Assumptions Setting

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 Introduction to actuarial assumptions (1)

• Actuarial assumption is an estimate of an uncertain

variable input into a financial model normally for
the purposes of calculating premiums or benefits;
• In any model assumptions are necessary to
generate output;
• The model is run with varying assumptions to
determine how sensitive is it to the output.
• Actuarial assumptions are based on historical
analysis.

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 Introduction to actuarial assumptions (2)

• Actuarial assumptions fall into two main categories:

1. Financial/economic assumptions – these will impact the
amount of future benefit; (e.g. investment return, price
inflation), .
2. Demographic assumptions – these will influence the
timing and probability of the benefit amount being paid.
(e.g. Mortality rate in term assurance)
• Therefore, the actuary is required to make assumptions
about the unknown future values of the key variables
affecting the amount and/or timing of the future cash
flows.
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Factors to consider when setting assumptions
(1)
1. The use of the assumptions. - For example whether the use is to price or
cost a new financial contract or to estimate the provisions (reserves) that
need to be held to meet future liabilities. Reserving basis tend to be more
cautious than pricing basis

2. The actuary should take particular care over the choice of the assumptions
that will have most financial significance;
3. Achieve consistency between the various assumptions in the basis;
4. Any legislative or regulatory constraints - In some Jurisdiction regulations
stipulate how assumptions should be determined to value assets and
liabilities;
5. Consider the needs of the client.

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Useful information when setting assumptions
(1)
• Historic data
This is likely to be the main source used in
determining assumptions about future experience.
• Examples :-
o In determining an assumption for future
investment returns data on past dividend yields on
equities and data on the total returns on relevant
classes of investment may be considered;

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Useful information when setting assumptions
(2)
o Past data on salary levels in a particular
country may be useful when making
assumption about future levels of salary growth;
o Inflation (both price and salary) data is useful in
determining an assumption for future benefit
growth;
o Claim amounts and/or frequencies (useful for
non-life insurance).

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 Use of past information (1)
• The use of past data should be combined with an analysis of recent
trends in the data and current forecasts of future experience.

• The relevance of the past data must be considered when projecting

future experience.

• Factors that may reduce in the relevance of historic data include:

1. Changes in underlying economic and social conditions;

2. Changes in market structure;

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 Use of past information (2)
3. Changes in terms and conditions and/or design of product;
• - e.g. changes in underwriting and/or level of benefit provided
• The relevance of past data must be balanced against the need for
sufficient data to make for a credible analysis.

4. Changes in the experience over time; -

• For mortality data, it is common to try to identify any trends in
the data, and to allow for this in future projections.

• This may also be useful when projecting claim frequencies for

non-life products.

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 Use of past information (3)
5. Effect of abnormal fluctuations
- e.g. when projecting future claim amounts
for non-life business, it may be appropriate to
remove any large one-off claims from the data
identifying any trends
- why?
- One – off large claims are unpredictable
hence they are high risk to the company.

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 Use of past information (4)
6. The past data should be split into homogeneous
groups with regard to the factors affecting future
experience.

- e.g. age, sex and type of employment are likely to

affect future rates of salary growth and mortality

• Small data sets can lead to credibility problems.

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 Use of past information (5)
7. The actuary should be careful to avoid reaching false conclusions
as a result simply of changes in the mix of the underlying
population in the past data i.e. changes in composition of
homogeneous groupings;
- e.g. For smokers and non-smokers there could be differences in
amount smoked and this can have impact on claims.

8. Consideration must be given to any changes in the way the past

data has been recorded over time

9. Consideration to errors in the data;

- give examples of errors in the data.

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 Using economic data (1)
• Economic data fluctuates not just in line with the general
economic cycle but also as economic and fiscal policy
changes;
• Economic data affect the amount of claims paid;
• There is a need to strip out fluctuations due to the latter, in
order to isolate the relationship with the economic cycle.
- For example for price inflation assumption:- To obtain
“Risk Free” real return, one could consider current yields on
long term index-linked gilts.

