Questions on reserving

I have answered your questions in turn below. Thank you for your comments, and in particular for letting us know about some errors in the Q&A bank. We will incorporate appropriate changes into next year's course.

Mark

1. Chapter 15 page 4. "Use of a negative non-unit reserve implies a mismatching risk". Why is there a mismatching risk?

If we expect negative cashflows in the future, then we need to set up a positive non-unit or sterling reserve (SR) now. Similarly, if we expect positive cashflows in the future, then we may set up a negative SR now. The negative SR can be used to offset part of the positive SR.

Mismatching risk occurs because the negative and positive cashflows are unlikely to occur at the same time. In particular, there is a danger that the positive cashflows occur after the negative cashflows, and so we still face a future valuation strain. Hence, negative SR may be restricted to remove this risk.

2. Chapter 11 page 9. Part of the LTICR is "0.3% of the gross capital at risk". Is this meant to be "gross sum at risk"?

The sum at risk and capital at risk are the same. Capital will be required to pay the difference between the the payout and reserve if we have more deaths than expected.

3. Chapter 11 page 11. Why isn't regulatory surplus = admissible assets - (mathematical reserves + MCR). Isn't the formula given overstating the surplus in case the BCRR was higher than the LTICR + RCR?

Yes, it would be more accurate to use your formula using the MCR.

4. Q&A bank part 2 solutions page 6 first line. Why are negative policy values eliminated? I thought that negative policy values are now allowed if there is no guaranteed surrender value?

The solution is now out of date given the recent changes to regulatory-basis only life firms. Policies with no guaranteed surrender values are now permitted to have negative reserves. Without-profits discontinuance rates can now be allowed for even when this would reduce reserves.

5. Q&A bank part 2 solutions 2.10(ii)(a) on page 18. Why does the solution assume that a net premium valuation will be used when there is an option to use a net premium or gross premium valuation for without profit policies under Peak 1.

I agree, unless you are told which valuation method to use in the exam, you should cover both net and gross premium valuations. The solution is now out of date as we can make a prudent allowance for discontinuance when setting our reserves.

6. Q&A bank part 2 solution (ii)(a) on page 12. I'm not sure why investing short will reduct the RCR if a Net Premium Valuation is used. I can't quite understand the explanation regarding low volatility of statutory liabilities.

The net premium valuation is relatively insensitive to changes in the valuation basis interest rate. If we reduce the valuation basis interest rate, we increase the reserves. However, we also increase the net premium which partially offsets the increase in reserves.

A reduction in interest rates will have a smaller impact on short-term bond prices than long-term bond prices. Hence, by investing in shorter term bonds than a matched position, we reduce the volatility of the assets, so that they behave in a similar way to the liabilities.