I have all questions with respect to pg 10, when the -ve non unit reserves be held topic Q1. 3rd point, "after taking account of future non-unit reserve................ there should be no future valuation strain" My question is, if there is no scope of -ve future cashflow, then why the company would be required to hold -ve non unit reserve ? Q2. 4th point "in aggregate, sum of all non-unit reserve should not be negative" My question is, if company (say) have prudent pricing assumptions due to which it has all reserves calculated as negative, then why not in aggregate it can be negative ? Q3. middle paragraph "does company want to hold negative non unit reserve? the answer may well be yes because they will reduce the total reserve under a contract............ and hence improve the capital efficiency of the product" My question is- why holding -ve reserve will reduce total reserve under the contract ? I guess, in case of -ve reserve co. will maintain nothing, inspite of that if it is maintaining negative reserve, then it means have to keep aside some resources for the same in addition. Also, how this will promote capital efficiency ?
Q1. Companies hold negative reserves when the net future cashflows are positive. The notes are saying here that we can only have negative non-unit reserves now if the insurer is still able to cover any negative cashflows in the future. Q2. If an insurer has negative non-unit reserves in aggregate then we have an insurer which has a negative amount of money. I don't think policyholders would be happy to put their premiums into a company that had no money at all, and worse than that, was actually in debt. Q3. Imagine a company with two new policies. One with reserve of +20 and one with reserve of -8. So in total the reserves are 12. This is less than 20, which is what the reserve would have to be if we weren't allowed negative reserves. Holding a reserve of 12 requires less capital than holding a reserve of 20. Best wishes Mark
Thanks Mark Could you please elaborate your explanation to my Q1 Also, for Q2, negative reserve means profitability which is arising due to prudent assumptions such that your experience is likely to be better than what was assumed in pricing. So, having no money maintained in the form of reserve isn't a problem You also talked about debt, I guess there will not be any debt as such in this case
Q1. Contracts can have negative cashflows in some years and positive in others. If a contract has net positive future cashflows (ie more positives than negatives) then it can have a negative reserve. However, it must still have positive funds available whenever there are negative cashflows. I'm hoping that answers your question, although I'm not entirely sure if I understand your question correctly. So give me more detail if this isn't it. Q2. I did mean that a negative reserve is effectively a debt. An example will help. Consider an insurer with zero assets and zero liabilities. It's cashflows at times 0, 1, 2, ..., 8 are -8, 1, 1, 1, 1, 1, 1, 1, 1, ie initially expenses are bigger than charges, but later the charges are bigger than the expenses. At time zero this insurer will have assets of -8. But luckily it has future profits of 8 and we can set u-p a reserve of -8 (we're using zero interest and mortality for simplicity). So it is solvent, A = L = -8. Although the company is in debt, it can use the future profits to repay the debt. Best wishes Mark
Agree, from your example, it will be a debt. But since pricing basis are prudent, then expected future inflows is higher than of outflows In this case also, calculated reserve will be negative. Consider GPV for instance initial expense+ benefits + renewal expenses - premium = -ve, then this cannot be considered as a liability. Now by looking at this, please help me in further understanding, do you feel in a similar way, if in case of all positive furture cashflow, there is a need to hold -ve reserve ?
I agree that when we price contracts with a profit margin then we expect the value of the premiums to exceed the value of the outgo (or equivalently for unit-linked, it is charges that exceed the outgo). So when we calculate a reserve using best estimate assumptions we often have a negative reserve early on (ie expected present value of premiums/charges exceeds that of the outgo). Remember that being able to hold a negative reserve is good news for the insurer as it reduces the assets it needs to hold to remain solvent. Consider my example again for an insurer that wasn't allowed to hold negative reserves. It incurs expenses at the start of the contract so A = -8. It is not allowed by regulation to hold negative reserves so L = 0. The company is insolvent as A < L. So it must ask its shareholders to provide an extra 8 of capital to keep the company solvent. Hence it is much better for the insurer if regulation allows negative reserves. Best wishes Mark
Hi Mark, can you kindly explain why the negative reserve is not 0 at time 0 (-8-(-1)-(-1)-(-1)-(-1)-(-1)-(-1)-(-1)-(-1))? I thought the negative reserve of -8 can only be held at time 1. Thank you!
Hi Kimiko We are calculating the reserves immediately after the policy has been sold. so the cashflow of -8 has already happened and so assets go down by 8. So the reserves only need to allow for the positive cashflows occurring in the future, so a negative reserve of -8. Best wishes Mark
I understand about the timing of the cashflows now. So the assets are made up of the -8 cash flow from t=0 and the liabilities are made up of the -8 negative reserves? Sorry but can you kindly breakdown how to get the asset and liability amounts? I think I’m a bit confused because it’s all negative. Can we say instead that we paid 8 so liability is 8 then the assets are 8 because of the negative reserve? Also if the assets is less than the liability, the company is insolvent? Is it true that if this happens, this is made up by the shareholders capital injection to prevent the company from going insolvent? Sorry for the numerous questions, thank you so much in advance!
Hi Kimiko Yes, the assets are made up of the -8 cash flow from t=0 and the liabilities are made up of the -8 negative reserves. No, we can't say that we paid 8 so liability is 8 then the assets are 8 because of the negative reserve. The assets are -8 because the insurer paid out some cashflows, eg expenses. The liability is -8 because in the future the insurer will receive positive cashflows. So the key thing to remember is that assets depend on what the cashflows have been in the past, reserves depend on what the cashflows will be in the future. In this particular example the actuary has priced the contract so that assets and liabilities are the same, but this is not necessarily always the case. Yes, if the assets is less than the liability, the company is insolvent. I would hope that the shareholders inject capital in advance to ensure that the insurer always has assets in excess of liabilities. It is probably too late to ask for a capital injection if assets are less than liabilities. Best wishes Mark
Thank you, Mark! Hmmm I understand the first part but for the insolvency part, how come the notes in Chapter 30 page 37 say this “If the surplus arising is negative, then capital may need to be raised.”? My understanding is that surplus = assets - liabilities, isn’t the company already insolvent if the surplus is negative? Why just “may” need to be raised?
Hi kimiko Yes surplus = assets - liabilities. However surplus arising is the change in the surplus over the year. So if the surplus at the start of the year is 200, and the surplus arising is -10, then the surplus at the end of the year is 190. In this case the insurer might still feel it has enough surplus and doesn't need to raise more capital. Best wishes Mark
