CHP 36

Question 1

Two main methods of valuation:

Answer 1

• Discounted cashflow approach
• Market-related approach
No matter which method is used, it is important when setting the discount rate used to value assets and liabilities that it is consistent.

Question 2

1.3. Discounted cashflow method

Answer 2

A key long-term assumption is future investment return expected.
Future cashflows arising from liabilities are discounted using this rate.
For consistency, assets are also discounted using long-term assumptions.
The major criticism of this approach is that it places a different value on the assets than market value and thus introduces another element of risk.

Question 3

1.4. Market-related approaches

Answer 3

Replicating portfolio: involves taking fair value of the liabilities as the market value of the portfolio of assets that most closely replicates the duration and risk characteristics of the liabilities.
The replicating portfolio can be done by using stochastic optimisation techniques (a form of asset-liability modeling). This forms the basis for the following 2 techniques:

Question 4

Replicating portfolio method 1: Mark to market

Answer 4

This is derived from financial economics.
The inflation rate, discount rate and related assumptions are derived from market info as follows:
• Assets are taken at market value
• Liabilities are discounted at the yields on investments that match liabilities – often bonds
• The bond yield may be based on government or corporate bonds – the latter will allow for credit risk
• A better, more complicated method will use term-standard discount rates – takes shape of yield curve into account.
• Market rate of inflation is derived from the difference between yields on portfolios of fixed interest and index-linked bonds.

Question 5

Replicating portfolio method 2: Bond yields plus risk premium

Answer 5

Starts by using a discount rate based on bond yields as in the mark-to-market method, but then adjusts it to take account of the returns expected on other asset classes as follows:
• Assets are taken at market value
• Liabilities are valued using a discount rate that is found by adjusting (usually increasing) bond yields by the addition of either a constant or a variable equity risk premium.
• Where a constant equity risk premium is used, the result is the same as mark-to-market method except value of liabilities is lower (usually).
• Variable risk premium is derived by a mix of market info and actuarial judgment (more common method)
• Some think that taking account of extra equity return is unsound unless the extra risk is taken into account. As a result some say liabilities should be valued using a risk-free rate.

Question 6

1.5. Stochastic deflators

Answer 6

These are stochastic discount factors that can be applied to a series of cashflows under a set or realistic scenarios to product market-consistent valuations of assets and liabilities.
Because deflators are themselves stochastic functions, each real world scenario has a different deflator.
The PV of future cashflows to which deflators are applied is the expected value of the deflated cashflows.
Because stochastic deflators are based on real world scenarios, they can be set to allow for the assessment of realistic risks.

Question 7

2.2. The move to market-based or fair value approaches

Two definitions of fair value:

Answer 7

• The amount for which an asset could be exchanged for a liability settled between knowledgeable, willing parties in an arm’s length transaction.
• The amount the enterprise would have to pay a third party to take over the liability

Question 8

2.2. The move to market-based or fair value approaches

Answer 8

There is sometimes no secondary liquid market in many of the liabilities required to be valued. Thus the identification of fair value from a market is not practical. Because of this, fair value of liabilities needs to be estimated using market-based assumptions.
One approach is to consider the liabilities as a series of options and to use option pricing techniques to value.

Question 9

2.3. Estimating fair values

Answer 9

The risk-free market value is the present value based on discounting future liability cashflows at the pre-tax market yield on risk-free assets. (use yield on government securities as a proxy)
Government securities, until recently have been of insufficiently long term to match all insurance cashflows. Some estimation of longer term yields was needed.

Question 10

2.4. Financial risk and fair value reporting

Answer 10

Financial risk associated with liability cashflow is normally allowed for in a market consistent manner (either by replicating portfolio or stochastic modeling) and the use of a suitably calibrated asset model.

Question 11

2.5. Mismatching risk and fair value reporting

Answer 11

Risk due to mismatching of assets and liabilities are excluded from fair value calculations. This is because inclusion of this risk would be inconsistent with the general principle that the fair value of liabilities should be independent of the assets held to meet them.

Question 12

2.6. Non-financial risks and fair value reporting

Answer 12

The adjustment for non-financial risks can be achieved by either:
• Adjusting expected future cashflows, or
• Adjusting the discount rate
These will depend on:
• The amount of the risk
• The cost of the risk implied by the market risk preferences

Question 13

3. Different methods of allowing for risk in cashflows

Answer 13

3. 1. Best estimate plus margin
4. 2. Contingency loading
5. 3. Discounting cashflows at risk premium

Question 14

3. Different methods of allowing for risk in cashflows

3. 1. Best estimate plus margin

Answer 14

Add an explicit margin for risk to the best estimate assumption.
Assessment of the margins required depends on the risk involved and its materiality to the final result.
Where a risk factor has been stable for long and is not exposed to economic events, just add a percentage loading. E.g. mortality loading for persons aged 30-55 in a developed country.
In other cases a more detailed analysis of experience from various sources (perhaps stochastic) may be needed t determine a margin consistent with the risk.

