What is Actuarial Assumption
An actuarial assumption is an estimate of an uncertain variable input into a financial model, normally for the purposes of calculating premiums or benefits. For example, a common actuarial assumption relates to predicting a person's lifespan, given their age, gender, health conditions and other factors. Actuaries use large tables of statistical data which correlate the uncertain variable to a variety of key predictive variables. Given the values for the predictive variables, a sound actuarial assumption can be made for the uncertain variable.
BREAKING DOWN Actuarial Assumption
An actuarial assumption estimates of an unknown value based on the methods of actuarial science. An actuarial assumption is made using statistical tools, such as the correlation of known values to possible outcomes for the unknown value. Typically, the preparation of an actuarial assumption requires complex mathematical and statistical techniques.
Actuarial assumptions are important because they allow for the equitable transfer of risk in many situations. For instance, when underwriting life insurance policies, it is important to understand the probability that the insured might pass away during the policy period. Given an accurate actuarial assumption for this probability, it is easy to calculate a fair premium for such a policy. Without the ability to accurately figure these probabilities, very few people would be willing to provide insurance. If they were, it would have to be more expensive to allow room for unexpected losses.
Assumption setting is an essential part of actuarial services across all practice areas – especially as the use of actuarial assumptions continues to rise in the Sarbanes-Oxley era and since the National Association of Insurance Commissioners (NAIC) promulgated the Model Audit Rule. Actuarial measurements are often part of financial statements and are an integral part of an organization's risk management practices.
Common Actuarial Assumptions
One of the most common actuarial assumptions made by insurance companies is the life expectancy projection of a person seeking life insurance. When someone applies for life insurance, an insurance company actuary considers the proposed insured's age, height, weight, gender, tobacco usage and certain data points, relating to health history. The goal of such an actuarial assumption is to establish a life expectancy for underwriting purposes.
In the investing world, actuaries also will make actuarial assumptions about pension plans. Using time value of money, calculations and certain values for investment returns and payout requirements, an actuary will make an assumption is made, so the company underwriting can have an estimate of funding requirements.