Dear Mark and Lynn: Examination is coming soon. Please help me with this. September2007 Examiners' report Q1(ii)(d)"switching out of corporate bond".paragraph 3 states: "The duration of the bonds is unchanged and so the underlying volatilities should also be broadly unchanged. However, the removal of credit risk might reduce the overall volatility of these assets. This would reduce realistic liabilities. " I feel confused about this. "realistic liabilities",in my point of view,refers to "with profit benefit reserve"+"future policy related liabilities". If my unerstanding is true, then realistic liabilities are calculated using market consistent approaches,irrespective of what types of assets are held. So why realistic liabilities would reduce after switching of corporate bonds? And,the following Q1(iii) states: “total capital required” has been defined as the sum of realistic reserves and the ICA capital requirement. I know the definition of "realistic reserves" when talking about without profit products. But I really don't know what is the definition of "realistic reserves" for with profit products? Please help me.Thanks in advance.
I agree, I don't think the realistic value of the without-profits liabilities have changed. However, the future policy related liabilities is the cost of the guarantees on the with-profits business. As government bonds are less volatile than corporate bonds the probability that the guarantee bites will be lower after the switch to government bonds. Hence the future policy related liabilities fall. A realistic reserve for a with-profits policy would be very similar to the calculation in Pillar 1 Peak 2 ie asset share plus the cost of guarantees (using the market value of matching derivatives). Best wishes Mark
Thank you, but I still don't understand... September2007 Examiners' report for Q1(ii)(b)"Purchase of interest rate derivatives".The examiners' report said:"Realistic liabilities will be unchanged, as will working capital." September2007 Examiners' report for Q1(ii)(d)"Switching out of corporate bonds".As you said:cost of guarantees will reduce → future policy related liabilities will reduce → realistic liabilities will reduce. In both (b) and (d),we make some changes to my assets. but why only (d) will change realistic liabilities?
Sorry to make sense of these solutions we need to be more explicit about which assets are changing. (b) and (d) are different as we are changing different assets. The realistic liabilities are largely made up of the asset share plus the cost of the guarantees (which you can think of as the cost of buying matching derivatives). In this question the asset share is backed by equities and corporate bonds and the policyholder will get the higher of the asset share and the guarantee. The cost of the guarantee is based on the volatility of these assets (as volatility is the key parameter in the Black Scholes equation). In part (b) we sell some of the free assets to buy derivatives. The assets backing the asset share have not changed, so the cost of the guarantee has not changed. The policyholder will still expect their payout to be based on equity/bond performance rather than the performance of the derivative. This is the approach used by insurers in practice, but I agree that the solution would have been much clearer if this had been stated explicitly. In part (d) the assets backing the asset share have changed from equities and corporates to equities and government bonds, so the volatility of the asset share has reduced and the cost of guarantees has reduced. I hope this helps to clarify the mystery. Best wishes Mark
