Interest rate stress on non-unit reserve value

Apologies but I'm not seeing the 'contradiction' here. It seems to be different ways of discussing the same basic idea.
It would normally be the case that non-unit reserves are negative, since you would expect future charges to be sufficient to cover future expenses + excess benefits and contribute to profit.
Bear in mind also that not all charges will be expressed as a % of fund. There could, for example, be a per policy admin charge.

 

In both questions we are basically having to justify an increase in interest rates as being the adverse SCR stress:

• in 2018 because that's what the question states
• in 2021 because the mismatched annuity portfolio and assets backing own funds will be the key drivers and that's the direction that will adversely impact both of those

In both cases, the impact on the non-unit part of the BEL for UL business is second order and so shouldn't be the focal point of the answer. The impact on the value of bonds held within own funds (or surplus assets) and the bonds backing annuities (particularly where we are told there is mismatching) will be the key drivers of the SCR impact.

In the 2018 solution, I agree that it does make the point that charges might be unaffected (if expressed as a % of funds) but it doesn't say that will be the case for all charges. Indeed, the full solution does point out that the impact will depend on whether charges are expressed in monetary terms or % fund. I think perhaps the confusion comes from the 2018 Examiners' Report phrase 'The value of charges less expenses will be discounted at a higher rate and this will result in a decrease in the BEL', which feels like it might be over-simplifying and trying to cover too much in one sentence. After all, we are trying to justify a positive SCR impact (as per the following solution line) and that would be driven by an increase in BEL ... or perhaps it isn't being clear enough about whether it means a decrease in absolute value terms (if negative). To the extent to which charges are expressed in monetary terms, the value of these will also reduce when the discount rate increases - and this would contribute towards increasing the BEL.

What actually happens to the NUR part of the BEL overall will depend on the balance between monetary charges, % fund charges, monetary additional benefits, % fund additional benefits and expenses within the cashflows. But this is likely going into too much detail on what is (as mentioned above) not the key SCR driver. If you look at our ASET for the 2021 question, you can see that we only cover the impacts relating to own funds and annuities in our full solution, relegating the NUR considerations to the 'Additional points' section. (There was no ASET written for 2018 papers but we would likely have done the same then.)

So what would have been important would have been to demonstrate your understanding that we need to consider both charges and expenses, and the fact that the discount rate would increase and therefore reduce present values.

 

Yeah agreed - this would have to be based on an (unstated) assumption that all charges were % fund and therefore unaffected. Since there are so many permutations around these NUR impacts, I would be inclined to focus on the line below it: credit being given for sensibly constructed arguments (which would hold whether you were considering +ve or -ve NURs).

In a way it is a shame that we don't have an ASET for this paper as we would have attempted to untangle all of this and express it a bit more clearly. On the other hand, that might have been quite hard work for us!

 

If a charge is expressed as a % of fund value (ie annual management charge) then we need to project forwards the unit fund value in order to determine the size of these future charges for the non-unit part of the BEL calculation. Solvency II is a risk-neutral market-consistent valuation, so all assets are expected to earn the risk-free rate. Interest rates up -> risk-free rates up -> projected returns on unit fund value up.

However, the discount rate will also increase (since discounted at risk-free rates). Since we are rolling up and discounting back at the same rates, the present value of these % of fund value charges is not impacted by any change in interest rates within the BEL calculation.

 

Yes, this all broadly sounds OK.

If the funds were invested in bonds then yes, an increase in interest rates would mean a fall in bond values and hence lower charges if these are expressed as a % of fund ... and therefore would lead to a higher BEL.

However, bear in mind that your point about the discounting is irrelevant to those charges, because the projection forward and discounting at higher rates will offset against each other, as per my post above.

The higher discount rate is only relevant to any fixed per policy charges and to the expenses. The impact overall will therefore depend on the weighting between each of the components.

Normally the non-unit part of the BEL would be expected to be negative. Higher discount rate -> smaller absolute value, ie a less negative non-unit part of the BEL, which would increase the BEL - and this supports the same direction as the other impact (as you say).

 

I think you are leaving out the discounting impact here.

Lower unit fund value at start of projections -> lower % fund charges (than before the stress is applied)

All else being equal, higher interest rates in projections -> higher projected % fund charges, but this is exactly offset by the higher discount rate applied to those projected % fund charges.

 

Yes that might be helpful, but do be careful to keep an eye on the number of available marks, the command verb and the number of other things that would need to be covered within the solution (eg if there aren't many marks available and there are other angles that need to be covered, not a good idea to go down this particular avenue in a lot of depth and detail).

 

These sound broadly OK, just bear in mind that:

• All of the above refers to just the impact on the non-unit part of the BEL, not to the BEL in total. The unit part of the BEL would fall if any of the unit funds held were invested in bonds, and this would need to be taken into consideration in the overall movement in BEL.
• Under Case 1, the above-mentioned impact on the size of the unit funds (if some are held in bonds) would impact the size of the % fund charges, and this would have the opposite impact to what you have described, since lower fund values -> lower charges -> higher non-unit part of BEL
• In reality, companies typically have both fixed and % fund charges in place, rather than having one or the other