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Draft for discussion at ICAEW IISC meeting, 20th June 2005 - page 46 / 51

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determine the appropriate allowance for each risk, although the Basis for Conclusions suggests an active approach to setting discount rates is desirable. It does however explicitly address one of the methodological criticisms of traditional EV that changing the assumed asset mix can lead to a change in value of business written.

The Basis for Conclusions appears to favour the ‘bottom-up approach’ to setting risk margins e.g. setting a discount rate on a product by product basis, directly reflecting the product’s risk profile. However, determining the appropriate discount rate is still problematic and subjective. It is not clear from the Basis for Conclusions that there is sufficient guidance to overcome this subjectivity nor indeed the ‘herding’ tendency that it criticises the traditional EV of displaying.

“The selection of risk discount rates in EV reporting has historically left significant room for judgement, which appears to have led in practice to a ‘herding tendency (i.e. the use of similar risk margins between companies) rather than an active differentiation on the basis of risks being run.” (108, G10.7)

One of the main changes from traditional EV practice relates to Principles 6 and 7 which requires that the costs of all financial options and guarantees70 must be explicitly valued and deducted from the value of in-force. In particular Principle 7 requires that the present value calculation includes the time value of financial options and guarantees, using stochastic techniques consistent with methodology and assumptions used in the underlying embedded value. This effectively incorporates the expected cost of the option into the valuation, and is an important advance on traditional EV techniques and should help to address some of the past criticisms. In addition the EEV require the disclosure of ‘the nature of, and techniques used to value, financial options and guarantees’. However, the methodology and assumptions used are not defined, or indeed confined to a set of choices, and therefore the Principles allow considerable scope and consequently comparisons between companies will be unlikely, ‘particularly where the approach chosen is not market consistent and the result is not benchmarked against a market-consistent calculation’. 71

As Towers Perrin Tillinghast note: Companies are likely to interpret the Principles as meaning that the assumptions for future investment returns should be real world (i.e. include expected risk premia). However, it is not clear how companies will discount the emerging cash flows, and therefore the cost of options and guarantees will represent. The approach may not be consistent with the market pricing of options, nor with the market consistent cost of options and guarantees which many European firms are already required to disclose as part of regulatory reporting.” (May 2004, Towers Perrin Tillinghast, Update, p1-8)

70 These options and guarantees are restricted to options that directly influence the benefits of the policyholder and whose potential value is impacted by the behaviour of financial variables. The definitions includes the most common guarantees, such as those underlying traditional business (including the guaranteed surrender values), guaranteed annuity options and guarantees within unit- linked contracts, but excludes insurance based options such as those which increase or extend the term of cover.

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O’Keefe et al. (2005)

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