Chapter 22

Question 1

Why is it more favourable to use the same prudent assumptions for pricing and reserving in the revalorisation method compared to other profit distribution methods?

Answer 1

• The revalorisation method applies mechanical increases to premiums and benefits (e.g., r% per year).
  
  • Using the same prudent assumptions ensures that reserves are sufficient to cover future guaranteed increases.
  • Surplus emerges naturally and gradually; the method is less sensitive to conservative assumptions.
  • Policyholders still benefit from increases without the risk of slower bonus emergence seen in methods like the contributions method.
  • Easier administration and consistency between pricing and reserving, reducing complexity and errors.
    Additions to benefits:
    Less suited: because bonuses create new guaranteed liabilities that require reserving immediately, but surplus from prudence emerges gradually → mismatch.

Question 2

How are shareholder profits for conventional without-profits business calculated in an EV framework?

Answer 2

• Supervisory reserves are set prudently (conservative assumptions).
  
  • Embedded value reserves use realistic/best-estimate assumptions.
  • Profit for shareholders = release of the margins (supervisory − EV reserves).
  • If assumptions match exactly → no profit emerges.
  • Differences in bases create positive profit over time as actual experience unfolds.
  • Ensures solvency while allowing shareholders to benefit from conservative pricing.

Question 3

Purpose of Embedded Value (EV)

Answer 3

1. Measures the economic worth of an insurance company’s existing business.
   
   2. Captures the future profit potential of in-force policies (Value of In-Force).
   3. Supplements the balance sheet, which only shows historical assets and liabilities.
   4. Enables performance comparison across companies or over time.
   5. Supports strategic decision-making: pricing, acquisitions, dividends, capital allocation.
   6. Reflects shareholder value creation, not just accounting profits.
2. for valuing the purchase and sale price of the business

Question 4

Best Estimate Valuation vs Embedded Value

Answer 4

• Best Estimate: Focus = policyholder security; PV of each policy’s cashflows; shows solvency.
  
  • Embedded Value: Focus = shareholder profit; PV of portfolio cashflows; accounts for cost of capital and reserve timing.
  • Discount rate: Higher = more prudence; reflects riskiness of future profits.
  • Key point: High reserves → delayed shareholder profits → lower EV.
• EV takes into account the cost of capital while BE doesn’t

Question 5

List the considerations for the reserving basis

Answer 5

• Purpose of valuation: published vs supervisory (going concern v break up, true and fair view, BE or other basis) vs internal

Consistency:
* the previous basis = an adjustment will need to be justified:
Weakening the basis:
= justification to regulators that it wasn’t just done to accelerate shareholder profits or improve reported solvency
= could also lead to increase insolvency risk and weakening of financial security
Strengthening the basis =
*needs justification to tax authorities that it’s not just being one to delay payment of tax
* reduces ROC
* leads to higher capital strain per policy =>increased P(insolvency). to avoid that=> reduce sales (marketing risk) or raise more capital ===> lower ROC

• the valuation of L must be consistent with that of A
• the valuation of L must also be consistent with the pricing basis
• supervisory valuation v internal valuation must be considered

Question 6

Why must the basis for valuing liabilities be consistent with that for valuing assets?

Answer 6

It matters because surplus (assets − liabilities) is the key measure of solvency. If assets and liabilities are valued on inconsistent bases, that solvency figure can be misleading:
* If assets are valued at market value but liabilities are discounted using an unrealistically high interest rate, you’ll understate liabilities → company looks stronger than it really is.
* If assets are valued at book value but liabilities are valued at market-consistent rates, you could overstate liabilities → company looks weaker than it really is.
* Regulators, investors, and management all rely on solvency numbers. If those numbers don’t reflect reality, decisions about dividends, capital injections, or writing new business could be dangerously wrong.

So consistency is about making sure the “balance sheet picture” of financial strength is true and fair, not distorted by mismatched valuation rules.

Question 7

Why must the basis for valuing liabilities be consistent with the pricing basis?

Answer 7

• At pricing, premiums are set assuming a certain reserving basis (e.g. interest, mortality, expenses).
  
  • If actual reserves use a stronger basis than assumed → higher reserves, greater capital strain, lower profit.
  • If actual reserves use a weaker basis than assumed → product may be overpriced and less competitive.
  • Consistency ensures the cost of reserves allowed for in premiums matches the reserves actually required, so profitability and capital strain emerge as expected.

Question 8

Why would the reserving basis differ from the pricing basis

Answer 8

◦ Uncertainty: For reserving, policies are already in force, providing more information than at pricing. This means better information about policyholders for demographic assumptions and, if data is credible, a good indication of future experience, leading to lower parameter uncertainty. Expense assumptions are also easier to assess for reserving as there are no future initial expenses, and less uncertainty exists over the volume and mix of existing business. BUT expense assumptions are still uncertain bc of new policy issues in the future
◦ Purpose and Valuation Approach: The extent to which margins are required depends on the valuation approach (prudent or realistic) and the purpose of the valuation. Supervisory valuations often require prudent assumptions, while pricing may use best estimate assumptions with risk allowed for via a risk discount rate

Question 9

How is risk a typically addressed when setting assumptions for valuing life insurance contracts, especially in the context of embedded values?

Answer 9

appropriate risk margins are needed to allow for the unpredictability of profit emergence. One way to account for risk is to use a risk discount rate that is higher than the risk-free rate, with a higher rate reflecting riskier future profits. A stochastic or market-consistent approach may also be adopted. Under a market-consistent approach, a risk-free rate is used for discounting, and investments are assumed to earn the risk-free rate. A risk margin is then deducted from the embedded value to reflect non-investment risks, often using a cost of capital approach. The embedded value method, unlike a best estimate valuation, explicitly accounts for the shareholders’ cost of capital, as future profits arise in excess of supervisory reserves

Question 10

What is an “embedded value” and for what purposes is it calculated, concerning assumption setting?

Answer 10

An embedded value provides a more realistic assessment of an insurer’s value, recognizing assets in excess of reserves and the value of future releases of reserve margins to shareholders. It may be calculated for published accounts or internal management purposes. The key determinant for the embedded value basis is its purpose.
It requires two bases: a reserving basis (always the supervisory reserving basis) and a projection basis. The projection basis, used for future shareholder profits, is often a best estimate basis for published or internal management accounts, but may be cautious for a purchase value in an appraisal