Inherited estate and working capital

[Gumbelc]

Hi,

What is the distinction between Inherited estate and Working capital under a withprofit business.

They both refer to excess of realistic asset over realistic liability? thanks.

 

[Lynn Birchall]

Hi

Yes, they both refer to excess of realistic assets over realistic liabilities. I'd say working capital was one particular assessment of this (ie as under Peak 2), and that "the estate" was less specific about how to calculate "realistic liabilities".

PS I'd suggest always defining these terms if using them in the exam

 

[Gumbelc]

Thanks, Kindly help explain my other questions

1. under EEV, cost of required capital is defined as:

= Amount of required capital - PV (future releases of the required capital allowing for investment return)

can this please be explained as i can't get my head around it. should this not be say cost of borrowing or coc e.g. 6% of the amount of required capital?

2. I want to understand how risk free rate can be derived from swaps. Swaps being exchange of fixed and floating interest rates so how is risk free derived from the swap arrangement. MCEV and solvency II refers to a move to swaps being used to derive risk free rate

Thanks.

 

[Mark Willder]

1. under EEV, cost of required capital is defined as:

= Amount of required capital - PV (future releases of the required capital allowing for investment return)

can this please be explained as i can't get my head around it. should this not be say cost of borrowing or coc e.g. 6% of the amount of required capital?

A numerical example may help. Consider an insurer with required capital of 100 which it intends to release one year later. It invests this at 4%, so that one year later it has 104. However, the shareholders require a return of 10%, so this capital release is only worth 104/1.1 = 94.55. So there is a cost of capital of 5.55.

Equivalently, we see that the required return is 10% but the actual return is 4%, so there is a shortfall of 6%. 6% of 100 is 6. Discount this back at 10% gives 5.55 as before. I think it is this second calculation that you had in mind, but it is equivalent to the first calculation used in the description of EEV.

2. I want to understand how risk free rate can be derived from swaps. Swaps being exchange of fixed and floating interest rates so how is risk free derived from the swap arrangement. MCEV and solvency II refers to a move to swaps being used to derive risk free rate

We are going to use the fixed rate in the swap as our risk free rate. This is risk free because if we hold cash it would earn the floating rate which we can then swap for a series of risk free cashflows at the fixed rate (they are risk free assuming that counterparty default is low).

We then consider swaps of different length to determine the risk free yield curve.

Best wishes

Mark

 

[Gumbelc]

very useful... Many thanks Mark

 

[qinfen]

Q&A 4.8 part ii,
the answer given keeps on saying the inherit estate is not like peak 1 statutory free assets?
Why are they different?

 

[Mike Lewry]

Q&A 4.8 part ii,
the answer given keeps on saying the inherit estate is not like peak 1 statutory free assets?
Why are they different?

Peak 1 WP reserves will cover guaranteed benefits, but typically not any accrued terminal bonus, which will therefore form part of the Peak 1 free assets.

Since the realistic value of WP liabilities is likely to be based on the full asset share, including accrued TB entitlement, the inhertited estate will not include accrued TB.

 

[qinfen]

Thanks.

One more question, in the part "keep it at boardly the same percentage", it says.."if it increases its with profit business, keeping inherited estate at the same percentage of liabilities would require benefits lower than asset shares to be paid."...
Why is the benefit lower than asset shares to be paid?

 

[Mike Lewry]

If WP business got larger, then the inherited estate would also need to get larger to keep the ratio the same. The extra money to build up the estate would have to come from deductions to WP asset shares (or equivalently targetting less than 100% of asset shares).

 

[qinfen]

Thanks.