20 - Setting Assumptions

Question 1

Which characteristics of cashflows do demographic assumptions normally affect?

Answer 1

Through timing and the number of cashflows.

Question 2

Which characteristics of cashflows do economic assumptions normally affect?

Answer 2

Through the amount / size of cashflows

Question 3

List the demographic assumptions needed for a pension scheme?

Answer 3

1. Rates of retirement in good health - early / late
2. Rates of ill-health retirement
3. Rates of withdrawal
4. Rate of new entrants
5. Rates of mortality for pre and post retirement
6. Proportion of married members
7. Average age of spouses
8. Spouse’s mortality
9. Salary scale

Question 4

List the economic assumptions needed for a pension scheme.

Answer 4

1. Investment returns
2. Discount rate for liabilities
3. Earnings inflation
4. Price inflation
5. Pension increases
6. Expenses

Question 5

Which source of data is generally the main source of information regarding setting assumptions?

Answer 5

Historical data

Question 6

List the possible sources of historical data when setting demographic assumptions.

Answer 6

1. National statistics
2. Industry data
3. Tables compiled by actuaries
4. Past information relating to the particular contract being considered.

Question 7

Give the situations where past data may be useful for setting economic assumtpions.

Answer 7

1. Dividend yields when setting expected future investment returns
2. Past data on salary levels in a particular country, industry or company when setting salary growth
3. History of inflation indices when setting assumptions about rates linked to inflation.

Question 8

List the conditions that could have changed that would lead to an insurance company past data not reflecting future experiences.

Answer 8

1. Underwriting practices
2. Distribution channels
3. Target markets
4. Product design features
5. Underlying mortality rates

Question 9

Which to characteristics of past data need to be balanced when setting assumptions.

Answer 9

Relevance and Credibility

Question 10

How could an insurance company set mortality assumptions when there is little past data available for a particular contract?

Answer 10

Using:

1. Data from similar contracts
2. Industry data
3. Reinsurers’ data

Question 11

What is a major concern when using National statistics?

Answer 11

The data reflects the entire population where the insured population usually experiences different trends.

Question 12

How can risk to a provider of financial benefits be allowed for using margins?

Answer 12

1. Adjusting the risk element of the risk discount rate
2. Using stochastic discount rates
3. Applying margins to the expected values

Question 13

Give three examples of profit criterion.

Answer 13

1. Net present value
2. Internal rate of return
3. Discounted payback period

Question 14

List the key factors that affect the choice of assumptions within actuarial modelling.

Answer 14

1. The use to which the model will be put
2. The financial significance of the assumption
3. Consistency between assumptions
4. Legislative and regulatory requirements
5. The needs of the client

Question 15

Which characteristics of past data may require that the data is adjusted to better reflect future experience. (7)

Answer 15

1. Abnormal fluctuations (& one-off events)
2. Changes in experience over time
3. Random fluctuations
4. Changes in the way in which the data has been recorded
5. Potential errors in the data
6. Changes in the mix of homogeneous groups within the past data (eg blue s white collar)
7. Changes in the mix of homogeneous groups to which the assumptions apply

Question 16

Give examples of current data.

Answer 16

1. Statements by governments or large banks
2. Industry forecasts
3. Views of companies’ directors
4. Relationship between the current yields on fixed-interest and index-linked bonds

Question 17

Describe the factors that influence the degree of accuracy required in a modelling assumption

Answer 17

1. Purpose of the model
2. Financial significance of the assumption
3. Whether the cashflows are once off or regular
4. Implicit assumptions

Question 18

Give the factors that make up the risk discount rate.

Answer 18

1. Risk-free rate / required return by shareholders

2. Combined with a risk premium

Question 19

List the features that make a contract design risker (6)

Answer 19

1. Lack of historical data
2. High guarantees
3. Policyholder options
4. Overhead costs
5. Complexity of design
6. Untested markets

Question 20

What is the purpose of a profit critetion?

Answer 20

To act as a measure of relative efficiency of a contract.

Question 21

Describe the issues with specifically using industry data to set assumptions.

Answer 21

1. May not be possible to split the industry data into appropriate groups
2. Industry stats may be out of date
3. More difficult to adjust industry data for abnormal fluctuations than internal data
4. Industry data is more likely to contain data errors
5. Industry data may not be in sufficient detail for the required purpose

Question 22

Describe how assumptions are set for claim amounts and numbers.

Answer 22

1. Statistical methods used for fit a distribution to past data
2. Adjust the distributions for changes in:
   - policy cover
   - underwriting
   - target markets
3. Use industry or reinsurer data if there is a lack of data

Question 23

Describe how assumptions are set for investment return

Answer 23

1. Depends on the types of assets and the mix of assets
2. Past data may be useful for projections of returns on different assets
3. Consider the investment environment
4. Modify past data to remove fluctuations due to past economic events
5. Net down the return for taxes and expenses

Question 24

Describe how assumptions are set for expenses

Answer 24

1. Recent expense analysis
2. Insufficient data could require using other methods:
   - expense data for similar contracts
   - industry data
   - reinsurer’s data
3. Modify the data for changes in experience such as admin or underwriting

Question 25

Describe how assumptions are set for commission

Answer 25

Set rates in line with the market for similar types of contracts

Question 26

Describe how assumptions are set for inflation

Answer 26

1. Inflation assumptions are needed from the middle of the investigation period to the middle of the period where claims are expected to be paid.
2. Use industry inflation indices
3. Extrapolate indices forward
4. Reinsurer help or industry experts - legal changes

Question 27

Give the advantages of NPV as a profit criterion.

Answer 27

Simpler decision making process

Question 28

Give the disadvantages of using NPV as a profit criterion.

Answer 28

1. Relies on a number of assumptions about efficient markets and correct discount rates
2. Not simple to present to non-technical people
3. Needs to be expressed as a ratio to be meaningful

Question 29

Give the advantages of using internal rate of return as a profit criterion.

Answer 29

1. It is a simple measure
2. Compatible with a shareholder required rate of return
3. Easily comparable with different types of investments

Question 30

Give the disadvantages of using internal rate of return as a profit criterion.

Answer 30

1. May not be unique
2. It might not exist
3. Difficult to relate to other non-rate measures

Question 31

Give the advantages of using discounted payback period as a profit criterion.

Answer 31

1. Useful when there are issues around available capital

2. Easy to explain as a break-even point

Question 32

Give the disadvantages of using the discounted payback period as a profit criterion.

Answer 32

It often does not agree with the NPV as a means of determining which of two projects to undergo as it does not take cashflows after the break even point into consideration.