Release of Reserves

[Ambitious]

I have quite often read that if the reserves are established on a prudent basis, the future profits are realised as ‘Release of reserves’ as the experience turns out realistic. We know that for endowment products (or any other saving product); the reserves increase every year as we approach the maturity...so actually there is no release of reserves but in fact escalation of reserves!!

If I understand it correctly, this can be interpreted as - the increase in reserves/liabilities is lesser than it would have been under realistic assumptions. Since we have realised better/realistic experience (in terms of investment return and high premium), we have made profit because the increment in reserves is lesser than this actual realisation.

Am I correct on this?

 

[jashworth]

I think you are a little muddled. The comparison is between the experience assumed when setting the prudent reserves and the actual/realistic experience.

The reserves continue to be set at prudent levels but there are fewer death claims as actual mortality is lighter than the prudent mortality assumption in the reserving basis. (this is for endowments). So the difference between the reserves held to meet the death claims and the actual death claims in a year is released contributing to profit.

Also the reserving basis will use a low valuation interest rate. As actual investment returns turn out to be higher than this an increase in reserves from one year to the next can be met from this higher return and no extra capital is needed from the shareholders. In effect the interest earnt on the reserves is higher than the prudent assumption.

The other source of profit I can think of is the office's expenses which will be set at prudent (high) levels in the reserving basis but will hopefully turn out to be lower than this in actuality.

By holding reserves higher than we realistically expect to need means that any improvement in the actual experience as it unfolds is a source of profit.

I hope this helps.

 

[Ambitious]

Thanks for the reply.