Ch 32: Provisions

Question 1

How are risk management and provisions interlinked?

Answer 1

Better risk management processes lead to lower provisions being required

Question 2

Why does a firm want to reduce its provisions seeing as they are security against insolvency?

Answer 2

Firms aim to maximise 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 the funds as efficiently as possible.

Question 3

Describe the relationship between model assumptions, provisions and the reasons for calculating provisions.

Answer 3

Provisions are highly dependent on the assumptions in the models used to calculate different scenarios (with different degrees of prudence), which in turn, are highly dependent on the reasons for calculating reserves.

Question 4

Give a key characteristic of the stakeholders involved when calculating provisions

Answer 4

The risk appetites of the stakeholders.

Question 5

Give the reasons for calculating individual provisions (10)

Answer 5

1) Determine the value of liabilities for published accounts.
2) Demonstrating supervisory solvency
3) Determining the value of liabilities for internal management accounts.
4) Valuing the provider for a merger or acquisitions.
5) Setting future contribution levels for a benefit scheme.
6) Valuing benefit improvements for a pension scheme.
7) Calculating discontinuance benefits.
8) Influencing investment strategy.
9) Providing disclosure information to beneficiaries.
10) To provide for excess credit losses for a bank.

Question 6

Give the general reasons for calculating global reserves

Answer 6

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.

Question 7

Give the purpose of a general provision (3)

Answer 7

1) Acts as additional protection against solvency.
2) Cover risks, both financial and non-financial, that cannot necessarily be attributed to individual contracts.
3) Reflect the degree of mismatching of assets and liabilities.

Question 8

Give the sources of non-financial risk that a company may face and wish to address through a global reserve.

Answer 8

• Operational risk
• Default risk
• Anti-selection
• Regulatory fines
• Miss-selling of products

Question 9

Explain why an insurer cannot accurately price for anti-selection

Answer 9

If the insurer was able to foresee or detect possibilities of anti-selection, they would include clauses in the contract 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.

Question 10

Give the main factor of a firm that influences its use of and balance between individual reserves and global reserves.

Answer 10

The firm’s risk management strategy.

Question 11

Give the different levels of provisioning basis, in order of which would produce the lowest provisions to the most.

Answer 11

1) Optimistic
2) Best estimate
3) Cautious/prudential

Question 12

Describe a general issue when it comes to consistency of provisioning basis between firms and why it is a concern.

Answer 12

Not everyone will see each of the strengths for provisioning in the same way. This causes differences in approaches even if the provisions are being calculated under the same strength of provisioning (degree of prudence). This causes issues when comparing results from different firms.

Question 13

Give the factors affecting the choice of basis and valuation method (4)

Answer 13

1) The reason a value needs to be determined (the purpose of the valuation).
2) The needs of the client, the stakeholders’ perspective and use of the value.
3) Legislative and regulatory requirements - method may be prescribed.
4) The nature of the assets used to back liabilities.

Question 14

Give the situations where the valuation of liabilities for provisions is affected by the nature of assets used to back those liabilities (3)

Answer 14

1) Liabilities are linked to the underlying assets (e.g. unit linked trusts or internal investment fund)
2) When the covenant of the sponsor has no value.
3) 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.

Question 15

Give the various purposes of calculating provisions for a financial service provider (9)

Answer 15

1) Published accounts
2) Supervisory solvency
3) Internal accounts
4) Liability transfer
5) Determining whether discretionary benefits can be awarded
6) Setting contribution levels
7) Calculating discontinuance benefits
8) Setting investment strategy
9) Disclosure information for beneficiaries

Question 16

Describe the considerations with regards to setting assumptions for provisioning for published accounts (4)

Answer 16

1) Will reflect legislation and accounting principles
2) Going-concern or a break-up basis
3) Reflect a true and fair value
4) Whether best estimate or prudent

Question 17

Describe the considerations with regard to setting assumptions for provisioning for supervisory solvency

Answer 17

1) The degree of prudence
2) Any prescribed methods/assumptions to be followed
3) Any disclosure agreements with regards to the use of actuarial judgement

Question 18

Describe the considerations with regards to setting assumptions and provisions for internal accounts

Answer 18

The best estimate is usually used

Question 19

Describe the considerations with regards to setting assumptions and provisions for liability transfers

Answer 19

1) A best-estimate method is usually used to achieve fairness.

Method and assumptions may differ due to:
- Power imbalance between concerned parties
- Stronger desires to proceed by one or the other party
- Recognising the need to hold margins to protect security.

Question 20

Describe the considerations with regards to setting assumptions and provisions for determining discretionary benefits

Answer 20

Likely to be prudential/cautious so as not to overstate the surplus

Question 21

Describe the considerations with regards to setting assumptions and provisions for setting contribution levels

Answer 21

Assumptions set will depend on the objectives of the parties involved and the structure of memberships.
Try to balance the level of benefits provided, the willingness of the sponsor and the security of the benefits offered.

Question 22

Describe the considerations with regards to setting assumptions and provisions for calculating discontinuance benefits

Answer 22

Usually, the best-estimate is fair, bus may use other basis depending on the situation

Question 23

Describe the considerations with regards to setting assumptions and provisions for setting the investment strategy

Answer 23

A realistic set of assumptions is usually used, combined with sensitivity and scenario testing.
Usually, a stochastic approach can add significant value.

Question 24

Describe the considerations with regards to setting assumptions and provisions for disclosure of information to beneficiaries

Answer 24

Assumptions will reflect legislation, but a realistic basis is usually used and a range of results is usually included/presented.