Negative Sterling Reserves

[calibre2001]

Hi all,

Been reading about this topic in the SA2 CMP/core reading and there're some bits I'm not totally clear about.

In Chapter 15 (CMP page 4), it states:

-Subject to the above conditions being met, it is permissible to hold a negative non-unit reserve under a contract. In aggregate, however, the non unit reserves may not be negative
-So it's saying that 'cross subsidising' between different policies at a policy level is acceptable and that when the effect is grossed up, there is no net effect (in absolute amount on the company at all). This makes sense. What I'm not so clear about is that if at a policy level, a company must ensure that unit reserve + non-unit reserve can meet guaranteed SV (which is why a surrender penalty is imposed), wouldnt this compromise on the net SV of different UL policies since the 'cross subsidising' using negative sterling reserves will affect the value of their non unit reserves??

-Use of a negative non-unit reserve may result in a mismatching risk
-Isnt a surrender penalty requirement used to minimise the difference between SV and unit + non unit reserves? Or is it refering to a another type of mismatch?

I suspect there are fundamental flaws in my understanding. Hope someone can point me to the right direction. Thanks!!

 

[Mark Willder]

This is a question about SA2 rather than ST2 so it goes beyond what most readers of this Forum need to know at this stage.

Surrender penalties

There is no direct link between the size of the surrender penalty and the negative non-unit reserves.

Surrender penalties for unit-linked contracts are set at outset of the policy eg as a pecentage of the unit fund. They are designed to recover any outstanding initial expenses and perhaps to recoup some of the profits that would have been made from the contract. Marketing considerations may severely restrict the size of the penalties.

Negative non-unit reserves are calcualted throughout the life of the contract as the excess of the value of future charges over future costs.

For example, many contracts have no surrender penalty after 5 years, but the value of future charges may still exceed future costs. Hence, any policy with a negative non-unit reserve will lead to a loss if it is surrendered - we cannot retrospectively set a surrender penalty to avoid this. For this reason we will assume a prudently high number of surrenders when calcualting a negative non-unit reserve.

Mismatching Risk

By holding a negative non-unit reserve on a policy you reduce the overall non-unit reserves of the insurer. In effect, the negative non-unit reserves are treated as an asset.

The policies with negative non-unit reserves generate a positive stream of cashflows for the insurer, while the policies with positive non-unit reserves generate a negative stream of cashflows. The mismatching risk occurs because the timing of these two sets of cashflows will be different.

The situation is identical to holding an asset such as bonds which generates a positive stream of cashflows, but at different times to the negative cashflows from say an annuity policy.