CH31 - Provisions

Question 1

Provisions

Answer 1

Provisions are amounts set aside to meet future liabilities.
The value placed on the provisions is highly dependent on the assumptions used, which, in turn, will be highly dependent on the reason(s) for calculating the provisions.

Question 2

Reasons for calculating individual provisions (10)

Answer 2

1. Determining the value of liabilities for published accounts
2. Demonstrating supervisory solvency (if separate accounts and reports are prepared for that purpose)
3. Determining the value of liabilities for internal management accounts
4. Valuing the provider for merger of acquisition (or transferring liabilities)
5. Determining whether discretionary benefits can be awarded (by determining the excess of assets over liabilities)
6. Setting future contribution levels for a benefit scheme
7. Valuing benefit improvements for a pension scheme
8. Calculating discontinuance / surrender benefits
9. Influencing investment strategy
10. Providing disclosure information to beneficiaries

Question 3

Global provisions

Answer 3

As well as calculating provisions in respect of each individual contract, there may be a requirement to calculate an additional global provision.
The purpose of this main global provision may be to:
1. act as additional protection against insolvency
2. cover risks, both financial and non-financial, that cannot necessarily be attributed to individual contracts (credit risk, operational risk)
3. reflect the degree of mismatching of assets and liabilities

The provider’s risk management strategy is an important influence on provision for risks.

Question 4

Different bases

Answer 4

As the timing and level of benefits, contributions and asset income is not certain, an actuary can never be certain that a set of assumptions will be correct.
The bases in order of increasing strength are: optimistic, best estimate and cautious.
A best estimate basis is a basis with an equal probability of overstating or understanding values.

Question 5

Factors affecting the choice of basis and valuation method (3)

Answer 5

The strength of the basis used depends upon:

1. the reason for (or purpose of) the valuation
2. the needs of the client
3. regulation and legislation

In many cases presentation of a range of values, or values for alternative scenarios, may be more useful to the client in making any necessary decisions.

The nature of the assets may also need to be taken into account when valuing liabilities.

Question 6

Setting assumptions with regard to the client

Answer 6

As well as considerations relating to different clients having different purposes, need to consider the client’s risk appetite and the interactions with other stakeholders.

Question 7

Setting assumptions with regard to published accounts (decisions by shareholders)

Answer 7

Shareholders and potential shareholders make decisions using information in a company’s accounts. It is, therefore, preferable for values to be included in the accounts that represent an actuary’s ‘best estimate’ of the future experience.

The assumptions will reflect legislation and accounting principles. Matters to be considered include:

• using a going concern or break-up basis
• reflecting a true and fair view
• whether best estimate of prudent

Another important consideration is consistency in approach from year to year.

Question 8

Setting assumptions with regard to supervisory solvency (decisions by regulators)

Answer 8

Regulators may wish to consider values that present a realistic picture of a provider’s finances. Alternatively, they may wish to consider values that intentionally understate (or perhaps overstate) the financial strength of the provider.

Need to consider the degree of prudence and any prescribed methods / assumptions to be followed, or whether left to actuarial judgement with a disclosure requirement.

Reference should be made to the rules and any guidance that may have been issued as to their interpretation.

Question 9

Setting assumptions with regard to internal accounts

Answer 9

A best estimate basis is typically used. Internal accounts are often used as a basis for decision making by the directors of the provider or the trustees (for a benefit scheme)

Question 10

Setting assumptions with regard to liability transfers

Answer 10

A best estimate basis might be used to calculate the value of liabilities to be transferred so as to achieve fairness for all parties and to achieve agreement between actuaries acting for different parties. However, a different basis might be used:

• due to a power imbalance between the parties concerned
• because of a stronger desire to proceed by one party
• to recognise the need to hold margins to protect security.

Question 11

Setting assumptions with regard to determining whether discretionary benefits can be awarded

Answer 11

For example this could be benefit improvements in a benefit scheme or the declaration of a bonus on with-profit contracts.

Likely to err on the side of caution so that surplus is not over-stated.

Question 12

Setting assumptions with regard to setting contribution levels

Answer 12

The assumptions used will depend on the objectives of the parties concerned and on the structure of the membership.

Whether the scheme is closed to new members or an open scheme will affect the average age of the active membership and this may generate a different future contribution rate than for the closed scheme.

The trustees are primarily concerned with the security of member’s rights, so they might want to overstate future contribution requirements - i.e. use a cautious basis. However, this mist be balanced against the basis not being so cautious that it would discourage the employer from providing the scheme because the contributions were so high.

Question 13

Setting assumptions with regard to calculating discontinuance benefits

Answer 13

A best estimate basis may be considered to be fair but other bases may be appropriate

Question 14

Setting assumptions with regard to setting investment strategy

Answer 14

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

Question 15

Setting assumptions with regard to disclosure information for beneficiaries (decisions by individuals)

Answer 15

Individuals may need to make decisions about the level of benefits required, the return that they gain on contributions and the security of benefit provision.

The assumptions will reflect legislation, but a realistic basis will typically be used, with a range of results also provided.

