20 - Principles, purposes, and users of valuations Flashcards
What are the primary purposes of valuations for a benefit provider?
Valuations are a routine and vital component of managing a benefit provider. The main reason for most valuations is to provide summary information regarding the financial position of the benefit provider to allow relevant parties to make sensible and informed decisions.
What fundamental principles of valuations are set out?
The fundamental principles of valuations specify aspects such as what investigations will be required, the timing of the valuation, and the frequency with which it is carried out. It also covers the method and basis adopted, and the level of accuracy required which will differ according to the purpose and users. The materiality of valuation results is informed by their purpose. For instance, a buy-out valuation to settle member liabilities requires that results are as accurate as possible, while a regular valuation to assess adequacy of contributions is less stringent.
Briefly outline the initial steps in the valuation process.
The initial steps in the valuation process, after summarising the valuation process into steps, generally include: consideration of the previous valuation, gathering information and data, and setting a basis.
Explain the principle of an appropriate degree of prudence in valuations.
A best-estimate valuation results in a 50% probability of the liability value being insufficient and a 50% probability of it exceeding what is required. A more prudent approach, with a less favourable position in desirable circumstances and a less optimistic position could be used. The purpose of prudence will determine what degree of prudence is appropriate. Historically, a prudent basis was achieved using a prudent basis from a risk management perspective to build sufficient margins, also called risk margins, to help quantify the protection these margins provide.
What is a Contingency Reserve and how does it differ from a best-estimate Liability?
A Contingency Reserve is an alternative to calculating liabilities using a realistic approach with no under- or overstatement of liability and adds explicit reserves to act as a buffer against adverse experience in the future. The balance sheet of an entity holding Contingency Reserves shows Value of assets and Available capital on one side. The value of liabilities, both best-estimate liabilities and Contingency Reserves together make up the total liabilities.
Explain the concept of a risk-based capital (RBC) approach used by insurance companies.
Insurance companies often use a risk-based capital (RBC) approach where they are required to hold additional capital over and above their reserves proportional to the risk taken. Capital requirements can be determined using a value-at-risk (VaR) approach. The balance sheet of an entity with a capital requirement shows value of assets and available capital on one side. The other side shows value of liabilities, with free capital being the difference between available capital and the capital requirement.
Define completeness as a principle of performing a valuation and list its key components.
Completeness as a liability valuation principle requires taking account of guaranteed benefits, options, expenses, and contractually-obligated premiums. Any premiums or contributions that are certain to arise can thus be treated as a negative liability. The valuation should account for all items once and only once and hence the actuary should take care to avoid any double-counting.
Explain the concept of consistent valuation of assets and liabilities.
Consistent valuation of assets and liabilities is complex because the way of valuing the liabilities is to discount cashflows consistently. This would require the actuary to discount the asset cashflows consistently with the liability cashflows, consistently resulting in the asset value offering markedly different market values. This results in market-consistent or fair value valuations where the assets should also be taken at market value.
Describe the market-consistent valuation overview for benefit provider liabilities.
The market value of a benefit provider’s liabilities is the amount that a third party would be willing to pay to take on arm’s length transaction in a deep and liquid market if the benefit provider’s book is filled due to an unforeseen event. For most health, social, and employee benefits, cashflows are uncertain and heavily dependent on transition rates in multi-state models. Assumptions for market-consistent indicators for setting some of the assumptions include mortality and morbidity assumptions, expense assumptions determined by reference to expense agreements available in the market, and an insurer providing a quotation for buying out a pensioner or long-term care (LTC) benefits-in-payment book.
What is the most common way to calculate the market-consistent value of liabilities and what does it involve?
The most common way to calculate the market-consistent value of the liabilities is to add a risk margin to the best-estimate liability (BEL). The risk margin should, in some cases, reflect the capital needed. Adjustments for the best-estimate basis items are explicit and are called risk margins. Alternatively, the cost-of-capital (CoC) approach could be used to calculate the risk margin.
Briefly explain the concept of deriving the risk-free discount rate in a market-consistent valuation.
In a market-consistent valuation, future investment returns are based on a risk-free rate of return, and the discount rates are also based on risk-free rates. The discount rate will differ by term and are effectively a yield curve. For the short term, the rate used as the starting point must have a deep and liquid market and be issued with a zero probability of default (e.g., government bonds, corporate bonds, or swaps). After selecting the risk-free discount rate, the next step would be to make a deduction for credit risk.
Describe the risk margins and the cost of capital (CoC) approach.
Where there are not as many deep and liquid markets for health, social, and employee benefits, the CoC approach is often used to calculate the risk margin. The CoC method for determining the risk margin involves: first, projecting the required capital at each future time period, which is the level of assets required in excess of the projected liabilities; second, multiplying the projected capital amounts by the CoC; and third, discounting the resulting market-consistent discount rates to give the overall risk margin. The CoC rate represents the opportunity cost of locking in capital to earn a risk-free rate rather than being able to invest it elsewhere for a potentially higher reward.
Explain passive and active valuation techniques and their key differences.
A passive valuation approach uses a methodology that is relatively insensitive to the market and so requires very infrequent updating. It uses the net premium method, which was covered in the Subject A213 course, but is no longer used in common practice.
Active valuation techniques involve more frequently updated assumptions and are more suited to market-consistent valuations and RBC approaches to assessing the capital requirements for market-consistent providers. Active techniques are also preferred for products with options and guarantees. The active approach is more stable, requires less subjectivity, and is simpler.
What is a key disadvantage of a passive valuation approach?
