Valuing Liabilities Flashcards
What are provisions?
Amount set aside to meet expected future liabilities
What do provisions depend on?
Assumptions used to value future expected cashflows
What uncertanities are in future cashflows, meaning assumptions will never be spot on?
Timing and level of cashflows is uncertain
Benefits/premiums/investment returns
What are BE assumptions for provisions?
Set of assumptions having equal probability of under and over estimating the actual value
Why not use BE assumptions? Who may want provisions?
Legislation Regulations Scheme rules Prescribed method isn't BE Client needs Shareholder valuation Policyholder/member valuation
How should results of provisions calculations be presented when presenting to a client?
Range of results shown
Range of scenarios - BE, worst case, best case
What assumptions might a regulator want used in a liability valuation? What will dictate which type of valuation to use?
Best estimate
Cautious - Understate strength
Optimistic - Overstate financial strength
Legislation
Professional judgment/guidance with disclosure
What assumptions may members/policyholders want used in liability valuation? Why?
BE Realistic Decide level of benefits Check security of benefits Change contribution level Cautious If risk averse on underprovision of benefits
What assumptions may shareholders (who are making decisions from accounts) want used in liability valuations, why?
BE in accounts
Make investment decision on it
Wrong decisions if another approach
When might the liabilities valuation method needs to take nature of assets into account?
Liabilities linked to underlying assets e.g. unit trusts
Covenant of sponsor has no value e.g. no promise to fully pay beenfits
Supervisory valuation of life insurer - valuation basis linked to features of backing assets e.g. yield
What are the reasons to calculate liabilities?
IPMADDOGS
In valuation fo gurantees, why shouldn’t you provide for the worst case scenario on every contract? How do you overcome this?
Unnnecessariliy large provisions
Stochastic approach taking business as a whole
Why might extra provisions above the sum of individual contract provisions be needed, give an example?
Financial and non-financial risks of company
e.g. Mismatching A and L
What do additional provisions for risks above individual contracts rely on, how to calculate them?
Risk management strategy (good one reduces provisions)
Monitoring and updating
Reduce exposure to fin/non-fin risks
e.g. ops risk
What issues are there in liability value calculation for published accounts?
Legislation Accounting principles of territory Going concern? True and fair value? Best estimate or another basis?
What are the issues in liability valuation for calculation of solvency demonstration?
Legislation Regulation Going concern? True and fair value? Guidance
What issues are there on assumptions that should be used for a liability valuation of closed benefit scheme?
Members getting older
Less contributions, more payments out
More retire/leave/die
What issues are there on assumptions that should be used for a liability valuation of open benefit scheme?
Leavers replaces by new members
Average age stay approximately constant
What is the main different assumption between open and closed benefit schemes for liability valuation?
Average age will be different
Leads to changes in contribution rate
What issues from company management point of view on assumptions for provision of benefits? What approach to management prefer? Why?
Risk appetite
Cautious approach -
BE too great risk of not meeting liabilities
In pension scheme trustees say too great risk of not getting funding correct
Why might a cautious approach for valuing provisions for risk not be good in a benefit scheme?
Reduced benefits as excessive provisions
Cuts in other parts of sponsor business
Insolvency is possible
Not in interests of employee beneficiaries
What are uses of sensitivity analysis in provision setting?
Find MAD in solvency calculations
Find global provisions for covering future adverse deviations
What is process of carrying out senstivity analysis, why not add individual tests up?
Start with central basis
Vary 1 assumption at a time and look at key assumption effects
Vary multiple assumptions
Multiple not equal to individual sum due to correlations and non-independancy
What are the issues on a transfer value of liabilities or assets? (e.g. MandA) What type of assumptions to use?
Must be fair to both parties
Best estimate
If one party has more power, then value in their favour
Both may agree for non-BE margins to protect security of benefits
What issues surround option and guarantee valuation?
Economy
Demographics e.g. age/health/employment status
Cultural bias
Consumer sophistication
Purpose of valuation
Prudence required
Selection - policyholder may select option that is immediately financially good, not the better values one
ITM/OTM - policyholder selects wrongly if in the money/out of the money
How can you value guarantees? Why not provide for worst case scenario in every contract?
Too large guarantees when not needed
Stochastic approach for whole business
Stochastic parameters to reflect valuation prupose
Why may CoG’s vary over time?
