The answer to question 15.2 lists a "sterling-related surrender penalty" as one of the crucial requirements to use negative sterling reserves. Can anyone explain how a surrender penalty can be sterling-related? I already appreciate that the negative non-unit reserve must be at less than or equal to the surrender penalty.
A sterling-related surrender penalty just means that the penalty must be a cash amount rather than a proportion of units. This is to ensure that the penalty will cover the missing reserves. Apologies to everyone who works outside the UK and doesn't use sterling as their currency. Contrast this with actuarial funding where the surrender penalty must be unit-related. So we could reduce our overall reserves by holding a negative sterling reserve of £100, but we would have to have a surrender penalty of at least £100. Alternatively, we could hold an actuarially funded unit reserve of 80% of the bid value of units, but we would need a surrender penalty of at least 20% of the units. I hope this clarifies things. Good luck with the studying. Mark
I thought negative sterling reserves at a policy level is permissible provided that, at a portfolio level, there are no negative sterling reserves i.e. cross-subsidising between reserves of policies. If "sterling-related surrender penalty" has to be used with negative sterling reserves, wouldn't this defeat the purpose of having a negative sterling reserves in the first place?
Yes, that's right. Effectively the policies with negative sterling reserves are borrowing money from the policies with positive sterling reserves. This is fine as long as overall the insurer has positive reserves. No, typically these policies recover their initial expenses through positive cashflows later in the term of the policy, so a penalty on early surrender is common. The purpose of negative sterling reserves is to reduce the insurer's reserving requirements to offset the initial expenses. To be allowed to hold negative sterling reserves we need to have positive sterling reserves and sterling-related surrender penalties too. The policies with negative sterling reserves will gradually repay their loan (from the positive sterling reserves) through the positive cashflows that arise on these policies. If all the policies (with negative sterling reserves) surrendered their would be no future cashflows to repay the loan. So we need a sterling surrender penalty to repay the loan instead. I hope this helps to explain why we need both positive reserves and a surrender penalty. Best wishes Mark
