Chapter 33: Valuation of liabilities Flashcards
What is the most important factors to consider when setting the discount rates used to value the assets and liabilities?
CONSISTENCY between the rates used.
Describe the traditional discounted cashflow method of valuing assets and liabilities.
Both assets and liabilities are valued by discounting the future cashflows using a rate that reflects the long-term future investment return expected.
What is the major criticism of the traditional discounted cashflow method of valuing assets and liabilities?
It provides a value of the assets that is different from the market value. It is difficult to explain to clients.
(Consequently, there has been a move towards market-related methods of valuing assets and liabilities)
Give two definitions of “fair value”.
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.
Give 2 examples of financial contracts for which it might be fairly straightforward to determine a fair value.
- Unit linked contracts - the value of the
liability is effectively known since it is the
value of the units and the unit price is
determined on a frequent basis. - The pensions in payment liabilities of a
benefit scheme - there may be an active
‘buyout’ market consisting of insurance
companies and other financial
organizations that are prepared to
provide immediate annuities to cover
pensions in payment.
What is the major difficulty in determining the fair value of a provider’s liabilities?
There is no liquid secondary market in most of the liabilities that actuaries are required to value, so the identification of fair amounts from the market is not practical. As a result, fair values of liabilities need to be “estimated” using market-based assumptions.
Describe the replicating portfolio - mark to market method of valuing assets and liabilities.
Assets are taken at market value.
Liabilities are discounted at the yields on investments that closely replicate the duration and risk characteristics of the liabilities - often bonds. The replicating portfolio can be determined using stochastic optimization techniques (asset-liability modelling)
Ideally, term-specific discount rates would be used to reflect the shape of the yield curve.
Other assumptions should also be market related, for example the market rate of inflation is derived as the difference between the yields on fixed interest and index-lined government bonds of an appropriate term.
Describe the replicating portfolio - bond yields plus risk premium method of valuing assets and liabilities.
The method is similar to the mark to market method with assets taken at market value and the liabilities discounted at the yields on investments that closely replicate the duration and risk characteristics of the liabilities- often bonds.
However, the liability discount rate is adjusted to reflect a risk premium.
The risk premium may be constant or variable.
However, some actuaries think that taking account of the extra return from other assets is unsound unless account is also taken of the extra risk, and that a risk premium should not be used.
Describe the asset-based discount rate approach for valuing assets and liabilities.
Assets are taken at market value.
An implied market discount rate is determined for each asset class.
The liabilities are valued using a discount rate calculated as the weighted average of the individual discount rates based on the proportions invested in each asset class.
The discount rate could be determined using the distribution of the actual investment portfolio or the scheme’s strategic benchmark (if the current aesst allocation is not representative of the scheme’s usual investment strategy)
Outline how the fair value of liabilities can be determined by performing a “risk-neutral” market-consistent valuation.
The value is determined as the present value of future liability cashflows, discounted at the pre-tax market yield on risk-free assets.
Such assets might be swaps or government bonds.
Outline the factors to consider when valuing guarantees.
- In general, a cautious approach is taken.
- However, unless all guarantees are in the
money, assuming the worst case scenario
in every case will build in too much
caution. - A stochastic model should be used for
valuing guarantees, to show the likelihood
of the guarantees biting and the
associated cost. Parameter values should
reflect the purpose for which the results
are required. - The value of guarantees and their
influences on consumer behavior will vary
widely according to the economic
scenarios and the sophistication of the
market.
Outline the factors to consider when assessing the cost of an option from the perspective of the provider.
- In general, a cautious approach is taken.
- However, this can build in too much
caution. - For example, a policyholder may not
exercise the highest cost option despite it
being financially better for them to do so. - It is necessary to allow for anti-selection
risk when valuing options, or to mitigate
this risk using eligibility criteria for
exercising the option. - Options and guarantees are not
necessarily independent; some
guarantees may make options more
valuable in certain circumstances. - They can be valued by finding a market
option that replicates it, using
deterministic and
closed form approximations e.g. Black
Scholes.
List the factors on which the option exercise rate assumption will depend.
- The state of the economy
- Demographic factors, e.g. age, health,
employment status - Cultural bias
- Consumer sophistication
State 2 examples of where the provider’s assumption that policyholders will always exercise an option that is in-the-money, may not be appropriate.
- The policyholder prefers to take the
alternative benefit as it is paid as a lump
sum cash amount. - The policyholder receives beneficial tax
treatment on the alternative benefit.
Describe 3 approaches to allowing for risk in the discounted cashflow method of valuing liabilities.
- Best estimate and margin - a margin is
explicitly built into each assumption. The
size of the margin reflects the amount of
risk involved and its materiality to the
final result. - Contingency loading - the liabilities are
increased by a certain percentage. The
size of the margin reflects the uncertainty
involved. This method is very arbitrary. - Discount rate - the discount rate is
DECREASED by a risk premium that
reflects the overall risk of the liability.
Sensitivity analysis can be used:
- to help determine the extent of the
margins needed in assumptions, to allow
for adverse future experience
- to determine the extent of any global
provisions required
Outline how risk can be allowed for in a market-consistent or fair valuation of liabilities.
- Financial risk
No need to adjust for financial risk.
Already implicitly allowed for, e.g. by using
a replicating portfolio. - Non-financial risk e.g. operational
Allowed for by adjusting the expected
cashflows or by adjusting the discount
rate.
Alternatively, an extra provision or capital
requirement can be held.
Adjustments depend on the amount of
the risk and the costs of the risk implied
by the market.
Outline 4 methods that a general insurance company might use for establishing provisions.
- Statistical analysis - used where many
claims following a known pattern. The
provision could be set equal to the
amount that keeps the probability of ruin
below a certain level. - Case-by-case estimates - used if the
insured risk is rare or there is large
variability in the outcome such as for
personal injury claims. - Proportionate approach - used for risks
that have been accepted but for which
the risk event has not yet occurred.
Provision is a proportion of the part of
the premium designed to cover claims.
The proportion will represent the
unexpected period of cover. - Equalization reserves - used to smooth
profits from year to year. May not be
recognized by the regulator, and can be
perceived by the tax authorities as a way
of deferring profit and thus tax.
