Investment section

The method and basis for any actuarial valuation will depend on the purpose of the valuation.

For most statutory valuations, the method and basis used to value both the assets and the liabilities will be prescribed by regulation.

However, in other cases, the actuary will often have freedom to choose the method and basis considered more appropriate

There are two main methods of valuing assets and liabilities: The value placed on a portfolio of asset can change for two distinct reasons:
Book value
The book value of an asset is the price originally paid at the date of purchase.
Advantages
  • objective
  • conservative (for assets expected to rise in value over time … e.g. equities, property)
  • easily understood
  • often used in company accounts (e.g. for fixed assets)
Disadvantages
  • easily manipulated (simply by selling and re-buying)
  • can be very different from current market value (so of limited use in deciding on whether asset is currently cheap or dear)
  • no corresponding method for valuing liabilities.
Written-up book value
Historic book value adjusted periodically for changes in value. But, introduces some subjectivity without addressing any of the fundamental problems with book value itself.
Market value
Represents the price at which the asset can be bought (or sold) in the open market. the mid-market price is often used (the mid price between bid price and offer price)
Advantages
  • objective
  • easily understood by most stakeholders
  • readily available (for many assets)
  • reflects the price at which the asset can currently be bought (or sold)
  • Allow for a more realistic and objective comparison between different companies.
  • remove much of the prudence and subjectivity inherent in traditional actuarial valuations.
Disadvantages
  • it can fluctuate wildly in the short term, which not reflect changes in the expected future proceeds. a very different valuation result may be obtained depending on the exact date of the valuation … which may not reflect any real change in the ability to meet the promised liabilities.
  • can be difficult to value liabilities consistently as there is usually no corresponding market for liabilities
  • not available for all assets e.g. property, unquoted shares
  • cannot be easily used to assess whether the asset is currently cheap or dear
  • A smoothed market value may be used to reduce the impact of short-term volatility (e.g. an average of the market value over the last month).
    However, this introduces an element of subjectivity into the valuation method and makes it even more difficult to value the liabilities consistently (as the appropriate discount rate for valuing the liabilities cannot be readily determined).
Fair value
In accounting terms, the fair value of an asset (or liability) represents the price at which it could traded (or settled) between two knowledgeable and willing parties.
If available, this will usually be taken as the market value.
In recent years, there has been a move towards the use of fair values when reporting in company accounts. The main reason for this is that it removes much of the subjectivity and prudence often included in actuarial valuations of assets and liabilities … allowing a more realistic and objective comparison between different companies (and between the same company in different years).
Discounted cash flow value
Advantages
  • it is consistent with the method used to value the liabilities.
  • more stable over time
  • may better reflect the true, underlying long‐term position of the investor
Disadvantages
  • for most assets, the resulting valuation is subjective (as it will depend on the chosen discount rate and, if appropriate, the chosen rate of growth in future income).
  • In particular, where an investment has some adverse features (e.g. higher uncertainty in amounts of future cash flows, poor marketability), the rate of interest used to discount these cash flows will usually be increased (to give a lower value).
  • the value may differ significantly from the market value, casuing difficulties in explaining
  • More complex
  • chaning the assets held can change the discount rate used -> change the value of the liabilities
  • fundammentally incorrect to distort future cash flows at a fixed rate of interest.
Arbitrage value
This technique is often used in the valuation of derivatives.