- Actuaries set assumptions in real terms where possible.

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 Using demographic data (1)
• Historic data can also be helpful when choosing
demographic assumptions.
• For example historic levels of mortality in a country or
company may help to choose assumptions for the number
of individuals who will survive to receive pensions or for
the extent to which benefit will be payable.
• The past data can also be used to project future
improvements in mortality.
• There may be a connection between demographic changes
and state of economy e.g. sickness rates ↑ as economy ↓

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 Using demographic data (2)
• However, mortality data can be affected by medical advances rather than
state of economy.

- Recent trends in these demographic assumptions need to be appropriate

for particular group under consideration;
(e.g. mortality applicable to the industry)

- But data may be insufficient to be credible if split into homogeneous

cells.

- An actuary must allow for changes in composition of homogeneous

groupings within group being considered when considering past data. (i.e.
mix may change).

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 Factors to be considered (1)

• When considering the assumptions to use to project future

experience, the actuary needs to consider the purpose for
which the assumptions are to be used and the significance
of each assumption in the overall result.
• This helps to assess the degree of accuracy required and
hence the extent to which it is necessary to remove
distortions from data.
• It also helps to judge whether the assumption should reflect
the best estimate of the future or it is appropriate to reflect
any uncertainty about future experience by an
overstatement or understatement within the assumption.
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 Factors to be considered (2)
(1) Purpose of the valuation

This will be very important in determining the level of prudence

included in the assumptions regarding future experience.

A valuation basis used for product pricing is likely to include little or no

margins on grounds of prudence (often referred to as a best estimate
basis). Why?

However, a valuation basis for the purpose of calculating reserves

(particularly statutory reserves used for demonstrating solvency) will
often include significant margins in the assumptions used.

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Other factors to be considered (3)
(2) Significance of assumptions
• The actuary should be very clear on which assumptions will have a
significant financial impact on the results.

• He/she should be aware that any errors in estimating these variables may
have a serious effect on future profitability.

• Also it is important to avoid being bias.

- For example when an actuary is determining fair compensation between
two parties it is important that the assumptions used are the actuary’s best
estimate of the future experience. Under-or over statement within the
assumptions will give one party a financial advantage at an expense of
the other.

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Other factors to be considered (4)
(3) Consistency of assumptions

In most cases, the actuary will be interested in projecting

both asset and liability cash flows (as asset cash flows will
be used to meet liability cash flows as and when they arise).
e.g. Consider discontinuance valuation of a pension scheme
the actuary might be comparing market value of assets with
liabilities valued on a consistent basis.

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 Significance of assumptions (1)
• Usually it is less important that each individual
assumption is “right”.
• It is more essential that the basis as a whole produces
acceptable values.
• Clearly: The greater the impact which an individual
assumption has, the more consideration given to it.
• For example: Asset-Liability modelling (“ALM”)
requires accuracy of each assumption since it impacts
on each future cash flow.

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 Implicit (Hidden) Assumptions (1)
• Actuary needs to be aware of any implicit assumptions within a model;
• e.g. 1 Life Assurance
Assume new business continues;
- this makes contribution to fixed expenses
e.g. Cost of the building used by the insurer
• e.g.2 The funding method for occupation Pension scheme may assume
that :-
(i) “new members continue to join or new policies continue to be
written hence the age/sex distribution will be maintained; or
(ii) no new entrants will join the group or no new policies will be written
and so existing population should be treated as a closed group.

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 Margins in Assumptions (1)
• To allow for risk from adverse future experience, actuary could
consider the following three options:-

- Adjust risk element of risk discount rate

- Use stochastic discount rate (risk of a particular product)

- Add margins to best estimate/expected parameter values

Question: List the main assumptions required by an actuary

modelling a final salary pension scheme.

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 Assumptions used in pricing (1)
Consider a detailed process of setting the assumptions used
for pricing a life insurance contract:-
• Note that, many of the issues raised will also be relevant
when setting assumptions in a pension fund and/or non-life
insurance environment.
• Assumptions will be required for all factors affecting the
amount and/or timing of the future liability outgo.
• Thus, there is a risk that the actual future experience for each
of these factors will be different to that assumed (and, hence,
the eventual cost of the liabilities will be different to that
expected).

