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Draft for discussion at ICAEW IISC meeting, 20th June 2005 - page 35 / 51





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higher than the expected long-term rate of interest (the so-called ‘risk discount rate’), i.e. an embedded value (‘EV’), tending to regard the whole contract as a financial instrument. It makes an allowance for the capital which must be tied up in the business to meet solvency requirements; the so-called ‘cost of capital’ (consistent with Abbott, 1999). Financial reinsurance deals normally use EV methodology to assess the level of finance that can be provided in relation to the expected future flow of profits on the portfolio which is being ‘securitised’.

In with-profits there is correlation between the future cash flows (‘C’) and the future rate of interest (‘i’) (both therefore random variables): and there is ‘feedback’ between the assets and the liabilities. Policyholders expect ‘Policyholders’ Reasonable Expectations’ (‘PRE’) to be met: which is generally interpreted as a requirement to pay smoothed asset shares (subject to a minimum guaranteed amount of the sum assured and declared reversionary bonuses) plus any additional contribution from the estate of the office to top up smoothed asset shares to current pay-outs, although, reasonably, it may be the intention to reduce this differential over time. The assets backing the with-profits portfolio can then be divided into the smoothed asset shares, the smoothing fund (which absorbs the difference between smoothed and unsmoothed asset shares), the fund to meet the cost of the guarantee (should it be called on) and the fund to match smoothed asset shares to current pay- outs. It would not seem unreasonable that fair value should represent the sum of these four components (less any shareholder share of asset shares that will emerge when terminal bonus is declared), which the authors call the policyholders’ PRE measure of with-profits liabilities. In terms of IAS37, PRE could be deemed to constitute a ‘constructive obligation’, and therefore fall to be included within the liability measure (which raises the question whether the whether the FFA should be split to reveal the amount in excess of the PRE measure i.e. the orphan estate). 66

For defined benefit pensions, where the ability to vary the future contribution rate allows the fund to invest in equities, one needs to allow for correlations between ‘C’ and ‘i' in measuring FV. ‘An approach based purely on gilt yields (as in IAS 19) would not seem appropriate.’

The role for the actuarial profession is to find a workable definition of FV of liabilities with robust and implementable guidelines for calculation, acceptable to the accounting profession. (See e.g. the US Society of Actuaries task force’s report in Vanderhoof & Altman, 1998.)

If FV of assets and liabilities is measured as above, should all changes go through the income statement? In favour of FV:

  • Gets as close to IAS 32 and E62 as possible, gets balance sheet at ‘realistic values’ and, if orphan estate shares were quantified, would give shareholder equity on a realistic basis.

  • But could be difficulties in agreeing on FV of liabilities: should it be ‘EV’ or ‘gross premium value on a best estimate basis with a profit margin’? For EV, would there be agreement on RAD or other parameters, e.g. rate of growth of the unit fund for unit-linked contracts? For a gross premium valuation, would there be agreement on parameters, e.g. future profit margins? Professional guidance will be needed.

66 Under the 1991 EU Insurance Accounts Directive (91/674/EEC) Art 27, the life assurance technical provision ‘shall comprise the actuarially estimated value of an insurance undertaking’s liabilities including bonuses already declared and after deducting the actuarial value of future premiums’ . So no allowance is made for the terminal bonus for with-profits policies which is instead normally covered by the FFA (Appendix D).


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