32 - Valuation of Liabilities Flashcards
1
Q
What are the two main approaches to valuing liabilities?
A
- Discounted cashflow approach based on long-term assumptions
- Market-related or fair value approaches
- Important to use consistent methods to value assets & liabilities
2
Q
Discounted cashflow method outline:
A
- Long-term assumption of future expected investment return is needed
- Future liability cashflows are discounted to present value using this rate
- For consistency, assets are also valued using the same approach, future cashflows discounted
3
Q
Major criticisms of DCF method:
A
- It places a value on assets different from mkt. value which introduces another element of risk
- This method is inappropriate for short-term valuations eg. discontinuance valuation for benefit scheme or break-up valuation for insurance company
4
Q
What are the two defns of fair value?
A
- Amt. for which an asset could be exchanged or a liability settled b/w two knowledgeable willing parties in an arm’s length transaction
- Amt. that the enterprise would have to pay a 3rd party to take over a liability
5
Q
Why is identification of fair values/market values not practical for liabilities? What is done as a result?
A
- Because there is no secondary market for many of the liabilities that actuaries are meant to value
- As a result, mkt. based approaches such as replicating and option valuing techniques are used
6
Q
Outline the mark to market method of valuing A/Ls:
A
- Assets are taken at mkt. value
- Liabilities are discounted at yields on investments that match the liabilities wrt term, currency & nature - often bonds
- Bond yield may be based on govt. or corporate bonds -> latter allows for credit risk
o Term-standard discount rates could be used to vary rates over time to reflect yield curve
o Mkt. rate of inflation derived as diff. b/w yields on suitable portfolios of FI & IL bonds - This tends to be conservative approach to valuation since its based on bond yields
7
Q
Outline bond yields + risk premium method of valuing A/Ls:
A
- Assets taken at market value
- Discount rate found by adjusting bond yields by adding a constant/variable ERP
- Adding constant ERP gives same result as mark to mkt method except this usually results in lower value placed on liabilities
- Adding variable ERP using mkt info & actuarial judgment gives a optimistic estimate of liabs
8
Q
Outline the asset-based discount rate method of valuation:
A
- Assets are taken at market value
- Implied market discount rate calculated for each asset class eg
o For FI securities it may by GRY
o For equities it involves estimating discount rate implied by current mkt price & expected div/sale proceeds
o Might be subjective for assets like property - Liabs are valued at the discount rate calculated as the weighted avg. of discount rates based on proportion of different asset classes held
- Discount rate could also be determined using scheme’s strategic benchmark or the dbn of actual investment portfolio
9
Q
Under what circumstances can an option/guarantee be exercised?
A
- In situations where the guarantees make the option more financially advantageous (in the money)
- Sometimes options are exercised even when the alternative would be better for the client financially eg. surrendering a LI policy because of having a better immediate use for the money
10
Q
Why might a p/h exercise an option even if its not in their best financial interest?
A
- Better immediate use for lump sum of cash eg. mortgage, financing home improvements, car, holiday
- Beneficial tax treatment in the hands of the individual
11
Q
How to value options & guarantees prudently?
A
- Assuming that options will only be exercised “in the money” is highly prudent even for solvency calculation
- Take up rate of the option will be set according to the level of prudence required
12
Q
What are the factors affecting the value of options?
A
- State of the economy (options must be scenario specific)
- Consumer sophistication
- Demographic factors eg. age, health, employment status
- Cultural bias eg. preference for cash to spend immediately
13
Q
Which method is the best for estimating the price of guarantees?
A
- A stochastic approach which takes the class of business as a whole
14
Q
What is sensitivity analysis used for?
A
- Used to determine the risk margins to place on assumptions used to set provisions
o While taking solvency capital into account - Used to determine the global provisions to be kept aside for potential future adverse experiences
15
Q
Outline how to carry out sensitivity analysis:
A
- Start with a set of central assumptions
- Change one assumption at a time in a logical manner
- Quantify the effect of assumption changes
- Then test the effects of multiple assumption changes
- Assumptions are usually neither independent nor fully correlated
=> Effect of applying two tests simultaneously will be less or greater than sum of individual effects
