Chapter 33: Valuation of liabilities

Question 1

What are the three approaches to valuation of liabilities

Answer 1

1. Discounted cash flow approach
2. Market-based approach reflecting assets held
3. Fair value approach

Question 2

What is the most important aspect of choosing a valuation basis

Answer 2

Assets and liabilities should be valued consistently, i.e., if a discount cash flow model is used to value the assets, then a consistent discount rate should be used to value the liabilities

Question 3

Explain what the discounted cash flow approach is

Answer 3

• Value both assets and liabilities by discounting the cashflows
• Assets are valued as the EPV of asset proceed
• Liabilities are valued as the EPV of future liability outgo
• Assumptions based on the long-term expectations
• Discount rate is based on the expected long-term return on the assets

Question 4

What are the advantages (3) and disadvantages (4) of discount cashflow approach

Answer 4

Advantages
+ Easy to achieve a consistent valuation between assets and liabilities
+ Because of the consistency and the fact that the assumptions do not vary over time, there is stability in the results
+ Actuarial judgement required in setting assumptions

Disadvantages
- Might be better to have a realistic picture of the cash flow
- Regulation might not allow and could prefer a market-based on a fair value approach
- Difficult to explain why assets arent their market value
- Require more calculations than a market-based approach

Question 5

Explain how the market-based approach for the valuation of liabilities works

Answer 5

• Assets are taken at market value
• Liabilities are valued using the current implied market discount rate for each asset class. For fixed-interest securities, it is the gross redemption yield and for equities, it involves estimating the yield implied by the current market price and expected dividend
• Liability valuation discount rate is the weighted average of the individual discount rates. This could be based on the actual proportions invested in each asset class or might be according to the strategic benchmark

Question 6

Explain what the fair value approach is

Answer 6

Definition: Amount for which assets exchanged / liabilities settled between knowledgeable, willing parties at arm’s length. Can be difficult as there is no market for liabilities as there is for assets

Two approaches: Replicating portfolio approach or risk-neutral market consistent approach

Question 7

Explain how the fair value approach for the valuation of liabilities works

Answer 7

• Assets are taken at market value
• Liabilities could be valued by finding a replicating portfolio of assets, possibly including derivatives, that most closely replicate the duration and risk characteristics of the liabilities
• The fair value of the portfolio of liabilities is then taken as the market value of the replicating portfolio. Could also add an additional constant/variable risk premium
• Alternatively, a risk-neutral market consistent valuation method could be used to estimate the fair value of liabilities. Liability cashflows are discounting using the pre-tax market yield on risk-free assets, such as government bonds or swaps

Question 8

What are the two things to consider when deciding on guarantees?

Answer 8

1. Likelihood of the guarantee biting
2. Financial consequences if the guarantee bites

Question 9

How are guarantees valued?

Answer 9

A stochastical model with suitable parameter values. Deciding on the parameter values, a cautious approach is taken

The likelihood of the guarantee biting has to do with the state of the economy and the financial sophistication of the market

Question 10

What factors influence if options will bite

Answer 10

• State of the economy
• Demographic factors (age, health, employer status)
• Cultural bias
• Consumer sophistication
• Tax
• Cash in hand

Question 11

How can risk be allowed in cashflows?

Answer 11

Best estimate plus a margin
* Risk margin is built into each assumption by using best esitmate assumptions together with an explicit margin for caution.
* The size of the margins depends on the risk involved

Contingency loading
* Risk allowed for by increasing the liability value by a certain percentage
* The size of the contingency reflects the level of uncertainty

Discounted cashflow at risk premium
* Cashflows are assessed on a best estimate basis
* Discounted at an appropriate rate of return that reflects the level of uncertainty