Sept 2020- Q3

[1495_sc]

Part i) Impact on assets is quite straightforward,

Risk margin and SCR is also ok.

BEL- I understand why BEL for with profits will be Asset share+ Cost of guarantee. This was also a question in Sept'22 paper.

However, while explaining BEL impact, wouldn't we typically consider just the fall in interest rate (hence higher BEL, like without profit policies)? Instead of breaking BEL into asset share and COG.

None of the remaining stresses will affect BEL directly hence only interest rate risk is relevant.

Typically, when we assess BEL impact,

UL BEL= impact on unit reserve and impact on non unit reserve
Non UL and non annuity BEL= PV of benefits + PV expenses - PV premium
Annuity BEL (immediate only)= PV of benefits +PV of expenses

For with profits, PV of benefits includes guaranteed bonus and assumption about future reversionary and terminal bonus.

Why not break the impact in this manner instead of with profits BEL= Asset share + CoG (difficult to come up with under exam conditions, unless Core Reading mentions this)?

 

[1495_sc]

ii) charges (to asset share) will be easier to increase on CWP compared with AWP. Why would this be? I thought AWP has more variable charges hence insurer has more discretion to increase charges.

 

[Lindsay Smitherman]

Part i) Impact on assets is quite straightforward,

Risk margin and SCR is also ok.

BEL- I understand why BEL for with profits will be Asset share+ Cost of guarantee. This was also a question in Sept'22 paper.

However, while explaining BEL impact, wouldn't we typically consider just the fall in interest rate (hence higher BEL, like without profit policies)? Instead of breaking BEL into asset share and COG.

None of the remaining stresses will affect BEL directly hence only interest rate risk is relevant.

Typically, when we assess BEL impact,

UL BEL= impact on unit reserve and impact on non unit reserve
Non UL and non annuity BEL= PV of benefits + PV expenses - PV premium
Annuity BEL (immediate only)= PV of benefits +PV of expenses

For with profits, PV of benefits includes guaranteed bonus and assumption about future reversionary and terminal bonus.

Why not break the impact in this manner instead of with profits BEL= Asset share + CoG (difficult to come up with under exam conditions, unless Core Reading mentions this)?

You could attempt to tackle this type of question by considering the BEL as PV guaranteed + PV discretionary, but I think that would make it harder to assess the impacts correctly.

We need to consider more than just the interest rate change. For example, a fall in the value of equities would cause the value of assets backing asset shares to fall (to the extent to which these are invested in equities) and an equivalent fall in the value of the unsmoothed asset share, which would therefore offset on the overall balance sheet. However, the cost of smoothing and the (market-consistent) cost of meeting guarantees would both increase, thus increasing the BEL and having a negative impact on the balance sheet. [Unless there were some derivative hedging in place.]

There is a similarity between WP business and {UL business with a guaranteed minimum benefit}. The asset share is like the unit reserve component, albeit with the additional complication of smoothing. Falls in the value of equities would make it more likely that the guarantees under either a WP contract or a {UL contract with guaranteed minimum benefit} to bite, hence increasing the BEL.

 

[Lindsay Smitherman]

ii) charges (to asset share) will be easier to increase on CWP compared with AWP. Why would this be? I thought AWP has more variable charges hence insurer has more discretion to increase charges.

There are no explicit charges in the product terms for CWP business. Deductions from asset share are completely within the insurer's discretion (subject to meeting PRE).

For UWP business, charges are more likely to be explicit within the product terms and may be fixed.

 

[1495_sc]

Thank you!

 

[prachi]

Q1
Ch 20, section 2.1 mentions that
Depending on how the actual bonus rate declared compares with expected level of regular bonus allowed for reserves, the company may experience a change in it's free asset.
Could you please explain how through example ?

Q2
Let's say if regular bonus declared and equivalent to the expectations (lets assume this is bcs of the actual asset performance which is equal to expected return of assets backing the with profit funds), then what will be movement in balance sheet?
What i can think is
1. Increase in Asset side of balance sheet by actual amount of investment return
2. If we take BEL as unsmoothed AS + COG, then there would be Increase in unsmoothed AS ( if actual return on investmentis used to compute AS) and this is equivalent to change observed in point 1.
Secondly, what about COG ? would it increase as bonus declared and therefore more guaranteed payouts OR it would be unchanged as both unsmoothed AS and BEL are increasing by same amounts?

Q3
How the components of balance sheet would change and therefore impact on surplus, if the bonus are higher than expected because the asset return is higher than expected.

Q4.
Chapter 20, section 2.1 mentions
"Both guaranteed and discretionary benefits are included in SII TP, increasing the guaranteed components relative to discretionary will likely increase BEL due to value of Cost of guarantee. "
I don't understand this clearly. BEL can either be determined as PV of guaranteed benefits +PV of discretionary (as also mentioned in chapter 11)
OR PV of unsmoothed AS + COG
Aren't the paragraph, mixing two approaches?

Q5.please explain : increasing guaranteed benefits relative to discretionary would lead to increase in SCR and RM

 

[prachi]

Q6. Is terminal bonus included in TP ?

