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IAI Actuarial Core Principles · Actuarial Mathematics for Modelling · Non-unit reserves for unit-linked contracts (zeroisation)

A unit-linked contract has a negative non-unit cash flow in its second policy year and positive ones in all other years. Under zeroisation, which statement about the profit signature is correct?

Profit in year 1 is reduced because a reserve is set up to meet the year 2 strain. That reserve, with interest, is released in year 2 to pay for the negative cash flow, so year 2 profit becomes zero.

  1. AProfit in year 1 is reduced by the reserve set up for the year 2 strain, and that reserve is released, with interest, in year 2Correct
  2. BProfit in year 2 is unaffected because the reserve is established only during year 2
  3. CProfit in year 1 is increased because the reserve is released at the end of year 1
  4. DThe reserve is spread evenly over all years of the term, so every year's profit is reduced equally
  5. No reserve is held because the negative cash flow is offset by the positive ones in other years

Explanation

Zeroisation requires a reserve at the end of year 1 equal to the present value of the year 2 negative cash flow. Setting it up reduces the year 1 profit. In year 2 the reserve and its interest are released to fund the strain, so the year 2 profit is zero. Netting across years is not allowed because reserves must meet each year's negative flow separately.

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