CHP 31

Question 1

When setting assumptions it is important to:

Answer 1

• Consider the use to which the assumptions will be put to, e.g. new product, reserves etc.
• Take particular care of the assumptions that will have the greatest financial impact.
• Consistency between assumptions
• Consider any legislative or regulatory constraints
• Consider the needs of the client

Question 2

1.2. Different types of basis

Answer 2

In order of increasing strength the bases will be:

Optimistic -> best estimate -> prudent -> cautious

Question 3

2.1. Historical data

Answer 3

This is likely to be the primary source for determining assumptions about future experience.
Examples of when past experience is useful as a starting point:
• Determining assumptions for future investment returns. E.g. dividend yields and returns on other asset classes. Where dividends are linked to an inflation index, past data on that index will be useful.
• Past data on salary levels in a particular country, industry or company
• History of inflation index for future benefit growth linked to either fully or partially to that index.
• Choosing demographic assumptions

Question 4

2.2. Current data and forecasts

Answer 4

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 the bonds are related.
Policy statements by government or controlling banks may also be useful when making assumptions about economic factors.
A scheme sponsor may be able to provide information on planned future salary increases or likely future rates of withdrawal.
In some cases, assumptions may be defined in regulation or legislation.

Question 5

3.1. Relevance and credibility of past data

Answer 5

It is unlikely to be sensible to take an average past rate and use this to project for future experience. Past data only provides information that can be considered when determining the most likely future experience.
Social and economic conditions are likely to have changed over any period in history. Consider the conditions that will apply in the future period to which the projections will relate and how those conditions will lead to a difference from the past data being used.
The relevance of past data to future projections must be balanced against the need for sufficient data for its analysis to be statistically credible.
In making a judgment about future experience this conflict between credibility and relevance must be managed.

Question 6

When using past data it is necessary to consider how to deal with:

Answer 6

• Abnormal fluctuations
• Changes in the experience with time
• Random fluctuations
• Changes in the way in which the data was recorded
• Potential errors in the data
• Changes in the balance of any homogenous groups underlying the data
• Heterogeneity with the group to which the assumptions are to relate.

Question 7

Changes affecting economic data

Answer 7

Economic data fluctuates with changes in economic and fiscal policy as well as general economic cycle.
Past data relating to investment returns, salary levels, dividend yields etc. fluctuates significantly over extended periods of time. Because of this, it could be thought that past economic data is only useful after the last significant change. This will however increase the random fluctuation and decrease the credibility of the data.
Therefore it is needed to use the earlier data and try strip out the fluctuations that relate to economic and fiscal conditions that differ from those that exist currently.

Question 8

Price inflation

Answer 8

Past levels of inflation index usually fluctuates significantly and are often a useful indicator of the economic conditions that existed.
Thus they are unlikely to be useful in determining an assumption of future levels of inflation. Current levels of inflation index may be a better indication of the future levels. E.g. government projections and the “risk-free” real returns indicated by the current yields on long-term index-linked bonds could be used.

Question 9

Use of real values

Answer 9

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

Question 10

Other adjustments

Answer 10

Making further adjustments to economic or fiscal changes is difficult to do other than subjectively.
Dividend levels could be adjusted to allow for changes in taxation applying to those dividends.
An explicit adjustment may be spurious – there may be tax changes to tax that have a much greater effect.

Question 11

Demographic changes

Answer 11

Much of the demographic data will also be affected by economic changes. Explicit adjustment is difficult and so judgment and analysis of fluctuations and trends will be important.
Mortality data is mainly affected by medical advances. Past data can be considered with this in mind.
This will probably result in emphasis of the most recent data with consideration of trends of past data. Also the underlying reasons for trends being important in determining the extent of future change.

Question 12

Changes in statistics recorded

Answer 12

Over time, stats produced by state or data recorded by companies may change. Such changes distort past data and could lead to inappropriate assumptions unless these changes are recognized.

Question 13

Errors in data recorded

Answer 13

These cause distortions and will not be as easy to pick up. Generally the verification of data has greatly improved due to increased computing power. Thus, older data carries the greater risk of data error, perhaps to the extent that it outweighs the usefulness of having more data.

