Market Consistent Valuation of Life Assurance Business

Abstract

In recent years there has been a trend towards market consistent valuation in those institutions for which actuaries have responsibilities. The larger United Kingdom with-profits insurance companies are now preparing realistic balance sheets, both for internal purposes and also at the request of the Financial Services Authority. International accounting standards have been moving to a fair value approach. Pension fund accounting under FRS 17 has also moved in this direction.In this paper we examine the reasons for the adoption of market consistent valuation and discuss some of the commercial implications and corporate valuation. We consider the methods and assumptions which can be used to develop market consistent valuations of cash flows typically encountered in the liabilities of financial institutions, together with some of the problems inherent in the calibration of models used for the valuation of these cash flows. The volatility assumption is crucial to the valuation of options and guarantees, and we discuss the relationship between historical and implied volatility.While most insurance companies initially adopted formulae to value their with-profits guarantees, several offices are now using a Monte Carlo simulation approach for their realistic balance sheets. The Monte Carlo approach enables allowance to be made for management discretion in bonus and investment policy, as well as policyholder actions. However, in many cases it is possible to develop analytical formulae for cash flows approximating those payable under insurance contracts.The valuation formulae have implications for the hedging of embedded guarantees. The authors discuss the construction of hedges for financial risks in with-profits funds, the separate perspectives of policyholders and shareholders, possible funds in which to hold hedging instruments, limitations of capital market hedging tools and the effect of taxation on hedge effectiveness.

EVA/RAROC vs. MCEV Earnings: A Unification Approach

“…The time effect based on the (non-life) MCEV valuation model described in Diers et al (2009) exactly corresponds to the unwinding U 1 . For MCEV calculations in life insurance, however, the time effect would be measured differently; financial options and guarantees imply the use of risk-neutral or deflator valuation techniques (see European Insurance CFO Forum, 2009a) and therefore the expected payoff should be evaluated using stochastic valuation techniques as described in Sheldon and Smith (2004).…”

“…36 See, for example, Hancock et al (2001); Danhel and Sosik (2004). 37 See, for example, Sheldon and Smith (2004); Exley and Smith (2006 Exley and Smith 7 show that the market value of equity, defined as the present value of all future dividends, is the sum of the book value of equity and MVA. Thus, the identity of franchise value and the present value of future EVAs holds true, regardless of the accounting standard chosen.…”

Assessing the cost of capital for longevity risk

“…The former ones, in particular, address the life business in general; the latter ones, on the contrary, usually focus on specific lines of business, but in most cases those involving young and young adult ages (e.g., participating endowment policies). Given the scope of this paper, we just mention contributions (typically with an informative style) modifying the traditional EV setting in a market-consistent way; see for example CFO Forum (2004, O'Keeffe et al (2005), Sheldon and Smith (2004), Tillinghast-Towers Perrins (2004.…”

Estimating long-term volatility parameters for market-consistent models

“…This, contrastingly, suggests averaged realised volatility. However, as σ T s Sheldon & Smith (2004) note, market consistency seems to require implied rather than historical volatility, which would again suggest using terminal distribution volatility. On the whole then, it would appear that there may be stronger theoretical evidence supporting the use of terminal forward-return distribution volatility rather than averaged realised forward-return volatility.…”