a) solution says in future years, the profit from the existing business will be higher than before which will increase the profitability measure on the other hand incoming new business will increase embedded value by less than previously, so reducing profitability measure compared with before. So overall effect on the subsequent years calculations will depend on the amount of new business that is actually sold relative to the amount of existing business in force.
So my question does this mean that if more new business profits from the existing business are diluted and effectively the profitability measure will decrease?
Yes, that's broadly right. What the solution is saying is that:
1. The strengthening of the reserving basis might result in a one-off reduction in the EV and hence a one-off reduction in EV profit (where EV profit is defined as being the change in EV). [I only say 'might' because this is only the case if the EV discount rate is higher than the expected investment return in the EV projection basis.]
2. However, there will be higher EV profits arising going forwards into future years
in respect of the existing business only (ie ignoring the addition of future new business). Bear in mind that the reserving basis used doesn't impact the total profits actually arising over the full duration of a contract, only the pace at which the profits emerge. The change in reserving basis here has deferred the emergence of EV profit: lower EV profit at the time of the change, but then
higher EV profits thereafter to balance this and so that the total profit arising is unchanged.
3. But we also have to consider that EV profit in future will also include the change in EV resulting from writing new business. As is consistent with point 1, the amount of EV profit arising for each new policy written is now
lower than it was before we did the reserving basis change.
Total impact on future EV profit =
impact on future EV profit in respect of existing business + impact on future EV profit in respect of future new business
The first part of this formula has gone up and the second part has gone down. Whether the overall impact is an increase or decrease therefore depends on the amount of new business written relative to the volume of existing business. If there is no (or very little) new business being written, we would expect the overall impact of the basis change on future EV profit to be an increase - since the first part of the formula dominates. If there is a huge amount of new business being written, we would expect the overall impact on future EV profit to be a decrease (at least until this amount of new business stops being written and the business starts to run off) - since the second part of the formula dominates.
b) the question also applies to this solution as well.
Yes - although only if
actual experience turns out to be unchanged from before (so that the total
actual profit arising from each tranche of business over its full duration is unchanged by the basis change).
Hope that helps.
