Chapter 32: Provisions

Question 1

Provisions

Answer 1

Provisions are the calculated amounts that need to be set aside to meet a provider’s future liabilities.

The value of the provisions will depend on the assumptions used to value the future expected cashflows.

Question 2

List 9 reasons why a provider calculates provisions

Answer 2

BAD MEDICS

• (value) Benefit improvements for a benefit scheme
• (determine the liabilities to be shown in the) Accounts and reports - published and internal
• (calculate) Discontinuance / surrender benefits
• (value the provider for) Mergers and acquisitions
• (determine) Excess of assets over liabilities and so whether any discretionary benefits can be awarded
• Disclosure of information for beneficiaries
• Influence Investment strategy
• (set) Contributions / premiums
• Statutory solvency report (determine liabilities to be shown)

Question 3

What is the difference between individual and global provisions?

Answer 3

Individual provisions relate to an individual contract or scheme member.

Global provisions cannot be allocated to individual contracts or members and relate to a provider’s liabilities as a whole

Question 4

Risks relating to mismatching of assets or liabilities

Answer 4

Changes in investment conditions may result in the liability cashflows increasing by more than the asset cashflows

This will affect the ability of the provider to meet the liabilities as they fall due and the solvency position of the provider

Question 5

Explain why an additional premium for mismatching would likely need to be established on a group rather than on a individual contract level

Answer 5

It is rare, for investment purposes, that liabilities of each individual contract are looked at separately and assets earmarked to each contract

It is much more likely that the investment strategy is determined by looking at the group of contracts as a whole.

Therefore, in the same way, the risk of mismatching is a global rather than an individual issue and hence provisions should be established on a global basis

Question 6

Give an example of one financial and one non-financial risk for which a provider might calculate global provisions

Answer 6

Financial risk - mismatching assets and liabilities

Non-financial risk - operational risk

Question 7

Basis

Answer 7

The term given to a collection of assumptions

Question 8

Best estimate basis

Answer 8

Set of assumptions that have an equal probability of overstating and understating the value of the assets and the liabilities.

Question 9

Optimistic (or weak) basis

Answer 9

Assumptions are chosen which collectively result in a high value of assets and/or a low value of liabilities.

Question 10

Cautious (or prudent/strong) basis

Answer 10

Assumptions are chosen which collectively result in a low value of assets and/or a high value of liabilities

Question 11

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

Answer 11

• Discount rate (used to discount the liabilities to their present-day values)
• Inflation of medical benefits (which may be higher than price inflation)
• Incidence of sickness and likely duration of illness, split by age, gender, and different types of illness
• Mortality rates
• Discontinuance rates (ie likelihood of member leaving the scheme)
• 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 12

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

Answer 12

• Past experience of the scheme
• Past experience of similar schemes, perhaps from industry-wide statistics
• Population statistics, for example, from the national healthcare system
• Discussions with the company as to its future intentions (for example, whether has an intention to perform a redundancy exercise)
• Projections of investment return, for example, based on the views of investment analysts or derived from market yields)
• Projections of indices relating to the inflation of medical benefits)

Question 13

State the 3 main factors that usually dictate the strength of the basis on which values should be determined

Answer 13

1. Purpose of the valuation
2. Needs of the client
3. Regulatory/legislative requirements

Question 14

Give 3 examples of how the nature of the assets held can impact the liability valuation

Answer 14

1. The liabilities may be specifically defined in terms of the performance of the underlying assets (e.g. unit-linked contract, unit trust)
2. When the covenant of the sponsor has no value, ie where the sponsor makes no commitment to make up any shortfall in a pensions fund, the benefits paid must have to be reduced to reflect the actual assets available.
3. For a market-consistent valuation of life insurance financial guarantees the liability value will depend on the volatility of returns on the assets held.