The active approach provides more useful information on how market volatility affects solvency. In extreme market conditions, an active approach can create onerous capital requirements that can make insurers rush to buy safer assets. Active approaches are thus pro-cyclical and are associated with systemic risk. Blending the two approaches can introduce the risk that the net solvency level is unrealistic or inappropriate.
What are some important considerations regarding the suitability of assumptions in valuations?
The assumptions should be suitable for the valuation exercise. This involves considering the appropriate degree of prudence, the consistency of the assumptions over time, and any restrictions that arise from accounting standards or regulations. Actuarial guidance must also be considered, and for valuations where the results will be published, economic assumptions, such as discount rates, are often specified, while demographic assumptions are often reviewed by relevant entities to reflect entity-specific assumptions. Setting assumptions is underpinned by the principle of proportionality.
What are the steps in performing a valuation?
The steps in performing a valuation include:
* Assessing purpose and users
* Considering the previous valuation
* Obtaining information and data, and checking
* Setting a basis
* Performing the calculations
* Comparing the position to that at the previous valuation
* Reporting on the results, which depends on the users and purpose
The International Actuarial Association (IAA) has issued guidelines of actuarial practice for social security programs, and these guidelines set out the principles to follow and the items to include in any reports produced.
Describe the main purposes of valuation concerning statutory reporting.
The main purposes of statutory reporting include:
* Statutory reporting: This is mandatory reporting of the financial condition of a benefit arrangement to the regulator, which can also be called supervisory valuations or returns.
* Published accounts: Here the valuation result is used as an input into financial statements that are publicly available.
* Distributing surplus: Proprietary insurers will need to decide how much surplus will be given to shareholders as dividends.
* Internal decision-making: Benefit providers can use valuation results as inputs to a large number of decisions including investment strategy, reinsurance arrangements, pricing and benefit design, assessing economic capital levels, and cost-benefit analyses relating to operational decisions.
What key aspects should be considered when obtaining information and checking data for a valuation?
Considering the previous valuation involves ensuring the closing valuation position at the previous valuation should be the same as the opening position for the current valuation. Previous valuation reports may also contain information about the future of the benefit provider, for example, benefit changes or closure. Obtaining and handling the data is particularly difficult for social security insurance as individual data will be unavailable in a usable form. The actuary will rely on national statistics and care should be taken to ensure these are appropriate. Data relating to covered lives and beneficiaries will be split by age, gender, and past employment service.
Discuss key considerations when setting a basis for a valuation.
When making a judgement as to appropriate assumptions to use to project future experience, the actuary will need to consider the purpose for which the assumptions are to be used. The starting point for reserving assumptions will be the expected future experience. When considering the strength of the valuation approach, various approaches have differing levels of prudence. A further consideration is whether negative reserves are allowed. The overall result for statutory purposes should be prudent and published accounts should provide a liability transfer value with the actuary preferring an optimistic although both bases would be close to best estimate. It is important to consider the implications of using inappropriate assumptions.
What are some common reasons for there often being no direct payments involved in a statutory valuation?
There are often no direct payments involved in a statutory valuation because:
* Funding levels that are too low or too high may trigger an intervention by the regulator.
* The use of weak assumptions may encourage benefit improvements that cannot be afforded.
* Assumptions used may affect benefits directly, for instance if benefits received related to their supervisory actuarial reserve on withdrawal as may be a requirement in a DB retirement fund.
* If the statutory result is used to set contribution rates, this will influence the actual cashflows.
* If surplus is determined based on the statutory result, it is important for this to be appropriately low in terms of both the level of surplus to be distributed and to whom it is distributed.
* To the extent that actual returns exceed the CoC, holding larger reserves would increase actual profits.
The assumptions required will depend on the calculations inherent in the valuation. Other assumptions in social security valuations include price inflation, earnings inflation, rate of benefit increases, covered earnings increases, economic activity rates, morbidity rates, and other benefit claim rates.
Describe the two main approaches to the analysis of any provider of benefits when performing calculations.
There are two present value methods:
Present value methods: A present value calculation focuses on the current value of future members’ or covered lives’ present and future expected benefit outgo and contribution income. Calculations are done at population subgroup level.
Projection methods: A projection approach aims to assess the expected number of contributors and beneficiaries, and the average benefit level for that group in each future year. The factor method is used to project future contribution income. The survival method is a fairly difficult method to switch to as one would need projections for people who started receiving benefits in previous years who are still eligible to receive them.
Explain how complications in the modelling of earnings can arise in valuations.
Complications in the modelling frequently arise where there are minimum or maximum earnings limits which affect the actual amounts of contributions income. For example, consider a scheme with minimum and maximum covered earnings for contribution purposes, consider that with price inflation, an increasing number of lower earners who used to fall below the lower limit will now be above the lower limit. In such cases it may be necessary to apply an earnings distribution, which is necessary anyway if benefits are related to covered earnings or means tested.
What is the importance of monitoring the valuation position over time?
Monitoring of the financial position of the arrangement is not possible without knowing the position at the previous valuation. Comparing results with prior valuations helps to assess the appropriateness of the previous assumptions done for the same benefit provider. The valuation process has been completed once the valuation is complete in terms of professional and legal guidance.
Explain the concept of statutory reporting and its frequency.
Statutory valuations usually occur annually, with less onerous quarterly reporting for insurers, up to triennially for an employer-sponsored retirement fund, and every 3 to 5 years for a social security arrangement. The two main reasons why regulators generally require statutory reporting are benefit security and compliance. The overall degree of prudence to support benefit security is likely to be addressed by contingency reserves and a minimum capital requirement by the regulator.
