Chapter 33

Question 1

List the different ways of valuing liabilities

Answer 1

DCF
Fair value, replicating pf, risk-neutral market-consistent approach
Market-based reflecting assets held

Question 2

What are the constraints when using the fair value approach to value L

Answer 2

Unavailable assets
Reinvestment risk
Cant allow for all risks in discount rate

Question 3

How to value options

Answer 3

• Take up rate, level of prudence (not 100%)
• They depend on economic conditions, so you can use a stochastic model or deterministic
• Use a market traded derivative that replicates the option in the liability.
• The value of the policy option would be equal to the market value of the derivative * take-up rate
• If the derivative is unavailable, use a theoretical derivative and calculate its value using black Scholes.

Question 4

Describe the ways that liabilities could be valued

Answer 4

• MV(L) IS HARD TO FIND
• Can be risk-based or cost of capital based
• DCF
• Market-based reflecting assets held= Value L using discount rate that reflects weighted average on backing assets where the yield where the yield is the current market implied rate= other assumptions myst also be market-based
  Fair-value= Amount for which A could be traded or L settled between knowledgeable, willing parties inn arms length transaction:
  Replicating portfolio = MV(L)=MV(replicating A-duration and nature)
  Risk-neutral market-consistent approach = MV(L) = SUM(CFiV) at ri where ri= risk-free rate for ZCBi less credit risk

Question 5

Describe how an insurance guarantee could be valued

Answer 5

• Use a cautious approach
• Use stochastic model to model interest rates and maybe 1 other variable
• Output would be used for P(bite), E(cost) and V(cost of G)
• Global basis not individual
• Or use a variety of deterministic scenarios