April 2017 Question 10 i)

[Anu Joshi]

Hello,
I am unable to understand the inflation adjustment done for Product recall costs and Property damage costs.

In the solution we have applied a 0.98 rate (as this has a deflation by 2%) for year 1-4 0.98^2.5. why are we using 2.5 ?Year 4 and 5 makes sense.

For third party property damage, we are using 1.025 for years 1-3. This is a one-off cost that occurs in year 4. What is the logic of inflating it till year 3 only.

Thanks

 

[Katherine Young]

Hello Anu, and good to hear from you again!

The question tells us that ‘product recall costs have deflated at 2% per annum over Years 4 and 5, with no inflation prior to that.’

In other words, we have:

• zero inflation until the last day of Year 3, then

• a sudden step change to deflation the next day, at the start of Year 4.

So, if we make the normal assumption that inflation (or deflation in this case) applies midway through Year 4 on average, then Year 3 will need only an extra half years’-worth of inflation compared to Year 4. And of course, the inflation adjustment for Years 1 and 2 will be the same as for Year 3.

As it happens, the examiners would have allowed an alternative approach whereby the inflation adjustment for Years 1 to 3 was the same as for Year 4.

As always, the moral of the story is to use the detail in the question and state appropriate assumptions.

Best wishes,

Katherine.

 

[Busy_Bee4422]

Hi

It seems the last part below was left unanswered.

For third party property damage, we are using 1.025 for years 1-3. This is a one-off cost that occurs in year 4. What is the logic of inflating it till year 3 only.

The question states that there is a once-off 2.5% increase at the start of year 4. We can therefore assume that the damage costs for years 4 and 5 already have the 2.5% included in them but costs for years 1 to 3 would have been 2.5% higher if they occurred after the start of year 4. So as part of the on-levelling process, we increase the claims for years 1 to 3 by 2.5%.

 

[Anu Joshi]

Hello Anu, and good to hear from you again!

The question tells us that ‘product recall costs have deflated at 2% per annum over Years 4 and 5, with no inflation prior to that.’

In other words, we have:

• zero inflation until the last day of Year 3, then

• a sudden step change to deflation the next day, at the start of Year 4.

So, if we make the normal assumption that inflation (or deflation in this case) applies midway through Year 4 on average, then Year 3 will need only an extra half years’-worth of inflation compared to Year 4. And of course, the inflation adjustment for Years 1 and 2 will be the same as for Year 3.

As it happens, the examiners would have allowed an alternative approach whereby the inflation adjustment for Years 1 to 3 was the same as for Year 4.

As always, the moral of the story is to use the detail in the question and state appropriate assumptions.

Best wishes,

Katherine.

Thank you Katherine