A Projected Cash Flow Methodology

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A projected cash flow methodology is used to calculate the interest rate risk solvency buffer under LICAT. There are four stressed scenarios and one base scenario prescribed by Office of the Superintendent of Financial Institutions (OSFI). The required capital is calculated based on the maximum loss under four prescribed stress scenarios. For the base scenario, the discount rate is risk free interest rate plus a spread, with the sum grading to an ultimate interest rate (UIR) plus an ultimate spread. The four stressed scenarios use stressed discount rate to calculate the present value of all assets and liabilities cash flows. Figure 1. Graphs of base scenario and OSFI’s prescribed stressed scenarios As Figure 1 shown above, the red line represents the base scenario. For cash flows from day 0 to year 20, the interest rate is the published risk free spot rate. For cash flows from years 20 to 70, the interest rate is linearly interpolated with the 20-year spot discount rate and the ultimate interest rate (UIR). For cash flows beyond 70 years, the interest rate is the UIR. (Office of Superintendent of Financial Institutions, September, 2016) Scenario I represent low short term interest rate and low long term interest rate. Thus, from the graph, scenario I is below the base scenario. Scenario iii represent high short term interest rate and high long term interest rate, so the purple line in the graph is always above the red line. Under LICAT, the interest rate risk solvency buffer is determined using a three-step approach. Firstly, calculate the difference in PV net cash flow between the base scenario and all four stressed scenarios. Secondly, determine the worst scenario which has the biggest difference in step 1. Finally, calcu... ... middle of paper ... ...ificant tail risk. What is more, LICAT uses the risk aggregation approach to calculate the total of each and all risk elements, which is a more accurate and reasonable approach to model risk. When determining the interest rate risk under LICAT, we used a projected cash flow methodology which has the following three advantages. Firstly, the cash flows help the life insurance companies to understand their position to meet the immediate financial requirement. Secondly, the cash flow projections are useful in terms of future planning, and it would be easier for the company to know if they are in a good position to carry on their business plans. Finally, it discounts all cash flows to the net present value which takes into account the impact of inflation, and thus, the approach under LCIAT is considered to be a better approach that captures all the risks more precisely.
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