Question 15

Outline the factors to consider when valuing the liabilities to be shown in the provider’s published accounts and reports (which are used for decision-making by shareholders)

Answer 15

1. Consider accounting principles and legislation in the country concerned.
2. Consider whether the accounts are to be prepared on a going concern basis or on a break-up basis
3. Consider whether they are required to show a true and fair view.
4. Consider whether the provisioing basis required is best estimate or some other basis, and precisely how the terms used are to be interpreted. (One of the accounting principles is prudence and this often results in the basis used being on the slightly prudent side of best estimate)

Question 16

Going concern (or funding) basis for insurance companies

Answer 16

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

Question 17

Break-up (or discontinuance or wind-up) basis for insurance companies

Answer 17

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, also known as a wind-up basis (the amount of an insurer’s acquisition costs incurred as premium is written but earned and expensed over the term of the policy - van google - maak seker hoe ander dit verstaan)

Question 18

Going concern basis for benefit schemes

Answer 18

Usully assumes that the benefit scheme will be continuing

Funding valuations are conducted to asses:

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

Question 19

Break-up basis for benefit schemes

Answer 19

Assumes that the scheme ceases to accrue future benefits on the valuation date

Question 20

Outline the factors to consider when valuing the liabilities to demonstrate supervisory solvency

(MAAK SEKER)

Answer 20

1. Consider the regulation and legislation in the territory concerned
2. Consider whether the accounts are to be prepared on a going concern basis or a discontinuance basis.
3. Consider whether the basis is prescribed or left to actuarial judgement
4. Consider whether there are any relevant rules and actuarial guidance.
5. Regulators may wish to consider values that present a realistic picture of the provider’s finances. Alternatively, they may wish to consider values that intentionally understate (or perhaps overstate) the financial strength of the provider.

Question 21

What basis should be used when valuing the liabilities to be shown in the provider’s internal accounts?

Answer 21

Best estimate, to provide a realistic picture for decision-making by management.

Question 22

Outline the factors to consider when valuing the liabilities for a transfer of liabilities between two providers

(MAAK SEKER)

Answer 22

1. The transferring company will prefer optimistic assumptions.
2. The receiving company will prefer cautious assumptions.
3. A best estimate basis is fair, and the need to to agree may result in a best estimate basis being used.
4. However, the basis will depend on the relative bargaining powers of both sides and relative supply and demand for liability transfers.
5. It is possible that the two sides agree that the transfer should not reflect a best estimate of future costs, for example if they recognize a need to hold a margin to protect the security of the benefits

Question 23

What basis should be used when determining whether discretionary benefits can be awarded or benefit improvements made?

(MAAK SEKER)

Answer 23

The provider may want to use assumptions that do not overestimate the surplus available in order to avoid being pressurized into distributing it as discretionary or additional benefits. Similarly, proposed benefit improvements should not be undervalued.

This is because such benefits may prove in practice to be more expensive than had been anticipated.

The most realistic indication will be based on best estimate assumptions, but a cautious basis (or range of assumptions) may be used.

Question 24

Outline the factors to consider when valuing the liabilities to set contributions for a defined benefits scheme, from the perspective of the trustees and the beneficiaries

(MAAK SEKER)

Answer 24

1. Cautious basis to ensure better security of benefits
2. But not so cautious that the sponsor believes the cost of benefits to be excessive and hence reduces future benefits, closes the scheme to future accrual, or pays a high contribution rate and becomes insolvent

Question 25

Outline the factors to consider when valuing the liabilities to set contributions for a defined benefit pension scheme, from the perspective of the sponsor

Answer 25

1. Optimistic if there is a high opportunity cost of capital.
2. Cautious if higher contributions now may lead to greater flexibility in the future.
3. Cautious if higher contributions may result in tax deferral.
4. Cautious if the sponsor wants to be viewed as paternalistic
5. Cautious if there is a low opportunity cost of capital
6. Cautious if better investment returns can be earned within the scheme leading to lower long-term costs.
7. Best estimate for stability of cost and a compromise between the above factors.

Question 26

What basis should be used when setting discontinuance terms, in order to be “fair” to all parties?

Answer 26

Best estimate, for fairness between those discontinuing, those remaining and the provider.

Question 27

Outline factors to consider when valuing the liabilities to set an investment strategy.

Answer 27

1. A large number of different scenarios should be examined - particularly best estimate and cautious.
2. A stochastic model could be useful in assessing the risks and values under each possible investment strategy.

Question 28

Outline the factors to consider when setting a basis to illustrate the level of benefits to which an individual is entitled, the level of investment return they might expect to receive and the contributions they might be required to make to target a specific level of benefits.

Answer 28

1. The assumptions should take into account the circumstances of the individual, e.g. age, gender, marital status.
2. Best estimate allows realistic decisions to be made.
3. A range of values communicates the uncertainty involved.
4. If the individual is averse to the risk of under-provision, a cautious approach may be appropriate

Question 29

DOEN EN p 5, 6, 7, 8, 18

Answer 29

JUST DO IT