33 - Valuation of Liabilities

Question 1

give the different approaches available when calculating the value fo liabilities.

Answer 1

1. Discounted cashflow approach.

2. Market-related approaches

Question 2

Give the key assumption when using a discounted cashflow approach.

Answer 2

The expected investment return

Question 3

Under which scenario is a discounted cashflow approach to valuing liabilities inappropriate.

Answer 3

When valuing short-term liabilities.

Question 4

Describe the discounted cashflow method for valuing liabilities.

Answer 4

A long-term discount rate is used to value both assets and liabilities.

Question 5

Describe the market-related approach to valuing liabilities.

Answer 5

A replicating portfolio approach or actual asset-based approach can be used where assets are valued at market value and a discount rate for liabilities is determined this way.

Question 6

Give the two definitions or fair value.

Answer 6

1. The amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm’s length transaction.
2. The amount that the enterprise would have to pay a third party to take over the liability.

Question 7

Explain the difference between “salary inflation” and “earnings growth”.

Answer 7

Salary inflation is an overall increase in salaries linked to general inflationary conditions and so is expected to be in line with inflation over the same period.
Earnings growth is an individuals growth over their working life and is influenced by individual circumstances and is usually above inflation as people move up their corporate hierarchy.

Question 8

Give different methods for setting the discount rate for valuing liabilities.

Answer 8

1. Traditional discounted cashflow
2. Replicating portfolio (mark to market)
3. Replicating portfolio (bond yields plus risk premium)
4. Asset-based discount rate.

Question 9

Describe the method of choosing the discount rate for valuing liabilities with the traditional cashflow method.

Answer 9

The discount rate is the same long-term rate as used for assets.

Question 10

Describe the method of choosing the discount rate for valuing liabilities with the mark to market method.

Answer 10

The discount rate implied by the market price of investments that match liabilities - usually bonds

Question 11

Describe the method of choosing the discount rate for valuing liabilities with the bond yield plus risk premium method.

Answer 11

The discount rate is the same as the mark to market method but then adjusted to take account of higher expected returns on other asset classes to bonds.

Question 12

Describe the method of choosing the discount rate for valuing liabilities with the asset-based method.

Answer 12

The discount rate is the expected return on assets, weighted by proportions held of each asset class.

Question 13

Describe the additional features to take into account when using corporate bonds for a replicating portfolio to value liabilities.

Answer 13

1. There is a marketability premium included

2. The credit risk of the bond is ignored

Question 14

Explain the level of prudence implied by using bonds in a replicating portfolio.

Answer 14

The discount rates are usually low since the expected returns on bonds are usually low. Thus, the basis is normally a conservative basis.

Question 15

Give a key issue when using bonds to value liabilities through a replicating portfolio.

Answer 15

There will be differences in return on the assets usually held to match liabilities if other assets to bonds are held, which would introduce further volatility in the matching and the implied assumption about the volatility of returns by using bonds should be assessed.

Question 16

Explain why the methods for valuing options and calculating accounting provisions may differ.

Answer 16

1. It is not always appropriate to assume that the highest cost option is always exercised due to the attraction of cash or tax-free benefits to individuals.
2. The risk of anti-selection should be allowed for when valuing options

Question 17

Give the factors that the assumptions used to price options depend on.

Answer 17

1. The state of the economy.
2. Demographic factors such as age, health and employment status
3. Cultural bias
4. Consumer sophistication

Question 18

Describe how consumer sophistication can influence the pricing of options

Answer 18

1. Wealthier people may require more flexibility and be able to do more price comparisons.
2. Older people are more technologically challenged

Question 19

Give the most appropriate method for pricing or valuing financial guarantees.

Answer 19

Stochastic methods over the class of business as a whole.

Question 20

Why is a stochastic method for valuing financial guarantees more appropriate than an individual basis or a deterministic approach.

Answer 20

1. Allows for the likelihood of the guarantee biting and its expected cost.
2. The guarantee may become more or less onerous over time depending on the experience.

Question 21

Give the uses of sensitivity analysis in the valuation of liabilities.

Answer 21

1. To help determine the extent of margins needed in assumptions, to allow for adverse future experience
2. In determining the extent of any global provisions needed.

Question 22

Give the restrictions on eligibility for options that can reduce the costs and likelihood of an option being exercised.

Answer 22

1. Limiting monetary amounts of options with a min or max
2. Limiting the times that the option can be exercised
3. Increasing underwriting
4. Non-revertable options
5. Restrictions on relationships to dependants
6. Minimum values that need to be involved with the options so as to cover admin costs
7. Restrictions on early retirement or ill-health claims.

Question 23

Give the different methods for allowing for risk in cashflows.

Answer 23

1. Building a margin into each cashflow
2. Apply an overall contingency loading by increasing the liability value by a certain percentage.
3. Adjust the discount rate to reflect the risk in the project liability.

Question 24

Describe how a replicating portfolio method for valuing liabilities accounts for financial risk.

Answer 24

The fair valuation has an implicit allowance for financial risk.

Question 25

Why is an adjustment for mismatching not usually made to a stochastic or replicating portfolio method for valuing liabilities?

Answer 25

To achieve independence fo the fair value of liabilities from the valuation of assets.

Question 26

Describe how allowance for non-financial risk is accounted for when valuing liabilities.

Answer 26

1. Adjusting cashflows
2. Adjusting the discount rate
3. An extra provision or capital requirement

Question 27

Give different methods for calculating provisions.

Answer 27

1. Statistical analysis - many claims are following a known pattern
2. Case-by-case estimate - individual assessment of claim records where there are few claims and variable claim amounts
3. Proportionate approach - base on amount of net premium yet to expire

Question 28

What is the purpose of an equalisation reserve?

Answer 28

To smooth results from year to year where there are low probability risks with a high and volatile outcome.