QA Bank Part 7 Flashcards
4 Advantages of a deterministic model
- simplicity
- clarity as to which economic scenarios have been tested
- speed of design and running
- ease of communication of results
3 Advantages of a stochastic model
- it tests a wide range of economic scenarios, including scenarios that may not have been thought of under a deterministic model
- it allows better for the random nature of variables and the correlations between them.
- it is more useful for assessing the impact of financial guarantees and options
Steps in developing and applying a deterministic model
- specify the purpose of the investigation
- collect, group and modify data as necessary
- choose the form of the model, identifying its parameters and variables
- ascribe values to the parameters using past experience and appropriate estimation techniques
- construct a model based on the expected cashflows
- check that the goodness of fit is acceptable
- run the model using estimates of the variables in the future
Define “Model Point”
A set of data representing a single policy or a group of policies.
It captures the most important characteristics of the policies that it represents.
Explain why model points may be used
The insurer may have very many policies and it may not be practical to run all the individual policies through the model.
Instead these policies are grouped into those that would give very similar results in order to determine a number of model points.
Important characteristics to be captured in the critical illness model points (8)
- term of the policy
- duration in-force
- sum assured payable on occurrence of a critical illness
- basis of policy (single life, joint life, last survivor)
- age of life
- gender of life
- health status of life
- smoker status of life
Define Model error
Model error means a model is developed that is not appropriate for the task at hand.
How might model error be assessed?
Model error can be assessed by checking the goodness of fit of the model output against actual data.
Define parameter error
Parameter error means incorrectly setting parameter values used when the model is run. Can involve individual parameters and/or correlation between parameters.
How might parameter error be assessed?
Parameter error can be assessed by carrying out sensitivity analysis to consider the effect of varying each of the parameter values.
When such sensitivity testing is carried out, allowance must be made for any correlation between parameters.
11 Main uses actuaries make of data
- Administration
- Accounting
- Statutory returns
- Investment
- Financial control, management information
- Risk Management
- Setting provisions
- Experience statistics
- Experience analyses
- Premium rating, product costing, determining contributions
- Marketing
How might an actuary use the Balance Sheet data when valuing an employee benefit scheme?
The balance sheet can be used to verify the value of the assets at the valuation date.
How might an actuary use the Income and expenditure statement when valuing an employee benefit scheme?
The statement will give cashflow information about contribution and investment income and benefit outgo that can be used to verify other data.
How might an actuary use the asset data when valuing an employee benefit scheme?
A full listing of the assets can be obtained, this can be used to verify whether the assets held:
- actually exist
- are admissible for valuation purposes,
- or whether their inclusion in the valuation is restricted by regulation or legislation.
5 Key considerations in setting assumptions in actuarial work
- consider the use to which the assumptions will be put
- take particular care over the choice of the assumptions that will have the most financial significance
- achieve consistency between the various assumptions
- consider any legislative or regulatory constraints
- consider the needs of the client
List features of a product design that will increase the financing requirement
- lack of historical data
- high guarantees
- overhead costs
- policyholder options
- complexity of design
Advantages of funding a pension scheme in advance from the viewpoint of the employer
- provides security for members, and hence meets paternalistic aims of employer
- may be required by regulation
- tax incentives may be given on contributions and/or investment return making funding in advance attractive
- competitor schemes may be funded in advance and therefore this scheme may need to follow suit to make it attractive to new and existing staff
- if an appropriate funding method is chosen, then liquidity concerns can be eased
- the employer has some degree of flexibility in relation to the timing of contributions
- a single premium at inception might be able to be invested at a known yield to provide appropriately timed cashflows thereby avoiding reinvestment risk and reducing costs.
