33. Valuation of liabilities Flashcards
What is the most important fact to consider when setting the discount rates used to value A and L or valuing A and L?
- Consistency between the two rates
Describe the traditional discounted cashflow method of valuing A and L
- A + L valued by
- Discounting future cashflows using
- Discount rate that=> reflects the long-term future investment return expected
What is the major criticism of the traditional discounted cashflow method?
- Produces V(A) that is different from MV(A)
- Difficult to explain difference to clients
Describe the market-based approach reflecting assets held, for valuing assets and liabilities
- Assets are taken at market value
- Determine implied market discount rate for each asset class
- e.g. For fixed-interest securities it may be GRY, equities = market price + expected dividend or redemption
- L are valued using a discount rate calculated as the weighted average of the individual discount rates based on proportions invested in each asset class
What are two definitions of fair value?
- 1.Amount for which an asset could be exchanged
- Or liability settled
- Between knowledgeable
- Willing parties
- In arm’s length transaction
- 2.Amount the enterprise
- Would have to a pay a 3rd party
- To take over the liability
Give two examples of financial contracts which it will be easy to determine a fair value?
- Unit linked contracts=> Value of liability is the value of the units. Unit price is calculated frequently
- Pensions in payment liabilities of a benefit scheme=> Active buyout market
- Consisting of insurance companies willing to provide immediate annuities
- To cover pensions in payment
What is the major difficulty in determining the fair value of a provider’s liabilities?
- No liquid secondary market
- Thus identification of fair values from the market is not practical
- As a result, fair value of liabilities=> needs to be Estimated using market-based assumptions
Describe the replicating portfolio method of valuing assets and liabilities?
- A taken at market value
- A replicating portfolio of assets is identified that most closely replicates
- Duration and risk characteristics of the liabilitites
- The fair value of liabilities is taken as the market value of the replicating assets
Describe the risk-neutral market-consistent approach to valuing assets and liabilities
- Discount future liability cashflows at pre-tax market yield on risk-free assets e.g. governement bonds or swaps
What factors should be considered when valuing guarantees?
- In general, cautious approach
- However, unless all gurantees are in the money, assuming the worst-case scenario in every case can build in too much caution
- Stochastic model for valuing gurantees => Likelihood of the guarantee biting+ associated E[cost]
- Parameter values=> depend on the purpose of the valuation
- Guarantees may become more or less onerous over time
- Value of guarantees and thier influences on consumer behaviour will vary => depending on economic scenarios and sophistication of the market
What factors should be considered when assessing the cost of an option from the view point of the provider?
- Cautious approach
- However, CAN BUILD IN TOO MUCH CAUTION
- e.g. Policy holder might not exercise the highest cost option despite it being financially better for them to do so
- When valuing options=> necessary to allow for anti-selection risk
- OR mitigate using eligibility criteria for exercising the option
- Some guarantees make options more valuable in certain circumstances=>NOT INDEPENDENT
- Deterministic + Closed form (BLACK SCHOLES) methods can be used
What factors will the option exercise rate depend on?
- State of the economy
- Demographic factors e.g. Age, health, employment status
- Cultural basis
- Consumer sophistication
When might policy holders not exercise options that are in the money?
- Policyholder may prefer to take the alternative benefit as it is a lump sum cash amount
- Policy holder receives beneficial tax treatment on the alternative benefit
What are the approaches to allowing for risk in the cashflows used for valuing liabilities?
- BE and margin=> Margin explicitly built into each assumption.
- Size of the margin= Amount of risk+ materiality on final result
- Risk factor has been stable=Margin simple % loading
- More uncertainty= Margin determined stochastically to meet risk tolerance
- Contingency loading=> Liabilities increased by certain %
- Size of the margin reflects the uncertainty involved
- Method is very arbitrary
- Discount rate=> Decreased by a risk premium that reflects the overall risk of the liability
How can risk be allowed for in a fair valuation of liabilities?
- Financial risk=> Replicating portfolio
- Or stochastic modelling approach.
- Mismatching risk ignored because
- Fair value of liabilities independent of the A held
- Non-financial risk=> adjusting expected cashflows
- Adjusting the discount rate
- Extra provision or capital requirement held
- Adjustments depend on the amount of the risk + cost of risk-implied by the market
What methods can an insurance company use for establishing provisions?
- Statistical analysis=> Many claims following a known pattern
- E.G if claim numbers and amounts follow a known distribution
- Provision = amount keeps probability of ruin below a specified level
- Case by case estimates=> if the insured risk is rare and volatile e.g. Personal injury claims
- Proportionate approach=> Accepted risks but risk event has not yet occured
- Equalisation reserves=> Smooth profits from year to year
- Not recognised by regulator
- May be seen as tax deferral
