Chapter 32: Provisions

Question 1

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 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

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

A set 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/pr a high value of liabilities.

Question 9

State the 3 main factors that usually dictate the strength of the basis on which values should be determined.

Answer 9

1. Purpose of the valuation
2. Needs of the client
3. Regulatory / legislative requirements

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.

Answer 11

• Consider accounting principles and
  legislation in the country concerned.
• Consider whether the accounts are to be
  prepared on a going concern or break-up
  basis.
• Consider whether they are required to
  show a true and fair view.
• Consider whether the basis required is
  best estimate or some other basis and
  how this is to be interpreted.

Question 12

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

Answer 12

• Consider the regulation and legislation in
  the territory concerned
• Consider whether the accounts are to be
  prepared on a going concern basis or a
  discontinuance basis.
• Consider whether the basis is prescribed
  or left to actuarial judgement.
• Consider whether there are any relevant
  rules and actuarial guidance.
• 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

• The transferring company will prefer
  optimistic assumptions.
• The receiving company will prefer
  cautious assumptions.
• A best estimate basis is fair, and the need
  to to agree may result in a best estimate
  basis being used.
• However, the basis will depend on the
  relative bargaining powers of both sides
  and relative supply and demand for
  liability transfers.
• 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

• Cautious basis to ensure better security of
  benefits.
• 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

• Optimistic if there is a high opportunity
  cost of capital.
• Cautious if higher contributions now may
  lead to greater flexibility in the future.
• Cautious if higher contributions may
  result in tax deferral.
• Cautious if the sponsor wants to be
  viewed as paternalistic
• Cautious if there is a low opportunity cost
  of capital
• Cautious if better investment returns can
  be earned within the scheme leading to
  lower long-term costs.
• 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

• A large number of different scenarios
  should be examined - particularly best
  estimate and cautious.
• 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

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