Depending on experience
Sophistication
Economy
Methods of setting a consistent discount rate between assets and liabilities valuation
Discounted cashflow
Replicating portfolio - market value method
Replicating portfolio - bond yield plus risk premium
Stochastic deflators
What are assets discounted at in discounted cashflow? Also liabilities
Cashflows discounted at long term future investment return assumptions
What is the major crticism of discounted cashflow for A and L
Asset value at time 0 is not the MV
What methods have been developed in finding consistent discount rate for AL valuations, with MV of assets being used
Replicating portfolio - MV method, Bond yields + RP
Stochastic deflators
Why are replicating portfolios good?
MV of assets used, so their fair value is used
Explain the replicating portfolio term in the rep portfolio valuation method?
Fair (market) value, put of portfolio most closely matching duration and risks of liabilities is found
What does market consistent method mean?
Market values for assets
Consistency in liability valuation
How can you find the replicating portfolio?
Use asset liability modelling, stochastic optimisation techniques
Explain Market value replicating portfolio method of valuing assets and liabilities using constant dicsount rate, in 5 points
- Asset value = MV
- Liability value = Discounted cashflow on yields on investments matching liabilities
- yield is bond yield - govt. or corp (allow for credit risk)
- Inflation = Yield on IL - FI bonds
- Term standard disc rates better
Explain bond yield + risk prem rep portfolio in 5 points, 2 disadvantages
- Asset value - MV
- Liabl value = discount at yields on govt bonds/corp bonds, add extra for equity risk premium
- ERP is constant of varying. If constant it’s M2M with lower lability value
- Disadvantage take extra return but no extra risk into account, so use risk free bonds
Explain stochastic deflator method of market consistent valuation of A and L
- Asset value = MV
- Stoch deflators = stoch discount factors
- One deflator per real world scenario
What is a fair value method?
One that seeks to place a mrket value on liabilities
When is it easy to determine the FV on liabilities?
Liquid secondary market
Contract has set values at exact times when can be terminated
What methods can an actuary use to determine FV of a liability?
Series of financial options, option pricing techniques
Risk free market value and adjust for financial and non-financial risk
How to calculate a risk free MV of liabilities? What requires estimation?
Discoutn expected futures cashflows by yield on risk free assets
Term of government bonds may not be logn enough
How to take financial risks into account in fair value method of valuin liabilities?
Replicating portfolio - match liabilities to a portfolio of assets
Stochastic modelling
Why is risk of mismatching not included in liability fair value valuation?
It’s supposed to be independent of assets held to meet them
How do you take non-financial risks into account in liability fv valuation? What do the adjustments depend on?
Adjust expected future cashflows
Adjust discount rate
Depend on amount o frisk, cost of risk implied by market
3 ways to allow for risk in cashflows in liability fair value valuation?
BE assumptions + MAD
BE liability * x%
Change discount rate ie. risky discount rate to reflect risk in project/liability
4 techniques for provisions for claims in GI, when are they used?
Statistical Analysis - large population
Case by case - rare, volatile amounts
Proportionate approach
Equalisation reserves - rare, volatile amounts
How does statistical analysis work?
Large population
Claims distribution approximately normal
BE = Avg cost of claim * # notified claims
For prudent provision take from normal distribution
How do case by case estimates work? Example? Disadvantage?
Rare, large volatility
Personal injury claims
Claims inflation needs to be watch out for
How does a proportionate approach work?
Premium = fair assessment of cost of risk + expenses + profit
If 25% covers expenses, commission, profit then 75% covers the risk
So provision should be 75% of the premium for the time period of the premium
How do equalisation reserves work?
Low prob, high volatility
Smooth profits by putting profits into a reserve in years of no claims, release in years of claims
These profits are still likely to be taxed
What 2 changes to accounting have there been recently?
Neutrality not prudence
Fair value not historical
What do the 2 accounting changes mean?
Revaluation of A and L at end of each accounting period
Revaluation reserve on gains, held until gain realised
What consequence do more frequent accounting reports have?
Volatility
What accounting concept will accounts be valued at normally?
Why?
Going concern
Should give true and fair value to performance and financial position
What ratios can be looked at to indicate strength of provisions?
Expenses/Premium income, commission/premium income, reinsurance paid for/premium income, operating ratio
