Market Consistency

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Definitions

In recent years there has been a trend towards market consistent valuation in those institutions, for which actuaries have responsibilities. The term `market consistent' has become increasingly popular as a description of liability valuations or, more generally, of cash flow valuations. However, there is no widely accepted definition of the term. A valuation algorithm is a method for converting projected cash flows into a present value. A valuation algorithm may be specified with reference to a set of calibration assets. We say a valuation is market consistent if it replicates the market prices of the calibration assets to within an acceptable tolerance. Market consistent valuation can take many forms. Two different models could produce different liability valuations and yet still both are market consistent. Several questions arise. There are four chief decisions:

(1) Which assets are to be used for calibration?

(2) How are model assumptions derived where insufficient market data exist?

(3) Which cash flows are to be valued? For example, what dividend tax credits (if any) are reflected in the market value of an equity share; to what extent are manufacturer expenses and capital costs reflected in option prices?

(4) Algorithms - when are deterministic projections, closed form solutions, numerical integration or Monte Carlo simulations to be used?

There are different approaches to calculating market consistent valuations; some of these differences may be explained by the different motivations for seeking market consistent valuations. At least three motivations are commonly advanced for examining a firm's operations on a market consistent basis:

(1) understanding the behaviour of a company's share price.

(2) measurement of solvency relative to a buy-out standard.

(3) producing comparable valuations which reduce the need for subjective judgement.

Further Information (PDF Format):
Market Consistent Valuation Of Life Assurance Business