Hi! I think I'm much confused about "smoothing cost" of WP business now, hope someone can help me with this. QUESTION1 SA2 September 2009 examer's report: Question 2(iii)(d) : Impact of higher equity returns on Peak2 working capital "However the cost of smoothing liability (part of the future policy related liabilities) would be expected to increase, and overall this should have a neutral effect on working capital." I feel very confused about this. In my point of view, higher equity return will tend to reduce the difference between my unsmoothed asset share and my current payout level, this will act to reduce(not increase) my future smoothing cost, Isn't it? QUESTION2 If a company charges the cost of smoothing when calculating asset share. Then,how to determine the amout of charges in practice? Can someone give me a simplest example to clarify this? It must be very helpful to me.
The smoothing cost is given by the payout less the asset share. So high equity returns last year will reduce the smoothing cost last year (we will probably have made a smoothing profit by paying out less than asset share). This increases assets and hence working capital. However, we aim to payout asset share on average, so the smoothing cost over time must be zero. If we underpaid last year we must overpay at some point in the future. This planned overpayment must be reserved for as part of the future policy related liabilities. This increases liabilities and hence reduces working capital. The above two effects cancel out and so the smoothing effect has a neutral impact on working capital. A very simple way to allow for smoothing when calculating an asset share is to accumulate the cashflows at a smoothed rate of return rather than the actual return. I hope these comments help. Good luck with the revision. Mark
