April 2009

[Avviey]

Hi

I have two questions for this paper:

1. The solution for part a) of iv)/Q1 on page 10, the 3rd to last paragraph says," ...So at such times, the swap cashflows will be based on a larger notional principal than needed..." I dont understand why the notional principal is larger as usually for a swap like this, the notional principal is not exchanged if it doesnt change for both parties.

2. Solution on page 20 of part iii) of Q2, I don't understand why regulatory impace will be reduced?

Thank you so much.

 

[Mark Willder]

I have two questions for this paper:

1. The ASET solution for part a) of iv)/Q1 on page 10, the 3rd to last paragraph says," ...So at such times, the swap cashflows will be based on a larger notional principal than needed..." I dont understand why the notional principal is larger as usually for a swap like this, the notional principal is not exchanged if it doesnt change for both parties.

Yes, when swaps are set up the notional principal is not exchanged. The notional principle remains fixed throughout the life of the swap.

The problem is that the number of swaps we need (ie the notional principal) of each term is related to the number of policies we expect to have in force at each future date. The question says that "the swap profile is based on the company’s best estimate of the expected income from loans being repaid". So if the number of surrenders is higher than expected then we will have entered into too many swaps (the notional principal will be higher than we need).

2. Solution on page 19 of part iii) of Q2, I don't understand why regulatory impact will be reduced?

A securitisation effectively involves selling some of the future profits to the securitisation bond holders in return for a cash lump sum.

So assets increase because the insurer receives the cash lump sum.

Peak 1 liabilities are unchanged if we do not need to reserve for the repayment of the bond. As the bond is usually payable out of future profits the FSA is usually happy for the repayment of the bond to be ignored (as we don't allow for future profits in Peak 1).

So the regulatory impact of the securitisation is an increase in free assets (as assets are up but liabilities are not).

The regulatory impact of the securitisation will be reduced if any part of the repayments under the securitisation are considered a liability by the FSA, eg if the securitisation includes any repayment guarantees.

The repayment guarantees must be reserved for (as we cannot default on them if profits fail to emerge). So assets go up but the liabilities go up to some extent too. So the regulatory impact is reduced.

Best wishes

Mark