Chapter 20 - Setting assumptions

Question 1

What are the main considerations when setting assumptions? (8)

Answer 1

Purpose of the model which assumptions underly
Financial significance of assumptions
Consistency between assumptions
Legislation and regulation
Client needs
Need for accuracy and prudence (see p.13)
- Purpose of valuation
- Accuracy of assumptions
- significance of errors
Effect on cash transactions (see p.14)
- Use "best estimate" or more/less prudent value
Implicit assumptions (see p.14)

Question 2

What is the difference between demographic and economic assumptions?

Answer 2

Demographic: Relate to size and distribution of the population. Would affect the timing or number of cashflows.
Economic: Relate to general level of economic variables. Would affect the level of income or outgo.

Question 3

What are the main things which must be managed/considered when using past data to set assumptions? (6)

Answer 3

Abnormal fluctuations
Changes in the experience with time
Random fluctuations
Changes in how data was recorded
Potential errors
Changes in the mix of homogeneous groups - within past data and to which the assumptions apply

Question 4

What are the most important assumptions used when pricing contracts? (3)

Answer 4

Margins (p.15)
Risk discount rates (p.16)
Profit criterion (p.16)

Question 5

What is a profit criterion and give 3 examples.

Answer 5

A single figure which tries to summarise the relative efficiency of a contract. IRR, NPV, Discounted Payback Period.