Hi there, I was wondering if someone would clear this up for me. I know the general idea is around: Regulation prohibits the discounting of future claims reserves. Here we are making Reserves look like Annuity Payments, and we can therefore discount them... We want to improve the apparent accounting position of the cedant. But does the above not imply that we are shrinking assets (reserves?)...?? The core reading seems to contradict the acted reading here..hence my confusion. Any help would be great. Thanks Sarah
You do know that reserves are liabilities, not assets, right? You need to hold assets to meet those future liabilities (i.e. to pay the claims for which you have reserved). If you use the assets backing the reserves to buy a discounted product (like an annuity), your assets can be less than the nominal value of your liabilities. Your reserves haven't changed (because they're based on your claims liabilities), but the assets you need to meet them have reduced. Hey presto, the balance sheet looks a bit better.
Sarah, I wonder whether the problem here is that the term "reserves" is being used to mean two different things. So let's start by making a distinction between claims provisions, i.e. balance sheet liabilities in respect of future claims, and capital, i.e. the excess of the assets over the liabilities. Now the claims provisions will consist of a positive gross claims provision and a negative provision for reinsurance recoveries, giving a total net claims provision. Let's suppose for simplicity's sake that we have no reinsurance other than this time-and-distance deal. On a balance sheet where discounting of claims provisions is not allowed, we enter the full undiscounted gross claims provision. The effect of the time-and-distance deal is then as follows. The undiscounted reinsurance recoveries are equal to the undiscounted gross claims provision. So, since we are not discounting claims provisions, the provision in respect of reinsurance recoveries is equal to the negative of the gross claims provision. Now obviously we have to pay for this reinsurance, but the amount we are paying is equal to the discounted gross claims provision, which is naturally smaller than the undiscounted provision. Therefore the assets are decreasing by an amount equal to the discounted gross claims provision but the liabilities are decreasing by an amount equal to the undiscounted gross claims provision. Still with me? Therefore the balance sheet capital increases by an amount equal to the difference between the undiscounted and discounted gross claims provisions, thereby improving the apparent solvency position. Make sense?
