Chapter 35: Valuing liabilities

Question 1

Provisions

Answer 1

Provisions are amounts set aside to meet future liabilities.

The value placed on the provisions is highly dependent on the assumptions used, which, in turn, will be highly dependent on the reasons for calculating the provisions.

Question 2

3 Bases

Answer 2

• optimistic
• best estimate
• cautious

Question 3

Best estimate basis

Answer 3

a basis with an equal probability of overstating or understating values.

Question 4

The strength of the basis used depends upon (3):

Answer 4

• the reason for the valuation
• the needs of the client
• regulation

Question 5

3 other factors that might affect the valuation basis

Answer 5

• Decisions by individuals
• Decisions by shareholders
• Decisions relating to investments

Question 6

10 Reasons for calculating individual provisions

Answer 6

• demonstrating supervisory SOLVENCY
• determining the value of liabilities for:
• —- published ACCOUNTS
• —- INTERNAL management ACCOUNTS
• valuing the provider for merger or ACQUISITION
• determining whether DISCRETIONARY benefits can be paid
• setting future CONTRIBUTION LEVELS for a benefit scheme
• valuing BENEFITS IMPROVEMENTS for a pension scheme
• calculating DISCONTINUANCE BENEFITS
• to provide disclosure information beneficiaries
• influencing INVESTMENT STRATEGY

Question 7

The purpose of global provision (3)

Answer 7

• act as additional protection against insolvency
• cover risks, both financial and non-financial, that cannot necessarily be attributed to individual contracts
• reflect degree of mismatching of assets and liabilities.

Question 8

The assumptions for calculating will depend critically both on… (2)

Answer 8

• the purpose for which the provisions are calculated

- the client for whom the calculation is for

Question 9

Purposes for which the provisions are calculated (8)

Answer 9

• The published accounts
• Demonstrating supervisory solvency
• The internal accounts
• Calculating discontinuance benefits
• Determining whether discretionary benefits can be paid
• Setting contribution levels
• Setting investment strategy
• Disclosure information for beneficiaries

Question 10

Assumptions used for published accounts (3)

Answer 10

The assumptions will reflect legislation and accounting principles. Matters to be considered include: (3)

• whether the accounts use a going concern or break-up basis
• whether the accounts require a true and fair view
• the degree of prudence in the basis

Question 11

Purposes for which the provisions are calculated:

- Demonstrating supervisory solvency

Answer 11

There will be a need for:

• prudence
• any prescribed methods / assumptions to be followed

Question 12

Purposes for which the provisions are calculated:

- The internal accounts

Answer 12

A realistic (best estimate set of assumptions is typically used)

Question 13

Purposes for which the provisions are calculated:

- Calculating discontinuance benefits

Answer 13

A best estimate basis may be considered to be fair. Other bases may be appropriate, eg a more cautious basis fi the aim is to encourage surrenders.

Question 14

Purposes for which the provisions are calculated:

- Determining whether discretionary benefits can be paid

Answer 14

Likely to err on the side of caution so surplus is not over-stated

Question 15

Purposes for which the provisions are calculated:

- Setting contribution levels

Answer 15

The assumptions used will depend on the objectives of the parties concerned. Eg trustees are concerned with the security of the benefits so will want prudcent assumptions, whereas the sponsor may not want to unduly tie up capital in the pension scheme, and so may prefer optimistic assumptions.

Question 16

Purposes for which the provisions are calculated:

- Setting investment strategy

Answer 16

A realistic set of assumptions is typically used, with sensitivity testing and scenario testing.

Question 17

Purposes for which the provisions are calculated:

- Disclosure information for beneficiaries

Answer 17

The assumptions will reflect legislation, but a realistic basis will typically be used, with a range of results also provided.

