CH19 - Setting assumptions

Question 1

Key factors affecting the choice of assumptions (5)LUNCH

Answer 1

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

Question 2

Main sources of data used for determining assumptions (2) + (5)

Answer 2

1. Historical data
2. Current data

Sources include:

1. Internal data
2. National statistics, published by government bodies and economists
3. Industry data
4. Actuarial tables
5. Reinsurers’ data

Question 3

When using past data the actuary needs to consider how to deal with and make adjustments for (7)

Answer 3

1. Abnormal fluctuations (and one-off impacts)
2. Changes in the experience with time
3. Random fluctuations
4. Changes in the way in which the data has been recorder
5. Potential errors in the data
6. Changes in the mix of homogeneous groups within the past data
7. Changes in the mix of homogeneous groups to which the assumptions apply

Question 4

Features that make a contract design riskier (6)

Answer 4

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

Question 5

Assumptions for pricing (3)

Answer 5

1. The extent to which margins against adverse future experience are required
2. The risk discount rate to be used
3. The profit criterion to apply

Question 6

Demographic vs Economic assumptions

Answer 6

Demographic assumptions, e.g. mortality rates, relate to the size and distribution of the population. They generally affect the timing or number of the cashflows.

Economic assumptions, e.g. investment returns, relate to the level of income or outgo. They generally affect the level of the cashflows.

Question 7

An actuary is modelling a pension scheme that includes both individuals who have an entitlement to receive a benefit in the future and current pensioners.

List the assumptions that would be needed for this model, categorising each assumption as decographic (9) or economic (6)

Answer 7

Assumptions needed for a model of a pension scheme might be:
Demographic factors:
1. Rates of retirement in good health (early, normal, late)
2. Rates of ill-health retirement
3. Rates of withdrawal (for reasons other than retirement or death)
4. New entrant rates
5. Rates of mortality before and after retirement
6. Proportion married
7. Average age of spouses
8. Spouses’ mortality
9. Salary scale (i.e. promotional increases)

Economic factors:

1. Investment returns, e.g. bond yields, equity returns
2. Discount rate (for valuing liabilities)
3. Earnings inflation
4. Price inflation
5. Pension increases
6. Expenses

Question 8

Examples of where past data may form a useful starting point for economic assumptions (3)

Answer 8

1. In determining an assumption for future investment returns, past data on dividend yields on equities and on the total returns on relevant classes of investment may be useful. Where dividends are linked to an inflation index, past data on that index may be useful.
2. Past data on salary levels in a particular country, industry or company may be useful when making an assumption about future levels of salary growth.
3. The history of an inflation index may also be useful in determining an assumption for future benefit growth that is linked either fully or partially to that inflation index.

Question 9

Examples of where current data may form a useful starting point for economic assumptions (3)

Answer 9

1. The relationship between the current yields for fixed-interest and index-linked bonds may provide some indication of the market’s view of future levels of the inflation index to which the bonds are related.
2. Policy statements by governments or controlling banks may also be useful when making assumptions about economic factors.
3. A scheme sponsor may be able to provide information on planned future salary increases or likely future rates of withdrawal.

Question 10

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

Answer 10

1. Underwriting practices
2. The distribution channels used
3. The target market
4. Product design features, e.g. level of the sum assured, term of contract
5. Underlying mortality rates, e.g. due to medical advances or the onset of a disease or epidemic

Question 11

Where a cashflow model is being used to price a product, the risk to the provider from adverse future experience could be allowed for by (3)

Answer 11

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

Question 12

Profit criterion

Answer 12

A profit criterion is often a single figure that tries to summarise the relative efficiency of contracts. By applying a profit criterion to different contracts and then ranking the results in order, it may be possible to determine which contracts make most efficient use of a company’s capital.

The methods of quantifying profitability include:

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