Chapter 21, unit pricing risk

[ViR]

Hi all,

In chapter 21, page 15, of the CMP, there is an ActEd question around "who will lose out if anti-selective surrenders occur on this (a proprietary unit-linked) business when the underlying value of assets has fallen", when the units are priced using a preceding day's (i.e. a higher than current market value of a unit) price.

The answer suggests that the policyholders should lose out in the "preceding price" scenario, but not in a "current price" scenario.

Would anyone happen know the mechanics of why any of the remaining policyholders would be affected, considering the basic equity principle of unit pricing?

Also, for general understanding, I am wondering if the following is correct (trying to connect SP2 and SA2 here a bit)...:

We know that every customer is allocated a number of units in the fund when they pay premiums, which will be cancelled upon surrender, with a preceding price (bid price) * # of units being paid - and then corresponding assets sold at expropriation prices (assuming this is the only transaction happening, so the units are being sold on bid basis)?

If the above is true (where "preceding" and "current" prices differ in their impact on policyholders/shareholders), at which stage of the process outlined above does this divergence in effect between these two groups of stakeholders occur?

Thanks,
Viktor

 

[Lindsay Smitherman]

If the surrenders were based on the previous day's price and asset values have fallen, the unit price at which the surrender benefits would be calculated would be higher than the current unit price. If the amount taken out of the unit fund in relation to the surrender amounts equals that (higher) amount (noting the important word 'if' in that statement), then this would mean that the unit price of the remaining units would fall: it would effectively have to be reduced to cover the loss. As you indicate, this would not be in line with the equity principle of unit pricing. Therefore, as the solution goes on to say, normally the amount taken out of the fund in such a situation would be based on the current price, so that it would then (normally) be the shareholders taking the loss rather than other p/hs.

However, what is even more likely (and will almost always be the case) is simply that the company does not allow surrenders to be based on a preceding price. Advance notice is required and the surrenders would be cashed in at whatever the unit price is on that day. Therefore no loss is made and who bears that loss is no longer an issue.