EV and VIF

[1495_sc]

Hello,

I need help in understanding VIF as calculated for EV.

I have seen multiple definitions in SP2 and SA2. Summarizing my understanding below-

1. VIF if the present value of future profits from existing business of insurer
2. It is equal to the release of margins in reserve (if prudent reserve is held)
3. It is also a part of free surplus under Solvency II regime. (How?)
4. Under Solvency II regime, although we calculate BEL, VIF will include following

• profits arising beyond contract boundaries (release of margins in reserve beyond contract boundary?)
• risk margin release
• difference between risk free return on BEL and projected investment return for calculating EV
• PV of future shareholder transfers , if not included in own funds (does this mean only when own funds does not subtract shareholder transfers although assets should be lower after shareholder transfer)

5. VIF was not shown as a part of supervisory Balance sheet and accounts before Solvency II. Which part of balance sheet is different such that we can see VIF now? Free surplus and required capital are there. Was it not present earlier? What about VIF?

Apart from the questions above in brackets, I would like to know how can we identify VIF in Solvency II Balance sheet? There is a diagram in EV chapter which shows PVIF is less than liabilities but it is not clear to me. We also claim that PVIF is the release of risk margin. Why would VIF not be simply equal to the risk margin in this case? Please help urgently.

Thank you

 

[1495_sc]

X4 assignment Q4.2 is a good question to test this concept. If you would like more context.

 

[1495_sc]

Surplus in Solvency II balance sheet is calculated as (own funds - SCR).
Free surplus (for calculating expected return on net assets component of EV) is net assets or (assets - liabilities)

Are we saying both are different types of surplus? Is free surplus simply (assets- BEL)? Why would we define free surplus differently for EV?

 

[Lindsay Smitherman]

Surplus in Solvency II balance sheet is calculated as (own funds - SCR).
Free surplus (for calculating expected return on net assets component of EV) is net assets or (assets - liabilities)

Are we saying both are different types of surplus? Is free surplus simply (assets- BEL)? Why would we define free surplus differently for EV?

Remember that EV can be calculated on any type of regulatory balance sheet, it doesn't have to be a Solvency II balance sheet.

Under EEV principles, it is necessary to split the excess of assets over liabilities into two separate components: free surplus and required capital, with the definitions of each being given under the principles.

 

[Lindsay Smitherman]

Hello,

I need help in understanding VIF as calculated for EV.

I have seen multiple definitions in SP2 and SA2. Summarizing my understanding below-

1. VIF if the present value of future profits from existing business of insurer
2. It is equal to the release of margins in reserve (if prudent reserve is held)

Yes - these points are correct

 

[Lindsay Smitherman]

3. It is also a part of free surplus under Solvency II regime. (How?)

I think what you might be referring to here is that if you hold a best estimate liability (like the BEL) then you are capitalising the present value of future profit margins in the balance sheet. As the BEL is PV future {benefits + expenses - premiums}, for RP business the BEL is reduced by the value of the future profit margins loaded into the premiums and, indeed, at early durations the BEL could well be negative.

 

[Lindsay Smitherman]

4. Under Solvency II regime, although we calculate BEL, VIF will include following

• profits arising beyond contract boundaries (release of margins in reserve beyond contract boundary?)
• risk margin release
• difference between risk free return on BEL and projected investment return for calculating EV
• PV of future shareholder transfers , if not included in own funds (does this mean only when own funds does not subtract shareholder transfers although assets should be lower after shareholder transfer)

This statement is a little too strong. VIF might include the points mentioned. In turn:

If there are contract boundaries, the BEL will not take credit for any future profits beyond those contract boundaries, hence these future profits are not implicitly allowed for within the BEL and (if the company wishes to bother to calculate a VIF) would therefore be part of the VIF.

The risk margin could be released into the VIF (ie effectively being treated as a prudential margin) - that would be the case if the company were starting the calculation by setting EV liabs = full TP. If it instead set EV liabs to just the BEL, the RM would form part of the required capital instead, in which case it would be valued in that separate part of the EV calculation (assuming an EEV type approach is being used) and not in the VIF.

There could be future profits arising if the investment return in the EV experience projection basis is greater than the risk-free rates used for the BEL calculation (this is equivalent to there being a prudential margin within the investment return assumption used in the BEL).

The point about PV future shareholder transfers refers to with-profits business only. This relates to the separate identification of PV s/h transfers as described at the top of page 8 in Chapter 10.

 

[Lindsay Smitherman]

5. VIF was not shown as a part of supervisory Balance sheet and accounts before Solvency II. Which part of balance sheet is different such that we can see VIF now? Free surplus and required capital are there. Was it not present earlier? What about VIF?

Apart from the questions above in brackets, I would like to know how can we identify VIF in Solvency II Balance sheet? There is a diagram in EV chapter which shows PVIF is less than liabilities but it is not clear to me. We also claim that PVIF is the release of risk margin. Why would VIF not be simply equal to the risk margin in this case? Please help urgently.

Thank you

Hopefully the previous answers have resolved this confusion. The only explicit 'VIF' that can be seen in the Solvency II balance sheet would be the {PV shareholder transfers} item if there is any WP business.

 

[1495_sc]

I think what you might be referring to here is that if you hold a best estimate liability (like the BEL) then you are capitalising the present value of future profit margins in the balance sheet. As the BEL is PV future {benefits + expenses - premiums}, for RP business the BEL is reduced by the value of the future profit margins loaded into the premiums and, indeed, at early durations the BEL could well be negative.

Alright. So are we saying that free surplus would only account for negative BEL? (Negative BEL is equivalent to asset, hence it will be a part of free surplus). And, EV includes free surplus hence negative reserve will be considered in this manner for EV.

 

[Lindsay Smitherman]

No - I'm saying that because a BEL is calculated on a 'best estimate' basis, it capitalises future profit margins. Hence the BEL is effectively lower by the {present value of future profit margins} and thus free surplus is higher by that amount. That's true whether or not the BEL ends up being negative. (Bear in mind that the BEL will never be negative for single premium business, but all profit is still capitalised immediately for such policies.)

 

[1495_sc]

I'm saying that because a BEL is calculated on a 'best estimate' basis, it capitalises future profit margins. Hence the BEL is effectively lower by the {present value of future profit margins} and thus free surplus is higher by that amount.

Free surplus = Assets- TP- SCR

How is present value of future profit margins reflected here? Is there any example which will be helpful here?

 

[Lindsay Smitherman]

I think my previous post has already explained this?

Let's say the best estimate liability = 100 and the equivalent prudent liability would be 120. This means that (simplistically, ignoring any 'lock-in' frictional cost) there would be a VIF of about 20.

If we define free surplus as {assets - liabilities - capital requirements}, then free surplus calculated using the best estimate liability will be 20 higher than free surplus calculated using the prudent liability (all else being equal).

 

[1495_sc]

Thank you, this was helpful!