Sep2011 Q2(iii)

[loadingr]

Question: A 40% drop of the equity market value, which used to back the with-profit fund. Asked to analysis the impact on Pillar I balance sheet.

In the Examiner's Report, it is said that "the equity stress to be applied in RCM is likely to be reduced, since the stress will be based on the average level of equity markets over a previous period rather than just on the current low level. However, there could be some offset from a higher volatility assumption."

I don't really understand the explanation here. If the equity stress were to be reduced, shouldn't it be because that the stress is applied on a lower current level, or say lower average level? Also, how can it be offset by a higher volatility assumption?

Many thanks!

 

[scarlets]

From what I've seen, they just stress equity market value down by by 20% or whatever, regardless of current MV.

I don't mean to hijack your question but want to ask the following: am wondering what happens under the old regime when equity MV drops 40% ? Doesn't this lead to higher equity div yield therefore reserves calculated with higher rate so required reserves are smaller? As it would seem very odd to need to hold less after an equity crash.

 

[loadingr]

Hi, Scarlets.

I think you are right saying the equity div yield will increase therefore reserve discounted at a higher rate so becomes smaller. This is because Peak 1 is essensially just a present value of future guaranteed liabilities.

While Peak 2 reserve has much more complicated movemets going on (increase in CoG while decrease in AS) so it's hard to say which direction it will go. And combining the two peaks, the movement on total capital requirement depends on which peak will bite.

Something more intuitive rather than theoritical, I think after a big crash in asset values, if the reserve remains the same or even increases, there will be a higher chance that the fund becomes insolvent. Although not always the case, the liability value does move in line with the asset value to some extent.

 

[Mark Willder]

Question: A 40% drop of the equity market value, which used to back the with-profit fund. Asked to analysis the impact on Pillar I balance sheet.

In the Examiner's Report, it is said that "the equity stress to be applied in RCM is likely to be reduced, since the stress will be based on the average level of equity markets over a previous period rather than just on the current low level. However, there could be some offset from a higher volatility assumption."

I don't really understand the explanation here. If the equity stress were to be reduced, shouldn't it be because that the stress is applied on a lower current level, or say lower average level? Also, how can it be offset by a higher volatility assumption?

The relevant stress test under the RCM is a fall or rise in the market value of equities of at least 10% and no more than 20%, depending on the average level of the FTSE All Share Index over the previous 90 days relative to its current level.

The 90-day rule was designed to provide some stability in falling markets and as a result the required further fall to be considered under this stress is likely to be lower than before. So the RCM is likely to be lower then before.

The change in volatility assumption that the Examiner's Report is referring to impacts on the future policy related liabilities. If equity volatility is assumed to increase following this sudden change in market values, then the time value of the guarantees valued in the FPRL will increase.

Best wishes

Mark