Chapter 35: Valuing Liabilities (1)

Provisions

In accounting standards, provisions are kept for liabilities known and assumed to exist at an
accounting date, whereas reserves are kept for value of liabilities above provisions (i.e. amount
required to meet additional liabilities).

But, in actuarial context these two terms are interchangeable.

Different bases

Basis is the term given to collection of assumptions.

The bases in order of increasing strength are: optimistic, best estimate, prudent, cautious.

 A best estimate basis is basis with an equal probability of overstating or understating

values.

 Optimistic (or weak) : assumptions are chosen such that high value is placed to assets and
low value to liabilities

 Prudent (or conservative / strong): assumptions are chosen such that low value is placed
to assets and high value to assets.

Going concern basis vs. Break up Basis

a) Insurance Companies

 Going concern basis (or funding basis): Insurer will continue to trade as normal

 Break up Basis (or discontinuance or wind-up basis):

o New businesses cease & current policies are terminated.
o Current p/h are given proportionate return of the premium.
o Deferred acquisition costs would be written off.

b) Benefit schemes
 Going concern basis: Benefit scheme will continue as normal
 Break up Basis:
o Scheme ceases to accrue future benefits.
o For a discontinuance valuation, if the liabilities are bought by another provider
or transferred to another scheme, then a MARKET VALUE approach is often
used for valuing assets of the scheme.
Factors affecting the strength of the basis
 Reason for the valuation (valuation for accounting purposes would be best estimate, but
for reserving purposes it would be prudent)
 Needs of the client and the client’s circumstances (beneficiaries, shareholders)
 Assumptions made by actuaries (actuarial judgment)
 Provider’s finances & solvency strength.
 Some basis would require high solvency capital and lower margins, whereas some basis
would require low solvency capital and high margins.
 Decisions by shareholders – decisions are made based on company accounting
information

 Decisions relating to investments – consider a range of different assumptions and

stochastic modelling.

 Liabilities linked to underlying assets e.g. unit trust

 Legislation requiring link b/w liability valuation basis and yield of underlying assets

 Maximum funding provision allowed (tax haven)

Provisions

 In life insurance, provisions are calculated using a formula or a DCF.

 In general insurance, provisions are calculated using statistical (e.g. run off triangle)
methods or case estimates

 For benefit schemes:

o In case of DB, provisions would be based on value of benefits evaluated through

DCF or a formula.

o In case of DC, provisions would be based on value of benefits which in turn

would be based on amt. of accumulated contributions (net of charges)

Calculating individual provisions

Reasons for calculating individual provisions:

 For published and internal accounts

 Demonstrating supervisory solvency
 For M’s & A’s

 Determining whether discretionary benefits can be paid

 Calculating discontinuance / surrender benefits

 Setting future contribution levels for a benefit scheme

 Valuing benefit improvements (i.e. increase in benefits) for a pension scheme

 To provide disclosure information to beneficiaries

 Influencing investment strategy

Calculating global provisions

There may be a requirement to calculate an additional global provision.

Purpose of global provision may be to:
 Act as additional protection against insolvency
 Cover risks, both financial and non-financial, that cannot necessarily be covered
 Reflect degree of mismatching of assets and liabilities.

Setting assumptions for calculating provisions

a) Assumptions used for published accounts

 The assumptions for published accounts will reflect legislation and accounting principles.
 Matters to be considered include:
 Using a going concern or break-up basis
 Best estimate basis or some other basis
 Reflecting a true and fair view
 Consistency in approach from year to year

b) Assumptions used for internal accounts of a provider

 Decided by directors of the providers or trustees (in case of pension schemes)
 A realistic (best estimate) set of assumptions is typically used.

c) Assumptions to be used for demonstrating supervisory solvency

  Key features of provisions for demonstrating supervisory solvency are:
 Prudence approach
 Method / Assumptions prescribed by supervisory authority

 Rules and regulations to be considered:

 Method of valuation for A’s and L’s; e.g. Market based, DCF
 Assumptions to value A’s and L’s
 Type of assets that can be held
 Level of global provisions

d) Assumptions used to calculate discontinuance benefits

 A best estimate basis may be considered to be fair.
 If the aim is to encourage surrenders then use a more cautious basis

e) Assumptions used to determine whether discretionary benefits can be given

 Provider may not want to overestimate the surplus to avoid being pressurized into
distributing it as discretionary benefits.

f) Assumptions used in setting contributions to a benefit scheme

 This depends on the objectives and preferences of the sponsor, beneficiary or trustee.
E.g. trustees are concerned with the security of the benefits so will want prudent
assumptions, whereas the sponsor may not want to unduly tie up capital in the pension
scheme, and so may prefer optimistic assumptions.

