Negative Reserve

[Arpan]

The Pricing actuary had recently priced a non participating 10 year regular premium endowment product which is now open to sales. The economic scenario has changed significantly as a result of which the valuation actuary had to revise his valuation assumptions. The first few policies sold for this product produced negative reserves.

Q.1. what are negative reserves?(elaborately explain when they can occur and why they are considered not good)

Q.2. Why do most regulators ask the insurance companies to set the negative reserves to zero in case of negative reserves?

 

[fischer]

Okay, let me try a long winded explanation here:

Valuations involve working out the reserves.

The reserves here are the present value of the net liabilities.

1. Consider the following example: At a particular valuation since the launch of the product, the following is observes: (time 0 is valuation date)

At time 0, 1, 2, 3, 4 the net liabilities are:
10, 5, -5, -15, -20.
Or, I can say, loss of 10 at time 0, loss of 5 at time 1, profit of 5 at time 2, profit of 15 at time 3 and profit of time 20 at time 4

2. Let's say valuation interest rate = 0 (i.e. discounting factor =1)

3. If I bring the loss at time 1 and the profits at time 2, 3 and 4 to time 0, then the total cashflows are a profit of 25 (10+5-5-15-20).

4. This profit can be thought of as a "negative liability", i.e. a negative reserve.

5. In practice, what will happen is that the company has a loss of 10 at time 0. To recover that loss, it will look at positive reserves elsewhere in the company and cover-up the loss. So, it has in effect, taken a loan from the positive reserve. This loan has to be paid back. It will be paid back the cash-flows of 5, 15 and 20 at times 2, 3 and 4.

To answer your second question: regulators don't think it is prudent to bring future profits forward as these are not guaranteed. So, they don't want companies taking advance credit for profits that may arise in the future.

Note - taking advance credit for future profits = holding negative reserves = overall reserves held reduced = not prudent.

Hope this helps. Sorry if I've mentioned stuff you alreay knew and just missed your question completely.

 

[Arpan]

thnks for your explanation :what I've understood is

that negative reserves are treated as assets (amount is due from policyholders which one may say as debtors) but these are assets which may be realised or not as policyholders, knowing their position, may withdraw and thus policy lapses resulting in losses to the company..

may be for this reason regulators ask the insurance companies ,as a matter of prudence convention, not to start considering it as an asset and rather keep the reserves as zero.

if you think it requires any polishing feel free to do so.

Okay, let me try a long winded explanation here:

Valuations involve working out the reserves.

The reserves here are the present value of the net liabilities.

1. Consider the following example: At a particular valuation since the launch of the product, the following is observes: (time 0 is valuation date)

At time 0, 1, 2, 3, 4 the net liabilities are:
10, 5, -5, -15, -20.
Or, I can say, loss of 10 at time 0, loss of 5 at time 1, profit of 5 at time 2, profit of 15 at time 3 and profit of time 20 at time 4

2. Let's say valuation interest rate = 0 (i.e. discounting factor =1)

3. If I bring the loss at time 1 and the profits at time 2, 3 and 4 to time 0, then the total cashflows are a profit of 25 (10+5-5-15-20).

4. This profit can be thought of as a "negative liability", i.e. a negative reserve.

5. In practice, what will happen is that the company has a loss of 10 at time 0. To recover that loss, it will look at positive reserves elsewhere in the company and cover-up the loss. So, it has in effect, taken a loan from the positive reserve. This loan has to be paid back. It will be paid back the cash-flows of 5, 15 and 20 at times 2, 3 and 4.

To answer your second question: regulators don't think it is prudent to bring future profits forward as these are not guaranteed. So, they don't want companies taking advance credit for profits that may arise in the future.

Note - taking advance credit for future profits = holding negative reserves = overall reserves held reduced = not prudent.

Hope this helps. Sorry if I've mentioned stuff you alreay knew and just missed your question completely.

 

[fischer]

Hi Arpan
I would rephrase it by replacing the term "assets" with "profits" and removing the part about PH being debtors completely.

This is because profits are made from actual past experience being better than expected. PH experience is part of this experience. For example, with a term assurance, future profits will depend on lower than expected mortality and so lower than expected cost of death benefit and so lower than expected total payout.

That said, I would suggest you wait for a few more posts just to make sure that my explanation is correct.

Good luck.

 

[SpringbokSupporter]

When we price a policy by profit testing would we allow for negative reserves in the profit-test model? Allowing for a negative reserve would imply that we are assuming funding from another policy with positive reserves, which is different from funding from a shareholder.