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Life Insurance principles > Chapter 13-15 > Flashcards

Chapter 13-15 Flashcards

1
Q

What is model risk?

A

Risk that the model is not a sufficiently accurate representation of reality to give reliable results.

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2
Q

What is parameter risk?

A

Risk that the parameters used within the model may not adequately reflect the future experience.

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3
Q

What does random fluctuation risk refer to?

A

Risk that the actual future experience may not correspond to the model and parameters adopted due to unpredictable fluctuations.

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4
Q

What is meant by the ‘expanding funnel of doubt’?

A

The variance of a parameter increases the further into the future you are trying to predict it.

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5
Q

Is each assumption in models a source of risk for an IC?

A

YES.

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6
Q

Which products are most exposed to assumptions as sources of risk?

A

Without-profits products, e.g. mortality

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7
Q

List some sources of risk to a LIC.

A

ACADEMICALVIEW.COM
* Aggregation & concentration of risk and credit failure
* Competition
* Actions of the board of directors or staff
* Data (policy & other)
* Expenses and the effect of inflation
* Mortality/morbidity/disability rates
* Investment performance
* Counterparties
* Actions of distributors
* Legal, regulatory and fiscal (tax) developments
* Volume of new business
* Inadequate management & control systems
* Embezzlement (fraud)
* Withdrawals (persistency)
* Climate change
* Options and guarantees
* Mix of new business by nature, size & source.

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8
Q

What is the importance of assessing individual risks in aggregate?

A

The potential financial impact on the insurer will depend on how individual risks emerge in the future and how they relate to each other.

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9
Q

What method is best for assessing the combined effect of individual risks?

A

Carrying out financial projections using stochastic methods, incorporating probability distributions of key risks.

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10
Q

Risk of loss has to be measured in terms of the effect it may have on the aims of the company. What are these aims?

A
  • Maximise profits
  • Maximise return on capital
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11
Q

What does the board want to be sure of with regards to the capital of the company?

A

The board wants to be sure that the capital in the company is being used to the best advantage - particularly where it needs to decide between a number of competing uses of that capital.

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12
Q

Overall insurer risk can be measured against the aims of maximising profits and return on capital, but it should also allow for …

A
  • Capital and other resources available to the insurer
  • Impact on supervisory solvency - cost of failing to meet public interest need
  • Cost of failing to meet requirements of any other applicable legislation
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13
Q

How can the company’s desired trade-off between risk and return be expressed?

A
  • Finding the appropriate risk-return combination
  • Maximising expected return subject to an acceptable degree of risk
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14
Q

What is credit rating?

A

An insurer’s credit rating is an external assessment of aggregation of risks and an indication of the likelihood of default.

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15
Q

How would an IC wish to arrange its business practices?

A

An IC will wish to arrange business practices and the overall risk profile such that it minimises the possibility of their credit rating being downgraded.

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16
Q

What are some consequences of a downgraded credit rating?

A
  • Adverse publicity - causing marketing difficulties
  • Greater difficulty & cost in raising additional capital - constraining the range of profitable activities the company may take part in.
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17
Q

How can the need to compete in a free market affect a LIC’s risk profile?

A

It may lead management to make decisions that increase its risk profile beyond available resources.

Some decisions might include (COIN):
* Charges and premium rates under NB contracts are reduced
* Offer additional options and guarantees under NB contracts
* Increase bonuses under existing contracts & salaries and commission in respective distribution channels
* Not increasing charges on EB with reviewable premiums

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18
Q

What is the role of directors in a life insurance company?

A
  • Make decisions affecting the running of the company
  • Impose proper systems of management and control
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19
Q

What role does an actuary have wrt to board of directors?

A

To make recommendations to how the LIC should operate so that its risk profile stays within the resources available to it.

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20
Q

Why do management risks arise?

A
  • The directors made a conscious decision to ignore sound risk management advice in pursuit of other competing aims
  • The control systems in place are inadequate or are not properly followed

This might arise:
* For competitive reasons
* Due to strategic company goals such as maximising NB volumes or amount of funds under management to maximise shareholder earnings

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21
Q

What is the main actuarial reason for needing policy data?

A

So that regular valuation of liabilities can be carried out, usually for insurance supervisory purposes

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22
Q

What risks exist as a result of the actuary not having direct control over policy data?

A
  • Risk that the company will not maintain adequate, accurate and complete records - result of valuation not accurate
  • Inaccurate data - could lead to actuary giving incorrect advice
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23
Q

What are the risks associated with the use of model points?

A
  • Risk that model points do not adequately represent underlying policy data
  • Model risk - risk that the model is an oversimplification of real company and behaves unrealistically
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24
Q

What other data is required by an actuary to determine assumptions?

