I am currently looking at Question 22.4 of the ActEd notes and wanted to clarify my thinking on the answer. The question looks at the different in EV depending on whether we include the CRR in the calculation of PVIF or not. It states that the EV will be higher when PVIF is calculated just using Mathematical Reserves. I think this is becauase, if we include the CRR in calculating PVIF, we will discount any cashflows at the risk discount rate. If we include CRR in the assets not required to cover liabilties, then we value at 'face value' (i.e. any discounting would be at the expected rate of return for assets). The risk discount rate is likely to be higher than the expected rate of return on assets, and so if we include in the calculation for PVIF the sum of PVIF and any assets not required to cover liabilities will be lower (due to the CRR being discounted at a higher rate). Am I correct in my thinking??
OK, thought I understood this but now it's confusing again. I thought if we held it as CRR rather than Free assets, then we would be forced to keep CRR amount as govt bonds rather than as Free asets in equities/property. Say at t = 10, holding 100 in CRR compared to holding 100 in Free Assets. If all that CRR is released at t = 20, then between t = 10 and t = 20 you haven't earnt as much on the govt bonds as you would in free assets for those 10 years, so it would be worth less. Does that tie in with the explanation? The comment Risk Discount Rate greater than expected return on assets is odd also. I can see how this is the case if forced to hold it in govt bonds but not when in free assets?
Yes, I think what you're saying is the same as the explanation. If you have 100 of free assets you can invest it how you like. So if you put it in equities and have a RDR equal to the equity return you end up with a value of 100. (An alternative easier explanation is to say that the free assets could be paid out to shareholders now and so they'd be worth 100). However, if you have 100 in the CRR then you'd probably invest in safe low return assets such as bonds (you don't have to, but you'd need an even bigger CRR if you invested in equities because your RCR/RCM would go up). The return on bonds between times 10 and 20 would be lower than the RCR, so the EV is less than 100 for these assets. Best wishes Mark
