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Profession: Defining discount rates

The Actuarial Profession is undertaking a research project on discount rates, the timing of which is particularly appropriate as there is a convergence of interest in discount rates from within and outside the Profession. A meeting was held at Staple Inn on 23 March to summarise progress on the project and to gather input from members of the profession. Charles Cowling, chairman of the Discount Rate Steering Group summarised the group’s brief:

>> To carry out a cross-practice, UK-focused piece of research
>> To look at current practice regarding discount rates within the Profession
>> To consider how and why risk is included in discount rates
>> To work towards a common language and framework to describe discount rates
>> To consider options to reduce diversity of practice (where appropriate).

Chinu Patel and Chris Daykin submitted the winning proposal to carry out research for the first stages of the project, pulling together information on current practice and looking at establishing a common language. The Steering Group will use this initial research to develop a framework and consider the possible impact of the project. It will also be seeking views from members of the profession and other interested stakeholders as the project progresses.

Chinu summarised the various uses of discount rates in his and Chris’ preliminary observations. They found that the methodology adopted varied widely and was usually driven by the purpose and context of the calculations, with regulatory and other requirements or guidance defining the detail further. They found that, regardless of the approach used, the calculations examined could be rationalised in terms of the nature and degree of risk embedded in the discount rate. Their suggestion was that it might therefore be fruitful to look in this direction for a general framework that enables different practices and the different contents of discount rates to be understood better. The rationalisation set out in Table 1 explains existing practices, with two categories chosen to capture the essence of the thought processes involved.

Inconsistent usage of terminology has been observed — one example is the use of the word ‘valuation’. Actuaries understand a valuation to be something different to what the man in the street takes it to mean. Another confusing piece of terminology is the term ’market-consistent’. Calculations under both of the categories above have been described as ‘market-consistent’, so there is clearly some disagreement about exactly what this term means, with some usage not being what a layman would consider ’market-consistent’.

Overall, terminology adopted by actuaries can prove confusing and a barrier to good communication. Terminology used elsewhere (including by non-actuaries) is no less confusing – examples were many variants of ‘risk-free’ and ‘risk-adjusted’ discount rates.

Several inconsistent uses of discount rates have been uncovered, which serve to illustrate the issues the project is trying to address. For example, for financial reporting purposes, an insurance company is required to use completely different assumptions to measure its annuity book and its pension liabilities for its own employees.

Chinu and Chris think that how risk is expressed in a discount rate might be the key to better communication with stakeholders — for example, a discount rate could be expressed as a least-risk reference rate plus various specified adjustments to reflect the associated risks.

There was debate from attendees around whether quoting one simple, discounted present value was becoming too dangerous or whether all clients want is a simple answer to what they see as a simple question and it’s therefore down to actuaries to distil the complex information, whilst ensuring they appreciate the key risks involved.

The initial research was completed by the end of April following a draft paper. Work on the framework for describing discount rates is now being refined the Steering Group which aims to publish its final proposals by the end of the year. Interested stakeholders should keep an eye out for further developments. Do get involved if you have an opinion on this subject.

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Amanda Prest is a consultant at Towers Watson