EV and implications of solvency regime

[1495_sc]

Hello,

Correlating few concepts of EV between SP2 and SA2 here.

Per SP2 Core Reading,

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

Hence,
PVFP (ie the present value of future shareholder profits)
= PV {Premiums + investment return - claims - expenses + release of reserves} (equation1)
= PV {Release of prudential margins in reserves} (equation2)

However, I did not clearly understand how would equation1= equation2 assuming that the supervisory reporting is performed on a prudential basis.

Further in SA2, it is mentioned that for jurisdictions which require liabilities stated on best estimate basis (perhaps Solvency II regime), there will be no release of prudential margins. Agree here.

However, for such jurisdictions, for PVIF, we will still consider -
a) profits beyond Solvency II contract boundaries
b) difference between BE investment return assumed in EV projection basis and discount rate used in BEL (including MA/VA in BEL calculation)
c) future shareholder transfers for with profits business
d) release of risk margin less cost of holding it

My question is
a) Does this mean that EV calculation is also governed by Solvency II basis? I thought Solvency II was only for Solvency II balance sheet and EV is not calculated for this balance sheet. Why will we still consider profits beyond contract boundaries if EV is Solvency II basis?
b) What is the rationale behind including difference between BE return on EV basis and BEL discount rate?
c) why will PVIF include release of risk margin? Isn't the risk margin included in technical provisions only under Solvency II?

Please help. Thank you in advance!

 

[Lindsay Smitherman]

Per SP2 Core Reading,
For without-profits business, the present value of shareholder transfers is effectively the release of any margins within the supervisory reserves relative to the assumptions used within the embedded value calculation.

Hence,
PVFP (ie the present value of future shareholder profits)
= PV {Premiums + investment return - claims - expenses + release of reserves} (equation1)
= PV {Release of prudential margins in reserves} (equation2)

However, I did not clearly understand how would equation1= equation2 assuming that the supervisory reporting is performed on a prudential basis.

See the end of the following SP2 thread for an explanation of this:
https://www.acted.co.uk/forums/inde...stions-september-2018.17838/page-2#post-70876

 

[Lindsay Smitherman]

However, for such jurisdictions, for PVIF, we will still consider -
a) profits beyond Solvency II contract boundaries
b) difference between BE investment return assumed in EV projection basis and discount rate used in BEL (including MA/VA in BEL calculation)
c) future shareholder transfers for with profits business
d) release of risk margin less cost of holding it

My question is
a) Does this mean that EV calculation is also governed by Solvency II basis? I thought Solvency II was only for Solvency II balance sheet and EV is not calculated for this balance sheet.

EV calculations start from the supervisory balance sheet. If the company is subject to Solvency II, it will start from the Solvency II balance sheet. EV basically = net assets (or free surplus + required capital minus cost of holding, if doing an EEV style embedded value) + PVIF. The 'net asset' part of the calculation will clearly depend on the supervisory reserves held. The PVIF will also depend on the supervisory reserves, as per the post above.

 

[Lindsay Smitherman]

a) Why will we still consider profits beyond contract boundaries if EV is Solvency II basis?
b) What is the rationale behind including difference between BE return on EV basis and BEL discount rate?
c) why will PVIF include release of risk margin? Isn't the risk margin included in technical provisions only under Solvency II
Why will we still consider profits beyond contract boundaries if EV is Solvency II basis?

On conventional business at least, we can think about future shareholder profit as the release of whatever component of the 'reserves' is not expected, on the EV projection basis, to be needed to meet future policyholder obligations. If it isn't needed to meet policyholder obligations, it must be expected to go to the shareholders - therefore is part of the EV.

So to what extent are the Solvency II technical provisions larger than they really need to be?

The BEL ignores future profits arising beyond the contract boundaries, and therefore is effectively larger than it needs to be (if such profits are expected to arise on a true best estimate basis). The excess value (ie the future profits beyond contract boundaries) would fall to shareholders, therefore would form part of the PVIF projections.

The BEL is discounted at a risk-free rate rather than a best estimate investment return, and therefore is larger than it needs to be (ie larger than it would be if using a true best estimate basis). The excess of what the company actually expects to earn on a best estimate basis, on the assets held to back the BEL, over the risk-free rate will fall to shareholders - so is part of the PVIF projections.

The risk margin is not expected to be needed to meet future policyholder obligations, so must be expected to fall to shareholders. So forms part of the EV.

 

[1495_sc]

See the end of the following SP2 thread for an explanation of this:
https://www.acted.co.uk/forums/inde...stions-september-2018.17838/page-2#post-70876

Thank you, this was helpful.

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

Regarding the part in bold above, can you please elaborate on why would this be the release of margin relative to EV assumptions and not simply release of margin? Or would this be same as simply release of prudential margin? (Margins over and above best estimate)

 

[1495_sc]

The BEL ignores future profits arising beyond the contract boundaries, and therefore is effectively larger than it needs to be (if such profits are expected to arise on a true best estimate basis

As BEL ignores future profits, shouldn't it be actually lower than it should be? I understand the need for adding this component to EV but just want to clarify this relation.

 

[1495_sc]

The risk margin is not expected to be needed to meet future policyholder obligations, so must be expected to fall to shareholders. So forms part of the EV.

EV calculations start from the supervisory balance sheet.

Good to know this! Although EV is surely reported to shareholders hence its a part of financial statements published on reporting basis- say US GAAP?

 

[Lindsay Smitherman]

Thank you, this was helpful.

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

Regarding the part in bold above, can you please elaborate on why would this be the release of margin relative to EV assumptions and not simply release of margin? Or would this be same as simply release of prudential margin? (Margins over and above best estimate)

As I mentioned above: future shareholder profit is the release of whatever component of the 'reserves' that are currently being held is not expected to be needed to meet future policyholder obligations.

For an EV calculation, what we are 'expecting' to happen in future (against which we will be assessing whether or not we need all of the reserves that have been set aside) is the EV projection basis.

 

[Lindsay Smitherman]

As BEL ignores future profits, shouldn't it be actually lower than it should be? I understand the need for adding this component to EV but just want to clarify this relation.

Just to be clear, BEL doesn't ignore all future profits. My statement was 'The BEL ignores future profits arising beyond the contract boundaries'.

Remember: BEL = money set aside now to meet future policyholder obligations. If we could take credit for future profits arising beyond contract boundaries, we could hold less money now to meet those future obligations (as we could use those future profits to do this, in part). Hence BEL would be lower.

But we can't take credit for those future profits, so BEL is higher than if we could.

 

[Lindsay Smitherman]

Good to know this! Although EV is surely reported to shareholders hence its a part of financial statements published on reporting basis- say US GAAP?

EV might be reported to shareholders, but not always so.
If a company reports its profits on a particular reporting basis, then when it projects forwards the future profits for the PVIF calculation it might be sensible to use that reporting basis to define what those projected profits are (ie the pattern in which they emerge).
But the starting point of net assets (or free surplus & required capital) and the subsequent release of 'reserves' within the projection depends on its supervisory reserving basis.