Chapter 2 - Provisioning

Question 1

Explain discounted cash flow valuation (DCFV)

Answer 1

Discounted cash flow valuation is a methodology for putting a present value on a stream of future values allowing for the time value of money. This is a forward looking approach and reflects the best estimate of future cash flows

Question 2

Name two other costing methods for stream of cash flows other than DCF and explain them

Answer 2

Historic cost valuation, the price at which an asset was acquired - can create anomalies in accounting
Amortised costing - the acquisition price smoothed on a linear trajectory to some terminal value. This terminal value can be zero for depreciating assets.

Question 3

Define market value and why liabilities are more complicated than assets

Answer 3

Market Value is the price at which an asset or liability is actually changing hands.
Liabilities are more complex mainly because of default risk.If a person takes on the risk and the person defaults - often can be valued based on assets.

Question 4

Give an example of how every liability is someone else’s asset

Answer 4

Annuity, asset to policy holder and liability to insurer

Question 5

Explain how broker quotes work

Answer 5

Broker quotes are prices (with an accompanying trade volume) at which a broker is willing to buy (bid price) or sell (ask price) an asset. The ask price is generally higher than the bid price giving brokers profit.

Question 6

Define the mid market value

Answer 6

The mid market value is the average of the ask price and the bid price.

Question 7

What does marking to Market mean?

Answer 7

Valuing an asset at its market value is called marking to market.

Question 8

Define fair value as per IFRS 13

Answer 8

the fair value of an instrument is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (an exit price)

Question 9

Define an orderly transaction

Answer 9

Orderly transaction means that the parties are willing (neither is under duress), knowledgeable (can use all relevant information, degree of expertise participants have) and the transaction is arms-length (not part of another transaction or deal).

Question 10

Why is discount rate setting always a battle between insurer and regulator

Answer 10

Regulator wants the insurer to have enough assets to cover the claims. Insurers want a high discount rate (would go very high if left unchecked), as it will give more of a gap between liabilities and assets. A reduction in liabilities such as this looks like profit to managers.

Question 11

As per Daykin & Patel’s report what framework did they recommend for discount rates being expressed and calculated

Answer 11

Discount rate to be expressed in terms of its embedded risk. They introduce two reference categories to help, namely matching calculations and budgeting calculations.

Question 12

Explain the matching valuation method

Answer 12

Liability is valued by reference to market instruments (or models to simulate market instruments) which seek to match the characteristics of the liability cash flows. The discount rates used are those implicit in the market prices of the matching instruments or a reasoned best estimate. Characterized by low risk with potential additions for credit or liquidity risk where some judgement is involved in setting the discount rate

Question 13

Explain the budgeting valuation (planning approach) method

Answer 13

Where the measurement of the liability is approached from the viewpoint of how the liability is going to be financed and so the discount rate is based on the expected returns from a predetermined investment strategy. Larger element of embedded risk in this.
Making a best estimate of future values and cash flows given existing assets and liabilities.
Generally arises where long term series of cash flows needs to be met and resources accumulated to pay for them, and there is time to adapt int he meantime.

Question 14

Define price and value to determine the difference

Answer 14

Price - amount for which a product changes ownership between a willing buyer and seller.
Value - the utility the product provides to the holder, implying subjective elements in its quantification

Question 15

What are market consistent discount rates

Answer 15

Value of an asset or liability is its market value if readily traded in a deep, liquid and transparent market, or a reasoned best estimate of what its market value would have been if such a market existed.
Discount rates consistent with such a valuation are referred to as ‘market consistent’ discount rates.

Question 16

What are some difficulties with using market consistent discount rate

Answer 16

May be difficult to identify financial instruments which have precisely the same characteristics as a liability
Argued if market consistent valuations are appropriate for ongoing financing of liabilities which are still accruing and developing with future economic and market conditions being as important as the current market situation. Turns long term financing considerations into short term measurement issues

Question 17

As per Daykin and Patel can you outline the key purposes for discounting they found.

Answer 17

Pricing for immediate market transactions. - Market consistency
Valuation of assets and accrued liabilities for monitoring solvency(insurers) and asset adequacy (pension schemes) - market consistency
Accounting for financial institutions and pension plan sponsors on a going-concern basis. - market consistency is suggested as debatable.
Aggregate funding of liabilities - long term considerations prevail
Transactions involving mutuality - long term considerations prevail

Question 18

Why would you use a lower discount rate for solvency than accounting?

