Class Test 4 & 5 2024: Ch 16,17, 32, 33, 34,35,36, 37, 38,39

Question 1

A relatively new life insurer in the local market sells conventional term and whole life assurance policies through a combination of call centres and independent brokers. Outline why it is important for the insurer to monitor aspects of new business sales

Answer 1

• To provide management with information, such as trends in sales/mix, to assist in strategic decision making. (Please note that if your answer has the word “trend” in it, it does not necessarily cover the same point as above.)
• To enable the insurer to compare actual sales volume to that expected. This is particularly important for a new company, as estimates of sales/mix etc. will be an important component of the pricing assumptions and the company will not have much experience in this regard. (Or: need to monitor demographic elements such as location (concentration risk), target market, age distribution etc.)
• Feedback into the actuarial control cycle will be of particular relevance to this relatively inexperienced company.
• Information on sales will be needed for the reserving process This is important to monitor since supervisory reserves will depend on the nature/type of business sold
• If volumes are lower it may invalidate assumptions relating to per policy expense loadings.
• If the volume of new business is much higher than anticipated this may introduce a risk of not having enough capital/financial resources to finance the new business strain.
• This is of particular importance to a relatively new company which may not have large resources.
• Operationally there is also a risk that the level of service being offered to clients and intermediaries may deteriorate as a result of high volumes of sales
• Functions such as underwriting may also suffer if sales volumes are too high.
• This can lead to future mortality experience being worse than expected
• This is exacerbated as the company sells mainly protection policies
• It will be important to compare new business volumes with those of competitors to ascertain growth in market share
• It can help assess the effectiveness of marketing campaigns
• It may be used to assist with executive remuneration based on sales volumes
• To ascertain commissions and the effectiveness of the distribution channels
• Need to monitor the average size of different types of policy to determine the extent of cross-subsidisation between policies
• The average size of policies may give an indication of the need for reinsurance
• Analyse by source of business:
• To compare the effectiveness of the call centre compared to the broker distribution channels.
• To determine the effectiveness of specific sales agents by monitoring volume and quality of business
  -Experience for the call centre is likely to be different to that of the brokers
• This is likely to be particularly so with mortality and persistency
• Monitoring of the take-up rate of quotations can be a useful indicator of the effectiveness of sales staff
• It could give an indication of whether the appropriate target markets are being reached. (Or: check if the product meets the needs of clients)
• It may be a regulatory requirement to monitor new business sales
• Need to monitor new business termination rates (link to expected volumes and expense assumptions, whether policies are sold to clients who do not need it etc.)

Question 2

a) Suggest the likely reasons why the free capital is higher under the economic capital basis.

Answer 2

• The regulator will probably require a company to hold more capital than the company would consider necessary. It will probably ensure that the capital assumptions are stronger than the insurance company would otherwise assume and therefore the liabilities and capital will be higher under solvency basis than the economic basis. Therefore the surplus (assets less liabilities less capital requirements) will be higher under the economic basis
• The regulator will make assumptions relating to the average risk about companies when considering suitable requirements for solvency capital. As an example in this case the mortality assumptions may not be appropriate to the experience and expertise of the company.
• The regulator will be likely to have a different (lower) allowance for the benefits of diversification between the annuity business and the whole life assurance business (i.e. mortality offsetting)
• In this case, the assets are the same but this will not always be the case if there are differences in regulation on certain asset classes, i.e. inadmissible assets
• The regulatory basis may have larger margins in the valuation of the liabilities than the economic basis
• • The insurer may have a higher risk appetite compared to the average insurer

Question 3

Using an internal model: Advantages

Answer 3

The internal model will reflect the company’s specific risk or business characteristics rather than the standard model which may have inappropriate assumptions embedded into the calculations based on an average company

• The internal model may allow for risks that are not covered in the standard model
• In this case the assumptions regarding mortality could be penal under the standard model and the company may have more appropriate experience which can help assess both the assumptions and the relative stresses for its capital model
• If the director’s hypothesis is correct then there will be a significant reduction in capital which could be used to fund new business or pay additional dividends, etc.
• The standard model may have approximations, which make comparing against competitors not that useful and may impact share prices/valuation of the company
• The internal model could be used for other purposes e.g. reinsurance structuring
• It will assist the company to understand its own risks better

Question 4

Using an internal model: Disadvantages

Answer 4

• The calculation under the standard model will be less complex and time consuming to calculate compared to building an internal model
• The company will need to explain in detail to the regulator why their model is valid and it is expected that the regulator will compare the results on the internal model to the standard regulatory model (i.e. it may have to prepare the standard calculation anyway)
• All of this could be very costly to the insurance company, especially if it chooses to use stochastic models to predict the stresses for the longevity and asset assumptions
• There will be significant expertise and resources needed to develop and maintain the model, which will be costly over both the short and long term
• After all the work, the regulator may not agree with the R0.1bn reduction in capital and once costs have been taken into account the benefit may be a lot lower
• Using a standard model will help give the public confidence in the results (Or: may need to explain the complex model to stakeholders) and analysts/investors may find it easier to compare to other companies that are using the standard formula

Question 5

A large life insurance company recently launched a new unit trust. The fund will invest in startup companies (also often referred to as “private equity” or “venture capital” funds). The minimum investment term is 8 years, with penalties applying on early redemption.

