What is Sensitivity Analysis?
Sensitivity analysis refers to the impact of the changes in the input variables on the target variable of a given model. In technical terms, we say that it depicts how changes in different independent variables have an effect on the dependent variable given a set of assumptions. This helps the company to understand the risks and potential return on the investments made by the organisation, hence affecting its financial health.
In the context of actuarial valuation, sensitivity analysis refers to the impact of changes in one or more actuarial assumptions on the future liabilities of the company, and hence on its finances. These actuarial assumptions include discount rates, salary growth rate, mortality rate, attrition rate, etc.
The key purpose of performing sensitivity analysis is to identify the assumptions that primarily affect the future liabilities of the company so that appropriate provisions can be made for it beforehand and the company does not suffer in the long term.
Importance of Sensitivity Analysis
- Risk Management: With the help of sensitivity analysis, companies have a better idea about how the changes with respect to the actuarial assumptions made earlier affect its financial liabilities, thus knowing the key risk areas. This helps the company to know better about mitigating these risks and better managing them, helping the company to take active steps before the damage would have been done.
- Making Informed Decisions: If the company knows beforehand the implications of changes in assumption rates, there would be better communication between the company and its stakeholders including investors, shareholders and the management, who can further make better and informed decisions. Thus, sensitivity analysis not only helps the company but also its associates by making informed strategies and hence better financial planning.
- Better Communication: As mentioned earlier, sensitivity analysis not only helps the company with better and informed decision making, but it also aids the company in communicating in a clear and transparent way with its stakeholders, thus making the whole process crystal clear. Hence, with better explanation of the influence of varying assumptions to the stakeholders, the company boosts its communication with them which is beneficial for them in the long run.
- Compliance with the Regulations: This is an important instance why sensitivity analysis is necessary with regard to actuarial valuation. Many accounting standards are set by the government which necessitates firms for sensitivity analysis in context of actuarial valuation. These regulations need to be followed irrespective of the type of company you are dealing with. Thus, sensitivity analysis ensures transparency and hence accountability, as well as enables the company with regulatory compliance as well.
- Resource Allocation: As the sensitivity analysis ensures that the company gets aware about the impact of changes in the input variables on the output, it gives the company a clear idea about the resources that would be required, thus enabling better resource allocation. Sensitivity analysis ensures that the funds used by the company are best utilized within the tasks performed by them.
How is Sensitivity Analysis Conducted?
- Our first step is to identify the dependent and independent variable. For example, attrition rate, interest rate, death rate can be sensitivities on which sensitivity analysis can be performed. In the context of actuarial valuation, we have our independent variables as the actuarial assumptions estimated and we need to assess its impact on the future obligations of the company.
- Our next step is building the model by stating the relationship between the assumptions and how it can be used to calculate future liabilities.
- Nextly, we need to be aware about which actuarial assumptions impact the most on the actuarial valuation and what is the range of values within which their impact is insignificant.
- This step involves altering the input variables and looking at its impact on the output variable, thus making different models. This can be done with the help of software like excel, python, etc.
- After modelling with the help of variables, we need to analyse the result and determine which assumptions have the maximum impact on the liabilities of the company.
- Our last step involves developing strategies based on our findings to mitigate the risks involved and hence make plans according to the different scenarios.
Conclusion
In conclusion, sensitivity analysis acts as a major tool to identify the actuarial assumptions that majorly impact the actuarial valuation and hence the future obligations of the company. It gives the company a clear idea about how changes in input variables, i.e. actuarial valuation assumptions affect the valuation process and hence the liabilities of the company. Hence, sensitivity analysis allows the company to identify the key risk areas, helping the company to mitigate them and make strategic plans beforehand.