Valuation Of Liabilities

Question 1

Traditional discounted method

Answer 1

Valuation of assets
Discounted proceeds using long-term assumptions

Valuation of liabilities
Discounted outgo using same long-term rate as used for assets

Question 2

Market-based, reflecting assets held

Answer 2

Valuation of assets
Market value

Valuation of liabilities
Discounted outgo using expected return on assets held (i.e. current implied market discount rates), weighted by proportions held in asset class

Question 3

Fair value: replicating portfolio

Answer 3

Valuation of assets
Market value

Valuation of liabilities
Market value of assets in the theoretical replicating portfolio

Question 4

Fair value: risk-neutral market-consistent

Answer 4

Valuation of assets
Market value

Valuation of liabilities
Discounted cashflows using risk-free rates

Question 5

Valuing options and guarantees

Answer 5

An individual might not always exercise the option that is in the money from the prospective of the provider

The risk of anti-selection needs to be allowed for when valuing options

An option within liabilities can be valued by finding a market option that replicates it. A closed form approximation may be used, e.g. Black-Scholes

Guarantees are usually best valued by a stochastic approach, allowing for the likelihood of the guarantee biting and it’s expected cost

Assumptions used for valuing options and guarantees, particularly relating to customer behaviors, need to be taken into consideration:
• the state of the economy (and hence must be scenario specific)
• demographic factors such as age, health and employment status
• cultural bias
• customer sophistication

Question 6

Sensitivity analysis

Answer 6

It 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

Question 7

Allowing for risk

Answer 7

For discounted cashflow valuation;
• build a margin into each assumption
• apply an overall contingency loading by increasing the liability value by a certain percentage
• adjust the discount rate to reflect the risk in the project or liability

For a fair valuation:
• no need to adjust for financial risk (already implicitly allowed for)
• for non-financial risk:
- adjust the cashflows (or discount rate)
- hold an extra provision or capital requirement such as the Solvency II risk margin

Question 8

Different methods of calculating provisions

Answer 8

For a general insurer:
• statistical analysis - if there are many claims, following a certain pattern

• case by case estimation - individual assessment of claim records where there are few claims

• proportionate approach - based on amount of net premium yet to expire

An equalization reserve may be set up to smooth results from year to year, where there are low probability risks with high and volatile financial outcome