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 Assumptions used in pricing (2)
• Consider the process of setting the appropriate
assumptions, with regard to:

(i) The expected future experience, i.e. best estimate of

the future; and

(ii) The extent to which margins against future adverse

experience are appropriate.

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 Assumptions used in pricing (3)
(1) Demographic assumptions
The main demographic assumption required to
price a life insurance contract is with regard to
the future mortality experience (i.e.
Mortality rates and how policies are sold).

The mortality rates used should reflect the

expected future mortality experience of the
potential policyholders.
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 Assumptions used in pricing (4)
• In this case, three factors are crucial to consider:

(i) The target market for the contract (which will depend largely on
the type of product and the methods by which the product is sold);

(ii) The level of underwriting applied;

for instance - Low underwriting level save cost however, more
substandard lives will be insured. Therefore, high mortality rates;

(iii) Allowance for improvements in future mortality experience;

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 Assumptions used in pricing (5)
• Even for a very large company, the mortality assumptions
used are likely to be based on a standard mortality table
(with appropriate adjustment for the above factors).
• Using published tables will save cost of carrying out full
analysis and reduces risk of errors.
• If possible, an appropriate adjustment would be derived by
analysing the company’s own experience relative to the
published table for the particular contract being considered.
- e.g. Analyse (Actual deaths/Expected deaths) at each
age if the ratio is > 1 then mortality assumptions are being
underestimated.
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 Assumptions used in pricing (6)
• In practice, this would be done for each homogeneous sub-group of
policyholders (e.g. by age, sex, smoking status, level of underwriting
etc), provided that a credible amount of data is retained within each
cell.
• If the company does not have sufficient data What other sources of
data might be used?
 Any thing published by the regulator
 National Bureau of Statistics
 Data from similar products
 Association of Insurers
 Reinsurers
 e.t.c.

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 Assumptions used in pricing (7)
• The relevance of the company’s own past data
must be considered, particularly where there
has been a change in underwriting procedures
and/or sales methods used.
• An appropriate allowance for trends in future
mortality is particularly important for annuity
contracts where increased longevity could
result in a financial loss to the insurer.

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 Assumptions used in pricing (8)
• Similarly, for contracts with a significant death
benefit (e.g. term assurance), appropriate
allowance for higher rates of mortality in future
should be included.
• The effect of selective withdrawals on past and
expected future mortality must also be
considered. e.g. For Term Assurance health
people tend to lapse policies and the company
remain with unhealthy lives.
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 Assumptions used in pricing (9)
• Setting an appropriate assumption for future
mortality is, clearly, also important in a
pension fund environment.
• Also, a similar approach can be used when
determining assumptions for morbidity and
critical illness rates for the pricing of health
insurance contracts.

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 Assumptions used in pricing (10)
(2) Investment return

The importance of the assumption regarding future investment return will depend
crucially on:

(i) The size of the reserve built up under the contract;

- type of contract is crucial (e.g. term assurance vs endowment assurance) ;

- i.e. Investment return is relatively unimportant for term assurance since very low
reserves are built up.

- frequency of premium payment may also be important (e.g. single premium vs regular
premium).
- i.e. here investment return is more important for single premium business as the insurer
gets single premium which needs to be invested.

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Assumptions used in pricing (11)
(ii) The extent of any investment guarantees
included
- nature of contract is crucial (e.g. non-
profit vs with-profit);
- a higher level of investment guarantee is
likely to mean that less risky assets are chosen
to back the liability.

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Assumptions used in pricing (12)
• Then, the assumed rate of future investment return will depend
on the likely mix of the assets held to back the contract in
future.
• The level of free assets will determine the extent to which the
company can depart from a matched investment position in the
hope of achieving higher returns.
• The actuary needs to consider the current and expected long-
term future return on each main asset class. e.g. This can be
done by looking at the past data within the company or look at
market information.

