What does this line mean in chapter 23 page 16 of the course notes? “If the purpose of the valuation is pricing the option (rather than setting the liability) then allowance should also be made for the additional reserves that should be held, both before and after exercise.”
Hi Kimiko This line is comparing two different types of valuation, for pricing and for reserving (ie setting the liability). When pricing we consider the profit each year, ie premiums less expenses less claims plus investment return less the increase in reserve. So the line you quote is just pointing out that in addition to needing a pricing basis assumption for the claims under the option, we also need an assumption for the claims on the reserving basis. Best wishes Mark
Hi Mark, can you kindly help me understand the end of the solution to Practice Question 23.4? I would think that the additional premium payable at the start would just be P_1 discounted.
Discounting P1 would ignore the impact of anti-selection amongst the option takers. So to value the option we must equate the value of all the benefits with all the premiums.