Answer 18

Why would you use a lower discount rate for solvency than accounting? For solvency purposes you want to make a more cautious assumption

Question 19

How do Daykin and Patel classify the purpose for matching calculations?

Answer 19

Accounting: 1AS 19 (pensions), IFRS17(insurance)
Statutory technical provisions (Solvency 2)
Capital requirements in insurance
Shareholder reporting of value of future margins
Risk transfer and hedging

Question 20

How do Daykin and Patel classify the purpose for budgeting calculations?

Answer 20

Accounting for directors pensions
Former Solvency 1 insurance regime
Pension funding: technical provisions, recovery plan
Shareholder reporting of value od future margins
Pensions transfer values
Government social time preference rate
Fundamental value in investment analysis.

Question 21

Example: Is this a budgeting or a Matching approach? What is Children’s hospital worth for treating kids

Answer 21

Could do DCF calculations on a budgeting approach. Funding matching assets is very complicated as what asset can match the value of treating kids patients.

Question 22

Explain a DC pension scheme

Answer 22

DC Scheme - I or my employer choose how much I put into the scheme and this money is invested. I may or may not have a choice over the investment strategy. I only get the money I put into this scheme at the value of investments and hence I bear all of the risk.

Question 23

Explain a DB scheme

Answer 23

DB Scheme - Is a promise based on salary progression. Example: 60% of your final salary, so contributions are variable. It’s a function of your final salary, not exposed to investment risks. But you’re exposed to other risks.

Question 24

Can you explain the rationale for matching calculations

Answer 24

Insurer can find a matching portfolio or bonds or other financial instruments whose cash flows exactly replicate those promised to the beneficiaries, in all possible outcomes. Expectation is for assets and liabilities to be accounted consistently so values are equal in this case. This implies that the market consistent value of the liabilities is the market value of the corresponding replicating portfolio.

Question 25

Explain why in practice there is often a mismatch between the matching portfolio and actual investment - and what effect does this have on liabilities

Answer 25

Firm may decline this for another portfolio with higher expected returns - Does this alternative strategy reduce liability costs? NO. The higher returns are rewards for bearing the mismatch risk against liabilities and rewards are earned over time as the risk is borne. The underlying premise is that the initial ‘value’ placed on the liabilities should not be reduced merely because we hope to benefit from future risky investment returns. Rewards should be recognized as the returns come through

Question 26

When does a matching process fail?

Answer 26

Matching process fails if there is no matching portfolio or if there are multiple at different market values- economically implausible in competitive markets as arbitrageurs should enter the market, buying the cheaper and selling the more expensive to make a risk-free gain.

Question 27

Define accounting arbitrage

Answer 27

Accounting arbitrage means a rearrangement of financial affairs to give a different accounting treatment, when little of economic substance has changed.

Question 28

Give an example of accounting arbitrage

Answer 28

1. Using historic cost accounting creates an accounting option for management; they can move from historic cost to market value by “bed and breakfasting”, which is selling an asset and immediately buying it back. This is accounting for the same thing in two ways.
2. Using a budgeting approach to value liabilities. This example is a budgeting example as we are asking “ I wonder what I think is going to happen given my current assets and liabilities”

Question 29

How does use of market consistent valuation techniques avoid accounting arbitrage

Answer 29

Effects of taking advance credit for risky asset returns in risky liability valuation is not allowed.
Also must use fair value accounting

Question 30

Who benefits from fair value accounting and what does it mean

Answer 30

With Fair value accounting the company has to recognise the asset at its market value. This is an advantage of matching strategy from the point of view of the shareholder. It’s a disadvantage for the managers as they like flexibility in accounting. Generally as a consequence users of financial statements are more confident in those using market consistent techniques

Question 31

Explain dynamic hedging

Answer 31

Dynamic hedging involves the adoption of a strategy in which the disposition of assets, liabilities or both is altered in a manner that seeks to align the economic behaviour of the assets with the behaviour of the liabilities. Where liabilities do not involve any option-like elements then usually there is little need to resort to extensive use of dynamic hedging processes.

Question 32

How does dynamic hedging work with practicalities? Use a guaranteed investment bond as an example

Answer 32

Insurers can’t easily diversify these products as all policyholders are into the same stock index. Instead they do dynamic hedging, they work out what is the chance the stock market has positive returns and invest that amount in the stock market and then invest the rest in 10 year bonds. It’s called dynamic hedging as if the market moves, then you recalibrate the probabilities and adjust the probabilities again. Dynamic hedging only works if you use market consistent liability valuation

Question 33

Explain a balance sheet hedge

Answer 33

Alternative to cash flow replication (that is matching asset cash flows to liabilities with regard to timing, currency and amount) is a balance sheet hedge.
Balance sheet values of assets and liabilities move together over short periods of time and under various defined stress conditions. The worst possible outcome is that a balance sheet hedge exists but is a poor match over the long term.

