CH17, flashcard 12 says that persistency assumptions are only needed if we are using cashflow method, and not formula method. But why is this so? If the insurer ignores lapse rate and uses formula method, aren't they putting themselves at risk of losses due to high lapse rate?
The formula method uses the big A and small a functions, eg from the yellow tables, to calculate values. These functions consider mortality rates, but not persistency rates, so we are implicitly assuming 100% persistency. Yes, I agree that assuming 100% persistency can be imprudent, eg if the surrender value is bigger than the reserve. On the other hand, assuming 100% persistency can be prudent if surrenders are a source of profit and surrender values are lower than the reserves. This is one of the reasons that the cashflow method is considered to be better than the formula method. In practice, where insurers use a formula approach, they will often perform a separate persistency check. For example, reserving rules could be set as the larger of a formula calculation or the surrender value, ie assuming the more expensive of no surrenders or 100% surrenders. Best wishes Mark
