Ch 32: Provisions

Question 1

Define the term provisions

Answer 1

Provisions are the calculated amounts that need to be set aside to meet a provider’s future liabilities.

The value of the provisions will DEPEND on the ASSUMPTIONS used to value the future expected cashflows.

Question 2

List 10 reasons why a provider calculates provisions

Answer 2

BAD MEDICS

• Benefit improvements for a benefit scheme
• Accounts and reports - published and internal
• Discontinuance / surrender benefits
• Mergers and acquisitions
• Excess of assets over liabilities and so whether any discretionary benefits can be awarded
• Disclosure of information for beneficiaries
• Investment strategy
• Contribution / premium setting
• Statutory solvency reports

Can also be used by a bank to provide for expected credit losses.

Question 3

What is the difference between individual and global provisions?

Answer 3

Individual provisions relate to an individual contract or scheme member.

Global provisions cannot be allocated to individual contracts or members and relate to a provider’s liabilities as a whole.

Question 4

Give an example of one financial and one non-financial risk for which a provider might calculate global provisions.

Answer 4

Financial risk - mismatching assets and liabilities

Non-financial risk - operational risk

Question 5

Basis

Answer 5

The term given to a collection of assumptions

Question 6

Best estimate basis

Answer 6

Set of assumptions that have an equal probability of overstating and understating the value of the assets and the liabilities.

Question 7

Optimistic (or weak) basis

Answer 7

Assumptions are chosen which collectively result in a high value of assets and/or a low value of liabilities.

Question 8

Cautious (or prudent/strong) basis

Answer 8

Assumptions are chosen which collectively result in a low value of assets and/or a high value of liabilities

Question 9

State the 2 main factors that usually dictate the strength of the basis on which values should be determined

Answer 9

1. Purpose & Client
   - the reason that a value needs to be determined
   - the needs of the client
   - regulation requirements
2. Nature of the Assets
   - when the liabilities are linked to underlying assets
   - when the covenant of the sponsor has no value
   - for a MARKET-CONSISTANT valuation of liabilities w.r.t. financial guarantees on life insurance contracts (since the value of the liabilities will depend on the volatility of returns on the assets held)

REGULATION is very important

Question 10

Give 3 examples of how the nature of the assets held can impact the liability valuation

Answer 10

1. The liabilities may be specifically defined in terms of the performance of the assets (e.g. unit-linked contract, unit trust)
2. Where the sponsor will not make up any shortfall in a pensions fund, the benefits paid must have to be reduced to reflect the actual assets available.
3. For a market-consistent valuation of life insurance financial guarantees the liability value will depend on the volatility of returns on the assets held.

Question 11

Outline the FACTORS to consider when valuing the liabilities to be shown in the provider’s PUBLISHED ACCOUNTS.

(best estimate)

Answer 11

1. Consider accounting principles and legislation in the country concerned.
2. Consider whether the accounts are to be prepared on a going concern basis (or is discontinuance happening)?
3. Consider whether they are required to show a true and fair view.
4. Consider whether the basis required is the best estimate or some other basis and how this is to be interpreted. (One of the accounting principles is prudence and this often results in the basis used being on the slightly prudent side of best estimate)

Question 12

Outline the factors to consider when valuing the liabilities to demonstrate supervisory solvency

(prudent)

Answer 12

1. Consider the regulation and legislation in the territory concerned
2. Consider whether the accounts are to be prepared on a going concern basis or a discontinuance basis.
3. Consider whether the basis is prescribed or left to actuarial judgement
4. Consider whether there are any relevant rules and actuarial guidance.
5. Regulators may wish to consider values that present a realistic picture of the provider’s finances. Alternatively, they may wish to consider values that intentionally understate (or perhaps overstate) the financial strength of the provider.

Question 13

What basis should be used when valuing the liabilities to be shown in the provider’s internal accounts?

Answer 13

Best estimate, to provide a realistic picture for decision-making by management.

Question 14

Outline the factors to consider when valuing the liabilities for a transfer of liabilities between two providers.

Answer 14

1. The transferring company will prefer optimistic assumptions.
2. The receiving company will prefer cautious assumptions.
3. A best estimate basis is fair, and the need to to agree may result in a best estimate basis being used.
4. However, the basis will depend on the relative bargaining powers of both sides and relative supply and demand for liability transfers.
5. It is possible that the two sides agree that the transfer should not reflect a best estimate of future costs, for example if they recognize a need to hold a margin to protect the security of the benefits.

Question 15

What basis should be used when determining whether discretionary benefits can be awarded or benefit improvements made?

Answer 15

The provider may want to use assumptions that do not overestimate the surplus available in order to avoid being pressurized into distributing it as discretionary or additional benefits. Similarly, proposed benefit improvements should not be undervalued.

This is because such benefits may prove in practice to be more expensive than had been anticipated.

The most realistic indication will be based on best estimate assumptions, but a cautious basis (or range of assumptions) may be used.

Question 16

Outline the factors to consider when valuing the liabilities to set contributions for a defined benefits scheme, from the perspective of the trustees and the beneficiaries

Answer 16

1. Cautious basis to ensure better security of benefits
2. But not so cautious that the sponsor believes the cost of benefits to be excessive and hence reduces future benefits, closes the scheme to future accrual, or pays a high contribution rate and becomes insolvent.

Question 17

Outline the factors to consider when valuing the liabilities to set contributions for a defined benefit pension scheme, from the perspective of the sponsor

Answer 17

1. Optimistic if there is a high opportunity cost of capital.
2. Cautious if higher contributions now may lead to greater flexibility in the future.
3. Cautious if higher contributions may result in tax deferral.
4. Cautious if the sponsor wants to be viewed as paternalistic
5. Cautious if there is a low opportunity cost of capital
6. Cautious if better investment returns can be earned within the scheme leading to lower long-term costs.
7. Best estimate for stability of cost and a compromise between the above factors.

Question 18

What basis should be used when setting discontinuance terms, in order to be “fair” to all parties?

Answer 18

Best estimate, for fairness between those discontinuing, those remaining and the provider.

Question 19

Outline factors to consider when valuing the liabilities to set an investment strategy.

Answer 19

1. A large number of different scenarios should be examined - particularly best estimate and cautious.
2. A stochastic model could be useful in assessing the risks and values under each possible investment strategy.

Question 20

Outline the factors to consider when setting a basis to illustrate the level of benefits to which an individual is entitled, the level of investment return they might expect to receive and the contributions they might be required to make to target a specific level of benefits.

Answer 20

1. The assumptions should take into account the circumstances of the individual, e.g. age, gender, marital status.
2. Best estimate allows realistic decisions to be made.
3. A range of values communicates the uncertainty involved.
4. If the individual is averse to the risk of under-provision, a cautious approach may be appropriate.

Question 21

Why is there a need for “global” provisions?

Answer 21

A provider will be exposed to a range of financial and non-financial risks, which creates a need for provisions ABOVE the sum of the provisions for all the individual contracts.

e.g. a mismatch reserve