Hello, In the notes, it states that if the actual reserves are set up more prudently than the reserves used for pricing, then there will be a higher cost of capital. I am unsure of why the cost of capital would be higher. Also, based on previous notes, if the investment income and the RDR are the same, then any change in reserves will not change profit. If this is true, are we assuming that the investment income and RDR aren't the same for the note in Chapt 18? Thanks much.
Hi JamaicanJem Thanks for your question. This is quite a technical one. In Chapter 17 Section 1.8 the notes describe two different approaches to the discount rate. The first is the use of risk discount rates, and the second is the use of a market-consistent valuation. I think you were thinking of a market-consistent valuation where the interest rate and discount rate would both be based on the risk-free rate, and so could be the same. Market-consistent valuations are associated with a best estimate calculation of reserves, with a separate calculation for required capital to introduce an element of prudence. The cost of capital could then be calculated using a risk margin as described in Section 2.3 of Chapter 20. However, the quotation you make from Chapter 18 Section 3.1 talks about reserves being calculated on a prudent basis, so this is not a market-consistent calculation. So instead the discount rate will be a risk discount rate and so will not be the same as the investment return. The reserves are likely to be backed by safe assets such as government bonds earning a low rate of return. While the risk discount rate will be higher reflecting the risk of the business, see the Core Reading in Chapter 15 which states "The net projected cashflows will then be discounted at a rate of interest, the risk discount rate, which is discussed further in Chapter 17. It may, for example, take into account: · the return required by the company, and · the level of statistical risk attaching to the cashflows under the contract, ie their variation about the mean as represented by the cashflows themselves." So in Chapter 18 we can see that making the reserves more prudent will increase the reserves. These reserves will only grow at the return on government bonds, say 2%. But the risk discount rate reflects the shareholders required return for risky business, say 8%. So there is a cost of capital of 6%. The higher the reserves, the higher this cost. The situation wouldn't actually be so very different if we used a market-consistent valuation except that the we would be increasing the required capital rather than the prudence in the reserves. Then using the equation on page 9 of Chapter 20 and a cost of capital charge of k_t=6% we get a similar result, ie bigger reserves or bigger required capital leads to greater cost of capital. Sorry, this is quite a technical answer. In summary, it's worth being aware that there are two separate approaches. The traditional approach is associated with prudent reserves ans risk discount rates. While the market-consistent approach is associated with best estimate reserves, additional required capital and risk margins. It won't always be explicitly stated which of these approaches are being used, but you'll be able to work it out from the ideas associated with each. I hope that helps, but do let me know if you have further questions. Best wishes Mark
Hi mark , I am reading SP1, In india June 2020 exams cancelled. I need your help, which subject sould I choose with Sp1, WHETHER CP1 OR SA1?
Hello Pankaj I'm sorry to hear that your exams have been cancelled. I'm guessing that you are now planning to take two IFoA exams in the September sitting. Please correct me if I'm wrong. Firstly I'd say that doing two of the later exams in the same sitting is an enormous amount of work. I'm assuming that you're already fully prepared for SP1 as you would be sitting it in June. But there's a lot to do for any extra subject you pick up now. I've already completed my first regular tutorials, so many students are already a significant way through the course notes. If you're going to take the Indian exams at the next sitting then you do have time. Both CP1 and SA1 have a lot of overlap with SP1. CP1 has similar chapters on data/assumptions/modelling/investment/reinsurance. SA1 is based on the same products as SP1. However, both CP1 and SA1 are very large courses that I would normally advise to be taken on their own. CP1 is considerably longer than SP1 and includes a lot of material on pensions, general insurance and life insurance - very little of the course is based on healthcare products. SA1 is a similar length to SP1, but is more advanced material including lots of technical aspects such as regulation, Solvency II reserving and tax. So you shouldn't underestimate the amount of work involved in taking these subjects in September. Given the more advanced material in SA1, it's normally best to take CP1 first. The best fit with SP1 is SP2. SP1 and SP2 cover very similar material (product design, models, reserving, risk etc), with the difference being that SP1 applies this material to healthcare products and SP2 applies it to life insurance. These would be the easiest two subjects to take together if you haven't already passed SP2. I hope that helps a little in making a difficult choice as to what subject to take next. Good luck with whatever exams you decide to take next time. Best wishes Mark