A
  • Mortality
  • Morbidity/disability
  • Expenses
  • Withdrawals
  • Conversion (quotes to policies)
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25
Why might internal data be inadequate?
* There might be missing data * Data may be inaccurate * There may not be enough data for credibility * Data may not be granular enough * The data may not be an accurate reflection of group of lives on which the investigation is based
26
Even where data are adequate ...
data may be proven to be inappropriate because of differences between population on which it was based and the population for which it will be used.
27
What are the data limitations for health and care products?
SHOTS * Smaller policy volumes and lower incidence rates limit the credibility of available data * Heterogeneity of products and markets limit the relevance of current industry data * Over time, changes to products and markets limit the relevance of past insurer data * Touchiness (Sensitivity) to socio-economic conditions, medical advances and longevity and health at older ages limit the relevance of past data for estimating future experience
28
What do actuaries have to make when carrying out an investigation?
Assumptions will need to be made as to future expenses incurred by the company.
29
When making assumptions about the future expenses, what should be allowed for?
Expense assumptions need to allow, implicitly or explicitly, either on a deterministic or stochastic basis, for inflation.
30
What risks are the result of having to allow for inflation in the expenses assumption?
Parameter risk and if stochastic methods are used, model risk.
31
If investment returns are modelled stochastically, ...
it is useful to model inflation stochastically.
32
Charges are allowed for in the premiums ...
implicitly or explicitly.
33
Describe the charging structure of non-unit and unit-linked contracts.
Non-linked: charges are implicit, they are invisible to the PH as they are included in the premium. Unit-linked: charges are explicit as they are deducted from the premiums before allocated to the fund or directly from the fund.
34
It is not possible to design charges that ...
exactly correspond to expenses of administering a product and change in line with changes in expenses.
35
What is the main risk that exist w.r.t. charges vs expenses?
There is a risk that charges accruing to the company in a year will not match the actual expenses of the company in that year.
36
What are the two main aspects that influence a LIC's ability to cover their expenses?
* For policies of long duration, higher than expected inflation may mean that original expense loadings are inadequate. * NB volumes influence the company's ability to cover fixed expenses.
37
What are the reasons for charges received being less than expected or allowed for?
* Persistency risk - charges required to recoup initial expenses are not received due to high withdrawal rates. * Investment performance risk - charges are fund-based, and the shortfall is due to low fund values because of poor investment returns. * NB mix or volume risk - to the extent that charges are linked to the average size/volume of NB, and these are smaller/lower than expected
38
What is expense risk?
Risk that actual expenses exceed expected due to inflation or other factors
39
What are the three types of risks associated with mortality assumptions?
* Model risk * Parameter risk * Random fluctuations risk
40
What is morbidity risk?
Risks associated with assumptions about future morbidity.
41
What is counterparty risk?
The risk that an entity in an agreement with an insurer will default or perform unsatisfactorily.
42
What actions may distributors take that could pose risks to insurers?
Distributors may: * Encourage lapse and re-enter where there are no exit penalties or no clawbacks of commission * Take advantage of loopholes in product design * Take advantage of opportunities arising from timing effects in unit pricing practices ## Footnote Insurers need to design products and processes to minimize these risks and engage with distributors to discourage bad practices.
43
What are the potential impacts of legal, regulatory, and fiscal developments on insurers?
Future changes can adversely affect the insurer and/or policyholders (PHs). ## Footnote Insurers must remain aware of changes in state attitudes towards long-term care (LTC) insurance.
44
What flexibility do insurers need in long-term care insurance (LTCI) contract design?
Insurers need flexibility in contract design and provision of benefits to manage changes in state attitudes to LTC. This flexibility helps avoid unpriced losses.
45
What is the capital available for writing NB?
Excess of assets over supervisory liabilities including any required solvency capital.
46
Parameters for future expenses will be based on a model of future NB. What will be the consequences of departure from this model?
Departures may invalidate parameters and may cause a mismatch between expense charges and actual expenses.
47
What difficulties can insurers experience in terms of NB?
* Too much business exceeding capital resources or administrative capacity * Too little business failing to cover overhead expenses and per-policy expenses increase ## Footnote Significant falls in volumes of NB can damage profitability, competitiveness and even LT viability of the insurer.
48
What are the risks associated with inadequate management and control systems?
Failure of controls may result in: * Financial losses for the insurer * Financial gains in some cases * Regulatory intervention * Reputational damage ## Footnote Risks arise from control failures and insufficient monitoring.
49
What is fraud?
General type of control failure, caused by deliberate intent of one or more parties.
50
Who are the main parties that might perpetrate fraud within an insurance company?
Main parties include: * Directors or staff * Policyholders (PHs) * Other outside parties (e.g., cyber risk) ## Footnote Fraud typically involves deliberate intent.
51
What risks are associated with withdrawal assumptions?
Risks: * Parameter risk * Model risk * Random fluctuations affecting withdrawal rates
52
What is the result of higher than expected withdrawals?
Fixed costs are spread over fewer policies = higher per-policy expenses than the company allowed for in pricing and this may feed through to PHs in the form of higher premiums.
53
What are the key aspects associated with withdrawal risk?
