X6.7

[Michal Piatra]

Hi Mark,
In solution to X6.7 iii) it says

It is possible that the valuation of liabilities is performed at an interest rate that is derived, or in some way related to, the yield on the asset portfolio.
Pressure on the free assets is likely to favour fixed interest in order to reduce the value of the liabilities.

Which in my opinion, implies that by having lower valuation discount rate the value of the liabilities would be lower, hence, less pressure on free assets.
This is a bit confusing to me, I would assume that value of liabilities (reserves) would increase by having lower discount rate unless there is a negative reserve. But in that case there is hardly pressure on free assets.

Am I missing some component in the valuation (e.g. investment income on reserves)?

Thanks.

Best wishes,

Michal

 

[Michal Piatra]

Hi Mark,

In the meantime, I found this was already answered here:
https://www.acted.co.uk/forums/index.php?threads/liability-valuation-interest-rate.17054/#post-66943
Which seems natural to me, that insurers are penalised in form of having more prudence when investing in riskier assets (although I wouldn't guessed that it is to such extent that effectively makes interest rate lower than on the fixed income)
However, when I was reading the solutions I couldn't make this link and thought it implies what I described above.
I don't think that this effect is described anywhere in the core reading, is it?

Cheers.

Best wishes,

Michal

 

[Mark Willder]

Hi Mark,

In the meantime, I found this was already answered here:
https://www.acted.co.uk/forums/index.php?threads/liability-valuation-interest-rate.17054/#post-66943
Which seems natural to me, that insurers are penalised in form of having more prudence when investing in riskier assets (although I wouldn't guessed that it is to such extent that effectively makes interest rate lower than on the fixed income)
However, when I was reading the solutions I couldn't make this link and thought it implies what I described above.
I don't think that this effect is described anywhere in the core reading, is it?

Cheers.

Best wishes,

Michal

Hi Michal

Yes, it does feel counter-intuitive at first that investing in assets with a higher return (such as equities) leads to higher reserves, but it will be true in any prudent solvency context.

The easiest way to see this is to think about it from the regulators point of view. The higher the risk the higher the reserves that the regulator will want the insurer to hold. So it must be the case that the prudence in the margins will outweigh the extra return of the asset.

Another thing to note is that the solution talks about the yield on the assets rather than their return. Although equities do have a higher expected return than bonds, this return is made up of two parts: income and capital. The yield for equities is the dividend yield, ie just the income part. So when setting the reserving assumption we are ignoring the capital growth, and so it is quite likely that the yield on the bonds is bigger than the yield on equities.

Best wishes

Mark