Ch 32: Provisions

Question 1

Define the term provisions

1

Answer 1

Provisions are the calculated amounts that need to be set aside to meet a provider’s future liabilities. The value of the provisions will depend on the assumptions used to value the future expected cashflows.

Question 2

List 10 reasons why a provider calculates provisions

Answer 2

BAD MEDICS

• Benefit improvements for a benefit scheme
• Accounts and reports - published and internal
• Discontinuance / surrender benefits
• Mergers and acquisitions
• Excess of assets over liabilities and so whether any discretionary benefits can be awarded
• Disclosure of information for beneficiaries
• Investment strategy
• Contribution / premium setting
• Statutory solvency reports

Question 3

What is the difference between individual and global provisions?

2

Answer 3

• Individual provisions relate to an individual contract or scheme member.
• Global provisions relate to a provider’s liabilities as a whole and include additional provsions for other risks

Question 4

Calculation of reserves on different types of insurance contracts

4

Answer 4

• Life: Discounted CF approach Reserve= EPV Benefits= EPV Outstanding premiums
• General: Run- off triangles
• Benefit schemes: DC: val benefit= accum contribution - charges
  : DB: Discounted CF
• Banks: Estimate and account for future credit losses

Question 5

Best estimate basis

3

Answer 5

• Set of assumptions that have an equal probability of overstating and understating the value of the assets and the liabilities.

Key Assumptions:
* Discount rate
* Benefit inflation
* Mort/Morb
* Discontinuance rate
* Expense inflation

Sources of info:
* Past experience
* Population Statistics
* Projections about future( inflation, investment ret)

Question 6

Optimistic (or weak) basis

1

Answer 6

• Assumptions are chosen which collectively result in a high value of assets and/or a low value of liabilities.

Question 7

Cautious (or prudent/strong) basis

1

Answer 7

• Assumptions are chosen which collectively result in a low value of assets and/pr a high value of liabilities

Question 8

State the 3 main factors that usually dictate the strength of the basis on which values should be determined

Answer 8

1. Purpose of the valuation
2. Needs of the client
3. Regulatory / legislative requirements

Question 9

Give 3 examples of how the nature of the assets held can impact the liability valuation

Answer 9

1. The liabilities may be specifically defined in terms of the performance of the assets (e.g. unit-linked contract, unit trust)
2. Where the sponsor will not make up any shortfall in a pensions fund, the benefits paid must have to be reduced to reflect the actual assets available.
3. For a market-consistent valuation of life insurance financial guarantees the liability value will depend on the volatility of returns on the assets held.

Question 10

Setting assumptions for published accounts

4

Answer 10

• Stakeholders use published info to make decisions so Best estimate should be used
• Assumptions made should also consider legislation and accounting standards
• eg Going concer basis: Accounting basis required for published accounts based on assumption insusrer will continue to trade
• eg Break up basis:assumes no future trade and is a wind up basis

Question 11

Setting assumptions for Solvency Requirements

4

Answer 11

• Regulators want values that are a realistic picture of finances, so cautious basis used
• Used to demonstrate solvency and could be prescribed by the PA
• eg BEL+ small margins + SCR
• eg BEL+ large margin

Question 12

Setting assumptions for internal accounts

1

Answer 12

• Best estimate, to provide a realistic picture for decision-making by management.

Question 13

Outline the factors to consider when valuing the liabilities for a transfer of liabilities between two providers.

4

Answer 13

1. The transferring company will prefer optimistic assumptions.
2. The receiving company will prefer cautious assumptions.
3. A best estimate basis is fair, and the need to to agree may result in a best estimate basis being used.
4. However, the basis will depend on the relative bargaining powers of both sides and relative supply and demand for liability transfers.
5. It is possible that the two sides agree that the transfer should not reflect a best estimate of future costs, for example if they recognize a need to hold a margin to protect the security of the benefits.

Question 14

What basis should be used when determining whether discretionary benefits can be awarded or benefit improvements made?

2

Answer 14

• The provider may want to use assumptions that do not overestimate the surplus available in order to avoid being pressurized into distributing it as discretionary or additional benefits. Similarly, proposed benefit improvements should not be undervalued.
• The most realistic indication will be based on best estimate assumptions, but a cautious basis (or range of assumptions) may be used.

Question 15

Outline the factors to consider when valuing the liabilities to set contributions for a defined benefits scheme, from the perspective of the trustees and the beneficiaries

2

Answer 15

1. Cautious basis to ensure better security of benefits
2. But not so cautious that the sponsor believes the cost of benefits to be excessive and hence reduces future benefits, closes the scheme to future accrual, or pays a high contribution rate and becomes insolvent.

Question 16

Outline the factors to consider when valuing the liabilities to set contributions for a defined benefit pension scheme, from the perspective of the sponsor

Answer 16

1. Optimistic if there is a high opportunity cost of capital.
2. Cautious if higher contributions now may lead to greater flexibility in the future.
3. Cautious if higher contributions may result in tax deferral.
4. Cautious if the sponsor wants to be viewed as paternalistic
5. Cautious if there is a low opportunity cost of capital
6. Cautious if better investment returns can be earned within the scheme leading to lower long-term costs.
7. Best estimate for stability of cost and a compromise between the above factors.

Question 17

What basis should be used when setting discontinuance terms, in order to be “fair” to all parties?

Answer 17

Best estimate, for fairness between those discontinuing, those remaining and the provider.

Question 18

Outline factors to consider when valuing the liabilities to set an investment strategy.

2

Answer 18

1. A large number of different scenarios should be examined - particularly best estimate and cautious.
2. A stochastic model could be useful in assessing the risks and values under each possible investment strategy.

Question 19

Outline the factors to consider when setting a basis to illustrate the level of benefits to which an individual is entitled, the level of investment return they might expect to receive and the contributions they might be required to make to target a specific level of benefits.

Answer 19

1. The assumptions should take into account the circumstances of the individual, e.g. age, gender, marital status.
2. Best estimate allows realistic decisions to be made.
3. A range of values communicates the uncertainty involved.
4. If the individual is averse to the risk of under-provision, a cautious approach may be appropriate.