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Old 12-07-2019, 08:01 PM
wilsonchan18 wilsonchan18 is offline
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Default Discounting of Liab. fur Future Investment Income

Hi All,

I am on the Assignment 1.2 and read the below from the text:
"The existing GAAP and/or regulatory accounting frameworks may not allows discounting of liabilities for future investment income, possibly due to reliability concerns."

Does anyone know how the investment income is related to the discounting of liab.? I understand that insurance need to do investment like short term bonds to match the liab. duration usually from the premium received. But I found the above text quite confused:
1. Why discounting is related to future investment income and
2. Why GAAP/Regulators would restrict that presentation of the financial presentation or management action?

Cheers,
Wilson
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Old 12-13-2019, 11:23 AM
BayesDeep BayesDeep is offline
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This article is short and provides a decent foundation: http://us.milliman.com/insight/pc/pd...e-liabilities/

Quote:
The existing GAAP and/or regulatory accounting frameworks may not allow discounting of liabilities for future investment income, possibly due to reliability concerns. Management, however, may believe that such present value discounting of liabilities is necessary to properly evaluate the financial results of the business units. Within the operation, management may believe that any reliability concerns can be adequately controlled.
1. Why discounting is related to future investment income and
* discounting is fundamentally about recognizing the changing time-value of money, but I think the reasoning for liabilities is somewhat indirect (since you're not investing the liability itself): essentially the assets on your balance sheet today will be earning investment income, but the liabilities on your balance sheet today are mostly due some time in the future. Your assets will grow due to investment income by the time the liabilities come due (read the Milliman paper for more nuances of investment income). Hence the argument for discounting liabilities by the Assets' return is that it puts your L and A on the same time-basis (otherwise your Ls are stated at future levels, but your As are stated at present time). The catch is that since asset returns are inherently uncertain (market volatility, credit risk, etc), so there is a lot of judgement about what discounting rate to choose. Companies have incentives to pick high discounting rates, like when market performance is high in the short term, companies may be inclined to extrapolate this too far into the future and discount too much, which creates solvency risks.

2. Why GAAP/Regulators would restrict that presentation of the financial presentation or management action?
* Regulators don't restrict management reports (see last sentence of quoted), but management reports are mostly views and opinions. Regulators may not allow discounting on regulatory reports for various reasons (too much judgement, inconsistent basis, costly to regulate because you have to study each insurer's mix of assets, etc)
* Restricting management actions is a deeper subject

Last edited by BayesDeep; 12-13-2019 at 11:27 AM..
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