Chap17- Margins on the assumptions

[deepansh]

Hi all,

It is mentioned in the CMP that when a formula model is used to price a contract, we can't adjust the risk through the risk element of the risk discount rate.

I don't get this.
My understanding is we can adjust for the risk by increasing the risk discount rate and use that to calculate EPV of benefits, expenses and premiums.

Can anyone please help?

Regards,
Deepansh

 

[Lynn Birchall]

Hi Deepansh

If we're using a formula approach (ie an equation of value along the lines EPV(premiums) = EPV(benefits) + EPV(expenses)) then increasing the interest rate at which its evaluated will reduce the premium calculated. Essentially, we're assuming we'll earn a higher rate of return on our assets.

Of course this is the opposite effect to what we want a risk adjustment to achieve, which is why the suggested approach with a formula is the application of margins to other assumptions.

Best wishes
Lynn

 

[deepansh]

Hi Deepansh

If we're using a formula approach (ie an equation of value along the lines EPV(premiums) = EPV(benefits) + EPV(expenses)) then increasing the interest rate at which its evaluated will reduce the premium calculated. Essentially, we're assuming we'll earn a higher rate of return on our assets.

Of course this is the opposite effect to what we want a risk adjustment to achieve, which is why the suggested approach with a formula is the application of margins to other assumptions.

Best wishes
Lynn

Thank you Lynn! I understand.

Just to confirm my understanding, under the cashflow approach, we can use a higher risk discount rate as we will be targetting a particular profit criterion (say NPV of X), so if we are increasing the risk discount rate our PV of cashflows will fall but to get the profit criterion we need to increase the premiums.

Is my understanding correct?

Regards,
Deepansh

 

[Lynn Birchall]

Yes, sounds good to me!

 

[deepansh]

Thank you Lynn for your prompt response!