Q&A Bank2

[Avviey]

Hi,

For part ii) of Q2.3:

1. What does "hypothecating assets" mean?

2. One of the course of actions in answer to slightly higher valuation rate for NP business than overall maximum allowed under the FSA rules is to increase the rate used for NP liabilities by allocating high yielding assets to NP business. Shouldn't it decrease the rate used for NP business as we knew it had higher valuation rate already... Im confused here.

Thanks so much again if anyone can help.

 

[Mark Willder]

Hi,

For part ii) of Q2.3:

1. What does "hypothecating assets" mean?

This means allocating different assets to different types of business, but only for the purpose of calculating the interest rate to use in the reserves. The assets have been hypothetically allocated, but the reality is that the assets are held in a single fund for the benefit of all business types.

The purpose of hypothecating assets is to find the assets which give the highest allowable interest assumptions for each type of business and hence the lowest reserves.

2. One of the course of actions in answer to slightly higher valuation rate for NP business than overall maximum allowed under the FSA rules is to increase the rate used for NP liabilities by allocating high yielding assets to NP business. Shouldn't it decrease the rate used for NP business as we knew it had higher valuation rate already... Im confused here.

The question proposes that we use last year's interest assumption. However, this is higher than the maximum allowed under the FSA rules. But by hypothecating assets in a smarter way we may be able to recalculate a higher maximum number (which may be higher than our desired interest assumption).

Best wishes

Mark

 

[Avviey]

Thank you Mark.

For the 2nd question, did it mean the company couldnt use last year's basis as it was higher than the maximum allowed, however in order to arrive at a high interest rate allowed under FSA rules, hypothecation was used?

 

[Avviey]

Q&a 2.4

Hi, for this question, it mentioned average premium basis for mortality investigation, I wonder why this is needed. Same as for interest, average premium bases are incldued too.

Sorry I forgot to ask earlier. Thanks so much again for the help.

 

[Mark Willder]

For the 2nd question, did it mean the company couldn't use last year's basis as it was higher than the maximum allowed, however in order to arrive at a high interest rate allowed under FSA rules, hypothecation was used?

The FSA doesn't work out the maximum interest rate. Instead, it leaves the company to calculate what it thinks the maximum is (and then of course the FSA checks this is legal). However, if the company calculates the maximum interest rate to be lower than the true maximum then the FSA won't correct it.

In this case we think that the company has perhaps initially calculated the maximum interest rate without hypothecation. Last year's assumption cannot be used as it is above this maximum.

However, by using hypothecation the company will calculate a higher maximum rate. This may be high enough to allow last year's assumption to be used.

Best wishes

Mark

 

[Avviey]

Thank you. I got it.

In this case, I just wonder what the relationship is between valuation interest rate and the overall maximum allowed as both are calculated by the company? ie. on one hand, it calculates valuation interest rate, on the other hand, it calculates overall maximum rate. Could it be the underlying assets on which these two rates are based (eg. hypothecation) or the margins that differentiates they two?

 

[Mark Willder]

In this case, I just wonder what the relationship is between valuation interest rate and the overall maximum allowed as both are calculated by the company? ie. on one hand, it calculates valuation interest rate, on the other hand, it calculates overall maximum rate. Could it be the underlying assets on which these two rates are based (eg. hypothecation) or the margins that differentiates they two?

Yes, the company calculates both its valuation interest rate and the maximum allowed interest rate, but I think hypothecation is unlikely to be the difference between the two.

The choice of the actual valuation interest rate will depend on how strong the insurer wants their basis to be. Using the maximum interest rate would mean using the weakest allowable basis. Many companies might prefer stronger reserves, eg because it gives a positive impression of the company to show that they are solvent even on a stricter basis.

The basis should not be changed for arbitrary reasons and it is desirable to maintain a comparable level of strength in the basis from year to year. So companies that have traditionally set their valuation basis to be stronger than the maximum will want to continue to do so.

Best wishes

Mark

 

[scarlets]

The purpose of hypothecating assets is to find the assets which give the highest allowable interest assumptions for each type of business and hence the lowest reserves.

Can we deduce form this that this regime gives 'credit' to firms for matching assets to liabilities in the form of higher valuation rate hence lower reserves ?

Is there such a 'credit' given under S2 for hypothecating assets? As it seems liabilities are discounted at risk-free rate adj for illiquidity. So where would the lower reserves come from under S2 for firms who match closely?

 

[Mark Willder]

Can we deduce form this that this regime gives 'credit' to firms for matching assets to liabilities in the form of higher valuation rate hence lower reserves ?

Yes

Is there such a 'credit' given under S2 for hypothecating assets? As it seems liabilities are discounted at risk-free rate adj for illiquidity. So where would the lower reserves come from under S2 for firms who match closely?

Solvency 2 gives credit for closer matching through less onerous stress tests and hence a lower SCR.

Best wishes

Mark

 

[scarlets]

Thanks Mark