I'm trying to understand the SII balance sheet. Technical provisions should represent the amount that the insurance company would have to pay in order to transfer its obligations immediately to another insurance company. The technical provisions consist of a best estimate liability and a risk margin (TP = BEL + RM). (1) If the liability is hedgeable then you use the market valuation of the liability (MVL). (2) If the liability is non-hedgeable then you use the (BEL + RM) discounted at the risk free rate. a) So does TP = MVL + (BEL + RM)? b) For hedgeable liabilities, does BEL = MVL, and RM = 0 or does the meaning of BEL only apply for non-hedgeable liabilities? c) What are examples of liabilities that are hedgeable and non-hedgeable?
Hi scr123, I am doing the SA2 exam in 3 weeks too, so let me have a go at this. I agree that TP = BEL + RM But liability is always market value regardless of whether it is hedgeable or not this comes in through by using the risk free rate to discount BEL, and investment return calibrated to risk-free rates. ie: market consistent basis. (Ref: Examiner report 2012 April question 2(i)) If it is non-hedgeable, then the "buyer" is exposed to the risk of the actual experience being different to Best Estimate (BE). Hence RM component So non-hedgeable risks has explicit Risk Margins added on top of the BEL. This comes in the form of the PV (Future Capital required, subset of SCR) in the Cost of Capital approach. This PV will be discounted using the risk free rate. To answer your question, a) TP = BEL + RM. No MVL, this is included in the BEL already. b) I agree for hedgeable risks, BEL = MVL & RM = 0; For non-hedgeable risk BEL = MVL and RM =/= 0 c) I don't know the answer to this too. Can any ActEd Tutor answer us? These are my own understanding of the core reading. Happy to be proven wrong. Regards, Trevor
Yes, this is basically saying that if you have got liability cashflows which can be replicated by a financial instrument with a reliable and observable market value, the value of the TP for those cashflows = the MV of that replicating instrument. Most liability cashflows will be non-hedgeable. Some elements of the investment bond products in Section 6 of Chapter 1 would seem to be hedgeable though.
Hi Lindsay, Just want to clarify what "hedgeable" means. If we say annuity payments being indexed-linked, this can be hedged by backing it with index-linked bonds If we are taking out reinsurance, there is a risk that they will default. This risk can be reduced by out credit insurance, or opting for a deposit-back arrangement. Is this considered a "hedge"? I am asking this because when I'm analysing whether an action of an insurer will change the RM, it depends on whether the action is a hedgeable one or not. If it is, then it will not be included in the "subset of the SCR", then it doesn't increase the RM.
If we are talking now about which risks are included in the Risk Margin (ie counting as non-hedgeable), then there is a list of such risks in the Core Reading included in Chapter 11 Section 2.2. As a broad rule of thumb, market risks (except interest rate risks which are of a longer duration than the longest available swap instrument) and credit spread type risks are not included in the RM, as there are (normally) deep and liquid markets in hedging instruments for these risks. Other risks are included in the RM. [It isn't enough that something exists that can be used to hedge them, it must be possible to obtain a 'fair value' for the hedging instrument - requiring a deep and liquid market.]
