Chapter 18-19: Models

Question 1

The prime objective of a model:

Answer 1

Enable actuary advising a LI’er to give appropriate advice so that it can be run in a sound way.

Question 2

Requirements of a model:

Answer 2

• Valid, rigorous for purpose
* Adequately documented
o Rigorous
• Reflects risk profile of the products
• Parameters should allow for signif features of the business modelled
• Input pars should be appropriate to business modelled and take economic and business environments into consideration
• Workings should be easy to interpret and communicate.
* Result displayed clearly.
* Sensible joint behaviour of variables
• Outputs should be capable of independent verification for reasonableness
• Must not be overly complex to avoid interpretability and communicable criteria as well as being expensive to run – unless required.
• Should be capable of development and refinement
• Range of methods of implementation should be available

Question 3

When creating model points for new business, consider (5)

Answer 3

• Most recent NB production
• Trends
• Intended marketing changes
• Planned new prod launches
• Imminent/pertinent legislative/fiscal changes

Question 4

Factors affecting sales volumes and persistency of life, health and care prods: (4)

Answer 4

• Economic morale
• Gov provision of welfare
• Tax
• LTCI depends on political commitment

Question 5

Factors influencing # MPs included: (8)

Answer 5

• Availability of computers
• Variability of contracts
• Complexity of contracts
• Age of company
• Stoch or det model
• Importance of investigation
• Time avail
• Sensitivity of results to more/fewer MPs

Question 6

4 LI models

Answer 6

• Single policy profit test model
• New business model
• Existing business model
• Full model office

Question 7

Dynamic model

Answer 7

One in which asset and liabilities are modelled to interact as they do in reality

Question 8

2 Approaches to setting/calibration of parameters:

Answer 8

• Risk neutral/market consistent calibration

- Real world calibration

Question 9

Risk discount rate

Answer 9

RDR = risk free rate + risk premium

Allows for:

• return required by the company
• level of statistical risk associated with the CFs

Question 10

Profit criterion

Answer 10

Single figure that tries to summarise relative efficiency of of contracts with different profit signatures

Question 11

3 Main profit criteria

Answer 11

• Net present value
• Internal rate of return
• Discounted payback period

Question 12

Net present value

Answer 12

The PV of future profits discounted at the RDR.

Economic theory: Choose investment with highest NPV. Choice is optimal

Positive sign: Return exceeds RDR

Question 13

Internal rate of return

Answer 13

The rate of return which makes the PV of CFs = 0

Question 14

2 Important assumptions for NPV to work

Answer 14

• Assumes free and efficient market

- Assumes each investment discounted at RDR that reflects risk of that investment

Question 15

3 “Problems” with NPV

Answer 15

• Difficult to interpret on its own (use a ratio_
• Says nothing about competition
• Subject to law of diminishing returns

Question 16

3 “Problems” with IRR

Answer 16

• May not be unique - If profit signature has more than one sign
• Cannot be related to measures such as commission/premiums
• May not exist - If make profit from the outset

Question 17

Discounted payback period:

Answer 17

Policy duration at which profits which have emerged so far, have a PV of 0 @ RDR.

Time it takes to recover initial investment with interest.

Question 18

“Problem” with DPP

Answer 18

Does not account for profits after DPP.

Question 19

Looking at premiums/charges ito marketability, may lead to reconsideration of: (4)

Answer 19

• Design of prod
• Distribution channel
• Company’s profit criterion
• Whether to proceed marketing the prod

Question 20

Disadvantages of capital intensive prods: (4)

Answer 20

• Problems with supervisory solvency
• Weakens resilience to falls in assets
• Reduces financial strength (free assets)
• Opportunity costs – could use to write more business

Question 21

Embedded value:

Answer 21

Value of future profit stream from the company’s EXISTING business together with value of net assets separately attributable to SHs.

Question 22

2 Bases on which assets and liabilities may be valued

Answer 22

• Supervisory basis

- Economic basis (expected)

Question 23

Dynamic solvency testing:

Answer 23

Project company’s revenue acc and balance sheet forward for suff period so that full effect of potential risks become apparent.

Question 24

Life insurers estate

Answer 24

The difference between realistic value of assets less realistic value of liabilities

Question 25

3 Reasons to hold capital

Answer 25

• Withstand adverse unexpected conditions
• Write more business
• Follow less restrictive investment strategy
• Smooth surplus dists
• Reduce need for reins
• Smooth div payments to SHs
• Allow company to seize opps as they arise

Question 26

Scenario testing

Answer 26

Sensitivity testing where several pars changed in consistent way.

Question 27

Main reasons for holding free assets?

Answer 27

REG CUSHION

Regulatory requirement to demonstrate solvency

Enable less reinsurance to be purchased

Guarantees can be offered

Cashflow timing management

Unexpected events cushion - ensure policyholder obligations met even in the event of adverse experience

Smooth profits: Smoothing dividend payments to shareholders and surplus distribution to policyholders

Help demonstrate financial strength and thus provide confidence to policyholders, shareholders and brokers

Investment freedom to mismatch in pursuit of higher returns

Opportunities i.e. mergers and acquisitions

New business strain financing

(See F102 June 2015 Q8 for example)

Question 28

Models assist the actuary advising a LI company with?

Answer 28

OP PAD

Other work involving financial projections
Product pricing

Projecting the future supervisory solvency position
Assessing:
- return on capital
- profitability of existing business
- capital requirements
Developing an appropriate investment strategy