Hello, I am currently going through your online tutorials and I am reviewing the video "Profit recognition (11:11)". When the liabilities is set to SII BEL, we assume that all the profit is released at t=0 but this is not the same for Traditional embedded value? I understand that EV is using a risk discount rate that is higher than risk free rate which is the reason. I am trying to understand this intuitively. At t=1, when the liabilities is set as SII BEL. I would expect profits to emerge if i looked at the cashflows e.g. Prem-(claims + expense) +interest in reserves etc.... Thanks
Just to add to this... as time progresses I would expect an unwind at risk free rate.. so wont profit emerge as well?
Hi - hmm, this is quite tricky to explain, so bear with me. On a 'normal' reporting basis, profit arising = premiums - claims - expenses + investment return - increase in reserves (or + release of reserves). If reserves are calculated on a fully best estimate basis and if experience turns out to be as expected, the cashflows in the above expression will all cancel each other out. Reserves are released to meet the claims and expenses arising, net of premiums received. The increase in reserves due to the investment return earned (what you refer to as the unwind) cancels out with the '+ investment return' element. So if reserves are on a best estimate basis, all profit loadings in premiums are capitalised at outset and no further profits arise (provided actual experience is in line with best estimate). In other words, if you put aside initially exactly what you expect to need to meet your future liabilities, you won't make any further profits in the future - you will just use up what you have put aside. If reserves are calculated on a prudent basis, however, we would expect there to be some profit emerging & this would simply equal the release of the prudential margins in the basis. For EV, profit arising is defined as the change in EV over the period. At outset this will be the initial EV, and again that will represent the capitalisation of profit loadings. Under Solvency II the capitalisation of profit has been discounted using a risk-free rate of return. Under a traditional EV approach and assuming that we have underlying prudent liabilities (so that there is an emergence of future profits in the form of prudential margins), the discounting is done using a risk discount rate, which would be expected to be higher than risk-free. Hence the initial value of discounted profits is lower under the traditional EV approach (higher discount rate) than it is under the 'liabilities = BEL' approach. But that shortfall, which is due to the risk loading in the discount rate, is then gradually 'paid back' over time through the emergence of little positive EV profits in each of the following years. Under the traditional EV approach, if actual experience is in line with the EV projection basis and no new business is added, there will be no additional EV profits arising other than the unwind of the discount rate. (There will also be investment return on net assets - but in the particular exercise that you refer to, this is ignored.) So, overall, you still get the same total profit arising over the period in each of the two cases - just in slightly different patterns. Effectively, the prudence that is allowed for through using a risk-loaded discount rate in the EV is gradually released over time. The details are a little more complicated than that, but hopefully that's enough to help you see what is happening?
