Chapter 21 - Surrender Values Practice question

Discussion in 'SP2' started by jack, May 21, 2022.

  1. jack

    jack Made first post

    Hi,

    looking at practice question 21.3 part (iii) we are asked to describe the problems caused by a share increase in interest rates.

    We are told the earned asset share may fall as the market value of assets will fall?
    we are also told in the answer “ current premium rates me be lower”

    question:
    1) why does a rise in the interest rate cause a fall in the market value of assets. And hence why would this fall in the market value of assets cause the asset share to fall. We use AS(t+1) = AS(t) * (1+i) ….
    So I think I am confused here as I thought the increase in interest rates would actually increase the asset share.

    2) why would premium rates be lower now as a result of this interest rate rise ?

    thanks for your help
     
  2. Lynn Birchall

    Lynn Birchall ActEd Tutor Staff Member

    Hi Jack

    (1) Remember that in the asset share formula you mention, the i is not referring to interest rates. For the asset share accumulation i is investment returns - this includes gains/losses due to changes in market values of assets held.
    The assets backing these without-profit policies are likely fixed-interest bonds. So, the argument is along the lines that a sharp increase in interest rates suggests higher bond yields & so falls in bond values.

    (2) If we consider pricing by equating the present value of benefits/expenses with present value of premiums, then using a higher interest rate in discounting would result in a lower premium. Intuitively, if future premiums are assumed to earn a higher return when invested, then the premium needed to cover the benefits/expenses will be lower.

    Hope these help!
    Lynn
     

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