Chapter 35: Valuing Liabilities I Flashcards
Provisions
Amounts of money that need to be set aside to meet a provider’s future liabilities.
Provisions are established for both individual contracts and globally.
10 Reasons why a provider calculates individual provisions
to determine the liabilities to be shown in
- the provider’s published accounts
- the regulatory returns
- internal management accounts
To provide DISCLOSURE INFORMATION to beneficiaries
to value the provider for MERGER/acquisitions
to calculate transfer values for a BENEFIT SCHEME
to determine:
- future CONTRIBUTIONS to a benefit scheme
- whether any DISCRETIONARY BENEFITS can be awarded
- benefit improvements for a benefit scheme
- an appropriate INVESTMENT STRATEGY
2 Reasons why a provider calculates global provisions
- as an extra cushion to cover the mismatching of assets and liabilities
- as a margin against the financial and non-financial risks to which a provider is exposed
Assumptions used for provisioning may be (3)
- best-estimate
- optimistic
- cautious
Best-estimate basis
Has equal probability of overstating or understating the values.
Optimistic basis
Places a low value on the liabilities relative to the assets.
Cautious basis
Places a high value on the liabilities relative to the assets.
Factors to consider when determining the liabilities to be shown in the provider’s published accounts
- consider whether the accounts are to be prepared on a going concern basis;
- whether they are required to show a true and fair view;
- whether the basis is prescribed by accounting standards which often require a slightly prudent approach.
BASIS used in determining the liabilities to be shown to demonstrate regulatory solvency
In general, the basis will be prudent, as reflected either by individual provisions calculated on a best estimate basis and a prudent solvency margin; or the converse.
BASIS used in determining the liabilities to be shown in internal accounts
Best estimate. I.e. realistic assumptions to help management make informed decisions.
BASIS used in determining an investment strategy
Use a stochastic approach to consider lots of options
BASIS used in setting contributions to a benefits scheme
The beneficiaries will want cautious assumptions, but no so cautious that the sponsor cannot afford the contributions and goes insolvent.
However, the sponsor may want optimistic assumptions if there is a high opportunity cost of capital.
Alternatively, the sponsor may want cautious assumptions, if there is a low opportunity cost of capital or if this will lead to future contribution flexibility or tax deferral.
A best-estimate approach reflects a compromise and may lead to the greatest stability in contributions.
BASIS used in setting a transfer value from a benefits scheme
A best-estimate basis helps ensure fairness between the member leaving, those members staying and the sponsor.
It is important not to overstate the value, since it is a one-off value that cannot be corrected by future adjustments.
BASIS used in valuing options
Options may move into or out of the money over time.
However, it is not necessarily the case that an option-holder will always exercise an option if it is in-the-money, and not exercise it if it is out-of-the-money.
When setting assumptions to value options, you should consider:
- the state of the economy
- demographic factors such as age, health and employment status
- cultural bias
- customer sophistication
- the risk of anti-selection
BASIS used in valuing guarantees
Guarantees should be valued stochastically. When valuing guarantees you should consider the economic situation and the financial sophistication of customers.
Guarantees and options are not independent. Some guarantees may make options more valuable in certain scenarios.
