Capital required

[1495_sc]

Hello,

In one of the questions in X series ( X3.2 ii), the solution mentions that capital is required for following purpose when writing new products

Development costs

1. advertising and selling
2. system development
3. product design and pricing
4. setting up new distribution channel
5. training salesforce for selling new product

Costs of selling and managing business

1. underwriting
2. advertising and marketing costs (over product lifetime)
3. investment and valuation
4. claims handling and servicing
5. new business processing
6. commission

Capital to write the business

1. BEL
2. risk margin
3. SCR

I understood all requirements except for BEL and Risk margin. Assets equivalent to BEL and RM are maintained. Capital is the requirement over and above liabilities. Why would capital be required for meeting BEL and RM? Wouldn't assets meet BEL and RM? Are we using capital and assets interchangeably here?

 

[1495_sc]

Also, I understand that SCR is a subset of the total capital maintained by insurance company. While SCR is the only capital shown in Solvency II Balance Sheet (as required by regulator), actual capital in GAAP/IFRS17 financial statements will be higher and be maintained for various other reasons. Please confirm if my understanding is correct.

 

[1495_sc]

In part iii) of the same question, we have talked about investment strategy of immediate annuities and term assurance.

For term assurance, the solution mentions that investment against BEL and free surplus, both needs to be considered. I did not understand why are we considering free surplus here. Would this not be relevant for investment strategy of annuity also?

 

[Lindsay Smitherman]

Hello,

In one of the questions in X series ( X3.2 ii), the solution mentions that capital is required for following purpose when writing new products

Development costs

1. advertising and selling
2. system development
3. product design and pricing
4. setting up new distribution channel
5. training salesforce for selling new product

Costs of selling and managing business

1. underwriting
2. advertising and marketing costs (over product lifetime)
3. investment and valuation
4. claims handling and servicing
5. new business processing
6. commission

Capital to write the business

1. BEL
2. risk margin
3. SCR

I understood all requirements except for BEL and Risk margin. Assets equivalent to BEL and RM are maintained. Capital is the requirement over and above liabilities. Why would capital be required for meeting BEL and RM? Wouldn't assets meet BEL and RM? Are we using capital and assets interchangeably here?

When you are writing a new product, you haven't received any 'assets' (premiums) for that product yet. So you have to have enough capital to be able to support all of the product development / launch expenses and to cover the excess of {initial expenses + TP + SCR} (assuming a Solvency II company) over initial premiums, once the business starts to be sold.

 

[Lindsay Smitherman]

Also, I understand that SCR is a subset of the total capital maintained by insurance company. While SCR is the only capital shown in Solvency II Balance Sheet (as required by regulator), actual capital in GAAP/IFRS17 financial statements will be higher and be maintained for various other reasons. Please confirm if my understanding is correct.

Be careful when you are referring to 'capital' - try not to confuse available capital, required capital and free capital. Available capital is the excess of assets over liabilities. SCR is an example of required capital. There is no equivalent required capital amount under accounting principles (since the accounts are more about profit recognition, rather than demonstrating solvency and protecting p/hs). Hence 'free capital' (if this is defined as the excess of available capital over required capital) would be higher in the accounts.

 

[Lindsay Smitherman]

In part iii) of the same question, we have talked about investment strategy of immediate annuities and term assurance.

Just imagine there is a sub-heading 'Free surplus' above the line starting 'The company must also ...'

 

[1495_sc]

When you are writing a new product, you haven't received any 'assets' (premiums) for that product yet. So you have to have enough capital to be able to support all of the product development / launch expenses and to cover the excess of {initial expenses + TP + SCR} (assuming a Solvency II company) over initial premiums, once the business starts to be sold.

Alright. So should we mention explicitly that all of these expenses and TP will be only over and above initial premium received in exam style answers?

 

[Lindsay Smitherman]

'should' is rather strong - it will depend on the question, how many marks there are, the command verb (therefore how much detail is required) etc ... but there's little to be lost by adding it in quickly as clarification.

Also be careful: we wouldn't expect to cover all the development / launch expenses with the first few premiums: their recovery would likely get spread over quite a period.

 

[1495_sc]

Thank you