C17 Setting assumption 1 Flashcards
Outline a general process for setting assumptions.
Process for setting assumptions
1. Investigate past experience and make best estimates of parameters from that experience.
2. Consider likely future conditions (including commercial and economic environment) during period for which assumptions will be used.
3. Determine what best estimates of assumptions will be, given expected future conditions.
4. Best estimates may need to be adjusted in order to include a margin.
Size of any margin will depend on:
purpose for which model is required
degree of risk associated with parameter.
State two factors that a company needs to balance in deciding on an appropriate number of years of past experience data to include in a mortality investigation.
Mortality investigation – data
Need to balance:
1. including enough years to have adequate volume of data
2. including few enough years to not introduce heterogeneity due to trends over time.
List six sources of mortality data that can be used in setting the mortality assumption for a product.
Sources of mortality data
1. Company’s past experience with product
2. Company’s past experience with similar product(s)
3. Reinsurance company data
4. Industry data, ie standard tables
5. International data
6. National statistics
State three features of a class of insured lives that a company may have to adjust for before using its past experience data to set mortality assumptions.
Adjustments to mortality rates for class of lives
Adjustments may be made to reflect:
1. Target market
2. Distribution channel
3. Level of underwriting
State two circumstances where the estimation of future mortality improvements is particularly important.
Future mortality improvements
Estimating future mortality improvements is particularly important:
1. for policies with longevity risk, eg annuities
2. when rates are guaranteed rather than reviewable
List three possible approaches that might be used for projecting future rates of mortality improvement.
Approaches to projecting future mortality improvements
The different approaches are:
1. expectations, based on expert opinion
2. extrapolation of historical trends
3. explanatory projection techniques, based on models of the bio-medical processes that cause death
State how each of the following might be taken into account when making projections of future mortality:
- cohort effect
- the combined effects of multiple factors
- random effects.
Other factors to allow for when projecting mortality
Cohort effect
Each year of birth cohort is modelled separately, allowing for specific mortality improvement rates by cohort (as well as by age and sex).
Multi-factor effects
Use multi-factor predictive modelling techniques (eg generalised linear models), which can take account of personal attributes along with external factors affecting mortality, allowing for any correlations and interactions between them.
Random effects
Use stochastic modelling (eg Lee-Carter or P-spline method).
List four factors that affect the investment return assumption when pricing a life insurance contract.
Factors affecting the investment return assumption when pricing
1. Significance of assumption for profitability of contract. This depends on:
level of reserves
extent of investment guarantees.
2. Extent of investment guarantees given under contract. This will affect asset mix.
3. Extent of any reinvestment risk. This will affect importance of future expected investment returns.
4. Intended asset mix for contract and current return and, where appropriate, likely future returns on these assets
For a contract that is priced using a market-consistent stochastic model, state whether the following assumptions should depend on the actual underlying assets held:
expected investment return
volatility of investment return.
Whether underlying assets affect assumptions in stochastic models
The expected investment return should be set as the risk-free rate, irrespective of the actual underlying assets held.
The volatility of the investment return and co-relation assumptions will depend on the actual underlying assets held.
Consideration required when choosing parameter values for expenses used in a pricing exercise
Consideration required when choosing parameter values for expenses used in a pricing exercise
-Parameter values for expenses should reflect the expenses expected to be incurred in processing and administering the contracts to be written for the business being priced.
-Parameters values will be determined by analysing the past experience of the company for the type of business being priced.
- The result of this analysis will be a split of expenses by function
- Possibly, whether the level of expenses are expected to be proportional to the level of premium or benefit, or can be expressed an an amount per contract.
Describe three methods of allowing for expenses that do not vary by policy size when setting premium rates or charges.
Methods of allowing for expenses that do not vary by policy size
- Individual calculation of premium rates or charges – normally only for very large cases as small cases would be very uncompetitive.
- Policy fee addition to premium (or deduction from regular benefit payments) for non-linked contracts or charges that match per policy expenses for unit-linked contracts.
This approach may need to be modified if policy fee or charges would be uncompetitive. Modifications lead to business mix risk for company (ie risk of too many small policies). - Sum assured differential, ie for non-linked contracts, charge different premium rates according to which band benefit falls into and for unitlinked contracts apply different charges (eg allocation rates) according to which band premium payable falls into.
List five factors that will be considered when setting the expense inflation assumption for product pricing.
Factors that should be considered in setting expense inflation assumption:
- Current rates of inflation, both for prices and earnings
- Expected future rates of inflation
- Recent actual experience of life insurance company or industry
- Difference between fixed-interest government bond yields and indexlinked government bond yields
- Investment assumption being used (be consistent)
Outline how to set the persistency assumption when pricing a product.
Setting persistency assumption for pricing
Should reflect expected future experience of contracts to be taken out
Based on analysis of company’s recent experience, ideally of same contract, else of any similar contracts
If company does not itself have adequate data, there may be industrywide experience it could use
Assess results to see if they have been affected by special factors, eg adverse economic situation
Adjust for differences in class of lives, eg benefit changes, distribution channel changes, target market changes
Add appropriate margins
Persistency assumptions are needed if using cashflow method but not if using formula method
State how the risk of adverse future experience can be allowed for when pricing life insurance contracts using
a cashflow model
a formula model.
Margins for risk
Pricing using a cashflow model:
Risk to company from adverse future experience would be allowed for either through:
risk discount rate
using a stochastic approach
assessing margins to apply to the expected values.
Pricing using a formula model:
Risk of adverse future experience would be allowed for by taking margins as the first and second approaches above are not available.
Explain what is meant by the term risk discount rate.
Risk discount rate
Risk discount rate is return on capital demanded by providers of that capital.
It is made up of:
return they could obtain from risk-free asset
plus a risk premium to compensate for volatility of return.
Risk discount rate can be determined by quantifying risk premium appropriate for company. One way of doing this is by using CAPM.
Market availability of capital should also be taken into account.
Market’s view of risk discount rate is not necessarily most apt for any given product, as different products will have different levels of riskiness.
