CHP 35 Flashcards
Provisions
Provisions are amounts set aside to meet future liabilities. The value of this will depend on the assumptions of future cashflows and growth.
1.1. The best estimate basis
As the timing and level of benefits, contributions and asset income is not certain, there is never certainty that a set of assumptions is correct.
Best estimate basis – basis that is thought to be equally likely to overstate and understate the values, it is based on judgment and is thus not unique. Best estimate is not necessarily the most suitable.
- Factors affecting the strength of the basis
The following factors will usually dictate the strength of the basis on which values should be produced:
• Reason why a value needs to be determined
• Needs of the client
• Requirements of any legislative or regulatory authority
In some cases the valuation method may also be described.
In many cases, presentation of a range of values for different scenarios will be of more use.
- Factors affecting the strength of the basis
2. 2. Decisions by regulators
Regulators may want to consider values that present a realistic picture of a provider’s finances. Alternatively they may intentionally want figures that understate/overstate the financial strength of the provider.
The assumption may be prescribed by legislation or left to actuarial judgment with a full disclosure requirement.
- Factors affecting the strength of the basis
2. 3. Decisions by individuals
Individuals need to make decisions about their level of benefits required, the return they expect on contributions and the security of the benefit provision.
In order to make these decisions, they need to see a realistic representation of the values. The uncertainty of the values should be clearly communicated so that they are aware of the risks of over or under contributing.
E.g. where an individual is averse to under provision, a prudent/cautious basis may be best.
- Factors affecting the strength of the basis
2. 4. Decisions by shareholders
Shareholders make decisions based on what is in the company’s books. For this reason, it is best for these to be done on a best estimate basis. Any other basis that either over or understate future experience may lead to wrong decisions being made.
- Factors affecting the strength of the basis
2. 5. Decisions relating to investments
There are times when it will be appropriate to consider the value of the assets when valuing a liability. E.g.:
• When liabilities are specifically linked to the underlying assets
• When the covenant of the sponsor has no value – sponsor sets up the fund but does not guarantee any shortfall.
• For supervisory valuation of life insurance contracts where legislation or regulation specifies a link between the liability valuation basis and features (usually the yield) of the backing assets.
A decision relating to the financing (including investments held to meet future liabilities) will involve the consideration of realistic and cautious values for a potentially large number of options.
A stochastic approach will likely add a lot of value in assessing risks and values under each possible strategy.
The need for “individual” provisions
Reasons for calculating provisions needed include the following:
- To determine liabilities to be shown in statements and reports
- To determine liabilities shown in reports for supervision of solvency (if separate from 1st bullet)
- Determine liabilities to be shown in internal management accounts and reports
- To value the provider for merger or acquisition
- Determine the excess of assets over liabilities and whether any discretionary benefits can be awarded
- Set future contributions to the benefit schemes
- Value benefits improvements for benefit schemes
- Calculate discontinuance / surrender benefits
- Influence investment strategy
- To provide disclosure information to beneficiaries
The need for “global” provisions
In addition to provisions on an individual level, global provisions may be required to demonstrate solvency over the provider as a whole. E.g. additional provisions may be required to cover risks from any mismatching of assets and liabilities.
A provider may be exposed to a number of financial and non-financial risks, which may merit an additional provision in excess of the sum of provisions for individual contracts.
The risk management strategy will be an important influence on level of provision needed for these additional risks. An effective and detailed risk management strategy will reduce exposure and reduce provisions.
Assumptions used for published accounts
These should be according to legislation and accounting principles governing the preparation of accounts and accounting principles. Matters to be considered include:
• Are accounts prepared on a going concern basis or break-up basis
• Are accounts prepared to show true and fair value
• Are provisions required to be assesses as best estimates or another basis and how the terms used are to be interpreted.
Assumptions used for demonstrating supervisory solvency
Key features: prudence and prescription of methods/assumptions by supervisory authority.
If separate accounts (from published) is required, the rules may differ. E.g. may be required to be prepared on a going concern or discontinuance basis.
Reference should be made to the rules and the guidance that may have been issued as to their interpretation.
Assumptions used in setting contributions to a benefit scheme
For benefit schemes the structure of the membership can have an effect on the assumptions used.
e.g.: a scheme closed to new business will have membership that will grow older, retire, leave or die. This will need to be considered when setting future contributions. The converse also holds for open schemes.
3.4. Setting the assumptions with regard to the client
A provider’s risk appetite will also influence the level of provisioning for risks. In managing the liabilities, there may be a desire to reduce the risk of provisions set aside being insufficient to meet the benefits promised. A person or company responsible for the management of the provision may therefore wish to consider values that are cautious.
The 50% probability of under provisioning of the best-estimate may be considered to be too great. E.g. a benefit scheme being valued on a discontinuance basis. The trustees will also consider the sponsor, that will not continue funding if the projected cost is too high.
