Lesson 1: Introduction to Cash Flow Modeling
What will This Lesson Cover?
Most of actuarial studies, especially those related to valuation and pricing, involve analyzing insurance cash flows. The cash flows are originated from two major sources, i.e. (1) actual cash flows from the company’s financial statements (profit & loss (“P&L”) account and balance sheets); and (2) projected cash flows generated from actuarial models. Although many actuarial studies focus on the liability cash flows, asset-liability management (“ALM”) uses both assets & liability cash flows to formulate, implement, monitor and revise strategies related to an insurance / takaful company’s financial objectives.
Due to the nature of massive calculations in actuarial studies, insurance / takaful companies use actuarial software (such as Prophet1) to generate projected cash flows within much shorter time. However, for the purpose of gaining good understanding on the cash flow modeling, it is recommended to learn setting up a cash flow model using spreadsheet – which is able to provide a better picture on how individual cash flow items are calculated (not a calculation “black box”!).
This course shall cover the following scopes:
- Liability cash flows – Only focus on liability cash flows, i.e. arising from the various events related to the policy life cycle, such as premium income and claim outgo. Investment yields in generating liability cash flows are constants (either single rate throughout projection period or varying by financial years), which are considered as weighted average yields of an investment portfolio. The investment portfolio may consist of different investment instruments, such as equity and bond.
- Deterministic models – Use only a single set of projection assumptions, i.e. does not consider randomness factors (opposite of “stochastic models”). Normally, every insurance / takaful company has its own set of Best Estimate (“BE”) assumptions that represent 50% confidence interval. For reserve and capital calculations, more prudent assumptions are used to represent higher % of confidence intervals. Sensitivity factors used to perform stress testing / sensitivity testing are not considered as components used to reflect randomness.
- No reinsurance – Only cover gross cash flows, i.e. without considering reinsurance arrangement. In simple words, reinsurance is an “insurance” purchased by an insurance company for the purpose of risk management. The insurance company may cede all or part of the risks from life insureds, depending on the company’s risk appetite.
Life insurance products without account balance & bonuses – For simplicity, this course refers to only life insurance products that are without account balance & bonuses, which normally aims to meet the savings or investment objectives (associated investment risks are borne by the policyholders). Types of products with account balance are universal life (non-unitized) and investment-linked (unitized).Life insurance products used throughout this course are limited to non-participating products, i.e. term insurance or endowment. Only consider the policy’s life assured in the projection (i.e. does not consider the payor, which may be a different person).
1 | The most popular actuarial software used in Malaysia.