Hello, could someone explain the distinction of each risk allowance in EEV? Thank you so much! In Ch 20 Question 20.4, the course note states that EEV allowances for risk may be made in: - Prudence of liability assumptions Shouldn't EEV assumption be best estimate? If so, how can there be prudence in liability assumptions? - Prudence of cf projection assumptions e.g. reduction in the expected long-term asset returns on corporate bonds to allow for credit risk Does this refer to the asset side (i.e. to reduce free surplus)? Or is this related to determination of RDR? - Deducting a risk margin from the PVIF How? and which risk margin is being referred to? - Establishing the cost of required capital - Valuation of options and guarantees - RDR
For EEV, there is no guidance on how the “risk-free rate” should be determined. There is freedom about whether or not to adopt a market-consistent approach. A market-consistent approach would use risk-free investment returns and discount rate and allow for non-investment risk using risk margins. However if a market-consistent approach is not adopted, assumed investment returns should be best estimate returns on the assets held at the valuation date, allowing for credit risk and should be equal to a risk-free rate plus a risk margin that reflects any risk not allowed for elsewhere in the calculation. Therefore the risk allowance could be made on either cashflows (Assets) or the discount rate (liabilities). The risk margin deduction from PVIF is just saying that the release of the prudence margins can be reduced to allow for the risk. It is essentially doing the same thing as the above alternatives, ie reducing the EEV. Hope this helps.
Hi, sorry but it just sounds so strange the term 'market-consistent approach' if you apply a risk free investment return to all your assets? That sounds very un-market like when you expect equity and property to give higher returns than gilts. Pity there's no numerical examples in the notes to illustrate all this more.
Hi Please note, the key idea from financial economics is that the value of liabilities is unaffected by the assets actually held. Under both Solvency II and MCEV Principles, cashflows are discounted at the risk free discount rate. However, this doesn't reflect the riskiness of the cashflows. So, SII adds a risk margin to the liabilities using the cost of capital method. Similarly the MCEV Principles deduct the cost of residual non-hedgeable risks from the VIF. Consider an insurance policy that will release a profit of 110 in one year's time. If a suitable risk discount rate is 10% then the market consistent VIF is 100. An alternative way to value the policy is to follow the MCEV principles. Here we discount the profit at the risk free rate of 4% (say) to give 110 / 1.04 = 105.76. We must then deduct the cost of residual non-hedgeable risks. If this cost is 5.76, then again we have the same market consistent value of 100. So we could say that the MCEV Principles have implicitly discounted the cashflows at 10% in this case. Hope this helps Thanks Em
By applying a risk free return to all asset classes, are we saying that their expected return = risk free rate but their volatility assumptions will be different?
If we the discount hedgeable liabilities at the risk free rate, we assume the market has priced in the risk already. We would accumulate the assets backing the BEL using the RF rate and then discount using this rate and so you end up valuing at the current market value. For non-hedgeable liabilities we take into consideration this extra risk via the risk margin. Does this help? Thanks Em
Hi Em, yes that does help a lot thank you. Can I just check something related to this: (1) when performing SII individual stresses, stressing equity, property, equity volatility, property volatility will affect asset side but not liability. (2) Stressing interest rate (the risk free rate?) will affect... both asset and liability values?
Hi I wouldn't isolate into these categories. It will depend on the company's response to the movement in property, equity, etc. It could impact both. For example, if we look at the definition of equity risk: "Risk that the value of an asset or liability will change due to fluctuations in the level or volatility of the market prices for equities." So by stressing equity could impact both assets and liabilities. Hope this helps. Thanks Em
Well, those were the categories of individual risk stresses I once had to churn out of a SII model for cost of guarantees. I just remember sometimes only the asset values would change (for eq fall, prop fall stress etc), sometimes just the liab, sometimes both.
I should have added that the resulting changes to assets or liabilities from the stresses of courses depended on the product being stressed.
