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Four Key Questions

Four Key Questions. Bondholder’s Original Cost Bond as a Financial Asset Extinguishing Price Third-Party Reimbursement. ISC Definition.

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Four Key Questions

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  1. Four Key Questions • Bondholder’s Original Cost • Bond as a Financial Asset • Extinguishing Price • Third-Party Reimbursement

  2. ISC Definition • “The fair value of a corporate liability is the amount that the enterprise would have to pay a third party at the balance sheet date to take over the liability.”

  3. Three Key Implications • Fair value of liability not necessarily equal to market value of countervailing asset • Market value of liability (as an asset) depends on credit risk of issuing company; FV of liability depends on credit risk of 3rd party • ISC definition is incomplete

  4. In the Insurance World... • Premium = PV of EL (no default) – PV of Default + Undwg Costs + PV (FIT on I.I.) • PV (asset) = PV of EL (no default) – PV of Default • Fair Value of Liability = Reinsurer’s Premium = PV of EL (no default) – PV of Reins’s D.O. + Rein’s Undwg Expenses + PV (FIT on Rein’s I.I.)

  5. Fair Value depends on ... • PV of EL (no default) • Underwriting expenses and FIT’s of Reinsurance Company • Financial Strength of Reinsurance Company

  6. AAA Monograph & Credit Risk • Cost of Capital Method to Determine RADR for a liability • RADR = rL = rA – e(rE – rA) • AAA unclear on scope of variables: company vs. third party • AAA appears to use company; should use third party

  7. AAA “COC Method” vs. Actuarial “Risk Loads” • AAA method – combined adjustment for time and risk via RADR • Actuarial methods – separate adjustment for time and risk (“risk load”) • If inputs are identical both methods give same answer • Two advantages of risk load approach

  8. FV of Insurance Liabilities & Actuarial Judgment • Need to “close loop” in ISC Definition • Still cannot reduce FV to “cookbook” approach – requires sound actuarial judgment to determine marginal surplus and cost of capital of third party

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