Chapter 31: Setting assumptions

Question 1

5 Key factors affecting the choice of assumptions for a model:

Answer 1

• the PURPOSE of the model
• LEGISLATIVE and REGULATORY requirements
• CLIENT NEEDS
• CONSISTENCY between assumptions
• the FINANCIAL SIGNIFICANCE of the assumptions

Question 2

When having past data, the actuary needs to consider how to deal with:

Answer 2

• abnormal fluctuations
• random fluctuations
• potential errors in the data
• changes in the experience with time
• changes in the way in which the data was recorded
• changes in the balance of any homogeneous groups underlying the data
• heterogeneity within the group to whom the assumptions are to relate

Question 3

Features that can make a contract design riskier (6)

Answer 3

• lack of historical data
• high guarantees
• policyholder options
• overhead costs
• complexity of contract design
• untested market

Question 4

Profit criterion

Answer 4

Single figure that summarises the relative efficiency of a contract.
E.g. NPV, IRR, discounted payback period

Question 5

Demographic assumptions

Answer 5

eg mortality rates.
They relate to the size and distribution of the population.
They generally affect the:
- timing
- number
of the cashflows

Question 6

Economic assumptions

Answer 6

eg investment returns
Relate to the level of income or outgo.
They generally affect the LEVEL of the cashflows.

Question 7

4 Examples of where past data may form a useful starting point for setting assumptions:

Answer 7

• determining an assumption for future investment returns.
• past data on salary levels in a particular country/industry/company may be useful when making an assumption about future levels of salary growth.
• History of an inflation index may be useful in determining an assumption for future benefit growth.
• Historical data can also be helpful when choosing demographic assumptions

Question 8

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 8

• adjusting the risk element of the risk discount rate
• using a stochastic discount rate
• applying margins to the expected values

Question 9

3 Common methods of quantifying profitability

Answer 9

• net present value
• internal rate of return
• discounted payback period

Question 10

Demographic factors (assumptions) needed for a pension scheme model

Answer 10

• 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

Question 11

Economic factors (assumptions) needed for a pension scheme model

Answer 11

• expenses - Ex
• pension increases - Pe
• discount rate (for valuing liabilities) - D
• investment returns - I
• earnings inflation- Tion from inflaTion
• price inflation -Tion

ExPeDITion

dividend yield is another economic assumption but not for pensions

Question 12

Where there is little past data available, mortality assumptions could be set using (3)

Answer 12

• data from a similar contract
• industry data
• reinsurers’ data

Question 13

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

Answer 13

• the distribution channels/SALES methods used
• the TARGET market
• UNDERWRITING practices
• underlying MORTALITY rates
• PRODUCT DESIGN features

Question 14

4 Sources of historical data

Answer 14

• national statistics, published by government bodies and economists
• industry data
• tables compiled by actuaries
• past information relating to the particular contract being considered

Question 15

5 Sources of Current Data and forecasts

Answer 15

• Policy statements by GOVERNMENTS OR BANKS may be useful when making assumptions about economic factors.
• There are many EXPERTS who provide alternative sources of estimates of future economic variables, most notably price inflation.
• A SCHEME SPONSOR may be able to provide information on planned future salary increases or likely future rates of withdrawal.
• The relationship between 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 bonds are related.
• In some instances, assumptions may be defined in REGULATIONS AND LEGISLATION

Question 16

3 assumptions which fluctuate and change over time:

Answer 16

• Changes affecting economic data
• Price inflation
• Demographic changes

Question 17

Changes affecting economic data

Answer 17

• Economic data fluctuates with changes in:
• ——->economic policy
• ——->fiscal policy
• ——->general economic cycle.

Past data for:
- investment returns,
- salary levels, 
- dividend yields
fluctuate significantly over an extended time-frame.

It is necessary to use earlier data and strip out fluctuations that relate to economic and fiscal conditions that differ from those that exist currently.

Question 18

What is the verdict on using past price inflation to set assumptions for future inflation?

Answer 18

Past levels of an inflation index 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.

Current index values may be a better guide to future inflation.

Question 19

Demographic changes/assumptions affected by:

Answer 19

• Affected by economic changes

- Mortality data is mainly affected by medical advances