CH32 - Valuation of liabilities

Question 1

Discounted cashflow approach for valuing assets and liabilities

Answer 1

Long-term discount rate used to value both assets and liabilities

• Regardless of which approach to the valuation is chosen, it is important that the valuation of assets and liabilities is consistent. For example, if a discounted cashflow approach is being used to value the assets then a consistent discount rate should be used to value the liabilities.

Question 2

Market-related approaches to valuing assets and liabilities

Answer 2

Replicating portfolio approaches or actual asset-based approach can be used to value the liabilities. Assets are valued at market value. Aim to determine market price of liabilities and hence discount rate.

• Regardless of which approach to the valuation is chosen, it is important that the valuation of assets and liabilities is consistent. For example, if a discounted cashflow approach is being used to value the assets then a consistent discount rate should be used to value the liabilities.

Question 3

Fair value

Answer 3

In recent years there has been an increasing move towards fair value methods.

Two definitions of fair value are:

1. the amount for which an asset 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 4

Setting the discount rate

Answer 4

In practise there is no secondary market for most liabilities. Therefore the market value cannot be found directly. Instead we need to try to find market-based assumptions.

Question 5

Setting the discount rate - traditional discounted cashflow

Answer 5

Assets:
Discounted cashflows using long-term rate based on actual holding or notional portfolio

Liabilities:
Discount rate is same long-term rate as for assets

Question 6

Setting the discount rate - replicating portfolio (mark to market)

Answer 6

Assets:
Market value

Liabilities:
Discount rate implied by market price of investments that match liabilities - often bonds

Question 7

Setting the discount rate - replicating portfolio (bond yields plus risk premium)

Answer 7

Assets:
Market value

Liabilities:
Discount rate as in mark to market method, but then adjusted to take account of higher expected returns on other asset classes

Question 8

Setting discount rate - asset-based discount rate

Answer 8

Assets:
Market value

Liabilities:
Discount rate is the expected return on assets, weighted by proportions held of each asset class

Question 9

Valuing options (4)

Answer 9

It is not always appropriate to assume that the highest cost option is always exercised. For example, the attraction of cash or a tax-free benefit might mean that individuals do not exercise an option that is in the money from the provider’s perspective.
The risk of anti-selection must be allowed for when valuing options.

Options in liabilities can be valued by finding a market option that replicates it. A closed form approximation may be used, e.g. Black-Scholes.

Contract values are highly sensitive to option pricing methods and assumptions. The assumptions used will depend on, among other things:

1. the state of economy, and hence must be scenario specific
2. demographic factors such as age, health and employment status
3. cultural bias
4. consumer sophistication

Question 10

Valuing guarantees

Answer 10

Guarantees are best valued by a stochastic approach, taking the class of business as a whole. A stochastic model allows for the likelihood of the guarantee biting and its expected cost.

Guarantees may become more or less onerous on the provider over time depending on how experience develops.

The value of guarantees and their influences on consumer behaviour will vary widely according to the economic scenarios and the sophistication of the market.

Question 11

Sensitivity analysis (2)

Answer 11

Sensitivity analysis can be used:

1. to help determine the extent of the margins needed in assumptions, to allow for adverse future experience.
2. in determining the extent of any global provisions required.

Sensitivity analysis can be done on single or multiple assumptions.