How Change in Assumptions Impact Actuarial Valuation Results
Actuarial valuation forms the backbone of long-term financial planning. It helps organisations manage risks in pensions, insurance, and employee benefits. But the accuracy of actuarial results depends heavily on assumptions. These assumptions act as the foundation of the entire valuation model. Even a slight change in any assumption can lead to a significant shift in the valuation results.
Let us explain how these assumptions work and how changing them impacts actuarial valuation.
What Are Actuarial Assumptions?
Actuarial assumptions are educated estimates used to project future outcomes. These estimates help calculate liabilities and future obligations. Actuaries use both economic and demographic assumptions.
- Economic assumptions include salary growth, inflation rate, discount rate, and investment return.
- Demographic assumptions cover mortality rates, retirement age, employee turnover, and disability rates.
These assumptions simplify the complex real-world scenario into a manageable mathematical model.
Why Are Assumptions Important?
Assumptions influence the estimated cost of future liabilities. Actuarial valuation helps stakeholders understand funding levels, risks, and funding gaps. If the assumptions are inaccurate, the valuation will not reflect the true financial picture. That is why actuaries continuously review and update them to match the changing environment.
Impact of Change in Discount Rate
The discount rate is one of the most sensitive assumptions in actuarial valuation. Actuaries use it to convert future cash flows into today’s value. If the discount rate increases, the present value of liabilities decreases. Conversely, if the rate decreases, the liabilities increase.
For example:
- A 1% drop in the discount rate can increase pension liabilities by 10-15%.
- This directly affects the company’s balance sheet and funding requirements.
Thus, even a minor change in the discount rate can significantly shift the actuarial results.
Influence of Salary Growth Assumption
Salary growth is another critical factor. It affects future benefit payments in a defined benefit pension plan. If salary growth increases, projected benefits also increase. This leads to higher liabilities and a possible funding shortfall. For organisations with large employee bases, even a small hike in the assumed salary escalation rate can cause a substantial impact.
Effect of Mortality Rate Assumption
The mortality rate assumption estimates how long employees and retirees are expected to live. If people live longer than expected, companies have to pay benefits for more years. This increases the total liability. Actuaries use the latest mortality tables and life expectancy trends to update this assumption. A 2-year increase in life expectancy can increase pension liabilities by 3-5%.
Changes in Employee Turnover and Retirement Age
Actuarial models also assume when employees will leave or retire. Higher employee turnover reduces long-term liabilities because fewer people qualify for long-term benefits. A delay in retirement age means benefits start later, which reduces present liabilities. However, incorrect estimation of these factors can lead to either overfunding or underfunding.
Volatility in Investment Return Assumptions
Investment return is an economic assumption used mainly in funding valuations. If expected returns are overstated, assets may fall short in the future. This results in a funding deficit that needs to be covered later. Actuaries often take a conservative approach to estimate expected returns. This helps prevent surprises in actual asset performance.
Role of Inflation Assumption
Inflation affects both salary and benefit payouts. If inflation is underestimated, the actual liabilities may be much higher than projected. Changes in inflation rates also influence discount rates, making it a double-impact factor.
Scenario Testing and Sensitivity Analysis
To assess the robustness of valuation results, actuaries perform scenario testing. This involves changing one assumption at a time to see the impact on final results. Sensitivity analysis shows which assumptions affect the valuation the most. This helps decision-makers understand where the risks lie.
For example:
- A valuation report may show that a 0.5% change in the discount rate causes a 7% shift in liability.
- This empowers management to make informed strategic decisions.
Real-World Implications for Stakeholders
Changes in assumptions affect multiple areas:
- Employers may need to contribute more to pension plans.
- Auditors must ensure assumptions are realistic and defendable.
- Investors look at actuarial liabilities to gauge financial health.
- Regulators may question sudden shifts in valuation outcomes.
This makes it essential to communicate assumptions clearly in financial statements and audit reports.
Key Takeaways
- Actuarial assumptions are vital to accurate financial projections.
- Changing a single assumption can drastically impact valuation outcomes.
- Assumptions must be realistic, current, and justified with reliable data.
- Regular review and sensitivity analysis help manage long-term financial risks.
Conclusion
Assumptions are the building blocks of actuarial models. Changing them—even slightly—can result in large shifts in financial projections. That’s why it’s critical to review and validate these assumptions regularly. Stakeholders must understand how each assumption works and what risks it brings.
Mithras Consultants is an independent actuarial and insurance consultancy firm providing qualitative financial and insurance solutions to its clients. Our goal is to provide business solutions customised to client‘s needs to help our clients make the best possible decisions on their financial, insurance, and risk management programs.
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