CP1 Additional

Question 1

Quantity theory of money

Answer 1

The quantity theory of money tells us that there is a direct relationship between the money supply and the level of prices

M x V = P x Y

where

M is the nominal money supply

V is the velocity of circulation

P is the price

Y is the number of transactions

Question 2

Methods used to value investments

Answer 2

• Market value
• Smoothed market value
• Fair value
• Discounted cashflow
• Stocahstic models
• Arbitrage value
• Historic book value
• Written up and written down book value

Question 3

Approaches for places a value on equity

Answer 3

• Market value
• Dividend discount model
  
  • mainly for unlisted shares
• Net asset value per share
  
  • For companies with significant tangible assets
• Value added measures
  
  • Economic value added (EVA) looks and one year’s results and deducts the cost of servicing the capital that supports those results
• Measurable key factors

Question 4

Investment objectives - principles

Answer 4

• Investement objectives should be clearly stated and quantified where possible
• Since it is generally often necessary and appropriate to invest in risky assets the objectives must be framed in such a way as to encompass the permitted degree of risk as well as the required total return and cashflow timing

Question 5

Multiple investment objectives for funds

Answer 5

• Being able to meet its liabilities as they fall due
• Proving that it will be able to continue to do so on an ongoing basis
  
  • on a realistic basis
  • on a statutory basis
• Proving that it could do so on a discontinuance basis

Question 6

Example of an explicit objective for an investment strategy using a model

Answer 6

• Maximise expected solvency level
• at the end of a three-year period
• subject to the probability of insolvency at any time over that period being < 0.1%

Modelling can be either deterministic or stochastic

Question 7

Operational issues related to models

Answer 7

• The model being used should be adequately documented
• The workings of the model should be easy to appreciate and communicate. The results should be displayed clearly
• The model should exhibit sensible joint behaviour of model variables
• the output of the model should be capable of independent verification for reasonableness and should be communicable to those to whom advice will be given
• T_he model must not be overly complex_ so that either the results become difficult to interpret and communicate or the model becomes too long or expensive to run. It is important to avoid the impression that everything can be modelled
• The model should be capable of development and refinement - nothing complex can be successfully designed and built in a single attempt
• A range of methods of implementation should be available to facilitate testing, parameterisation and focus on results
• The more frequently the cashflows are calculated the more reliable the output from the model, altheough there is a danger of spurious accuracy. The less frequently the cash flows are calcualted the faster themodel can be run and results obtained.

Question 8

Personal data must

Answer 8

• be processed fairly and lawfully
• be obtained and processed for specified purposes
• be adequate, relevant and not excessive for the purpose concerned
• be accurate and, where necessary, kept up to date
• not be kept longer than necessary for the purposes concerned
• be processed in accordance with the individual’s rights under the Act
• be processed securely
• not be transferred to a country or territory outside the European Economic Area unless that country or territory ensures an adequate level of protection

Question 9

Consequences of non-compliance with the relevant data protection laws

Answer 9

• Individuals who commit criminal offences may be prosecuted
• Organisations can be fined for serious breaches
• Breaching data protection rules could lead to adverse publicity which can lead to significant reputational damage for an organisation

For anonymous data the obligations on an organistion are considerably less. In the UK, anonymous data does not constitute personal data and the duties and obligations of the Data Protection Act do not apply.

Question 10

Big data can be characterised as

Answer 10

• Very large data sets
• Data brought together from different sources
• Data which can be analysed very quickly - such as in real time

Question 11

Explain “big data analytics”

Answer 11

“Big data analytics” is the process of analysing the large data sets to uncover patterns, trends, correlations and other details that can be used to inform decision-making within the organisation

Question 12

Issues with big data

Answer 12

• Organisations have to be careful to avoid big data being seen to be excessive or not relevant, and must be transparent when collecting big data
• Anonymisation can be used to avoid the data being classified as personal

Question 13

Data governance policy

Answer 13

A data governance policy is a documented set of guidelines for ensuring the proper management of an organisation’s data.

Should provide the organisation’s stakeholders with confidence that the organisation is dealing appropriately with the data it holds.

Sets out guidelines with regards to

• Specific roles and responsibilities of individuals in the organisation with regards to data
• How an organisation will capture, analyse and process data
• issues with respect to data security and privacy
• the controls that will be put in place to ensure that the required data standards are applied
• How the adequacy of the controls will be monitored on an ongoing basis with respect to data usability, accessibility, integrity and security

Question 14

Data governance risks

Answer 14

Organisations that do not have adequate data governance procedures can be exposed to risks relating to

• legal and regulatory non-compliance
• inability to rely on data for decision making
• reputational issues
• incurring additional costs (e.g. fines and legal costs)

Question 15

Advantages of algorithmic trading

Answer 15

• increased speed and efficiency of trading
• can result in lower dealing costs on trades
• can potentially facilitate the execution of complex trading strategies that would not have previously been possible

Question 16

Risks associated with algorithmic trading

Answer 16

• Error in the algorithm or data used to parameterise the model could be wrong (leading to losses rather than expected profits)
• The algorithm may not operate properly in adverse conditions
• In very turbulent conditions, trading in individual stocks, or even entire markets, may be suspended before an algorithmic trade can be completed.
• Main risk of algorithmic trading is the possible impact on the financial system

