Hi In the Surrender Values chapter of the ActEd notes (Ch. 22, p. 19), the notes give 5 situations for regular premium without-profits endowments. Situation 1 states that the matched asset share drops a lot should interest rates rise suddenly. Two questions: why "matched" - i.e. does this refer to the same direction of movement?, and why would the asset share drop "a lot"? I reread the Asset Share theory and understood all the components of the asset share to be "locked" by experience, i.e. current experience can't change the past experience assumed by the asset share calc. The only component could be the unrealised capital gains in the investment income. Should you have fixed interest backing assets / reserves, the capital gains figure will drop by the MTM adjustment. Is this component enough to cause the asset share to drop by "a lot" - surely this will also depend on the duration of the contract? What am I missing? Thanks.
Chapter 22, page 19, Situation 1 "Why matched?" We're assuming the assets backing the policy are matched to the liability - matched by nature, term and currency (see Chapter 29, Section 3 for more on matching). So we're invested in fixed-interest default-free bonds of an appropriate duration. This is why asset shares will drop when interest rates rise. If we weren't matched, we might have been investing in cash, say, which wouldn't immediately drop in value when interest rates rise. "Why drops a lot?" Thanks for bringing this up - I agree we can't say this as we don't know how much interest rates have changed. Also, since we're late on in the term, even a large change in interest rates would have a relatively small impact on short-dated bonds. I'll make sure we change this part of the Notes. You're right that current experience doesn't change the past asset share, but it does affect the current asset share as it develops over time. So a rise in interest rates today won't affect the asset share as at the end of yesterday, but it does affect the asset share calculated as at the end of today.
Thanks, Mike. I think my impression of the asset share might be missing a couple of important points. In calculating the asset share, one uses actual experience to date except for smoothing across mortality experience a bit. Why would the asset share drop if interest rates rise. Is it the investment returns component through capital losses, or another part of the asset share that contributes the drop?
If interest rates rise, the value of fixed-interest bonds falls, ie either the unrealised gains to date fall, or the unrealised losses increase, or the unrealised gains are turned into losses. Either way, this fall in value is immediately reflected in the current asset share through the investment return component.
