Promissory Note Valuation-Illiquidity Discounts

The Price of Illiquidity

Lack of transaction data lowers the value of an asset. Fair Market Value of a financial asset (a private promissory note is an example) is based on observing and comparing actual transactions under current marketplace conditions. But, if no transaction data exists that demonstrates the prices and the discounts being applied by the market, assumptions must be made to arrive at Fair Market Value. The lack of actual market transaction data, and the lack of an active market to transact in, automatically lowers the value of an asset. Discounts must be applied that represent the additional risks and costs related to illiquid assets.

Illiquid assets (difficult to sell assets) are worth less than those that can be rapidly and cheaply converted to cash, at a reasonable price. Investors are willing to pay a premium for assets that are more liquid. For illiquid assets like promissory notes, where a market may not exist, the appraiser must develop a Fair Market Value approach based upon a hypothetical market, which incorporates the assumptions potential market participants would use in purchasing the asset. These assumptions invariably include discounting the note to reflect its illiquidity.

Discounts

Illiquidity is a major negative factor for appraisers who value assets that do not have readily available market quotations. The absence of liquidity lowers the value of the asset by the illiquidity discount. All other things being equal, the more illiquid the asset is, the less value it has. Determining the appropriate discount and applying it in the valuation of illiquid financial assets is now, and has always been a challenge.

When an illiquid asset is valued, its level of illiquidity is related to other financial assets of similar nature, and to the economic conditions, as of the appraisal date. A discount amount is derived from this analysis based on mature, reasonable and experienced judgment.

Valuing and Appraising Promissory Note Illiquidity

There is no exact formula or rule-of-thumb for arriving at the Fair Market Value of a private promissory note. It is a “Judgment process” that requires a sound method and an experienced expert to arrive at a reasonable, defensible conclusion of value. It should be based on what investors are willing to pay for similar assets having similar risk characteristics as of the valuation date.

Any method selected to be used will have its shortcomings. Like many other specialty skills, estimating an appropriate discount for an illiquid note requires judgment. The court cases have recognized the value of an appraiser’s judgment over mechanical applications of rules of thumb and theoretical formulas.

What is Fair Market Value?

Fair Market Value is the price at which the note would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. It is the price received for selling an asset in an orderly transaction between anonymous market participants, not adjusted for transaction costs.

Factors Considered

Factors considered relating to the borrower and to the promissory note transaction are: financial statements, credit ratings, employment and earnings, payment history, amount and nature of collateral security, repayment terms and conditions of the loan, economic outlook, amount of control of the asset, restrictions on transferability, and costs associated with collecting if default occurs, plus additional items dictated by the specific asset.

All of these factors must be considered when selecting the appropriate discount for lack of liquidity. These factors are used as a guide, but the judgment of the appraiser remains the key.

Conclusions

Experienced judgment, specialized training and education, and common sense are all keys to arriving at a reasonable and defendable discount for illiquidity.

Technology, Discounts, Customer Education to Drive Telematics Auto Insurance

Insurers are recognizing the importance of discounts to penetrate U.S. and Canadian markets. But this calls for the combination of product features.

Something seriously required in favor of the auto insurance policy holders in United States of America and Canada. UBI adoption is growing at a frenetic pace in North America according to the figures released by BI Research. Market watchers are keenly observing the growth of auto insurance and the factors that can pose challenges to auto insurance industry. Figures depict a rosy picture. Telematics based auto insurance growth rose from 4.1% in 2015 to 6% in 2016 in North America. The growth is pegged at 19.2% in 2019. What is the role of telematics expertise in expanding market reach? Can discounts increase the subscriber base? Is there any pitfall? Let us explore.

Insurers are constantly on the lookout for cost effective ways of doing business with telematics. But convincing policy holders seem to be their challenge. Yesterday’s know how is passe with newer and sophisticated knowledge developing on ICT front. Data collection and customer engagement hold the key for success in the wired world today. Aspiring policy holders can be convinced by the insurers with cutting edge technologies like: Driving data capture, direct marketing channel, Roadside assistance (NSD Partner), Geo analytics and gamification to mention a few. The millennial and Gen Z are technophile demography for the telematics market.

Technical features are for risk mitigation and discounts are for cost reduction. If both factors are combined market penetration is easier. At this point an expert is taking a balanced view. Donald Light the director of Celent, a research and consulting firm, is of the opinion that a combination of both discounts and surcharges can provide a bright future for telematics in Canada. He was sharing his view during ‘Insurance Telematics Canada 2016’ in Toronto. We all know surcharges are additional premiums against risky driving behavior. And Light suggest this to change the driver perception on their driving.

What perception Light wants to change? People pay a price for a product or service on their perception on quality. The same theory is applicable to one’s perception towards driving. If one thinks he is a ‘better driver’ and not an average driver which he actually is, then encouraging them to implement telematics mobile app to avail discounts will become a demanding task. Because his self esteem comes in the way of enhancing his driving behavior and accepting drive score as ultimate criteria for improving his driving. It is at this very stage only education is needed to change perceptions.

The very purpose of UBI is to reward the well behaving drivers on criteria like speed, acceleration, phone use etc. Vast part of the population are mobile and it makes sense for them to implement telematics mobile app on their mobile devices to mitigate accidents as well as earning drive score to avail policy premium discounts. Education is needed to change wrong perceptions of drivers to accept UBI as fair and to understand what standard driving behavior is.

Education should be extended on ensuring cyber security as telematics mobile apps are also prone to cyber attacks. This should be seen in the context where 60% of cars and trucks are going to be connected on net by 2017. This means tailored telematics services should address cyber security issue also to gain more acceptance in the market.

Switching to telematics is a good option; it is also promising for the insurance sector that wants to expand its reach. Cutting edge technical features, discounts for drive scorecards as well as surcharges for errant driving behavior can increase the acceptability of mobile telematics thereby attracting new mobile subscribers. If these issues are addressed, auto insurance market penetration will become easy.