Chapter 33: Valuation of liabilities Flashcards
(17 cards)
What are the most important factors to consider when setting the discount rates used to value the assets and liabilities?
Consistency between the rates used for asset and liability valuations
Describe the traditional discounted cashflow method of valuing assets and liabilities.
Both assets and liabilities are valued by discounting the future cashflows using a rate that reflects the long-term future investment return expected.
The rates and assumptions are based on actuarial judgement.
What is the major criticism of the traditional discounted cashflow method of valuing assets and liabilities?
It provides a value of the assets that is different from the market value. It is difficult to explain this to clients.
(Consequently, there has been a move towards market-related methods of valuing assets and liabilities)
Give 2 definitions of “fair value”
- The amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm’s length transaction.
- The amount that the enterprise would have to pay a third party to take over the liability
note: fair values implies that a market-related approach is used
Give 2 examples of financial contracts for which it might be fairly straightforward to determine a fair value
- Unit linked contracts - the value of the liability is effectively known since it is the value of the units and the unit price is determined on a frequent basis.
- The pensions in payment liabilities of a benefit scheme - there may be an active “buyout” market consisting of insurance companies and other financial organisations that are prepared to provide immediate annuities to cover pensions in payment
What is the major difficulty in determining the fair value of a provider’s liabilities?
There is no liquid secondary market in most of the liabilities that actuaries are required to value, so the identification of fair amounts from the market is not practical. As a result, fair values of liabilities need to be “estimated” using market-based assumptions.
Describe the replicating portfolio - mark-to-market (market value) method of valuing assets and liabilities
Market information provides assumptions: inflation and discount rate, and related assumptions.
1. Assets are taken at market value
2. Liabilities are discounted at yields on investments that match the liabilities (often bonds). May be government or corporate bonds - but adjust corporate bonds to allow for credit risk.
3. The (market rate of) inflation can be taken as the difference between yields on suitable portfolios of fixed and index-linked bonds.
note: a better way would be to use the discount rates provided by the yield curve
Describe the replicating portfolio - bond yields plus risk premium method of valuing assets and liabilities
The method is similar to the mark to market method with:
1. Assets taken at market value
2. Liabilities discounted at the adjusted yields on investments that closely replicate the duration and risk characteristics of the liabilities - often bonds. The discount rate used is found by adjusting bond yields by the addition of a constant/variable Equity Risk Premium
However, some actuaries think that taking account of the extra return from other assets is unsound unless acount is also taken of the extra risk, and that a risk premium should not be used.
Note: This method starts by using a discount rate based on bond yields as in “mark to market methods”, but then adjusts discount rate to take into account the expected returns on other assets classes.
Describe the asset-based discount rate approach for valuing assets and liabilities
- Assets are taken at market value
An implied market discount rate is determined for each asset class (e.g. fixed interest assets = GRY; equities = discount rate implied by market price and the expected dividends and sale proceeds)
The liabilities are valued using a discount rate calculated as the weighted average of the individual discount rates based on the proportions invested in each asset class.
The discount rate could be determined using the distribution of the actual investment portfolio or the scheme’s strategic benchmark (if the current asset allocation is not representative of the scheme’s usual investment strategy)
Outline how the fair value of liabilities can be determined by performing a “risk-neutral” market consistent valuation
The value is determined as the present value of future liability cashflows, discounted at the pre-tax market yield on risk-free assets.
Such assets might be swaps or government bonds
Outline the factors to consider when valuing guarantees
- In general, a cautious approach is taken.
- However, unless all guarantees are in the money, assuming the worst case scenario in every case will build in too much caution.
- A stochastic model should be used for valuing guarantees (taking the class of business as a whole), to show the likelihood of the guarantees biting and the associated cost. Parameter values should reflect the purpose for which the results are required.
- Guarantees may become more or less onerous over time.
- The value of guarantees and their influences on consumer behaviour will vary widely according to the economic scenarios and the sophistication of the market.
