Hello, I am struggling to understand Virtual Capital as explained in the core reading. Please could you help with the questions below on Virtual Capital? 1- The core reading says: 'A block of capital is chosen and that part of the liability relating to policies of the longest term is reinsured'. Why only the part of the liability relating to the longest term is reinsured? Does this means that the rest of the business is not insured? 2- The core reading says: ‘Reinsurance cover is written off using surpluses within the insurer as they arise. Typically, the reinsurance cover will be increased each year with interest and written down by a pre-determined amount over, say 5 to 7 years’. How does this work in practice? Why does the insurer reduce the reinsurance cover when the surplus emerges? 3- What cash flows takes place? What changes to balance sheet in terms of changes to reserves, assets and liabilities takes place? Is the impact on regulatory and realistic balance sheet the same? Regards
Yes, this means that the rest of the business is not reinsured. Only the longest liabilities are reinsured. Virtual Capital is used for with-profits policies such as endowments. The insurer probably isn't all that worried about the mortality risk on these policies (it could always change the bonus rates anyway). So the purpose of this transaction is to improve the capital position. The longest liabilities are chosen because it gives the maximum amount of time for profits to emerge, so that the insurer can recapture the risks. The idea is that the probability that the reinsurer will ever have to pay any claims is very small (and so the reinsurance is cheap). An example may help. We could reinsure the claims at the start of the policy. So the liabilities could go down by 100 say, but the reinsurer would charge 105 say for this, and so our capital position has actually got worse (the insurer won't have made much profit in the early years and so will not have been able to recapture the risks and so the reinsurer almost certainly has to pay out). So instead we reinsure the claims at the end of the policy. So liabilities go down by 50 say. We promise the reinsurer that we will take back this risk if we make surplus of 50 over the lifetime of the policy. Given the bonus loadings in the policy we are almost certain to do this, so the reinsurer is unlikely to need to pay the claims and charges only 2 (it would probably actually spread this charge over the future years too). So our capital goes up by 48. We must reduce the reinsurance cover as this is a requirement of the treaty. The reinsurer has kindly offered to take on our risks for practically nothing, but only because we have promised to take the risks back if we make surpluses. So going back to our example. Imagine if surplus is 10 in years 2 to 6, we would reduce the reinsurance cover to 40, 30, 20, 10 and then zero in each year. Note, the reinsurer does not give us a refund of reinsurance premiums (because we didn't pay for this cover in the first place). Note also that our capital position is unaffected. We make a surplus of 10, so assets are up by 10, but we reduce our reinsurance by 10, so liabilities are up by 10. So that's the trick really. We can't afford to take on the risk at the start of the policy, so gradually we take on the risk as surpluses emerge and we have the necessary capital. Like many of these clever financial transactions (eg securitisation too), the impact is really on Peak 1 and not the realistic measures. Using the earlier example. In the first year, Peak 1 reserves go down by 50. We pay the reinsurer 2. So Peak 1 capital is up by 48. In the next 5 years the surplus is 10, but liabilities go up by 10 (as we recover the risk), so capital is unchanged. In subsequent years, the reinsurance treaty is now cancelled. All surplus goes to the insurer. Turning to the realistic position. At outset we pay the reinsurer 2 and so the realistic capital goes down by 2. Our reserves are down by 50 but we have promised to pay surpluses of 50 to the reinsurer and these cancel out. In the next 5 years, the liabilities go up by 10, but the debt to the reinsurer goes down by 10 and these cancel out. In subsequent years, the reinsurance treaty is now cancelled. All surplus goes to the insurer. I hope this helps, but let me know if its not clear. Good luck in the exam. Mark
Hi Can someone explain where these reserves and assets fall exactly in Peak 1 and Peak 2. As I understand - expected surpluses we promise to pay reinsurer we don't have to put as a liability in peak 1 since they are contingent. Also, we don't need to account for the reinsurance recoveries as an asset since they are not certain. But for peak 2 they need to be accounted for. Where would we account for them - in WP benefit reserve section or as a future policy related liability? Also - what would the effect now be in terms of solvency 2 for this type of arrangement? Assets? Best Est L's? sCR?
Financial reinsurance is only effective on Peak 1. These kinds of arrangements will no longer be used once we move over to Solvency II. I'd imagine the insurers/reinsurers would close any outstanding arrangements. I imagine that financial reinsurance will appear in the FPRL, but the payments to/from the reinsurer will largely cancel out. Best wishes Mark