Question 16

Provisions vs reserves

Answer 16

A potential source of confusion in the term used to denote the value assigned to the liabilities. It has been the practise of accountants to use the word ‘provision’ to denote the value of a liability that is known or assumed to exist at the accounting date, and to confine the term ‘reserve’ to any amount, over and above the provisions, that is available to meet additional liabilities, either in respect of future events or in respect of past events for which the provisions may prove to be inadequate. However, among insurers, and also among actuaries, there has been a long established practise of applying the term ‘reserve’ to both categories.

Question 17

Steps to determine the appropriate provisions (2)

Answer 17

In order to determine the appropriate provisions, the actuary will need to:

1. choose a valuation method, and
2. make assumptions about the future (collectively the assumptions are known as the basis)

Question 18

Numerical calculations of provisions - life insurance
Example: A 10-year annual premium term assurance policy is issued to a group of lives aged 40 exactly. The sum assured is £20,000 and is payable at the end of the year of death. The annual premium is £100 and expenses are assumed to be zero.
Write down an expression for the reserve immediately before the sixth premium is due.

Answer 18

In life insurance, reserves are typically calculated using either a formula or a discounted cashflow approach.

Solution:
Since expenses are being ignored, the reserve can be calculated as the expected present value at the end of the fifth year of the outstanding benefits less the outstanding premiums.
This gives 5V1 45:5-| = 20,000 A1 45-| - 100 a** 45:5-|

Question 19

Numerical calculations of provisions - general insurance

Example: run-off triangle method

Answer 19

Outstanding claims reserves in a general insurance context are normally calculated using statistical (e.g. run-off triangle) methods or case estimates.

Solution:

1. Produce a table of cumulative claim payments
2. Determine the development factors for successive development years
3. Use the development factors to project the cumulative claim payments
4. Determine the outstanding claims reserve by subtracting, for each accident year, the claims paid to date (leading diagonal figures) from the total projected claims (last column figures).

Question 20

Numerical calculations of provisions - benefit schemes

Example: Derive a formula to value a death-in-service benefit of a multiple of four times the salary at the date of death for a member aged 30 exactly at the valuation date.
Assume that normal retirement age is 60 and ignore expenses and all other possible exits from the scheme. State any additional assumptions that you need to make.

Answer 20

The method used to value the benefits of a benefit scheme will depend on whether the scheme is defined contribution or defined benefit in nature.

For a defined contribution scheme, the value of the main benefits is equivalent to the amount of the accumulated contributions net of charges.

For a defined benefit scheme, the benefits are defined by a formula, and we can use a discounted cashflow approach to value the benefits.

Question 21

List the key assumptions the actuary will need to make to value the benefits from an employer-sponsored medical benefits scheme (6)

Answer 21

1. discount rate (used to discount the liabilities to their present day value)
2. inflation of medical benefits (which may be higher than price inflation)
3. incidence of sickness and likely duration of illness, split by age, gender and different types of illness
4. mortality rates
5. discontinuance rates (i.e. likelihood of members leaving the scheme)
6. future entry rates to the scheme and likely entry age / gender of employees (if the contribution rate for the future is being set too)

Question 22

Suggest sources of information that the actuary could use to set a best estimate basis to value the benefits from an employer-sponsored medical benefits scheme (6)

Answer 22

1. past experience of the scheme
2. past experience of similar schemes, perhaps from industry-wide statistics
3. population statistics, for example from the national healthcare system
4. discussions with the company as to its future intentions (for example whether it has an intention to perform a redundancy exercise)
5. projections of investment returns, for example based on the views pf investment analysis or derived from market yields
6. projections of indices relating to the inflation of medical benefits

Question 23

Examples where the nature of assets need to be taken into account in order to value the liabilities (3)

Answer 23

1. When the liabilities are specifically linked to the underlying assets, such as a unit trust or internal investment fund.
2. When the covenant of the sponsor has no value, e.g. when a pension fund is set up by a sponsor, but the sponsor makes no commitment to provide funds to make up any shortfall should the assets held turn out to be insufficient to meet the benefits promised. In this situation the benefits paid may need to be reduced to reflect the actual assets available.
3. For the 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 24

Going concern basis (or funding basis) vs Break-up basis (or discontinuance or wind-up basis) for insurance companies

Answer 24

Going concern basis:
The accounting basis normally required for an insurer’s published accounts, that is based on the assumption that the insurer will continue to trade as normal for the long-term future.

Break-up basis:
A valuation basis that assumes that the writing of new business ceases and cover on current policies is terminated. In relation to general insurance policies, current policyholders would normally be entitled to a proportionate return of the original gross premium. Deferred acquisition costs would probably have to be written off.

Question 25

Going concern vs break up basis for benefit schemes

Answer 25

A going concern basis usually assumes that the benefit scheme will be continuing. Funding valuations are conducted to assess:

1. whether the assets of the scheme are sufficient to cover the liabilities on a continuing basis
2. the contribution rate for the scheme (to cover future benefit accrual and rectify any shortfall within the scheme
3. an appropriate investment policy

A break-up basis assumes that the scheme ceases to accrue future benefits on the valuation date.