Chapter 36: Valuing liabilities (2)

Question 1

2 Sets of Approaches to valuing assets and liabilities

Answer 1

• Discounted cashflow approach

- Market value approaches

Question 2

Discounted cashflow approach

Answer 2

long-term discount rate used to value assets and liabilities

Question 3

Stochastic deflators

Answer 3

Used to calculate values of assets and liabilities on a market-consistent basis by applying deflator to a series of cashflows under a set of realistic scenarios.

Question 4

2 Definitions of fair value

Answer 4

1. The amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm’s length transaction.
2. The amount that the enterprise would have to pay a 3rd party to take over the liability.

Question 5

3 Different methods of allowing for risk in cashflows

Answer 5

• Build a margin into each assumption
• Apply a contingency loading by increasing the liability value by a certain percentage
• Adjust the rate of return to reflect the risk in the project or liability

Question 6

3 Different methods of calculating provisions

Answer 6

• Statistical analysis (if many, claims following known pattern)
• Case-by-case estimate (individual assessment of claim records where there are few claims)
• Proportionate approach (base on amount of net premium yet to expire)

Question 7

Replicating portfolio method

Answer 7

Using a replicating portfolio method involves taking the fair (market) value of the liabilities as the market value of the portfolio of assets that most closely replicates the duration and risk characteristics of the liabilities.
The replicating portfolio can be established by using stochastic optimisation techniques, ie a form of asset / liability modelling.

Question 8

Mark to market

Answer 8

The inflation rate, discount rate and related assumptions are derived from market information as follows:

• assets are taken at market value
• liabilities are discounted at the yields on investments that match the liabilities - often bonds
• the bond yield may be based on government bonds or corporate bonds - the latter will allow for credit risk

Question 9

Discounted cashflow method:

Key long-term assumption

Answer 9

future investment return expected.

Question 10

1 Major criticism of the Discounted cashflow method

Answer 10

It places a different value on the assets from the market value, which introduces an additional element of risk.

Question 11

3 Market-related approaches

Answer 11

• Asset-based approach

Replicating portfolio methods:

• mark to market
• bond yields plus risk premium

Question 12

An asset-based discount rate for liabilities can be set where (3)

Answer 12

• Assets are taken at market value. An implied market discount rate is determined for each asset class.
• 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 class.
• The discount rate could be determined using the distribution of the investment portfolio or the scheme’s strategic benchmark.

Question 13

Replicating portfolio method

Answer 13

Involves taking a fair (market) value of the liabilities as the market value of the portfolio of assets that most closely replicated the duration and risk characteristics of the liabilities.

Question 14

Replicating portfolio method 1:

Mark to market

Answer 14

The inflation rate, discount rate and related assumptions are derived from market information:

• assets are taken at market value
• liabilities are discounted at the yields on investments that match the liabilities - often bonds
• the bond yield will be based on government bonds or corporate bonds - the latter will allow for credit risk
• a better approach would be to use term-standard discount rates that vary over time to reflect the shape of the yield curve
• the market rate of inflation is derived as the difference between the yields on suitable portfolios of fixed-interest and index-linked bonds

Question 15

Replicating portfolio Method 2: Bond yields plus risk premium

Answer 15

Starts using a discount rate based on bond yields, but then adjusts it to take account of returns expected on other asset classes:

• assets are taken at market value
• liabilities are valued using a discount rate that is found by adjusting bond yields by the addition of either a constant or a variable equity risk premium

Question 16

Examples of OPERATIONAL risks faced by a retirement benefit scheme. (3)

Answer 16

• Inefficient administration systems, leading to higher than expected expenses of paying benefits.
• Incorrect benefit calculations leading to over-payments of benefits
• Incorrect benefit calculations leading to under-payment of benefits, leading to complaints and reputational risk to the scheme and sponsor.

Question 17

Examples of EXTERNAL risks faced by a retirement benefit scheme. (3)

Answer 17

• The government includes additional regulation that the scheme must adhere to.
• Tax breaks available to the pension scheme are removed, increasing costs.
• Competitor companies offer a more attractive pension scheme.

Question 18

What are the disadvantages to carrying out case-by-case estimates as opposed to statistical analysis to calculate the provision? (4)

Answer 18

• TIME-CONSUMING (and thus expensive)
• risk that the case assessors may have INSUFFICIENT EXPERTISE (incorrect assessment)
• the PROCESS IS SUBJECTIVE and there is a risk of bias by the assessors
• this approach CAN ONLY LOOK AT REPORTED CLAIMS, a separate approach will be needed to evaluate incurred but not reported claims.