Sept 2020

[prachi]

Hi,

I got bit confused while reading solution to Q3 in sept 2020 paper. Could you please help me to understand below excerpts and if we can tell the direction of change in BEL and own funds ?

"
The asset share will be impacted depending on the investment strategy of the conventional with profit fund… [½]
• … but the movement in the asset share is likely to match the movement in the assets baking the asset share… [½]
• However, the matching may not be exact. [½]
• Any allowance for smoothing may impact the own funds, if it is assumed that the full impact of the shock would not feed through to smoothed asset share."

Cost of guarnatee:
• It is also possible for the asset share to fall below the level of any bonuses guaranteed to date which would result in an impact to own funds. [1]
• The impact on guarantee cost will depend partly on how “in-the-money” guarantees currently are"

Also, Why the answer do not mention that decrease in interest rate would lead to increase in BEL ?

 

[Lindsay Smitherman]

Remember that WP contractual benefit = higher of {guaranteed benefits, smoothed asset share}. For WP business, the BEL will therefore approximately equal: (current) asset share + cost of guarantees + any cost of smoothing.

If investment values have fallen materially, the value of balance sheet assets will fall but the smoothed asset share (on which benefits are based) will not have fallen as much, so the BEL also doesn't fall by as much. Hence own funds are likely to be reduced.

If the asset share falls, the cost of guarantees component of the BEL will increase (this being the extra cost of guaranteed benefits over and above asset share).

The solution point about how in-the-money the guarantees are actually comes after the discussion about the guaranteed annuity rate (GAR) being impacted by the change in interest rates. The amount of this increase will partly depend on the extent to which the guarantees were or were not already 'biting'. If current interest rates are a long way from causing the GAR to bite and remain a long way out-of-the-money after the movement, the change in cost of guarantee might not be that big. Similarly if they are currently a long way into-the-money. But if the interest movement causes the GAR to move from being out-of-the-money to being into-the-money, there might be a more material change in cost of guarantee.

If you are struggling to understand solutions in the Examiners' Report, bear in mind that our ASET products provide more explanation of them.

 

[Lindsay Smitherman]

Also, Why the answer do not mention that decrease in interest rate would lead to increase in BEL ?

Lower interest rate means lower discount rate, but it also means lower rate of return at which the asset share will be accumulated within the benefit projection, and hence lower expected benefits (ignoring the separate point about impact on cost of guarantees). We are basically projecting forwards and then discounting back at the same rate (albeit a lower rate than it was before the interest rate movement) so we just get back to the same value. So there isn't the same direct impact on BEL that there is for conventional without-profits business - where we only have discounting, due to there being fixed benefits.

We can see the comparison with unit-linked business: the unit fund part of the benefit is projected forwards and discounted at the same risk-free rates, therefore is just held at current fund value (= the unit reserve part of the BEL), irrespective of the level of interest rates.