Question 34

In the situation where investment strategy deviates from the theoretical match. - is market consistent valuation still appropriate for financial management ?

Answer 34

The alternative is that advance credit might be taken for the expected additional asset returns, in the form either of assets valued above market or liabilities below.
Studies argue a matching valuation remains appropriate even when assets and liabilities are mismatched. In this case, reported income will reveal some volatility, but this is arguably an appropriate reflection of the chosen risk profile.

Question 35

Give an example of a risk, rewarded in financial markets, that may not flow through to shareholders

Answer 35

An insurer may invest in illiquid assets but that illiquidity does not necessarily impact the insurer’s shareholders who can buy or sell their shares regardless.

Question 35

How is the performance of the asset manager and performance of underwriters assessd - by comapring what?

Answer 35

Performance of the assets manager is assessed by comparing Actual asset portfolio and theoretical matching portfolio

Performance of underwriters is assessed by comparing liabilities and theoretical matching portfolio

Question 35

Explain EMH in the context of investment management

Answer 35

The efficient market hypothesis states that market prices reflect all available information and therefore markets provide the best indicator of fundamental worth.
Empirical evidence for and against market efficiency is hotly disputed.
Could be a viewpoint as a consequence of assuming investors are rational and it would imply that active asset management is futile

Question 35

How does EMH link with market consistent valuation?

Answer 35

The market consistent valuation incorporates the market view as expressed in asset prices, without venturing an opinion as if they are where they ought to be - Argument against is that it assumes the market price is right.
Counter argument is consistency between assets and liability: Whether or not you believe markets value assets in a rational way the counter augment is you want liabilities to be valued consistently with the assets, particularly for shareholders.
The justification for market consistency is not related to market efficiency but to the assertion that markets generally respect the law of one price/principle of no arbitrage.

Question 36

Relate market consistent valuation to budgeting approach

Answer 36

Market consistent valuation which we detail earlier is a special case of a budgeting calculator - one where substantial risk of not meeting future cash flows has been eliminated through investing the available funds in appropriate instruments.

Question 39

Where are budgeting calculations relevant in and insurance environment?

Answer 39

Assessment of shareholder or enterprise value or some current approaches to statutory reserving and accounting liabilities. In a UK pensions environment around the funding of DB schemes.

Question 40

Why would budgeting valuation be used for individual transfer values in a pension scheme?

Answer 40

Why run DB pension schemes under a budgeting approach as it seems like a fixed cash flow? In reality you’ve only offered fixed cash flows to a minority of scheme members as they only become fixed when someone retires. Before that the cash flows are related to their final salary. Which to some extent means this liability is within the employer’s control.

Question 41

What real world complexities can the budgeting approach allow for?

Answer 41

Assumptions will be made about both the type of investments that will be made and the level of return that can be anticipated in the future. Can take into account:
Illiquidity premium/default risk - Best estimating what will happen so can take account fo possible haircuts. Cant with matching
Equity risk premium or other “out performance” premium.
Effects of tax and expenses of investment

Question 42

Define haircut

Answer 42

Haircut is when you’re forced to sell an asset and you get a lower value for it than you paid.

Question 43

How would the discount rate be assessed in a DB scheme

Answer 43

Trustees/Managers will have agreed approach to investment strategy in terms of expected return from assets depending on current financial position of the scheme and level of support from the sponsor standing behind it.
Return seeking rather than matching investments will be more volatile.
A starting point in assessing the discount rates to use is the return that the pre-determined investment strategy could be expected to achieve, together with the range of future returns that might be experienced around this expected level.

Question 44

Explain expected return is generally not used to value target fund needed to meet liabilities

Answer 44

Expected return is a realistic outcome but in funding reviews managers generally take a margin to produce a more prudent view of the current target fund needed to meet future liabilities

Question 45

In a pensions cheme what are the two resources for meeting liabilities

Answer 45

Future investment return and future new contributions. Where the level of prudence is pitched will alter the anticipated balance between these two sources of funds.

Question 46

How would an unfunded pension arrangement be assessed for discount rate?

