The Staple Inn Actuarial Society

THE VALUE OF ACTUARIAL VALUES

17 December 1998
Pemberton, John M.

Synopsis

Should we value an asset at an amount calculated using actuarial discounted cashflows, or at its current market price? Much hinges on this question - the possible answers dictate quite distinct programmes for the development and practice of the valuation of long-term business, and the theory and practice of the associated investment management.

Under what circumstances does the actuary wish to ascribe a value to an asset? Generally the actuary is facing a set of future asset/liability cashflows of which there is some, generally imperfect, knowledge available, and has a requirement to ascribe a number, or perhaps numbers, to characterise the financial position of the owner of the cashflows, for some defined purpose. The context for investment valuations can be characterised quite generally in this way - for traders we may often think of the liabilities as being cash.

The values placed on assets by traditional actuarial approaches are subject to the criticism that they can differ significantly from current market prices. The pricing approach has been proposed in response to such concerns, perhaps most notably in Exley et al, 1997, which has advanced this debate considerably.

The importance of these valuation issues is accentuated by recent proposals from the accounting profession which advocate the use of current market prices as a measure of value for long-term businesses, at least on the asset side of the balance sheet. The changes to dividend taxation as a result of the budget of 2 July 1997 have “also thrown into sharper relief the debate on the methods of valuing assets” (Masters et al, 1997, Section 502).

This paper attempts to progress this debate further. Whilst concerns about price/value differentials which arise from traditional actuarial valuations are valid, the pricing approach is unable to make necessary allowance for investor-specific circumstances, such as the tax and risk position. In addition to these position-driven price/value differences, opinion differences and mean reversion of prices may also lead to price/value differentials.

The relationship between price and value is thus complex. This paper proposes a “refined actuarial” approach to valuation: whereas the actuary should make appropriate use of the information available from market prices, it is also appropriate to consider the price/value differentials which may exist in any specific situation, and allow for these in deriving a helpful measure of value. In some cases, it may be appropriate to use assumptions more closely related to the market. In other cases, making adjustments to current market prices may be appropriate.