Question 17

Benefits of using one single, integrated system for all data

Answer 17

• reduced chance of existing data being corrupted
• reduced chance of inconsistent treatment of information, between products or over time
• there is likely to be a better level of control over those who may enter information or amend information
• information will be easier to access, as it will not involve collating information from several systems
• Time will not need to be spent reconciling data from different systems

Question 18

Problems with industry-wide data

Answer 18

• Data will usually be less detailed than internal data
• external data are often more out-of-date than internal data
• the data quality will depend on the quality of the data systems of all of its contributers
• Not all organisations contribute, and the organisations that do contribute are not representative of the market as a whole

Question 19

Reasons for heterogeneity in industry data

Answer 19

• Companies operate in different geographical of socio-economic sections of the market
• the policies sold by different companies are not identical
• sales methods are not identical
• the companies will have different practices, e.g. underwriting or claim settlement standards
• the nature of the data stored by different companies will not always be the same
• the coding used for the risk factors may vary from organisation to organisation

Question 20

Factors affecting heterogeneity of mortality/morbidity

Answer 20

• occupation
• nutrition
• housing
• climate/geography
• education
• genetics

These risk factors become less significant in old age, leading to a mortality convergence

Question 21

Five main forms of selection

Answer 21

• Temporal initial selection
  
  • lelvel of risk diminished or increases since the occurrence of a selection process
• Class selection
• Time selection
  
  • population of individuals from different calendar years
• Adverse selection
• Spurious selection

Question 22

Cost vs. price

Answer 22

• cost of benefits is the amount that should theoretically be charged for them
  
  • premiums = benefits + expenses + contribution to profit
  • • tax
  • • commission
  • • contingency margins
  • • options and guarantees
  • • cost of capital
  • • investment income
  • • reinsurance cost
• the price of the benefits is the amount that can be charged under a particular set of market conditions and may be more or less than the cost. Factors influecing the price:
  
  • distribution channels used
  • level of competition in the market
  • approach taken to expense and profit loading (e.g. marginal costing)

Question 23

Through an effective risk management process, a provider of financial benefits will be able to

Answer 23

• avoid surprises
• improve the stability and quality of their business
• improve their growth and returns by exploiting risk opportunities
• improve their growth and returns through better management and allocation of capital
• identify opportunities arising from natural synergies
• identify opportunities arising from risk arbitrage
• give stakeholders in their business confidence that the business is well managed

Question 24

Ideally, the risk management process should

Answer 24

• Incorporate all risks, both financial and non-financial
• Evaluate all relevant strategies for managing risk, both financial and non-financial
• consider all relevant constraints, including political, social, regulatory and competitive
• exploit hedges and portfolio effects among the risks
• exploit the financial and operational efficiencies within the strategies

Question 25

Reverse stress test

Answer 25

Construction of a severe stress scenario that just allows the firm to be able to continue to operate its business plan

Question 26

Aggregation of fully independent risks

Answer 26

Question 27

Aggregation with correlation matrix

Answer 27

Question 28

Explanation of copula

Answer 28

• A copula is a function which takes as inputs marginal cumulative distribution functions, and outputs a joint cumulative distribution function
• Provides a way of calculating joint probabilities
• Different copulas are used to describe different degrees of dependence between random variables
• Copulas are used widely in quantitative finance to model tail risk

Question 29

Example of a risk register

Answer 29

Question 30

Two definitions of fair value

Answer 30

1. The amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm’s length transaction
2. the amount that the enterprise would have to pay a third party to take over the liability

Question 31

Methods to calculate provisions for general insurers

Answer 31

• Statistical analysis
  
  • If population is large enough
• Case-by-case estimates
  
  • if the insured risks are rare events and have large variability in outcome
• Proportionate approach
  
  • for risk events that have not yet occurred, e.g. 75% of the premiums
• Equalisation reserves
  
  • Set up reserves in good year to smooth results (not really provisions)

Question 32

Options for provisions of outstanding benefit payments in case a scheme is being discontinued

Answer 32

• Continuation of the scheme without any further accrual of benefits
• transfer of the liabilities to another scheme with the same sponsor
• transfer of the funds to an insurance company
• transfer of the liabilities to a central discontinuance fund, operated on a national or perhaps industry-wide basis

Question 33

Startup capital requirements

Answer 33

• Setting up suitable management systems to administer the liabilities
• Collecting premiums / contributions
• Paying commissions to third parties
• Investment expenses
• Administration expenses
• Additional capital requirements for statutory requirements

Question 34

Types of financial reinsurance

Answer 34

• Contingent loan
• Deficit account (cash financing)
• Virtual capital (non-cash financing)
• Oringinal terms (“OT”) reinsurance (or coinsurance)

Question 35

Reasons to analyse surplus

Answer 35

• Assisting the management in decision making
  
  • financial effect of divergences
  • determine financially significant assumptions
  • show financial effect of writing new business
  • distribution of surplus
  • management information
  • information on trends
• Providing information for other purposes
  
  • executive remuneration schemes
  • Publication in accounts
• Data and calculation checks
  
  • validation of calculations / assumptions
  • independent data check, reconciliation over periods
  • completeness of description (demonstrate that the variance in the financial effects of the individual sources is a complete description of the variance in the total financial effect)