 Membership grouping of benefit scheme (i.e. some schemes may have more active
members, whereas some schemes may have more pensioners)

g) Assumptions used to determine disclosure information for beneficiaries

 The assumptions will reflect legislation; a realistic basis would be most appropriate

h) Assumptions used to set investment strategy

 Best estimate basis is most appropriate (together with sensitivity and scenario testing)

i) Other assumptions
 Security of schemes (trustees concern)
 Opportunity Cost of capital (sponsor’s concern)
 Tax
Sensitivity testing (used to determine extent of margins)
Process is:
  Start with a central set of assumptions
 Quantify the effect of assumption changes (single and multiple changes)
 Check for independence and correlation of variables

Valuing Liabilities
A best estimate basis might be used to calculate the value of liabilities to be transferred:
 to achieve fairness for all parties
 to achieve agreement between actuaries acting for different parties
 to comply with legislation

A basis other than best estimate might be used:

 due to a power imbalance between the parties concerned
 because of a stronger desire for one party to go ahead with the transfer
 to recognize the need to hold margins to protect security

Setting assumptions for valuing options and guarantees

A more cautious approach than normal is taken when valuing options and guarantees.
The most sophisticated way is to use a stochastic model.

Options and guarantees are not independent. Some guarantees may make options more valuable.
E.g. In case of annuities, individuals may opt for the option to take a large lump sum over the
option to have a higher guaranteed rate for full time pension period.

Factors affecting the value of options

When valuing options, it is best to assume highest cost option (i.e. assuming holder of option
always exercises). But this may be taking a too cautious approach.
Contract values are highly sensitive to option pricing methods and assumptions.
The assumptions used will depend on:
 Margins included  Liquidity issues for companies
 Cashflows (any discretionary  Risk appetite of individual
benefits)  Risks involved such as anti-selection
 Tax rates  Economic Scenario
 Costs of administration options  Demographic factors such as age,
 Legislation health, employment status
 Probability of company having a  Cultural bias
shortage of funds  Sophistication of market / consume
Factors affecting the value of guarantees

Guarantees: best valued by taking class of business as a whole.

Likelihood and expected cost of guarantee depends on:
o Investment returns
o Minimum maturity value

A stochastic approach is useful because:

o It closely replicates pattern of investment returns in the real world.
o Range of likely outcomes with associated probabilities are generated

Supervisory prescription

+ ensures consistency between different schemes and between actuaries

+ ensures consistency over time
+ may aim to ensure appropriate assumptions are used

– The assumptions may not be suitable for valuing all schemes

– The assumptions may become outdated over time
– It takes time to change regulation so it can be difficult to ensure the assumptions are up-to-date.

Actuarial judgment

+ allows actuaries to include factors that are specific to the individual scheme
+ allows actuaries to exercise their professional judgment
+ can easily be updated over time

– Assumptions may not be appropriate and may be manipulated

– There will be costs if the regulator checks the appropriateness of the assumptions used

(i) Trustees – are primarily concerned with the security of members’ rights so they might
want to overstate future contribution requirements – i.e. use a cautious basis. However,
this must be tempered against the basis not being so cautious that it would discourage the
employer from providing the scheme because the contributions were so high.

(ii) Sponsor – pays contributions so won’t want to pay more than necessary unless
particularly paternalistic. Sponsor may overpay (take cautious approach) to keep
employees happy or might underpay (take optimistic approach) to make use alternative
use of capital. Flexibility over future contributions may be another key requirement.

