33. Valuation of liabilities TO DO Flashcards
What is the most important fact to consider when setting the discount rates used to value A and L?
- • Consistency between the two rates
- Describe the traditional cashflow method of valuing A and L.
- A + L valued
- Discounting future cashflows
- Discount rate=> reflects the long-term future investment return expected
What is the major criticism of the traditional discounted cashflow method?
- • Produces V(A) MV(A)
- o Difficult to explain difference to clients
- • => MV(A)+ MV(L)
What are two definitions of fair value?
- Amount for which an asset could be exchanged
- Or liability settled
- Between knowledgeable
- Willing parties
- In arm’s length transaction
- Amount the enterprise
- Would have to a pay a 3rd party
- To take over the liability
What financial contracts will it be easy to determine a fair value of?
- Unit linked contracts=> Value of liability is the value of the units. o Unit price is calculated frequently
- Pension in payment liabilities of a benefit scheme=> Active buyout market o Consisting of insurance companies willing to provide immediate annuities o To cover pensions in payment
What is the major difficulty in determining the fair value of a provider’s liabilities?
- No liquid secondary market
- Identification from the market is not practical
- Fair value of liabilities=> Estimated using market-based assumptions
What is the replicating portfolio mark to market method of valuing assets and liabilities?
- A taken at market value
- L discounted at the yield of investments o Closely replicate duration and risk characteristics-bonds o RP=> Using stochastic optimisation techniques-ALM
- Term specific discount rates=> reflect shape of the yield curve
- Other assumptions=> Market related o Market rate of inflation= yield on inflation linked-yield on fixed interest
- o Over the same term
What is the replicating portfolio- bond yield plus risk premium method of valuing assets and liabilities?
- A taken at market value
- L discounted at yields on investments: o Closely replicate duration and risk characteristics-bonds
- L discount rate= Discount rate + Risk premium
- Risk premium o Constant o Variable
- CRITICISM=> Taking account of extra return should only be done if extra risk is accounted for
- o HENCE NO ADDITIONAL RISK PREMIUM
What is the asset-based discount rate approach for valuing A and L?
- A taken at market value
- Implied market discount rate is determined for each asset class
- Liabilities discount rate calculated as weighted average of: o The individual discount rates of the assets classes o Based on the proportion invested in each class
- Could be determined using the schemes actual split or
- Strategic benchmark if the scheme has invested differently to usual
How can the fair value of liabilities be determined by performing a ‘risk neutral’ marketconsistent valuation?
- PV(Future L cashflows)
- Discount rate= pre-tax market yield on risk free assets
What factors should be considered when valuing guarantees?
- Cautious approach
- WORST CASE ASSUMED IN EVERY SCENARIO=> TOO MUCH CAUTION
- o Unless all guarantees are monetary
- Stochastic model=> Likelihood of the guarantee biting+ associated E[cost]
- Parameter values=> Reflect the purpose for which the results are required
- Guarantees may become +- onerous over time
- Economic scenarios+ sophistication of market=> value of guarantees and +influence on consumer behaviour
What factors should be considered when assessing the cost of an option from the view point of the provider?
- Cautious approach
- CAN BUILD IN TOO MUCH CAUTION
- Policy holder might not exercise the highest cost option
- Valuing options=> allow for anti-selection risk
- OR mitigate using eligibility criteria for exercising the option
- Some guarantees make options more valuable in certain circumstances=>NOT INDP
- Deterministic + Closed form (BLACK SCHOLES) methods can be used
What factors will the option exercise rate depend on?
- State of the economy
- Demographic factors
- 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 o Size of the margin= Amount of risk+ materiality on final result
- Risk factor has been stable=Margin simple % loading
- More uncertainty= Margin determined stochastically-Meet R T
- Contingency loading=> Liabilities increased by certain % o Size of the margin reflects the uncertainty involved o 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 market consistent fair valuation of liabilities?
- • Financial risk=> Replicating portfolio o Or stochastic modelling approach o Mismatching risk ignored
- ✓ Fair value of liabilities independent of the A held
- Non-financial risk=> adjusting expected cashflows
- Adjusting the discount rate
- Extra provision or capital 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 o E.G if claim numbers follow a known distribution
- o Provision = amount keeps probability of ruin to a<below a specified level
- Case by case estimates=> if the insured risk are rare and volatile
- Proportionate approach=> UPR
- Equalisation reserves=> Smooth profits from year to year o Not recognised by regulator o May be seen as tax deferral
- Chapter 34- Reporting results
