Ok major brainfreeze here - I know this probably belongs in an early CT thread. I believe that.... Higher valuation rate of interest means improved solvency hence we reduce it for prudence if needed. Looking at our solvency we have A, L and our A-L (also mismatches such as cost of guarantees etc). A and L should offset perhaps the effect on L dominating due to any mismatching in term although this effect should be small if matched correctly (generally increasing i reduces future L however we will also see a corresponding reduction in A ignoring mismatches). The A-L will increase with valn i. The cost of guarantees will reduce (this being one of our mismatches). The more significant factor of the latter 2 will depend on their relative sizes but we can assume in most cases the A-L factor is more significant. Is this all correct ie are we just considering the effect of the valn i on the free assets? I'm ignoring capital requirements here as I'm just looking for a simple overview also I'm not assuming its a WP fund. Thanks
I think you are muddling two things together here. The valuation rate of interest depends on two things: the return on the underlying assets (largely the dividend yield and gross redemptrion yield) and the margin for prudence. A low yield will lead to a high value for both assets and liabilities. As you say, if you are well matched then the impact of changes in this yield will cancel out. If your liabilities are longer than your assets, then an increase in yields will cause the liabilities to fall faster than your assets. So a high yield may be good for solvency in that sense. However, if your free assets are invested in bonds then a high yield will reduce their value. For a given yield, the bigger the margin in the valuation basis, the lower the valuation interest rate. So if margins go up, valuation interest will fall, liabilities will rise, but there will be no corresponding change in assets. I hope this makes clarifies what's going on with interest rates. Best wishes Mark
Thanks Mark I am still stuck on this: You say valn i ~ f (return on backing assets, margin for prudence) where the margin for prudence is a negative adjustment to valn i This I get. I'm getting stuck on understanding how the relative solvency position of A - L is changing with the use of a common factor (being applied to both A and L projections) ignoring the obvious effect on A - L. Do we incorporate the prudent margin in A also? Are we comparing projected A v projected L or are we comparing current mv of A vs projected L in a solvency projection? I am presuming it is the former. Can you maybe explain where exactly the valn i is being used i.e. which cashflows maybe that will help me sort out whats going on? Are we using different rates to project back as opposed to forward? I really should have kept my ST2 notes thanks again
Ok think its after hitting me. We are comparing mv of A vs. projection of L. Using a higher valn i reduces future L and so increases A - L and so improves our solvency. I think I was getting lost in the subtlety of "improves the solvency" as worded in the solutions when its really "improves the perceived solvency" or at least that makes it easier for me to understand in my head. Have I gone down another blind alley or is this correct?