Disadvantages of funding a pension scheme in advance from the viewpoint of the employer
- opportunity cost of investing money in the pension scheme rather than in the business
- method must be chosen carefully as some methods may require significant funds to be found at certain points in time
- not all methods give a realistic assessment of cost
Outline the factors that will affect the price charged for the transfer of liabilities on a merger or acquisition
- theoretical value of the liabilities
- relative bargaining power of the parties involved
- size of the transaction relative to the whole deal
- supply of parties seeking a merger or takeover by a larger organisation and the number of acquirers with adequate finance in the market.
Define variable expenses
those that vary directly according to the level fo business being handled and may be linked to the number of policies or claims or the amount of premiums or claims.
Define fixed expenses
Those that, in the short to medium term, do not vary according to the level of business being handled
Define direct expenses
Those that have a direct relationship to a particular class of business.
Define indirect expenses
Those that do not have a direct relationship to any one class of business. They need to be apportioned between the appropriate classes.
Net present value
The expected present value of the future cashflows under a contract, discounted at the risk discount rate.
Main advantage of Net present value
Given a choice between two different sets of cashflows, economic theory dictates that the investor should choose that with the higher net present value.
Assumptions of “Net present value being the default choice under economic theory”
Assumes
- a perfectly free and efficient capital market
- that the NPV is calculated using a discount rate, which correctly reflects the inherent riskiness of the product.
Internal Rate of Return
The internal rate of return is the discount rate that would give a NPV of 0.
3 Advantages of the internal rate of return
- simple measure
- compatible with shareholders saying “we want a return of at least x%”
- easily comparable with other forms of investment (other products, projects)
4 Disadvantages of Internal rate of return
- may not be unique
- it may not exist
- it is difficult to relate to other measures (eg premium income)
Discounted payback period
This is the earliest policy duration at which the accumulated value of profits is 0.
2 Advantages of the discounted payback period
- It is a useful means of comparing products if capital is a particular problem
- It is easy to explain as a “break-even” point
Disadvantage of the discounted payback period
It will often not agree with the net present value as a means of deciding between 2 different sets of cashflows because the discounted payback period ignores cashflows subsequent to the discounted payback period itself.
6 Methods of financing benefits
- pay-as-you-go
- lump sum in advance funding
- terminal funding
- regular contributions
- just-in-time-funding
- smoothed pay-as-you-go
2 Groups of Factors influencing the method of financing benefits chosen
- then needs of the various parties
- external factors
When choosing a method to finance benefits, the needs of various parties may consist of factors such as ()
- security of the benefits
- flexibility of contributions
- stability of contributions
- opportunity cost
- liquidity / cashflow
- realism
- risk allocation
Factors influencing the chosen method of financing benefits:
- security of the benefits
(members/trustees)
The further in advance the benefits are funded for, the more secure they will be.
Factors influencing the chosen method of financing benefits:
- flexibility of contributions
(sponsor)
Regular funding is more flexible than - say - lump sum funding.
Factors influencing the chosen method of financing benefits:
- Stability of contributions
(sponsor)
Advance funding can allow a sponsor to pay for pension benefits gradually, and in a more stable manner than pay-as-you-go.
Factors influencing the chosen method of financing benefits:
- Opportunity cost
(sponsor)
There is an opportunity cost associated with the method of funding, which doesn’t occur with pay-as-you-go, as the monies could be used by the sponsor on other projects.
Factors influencing the chosen method of financing benefits:
- Liquidity / Cashflow
(Sponsor)
Advance funding provides good protection against cashflow problems provided that the assets held are marketable, produce cashflows when required, or if there is an adequate contribution flow.
Factors influencing the chosen method of financing benefits:
- Realism
A funding plan with low contributions now and high contributions later may give the sponsor an unrealistic view of the cost of the benefits in the short term.
Factors influencing the chosen method of financing benefits:
- Risk allocation
Different approaches to the incidence of funding will also affect the allocation of risk between the individual or company exposed to the contingent event, and the provider of a financial product to mitigate those risks.
External factors influencing the chosen method of financing benefits
- legislation restricting the method used for financing of benefits
- tax incentives / disincentives of, for example, funding over pay-as-you-go.
