Hi - your thinking is along the right lines, although it's a little more involved than that.
As you indicate, profit will emerge in the EV projections to the extent that the investment return assumed in the projection (or 'experience') basis differs from the discount rate used for the liabilities. As you say, if the liabilities are determined under Solvency II then the latter will be a RF rate, possibly +MA or +VA (depending on meeting the various requirements, regulatory approval etc).
Under MCEV, if the assumed investment return is RF + illiquidity premium then there may be very little difference between this and the liability discount rate, since the MA and VA are intended to represent the illiquidity premium. However, the latter are effectively set by EIOPA: the MA through the fundamental spread, and the VA is based on a 'representative portfolio' rather than actual assets held (plus is calibrated to be less than the theoretical illiquidity premium). The company's own view of the illiquidity premium might well therefore differ from the MA/VA allowance, and thus there would be some profit arising due to the difference. Also, the company might believe that it could include an illiquidity premium in its projection basis, but might not have obtained approval for an MA/VA adjustment under Solvency II, in which case we again have a difference which would generate projected profit.
For EEV, bear in mind that the underlying basis was not prescribed in as much detail as it was under MCEV. EEV could be done on a market-consistent basis, in which case the argument would be as above - although fewer companies included an illiquidity premium than we see under MCEV (since the MCEV principles gave more detail and direction on this aspect). However, EEV could also be calculated using a 'traditional' basis, ie best estimate expected future investment returns. In which case, investment profits would be expected to arise in relation to the difference between this best estimate return and the risk-free rates used within the Solvency II liabilities.
Hope that makes sense.
Hi Lindsay,
Thanks for your reply! That makes perfect sense. Just want to clear 2 things:
1. when calculating MCEV with Solv II liabilities, does the illiquidity spread embedded in the investment assumption cover the spread for default risk? I'm asking because in Solv II discount rate fundamental spread is explicitly deducted from MA (I guess there's a same deduction of default spread in VA calculation?), so wondering if the illiquidity spread in investment assumption in MCEV also deducts default spread, such that no profit emerges from the difference in default spread as well.
If the answer is Yes, then are the methods of calculating default spread under MCEV investment assumption and Solv II discount rate the same? Or in companies' real practice, would they set these 2 the same value?
2. when calculating traditional basis EEV with Solv I liabilities, then would companies use the same discount rate as their BE investment assumption, i.e. risk free + their own view of a spread?
Basically I'm trying to come up with a table below (sorry about the format! hope it's comprehensible...). Could you help me if the understanding is correct or not? Thank you so much!!!
Assume rf is the same and spreads are different due to difference in various valuation methods. The first 3 columns are conditions and the last 2 are conclusions.
reason 1: differences in the methods adopted for calculating spreads.
reason 2: investment doesn't include spread while discount rate has spread.
………........Invmt assup………...Disc assup-Solv I...….Disc assup-Solv II.....
Invmt variance-Solv I.....Invmt variance-Solv I
MCEV........rf+illiquid sprd……..rf+sprd…………………..rf+MA or VA...……....Yes, reason 1...…………....Yes, reason 1
EEV-MC.....rf(most likely)……...rf+sprd…………………..rf+MA or VA...….......Yes, reason 2..................Yes, reason 2
EEV-Trad...rf+sprd..................rf+sprd.....................rf+MA or VA............NO..................................Yes, reason 1