Chapter 20: Setting assumptions Flashcards
What are the 5 most important things to consider when setting assumptions?
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
Give three examples of where historical data will be a useful starting point for setting economic assumptions
- Past investment data on dividend yields and total returns for setting future investment return assumptions
- Past inflation index data for setting assumptions for BENEFIT GROWTH that is linked to inflation
- Past data on salary levels in a particular country, industry or company for setting salary growth assumptions
Give 4 examples of where current data and forecasts may be useful for setting assumptions
- 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.
- Policy statements by governments and banks can help in setting economic assumptions
- Sponsors may be able to give indications of planned salary increases or withdrawal rates for a benefit scheme.
- Assumptions may be defined in regulations or legislation
Why may past data not be relevant for the future?
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)
Assumptions affected by changes in social, economic, and fiscal conditions
- Social trends, such as medical advances, affect mortality data
- Economic conditions affect FINANCIAL ASSUMPTIONS such as dividend yields, salary growth, inflation rates, and investment returns
- Economic conditions, such as a recession, also affect DEMOGRAPHIC ASSUMPTIONS such as withdrawal rates, take up rates and claim rates
- Fiscal changes affect dividend yields, salary growth and investment returns
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
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
What are the main considerations when using data from standard mortality tables to set assumptions?
- The data may not be relevant to the intended population
- 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
What 6 factors affect the need for accuracy and prudence when setting assumptions?
- The purpose of the valuation
- The significance of each assumption to the overall result
- Whether the individual cashflows are important or whether the overall value resulting from a combination of cashflows is important
- The financial significance of any errors
- Whether the valuation is for cash transactions (which cannot be corrected at a later date)
- Implicit Assumptions
Give an example of an ‘implicit’ assumption in a pension scheme
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
List 3 ways in which margins for risk can be built into assumptions when pricing
- Margin in the risk discount rate
- Use a stochastic discount rate
- Applying margins to the expected values
Give 4 examples of profit criteria that could be used when pricing an insurance contract
- NPV of profits
- IRR
- Discounted payback period
- A ratio involving the NPV of profits such as the NPV of profits divided by distribution costs
List 6 features that will make an insurance contract design riskier
- Lack of historical data
- High guarantees
- Policyholder options
- High overhead expenses
- A complex design
- An untested market
Demographic assumptions
eg mortality rates. They relate to the size and distribution of the population. They generally affect the: - timing - number of the cashflows
Economic assumptions
eg investment returns Relate to the level of income or outgo. They generally affect the LEVEL of the cashflows
Demographic factors (assumptions) needed for a pension scheme model
- 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)
