Chapter 14 Assumptions (1) General considerations

Question 1

General considerations when setting assumptions

Answer 1

When setting assumptions it is important to:
- Purpose: consider the use to which the assumption will be put
- Consistency: achieve consistency between the assumptions AND rltd products
- Financial significance: where to focus attention
- Constraints: consider any legislative or regulatory constraints
- Stakeholder needs: consider needs of clients
- Parameter accuracy: ensure that the parameters are produced accurately from the data
- Data rel, acc & cred (x3): ensure that the data used to derive assumptions are relevant to insured lives
- Flexibility of bases: ensure that bases used for periodic valuations are flexible to reflect changing risk circumstances
- Downside risk: consider downside risk?

Question 2

Deriving assumptions for pricing purposes

Answer 2

-The starting point is a best estimate bases for assumptions, however, margins will be necessary to guard against adverse future experience.

• Where a cashflow model is used, risk from adverse future experience may be allowed for:
  
  • through assessing what margins to apply
  • through using a stochastic approach
  • through the risk element of the risk discount rate
• The margins (see Q&A 3.3, have included the additional factors in bold italics below) incorporated in the basis & the price charged depend on
  
  • company’s nature of market
  • company’s USP (unique selling proposition)
  • company’s attitude to risk
  • credibility, accuracy, relevance of data
  • size of company’s free assets or parental guarantee
  - 1.extent of uncertainty in the parameters, which reflects credibility, accuracy and relevance of data used to estimate them
  - 2.extent of statistical risk inherent in future experience (due to random fluctuations)
  - 3.financial significance of adverse experience due to 1 and 2
  - 4. extent of guarantees in the product - which is incorporated in 3
  - 5. Company’s attitude to risk
  - 6. Size of free assets/extent of parental guanrantees
  - 7. proprietors required return on capital ( because it’ll will affect RDR - higher RRoC -> higher RDR -> higher margin)
  - 8. Competitive nature of the market and the company’s unique selling position

Question 3

Deriving assumptions for reserving purposes

Answer 3

• The starting point is a best estimate basis for the assumptions.
• principles involved in deriving these assumptions will be equivalent to those used in pricing.
• basis derived here will be similar to the pricing basis.
• it is necessary include margins to reduce chances of reserves being insufficient.
• For some purposes include statutory & published accounts margins may be incorporated.
• Consideration whether accounts are on going-concern basis or break-up basis
• Whether true and fair-view
• where there is any legislation or guidance on the basis or assumptions to use.
• for internal management purposes - margins may not be needed.

Question 4

Deriving assumptions for determining profitability

Answer 4

• the basis is likely to be fairly realistic, although it will depend on the specific purpose.
• principles are same as those of cashflow model.
• however allowances for risk may be different.
• Embedded value is the present value of shareholder profits in respect of existing business of a company, including the release of shareholder-owned net asses.
• Appraisal value is the sum of of embedded value and goodwill and is often used when valuing a long-term insurance company for merger or acquisition.

Question 5

Example of situations embedded value is calculated

Answer 5

• to establish a value of the business, for internal purposes
• to include in financial statements
• to assess the major part of an appraisal value for sale or purchase
• to analyse future surpluses for RI embedded value financing
• to assess growth in EV for the payment of bonuses to staff or salespeople

Question 6

Calculation of embedded value

Answer 6

• Can be calculated as the sum of :
  1. The shareholder-owned share of net assets
  2. The PV of future shareholder profits arising on existing business.
• The calculation may differ by types of business:
• Conventional without profits: PV of future premiums + investment income - claims - expenses + release of supervisory reserves.
• Unit-linked business: PV of future charges - expenses - benefits in excess of unit fund + investment income earned on and the release of any non-unit reserves.

Question 7

Calculation of Appraisal value

Answer 7

-The starting point to value a company for M&A is the embedded value calc.
-Important element is goodwill
Assumptions
-If an appraisal is being prepared as a sale value it is likely to be based on realistic assumptions without margins.
-The determination of bonuses for staff requires a realistic basis.
-EV calcs need to include appropriate allowance for risk margins to allow for unpredictability of profit emergence for health & care insurance business.
-Discount rate used reflects the risk inherent in these cashflows.
-a stochastic or market-consistent approach may be adopted.