Chapter 20: Setting assumptions

Question 1

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

Answer 1

1. Consider the use to which the assumptions will be put
2. Take care over the choice of the assumptions that will have the most financial significance.
3. Achieve consistency between the various assumptions
4. Consider any legislative or regulatory constraints
5. Consider the needs of the client

Question 2

Give 3 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 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 by 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

Abnormal fluctuations
Random fluctuations
Changes in regulation
Heterogeneity within the group to which the assumptions will apply
Errors in the data
Recording differences

Question 5

Discuss fluctuations and changes over time

Answer 5

Changes affecting economic data
Economic data fluctuates with changes in economic and fiscal policy as well as with the general economic cycle.
It could be though that economic and fiscal changes mean that most past data are irrelevant and so only data that relate to a period after any recent significant change can be used.

Price inflation
Past levels of an index to measure price inflation usually fluctuate significantly and are often a useful indicator of the economic conditions that existed.
They are therefore unlikely to be very useful in determining an assumption for future levels of inflation.

Use of real values
Past data for price inflation can be very useful in determining other economic assumptions, as conversion of past economic data into real terms will often remove much of the fluctuation.

Other economic adjustments
Making any further adjustment for economic and fiscal changes is difficult to do other than subjectively.

Demographic changes
Much of the demographic data will also be affected by economic changes.

One-off impacts
One-off impacts in the past data will also need to be considered to ensure that the assumptions are valid.
Historical data relating to exceptional or one-off events should be disregarded in an analysis of trends. Alternatively, the data might be adjusted to a more ‘normal’ value for that period.

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 are 6 factors that 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)
6. Implicit assumptions

Question 9

Give an example of an implicit assumptions 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

List the features that will make an insurance contract design riskier

Answer 11

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

Question 12

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

Answer 12

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