Actuarial Society of Hong Kong
rd Appointed Actuaries Symposium
3rd
Valuation Interest Rate in Low Interest
Rate Environment –
UK GAAP / Achieved Profits
Lilian
Lilian Ng
Ng
12
12 November
November 2003
2003
1
Contents
• UK GAAP Valuation Rates of Interest – Determination
• UK GAAP Valuation Rates of Interest – Impact of Low Interest
• Achieved Profits – General Principles
• Achieved Profits - Components
• Achieved Profits – Assumption on Investment Returns
• Achieved Profits – Impact of Low Interest
2
UK GAAP
Determination of Rates of Interest
The determination of the valuation rates of interest is specified in the Interim Prudential
Sourcebook of Insurers (5.11 Rates of Interest).
Admissible Assets
Asset Class
• Fixed Interest Securities
Valuation Rule
• Gross redemption yield at MV – Rule 5.11(4)
−Account for credit risk and default risk
• Variable Interest Securities (Indexed Linked)
• Gross redemption yield at MV – Rule 5.11(6)
−Account for credit risk and default risk
• Equities / Land
• Gross running yield – Rule 5.11(5)
Reduced by 2.5%
- Rule 5.11(2)
−Account for known change in payment of
income or dividends
Valuation Rates of Interest
3
UK GAAP
Determination of Rates of Interest
Investment yield for sums to be invested in the future in accordance to
Rule 5.11(9) and 5.11(10)
Investments to be made more than 3 years after the Valuation Date:
Must NOT exceed the lowest of:
•
Long term bond yield current on the Valuation Date*
•
3% + 2/3 X (yield in 1. – 3%)
•
6.5% p.a.
*For liabilities denominated in UK sterling, use 15 year yield for UK Government fixed interest securities jointly compiled by
the Financial Times, the Institute of Actuaries and the Faculty of Actuaries. For liabilities denominated in other currencies,
same level of prudence as for sterling denominated liabilities.
Investments to be made 3 years or less after the Valuation Date:
Must NOT exceed the “Valuation Rates of Interest” based on current asset portfolio adjusted
linearly over the same 3 years to the yield as determined for more than 3 years.
Rate of interest must not exceed the adjusted overall yield on weighted average.
4
UK GAAP
Impact of Low Interest Rate
Valuation rates of interest depend on both yields from existing asset portfolio as well as
the current long term risk free yield
Falling Interest Rates
• Yields from existing asset portfolio (with significant fixed interest content) normally
higher than current long term yield
• Upper limit (basing on current long term risk free yield) on investments made after the
valuation date would kick-in and drive the magnitude of the valuation rates of interest
=> likely leading to lower valuation interest rates
Lower Valuation Rates of Interest
• Produce higher valuation liabilities and consequently solvency margin requirements
(tying up further capital)
• Distributable surplus to shareholders for with-profits plans would be impacted
dependant on the fall in valuation interest rates and any compensation effect from a
review of bonus declaration
5
Achieved Profits
General Principles
Objective of the achieved profits method is to recognise profit as it is earned arising from
contracts of long term insurance business
• The Achieved Profit for a period is defined as:
The change in shareholder interest or present value of in force business from the beginning
of the period to the end of the period PLUS the statutory profit transferred to shareholders
during the period. Value Based Management.
• Achieved Profits vs Statutory Profits
‰Under statutory basis, profit / surplus in a particular year is the net cash flow less the required
increase in policyholders’ reserves.
‰Both bases produce the SAME total absolute amount of profit ignoring time value.
‰The variance is the TIMING that the profit is recognised and appears in the accounts.
Statutory Profits
Achieved Profits
25
60
20
50
15
Total Profits
10
5
0
-5
-10
-15
1
2
3
4
5
6
7
8
9
10
40
30
20
10
0
1
2
3
4
5
6
7
8
9
10
6
Achieved Profits
Components
Achieved Profit in respect of an accounting period arises from 3 sources, New Business,
In Force and Changes in external economic circumstances.
New Business
+
In Force Business
+
Changes in
External
Economic
Circumstances
Profit arising at the time of sale on new policies written during the
accounting period
+ the profit arising in the period from sale to the end of the accounting
period
• Change in the time value of the shareholders’ interest in expected
cash flows and release of margins in the period on contracts in
force at the start of the contract (Unwind of Discount)
• Profit / loss arising from differences between actual and assumed
experience during the period (Experience Variances) excluding
investment related variances
• Impact due to change in experience assumptions and/or risk
margins affecting future cash flows (Change in Bases)
Effect of changes in extraneous economic variables (interest, inflation)
including associated changes to valuation bases, that are beyond the
control of management as reflected in asset values or revised
experience assumptions and / or discount rates or bonus rates
7
Achieved Profits
Assumption on Investment Return
The assessment of appropriate investment assumptions as to future experience should
have regard to the past, current and expected future experience (+relevant external data)
• Net cash flows are assumed to be invested or disinvested in accordance with the investment
strategy of the insurer.
• Fixed Interest – reflect the actual portfolio with a reinvestment rate for positive cash flows
based on current fixed interest returns. For countries where longer term fixed interest
markets are underdeveloped, assumptions should be based on an assessment of longer
term economic conditions. Adjustment for default risk.
• Equities – based on a margin over the corresponding risk free return assumed.
• Unit Linked – consistent with the investment returns assumed for underlying asset types.
• Discount Rate – allowance for a risk margin. Responsibility of the directors of the
company reporting on AP basis to determine the discount rate (and assumptions). In
reaching their judgement the directors should seek actuarial advice.
8
Achieved Profits
Impact of Low Interest Rate
The impact of on each component of Achieved Profit due to lower interest assumption
would vary…..
I (interest) – move in line with current risk free rate
New Business
D (discount) – move in line with current risk free rate plus risk margin (fixed)
Impact by the change in GAP (I-D) more than the change in I and D alone.
• Unwind of in force business – higher PV of cash flow with lower I offset by
lower D.
In Force Business
• No direct impact on non-investment related experience variances. May
have indirect impact on claims due to change in bonus rates…..
• Any restatements in PV of in force excluding changes due to external
economic circumstances are included here.
Changes in
External
Economic
Circumstances
As the name implies, any effect of changes in extraneous economic variables
(interest, inflation) including associated changes to valuation bases, beyond
the control of management reflected in asset values or revised experience
assumptions and / or discount rates or bonus rates would fall here.
9
Thank You
10