SP2 2017 April Question 5 (ii)

[Tong_Tong]

Could someone help me to understand why the interest rate assumptions are based on the pricing assumptions, which in turn is based on based on backing assets backing the liabilities. Why?

My understanding is that the assumptions used to calculate surrender value are most likely "realistic". As a results we do not need to use risk free rate as interest rate. We can use the yield from the assets backing the liabilities. The assets do not behave exactly like the liabilities so we adjust for credit risk??

Thanks,

Tong ​

 

[Mark Willder]

Hello Tong

I agree that we might use realistic assumptions, but we might also use pricing assumptions instead. It all depends on how much profit the insurer thinks it should make from the contract.

Section 5.2 of Chapter 21 explains this in detail. If we used realistic assumptions then the insurer would make all the profit it expected to make on the contract - this might be considered unfair as the contract has not reached the end. By using the pricing assumptions (which include a margin), the insurer will make only the accrued profit to date, which might be considered fairer to the policyholder.

The pricing assumption may then be based on the assets backing the liability with an adjustment for credit risk. Some prudence may be made in the assumption to reflect risk, eg of higher defaults or reinvestment risk.

I hope this helps to clarify the solution.

Best wishes

Mark