Chapter 36: Valuing Liabilities (2)

Approaches to valuing assets and liabilities

DCF: Using long-term discount rate to value assets and liabilities.

Market Value: Assets are valued at market value, aim to determine market price of liabilities and
hence discount rate. Replicating portfolios can be created.

DCF
Calculated by determining long-term rate based on actual holding or notional portfolio

DCF analysis uses future free cash flow projections and discounts them to arrive at a PV, which
is used to evaluate the potential for investment.

Calculated as:

C F1 C F2 C Fn
DCF= + 2
+…
1+ r ( 1+ r ) ( 1+r )n

The Discount rate (r) is used calculating the WACC (Weighted Average Cost of Capital)
Cost of Capital (both debt and equity) is the required rate return on a portfolio company’s
existing securities. It is the minimum return that the investor expects for providing Capital to the
company.

Here D is the total debt, E is the total shareholder’s equity, Ke is the cost of equity, and Kd is
the cost of debt. The market values of debt and equity should be used when computing the
weights in the WACC formula.

Criticism of method: Different value from market value (therefore add element of risk)

Value of assets: Using DCF (correct prospective dividend yield index)

Value of benefits: Long term discount rate & price inflation

Market related approaches

A replicating portfolio involves taking the 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)

All assumptions used should be market-related and consistent.

The replicating portfolio can be established by using stochastic optimization techniques.

a) Replicating portfolio Method 1: Mark to market

 Assets are taken at market value.

 Liabilities are discounted at the yields on investments that match liabilities (often bonds).
The bond yield may be based on government bonds or corporate bonds

 A better, but more complicated, approach would be to use term-standard discount rates
that vary over time to reflect the shape of the yield curve.

b) Replicating portfolio Method 2: Bond yields plus risk premium

 Assets are taken at market value.

 Liabilities are valued using a discount rate by adjusting (usually increasing) bond yields
by the addition of either a constant or a variable equity risk premium, or if other
investments are held a risk premium to reflect the additional return on those classes
compared to bonds.
 Where a constant equity risk premium is used, the result is the same as for the mark to
market method except that, all other things being equal, the value of the liabilities is
(usually) lower.

This is because liabilities are now discounted at a higher rate.

It is more common to use a variable risk premium, which is derived by a combination of

market information and actuarial judgment.
Setting the discount rate

Method Valuation of assets Valuation of liabilities

DCF Long term rate based on Same as long term assets

actual holding or notional
portfolio
Replicating Portfolio: Mark Market value Rate implied by market price
to market of investments that match
bonds
Replicating Portfolio: Bond Market value Rate implied in mark to
Yield + Risk Premium market method adjusted to
expected return on other
asset classes

Stochastic deflators

A deflator is a stochastic discount factor which can be applied to a series of cashflows under a set
of realistic scenarios to produce market-consistent valuations of assets and liabilities.

As stochastic deflators are based upon real-world scenarios, they can be set to allow for the
assessment of realistic risks.

In practice, an insurer would feed the stochastic investment runs into a model office system to
get a set of stochastic cashflow streams.
Given a matrix of cashflows C n ,t (where t refers to the timing of the cashflows and n to the
particular stochastic run) and a matrix of deflators Dn , t the value of the time t cashflow is the
average of (over all the stochastic runs n= 1,000, say) S(D n ,t C n ,t ) . Summing over all the times t
would give the value of the insurance contract.

Fair value reporting

Two definitions of fair value are:

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 third party to take over the liability.

These methods aim to find the market value of liabilities, but in practice there is no secondary
market for most liabilities. Therefore the market value cannot be found directly. Instead we need
to try to find market-based assumptions.

Estimating fair values

The risk-free market value is the PV based on discounting future liability cashflows at the pre-
tax market yield on risk-free assets (e.g. government bonds).

However, a range of government bonds have not been of sufficiently long a term to match all
insurance cashflows & estimation of yields in respect of notional longer-term assets is required.

Financial risk and fair value reporting

Financial risk associated with the liability cashflow is normally allowed for in a market
consistent manner either by a replicating portfolio (i.e. a portfolio of assets which exactly
matches the liabilities) or through stochastic modelling.

In this case, discounting of future liability cashflows is done at a higher rate (reflecting higher
expected returns)

Non-financial risks and fair value reporting

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.

These adjustments will depend on:

 the amount of the risk
 the cost of the risk implied by market risk preferences

Mismatching risk and fair value reporting

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.

Different methods of allowing for risk in cashflows

 1. Best estimate plus margin

A risk margin is built in to each assumption by using “best estimate” assumptions together with
an explicit margin for caution.

 It may be reasonable to add a simple percentage loading.

 In some cases, a detailed analysis of experience may be needed to determine a margin

consistent with the risk appetite. E.g. stochastic modelling

Care should be taken in considering the overall effect when introducing margins, since the
introduction of small margins in many assumptions might lead to a cumulative effect of the basis
being stronger than desired.

Advantages:
 The degree of caution introduced can clearly be identified.
 Such a margin may be easier to explain to clients.

Disadvantages:

 It is difficult to assess the appropriate allowance to be made.

 Different assumptions should not cancel out
 Using lots of individual prudent assumptions lacks transparency and can be harder to
explain to clients compared with a single explicit contingency margin.

2. Contingency loading

This approach is to increase the liability value by a certain percentage. The choice of loading is
effectively another assumption and should ideally reflect the degree of uncertainty that exists.

It would, therefore, be expected to increase with the value of the liabilities but not in a
proportionate manner.

3. Discounting cashflows at a risk premium

This is the traditional discounted cashflow approach where the cashflows are assessed on a best
estimate basis, and then discounted at a rate of return that reflects the overall risk of the project
or liability.

Different methods of calculating provisions

Statistical analysis
If insurance 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.

E.g.: Best estimate provision would be used by multiplying average cost of claim with number of
claims. 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 insured risks are rare & have large claim variability, 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
Making provisions for risks which a provider has accepted but where the risk event has not yet
occurred. Premium charged is a fair assessment of the cost of the risk, expenses, and profit.

E.g.: If a premium basis allows for 25% of the premium to cover expenses, commissions and
profit, then one approach to establishing a provision for the unexpired part of a year’s cover is to
assume that 75% of the premium covers risks equally through the period of the policy.

Equalization reserves
When a 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 when such an event occurs the company may show a significant reduction in profits; and
when no event occurs, profits will be greater than the long-term average.

To smooth results, a company may establish a claims equalization reserve in years when no
claim arises, with a view to using the reserve to smooth results when a claim does occur.