In the case of an employer sponsor, a cautious approach could also lead to other cuts in the business, or insolvency. This may also not be in the best interest of employee beneficiaries.
3.5. Sensitivity testing
The assumptions used for setting provisions are estimates of future experience, taking any solvency capital requirements into account. Thus they will be expected values with possible margins for adverse experience. Sensitivity tests can be used to determine the margins.
Sensitivity analysis can be used to set global provisions.
When doing sensitivity analysis, is it’s important to change assumptions singly in a logical manner. Normal practice is to start with a central set of assumptions and vary them in turn to quantify the effect.
Also test the effect of multiple assumption changes. Assumptions is usually not independent or fully correlated and applying 2 tests simultaneously will be greater or less than the sum of individual results.
4.1. Reasons for liability transfers
E.g. the insurer has stopped writing a certain line of business.
When liability is transferred, it is important that both the transferring and receiving parties view the terms as fair.
- Assumptions used in valuing options and guarantees
In general, setting the approach for options or guarantees, a cautious approach is taken. But a cautious valuation basis will not automatically produce cautious terms for an option or guarantee.
Options and guarantees are not independent, some guarantees may make options more valuable in some scenarios.
Option holder behaviour may be influenced by the option that is immediately financially advantageous, rather than the option that have potentially the most value (but the benefit is realized in future).
E.g. an option to purchase an annuity may be in the money but clients still prefer to take a lump sum payment rather than a higher ongoing annuity.
5.2. Options assumptions
Options will move in and out of the money depending on market conditions.
In placing a value on an option when setting provisions, the highest cost option is usually assumed.
This may build too much caution into the valuation. Many options are significantly dependent on the option holder’s behaviour – policyholders may fail to exercise an option that is in the money or vice versa.
With options there is the risk of selecting against the provider. This can be guarded against by setting eligibility criteria or by setting terms that favour one option over another.
Factors affecting the value of options
Contract prices are highly sensitive to option pricing methods and assumptions. The assumptions used will depend on (amongst other things):
• State of the economy, and hence must be scenario specific
• Demographic factors – age, health, employments status, etc.
• Cultural bias
• Consumer sophistication
These sensitivities may change over time, e.g. as consumers become more aware of options and improve their ability to evaluate the relative merits of electing options.
5.3. Guarantees assumptions
With guarantees, the risk is that the guarantee will bite and the cost will be higher than would have otherwise been the case. Unless all guarantees are in the money, providing for the worst-case scenario for every contract will result in unnecessarily large provisions. Guarantees are usually best valued using a stochastic approach, taking the class of business as a whole. The inputs to the stochastic model should reflect the purpose for which the results are required. Level of prudence required (or the risk that the provision established will be inadequate) will affect the results.
Factors affecting the value of guarantees
Guarantees can become more or less onerous on the provider, depending on how experience develops.
The value of guarantees and the influence on consumer behaviour will vary widely according to economic scenarios and the sophistication of the market.
Calculate liability reasons
Investment strategy Premium setting MandA's Accounts (published and internal) Discretionary beenfits Discontinuance benefits Option terms Gtee costs Statury valn
Sources of surplus
Changes in assumptions/legislation A reclaculation Modified conribution rate Bulk transfer of liabilities Options taken up Discretionary benefits Interest on surplus Actual not equal to expected Errors
What is post loss funding?
Contingent capital, bonds convert to equity on specified event, e.g. capital falling below SCR
4 problems with Mark2Market
Choice of corporate bonds or govt (corporate lowers the liability value)
No asset matching the duration of the liability, government or corporate
No liquid market for the types of liability e.g. mortality. Consider a series of options
Non-financial risk is not automatically allowed for
What are the assumptions underlying the discounted dividend model?
D, an annual dividend first paid at time 1
i, constant effective annual required rate of return,
g constant effective annual rate of dividend growth
i>g
i, g both real or both nominal taxes and expenses ignored
Dividends are reinvested at rate i
Share held in perpetuity
What 3 things must you have to be insurable
P/h has interest in the risk
Financial and quantifiable nature
Amount paid by insurer relates to the financial loss incurred
What 6 other things would you like in an insurable risk
MUDPIS Moral hazard avoided Ultimate limit to liability Data to price the risk Pooling of similar risks Independent risk events Small probability of occurrence
What are the risk management tools?
MURDA Management and control systems Underwriting and claims control Reinsurance Diversification ART
Describe the ACC
Specify, develop solution, monitor experience
Carry out in professional manner, taking into account, commercial and general environment and needs of stakeholder
Specify includes state objectives, analyse risks
Develop includes build a model, come up with assumptions, do testing
Monitor compares actual to expected, trends and feed back into ACC
Considerations when writing a report
Competence Conflicts of interest Know the client Written communication clear and level is good Clearness Assumptions needed and made Risks regarding results Regulations, professional guidance