Impact of overestimating or underestimating provisions

Overestimating (underestimating) provisions delays (accelerates) the
emergence of profits but does not affect the total amount of profits.

If provisions are overestimated, this may:

 Result in a more restrictive investment policy

 Tie up K that could be used more productively elsewhere, e.g. in writing new business

 resulting in a lower return on capital for shareholders and lower profits, which may
adversely affect the share price

 Reduce the published free assets which are often used as an indication of financial
strength by customers and brokers, possibly resulting in loss of business.

If provisions are underestimated, this may:

 Result in an acceleration of emergence of profits, dividend and tax

payments

 Overstate the free assets available to the company resulting in a less

restrictive investment policy

 Use of this apparent free capital, e.g. to write new business, but this
could jeopardize the company’s future solvency, as the actual capital
available is less than that implied.

 The regulator may intervene if it is discovered that the provisions are

inadequate.

Understated

 The liabilities will be understated

 More tax payments
 Increasing the expectations of the shareholders (regarding dividends)
 The solvency will be overstated
 Investment might take an aggressive position which might not be
appropriate
 Inappropriate reinsurance arrangements in place
 If this assumption is used for pricing, then premium rates charged
would be too low
 Regulatory issues
Setting the terms for the option and valuing it

A starting principle is usually that a scheme should suffer neither profit nor
loss if the option is exercised, i.e. that the terms for the option are
actuarially neutral

This will require an equation of value to be set up b/ w the two sets of

benefits being exchanged.

The option will need to be revalued periodically to reflect changes in the key
assumptions.

Mortality assumptions and selection

Option is exercised by members

 in poor health
 having young dependents

Age of the dependents should be considered while setting the terms in each
individual case.
Assume that most people with dependents exercise the option.

Discount rate

An appropriate discount rate (e.g. on bond yields) will need to be assumed

for valuing the option.

Other:

 Product design
 Admin costs
 Discretionary benefits
 PREs
 Legislation
 Valuation assumptions
 Trust deed
 Accounting implications
 Easy for member to understand the option terms
 Not deviating too much from options of other schemes
Regulation of adequacy of provisions

 Aim is insurers can meet claims and expenses using asset levels

 Claim reserves help in giving extra cushion to assets (if experience is

not good)

 Asset reserves can help to prevent credit risk & tackle volatility in
market prices of assets

 As a supervisory test it needs to be:

 Prevents insolvency
 Easy to understand, apply and check
 Objective
 Appropriate for a range of general insurers
Requirement to hold in excess of assets over the provisions may
not be appropriate for all insurers.

However, the test should not be so prudent that it affects an insurer’s ability
to write business / develop new products.

Drawback in solvency regulatory regime

It does not consider:

 Mismatching risk between A’s & L’s
 Short tail vs. Long tail business
 Reserving requirements / Margins
 Valuation methods
 Insurer’s strength of basis.
 Reinsurance arrangements
 Internal control systems
 Liquidity issues
 Actual Capital requirement
A solvency requirement should not be looked in isolation but rather in conjunction with
provisioning requirements.

Method of calculating provisions: If claims provisions are discounted at a

market-related discount rate reflecting the assets held, then the asset and
liability valuation will move in line.

Parameters should represent the actual current experience or future experience.

1. Using claims paid and premiums received as provisions:

 These are objective, easily measureable and consistent treatment across companies
(assuming accounting policies are uniform across companies).

 However, better measures would have been claims incurred (which would include IBNR
claims, IBNER claims) and earned premiums

 Premiums would not necessarily reflect the level of risk taken as premiums can be set at
competitive levels.

2. Using additional assets expressed as a % of provisions

 Should not be so prudent, that company holds additional free assets

 Assessing the value of extra assets is simple and objective and easily verifiable.
However, there might be some assets for which market value is not available.

3. Using a fixed amount as provisions

 Minimum threshold amount could cope with volatility in claims experience

Components of provisions

 UPR
 Additional URR
 Provisions relating to reported but not settled claims
 IBNR & IBNER reserves
 Claim equalization reserve
 Catastrophe reserve
 Claim handling expense reserve
 Reserves for re‐opened claims