In the core reading it is stated that Prospective surrender value tells us how much the policy is worth to the company. But in the calculation we are deducting future premiums from expected future benefits and expenses. Let's assume we are using best estimate. How dose it tell the worth from the companies point of view? Is it not the reserve we need to keep to payoff future liabilities? To know the worth to the company should we not calculate the profit grid at each time interval and then discount it back to the time of surrender? Thanks,
Hello Pulkit Thank you for your question. This is a complex question as you've discussed a range of ideas from the surrender value, reserving and embedded value topics. Chapter 21 discusses many different ways that a surrender value could be calculated. Each method has it's advantages and disadvantages. A common question is to apply the surrender value principles from the start of Section 2 to discuss a given method's strengths and weaknesses. The Core Reading in Section 4.2 states "If a realistic basis is used with this (prospective) method, it will produce a surrender value that represents what the contract is worth to the company." The Core Reading means that using a realistic prospective basis gives us the most realistic estimate of the cost to the company of keeping the contract going. So if we pay this as a surrender value then the insurer will make the same profit as if the contact had remained in force. You suggested that we should calculate the expected present value of the profits from the contract. Your approach sounds just like an embedded value. An embedded value would give us what the contract is worth to the shareholders in terms of future profits. Note that this is not what the Core Reading means - the Core Reading is looking at what the future cashflows are worth to the policyholder. Section 5 goes on to compare different approaches to calculating the surrender value and calculating the profit that the insurer would make in each case. If we use the prospective basis, the profit we make depends on the basis we use. The stronger the basis we use, the larger the present value of the cashflows, and hence the larger the surrender value. The larger the surrender value is, the smaller the profits for the insurer. If we use the realistic basis then the insurer makes the same profit as if the contract had continued to the end. If we use the pricing basis with some margins, then the insurer makes the profit accrued so far. If we use the reserving basis with large prudent margins, then the insurer makes less profit than in the two cases above as the surrender value is larger. In fact, the insurer would often make a loss. A prudent reserving basis ensures that we have enough assets in reserve to pay the claims even if things go worse than expected. So although the reserve represents the assets the insurer is holding to cover the liability, it does not represent what the insurer is expecting to pay out in normal circumstances. The embedded value captures this idea by calculating the profits that will be made as the prudent margins in the reserves are released over time. I hope that has answered your question, but I appreciate that the interaction between these various factors is complex. Do let me know if you have further questions. Best wishes Mark
Thanks a lot Mark. This was indeed very helpful. It is know now, the difference between worth to a company and worth to a shareholder. Also, the graph of surrender value is much more clear. I do have a counter question: Let's say we are using the same basis for Surrender value and reserving. Both is done using prospective method. Now, will the surrender value be same as reserve at any point in time? I understand it is very unlikely that the company will use same basis in both calculations but the reason I kept it same to understand if there is any difference in methodology, apart from surrender penalty. Regards, Pulkit
Hello Pulkit The answer to your question depends on the reserving basis used and this varies between countries. In some countries, reserves are calculated using best estimate assumptions (with a large amount of solvency capital on top). In this case it would be possible to use the reserving basis to calculate the surrender value too. However, it may be considered to be unfair to the policyholder as the company will make the same amount of profit as it would have had from a contract that remained in force to maturity. In other countries, reserves are calculated using very prudent assumptions. In this case it wouldn't be suitable to use this as a basis for the surrender value calculation as the insurer would generally make a loss. One exception to this would be late in the contract term when the choice of basis makes little difference to the calculation (eg because there will be very little discounting involved). The fairest basis to use is probably a slightly prudent basis such as the one used to price the contract. In this case the insurer only receives the accrued profit. However, this basis would normally not be prudent enough to use for reserving. So although reserves and surrender values could be calculated in the same way as a prospective calculation, it is unlikely that they will use the same basis. I hope this helps. Best wishes Mark
