Chapter 33 - Valuation of Liabilities

Question 1

Valuation Methods for valuing liabilities

Answer 1

There are many different valuation methods. It is important that the valuation of assets and liabilities is consistent

1. Traditional Discounted Cashflow approach
2. Market Based Approach reflecting assets held
   - Liabilities could be valued using a discount rate that reflects the weighted average yield on the backing assets held, where this yield is based on the current implied market discount rates
3. Fair valuation
   - Two definitions of fair value are:
4. the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm’s length transaction
5. the amount that the enterprise would have to pay a third party to take over the liability
   - is usually market value when possible
6. Replicating Portfolio Approach
   - One approach to estimating fair values is to find a ‘replicating portfolio’ of assets that most closely replicates the duration and risk characteristics of the liabilities. The fair (i.e. market) value of the portfolio of liabilities is then taken as the market value of the replicating assets
7. Risk neutral market consistent approach
   - This involves discounting future liability cashflows at the pre-tax market yield on risk-free assets, such as government bonds or swaps.

Question 2

Sensitivity Analysis

Answer 2

The assumptions used for setting provisions are estimates of future experience, taking any requirements for solvency capital into account. They are the expected values plus risk margins for adverse future experience. Sensitivity analysis can be used to determine these margins.

Sensitivity analysis could also be used to assess the extent of any global provisions that may need to be set up to cover potential future adverse experience

Question 3

Provision Calculation Methods

Answer 3

• Statistical analysis
  If the population exposed to a risk is large enough, and the consequence of a risk event is approximately normally distributed, then a mathematical approach to establishing a provision for the risk will give a valid answer.To establish a prudent provision that would be sufficient at a ruin probability of any given percentage, a simple analysis of the normal distribution will generate the required result
• Case-by-case estimates
  If the insured risks are rare events and also have a large variability in outcome, then statistical analysis may break down

Proportionate approach
- An alternative approach, especially in making provisions for risks which a provider has accepted but where the risk event has not yet occurred, is to set a provision on the basis that the premium charged is a fair assessment of the cost of the risk, expenses and profit. If a premium basis allows for 25% of the premium to cover expenses, commissions and profit, then one approach to establishing a provision for the unexpired part of a year’s cover is to assume that 75% of the premium covers risks equally through the period of the policy

• Equalisation reserves
  An example of the issues discussed above occurs where a product provider might wish to exhibit stable results from year to year, but where the portfolio contains low probability risks with a large and highly volatile financial outcome. In years where such an event occurs, the company may show a significant reduction in profits; where no event occurs, profits will be greater than the long-term average.

To smooth results, a company may establish a claims equalisation reserve in years when no claim arises, with a view to using the reserve to smooth results when a claim does occur.

These reserves do not fit with the definition of a provision, but nevertheless are used in some jurisdictions for general insurance. Note that not all regulatory regimes recognise equalisation reserves.Tax authorities are often not prepared to take such reserves into account in computing profits. Equalisation reserves are seen as a way of deferring profits and hence tax.