expected total return. It is adjusted for risk by taking 97.5% of the "reliable" yield.

For example, for UK governemnt bonds, the reliable yield is the full gross redemption yield, but for corporate bonds this would need to be reduced to allow for credit risk.

For equities, the reliable yield is taken to be (broadly) the average of the dividend yield and the earnings yield, to prevent too much credit being taken for the volatile capital gains.

Thanks for your reply.

I take it that the reliable yield is taken from the assets backing the liabilities. If so, is it the case that an institution could choose to invest in high dividend yielding equities that are not expected to deliver much capital growth and hence reduce their liability values? If not, then I'm still somehwat confused as to how a particular asset distribution may allow a company to use a higher investment assumption and thereby reduce the value of the liabilities.

 

[Mark Willder]

I take it that the reliable yield is taken from the assets backing the liabilities. If so, is it the case that an institution could choose to invest in high dividend yielding equities that are not expected to deliver much capital growth and hence reduce their liability values? If not, then I'm still somehwat confused as to how a particular asset distribution may allow a company to use a higher investment assumption and thereby reduce the value of the liabilities.

Yes, the yield used to discount the liabilities is based on the assets backing the liabilities.

Investing in bonds rather than equities would lead to a higher discount rate and lower value of liabilities. This is for two reasons. Firstly the regulations would make an allowance for risk which would reduce the discount rate for any investment in equities. Secondly the regulations tend to be based on income rather than capital returns which further reduces the interest rate for equity investment.

However, the actual investment return from equities is expected to be higher than bonds. So the insurer faces a difficult question - should it invest to get the highest returns or to minimise its reserves?

Similarly, investing in equities with a high income yield would lead to a higher discount rate. But again, high yielding equities produce less capital growth and tend to underperform lower yielding equities in the long term.

Best wishes

Mark