Answer 46

Cash flows are met fully from contribution income – there is no fund to be a source of investment return. In this case get discount rate from analysis of the return on notional portfolio made up of assets that would be held if the benefits were on a funded basis. Alternatively the discount rate for assessing the liability could be based on the IRR

Question 47

How can one measure the exposure of the pensions schemes sponsor

Answer 47

The difference between the different target funds from the ongoing funding assessment and that associated with the more market consistent value (where risks of failure have been eliminated) will reflect the ultimate exposure to the pension scheme’s sponsor.

Question 48

What is the plan sponsor for a pension scheme?

Answer 48

The plan sponsor is responsible for paying the employees the retirement income that they are entitled to from the plan.

Question 49

Define prudence

Answer 49

Prudence is the action of incorporating in a safety margin or using ‘strong assumptions’.
Opposite of prudence is optimistic, adventurous, aggressive or using ‘weak assumptions’.

Question 50

Give an example of prudence being different for individuals and firms - ALWAYS ASK WHO STANDS TO GAIN

Answer 50

Pensions longevity - prudent assumption is that people live a long time. This would mean the insurer will pay out a long time. For the individual however it’s not so clearly cut. For an old man, a prudent assumption is that he lives long and has to pay lots of care home fees or he dies tomorrow so should enjoy his evening with takeaway

Question 51

What is a prudent assumption for rates of sickness and who benefits

Answer 51

Prudent assumption would be that more people being sick is a bad outcome. But it’s a good outcome for private hospitals.

Question 52

What are possible causes of default for a pension scheme and why is it so important not to.

Answer 52

Improper discount rate (too high) on earnings , investment assumption in general, sponsor fails (supposed to top up the plan), asset price crash, fraud, people live longer.
Pension schemes are cases where there is asymmetry. Default is catastrophic so preventing default is more important than preventing surpluses.

Question 53

Summarise considerations of when to use the budgeting approach

Answer 53

Higher discount rate, lower present value
Used where cash flows are variable, negotiable
and spread over multiple future periods.
Significant risk that the budgeted cash flows
will be more adverse than planned.
Does not require matching assets to exist ex: great for share valuation with dividends
Traditionally used in pension work

Question 54

Summarise the considerations of when to use a matching approach

Answer 54

Used for an immediate transaction (or for one
immediate decision that fixes future cash flows)
Lower discount rate, higher present value
Close matching so there is a low risk that cash
flows materially deviate from the forecast.
Requires the identification of a matching asset,
or at least a reasonably close match to
aggregate cash flows.
Traditionally used in insurance work.

Question 55

Compare a budgetign approahc to a matching approach in terms of return

Answer 55

With more time the budgeting approach (return on shares) will be higher than matching risk free assets. Even a prudent budgeting approach is still less prudent than a matching approach

Question 56

Is there any room for prudence under matching approach?

Answer 56

Is there room for prudence under the matching approach? - Idea here for assets being more or less liquid. If you have a very prudent effect you’ll be looking at more liquid assets as it gives a higher PV of liabilities.

Question 57

Explain the matching adjustment

Answer 57

In insurance regulation (Solvency 2), the matching adjustment (MA) is an adjustment made to the risk-free interest rate when the insurer sets aside a portfolio of assets to back a predictable portion of their liabilities. It is based on the yield spread over the risk-free rate credit spread of the assigned portfolio of matching assets, minus a fundamental spread that accounts for expected default and downgrade risk

Question 58

What are the benefits of the matching adjustment

Answer 58

Increases the numerator of the Solvency II ratio (own funds)
Decreases the denominator (The capital requirement)
With great capital benefits however come the great approval requirements - requirements for a matching adjustment compliant portfolio and must identify eligible assets which can be hard.

Question 59

Describe the portfolio construction process to maximise MA level

Answer 59

Portfolio construction as a constrained optimisation problem aimed at maximising the MA level from an investment universe of fixed income assets with appropriate credit fundamentals, subject to compliance with the cash flow tests, the investment guidelines and the spread capital charge limit.

Question 60

How do Credit rating downgrades impact MA portfolios

Answer 60

Higher haircuts and cash injection: rating downgrades give rise to higher haircuts applied to the asset cash flows
Cost of downgrade adjustment (CoD)

The overall exposure of the MA portfolio to rating downgrade is quantified by applying ‘parallel’ rating shocks

Question 61

What are the challenges Currency hedging raises for a MA portfolio and how should they be considered

Answer 61

Liquidity levels required to support potential collateral calls are incorporated as constraints in the portfolio construction phase
Stress testing of the matching and liquidity position under adverse FX
The application of the matching adjustment has the potential to support the level and the stability of an insurer’s solvency position by increasing their own funds, reducing required capital, and aligning the market sensitivity of the liability and asset portfolios - complex and needs ongoing management.

