With regards to investment risk for without profits and with profits policies, am I correct in saying that the investment risk for a with-profits policy is lower than that on a comparable without-profits policy? Is this because the reserve on a with-profits policy is likely to be lower than a comparable without-profits policy, as the premium for the former tends to be bigger implying a lower reserve?
I have a few comments to make – First of all, the Reserves on the with-profit policy are not likely to be lower than under the without profit policy. You are correct in stating that the premiums in WP are larger but so are the benefits. Reserves are often set prudently by taking into account of the future bonuses implicitly or explicitly, so the PV of the future benefits will be larger as well leading to higher reserves. As a result of sizeable reserves under WP policies, the investment (and re-investment risk on regular premiums) risk is large enough in the with profit business. Please note that WP policies also have a guaranteed sum assured like W/O profit business, over which the bonuses are paid. However, the most important point to consider in WP business the profit sharing. The risks of an Insurance company are shared with the policyholders through lower/higher bonus distribution. This reduces most of the risks (including the investment risk) on the WP business for an insurance company. A form of investment risk I can see with WP business is of the bad reputation, by not meeting PRE if the assets perform badly (That’s what happened in past few years in the UK). Hope it helps.
I agree with what you have said. I read in the notes that term assurance contracts have low investment risk because the reserves tend to be smaller. I therefore took this statement and applied it in the context of comparing without-profits and with-profits contracts. If we have look at a without-profits and with-profits policy that charge the same premium, then you are likely to find that with-profits policy will have a lower sumassured initially and at the expected time of claim (if experience goes as expected) the sumassured plus bonuses will be equal to the sum assured of the without-profits contract. So on average, I think, the reserves will be similar. But initially the with-profits contract should have smaller reserves and as time goes on the reserves will get closer to the without-profits reserve. Also I may be wrong in my thinking of what "Investment Risk" actually means. I tend to think of it in the "expected vs actuals cashflows" context. If reserves are small then expected and actual investment returns in monetary terms will be small and hence will not a significant cashflow. Therefore that's why, I think, investment risk is not significant for policies with low reserves.
. Investment risk is simply receiving lower investment returns than assumed. If the reserves are lower, then the impact of the Investment risk is lower and vice versa. Think if you assumed 6% and you received only 4% over the year, if two separate reserves were 100 and 2000, then the risk is of 2%*100 = 2 and 2%*2000 = 40 on two reserves. Hence, the impact is larger on larger reserves which is the latter in the example.
"At the inception of the contract, the present value of the benefits includes the future bonuses so it is not likely to be less than the W/o profit benefits with the same premium. It should only differ slightly, otherwise there is a big inconsistency between different products, which is not theoretically correct." But I have always thought that Reserves are always calculated on the benefits guaranteed so far. If we are at inception, then at time 1 the asset share is expected to be bigger than the reserve. Therefore a bonus will be declared which will bring the reserve closer to the asset share at this time.
Prudent Reserves are calculated with the inclusion of the expected future bonuses. This is one of the principle of setting Reserves. If you do not include the future bonuses then you immediately cappitalise the profits at time 0. For first few years, asset share is generally very low or even negative. The bonus may not be declared by looking at the asset shares for first few years. This is where the concept of discretion in bonus declaration comes in.