Question 14

Changes in the constituents of the population

Answer 14

Past data may give false results due to changes in balance between homogenous groups over time. E.g. past levels of salary growth may reflect a change in the overall composition of the workforce rather than real salary level changes for individuals.

Question 15

Splitting the population into homogenous groups

Answer 15

Split the population into groups that fit a set of assumptions. In practice, the information required to split the data reliably will not be available. In addition, splitting the data may result in a significant reduction of credibility. Thus past data will usually need to be adjusted in a subjective manner to allow for differences in the characteristics of the individuals concerned.

Question 16

3.5. Standard tables

Answer 16

In some countries, data have been analysed on a national or industry level. (mortality and morbidity is most common)
Countries may analyse the whole population’s experience based on censuses.
One advantage of census data is that it includes all lives and not just ones with insurance contracts. Thus this data usually includes lower socio-economic groups that distort the experience of lives that have insurance contracts.
When using standard tables, the same considerations will need to be taken into account when using the company’s own past experience data. In particular whether the data is relevant to the intended population at which the product is marketed, or whether adjustments need to be made to the data to reflect continuation of past historical trends.

Question 17

Purpose of the valuation

Answer 17

What will the financial significance be of the assumptions. This will help assess the degree of accuracy required and hence the extent to which it is necessary to try remove distortions from data.
Also helps to see if best estimate of future experience should be used or a margin for prudence to be added.

Question 18

Accuracy of assumptions

Answer 18

Where assumptions are used to place a capital value on future cashflows, it is not necessary to make judgments on the accuracy of each individual assumption. Rather determine if the overall value resulting from the combination of assumptions is appropriate.
If the individual cashflows are important, it may be necessary of the accuracy of each assumption to be assessed.

Question 19

Significance of errors

Answer 19

The consideration of the potential financial significance of errors will help assess the degree of accuracy required. From this the extent of margins needed or level of risk being taken can be seen.

Question 20

4.2. Effect of assumptions on cash transactions

Answer 20

It is important that the assumptions used are the best estimate of future experience. Under or over-statement will give one party and advantage at the expense of the other.
As a result, each party will have a preference for which side of best-estimate they would like to see each assumption.

Question 21

4.3. Implicit assumptions

Answer 21

Be aware of implicit assumptions in a model and consider the effects of these. E.g. the funding method for an occupational pension scheme may assume that:
• New members continue to join and thus age/sex distribution remains the same.
• 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 22

5.1. Margins

Answer 22

The assumptions will be estimates of the expected values for the parameters. 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:
• Adjusting the risk element of the risk discount rate
• Using a stochastic discount rate
• Applying margins to the expected values.

Question 23

Profit margins

Answer 23

Owners of the provider decide where to invest by comparing returns offered by different projects, relative to the risks that are run.

Question 24

5.2. Risk discount rates

Answer 24

Not all products are equally risky, the provider should consider itself an investor in products that will deliver a return. A change in the mix of business will change the market’s evaluation of the provider’s risks.
Design and launch of a financial product is a project, and the features of project assessment and project management are just as appropriate in these circumstatnces.

Question 25

The following features can increase the risks in a product design:

Answer 25

•	Lack of historical data
•	High guarantees
•	Policyholder options
•	Overhead costs
•	Complexity of design
•	Untested market
These risks are not easy to assess and is even harder to say what effect they should have on the risk discount rate.

Question 26

5.3. Profit criterion

Answer 26

Often a single figure that tries to summarise the relative efficiency of contracts. By applying a profit criterion to different contracts and then ranking the results in order, it may be possible to determinie which contracts make most efficient use of a company’s capital
Methods of quantifying profitability include:
• NPV
• IRR
• Discounted payback period
e.g. a possible profit criterion for an insurer is that the NPV of profits emerging from each of its product lines as a predetermined proportion of the distribution costs – this will reduce bias towards products with high commission payouts.

Question 27

Methods of quantifying profitability include:

Answer 27

• NPV
• IRR
• Discounted payback period
e.g. a possible profit criterion for an insurer is that the NPV of profits emerging from each of its product lines as a predetermined proportion of the distribution costs – this will reduce bias towards products with high commission payouts.