Ch 20: Setting assumptions

Question 1

What are the 5 most important things to consider when setting assumptions?

Answer 1

LUNCH

Legislative or regulatory constraints
Use (i.e. purpose) to which the assumptions will be put
Needs of the client
Consistency between the various assumptions
How financially significant the assumptions are

Question 2

Give three examples of where historical data will be a useful starting point for setting economic assumptions

Answer 2

1. Past investment data on dividend yields and total returns for setting future investment return assumptions
2. Past inflation index data for setting assumptions for benefit growth that is linked to inflation
3. Past data on salary levels in a particular country, industry or company for setting salary growth assumptions

Question 3

Give 4 examples of where current data and forecasts may be useful for setting assumptions

Answer 3

1. The difference between current yields on government fixed-interest and index linked bonds of an appropriate term can be used to estimate market levels of future inflation.
2. Policy statements by governments and banks can help in setting economic assumptions
3. Sponsors may be able to give indications of planned salary increases or withdrawal rates for a benefit scheme.
4. Assumptions may be defined in regulations or legislation

Question 4

Why may past data not be relevant for the future?

Answer 4

BEST ARCHER

Balance of homogenous groups underlying the data may have changed

Economic situation may have changed
Social conditions may have changed
Trends over time, eg medical, demographic

Abnormal fluctuations
Random fluctuations
Changes in regulation
Heterogeneity within the group to which the assumptions will apply
Errors in data
Recording differences (e.g. in categorization of smoker)

Question 5

Assumptions affected by changes in social, economic, and fiscal conditions

Answer 5

1. Social trends, such as medical advances, affect mortality data
2. Economic conditions affect financial assumptions such as dividend yields, salary growth, inflation rates, and investment returns
3. Economic conditions, such as a recession, also affect demographic assumptions such as withdrawal rates, take up rates and claim rates
4. Fiscal changes affect dividend yields, salary growth and investment returns

Question 6

Give an example of where a change over time in the balance of homogeneous groups underlying the data can lead to a misleading assumption for an employee benefit scheme

Answer 6

If the data for an employee benefit scheme is not subdivided by type of worker then past levels of salary growth will be distorted by changes in the composition of the workforce

Question 7

What are the main considerations when using data from standard mortality tables to set assumptions?

Answer 7

1. The data may not be relevant to the intended population
2. The data may be out of date and need adjusting for trends in mortality between the date to which the data relates and the date to which it is expected to apply

Question 8

What 5 factors affect the need for accuracy and prudence when setting assumptions?

Answer 8

1. The purpose of the valuation
2. The significance of each assumption to the overall result
3. Whether the individual cashflows are important or whether the overall value resulting from a combination of cashflows is important
4. The financial significance of any errors
5. Whether the valuation is for cash transactions (which cannot be corrected at a later date)

Question 9

Give an example of an ‘implicit’ assumption in a pension scheme

Answer 9

Whether or not the scheme is open to new entrants.

For example, the funding method for an occupational pension scheme may assume that:
- new entrants continue to join or new policies continue to be written and therefore the age / sex distribution of a population will be maintained

• no new entrants will join or no new policies will be written and so the existing population should be treated as a closed group

Question 10

List 3 ways in which margins for risk can be built into assumptions when pricing

Answer 10

1. Margin in the risk discount rate
2. Use a stochastic discount rate
3. Applying margins to the expected values

Question 11

Give 4 examples of profit criteria that could be used when pricing an insurance contract

Answer 11

1. NPV of profits
2. IRR
3. Discounted payback period
4. A ratio involving the NPV of profits such as the NPV of profits divided by distribution costs

Question 12

List 6 features that will make an insurance contract design riskier

Answer 12

1. Lack of historical data
2. High guarantees
3. Policyholder options
4. High overhead expenses
5. A complex design
6. An untested market

Question 13

Demographic assumptions

Answer 13

eg mortality rates.
They relate to the size and distribution of the population.
They generally affect the:
- timing
- number
of the cashflows

Question 14

Economic assumptions

Answer 14

eg investment returns
Relate to the level of income or outgo.
They generally affect the LEVEL of the cashflows.

Question 15

Demographic factors (assumptions) needed for a pension scheme model

Answer 15

• rates of retirement in good health
• rates of ill-health retirement
• rates of withdrawal
• new entrant rates
• rate of mortality before and after retirement
• proportion married
• average age of spouses
• spouses’ mortality
• salary scale (ie promotional increases)

Question 16

Economic factors (assumptions) needed for a pension scheme model

Answer 16

• expenses - Ex
• pension increases - Pe
• discount rate (for valuing liabilities) - D
• investment returns - I
• earnings inflation- Tion from inflaTion
• price inflation -Tion

ExPeDITion

dividend yield is another economic assumption but not for pensions

Question 17

5 conditions that could have changed that will lead to an insurance company’s past term assurance data not reflecting its likely future experience.

Answer 17

• the distribution channels/SALES methods used
• the TARGET market
• UNDERWRITING practices
• underlying MORTALITY rates
• PRODUCT DESIGN features

Question 18

Changes affecting economic data

Answer 18

• Economic data fluctuates with changes in:
• —–>economic policy
• —–>fiscal policy
• —–>general economic cycle.

Past data for:
- investment returns,
- salary levels,
- dividend yields
fluctuate significantly over an extended time-frame.

It is necessary to use earlier data and strip out fluctuations that relate to economic and fiscal conditions that differ from those that exist currently.