• We are pleased to announce that the winner of our Feedback Prize Draw for the Winter 2024-25 session and winning £150 of gift vouchers is Zhao Liang Tay. Congratulations to Zhao Liang. If you fancy winning £150 worth of gift vouchers (from a major UK store) for the Summer 2025 exam sitting for just a few minutes of your time throughout the session, please see our website at https://www.acted.co.uk/further-info.html?pat=feedback#feedback-prize for more information on how you can make sure your name is included in the draw at the end of the session.
  • Please be advised that the SP1, SP5 and SP7 X1 deadline is the 14th July and not the 17th June as first stated. Please accept out apologies for any confusion caused.

Cost of guarantees

E

echo20

Member
I'm a bit confused about what is included in the cost of guarantees in the Future Policy-Related Liabilities. Basically, are future regular bonuses consistent with PRE accounted for? i.e. in an individual stochastic model simulation, would you project future cashflows and calculate the cost of guarantee as [guaranteed benefits including future bonuses] less [projected asset share], or just [current guaranteed benefits] less [projected asset share] (or something else)?

Also, can someone explain in simple terms the difference between a risk-neutral calibration and a real-world calibration?

Thanks :)
 
I'm a bit confused about what is included in the cost of guarantees in the Future Policy-Related Liabilities. Basically, are future regular bonuses consistent with PRE accounted for? i.e. in an individual stochastic model simulation, would you project future cashflows and calculate the cost of guarantee as [guaranteed benefits including future bonuses] less [projected asset share], or just [current guaranteed benefits] less [projected asset share] (or something else)?
Click to expand...

Yes, future RB consistent with PRE should be allowed for so that the cost of guarantee is [guaranteed benefits including future bonuses] less [projected asset share].

Also, can someone explain in simple terms the difference between a risk-neutral calibration and a real-world calibration?
Click to expand...

A model that uses a real-world calibration will show scenarios that follow the distribution of what we realistically expect. For example, we might realistically believe that the value of a share in one year's time could be 130, 110 or 70 with equal probability.

If we had a put option with strike price of 100 then we would expect a payoff 100 - 70 = 30 in one-third of the scenarios. So the expected payoff is 30 / 3 = 10.

However, the price of this option would not be 10. Investors are generally risk averse, so they would be prepared to pay a higher price for the option (ignoring discounting for simplicity), say 15.

A risk neutral calibration gives a model that would replicate market prices. For example, the Black-Scholes equation uses a risk neutral valuation. There are lots of ways to calibrate our model to be risk neutral, but one possibility is that the value of this share in one year's time could be 130 (with prob. 0.25), 110 (with prob. 0.25), or 70 (with probability 0.5), so that the expected option payoff is (100-70) x 0.5 = 15 as required.

Best wishes

Mark
 
Thanks Mark - that was quick! Just one follow-up point: would projected terminal bonus be included?
 
Just one follow-up point: would projected terminal bonus be included?
Click to expand...

The FPRL covers:
  • costs of guarantees
  • cost of financial options
  • cost of smoothing
  • cost of planned future enhancements to benefits not already allowed for in either the retrospective or prospective methods.

We wouldn't need to allow for terminal bonus in the cost of guarantees as we'd cut the TB to zero if the guarantees were biting.

However, we would need to allow for TB in the cost of smoothing in order to cover the costs of smoothing payouts to above 100% of asset shares.

Best wishes

Mark
 
You must log in or register to reply here.
Back
Top