Assumptions

Question 1

Factors affecting the choice of assumptions

Answer 1

• the use to which the model will be put
• the financial significance of the assumptions
• consistency between assumptions
• legislative and regulatory requirements
• the need of clients

Question 2

Historical and current data

Answer 2

Sources:
• internal data
• national statistics
• industry data
• actuarial tables
• reinsurer’s data

Considerations and adjustments will be needed for:
• abnormal fluctuations (and one-off impacts)
• changes in the experience with time
• random fluctuations
• changes in the way in which data has been recorded
• potential errors in the data
• changes in the mix of homogenous groups within the past data
• changes in the mix of homogenous groups to which the assumptions apply

Current data could also be useful in setting assumptions, such as statements by governments, industry forecasts, etc.

The relationship between current yields on fixed interest and index linked bonds is a good indicator of future expected inflation

Question 3

Assumptions for pricing

Answer 3

Margins: acts as a guard against adverse future experience

Risk discount rate: used to discount the pricing cashflows
Risk free rate of return OR shareholders’ required rate of return
+ risk premium
The following features may make a contract design riskier:
• lack of historical data
• high guarantees
• policy options
• overhead costs
• complexity of design
• untested market

Profit criterion:
A single figure that summarizes efficiency. Common criteria includes NPV, discounted payback period, IRR
Competitive pressures prevent too much prudence