Chapter 32: Provisions Flashcards
Provisions
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.
List reasons why a provider calculates provisions.
BAD MEDICS
- Benefit improvements for a benefit
scheme - Accounts and reports - published and
internal - Discontinuance / surrender benefits
- Mergers and acquisitions
- Excess of assets over liabilities and so
whether any discretionary benefits can be
awarded - Disclosure of information for beneficiaries
- Investment strategy
- Contribution / premium setting
- Statutory solvency reports
What is the difference between individual and global provisions?
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.
Give an example of one financial and one non-financial risk for which a provider might calculate global provisions.
Financial risk - mismatching assets and liabilities
Non-financial risk - operational risk
Basis
A set of assumptions.
Best estimate basis
Set of assumptions that have an equal probability of overstating and understating the value of the assets and the liabilities.
Optimistic (or weak) basis
Assumptions are chosen which collectively result in a high value of assets and/or a low value of liabilities.
Cautious (or prudent/strong) basis
Assumptions are chosen which collectively result in a low value of assets and/pr a high value of liabilities.
State the 3 main factors that usually dictate the strength of the basis on which values should be determined.
- Purpose of the valuation
- Needs of the client
- Regulatory / legislative requirements
Give 3 examples of how the nature of the assets held can impact the liability valuation.
- The liabilities may be specifically defined
in terms of the performance of the
assets (e.g. unit-linked contract, unit
trust). - Where the sponsor will not make up any
shortfall in a pensions fund, the benefits
paid must have to be reduced to reflect
the actual assets available. - For a market-consistent valuation of life
insurance financial guarantees the
liability value will depend on the volatility
of returns on the assets held.
Outline the factors to consider when valuing the liabilities to be shown in the provider’s published accounts.
- Consider accounting principles and
legislation in the country concerned. - Consider whether the accounts are to be
prepared on a going concern or break-up
basis. - Consider whether they are required to
show a true and fair view. - Consider whether the basis required is
best estimate or some other basis and
how this is to be interpreted.
Outline the factors to consider when valuing the liabilities to demonstrate supervisory solvency.
- Consider the regulation and legislation in
the territory concerned - Consider whether the accounts are to be
prepared on a going concern basis or a
discontinuance basis. - Consider whether the basis is prescribed
or left to actuarial judgement. - Consider whether there are any relevant
rules and actuarial guidance. - 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.
What basis should be used when valuing the liabilities to be shown in the provider’s internal accounts?
Best estimate, to provide a realistic picture for decision-making by management.
Outline the factors to consider when valuing the liabilities for a transfer of liabilities between two providers.
- The transferring company will prefer
optimistic assumptions. - The receiving company will prefer
cautious assumptions. - A best estimate basis is fair, and the need
to to agree may result in a best estimate
basis being used. - However, the basis will depend on the
relative bargaining powers of both sides
and relative supply and demand for
liability transfers. - 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.
What basis should be used when determining whether discretionary benefits can be awarded or benefit improvements made?
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.
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.
- Cautious basis to ensure better security of
benefits. - 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.
Outline the factors to consider when valuing the liabilities to set contributions for a defined benefit pension scheme, from the perspective of the sponsor.
- Optimistic if there is a high opportunity
cost of capital. - Cautious if higher contributions now may
lead to greater flexibility in the future. - Cautious if higher contributions may
result in tax deferral. - Cautious if the sponsor wants to be
viewed as paternalistic - Cautious if there is a low opportunity cost
of capital - Cautious if better investment returns can
be earned within the scheme leading to
lower long-term costs. - Best estimate for stability of cost and a
compromise between the above factors.
What basis should be used when setting discontinuance terms, in order to be “fair” to all parties?
Best estimate, for fairness between those discontinuing, those remaining and the provider.
Outline factors to consider when valuing the liabilities to set an investment strategy.
- A large number of different scenarios
should be examined - particularly best
estimate and cautious. - A stochastic model could be useful in
assessing the risks and values under each
possible investment strategy.
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.
- The assumptions should take into account
the circumstances of the individual, e.g.
age, gender, marital status. - Best estimate allows realistic decisions to
be made. - A range of values communicates the
uncertainty involved. - If the individual is averse to the risk of
under-provision, a cautious approach may
be appropriate.
