Negative reserves

[Benjamin]

Conceptual question on negative reserves - I get that on paper, if you take credit for future surpluses then your time-zero strain is lower but unclear on how this plays out on a cashflow basis as ultimately, you still need to pay for your inception expenses and initial commissions to create the policy.

Or put a different way, conceptually the idea that you may be able to reduce your SCR by the value of future surpluses makes sense but as it's a future cashflow, it doesn't put cash in your pocket now, so I don't understand how it can be viewed as helping to "offset the initial expenses and commissions then incurred" (Online Classroom, Reserving Methods, 16:30).

Could you please clarify?

 

[Benjamin]

Further to this, just btw, is that I don't follow the idea that negative non-unit reserves are taken as a loan from other positive reserves held by the company.
Reserves raised in respect of non-UL policies are raised because they are required there so how is it that the funds are free to be loaned out?

 

[Mark Willder]

Conceptual question on negative reserves - I get that on paper, if you take credit for future surpluses then your time-zero strain is lower but unclear on how this plays out on a cashflow basis as ultimately, you still need to pay for your inception expenses and initial commissions to create the policy.

Or put a different way, conceptually the idea that you may be able to reduce your SCR by the value of future surpluses makes sense but as it's a future cashflow, it doesn't put cash in your pocket now, so I don't understand how it can be viewed as helping to "offset the initial expenses and commissions then incurred" (Online Classroom, Reserving Methods, 16:30).

Could you please clarify?

Yes, I agree that you still have a liquidity strain at the start of a regular premium contract because initial expenses often exceed the first premium. Some of your reserves will need to be held in cash to cover this.

However, we often do not have a solvency strain from writing new business. For example, if reserves are set using best estimates then future premiums (or charges if it's unit-linked) should exceed future claims and expenses, so we have a negative reserve.

We only need to hold reserves in aggregate for the company. So negative reserves on one contract can offset positive reserves on another.

An example may help. A company has positive reserves of 1,900 and assets of 2,000 held in cash, so it has free assets of 100 and is solvent. It sells a policy and incurs expenses of 100, but only gets a premium of 20. It can afford to do this, but now its assets go down to 1,920. However, the premiums on the new contract exceed the claims/expenses and so it sets up a negative reserve on this contract of -130. Total reserves are now 1,900-130=1,770, assets are 1,920, and free assets are 1,920-1,770=150. So its solvency position has improved, ie the negative reserves have more than offset the initial expenses.

I hope this helps to clarify.

Best wishes

Mark

 

[Mark Willder]

Further to this, just btw, is that I don't follow the idea that negative non-unit reserves are taken as a loan from other positive reserves held by the company.
Reserves raised in respect of non-UL policies are raised because they are required there so how is it that the funds are free to be loaned out?

Let' say an endowment assurance contract has a reserve of 200. Ignoring deaths for simplicity, it doesn't need this money until maturity in say 20 year's time.

Now consider a ten year unit-linked savings contract we have just sold. We expect the present value of charges over the ten year term to exceed claims/expenses by 130. So we set up a negative non-unit reserve of -130.

In total the company has reserves of 200-130 = 70. The company owes money to the endowment policyholder, but the unit-linked policyholder owes money to the company. In total we have enough money (the regulator wouldn't be happy if our total reserve was negative). We will be ok because the unit-linked debt is repaid over ten years (ie the charges will be received) and these will be received before we need to make the payout on the endowment.

I hope this helps to clarify this.

Best wishes

Mark