Key aspects include: * Financial risk of surrender value being higher than asset share at withdrawal - exacerbated by mismatched initial expenses and charges * Risk to mortality experience due to selective withdrawals * Increased per-policy fixed expenses from loss of business volume
54
What types of climate risks can financial companies face?
Climate risks are categorized as: * Physical risks - 1st order effects of environmental changes, e.g. mortality/morbidity insured population due to global warming * Transition risks - economic, political and market changes as a result of efforts to mitigate climate change * Liability risks - injured parties seeking compensation for impacts of climate change ## Footnote Each category represents different impacts of climate change on financial stability.
55
What is the purpose of options and guarantees in insurance contracts?
They offer terms in advance of the event to which terms relate.
56
Even if the guarantee on a contract is low ...
there is still some risk that IC will have to find some money to cover the shortfall in value of unit fund.
57
How can an IC value options and guarantees?
* Use a range of deterministic scenarios, ranging from pessimistic to optimistic, assign probabilities to outcomes and take an expectation - might be highly subjective i.t.o. scenarios chosen and the probabilities assigned * Stochastic model might be better, but the IC will still have to choose a suitable model and parameters. The model would be run using simulations, produce several thousand values for unit fund @ maturity and hence the cost of the guarantee/option is derived from the investment returns generated by the model.
58
The severity of the risks from options and guarantees depend on how ...
* likely the guarantee is to bite * likely the assumed take-up rate of the option
59
What can reduce the risk faced by an insurance company from options or guarantees?
Using a suitable derivative can greatly reduce risk exposure. ## Footnote This is crucial for managing financial uncertainties associated with guarantees.
60
How can a significant change in the mix of new business (NB) by nature and size impact an insurer?
It can lead to significant changes in: * Risk profile - expense risk * Capital needs ## Footnote This change may not align with available resources.
61
A change in the mix by nature of NB might involve, e.g. a change in mix by:
* Class of business * Type of contract * Contract design * Premium frequency
62
To what is the coverage of per-policy expenses particularly vulnerable?
To a reduction in the average size of policies issued. If the average policy size is smaller than expected, the income from charges and premium loadings reduce and is unlikely to be matched by a reduction in expenses.
63
Why is the demographic and expense experience likely to differ between distribution channels?
* Different sales methods * Variations in underwriting * Differences in population reach ## Footnote These factors can invalidate demographic and expense assumptions.
64
What should a LIC do if it wants to charge the same price for a product through different distribution channels, despite different expected experience?
Use a weighted average of experience, which depends on the mix by source - if the mix turned out differently, company may make or lose money.
65
When will LIC not be exposed to risk of changes in mix by source?
If they price differently for different distribution channels and achieve the same level of profitability in those channels.
66
Why will model & parameter risk always exist?
Actuaries cannot predict the future with complete certainty, but the extent of the risk will depend on the quality & relevance of any existing data.
67
How will random fluctuation risk likely arise?
If the numbers exposed to risk are not large enough for the law of large numbers to apply.
68
Why will there always be an "expanding funnel of doubt" no matter how good the experience are?
There will always be new diseases and sudden medical advancements.
69
The risk is that mortality ...
turns out to be more adverse than assumed in the models.
70
Why are model, parameter and random fluctuations risk likely to be more severe for morbidity and disability rates?
* Complexity of the products * Lack of reliable & applicable data * Smaller policy volumes
71
What is the main risk for IP & LTCI?
That claim inception rates and claim durations are higher than expected.
72
What is the main risk for CI?
That rates of diagnosis of CIs specified in the contract are higher than expected.
73
On what bases can assumptions be made for the rate of return on amounts to be invested in the future or existing assets of the company?
Deterministic or stochastic bases. It needs to allow for income & capital appreciation.
74
How can the deterministic and stochastic approaches be used for modelling investment returns?
Deterministic - random fluctuations can be explored by sensitivity testing. Stochastic - investment returns are modelled as outcomes of random variables with specified probability distributions. Advantage: enables us to model inherent volatility in some asset classes. Random fluctuations are modelled explicitly.
75
What are examples of error in a stochastic investment model?
* Probability density function inappropriate * Time-series relationships between outcomes at different times not specified appropriately
76
In general, the ______________ of a contract and the ________________________________ of the contract the _____________ is the investment return assumption(s).
* longer the term * greater the extent of the savings component * more significant the
77
Why is separate projection of income and capital gains common?
The tax treatment of the two may differ.
78
Why are investigations involving a comparison of assets and liabilities subject to capital values risk?
* These investigations tend to be a snapshot at one point in time. * There is a risk that the IC appears solvent on one day and could become insolvent the following day after a change in the asset values.
79
What are examples of counterparty risk?
CORD * Corporate bonds held as investments (credit risk, non-payment of coupons or capital by issuer) * Outstanding arrangements (poor quality service of a company, may lead to marketing risk) * Reinsurance agreements * Distribution arrangements (non-recovery of broker balances)
80
How does counterparty risk arise from outsourced functions?
Poor service from outsourced company could result in complaints from PHs and costs for IC to put things right.

Life Insurance principles (12 decks)

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