Outline the factors to consider when assessing the cost of an option from the perspective of the provider
- In general, a cautious approach is taken.
- However, this can build in too much caution.
- For example, a policyholder may not exercise the highest cost option despite it being financially better for them to do so.
- It is necessary to allow for anti-selection risk when valuing options, or to mitigate this risk using eligbility criteria for exercising the option
- Options and guarantees are not necessarily independent; some guarantees may make options more valuable in certain circumstances.
- Deterministic and closed-form (e.g. Black-Scholes) methods could be used.
State 4 factors on which the option exercise rate assumption will depend
- The state of the economy
- Demographic factors, e.g. age, health, employment status.
- Cultural bias
- Consumer sophistication
State 2 examples of where an assumption of the policyholders always exercising an option that is in-the-money from the provider’s perspective may not be appropriate
- The policyholder prefers to take the alternative benefit as it is paid as a lump sum cash amount. Cash in-hand has a powerful influence on an individual’s decision.
- The policyholder receives beneficial tax treatment on the alternative benefit. Taking a % lump sum of pension, as it is tax-free. Uses rest of pension to purchase annuity-based income (which is taxed)
Describe 3 approaches to allowing for risk in the cashflows used for valuing liabilities
- Best estimate + Margin - a margin is explicitly built into each assumption. The size of the margin reflects the amount of risk involved and its materiality to the final result.
- Contingency loading - the liabilities are increased by a certain percentage. The size of the margin reflects the uncertainty involved. This method is very arbitrary.
- Discount rate - the discount rate is adjusted by a risk premium that reflects the overall risk of the liability. Usually defined by governing bodies.
Outline how risk can be allowed for in a market-consistent or fair valuation of liabilities
Financial risk associated with the liability cashflow is normally allowed for in a market-consistent manner either by a replicating portfolio or through stochastic modelling and the use of a suitably calibrated asset model.
The risks associated with the general mismatching of assets and liabilities are on the whole excluded from fair value calculations. This is because inclusion of this risk would be inconsistent with the general principle that the fair value of liabilities should be independent of the assets held to meet the liabilities.
The adjustment for non-financial risks can be achieved either by adjusting the expected future cashflows or by an adjustment to the rate used to discount cashflows. Alternatively, an extra provision or a capital requirement, such as the risk margin under Solvency II, can be held for non-financial risks.
These adjustments will depend on:
* the amount of risk
* the cost of the risk implied by market rate preferences.
Outline 4 methods that an insurance company might use for establishing provisions, particularly a general insurance company
- Statistical analysis: If the population exposed to a risk is large enough, and the consequence of a risk event is approximately normally distributed, then a mathematical approach to establishing a provision for the risk will give a valid answer. To establish a prudent provision that would be sufficient at a ruin probability of any given percentage, a simple analysis of the normal distribution will generate the required result.
- Case-by-case estimates: If the insured risks are rare events and also have a large variability in outcome, then statistical analysis may break down. The case-by-case examination involves the claims assessor examining each individual claim file for the reported claims and assessing the likely cost of settling each claim.
- Proportionate approach: An alternative approach, especially in making provisions for risks which a provider has accepted but where the risk event has not yet occurred, is to set a provision on the basis that the premium charged is a fair assessment of the cost of the risk, expenses and profit. If a portfolio is such that there is no method of assessing a required provision with any degree of confidence, this suggests that the risks ought to be transferred elsewhere.
- Equalisation reserves: An example of the issues discussed above occurs where a product provider might wish to exhibit stable results from year to year, but where the portfolio contains low probability risks with a large and highly volatile financial outcome. In years where such an event occurs, the company may show a significant reduction in profits; where no event occurs, profits will be greater than the long-term average. To smooth results, a company may establish a claims equalisation reserve in years when no claim arises, with a view to using the reserve to smooth results when a claim does occur.
