Here you can find information about the following applications of Prophet:
Profit testing is used to help design and price future new business which may be written by a life assurance company. It helps the actuary set the premium rates and benefits which can be afforded. It is also the main building block for most of the other types of calculations described below.
In Prophet, a "profit test" is a cash flow projection of a single policy. In this projection, probabilities are applied to the various events that can occur during the projection, for instance of the policyholder surrendering the policy, or dying.
Account is also taken in the profit test of the need for the company to set up reserves to meet future liabilities. Assumptions are made as to the investment return that would be earned on the assets backing these reserves. An allowance is also made for the cost of selling and administering each policy.
The resulting cash flow is a stream of the expected profits - the profits likely to be earned by the company from the policy. There is normally a loss in the month of sale, called new business strain. This arises because the initial costs and reserves required to be set up usually exceed the initial premium paid. The pattern of profit is often referred to as the profit signature of the policy.
The value of the policy to the company at any point in time is obtained by discounting the future profit flows at a suitable rate of interest which is typically called a risk discount rate. A risk discount rate is an interest rate higher than that assumed to be earned on investments to take into account the uncertainty that the profit will actually emerge in the future.
Insurance companies must periodically demonstrate to the regulatory authorities that they are solvent. This requires, amongst other things, a valuation of their policy liabilities to determine an adequate level of reserves. This valuation is usually made using more prudent assumptions than are expected to occur in practice.
There are two main alternative approaches to the valuation calculations. For conventional (also called traditional) business, the normal approach is that valuation factors are constructed using actuarial commutation factors and are applied to the benefits attaching to each policy to determine the appropriate reserve.
The second approach is to perform a cash flow projection for each policy, starting from the valuation date and using conservative assumptions. For example, one normally assumes that the policy does not lapse or surrender in the future. This approach is commonly adopted for unit linked business and in recent years has begun to be adopted for conventional business.
The reserves that are set up are not normally allowed to be less than the current surrender value.
In life assurance terminology, a model office is an actuarial representation of the finances of a life assurance company. Such models are primarily used to project the financial position of the company.
A model office projection is built up from individual profit tests of existing business and, if required, of future new business. For existing business the starting point for the projection is usually the policy records as at the start date of the projection. In many cases, representative policies called model points are generated using a grouping process. These model points are then used instead of individual policy data to reduce the processing required.
If a projection of the in force business is made using expected future experience and the profit stream is then discounted at a risk discount rate (in other words using assumptions comparable to those in a profit test) a value is obtained for the existing business. This is known as the embedded value of the business. This term is usually defined to include any existing accumulated profits or surplus held. This latter item is called the net asset value. If the value of future new business is added to the embedded value, the resulting amount is known as the appraisal value.
Many companies monitor their financial health through the progress of the embedded value from year to year and may include it in consolidated group accounts.
Applications of Business Planning could include:
The Business Planning system can be tailored to your specific business. This is mainly driven by your company structure but other specific features of your business can be programmed in, since Prophet is an open system.
So, Business Planning can be supplied either:
The uses of Prophet outlined in the previous sections are all primarily concerned with the liabilities of the insurance company, with a simple approach being adopted for modelling the investment return earned.
In asset/liability modelling, in addition to this model of the liabilities, a projection of the assets is also made and the relationships between the two are explored. This enables projections of a complete revenue account and balance sheet for the company to be made.
Traditionally, asset/liability modelling has primarily been concerned with cash flow matching. This is the testing of the degree to which asset proceeds match liability outgo, both by amount and by timing. In some countries it has developed further to include resilience (or stress) testing. This type of investigation looks at the consequences of a rise or fall in asset yields and/or values. In particular it investigates whether the company should set up additional reserves against this eventuality, taking into account that it might need to change its liability valuation basis in these circumstances to demonstrate solvency.
In recent years the term asset/liability modelling has come to be associated with dynamic and stochastic projections.
In a dynamic projection, the behaviour of the assets has an effect on the projection of the liabilities and, conversely, the behaviour of the liabilities has an effect on the projection of the assets. These relationships are specified within the model office as rules which are evaluated as the projection evolves rather than being entered as predetermined values. In Prophet we use the term "decisions" for these rules because they model management decisions that might be taken in the emerging circumstances. Typical decisions that might be modelled include the bonus rates declared each year, the statutory valuation and embedded value bases used at each year end and the investment strategy adopted, taking into account the investment performance achieved.
A stochastic projection is a projection in which some of the assumptions, typically those which model future investment or economic performance, are generated using a statistical model. This generates a series of sets of assumptions, called simulations, each of which has the same probability of being achieved. Together they represent a probability distribution for those assumptions. Product or model office projections are run for every simulation and hence produce results which are probability distributions for the outcome for the product, fund or company projected.
Stochastic projections essentially measure the riskiness of the projected outcome. A typical investigation would involve the stochastic projection of a number of alternative scenarios, followed by a comparison of the outcomes relative to their riskiness. The measures of outcome (or "reward") and riskiness would be chosen to be appropriate for the company, for instance they might be the mean free assets relative to the probability of the company becoming insolvent or they might be the mean overall bonus allocations relative to the volatility of the rates that can be declared.
Prophet's asset/liability modelling capability is being used extensively by life assurance companies to help them in their management of their business. Many of these companies are utilising our experience in this area to help them build suitable models and to interpret the results produced by those models. In particular, Prophet is being used to quantify risks that have been exposed by the shift in many countries to a relatively low inflation and interest rate environment and thereby to determine suitably amended investment, bonus and business strategies for the future.
In the UK, companies are typically exploring the interaction of bonus policy with future investment performance and are seeking new ways to optimise the balance between policyholder and shareholder returns, and the risks they incur. This feeds through to investment strategy, bonus policy and product design. In Continental Europe, the issues brought about by reduced rates of inflation and interest rates are frequently different. Typically, companies are concerned with measuring the effects and consequences of increasing the proportion of assets invested in equities.
A driving force for all companies is to find ways of ensuring that sufficient assets are built up in the future to meet policy guarantees.
The statutory valuation basis normally leads to the company incurring a loss when a policy is sold, followed by profits thereafter. For many types of products these profits are concentrated more in the later years of a policy than in its early years. This pattern rarely reflects either the work done or the risks borne by the company so, in a number of countries, attempts have been made to find a more appropriate method of profit recognition.
One common method is to use embedded value profits since this gives a measure of the value added in any accounting period. Other methods used are the accruals method and achieved profits in the UK, margin on services in Australia and GAAP in the USA. More recently the International Accounting Standards Board (IASB) has been developing a set of International Financial Reporting Standards (IFRS) which will apply to insurance companies as well as other companies.
These methods of profit recognition typically require a projection on a basis different both from the future expected experience and from the statutory valuation basis.
Further details on using Prophet for US GAAP reporting are available here.
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