 

[Lindsay Smitherman]

Q6. Is terminal bonus included in TP ?

Yes

 

[Lindsay Smitherman]

Q1
Q4.
Chapter 20, section 2.1 mentions
"Both guaranteed and discretionary benefits are included in SII TP, increasing the guaranteed components relative to discretionary will likely increase BEL due to value of Cost of guarantee. "
I don't understand this clearly. BEL can either be determined as PV of guaranteed benefits +PV of discretionary (as also mentioned in chapter 11)
OR PV of unsmoothed AS + COG
Aren't the paragraph, mixing two approaches?

Under Solvency II, the BEL for with-profits business has to be presented as two separate components: the part that relates to guaranteed benefits and the part that relates to discretionary benefits.

The BEL for WP business approximately equates to the current asset share plus the (market-consistent) cost of guarantees.

 

[Lindsay Smitherman]

Q1
Ch 20, section 2.1 mentions that
Depending on how the actual bonus rate declared compares with expected level of regular bonus allowed for reserves, the company may experience a change in it's free asset.
Could you please explain how through example ?

If the actual bonus declaration is higher than was previously anticipated in the BEL, the new BEL will have to reflect the higher level of guaranteed benefits, therefore the market-consistent 'cost of guarantees' component of the BEL will increase (more likely that the guaranteed benefits will bite).

 

[Lindsay Smitherman]

Q1
Q2
Let's say if regular bonus declared and equivalent to the expectations (lets assume this is bcs of the actual asset performance which is equal to expected return of assets backing the with profit funds), then what will be movement in balance sheet?
What i can think is
1. Increase in Asset side of balance sheet by actual amount of investment return
2. If we take BEL as unsmoothed AS + COG, then there would be Increase in unsmoothed AS ( if actual return on investmentis used to compute AS) and this is equivalent to change observed in point 1.
Secondly, what about COG ? would it increase as bonus declared and therefore more guaranteed payouts OR it would be unchanged as both unsmoothed AS and BEL are increasing by same amounts?

Q3
How the components of balance sheet would change and therefore impact on surplus, if the bonus are higher than expected because the asset return is higher than expected.

I think you are over-complicating things here and need to separate out the impact of a bonus declaration being higher than expected and the impact of investment returns being higher than expected.

Just declaring a regular bonus of 1% rather than the expected 0.5% has no direct impact on assets, but the BEL will increase (as noted above) due to the higher COG. [And similarly SCR and possibly RM per next question ...]

 

[Lindsay Smitherman]

Q5.please explain : increasing guaranteed benefits relative to discretionary would lead to increase in SCR and RM

Increased level of guaranteed benefits -> increased market risk -> higher SCR

There might also be an increase in insurance risk, to the extent that guaranteed death benefits are increased. This would also contribute to a higher SCR ... and could also mean a higher RM.

 

[prachi]

I think you are over-complicating things here and need to separate out the impact of a bonus declaration being higher than expected and the impact of investment returns being higher than expected.

Just declaring a regular bonus of 1% rather than the expected 0.5% has no direct impact on assets, but the BEL will increase (as noted above) due to the higher COG. [And similarly SCR and possibly RM per next question ...]

Hi Lindsay,
Thank you for answering my questions.
I have one follow up query.
Basically I am trying to understand impact on analysis of surplus in WP business.
If bonus declared is same as expected, then how will it impact change in surplus from t1 to t2?
If not impact then why no impact?

 

[prachi]

Under Solvency II, the BEL for with-profits business has to be presented as two separate components: the part that relates to guaranteed benefits and the part that relates to discretionary benefits.

The BEL for WP business approximately equates to the current asset share plus the (market-consistent) cost of guarantees.

Hi,
Ithanks you for the reply. If a company decides to increase bonus in the future then discretionary component will increase and therefore Bel would increase.
But if cosider the other approach of bel calculation i.e. AS + COG , then how this will impact the these components ?

 

[Lindsay Smitherman]

Hi Lindsay,
Thank you for answering my questions.
I have one follow up query.
Basically I am trying to understand impact on analysis of surplus in WP business.
If bonus declared is same as expected, then how will it impact change in surplus from t1 to t2?
If not impact then why no impact?

If any item of experience (whether investment returns, mortality, expenses, bonus rates etc) turns out to be the same as is expected in the liability valuation basis then, by definition, there is no surplus arising from that item.

 

[Lindsay Smitherman]

Hi,
Ithanks you for the reply. If a company decides to increase bonus in the future then discretionary component will increase and therefore Bel would increase.
But if cosider the other approach of bel calculation i.e. AS + COG , then how this will impact the these components ?

Not completely sure what you mean here by 'increase bonus in the future' - need to be very careful with expressing these ideas. For example, the company might already be expecting to increase its future RB rates within its BEL calculation (which will allow for expectations of future RB rates).

