Exam Question - Q2 Sep 2012

[rosesmary]

Hi all,

I attempted the following question in Sep 2012 and I couldnt understand the question:

Below is the extract:

A life insurance company has only ever sold term assurance business. It has just finished analysing its mortality experience for the past year. The conclusion of the study is that mortality has worsened, requiring a change to the company’s mortality assumptions.
The company uses two sets of mortality assumptions in its embedded value
calculation. One set is used to project experience and is realistic; the other is used to calculate future reserves and is prudent.

Can someone explain to me what "the realistic assumption" is? And why any company uses two sets of assumption : "realistic assumption" and "prudent assumption" to calculate reserves and EV?

Thanks a lot

 

[cjno1]

Can someone explain to me what "the realistic assumption" is? And why any company uses two sets of assumption : "realistic assumption" and "prudent assumption" to calculate reserves and EV?

A "realistic" assumption can also be known as "best estimate" and is just our best guess at what the mortality will be in the future. In still other words, if you can say "there's a 50% chance that mortality will be higher than X, and a 50% chance that it will be lower than X" then your "realistic" assumption for mortality is X.

When you want to project experience, you want to work out what the future looks like in the most realistic scenario, so you use your realistic basis. This basis is generally used in pricing and in embedded value calculations, where you are looking for best estimate figures.

When you want to calculate reserves, you need to be more prudent than this, since obviously you don't want a 50% chance that your reserves aren't high enough to pay your claims! So you will use a prudent assumption, which means one which is conservative, or safe.

To use a numerical example, if my "realistic" assumption is that 10 people will die next year, then in my reserves for a term assurance I might assume that 13 people are going to die. This will mean I have to hold higher reserves to cover these extra deaths. Then, in the next year if my best estimate is right, I will release those additional reserves for the 3 people who didn't die, but if it's a particularly bad year and 11, 12 or even 13 people die then I still have enough money to pay those claims because my reserve was "prudent".

Hope that clears it up for you.