Ch 33: Valuation of liabilities

Question 1

Give the different approaches available when calculating the value for liabilities

Answer 1

1) Discounted cashflow approach
2) Market-based approach
3) Fair value approach

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-value approach to valuing liabilities

Answer 5

A replicating portfolio approach or actual assets-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 of fair value

Answer 6

1) The amount for which assets 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

Give different methods for setting the discount rate for valuing liabilities (4)

Answer 7

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

Question 8

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

Answer 8

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

Question 9

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

Answer 9

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

Question 10

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

Answer 10

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

Question 11

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

Answer 11

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

Question 12

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

Answer 12

1) There is a marketability premium included.
2) The credit risk of the bond is ignored.

Question 13

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

Answer 13

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

Question 14

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

Answer 14

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 15

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

Answer 15

1) It is not always appropriate to assume 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 16

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

Answer 16

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

Question 17

Describe how consumer sophistication can influence the pricing of options

Answer 17

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

Question 18

Give the most appropriate method for pricing or valuing financial guarantees

Answer 18

Stochastic methods over the class of business as a whole

Question 19

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

Answer 19

1) Allows for the likelihood of the guarantees biting and its expected cost.
2) The guarantee may become more or less onerous over time depending on experience.
3) Allows for a distribution of values with their associated probabilities.

Question 20

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

Answer 20

1) Limit monetary amounts of options with a min or max.
2) Limiting the times that the option can be exercised.
3) Increasing underwriting
4) Non-revertible options
5) Restrictions on relationships to dependents
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 21

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

Answer 21

The fair valuation has an implicit allowance for financial risk

Question 22

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

Answer 22

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

Question 23

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

Answer 23

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

Question 24

Give different methods for calculation provisions

Answer 24

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 - based on amount of net premium yet to expire

Question 25

What is the purpose of equalisation reserve?

Answer 25

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

Question 26

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

Answer 26

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

Question 27

Give the different methods for allowing for risk in cashflows

Answer 27

1) Building a margin into each cashflow
2) Applying 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.