Ch20: Setting Assumptions

Question 1

When setting assumptions it is important to: (5)

Answer 1

• Consider the use to which the assumptions will be put
• Take care over the choice of assumptions that will have the most financial significance
• Achieve consistency between the various assumptions
• Consider any legislative or regulatory restraints
• Consider the needs of the client

Question 2

Demographic vs economic assumptions

Answer 2

Demographic assumptions:
- e.g. mortality rates
- relates to the size and distribution of the population.
- Generally affect the timing and number of cashflows

Economic assumptions:
- e.g. investment returns
- relate to the level of income or outgo

Question 3

Extent to which information may be useful headings (5)

Answer 3

• Relevance and credibility of past data
• Fluctuations and changes over time
  + Changes affecting economic data
  + Price inflation
  + Demographic changes
  + One-off impacts
• Data recording
  + Changes in statistics recorded
  + Errors in data recorded
• Heterogeneity
  + Changes in the constituents of the population
  + Splitting the pop into homogeneous groups
• Standard tables

Question 4

Relevance vs credibility of data:

Answer 4

Relevance of past data must be balanced against the need for sufficient data for its analysis to be statistically credible

Question 5

When using past data, important to consider how to deal with: (7)

Answer 5

• Abnormal fluctuations
• Changes in experience over time
• Random fluctuations
• Changes in the way data was recorded
• Potential errors in the data
• Changes in the mix of homogenous groups within past data
• Changes in the mix of homogenous groups to which the assumptions apply

Question 6

2 negatives and 2 considerations to use standard tables

Answer 6

Negatives:
- Census data included all lives, not just the restricted population who buy insurance contracts.
(includes lower social-economic groups, distorts the experience of lives effecting insurance
contracts)
- Increased risk that the data is out of date by the time it is published

Considerations:
- Whether data is relevant to the intended population at which products are marketed
- whether adjustments need to be made to the data to reflect continuation of past historical trends

Question 7

Other factors to consider when determining the assumptions (other than past data) (3)

Answer 7

• The need for accuracy and prudence
  + Purpose of valuation (significance of each assumption to overall result; helps assess the
  degree of accuracy required; extent to which it is necessary to try to remove distortions
  from the data; helps judge whether assumption should be best estimate or adjusted for
  prudence to reflect uncertainty; degree of prudence depends on objectives of client)
  + Accuracy of assumptions (Sometimes unnecessary to make judgement about accuracy of
  each individual assumption but rather the accuracy of the overall value resulting from the
  combination of assumptions.
  + Significance of errors (Potential financial significance of errors helps assess the degree of
  accuracy required)
• Effect of assumptions on cash transactions
  + When determining a once off payment, it cant be corrected by future adjustment to
  payments, therefore necessary to use best-estimate of future experience
  + Over or under statement would give one party direct financial advantage.
• Implicit assumptions
  + Necessary to be aware of implicit assumptions within a model and consider the effects of
  these.
  + Sometimes non-numeric assumptions, working away in the background

Question 8

After assumptions of future experience are made, further three factors to consider when pricing contracts:

Answer 8

• Extent to which margins against adverse future experience need to be applied
  + Apply margins to expected values of parameters
  + Profit margin
• Risk discount rate to be used
  + Sum of either expected return or required return and a risk margin
• Profit criterion to apply
  + Single figure which summarizes the relative efficiency of products, determine which
  contracts make most efficient use of capital.
  + NPV, IRR, Discounted payback period

Question 9

Features that can increase the risk in a product design: (6)

Answer 9

• Lack of historical data
• High guarantees
• Policyholder options
• Overhead costs
• Complexity of design
• Untested market