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Assumptions used in pricing (13)
• Allowance should be made for any changes in the
future economic environment and also for the
effects of any expected changes in taxation and/or
regulation.

Setting an assumption for future investment return

will also be crucial in a pension fund environment,
but is likely to be much less significant in non-life
assurance because non-life business liabilities tend
to be short-term.
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Assumptions used in pricing (14)
(3) Expenses and commission

Allowance for expenses should include the following marginal costs:

- initial acquisition costs (e.g. Commission to brokers);

- underwriting :- expenses vary with the level of underwriting;
- administration (both initial and renewal) ;
- renewal commission (if appropriate);
- investment;
- claim/maturity administration :- expenses payable on maturity or surrender of
the policy;
In addition, a contribution to the fixed costs of the business (e.g. rent, salaries)
should also be included.

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Assumptions used in pricing (15)
• An expense analysis will be conducted using the past experience of
the company to determine an appropriate contribution to the
overall expenses for each product.

What might be done if the company does not have sufficient past
data for a particular product to carry out an expense analysis?
- The company should look at:
- Data similar products;
- Data from reinsurers;
- Association of insurers.

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Assumptions used in pricing (16)
• The extent of any cross-subsidies of per-policy (i.e. fixed)
expenses between large and small policies is crucial here.
Charge low expenses for lower premiums this will be
compensated by charging higher expenses for larger
premiums.

An appropriate allowance for future expense inflation

also needs to be determined. The largest element of future
costs will usually relate to staff salaries, thus the actuary
needs to estimate the future rate of earnings inflation.

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 Assumptions used in pricing (17)
(4) Withdrawals

• The assumed rates of future withdrawals should reflect the expected

experience of the potential policyholders.

• Again, the company’s own past data for the particular contract should
be used .

• However, if this is not available or is insufficient, then experience from

similar contracts and/or industry-wide data (if available) may be used.

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Assumptions used in pricing (18)
• What factors are likely to affect future rates of withdrawal?
- Selective withdrawals
- Surrender benefits (i.e. The actual benefits you offer)
- Competition (if cheaper products are available elsewhere in
the market

Why might the company’s own past data not be very relevant
in helping to determine future rates of withdrawal?
- The company data may not be enough
- Does not reflect future developments e.g. Competition.

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Assumptions used in pricing (19)
(5) Other factors
• In non-life insurance business, assumptions
regarding investment return, mortality and
withdrawal experience are unlikely to be
required.
• The key assumptions relate to claim amount
and claim frequency (in addition to an expense
analysis, as described above).

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 Margins (1)
• The assumptions derived above will be best estimates of the expected future
experience for each variable.
• Allowance for future adverse experience can be made in one of two ways:

(i) Incorporating explicit margins into each of the assumptions in the

valuation basis and calculating the premium using the equivalence principle

- i.e. equating the EPV of future income with the EPV of future outgo
- Example of explicit margin we believe investment will be 7% p.a. but we
deliberate assume 6% p.a. Therefore, a 1% p.a. margin. This will reduce the
risk of loss as a result of adverse experience.

(ii) Allowing for the risk through use of an explicit risk discount rate and an
appropriate cash flow model

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 Margins (2)
• By including margins in the pricing basis, the risk of
a loss as a result of adverse future experience is
reduced.

• In effect, the two methods are equivalent (they

include a cushion for prudency), and the company
will face a loss once the margin has been “used up”.
• As indicated above, the extent of the margins
incorporated will depend on the purpose of the
valuation.
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 Margins (3)
• For pricing, a key concern is the need for competitive
premiums. However, the actuary must consider the level
of risk associated with each parameter and the financial
significance of that risk.

For reserving, the extent of the margins will depend on the

purpose of the investigation. For statutory purposes, the
margins incorporated are likely to be reasonably prudent.
However, for an internal valuation to assist with business
management (e.g. assessing investment and/or reinsurance
strategies), a more realistic basis may be used.

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