I have a question on effect of strength of reserving basis when compared against that of premium basis. I don't understand why profit is capitalised when premium basis is more prudent than reserving basis? I think the main reason for any capitilisation is difference in mortality and interest rate assumption. Having a greater interest rate will reduce reserves and assuming heavier mortality will further increase reserves, but how does this result in capitalising profits? Could you please explain this concept?
Hi The idea is that if the premium basis is prudent, then the premiums it produces will be more than enough to cover the realistic expected cost of benefits plus and expenses. So, if we then calculate a reserve on a more lenient basis than the premium basis, ie work out "Value of benefits + Value of expenses - Value of premiums", the answer would be negative early on (as the prudent premiums are more than enough to cover the benefits and expenses). The part of the premium that isn't needed to cover benefits and expenses is the profit. The fact that " - Value of premiums" reduces the reserve is the capitalisation of future profits.
This will lead to negative reserves since exp premiums are greater than expected benefits/costs. But if there are regulations to cap the effect of negative reserves (i.e. in aggregate reserves must be non negative), are negative reserves still a bad thing?
Insurers might have some policies with positive reserves (eg +100) and some with negative reserves (eg -50). In the UK it is permissible to hold negative reserves, and so in this case the total reserves would be 50. The insurer would be solvent as long as its assets exceeded 50. Negative reserves can be dangerous though. If all the policies with negative reserves lapsed, then the insurer would need reserves of 100 and so might become insolvent. For this reason, the reserves are calculated using prudent assumptions to allow for the possibility that at least some of the polcies might lapse. This might lead to a lower negative reserve (eg -40). In practice it is very unlikely that all policies would lapse and so a prudently low negative reserve should be fine. However, in other countries it is usual to take an even more prudent view. They assume that all policies with a negative reserve lapse straight away. These policies then have reserve of zero, and so the total reserve is 100 in our example. We are strying onto SA2 territory with this discussion. Knowledge of UK regulations is not required for ST2.
