Hi I'm a bit confused about the relationship between VIF (value in force or present value of future profits) and statutory reserves. I had always thought that there was an inverse relationship between the two, ie when VIF goes up then reserves reduce as these reserves have been released as profits. But looking at it in a different way, if we held larger reserves, then our VIF will also be larger right, since eventually these larger reserves would all be released as profits. So this would imply that reserves and VIF are not inversely related as larger reserves lead to larger VIF. Have I got this wrong? Which leads to my next question - if larger reserves lead to larger VIF, then wouldnt this imply that life companies are better off just holding unnecessarily large amount of reserves as this would just get released as profits in the future? Or does this not happen due to the cost of capital of holding large reserves? Greatly appreciate any help in clearing my confusion. Thanks Razen
I'll give this one a go but more than happy for any additional input. 1. One way to think about this is to view statutory reserves as the sum of realistic reserves and VIF. VIF therefore represents the release of prudence in the stat reserves. An increase in stat reserves (e.g. from increasing the stat expense basis) will increase VIF. This is because the assets distributable to shareholders would have increased. Equivalently, a reduction in stat reserves will decrease VIF. 2. Although higher reserves leads to a higher VIF as the prudence is released the change in reserves and change in VIF is unlikely to be one-for-one (ignoring market-consistent ideas). The direction will depend on the investment return assumption relative to the risk discount rate used to determine VIF. For example, if the rdr is bigger than the investment return assumption, then an increase in reserves will reduce net assets by more than the increased VIF (hence EV will fall). The total amount of profits generated from the business/product isn't affect by all of this - only the timing that those profits are recognised. It's best to try to understand the relationship between vif and net assets by thinking through the impacts from first principles rather than by hard and fast rules. I hope the above clears things up.
The reserves do not affect the absolute amount of profits released but the timing.Due to deferment of profit releases the VIF would fall as reserves increases. Am i right ? Can Acted tutors help to clarify if i am wrong.
All other things being equal, yes, this is right. However, if we go deeper, then changing reserves might change investment strategy, for example, which is likely to change the absolute amount of profit. The same will be true for other management actions that would be affected by the level of reserves. You're partially right assuming you mean EV rather than VIF (it's important to consider the affect on free surplus as well as on VIF). See mugono's point 2 for more on this. You need to consider the greater earnings on reserves as well as the deferment aspect, so the overall impact could, in theory be in either direction. For traditional EVs, the deferment would be more significant since (RDR > return on reserves), but for market-consistent methodologies, they could be broadly the same. If frictional costs are taken into account, then increasing reserves will still lead to a fall in EV.