Question 15

3. Different methods of allowing for risk in cashflows

3. 2. Contingency loading

Answer 15

This approach increase the liability by a certain percentage.
The choice of this “contingency loading” is another assumption and should ideally reflect the degree of uncertainty.
It will thus be expected to increase with the value of liabilities but not in a proportionate manner.
Given the analysis tools available, this approach is falling out of favour as excessively arbitrary.

Question 16

3. Different methods of allowing for risk in cashflows

3. 3. Discounting cashflows at risk premium

Answer 16

This is the traditional discounted cashflow approach where cashflows are discounted at a best estimate basis and then discounted at a rate of return that reflects the overall risk.
What is the appropriate discount rate? How do we thus compare different projects or products based on this?

Question 17

4. Different methods of calculating provisions

Answer 17

4. 1. Statistical analysis
5. 2. Case-by-case estimates
6. 3. Proportionate approach
7. 4. Equalization reserves

Question 18

4. Different methods of calculating provisions

4. 2. Case-by-case estimates

Answer 18

If the insured risks are rare events and also have large variability in outcome, then statistical analysis may break down.

Question 19

4. Different methods of calculating provisions

4. 3. Proportionate approach

Answer 19

An alternative, 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 portfolio is such that there is no method of assessing a required provision with any degree of confidence, the risk should be transferred somewhere else.

Question 20

4. Different methods of calculating provisions

4. 4. Equalization reserves

Answer 20

E.g. where events are low probability but high financial impact, the company will show above average profit for years with no events and below average for years with claims.
To smooth results an equalization reserve may be set up in years with no claims.
These reserves do not fit in with the general definition of provision but are widely used in general insurance.
Tax authorities are often not prepared to take such reserves into account in computing profits.
Equalization reserves are a way of deferring profits and thus tax.

Question 21

4. Different methods of calculating provisions

4. 1. Statistical analysis

Answer 21

If the population that is exposed to a particular risk, the consequence of the risk event will be approximately normally distributed. In this case a mathematical approach to establish a provision for the risk will give valid results.

Question 22

What goes into the costs of a product?

Answer 22

Admin
Underwriting
Capital requirement and it's opportunity cost
Commission
Asset management costs
Overheads
Market research
Costs of paying regular benefits from bank
Checking someone hasn't dies
Valuation costs

Question 23

17 things on a proposal form

Answer 23

name/address/dob
age/height/weight/sex
smoker/alcoholic
marriage status
occupation/salary
exercise per week
current insurance and how much
existing problems, history
family members and their history
dangerous hobbies
anything else to inform

Question 24

What to state in cashflow questions

Answer 24

who's perspective
main cashflows (premiums, benefits, expenses, investment income)
description of cashflow (positive or negative, lump sum, variable, certainty of timing/amount/term

Question 25

What to think about in contract design?

Answer 25

Types of benefits
Payment received for cover
Charges for cover will they meet expenses
Objectives of the policy

Question 26

What order is DR RUB

Answer 26

Risk analysis at high level
Risk register
Upside risk as well as downside
Brainstorm
Desktop analysis to supplement brainstorm

Question 27

What is the WACC? what is the alternative?

Answer 27

The rate of return that needs to be earned on the capital to be used if the existing s/h would be no better or worse off
“the cost of raising incremental capital” to carry out the project
you can increase it to reflect risk
look at other companies discount rates

Question 28

Give the project appraisal steps from start to finish

Answer 28

1. Ideal
2. Will it be authorised SPURS
3. Risk identifying DR RUB
4. Matrix and mitigation PNE FC PB/FAT SIR
5. Write investment submission FIRM PEN
6. Last minute decisions LAND HO
7. Accept/Reject
8. . Figure out how to finance it (part of FIRM PEN)
9. Make a good project PROJECT CRAMPS
10. Write up your strategy document PROSE
11. Finish project on time/budget and hand over to owner

Question 29

Why wouldn’t you regulate a market?

Answer 29

Market is new and regulation not yet been determined
Only professionals in it
No abuse can be done, like term assurance

Question 30

What can changing the short term interest rate effect?

Answer 30

Spending, exchange rate, demand for money, currency/trade balance
Spending increases if lower interest rates (corporate and consumer)
Exchange rate falls - overseas investors earn less in deposits
Demand for money increases, so money supply increases so inflation
Currency/trade balance remains unchanged if globally all are reducing rates