If a company declares a higher RB than it was expecting to, then the guaranteed benefits (which include declared RB) will be higher than expected, but the value of future discretionary benefits will be lower, all else being equal. This is because the company will still aim to pay out asset share at maturity, so if accrued RB is higher, eventual TB will be lower. (It won't be an exact offset: the BEL overall will be slightly higher due to the higher time value of the inherent guarantees - higher RB means that the guaranteed benefits are now a little more likely to 'bite' at maturity.)

If the company is recalculating its BEL on a higher expected future RB rate than previously, the BEL overall will similarly increase only slightly because future TB expectations will reduce (all else being equal) so that asset share continues to be paid out. The increase is, as above, due to a higher value of COG.

AS + COG is not another 'approach of BEL calculation', it's an approximation of what the BEL equals for WP business. AS is unchanged, COG will increase slightly by the higher time value of the inherent guarantee (as above).

 

[Tong_Tong]

There are no explicit charges in the product terms for CWP business. Deductions from asset share are completely within the insurer's discretion (subject to meeting PRE).

For UWP business, charges are more likely to be explicit within the product terms and may be fixed.

The answer for question part (ii) mentions that a decision will be made on how the charges for GAR will need to be split. In this case how would it work? Let’s say the fund is a 90:10 fund. Say the expected cost of GAR is roughly £100, does that mean £90 will be deducted from the asset share calculation and this will be the policyholder’s share of the GAR cost, and the other £10 will just be deducted from the insurers Profit and loss company account itself and this will be the shareholder’s share?

 

[Lindsay Smitherman]

This relates to a company that is potentially facing a significant increase in the actual cost of guarantees, so it needs to consider how it will cover that extra cost. Will it be met through increased charges to the asset shares? From the estate? Will shareholders be required to contribute towards the extra cost, particularly if the estate would not be sufficient to meet it? If it is charged to asset shares, how will it be split between WP p/hs, eg charging more to those with a higher chance of the guarantee biting?

If the estate (including guarantee charges deducted) were not sufficient to meet the extra cost and shareholders were required to step in, they could do this either by paying the extra cost directly, by not taking their normal shareholder transfers out of the fund and/or by injecting additional capital into the WP fund.

In 'normal' circumstances (ie ignoring the fact that the actual cost of guarantees is expected to be high in this question scenario) if a charge of 100 is deducted from an asset share, this will result in an eventual reduction in TB of 90 and a reduction in related shareholder transfer of 10. However, since that charge of 100 would fall into the estate, and shareholders 'own' 10% of the estate in a 90:10 fund, they haven't lost that money as yet. All that has happened when we deduct a charge from asset share is that asset shares reduce and the estate increases by the same amount (unless it's a direct charge to shareholders - but that's a different type of arrangement, such as under an expense deal). But then if there is an actual cost of guarantee of 100 incurred, this will be paid out of the estate, so the shareholders' share of the estate will fall by 10 and they have effectively therefore paid 10% of that actual cost.

[It is important to keep the concepts of charges and actual costs distinct.]

 

[prachi]

You could attempt to tackle this type of question by considering the BEL as PV guaranteed + PV discretionary, but I think that would make it harder to assess the impacts correctly.

We need to consider more than just the interest rate change. For example, a fall in the value of equities would cause the value of assets backing asset shares to fall (to the extent to which these are invested in equities) and an equivalent fall in the value of the unsmoothed asset share, which would therefore offset on the overall balance sheet. However, the cost of smoothing and the (market-consistent) cost of meeting guarantees would both increase, thus increasing the BEL and having a negative impact on the balance sheet. [Unless there were some derivative hedging in place.]

There is a similarity between WP business and {UL business with a guaranteed minimum benefit}. The asset share is like the unit reserve component, albeit with the additional complication of smoothing. Falls in the value of equities would make it more likely that the guarantees under either a WP contract or a {UL contract with guaranteed minimum benefit} to bite, hence increasing the BEL.

Que 1
So as an approximation we can consider BEL as unsmoothed asset share + cost of guarantee + cost of smoothing
Is it correct?

Que 2
Can this cost of smoothing be negative sometimes if we use above formula? For eg , if unsmoothed AS is 1000$
Guarantee is $650
And smoothed asset share is $800
How does the BEL look like. Assume that company payout maximum of guarantee or smoothed AS?

 

[Lindsay Smitherman]

For conventional business, BEL = PV { Future benefits + future expenses - future premiums }
For WP business, benefit = max { smoothed asset share, guaranteed benefits }
Inputting that into the above gives the approximation that BEL = current unsmoothed asset share + cost of guarantees + cost of smoothing (although in practice companies might combine the latter two items, ie absorb the third into the second)

Yes the cost of smoothing could be negative - but bear in mind that the longer the outstanding duration of a policy, the less likely there is to be any material 'cost of smoothing', since by the time the benefits have been projected forward to the payment date, the smoothed and unsmoothed values will have trended back towards each other. [If there is a material discrepancy between smoothed and unsmoothed asset shares at present then this must be due to a significant (and relatively recent) market movement; over the next few years the smoothing mechanism allows the company to gradually bring the smoothed asset share to be closer to the actual (unsmoothed) asset share, so there would be very little (if any) 'cost of smoothing' at the benefit date, which is what is relevant to the BEL calculation.]