Actuarial Funding

I don't understand this statement on page 12 of Chapter 13. Can somebody help?

When actuarial funding, only the residual annual profit flows from the unit fund can be counted towards our future cashflow projections: the full management charge is no longer available for this purpose.

 

I too had exactly the same question!

I am guessing that, they are saying that, when setting up non-unit reserves (assuming actuarial funding), you should consider the
FMC less value of lost units less cost of death benefits (all under actuarial funding).

Going back to the example in the notes:
If we did not use actuarial funding then, the 2nd item of profit would be £66.69 and we would use this in working out the non-unit reserve.

If we use actuarial funding then, the 2nd item of profit drops down to £5.91 and we would use this in working out the non-unit reserve.

Would really appreciate if someone could help out on this.

 

When actuarial funding we take advance credit for (most of) the future management charges. Having taken credit for them in advance we can't take credit for them again in our projections. Does that not make sense? Apologies if your question is more subtle then this and I've missed the point.

 

Read this first - on actuarial funding

Guys.... If you wanna start from the basics on actuarial funding , then read this .....
http://www.hindu.com/2007/09/03/stories/2007090356001600.htm

 

Hi
Need some help here.
Actuarial funding as I understand is that the Insurer allocates less Units to the PH then he declares to the policy holder. This creates Matching by time and "currency" (Currency being Cash here). All fine.
But does not it create a mismatch as follows...
The company has to create extra units every year till all the missed units has been filled in. What if the NAV of the units go up. Wont the Insurer has to pay dearly this time? There is an absolute mismatch of the liabilities and assets owned here.
mmm... Any one, Will you please dust my brain?

 

I don't know why accounting standards don't allow for companies to take credit for future profits. Can't this be done indirectly by securitisation or financial reinsurance - which effectively is taking credits for future profits.

Also how does actuarial funding affect financial reporting? Will the assets and liabilities reflected in the financial statements be the same as that that was shown to the policyholder? Or does actuarial funding allow the life company to reduce the value of the assets/liabilities in the financial statements?

 

Accounting standards are based on the premise of only taking credit for profits actually earned to date (so past periods only). This avoids companies massaging their financial results in a year of bad returns. Actuarial funding, securitisations etc are all methods to get around this.

Securitisation involves selling future profit streams out into the investment market, i.e. raising capital from external sources. They are however expensive to arrange, difficult to change / control once set up and can require a high level of resource to seperate the value of securitised profit streams from total profit in future years (as the underlying book of business, actuarial bases and economic conditions change). This is only an option if you have a large book of similar policies with a steady profit stream, easily separated from the rest of the business.

Actuarial funding is a lot easier & cheaper to set up as its done internally and involves freeing up capital within the organisation. From a systems and valuation perspective it is a lot easier to control.

The unit liabilities and unit funds shown in the financial results will be based on the actuarially funded value of capital units. Cashflow in excess of that needed to cover the actuarial funded value of units can be used to back new business strain etc.

As time progresses and the actuarial funding factor approaches 1 the company will top-up the value in the unit fund to ensure the unit fund remain in line with the unit liability - i.e. actuarial funding of units are actually the company 'borrowing' from the policies at the start and putting that money back in over time. This is usually done automatically by unit administration systems. The increased cost of putting units back at higher unit prices can be seen as the cost of borrowing those units ('interest'?) in the first place - actuary.jk hope this answers your question!

 

Also, (for actuary.jk) - have a look at the end of the example on page 10 of Chapter 14 in the notes. Here it says "The core reading suggests that the [residual] profit is calculated as:

[fund management charge] minus [unit fund shortfall]"

So, if unit growth rates are high, then the shortfall will increase because this is proportionate to the size of the unit fund, as you say. But the fund management charge will increase in the same proportion - ie there is a perfect match here between the assets (fund management charge) and liabilities (unit fund shortfall). So in theory there should be no problem.

 

When determining the actuarial funding factor, why does the interest rate have to be the difference between FMC on capital units and FMC on accumulation units?

 

We *know* we need at least the accumulation unit AMC charge to cover regular expenses. If we actuarially fund using the difference between capital unit AMC & accumulation unit AMC, the excess capital unit AMC in future years should offset the unwinding of the funding factor without risking our ability to cover regular expenses.

 

The difference between the two rates is the maximum interest rate you can use. A small point but worth noting.

 

Agree (forgot to put in original reply) - if you use a higher rate you will have to find extra money (over the available capital AMC) to cover the unwinding of the funding factor in future years.

 

If we were to ignore mortality, the actuarial funding factor will grow by (1+i) at the end of each year. We would then want to ensure that it doesn't grow by too much resulting in the non-unit fund providing funds to the unit-fund. Is this correct?

 

Because the difference is the portion of the annual management charge that can be used to purchase further units. If, for example, the AMCs on the capital and accumulation units were 5% and 1% respectively, and we assume that 1% is enough to cover fund management and renewal expenses on the policy, then we have an extra 4% each year which we do not need.

So we take advance credit for that 4% to reduce our unit reserves. When the charges actually accrue, we use them to buy unit instead. So every year, we can buy an extra 4% units using this charge. So it is like an interest rate, except that we are thinking in terms of number of units rather than in terms of the pound (or dollar or rand) value of the units.

 

Its a lot easier if you think about it in terms of units rather than in monetary terms.
At the end of each month it charges an AMC of x% of the unit-fund. ie it cancels x% of the existing units. At the same time the Actuarial funding factor increases by approximately (1+i)% (not including mortality effects). So the company needs to increase the fund by i% units. Provided i% is not greater than x% less an allowance for renewal expenses, then the company has a perfectly matched charge/cost, but expressed in terms of units not money.
The allowance for renewal expenses is typically the AMC on the accumulation units. This will be expressed in monetary terms so will not be perfectly matched.
Note that Actuarial Funding improves the matching on the product. By capitalising the future fund charges into monetary terms, it improves the matching of initial expenses and charges. Simulatanaously, the future charges are expressed in unit-terms, which matches the cost of the funding: so everyone is a winner!

 

Hi - Below is Q&A from the Smart Revise tool:
Why do we not actuarially fund all future fund management charges under unit-linked policies?
Answer:
This is because some of the annual charge is needed to cover annual outgo. Prefunding all the charges will mean there are none left to cover the ongoing costs. This will leave the company with negative cashflows, which is imprudent.
I have not fully understood the question & so have not understood the answer.
1) Is the question saying -"why don't we take credit for the full future FMC instead of only part of it"?
2) If charge on cap units = 5% and charge on accum units = 1%, then does "taking full credit for future FMC" mean that the discount rate factor would be = 5% instead of 4% that would otherwise be taken?

Any help will be much appreciated.
Cheers