Ch 33: Valuation Of Liabilities Flashcards
What is the most important factors to consider when setting the discount rates used to value the assets and liabilities?
CONSISTENCY between the rates used for asset and liability valuations
Describe the traditional discounted cashflow method of valuing assets and liabilites
Both assets and liabilities are valued by discounting the future cashflows using a rate that reflects the long-term future investment return expected.
The rates and assumptions are based on actuarial judgement.
What is the major criticism of the traditional discounted cashflow method of valuing assets and liabilities?
It provides a value of the assets that is different from the market value. It is difficult to explain to clients.
(Consequently, there has been a move towards market-related methods of valuing assets and liabilities)
Give two definitions of “fair value”
- The amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm’s length transaction.
- The amount that the enterprise would have to pay a third party to take over the liability
Give 2 examples of financial contracts for which it might be fairly straightforward to determine a fair value.
- Unit linked contracts - the value of the liability is effectively known since it is the value of the units and the unit price is determined on a frequent basis.
- The pensions in payment liabilities of a benefit scheme - there may be an active ‘buyout’ market consisting of insurance companies and other financial organizations that are prepared to provide immediate annuities to cover pensions in payment.
What is the major difficulty in determining the fair value of a provider’s liabilities?
There is no liquid secondary market in most of the liabilities that actuaries are required to value, so the identification of fair amounts from the market is not practical. As a result, fair values of liabilities need to be “estimated” using market-based assumptions.
Describe the replicating portfolio - mark to market method of valuing assets and liabilities
(in own words: this methods uses Financial Engineering techniques. Put assets in rep. port. that have the same RISK characteristics and BEHAVE in the SAME way as liabilities, and then construct and price this replicating portfolio using the market based discount rates.
Now the price of the replicating portfolio (with underlying assets) should be the price of the liabilities)
Assets are taken at market value.
Liabilities are discounted at the yields on investments that closely replicate the duration and risk characteristics of the liabilities - often BONDS. The replicating portfolio can be determined using stochastic optimization techniques (asset-liability modelling)
Ideally, term-specific discount rates would be used to reflect the shape of the yield curve.
Other assumptions should also be market related, for example:
- Inflation -> the market rate of inflation is derived as the difference between the yields on fixed interest and index-lined government bonds of an appropriate term.
Describe the replicating portfolio - bond yields plus risk premium method of valuing assets and liabilities
The method is similar to the mark to market method with:
- assets taken at market value
- liabilities discounted at the (adjusted) yields on investments that closely replicate the duration and risk characteristics of the liabilities - often bonds.
–> The discount rate used is found by adjusting bond yields by the addition of a constant/variable Equity Risk Premium
However, the liability discount rate is adjusted to reflect a risk premium (such as.
The risk premium may be constant or variable.
However, some actuaries think that taking account of the extra return from other assets is unsound unless account is also taken of the extra risk, and that a risk premium should not be used.
– This methods starts by using a DISCOUNT rate based on BONDS YIELDS as in “mark to market methods”, but then ADJUSTS DISCOUNT RATE to take into account the expected returns on other assets classes.
Describe the asset-based discount rate approach for valuing assets and liabilities
Assets are taken at market value.
An implied market discount rate is determined for each asset class.
(e.g. fixed interest assets = GRY; equities = discount rate implied by market price and the expected dividends and sale proceeds)
The liabilities are valued using a discount rate calculated as the weighted average of the individual discount rates based on the proportions invested in each asset class.
The discount rate could be determined using the distribution of the actual investment portfolio or the scheme’s strategic benchmark (if the current asset allocation is not representative of the scheme’s usual investment strategy)
Outline how the fair value of liabilities can be determined by performing a “risk-neutral” market-consistent valuation.
The value is determined as the present value of future liability cashflows, discounted at the pre-tax market yield on risk-free assets.
Such assets might be swaps or government bonds.
Outline the factors to consider when valuing guarantees
- In general, a CAUTIOUS approach is taken
- However, unless all guarantees are in the money, assuming the worst case scenario in every case will build in too much caution.
- A STOCHASTIC model should be used for valuing guarantees (taking the class of business as a whole), to show the likelihood of the guarantees biting and the associated cost. Parameter values should reflect the purpose for which the results are required.
- Guarantees may become more or less onerous over time.
- The value of guarantees and their influences on consumer behavior will vary widely according to the economic scenarios and the sophistication of the market.
Outline the factors to consider when assessing the cost of an option from the perspective of the provider
- In general, a cautious approach is taken
- However, this can build in too much caution.
- For example, a policyholder may not exercise the highest cost option despite it being financially better for them to do so.
- It is necessary to allow for anti-selection risk when valuing options, or to mitigate this risk using eligibility criteria for exercising the option.
- Options and guarantees are not necessarily independent; some guarantees may make options more valuable in certain circumstances.
- Deterministic and closed-form (e.g. Black Scholes) methods could be used.
State 4 factors on which the option exercise rate assumption will depend
- The state of the economy
- Demographic factors, e.g. age, health, employment status
- Cultural bias
- Consumer sophistication
State 2 examples of where an assumption of the policyholders always exercising an option that is in-the-money from the provider’s perspective may not be appropriate
- The policyholder prefers to take the alternative benefit as it is paid as a lump sum cash amount.
–> cash-in-hand has a powerful influence on an individual’s decision. - The policyholder receives beneficial tax treatment on the alternative benefit.
–> e.g. taking a % lump sum of pension, as it is tax-free. Uses rest of pension to purchase annuity-based income (which is taxed)
Describe 3 approaches to ALLOWING FOR RISK in the cashflows used for valuing liabilites
- Best estimate + Margin - a margin is explicitly built into each assumption. The size of the margin reflects the amount of risk involved and its materiality to the final result.
- Contingency loading - the liabilities are increased by a certain percentage. The size of the margin reflects the uncertainty involved. This method is very arbitrary.
- Discount rate - the discount rate is DECREASED by a risk premium that reflects the overall risk of the liability.
–> usually defined by governing bodies.
