Q&A bank 2.3 (ii)

Discussion in 'SA2' started by scarlets, Apr 1, 2012.

  1. scarlets

    scarlets Member

    The question and answer for Q&A bank 2.3 (ii) makes no sense to me. Please explain what section of the notes it is referring to & what this question is trying to get us to understand.
     
    scarlets, Apr 1, 2012
    #1
  2. scarlets

    scarlets Member

    For Q&A 2.4, again what material is this based on? I ask as with a cut-down discussion on the regime before S2 I'm not sure the material left in the notes helps us to answer a question as detailed as this. Same comments for Q&A 2.8 (i) & (ii)
     
    Last edited by a moderator: Apr 1, 2012
    scarlets, Apr 1, 2012
    #2
  3. scarlets

    scarlets Member

    I don't quite understand why matching a without-profit liability with an equity rather than a bond means the valuation rate of interest reduces? Doesn't this mean you need more equities to match a without profit liability than you would if you had bonds? Doesn't make sense to me, as equities have better expected return. Confusing.
     
    scarlets, Apr 1, 2012
    #3
  4. Mark Willder

    Mark Willder ActEd Tutor Staff Member

    This question is testing the first bullet point on page 8 of Chapter 11 which states:

    "Valuation rates of interest cannot exceed 97.5% of the risk-adjusted yields on the backing assets (“risk-adjusted” means having reduced the yield on the backing assets to allow for the risk of default). "

    The key thing to understand is that the insurer is free to choose its own valuation rate subject to this maximum and that a wide range of approaches can be used. It is usually most efficient to hypothecate assets to certain liabilities in order to reduce the overall liabilities.

    This question has been discussed in thread "Q&A Bank 2" by Avviey, and was last updated on 20/1/12.

    Yes, some material has been cut on the FSA solvency regime, although the missing material is not relevant to these questions.

    Both of these questions look at how to perform valuations, in particular the monitoring process and assumptions required. Hopefully you can have a reasonable bash at these questions using your knowledge of ST2. However, we return to the topic of assumption setting in Chapter 28.

    The reason goes back again to the first bullet point on page 8 of Chapter 11 which states:

    "Valuation rates of interest cannot exceed 97.5% of the risk-adjusted yields on the backing assets (“risk-adjusted” means having reduced the yield on the backing assets to allow for the risk of default). "

    The ActEd text goes on to explain further:

    "For equities it is the dividend yield (if the dividend yield is more than the earnings yield) otherwise it is the average of the earnings yield and the dividend yield."

    So, I agree that equities have a higher expected return, but the dividend yield on equities is usually lower than the return on bonds. We then need to reduce the yield further to allow for the higher risk of equities.

    So the outcome is that we use a lower valuation interest rate if we invest in equities than bonds. Hence, as you suggest, we need to back the liabilities with a greater amount of equities than bonds.

    This is reasonable given the cautious nature of the FSA returns. By holding a high market value of equities the policyholders are protected to some extent from a fall in equity values.

    Best wishes

    Mark
     
    Mark Willder, Apr 10, 2012
    #4
  5. scarlets

    scarlets Member

    I struggle to tie this logic in with what's taught in the what, previous 14 subjects.

    For a company, then to back a liability to be given a choice to hold less in bonds or more in equities then surely it's a no-brainer to hold more equity if you can. Then why bother holding any government bonds unless you had to.

    How can this be good for policyholders given the more volatile nature of equities? Surely policyholders are better protected with a company that holds mostly govt bonds compared to a company holding mostly equities.

    And why diversify your equity holding anyway. If you buy equities in company X with a very high default risk, then you do your risk-adjusted thing meaning you can hold even more of it. This would seem to encourage companies to hold more risky assets.

    Also when stock markets crash aren't companies supposed to sell equities and buy bonds.

    Confusing.
     
    scarlets, Apr 11, 2012
    #5
  6. scarlets

    scarlets Member

    To be frank, section 5 & 6 from chapter 25 onwards of this course does look like making up the numbers. If this is mainly ST2 material then why not examine it there and be done with it? As it doesn't look like much of this is examined in SA2 anyway so why include these chapters.
     
    scarlets, Apr 11, 2012
    #6
  7. scarlets

    scarlets Member

    Expanding on this one.

    Say a liability can be backed by equities worth 150 or bonds worth 120, say.

    Currently you hold the 120 bonds. Then you decide that's too boring, not enough return for shareholders. So you sell 120 bonds and buy 150 worth of equities.

    How can you then say this is equivalent protection for policyholders as you've had to take 30 from company free assets to buy the more volatile equities. Surely that is less security for policyholders as your free asset ratio is damaged & investments backing their liabilities are more volatile.
     
    scarlets, Apr 11, 2012
    #7
  8. scarlets

    scarlets Member

    Noting that this is the 'old' regime.

    For S2, the notes say you discount liability cash-flows with risk-free rate (allowing for illiquidity premium). No adjustments there for whether you back that asset with an equity or a bond (apart from illiquidity adj?)

    Doesn't S2 mean less protection compared to old regime? As if the risk-free rate is 4% say and dividend yield is 2% then under S2 you would discount at higher rate hence lower reserves?
     
    Last edited by a moderator: Apr 11, 2012
    scarlets, Apr 11, 2012
    #8
  9. Mark Willder

    Mark Willder ActEd Tutor Staff Member

    You're missing a key point here. If an insurer wants to hold a large quantity of equities it will need to raise capital to allow it to do this (or have a substantial free estate).

    An example may help. Consider a liability to pay 104 in one year's time. If the risk adjusted yield on bonds is 4% then this liability can be backed by 100 in bonds.

    Alternatively the insurer could back the liability with equities. Lets say these have a risk adjusted yield of 2%. The liability can then be backed by 101.96 in equities.

    So the shareholders are faced with a choice. Either supply enough capital to cover a liability of 100, or supply more capital to cover 101.96. The shareholders will generally want to supply as little capital as possible, so they'll opt for the bond investment. Once we add in the impact of the RCR or RCM the difference between the required capital becomes much greater.

    That's the point of free assets - they offer greater investment freedom. In your example the insurer has opted to use the free assets to invest in equities that offer a higher expected return. If equity values fell by 30, the insurer would still be able to switch into bonds and remain solvent.

    Now consider an insurer with less free assets. Say the total assets are only 130. They would be unable to switch into equities as you suggest without a capital injection from shareholders.

    The FSA will be equally happy with both insurers as they both meet its regulations. The first insurer has a more risky investment strategy but has greater assets. The second has a safer strategy but lower free assets.

    Yes, for Solvency II the liabilities are discounted at the risk-free rate. However, SII has a much more advanced mechanism for evaluating market risk through the SCR than the very simplistic approach uses in Peak 1 (through the risk adjusted yield and RCR).

    Best wishes

    Mark
     
    Mark Willder, Apr 12, 2012
    #9

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