32 - Provisions Flashcards
How are risk management and provisioning interlinked?
Better risk management processes lead to lower provisions being required.
Why does a firm want to reduce its provisions seeing as they are security against insolvency?
Firms aim to maximize returns for the assets they hold and keeping cash reserves or very low-risk investments usually provide lower returns compared to other riskier investments. Thus the firm wishes to hold as few reserves as possible, without compromising their ability to meet liabilities as they fall due, in order to use their funds as efficiently as possible.
Describe the relationship between model assumptions, provisions and the reasons for calculating provisions.
Provisions are highly dependent on the assumptions in the models used to calculate worst case scenarios, which in turn, are highly dependent on the reasons for calculating reserves.
Give a key characteristic of the stakeholders involved when calculating provisions.
The risk appetites of the stakeholders.
Give the reasons for calculating individual provisions.
BAD MEDICS
Benefit improvements for a pension scheme
Accounts and reports (published or internal)
Discontinuance / surrender benefits
Mergers and acquisitions or liability transfer
Excess of assets over liabilities for discretionary benefits
Disclosure information for beneficiaries
Investment strategy
Contribution / premium setting
Statutory or solvency reports
Give the general reasoning for calculating global reserves.
Some factors that need to be provisioned for are hard to project and set assumptions for (Discontinuance rates, guarantees being exercised). Thus a global provision is set up to account for any differences between the model expectations and the actual experience.
Give the purpose of a general provision.
- Act as additional protection against insolvency
- Cover risks, both financial and non-financial, that cannot necessarily be attributed to individual contracts
- Reflect the degree of mismatching of assets and liabilities.
Give the sources of non-financial risk that a company may face and wish to address through a global reserve.
Operational risk Default risk Anti-selection Regulatory fines Miss-selling of products
Explain why an insurer cannot accurately price for ant-selection.
If the insurer was able to foresee or detect possibilities of anti-selection they would include clauses in the contracts to negate these.
They do this since anti-selection depends too much on client knowledge and willingness to apply effort. Human behavior is notoriously hard to model and predict.
Give the main factor of a firm that influences its use of and balance between individual reserves and global reserves.
The firm’s risk management strategy.
Give the different level of provisioning basis, in order of which would produce the lowest provisions to the most.
Optimistic
Best estimate
Cautious
Describe a general issue when it comes to consistency of provisioning basis between firms and why it is a concern.
Not everyone will see each of the strengths for provisioning in the same way and this causes differences in approaches even if the provisions are being calculated under the same strength of provisioning. This causes issues when comparing results from different firms.
Give the factors affecting the choice of basis and valuation method.
- The reason a value needs to be determined (the purpose of the valuation)
- The needs of the client, the stakeholder’s perspective and use of the value.
- legislative and regulatory requirements - method may be prescribed
- The nature of assets used to back liabilities.
Give the situations where the valuation of liabilities for provisions is affected by the nature of assets used to back those liabilities.
- Liabilities are linked top the underlying assets - unit trusts r internal investment fund
- When the covenant of the sponsor has no value
- For market-consistent valuation of liabilities in relation to financial guarantees on life insurance contracts, since the value will depend on the volatility of returns on the assets held.
Give the various purposes of calculating provisions for a financial services provider.
BAD MEDICS
Benefit improvements
Accounts - internal or published
Disclosure of information to beneficiaries
Mergers, acquisitions or liability transfers
Excess of assets over liabilities - discretionary benefits / shortfall payments
Discontinuance benefits
Investment strategy
Contribution or premium setting or adjustment
Statutory or solvency reports
