October 2015 Q1(iv) - Discussing the EEV basis

[Satya]

Hello,

In this question we are given the year end 2013 basis, the actual half year 2014 experience and asked to discuss why the company has set the year end 2014 basis as it has.

This company is using Solvency I rules. We can tell this because the PVIF is strongly positive in the table for question 1.(ii).

I had a go at this question and made some points about how the basis is likely to be set to be prudent, which could explain how the basis for year end 2014 has been set (and to help explain why it is different to the actual experience in half year 2014).

Anyway, there was nothing about the assumptions having margins for prudence in the examiners report for this question.

My question is - is my point about prudence correct here? Under Solvency I, the EEV assumptions must have some margins in them relative to best estimate so that the PVIF is positive.

P.S. I'm not trying to ask whether I'd score any marks for such arguments in the exam, rather the question is: am I correct in principle?

P.P.S. I also appreciate that, if a question like this were to be asked again, it would likely be under Solvency II rules and so the basis used in the EEV calculation would be best estimate, which would make the above points irrelevant.

 

[Lindsay Smitherman]

Hi - it sounds like you are confusing the experience (or projection) basis with the reserving basis. Both of these bases are needed for EV calculations, because we have to project and value future profits arising. Thus assumptions are needed in relation to the reserving basis in order to determine the pattern of release of current reserves within that future profit recognition.

So, for example, profit for without-profits business = premiums + investment earnings - expenses - claims + release of reserves.

Most of these items will be projected purely using the experience (or projection) basis assumptions. However, to calculate the 'release of reserves' item and the investment earnings on the reserves held, we need the amount of future reserves to be projected. Hence the second set of assumptions is required: the reserving basis.

The exam question that you refer to is setting out the components of the 'experience basis' (this is stated in the question wording), not the reserving basis.

You are correct that the company will be using Solvency I prudential assumptions for the reserving basis within its EEV calculations. This is because the question was set before Solvency II came into force (1 Jan 2016). (And, as you say, there is substantial VIF.)

However, under EEV Principle 9, the experience basis should be best estimate (see Chapter 19 of the current Course Notes).

Hence the extent to which there might be any prudential margins is not relevant in relation to the experience basis, as we have here - and that is why this idea doesn't appear in the solution.

Effectively, VIF is the emergence into profit of any differences between the reserving basis used and the experience (projection) basis. It is important to remember that there are these two sets of assumptions needed for EV calculations.

Has that helped?

 

[Satya]

Hi Lindsay, that has really helped! I had not realised there were 2 bases being used!