Chapter 24: Consistent valuation of assets and liabilities

[mugono]

Evening,

Consistency between the valuation of assets and liabilities is an idea that comes up a number of times in the course.

It makes sense to me that we can only take the market value of assets where we have a market value of the corresponding liabilities (if available) or use market based discount rates.

Question:

When we calculate liabilities using a stable rate of interest , would we treat our assets as though it was invested in a suitable index and discount the cashflows using long term assumptions?

(Is this a possible approach that may be taken in practice where valuation interest rates are used to derive liability values).

Any comments would be most welcome, this has been on my mind for days!!

Thanks.

 

[Mark Willder]

Consistency between the valuation of assets and liabilities is an idea that comes up a number of times in the course.

It makes sense to me that we can only take the market value of assets where we have a market value of the corresponding liabilities (if available) or use market based discount rates.

Question:

When we calculate liabilities using a stable rate of interest , would we treat our assets as though it was invested in a suitable index and discount the cashflows using long term assumptions?

Chapter 24 looks at valuing assets. Chapter 36 goes on to discuss the valuation of liabilities.

One possibility is to use a discounted cashflow approach for both the assets and the liabilities using stable long-term assumptions. We could then value the assets approximately using a suitable index as you suggest. However, this approach is used much less today, and market values are more common.

The more usual approach is to value assets and liabilities in a market consistent way. Chapter 36 describes two possible methods.

It is also possible to value assets at market value and liabilities at a discounted cashflow value. This approach is common for life insurance valuations. A prudently low valuation interest rate (less than the market rate) is used to value the liabilities. As the calculated liabilities will be larger than a best estimate of their cost, the insurer will be forced to hold additional assets to cover them, so that the risk that claims cannot be paid is small.

Best wishes

Mark