Comment on the suitability of this unit trust as an investment for individuals.

Answer 5

Generally only suitable for wealthy individuals…
…due to the risk involved and term of investment.

High risk of default of individual start-ups.

Provides diversification from other asset classes.

Particularly in early years, the fund is unlikely to provide income, therefore need to consider cash flow needs.

Tax efficient as most of the return will be in the form of capital gains as opposed to income.

Longer term returns expected to be above inflation and returns of most other asset classes.

There are a number of start-ups in the fund, providing diversification and reducing risk.

Performance linked to economic cycle and growth. Market values can be very volatile.

Infrequently valued.

Prices often subjective, especially in early years.

Requires expertise.

Difficult to value start-ups in early years as losses are likely.

True market values not known until companies are sold.

Question 6

In addition to a company’s financial statements, additional reports accompanying the accounts are often published. List topics that these reports typically include?

Answer 6

• Performance of the company against key objectives
• Investment strategy and investment performance
• Progress against long-term and short-term strategic objectives
• Company’s attitude to risk
• The key risks it faces
• How it manages and mitigates those risks
• The company’s governance arrangements
• How the Board assures itself of independence

Question 7

An insurance company has breached the required solvency capital requirements and is at risk of becoming insolvent. Discuss the regulatory intervention, and the consequences thereof, that the insurance company can expect after it breached the regulatory solvency requirements.

Answer 7

• If the required level of solvency capital is breached, the regulator intervenes to protect the interests of existing or prospective policyholders
• As a first step, the regulator will apply increased scrutiny
• This will typically entail regular monitoring such as requiring monthly reporting from the insurer which will place strain on the insurer’s resources as much more additional reporting is required
• In most cases, the company will be required to establish a recovery plan, and this will be monitored closely by the regulator
• The recovery plan may include some/all of the following: − Changing the investment strategy to invest in assets that better match liabilities
  − Increasing the amount of reinsurance it has in place
  − Limiting the levels of new business sold
• If the insurer’s financial position is serious, then the regulator may require it to close to new business, so that new policyholders are not entering into a legal agreement where the product/benefit provider’s solvency may be in doubt.
• Closure to new business is normally a last resort, because it is unlikely that the insurance company will be able to re-open.
• The exception would be if there are large front-end expense charges in the business recently written, when capital can be rebuilt quickly as the new business strain is released.
• In normal circumstances, a regulator is unlikely to permit re-opening to new business until the company has substantially more than the minimum capital requirements built up.
• If a company maintains the infrastructure (staff, premises, systems) to enable it to reopen, these costs will be a further drain on capital while no business is being written.
• If a provider closes to new business, it will still have outstanding liabilities from the business written that will need to be met.
  However, in these circumstances it should be possible to make significant cost savings.
  These, coupled with the release of capital previously tied up in financing the new business strain of the business on the books, should enable the company to meet these liabilities in the short term.
• In the longer term, diseconomies of scale will bite and further actions will be needed.
• Due to reputational risk more existing policyholders may lapse which will exacerbate the problem
• The regulator may place the company in curatorship where the management is taken over by the curator in order to save the business / run it down in an orderly way
• The insurer may be sold to, or merged with, another provider who takes on the liabilities

Question 8

One of the largest insurance companies located in a particular country has received an offer to be purchased by an overseas private equity firm. Identify the different stakeholders involved in the proposed purchase, commenting for each how they might prefer the company’s provisions to be calculated.

Answer 8

Stakeholders and how they may prefer the provisions to be calculated:

• Private equity investor (i.e. the potential buyer)
  o Assumptions that are more likely to overstate/understate the liabilities/assets may lead to wrong decisions being made
  o Prefers values that represent an actuary’s best estimate of future experience
  o But also have an interest in the price being as low as possible
  o Higher liabilities will lead to a lower price being paid (NAV is less) therefore would be on the more prudent side of best estimate
• Management / Board of Directors of the insurer
  o Will want the full picture to decide whether or not to proceed with the sale
  o Therefore they will want to see a range of figures on different assumptions
  o A stochastic approach / scenario tests could add value in this situation
• Regulators (two will be involved)
  o May wish to see a realistic picture of the provider’s finances or figures that intentionally understate the financial strength (or prudent basis)
  o To ensure current policyholders continue to be protected
  o May also consider provisions on a discontinuance basis
• Current shareholders of the insurer
  o They will want to make their own assessment of the sale so will request to see an actuary’s best estimate value
  o But also want price as high as possible
  o Lower liabilities will lead to a higher price being paid (NAV is higher) therefore would be on the more optimistic side of best estimate
• Policyholders of the insurer
  o Will want to ensure security of benefits is not worsened post-transaction if provisions are undervalued o
  i.e. may prefer a prudent basis