Question 18

Why might a best estimate basis be used to calculate the value of liabilities to be transferred? (3)

Answer 18

• so as to achieve fairness for all parties
• so as to achieve agreement between actuaries acting for different parties
• so as to comply with legisltation

Question 19

Why might a basis other than best estimate be used to calculate the value of liabilities to be transferred? (3)

Answer 19

• due to a power imbalance between the parties concerned
• because of a stronger desire to proceed by one party
• to recognise the need to hold margins to protect security.

Question 20

Contract values are highly sensitive to OPTION PRICING methods and assumptions.
The assumptions used will depend on, (4)

Answer 20

• the state of the economy, and hence must be scenario specific
• demographic factors such as age, health, employment status
• cultural bias
• consumer sophistication

Question 21

Going concern basis (funding basis)

Answer 21

The accounting basis normally required for an insurer’s published accounts, that is based on the assumption that the insurer will continue to trade as normal for the long-term future.

Question 22

Break-up basis

Answer 22

The valuation basis that assumes that the writing of new business ceases and cover on current policies is terminated.
Current policyholders would normally be entitled to a proportionate return of the original gross premium.
Deferred acquisition costs would probably have to be written off. Also known as a wind-up basis.

Question 23

2 Key features of provisions for demonstrating supervisory solvency

Answer 23

• prudence

- prescription of methods / assumptions by the supervisory authority

Question 24

4 other rules governing the preparation of these accounts and reports

Answer 24

• method of valuation used to value both the assets and the liabilities eg market-based, discounted cashflow
• assumptions used to value both the assets and the liabilities
• types of assets that can be held
• level of global provisions to hold

Question 25

6 Key assumptions required to value a medical benefits scheme

Answer 25

- DISCOUNT RATE - MEDICAL BENEFITS INFLATION - incidence of sickness and likely duration of illness, split by age, sex and different types of illness - MORTALITY rates - DISCONTINUANCE rates - future ENTRY RATES to the scheme and likely entry age / sex

Question 26

Information to set the assumptions required for a medical benefits scheme (6)

Answer 26

- past experience of the scheme - past experience of similar schemes - population statistics - projections of investment returns - projection of indices relating to medical benefits inflation

Question 27

3 Examples of financial and non-financial risks for which global provisions may be required

Answer 27

- market risk - credit risk - operational risk

Question 28

6 reasons for internal management accounts to be prepared

Answer 28

To look at - profitability - solvency - liquidity - the effectiveness of reinsurance - efficiency - financial strength

Question 29

2 Uses for sensitivity analysis

Answer 29

- To determine the margins required on the expected values to take account of adverse future experience. - To assess the need and extent of any global provisions that may need to be set up to cover potential future adverse experience.

Question 30

What are the risks to an individual over-contributing to a pension fund? (2)

Answer 30

- the individual may not be making the best use of the money - the individual may breach regulatory limits (if there is a maximum benefit payment allowed)

Question 31

Why might a stochastic approach add significant value in assessing investment strategies?

Answer 31

It can more closely replicate the pattern of investment returns in the real world. In addition, the output of running the model indicates the range of likely outcomes, providing additional information.

Question 32

How might the DISCOUNT RATE FOR FUTURE CASHFLOWS assumption differ according to whether - going concern basis, or - a break-up basis is being used?

Answer 32

going-concern valuation: - More likely to use longer-term investment assumptions break-up valuation: - shorter term (market value) investment assumptions

Question 33

How might the EXPENSES assumptions differ according to whether - going concern basis, or - a break-up basis is being used?

Answer 33

for break-up valuation, the future liability cashflows will need to include the expenses associated with discontinuing or terminating the business.

Question 34

How might the DISCONTINUANCE RATE assumptions differ according to whether - going concern basis, or - a break-up basis is being used?

Answer 34

withdrawals might be assumed to increase if a provider breaks up as customers become worried about the security of their benefits.

Question 35

How might the INSURANCE assumptions differ according to whether - going concern basis, or - a break-up basis is being used?

Answer 35

A break-up basis may assume that the insurer is wound up and that its liabilities are bought out by other insurers. The value of these liabilities will therefore be the price charged by the other insurers to take on the liabilities.