Question 62

What margins are added to risky assets and risk liability valuations - how are they valued and are there any exceptions

Answer 62

The valuation of a risky asset could use a DCF calculation minus a risk margin.
The valuation of a risky liability could use a DCF calculation plus a risk margin.
An exception to this occurs with an internal hedge present between an asset and a liability.
Ex: reinsurance: the cedant might value the reinsurance asset with an additional risk margin on top of the DCF as it reduces the risk for the insurer.

Question 63

How can the risk margin be incorporated into the discount rate for assets and liabilities?

Answer 63

The risk margin can be incorporated into the discount rate so that (in the absence of internal hedges): we place an upward adjustment on the discount rate for risky assets and a downward adjustment for risky liabilities.

Question 64

Define contractual and expected cash flows and detail how their discount rate will differ

Answer 64

Contractual cash flows - amount of cash flow promised in a legal contract
Expected cash flows - a probability-weighted average of all possible outcomes.
The discount rate for contractual cash flows would usually be the higher of the two, as it has to allow for expected defaults in addition to a risk margin for uncertainty in cash flows.

Question 65

Compare BEL and fair value of a liability

Answer 65

These two valuation methods will not be the same number. Best estimate liability plus a risk margin will be the fair value of a liability

Question 66

What is the formula for technical provisions

Answer 66

Technical provisions= Technical provisions = Best Estimate Liability (discounted at i) + risk margin

The technical provisions are different also to the required assets or collateral.

Question 67

What are three ways to calculate risk margins

Answer 67

Prudent discount rate
Higher quantile
Cost of capital method

Question 68

Describe the projecting cash flows at percentiles method as a risk margin method

Answer 68

One risk margin method is to model cash flows at a particular percentile, so that there is a specified (usually small) probability of the assets being inadequate to cover the liabilities.

Question 69

How will risk appetite influence the discount rate

Answer 69

A pension fund or an insurer with a low risk appetite would require a high degree of confidence in meeting liabilities, which implies a lower discount rate, while higher risk appetite would lead to a higher discount rate.

Question 70

Explain the cost of capital method of risk margin calculation

Answer 70

Required for technical provisions under the European Solvency II regulations
Regulators will impose minimum solvency margins on financial firms ex: to continue writing new business a firm must ensure Assets>=1.2*Liabilities
This capital requirement must be financed from somewhere - shareholders generally and
they hence require an additional return (6% per annum in the Solvency II regulations).
The cost of capital then is calculated as the minimum capital requirement multiplied by the extra required return. The risk margin for the liability is computed as the present value of these capital costs.
It’s worth noting many firms voluntarily hold more than the minimum required capital.

Question 71

Whats the formula for the capital requirement

Answer 71

Margin M x Technical provisions (This is Amount of capital insurance firm has to hold)

Question 72

What does K stand for in cost of capital method

Answer 72

k=Cost of capital (required return in excess of risk free rate)

Question 73

What is CSM

Answer 73

Contractual Service Margin - IFRS17 concept. This represents the unearned profit that an entity expects to earn as it provides services.

Question 74

What is CAT equilisation fund and how did they work

Answer 74

Catastrophe equalisation funds are not widely used now but were an example of backward looking reserves.
A fixed proportion of premium income would be held back each year in a separate fund and allowed to accumulate up to a maximum. Exceptional losses arising from a single event could be settled by drawing down on the accumulated fund. The catastrophe equalisation funds smoothed profits over different years, which made the business look less risky.
Because of the retrospective nature of equalisation reserves like this this would not be accepted as a legitimate way of valuing liabilities.

Question 75

What are some macro economic consequences of Asset and Liability valuation

Answer 75

The time horizon of shareholders typically exceeds the term in office for chief executives
If accounting or solvency regulations specify that the yield on a particular bond should be used for discounting liabilities, - Bond could be driven up
The move from a budgeting to a matching approach in defined benefit pensions and the stricter accounting that accompanies reduces the schemes appetite for taking risks as volatility of assets relative to liabilities now directly affects accounting profit.
The regulatory treatment of certain assets and liabilities can affect the demand for those instruments
Industry has argued that liability valuations or capital requirements should be eased at times of financial distress, a process known as forbearance.

Question 76

What are arguments for and against forbearance

Answer 76

Argument for: does not matching adjustment allow firms to take account of higher illiquid bond yields in times of distress. Example of this. Counter argument - removes solvency protection from consumers when they ended it most.