Embedded value Core reading part

[Ivanhoe]

Part of core reading

For without-profits business, embedded value is effectively the release of any margins within the solvency reserves relative to the assumptions used within the embedded value calculation.

A large part of embedded value constitutes of net assets as well (I am referring to the example of Acted in section 2.4 where best estimate valuation and EV is compared). So, why does this para state that embedded value (EV) is effectively.......


It is important that the reserves used in the determination of net assets are
consistent with those used in the determination of the present value of future
profits.

What does "consistent" mean? In this regard, an extract from Sep 2009 problem that is comparing the experience assumption of EV with Supervisory assumptions

Supervisory reserves are determined by discounting future liability cashflows
using a risk-adjusted yield based on the assets being used to back the liabilities with a prudent margin built in. The prudent margin is deducted from the discounting yield for supervisory reserve calculations.
The yield permitted may only be based on income and not on total investment
return including gains.

For the PVFP calculation, two different types of “investment return”
assumptions are required: one to project investment returns into the future and one to discount the future profits (the risk discount rate). Projected future investment returns within the PVFP calculation will be based on the total expected return and are unlikely to include any material prudent margins

What do they mean by "projecting investment returns"?Does it imply the interest that we earn on opening reserves each year i.e the realistic rate?

What is the rate that is then considered for the reserves in Present value of future profits calculation? My understanding is that it is the same prudential rate that we consider for setting of the supervisory reserves since they ought to be consistent. Will some one please explain?

 

[Lynn Birchall]

It is important that the reserves used in the determination of net assets are
consistent with those used in the determination of the present value of future
profits.

What does "consistent" mean?

Suppose we're considering without-profits business. We know that the EV is
(1) s/h owned net assets +
(2) present value of future s/h profits arising on inforce business (PVIF).

Essentially:
(1) is "total assets - supervisory reserves (and required solvency capital)"
(2) is release of the prudence margins in the supervisory reserves (and required solvency capital) as profits (PVIF)

More prudence in the determination of the supervisory reserves (and required solvency margins) therefore reduces (1) and increases (2) (everything else being equal).

We need to be careful in the determination of EV to use consistent reserves in both parts.

In this regard, an extract from Sep 2009 problem that is comparing the experience assumption of EV with Supervisory assumptions

Supervisory reserves are determined by discounting future liability cashflows
using a risk-adjusted yield based on the assets being used to back the liabilities with a prudent margin built in. The prudent margin is deducted from the discounting yield for supervisory reserve calculations.
The yield permitted may only be based on income and not on total investment
return including gains.

For the PVFP calculation, two different types of “investment return”
assumptions are required: one to project investment returns into the future and one to discount the future profits (the risk discount rate). Projected future investment returns within the PVFP calculation will be based on the total expected return and are unlikely to include any material prudent margins

What do they mean by "projecting investment returns"?Does it imply the interest that we earn on opening reserves each year i.e the realistic rate?

What is the rate that is then considered for the reserves in Present value of future profits calculation? My understanding is that it is the same prudential rate that we consider for setting of the supervisory reserves since they ought to be consistent. Will some one please explain?

The "projecting investment returns" is relating to the investment return we're projecting to earn each year on the opening reserves plus premium less expenses. Yes, in this ST2 context, this is typically the "realistic rate".

Remember that in our PVIF we are discounting the projected future profits. Our formula for profit in each future year is of the form:
Profit = P + I - E -C - (increase in supervisory reserves + solvency capital).

The calculation of the supervisory reserves here is the part that uses the prudent interest rate you mention.

The I here is the realistic projected investment return just described.

As the 2009 solution mentions, these projected future profits are then discounted using a risk discount rate.

Best wishes
Lynn

 

[Ivanhoe]

Thanks.. I wanted to know if "consistent"meant "equal"?From your response it does seem to mean "equal"